Unlocking the Source of Long-term Equity Returns

A recent study by OSAM Research looked at the source of returns in US market over the past 35 years. It echoes work we have done on the Australian market over a shorter period of time (2006 – 2021). One result stands out to us – the compounding effect of small actions over time adding up to large differences in the returns realised by shareholders.

Return de-composition is the analysis of the investment return shareholders achieve, separated into the components of dividend yield, EPS growth and re-pricing by the market (P/E multiple re-rating and de-rating). This US study shows that almost 80% of returns over the past 35 years came from fundamental drivers (EPS and dividend yield) and 20% came from a P/E re-rating across the market resulting from structural declines in interest rates.

One small action which compounded over time and often goes un-noticed is the dilution shareholder experience through issuance of new shares in all forms. Mergers and acquisitions, executive compensation, recapitalisation in times of stress or reductions through share buybacks. In a market moving further and further up the Profit and Loss statement to assess financial performance the longer this bull market continues – from net income, up to EBIT, then EBITDA and now sales – it is easy to lose sight of the economic leakage draining returns from shareholders between what is promoted by management and what determines actual investor returns.

What stood out to us as quality and small cap investors from the US study was:

Small Cap Growth vs Equity Dilution: although US small caps grew operating earnings almost 2.5% per annum faster than large caps over 35 years, they gave three quarters of this back in the form of equity dilution from new shares. Overall EPS grew only slightly (0.5% per annum) faster than large caps as a result. That is a lot of leakage.

Large Cap Quality: Quality large caps not only grew aggregate earnings faster than the broader market but compounded this through a lack of equity dilution (indeed they were net re-purchasers of shares) to an almost 2% per annum EPS growth advantage over 35 years.

This study did not look at the performance composition of quality inside US small caps but we have undertaken similar analysis in the Australian market which we discuss below. Our conclusion is that investing in quality small caps provides investors the benefits of higher growth in small caps with much less dilution. Shareholders capture significantly higher long term EPS growth and total investment returns as a result.

All This Effort for 1% Per Annum Growth in Australian Equities?

Many investors are surprised to learn the realised EPS growth over the past 15 years for the S&P / ASX 300 Index has only been 1% per annum. Not even keeping pace with nominal GDP growth. There are two main reasons for this. Firstly, high dividend payout ratios demanded by Australian investors can require equity funding (DRPs) and secondly new share issuance over the period has been very high – and in some cases (Banks, REITs, Insurance) done at very unfavourable prices due to crisis capital raisings (GFC, COVID). Examples of per annum growth rates in shares outstanding from 2005 to 2021 across sectors include: NAB (4.5%), BOQ (11.9%) GMG (11.9%), ORG (4.7%), TAH (8.9%), WES (6.3%), TCL (9.9%), STO (6.5%), BSL (6.2%), BLD (3.3%), SHL (3.3%). BHP, RIO and CSL are rare examples of large cap Australian stocks that have reduced their shares outstanding over the period.

Small Caps are Even Worse

For Australian small caps (S&P / ASX Small Ordinaries Index), growth in EPS over the past 15 years has been negative 1% per annum. Investors underestimate just how much equity issuance is required to fund new projects to a positive cash flow position. To get Lynas Rare Earths (LYC) to its current position, shares outstanding grew at 22.3% per annum for 15 years. There are 28x more LYC shares outstanding today than in 2005. For Mesoblast it has been 12% per annum and they are not even cash flow positive yet. In the 11 years since 2010 NextDC has issued new shares at a rate of 17.3% per annum. We suspect this high rate of equity issuance will also be true for the current generation of speculative small resource and industrial projects over the coming years. Business cases may ultimately prove sound, but the equity dilution on existing shareholders will be large to achieve sustainable operating cash flows.

Quality small companies in Australia share similar features to small caps in the US (higher earnings growth) combined with the benefits of quality (less equity issuance dilution) to result in much higher EPS capture for investors. The benefits to returns are not trivial – on our estimation, quality small caps grew EPS by more than 8% per annum greater than the index over the past 15 years. That they delivered an extra 1% per annum in dividend yield along the way was an extra quality bonus.

Our clear expectation investing in quality small caps is higher realised EPS growth compounding over the long term. This should translate into higher excess returns, but as we will see below, the impacts of P/E multiples can overwhelm this in the short term.

Markets Building Castles in the Air

Our investment process is designed to find quality businesses that can deliver and compound fundamental value to shareholders over time. Over the past three years we have captured almost 20% per annum in fundamental returns (16% p.a EPS Growth and Dividend Yield of 3.5% p.a) but have given back almost 4% per annum in P/E de-rating. Our process of finding companies that grow cash flow at high rates is working but clearly not what the market is interested in (aka paying for) right now.

The ASX300 Index has been consistent with its historic trend of 1% per annum EPS growth over the past three years but has benefited from a P/E re-rating enough to give investors an extra 7% per annum return. The Small Ords Index has done one better, with no EPS growth in the past three years, but an 11% per annum return from P/E re-rating. Microcaps are in a league of their own with earnings all but disappearing across much of this market, yet a return more than 2x that of small caps and 3x that of large caps over the past three years.