- January 1885 - December 1925 -------------> 7.3%
- January 1926 - June 2009 -------------------> 9.6%
- January 1885 - December 2008 -------------> 8.3%
I don't have access to small company equity returns but they are generally 2% higher than those of large company stocks over the long run. In US, one can find uptodate equity returns free of cost in the Stocks, Bonds, Bills & Inflation (SBBI) Yearbook published by Morningstar's Ibbotson unit at a reasonably big public library. Per my understanding the equity returns of developed international markets (usually referenced by the acronym EAFE -> Europe, Australasia and Far East) are comparable to US equity markets. There is not much data available on the internet for the Indian equity markets but over the last 30 years the returns have been around 20% (although it appears phenomenal at first glance, please account for factors like the relatively short time period, very high inflation and the commensurate currency devaluation, large P/E multiple expansion before you write off the other equity markets in the world).
To assess the attractiveness of equity returns in relative terms, one should compare the US equity returns above with the US government bond returns of 5.7% & US inflation of 3% during the 1926-2008 timeframe. Clearly the equity markets have beaten bonds & inflation by a wide margin. But before euphoria grabs you and you decide to put all your savings into equities do remember that equity markets have a tendency to choke for prolong periods of times as indicated in one of my previous posts.
To get a better perspective on future equity returns lets first analyze the components of equity returns. As per investment theory equity returns can be decomposed into following components:
Expected Equity Returns = Dividend Yield + Earnings Growth + P/E changes
Earnings Growth can be further decomposed into Inflation + Real Earnings Growth (i.e. excluding the effect of inflation from absolute earnings growth number). For a detailed treatment one can also refer to the Grinold & Kroner model. As per this model:
Expected Returns = Dividend Yield + Inflation + Real earnings growth - Change in number of shares outstanding + Change is P/E
In one of the previous posts, I took potshots at Mr. Ajit Dayal for suggesting a 20% annual return for the India stock markets but did not offer any return expectation to counter that. I think we now have the necessary building blocks to calculate the anticipated future returns of the Indian stock market. Using the broad index S&P CNX 500 as a proxy for indian stocks here are the values for the various components of the Grinold & Kroner model as of January 19, 2010:
Dividend Yield: The current dividend yield of CNX 500 is about 1%
Absolute Earnings Growth (Inflation + Real Earnings Growth): As per a recent RBI quarterly survey of professional forecasters, the maximum value of corporate earnings growth for a relatively decent year like 2009 was quoted as 15%. Lets assume this value will hold true for the next 10-15 years.
Change is shares outstanding: Lets assume a number of 3% per year considering the plethora of mega IPOs (by both government & private companies) & QIPs in the recent past. One can expect such trend to continue over next 10-15 years in view of the widespread optimism among the Indian investors & the insatiable desire of big corporate houses to acquire large global companies (LyondellBassel, Jaguar, Corus Steel, Novelis, etc.)
P/E Changes: The current P/E of the market is 21.47. Per this CNX 500 P/E graph a more realistic P/E after a decent earnings growth of 15% p.a. for 10-15 years would be 17. This would result in a P/E multiple contraction of 2.31%.
After putting all these values in the Grinold & Kroner equation, the expected return over the next 10-15 years for the Indian stock market turns out to be: 10.7% (1+15-3-2.3). I know this would come as a rude shock to all the optimists reading this article. Well the actual returns can turn out to be higher but expecting 20% as suggested by some experts is clearly a stretch as far as market fundamentals are concerned.
