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Great expectations
Are investor expectations too optimistic?

The bigger they are, the harder they fall, as the saying goes. During this past week, investors felt the power of that statement when the giant of Canadian capital markets, Nortel Networks, tripped over its "disappointing" financial results. I highlight the word "disappoint" because 42 per cent revenue growth and projected 30 per cent growth is not exactly what makes for an awful earnings report. However, analysts on both Bay and Wall streets were very disappointed in Nortel's results and pushed the stock price down 27 per cent in a matter of two days.

Reason for the drop

It sounds counterintuitive to be disappointed by seemingly high rates of growth, but what transpired this week is really the result of unrealistic expectations. Nortel's results for the most recent quarter were fine, but analysts expected the company to revise, upward, its projected growth over the next few years. When Nortel announced projected growth in operating profit of 30 to 35 per cent (rather than 40 per cent or above), selling pressure on the stock broke loose.

Nortel's share price was pushed up to its high of $124.50 this summer on the expectation that growth would continue at the speed of light. As soon as the expectation came down, so did the stock price - hard and fast. If investors think Nortel can hit that range of growth for the next few years, they may be looking at an annualized return of 10 per cent to 14 per cent, based on its October 26, 2000 closing price of $69.80. While that sounds great, it's really an optimistic estimate because it's based on the company exactly meeting its projections - no more no less.

While I can't tell you exactly what to expect from Nortel, I do have strong opinions on how realistic investors are regarding their view of the future. Simply put, most investors are overly optimistic in their expectations, and underestimate the level of risk needed to achieve their desired returns. Most investors have become accustomed to annualized returns of 9 to 10 per cent from their entire portfolios, but don't want to lose much more than 10 or 12 per cent. However, had you invested entirely in Canadian stocks, you would have achieved this return, but with much more risk.

Warren Buffett, in a 1999 Fortune Magazine article reminded readers of the critical factors that determine returns earned by shareholders, in aggregate, over a long period of time (i.e. 20 years or more): interest rates, economic growth, and current valuations. The impact of interest rates is based on the "time value of money" concept: a dollar ten years from now is worth less than that same dollar today. If rates are low, the impact on stock prices is low, but when rates are high, the impact weighs heavy.

History

If we look back into recent history, hindsight shows us that all three factors were hard at work in producing the 15.3 per cent annualized return posted by the TSE 300 for the ten years ending September 30, 2000. Interest rates (and inflation) fell substantially, economic growth was strong, and stock prices were more modest than today's levels. Of course, hindsight is always 20/20, so what does the future hold? Well, I'm not about to provide bold predictions, but I do have an idea of where the number may fall.

Looking Forward

Since interest rates are neither extremely low nor high, let's assume (as Buffett did) that interest rates remain stable. That leaves two key factors: economic growth and current prices. Economic growth is generally measured by "real" gross domestic product (GDP). GDP is a number representing the total value of all goods and services produced by our economy. So, real GDP represents the total growth of all businesses in our economy, net of inflation. Economic forecasts for Canada are in the 2.5 to 3 per cent range for real growth. If we assume inflation to be about the same amount, we're looking at total economic growth of 5.5 to 6 per cent - a bit above what we've actually experienced over the past thirteen years. The last, and less significant, part of stock returns is the dividend, but with dividend yields quite low, we can't count on more than 1 per cent from dividends. Add all of those items up and you've got the makings of 6 to 7 per cent annualized stock returns. Buffett, in his Fortune interview, came up with total growth of 6 per cent - 2 percent inflation, 3 per cent real economic growth, and 1 per cent in dividends.

While that sounds ridiculously low in comparison to the past ten years, there is an important difference in what happened then, and what is likely to occur in the future. Though it's tough to nail down exactly how much each component made up of that 15.3 per cent return figure, the one important difference is that interest rates are not likely to decline substantially, if at all. Taking out that part of the equation leaves a more modest expected return figure.

Okay, I haven't talked yet about current stock prices. Taking our economic growth assumption above and factoring in today's prices (i.e. P/E ratio - the average price paid for each dollar of after-tax profit) results in an expected return of 9 per cent annually. I'd call that the optimistic estimate. So the next ten years is likely to see stock prices, in aggregate, rise by 6 to 9 per cent annually. While some will obviously earn more than others, that's what I would call a reasonable estimate of the next ten years of equity investing in Canada.

Impact on portfolios

Tossing numbers around is fine but what does it mean to your portfolio? It means going back to the basics of portfolio design: prudent diversification by asset class, geography, and management style, while keeping an eye on fees. It means staying away from funds and stocks that just went up 1000 per cent and not making big bets on hot sectors.

Does this modest projection mean we should all just dump our stocks, in favour of the safety of bonds? Absolutely not. Over long periods of time, stocks do deliver the best return above inflation. Besides, my projection could be wrong. Depending on which side the actual figure falls, investors can do themselves a favour by having well-balanced portfolios.

Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com
 
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