Last year’s equity market collapse made stocks look poor on a 10-year view against cash and bonds. But they remain the best way to get exposure to long-term economic growth. Lucy MacDonald makes the case for equities

Every so often, since the Lutheran struggles in 16th century Europe, the Christian church has used the declaration of a Status Confessionis when plunged into a fundamental crisis of faith. The declaration serves the purpose of creating space for the truth to become manifest, a kind of reflective pause.

Since its invention in 16th century England, the stock market has also faced periodic questioning of its efficacy in serving the long-term needs of the investing public. After the worst year in equity markets since 1931, this article is intended to serve as a reflective pause to consider the investment environment for equities in 2009 and beyond in the light of recent events.

The credit crisis has led to a huge spike in volatility and risk aversion, with the VIX rising to well over twice its previous high. The shock from the bankruptcy of Lehman Brothers, and the resultant freeze in credit markets has led to assets being liquidated, and cash hoarded throughout the economic system in a great, ongoing global deleveraging exercise. This is involving most financial institutions, particularly investment banks and hedge funds. Equities have suffered to some extent from their liquidity in this exercise, leading to increased supply and sharply negative returns. Unfavourable comparisons of performance can now be made with cash and bonds over the last 10 years.

The fact remains, though, that despite the disastrous year of 2008, equities have still provided better long-term real returns than cash or bonds at 5.8% since 1900, against 1.9% for bonds, and negative returns for cash. Dividends, a key feature of equities, account for an increasing proportion of returns over time. Equities are an enduring success story because the model works. As the numbers suggest, equities in the long term are a good store and grower of wealth, while providing the finance for all kinds of human economic endeavour and adventure, bringing benefits to active and passive participants.

Equities were and remain an efficient risk-diversifying financing model and history will tell whether more recent financial innovations endure this long. The joint stock company allowed investors to participate in the growth of industries, economies and companies in the real world of innovation, animal spirits, technological advance, effort, salesmanship, and trade - the grassroots of human economic endeavour. Naturally, the returns on these endeavours have been more volatile than the returns on lending to a government, but this volatility works in both directions. Happy accidents and discoveries form as much part of business as mistakes. One dollar invested in 1802 has grown to $7.5m today, and even historic effects like crashes in 1929, 1974 and 2008 become insignificant in this context.

But for those of us who have less than 200 years to wait and pensions to manage, what returns should we be expecting from equity markets in the nearer future? Has anything changed in the past year to alter the attractiveness of equity as an investment class over the long term? I would argue no. The epicentre of these events has been in the credit markets. The equity model is not broken, but I would concede it has been severely impacted, particularly in the banking sector, which has probably changed for good.

The events of 2008 with direct impact on equity investors have been the rise in risk aversion and loss of confidence, the higher liquidity preference, the increased concerns over corporate liquidity and solvency, falling corporate profits, deleveraging and rising government participation and ownership in the banking system. The correct level of risk premium for this environment is difficult to judge, but a historical high is not inappropriate. Equities have been used as a source of liquidity, and as banks in particular refinance, equity investors are likely to be called on for more recapitalisations in the year ahead. Investors can and should be selective as these will not be isolated opportunities.

While valuation in itself is not enough to end a bear market, we are currently offered a more reasonable absolute entry point than we have seen for many years. As already stated, for some areas of the market like banks with government ownership, historical valuation ranges will no longer be appropriate and dividends are likely to be scarce. Elsewhere, a sufficiently long valuation range should still be relevant.
Corporate earnings momentum has yet to stabilise, but we have seen rapid and sharp earnings downgrades in the second half, bringing estimates closer to reality.

What are the implications for stock selection? Transparent deliverable growth should remain at a premium at this stage, and historically this has tended to be sustained into the early stages of an upturn. During a period of lower growth, investors favour: companies that can maintain their profitability in a more challenging environment either due to structural growth in their industries or regions of operation, or the ability to improve margin through increased productivity and cost cutting (which often requires a change of management); industries or companies that can restructure; and companies that can gain from weaker competition or acquisition opportunities thrown up by capital distress. New relative winners may emerge - beneficiaries of increased infrastructure spending by governments, higher concerns about financial and physical security, companies assisting with the deleveraging process, trading down and cost saving.

In the midst of the ongoing deleveraging, strong corporate liquidity and cash flow should remain attractive features, both as safety features and giving the flexibilty for shareholders to take advantage of distressed situations. In core holdings, investors should have manageable funding requirements. But there is potential, as the cycle progresses, to take on some credit risk of deleveraging businesses with strong core franchises.

Valuation metrics tend to be short term after a systemic shock, so sustainable yield should be a focus, particularly as yield on cash and fixed interest is going to be difficult to find. EV/sales, P/BV (if realistic) and normalised P/E are all being used again. As and when sentiment improves, and earnings estimates stabilise, forward P/Es and DCFs (discounted cash flows) will once again be trusted. In DCFs at present, the implied discount rate is reassuringly high, allowing long-term investors to buy stocks at historically attractive valuations.

Volatility will remain a feature. Stock (and credit) picking is imperative and avoiding danger will remain key. Portfolio construction should take account of the higher volatility, which could otherwise drown out underlying returns.

This reflective pause is reaching its conclusion, and investment decisions must again be made. The year 2008 was historic and dramatic, and its aftermath will be slower growth, increased volatility and greater stock-specific risk. Equity market returns over the coming years are likely to be below historic averages but should be positive. Government and Central Bank responses have been quicker and more significant than on previous occasions in both fiscal and monetary terms. Rate cuts are being undertaken. Inflation is falling and deflationists have the short-term evidence in their favour; further out there is more debate.

We should assume equity will survive, and that investing wisely over the next year should provide decent long-term returns. However, the kind of equity investors want to buy in the short term is likely to be defined by their recent dramatic experience: income generating, predictable and transparent.
 
Lucy Macdonald is managing director and chief investment officer for global equities with RCM