How to harness compounding, the client's best friend

Einstein called compounding the “eighth wonder of the world,” Jim Rogers refers to it as “the magic of investing” and hedge fund legend Seth Klarman once noted that “the effects of compounding even moderate returns over many years are compelling, if not downright mind boggling”.

The cold hard mathematics of compounding underpins the case for income-driven strategies and the patient reinvestment of dividends or coupons to maximise both capital growth and income over the long term.

An analysis of compound returns can also help advisers and clients keep a top-down perspective on what stock markets are currently pricing in, by way of trend economic and corporate profits growth – and whether these expectations are realistic or not.

Anyone who believes in mean reversion – and that economic booms and busts serve to normalise returns over time – will pay particular interest when a stock index has generated higher-than-average returns over a long period (as this may suggest the benchmark may be overvalued and primed for a fall), or when it has served up lower-than-average returns (as this may suggest the index may be undervalued and poised to recover).

This column will always be loath to argue that “it is different this time” and so adheres to the mean-reversion view of the world. As such it is instructive to see how leading global equity indices have done over the last 10 years relative to their longer-term history.

Performance over the last 10 years suggests Emerging Markets have the strongest upside potential over the next 10, if they mean revert

Source: Thomson Reuters Datastream

Four immediate conclusions spring from the above table:

  • First, Latin America and the USA have done best on a compound annual return basis, at least going as far back as the data from Thomson Reuters Datastream permits this column to go. Asia and Japan have done the worst, as per the figures in the column entitled “Total.”
  • Second, long-term compound annual returns (and the data covers capital returns only) look to be a decent approximation of long-term nominal GDP growth (growth with inflation added in) across most of the regions. This makes sense as ultimately a company’s share price will follow long-term profit and cash flow progress and very few if any individual firms can outgrow GDP for too long (as the competition catches up, customers rebel and seek alternatives or the regulator gets involved).
  • Third, the returns of the last 10 years pale next to those generated over the total time periods involved. This also makes sense. Many indices were close to all-time highs ten years ago and the 2007-2009 bear market hit as the Great Financial Crisis ripped around the world, since which point trend economic growth has generally been sluggish at best.
  • Finally, if the indices do mean revert, there could be most upside in Latin America and Emerging Markets and the least in the USA and Western Europe (using Germany’s DAX as a proxy, as it has a longer history that the Stoxx indices). Latin America is beset by soft commodity prices, fears over what Trump-inspired protectionism could mean for the economies (particularly in Mexico’s case) and corruption-riddled politics (notably in Brazil) so perhaps the darkest hour will precede a new dawn. Equally, frantic central bank efforts to pump up economies have at least juiced up asset prices in the US and Europe (and to some degree the UK too), so there may be more factored into valuations here than elsewhere.

The world in pictures

To keep this column brief, the following section merely shows the long-term charts for each region, showing the index, 10-year compound annual return at any point in time and the long-run compound return (the flat line).

This illustrates the table above, pressing the claims of mean reversion fans everywhere that the time to look at a region is when returns have been poor and the time to take evasive action is when they are temptingly strong.

The FTSE All-Share’s modest compound returns mirror the patchy rate of economic growth in both the UK and globally since 2007, with a crunching recession thrown in right at the start and an anaemic upturn to follow:

FTSE All-Share ten-year compound returns history since 1972

Source: Thomson Reuters Datastream

America offers a similar picture:

S&P 500 ten-year compound returns history since 1974

Source: Thomson Reuters Datastream

Boosted by Abenomics Japan is making a bid to return to the glory days of the 1980s, but it still has a long way to go:

Nikkei 225 ten-year compound returns history since 1965

Source: Thomson Reuters Datastream

After a strong run, German returns are cooling a little:

DAX ten-year compound returns history since 1975

Source: Thomson Reuters Datastream

Emerging markets have been out of favour for most of this decade, even if signs of a recovery have started to emerge in the last 18 months, helped by a stabilisation in some key commodity prices and hopes for political, social and economic reform, owing to changes of President in Argentina and also Brazil.

MSCI Emerging Markets ten-year compound returns history since 1988

Source: Thomson Reuters Datastream

MSCI Asia Pacific ex-Japan ten-year compound returns history since 1988

Source: Thomson Reuters Datastream

MSCI Latin America ten-year compound returns history since 1988

Source: Thomson Reuters Datastream

Base effect

There is one wrinkle which must be considered relating to this analysis and that is the base effect.

It can be argued that the base for comparison of 10 years ago is an unduly tough one, since it features stock market highs just ahead of the worst financial crisis and bear market in several generations.

Figures which point to a tempting-looking period of sub-trend returns could therefore be deceptive.

To stress test the figures, the final table shows the impact on 10-year compound returns if the leading indices stay flat for the next two years (as by 2009 the worst was over and markets had largely bottomed).

Performance over the last 10 years suggest Emerging Markets have the strongest upside potential over the next 10, if they mean revert

Source: Thomson Reuters Datastream

Latin America intriguingly shows negative compound returns and Emerging Markets overall still look to offer the best upside, assuming that they are capable of mean reverting over time.

None of this is a guarantee for the future but the UK looks less attractive and Japan, Germany and especially the USA would provide above-trend returns for 2009-2019, even if their headline indices go nowhere for the next two years. An acceleration in economic growth and corporate earnings growth could help here, although there remains the risk that record low interest rates and Quantitative Easing (QE) have pulled forward demand and puffed up valuations to levels which may be hard to maintain if rates start to rise and stimulus is withdrawn, no matter how slowly.

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.