Sometimes it seems Australian share prices are driven more by US sentiment, than by a belief of understanding about their intrinsic value.
The AMP’s chief economist, Dr Shane Oliver says that despite outperforming global shares over the last decade, Australian shares continue to provide better return prospects than mainstream global shares (dominated by the US, Europe and Japan).
The relative success of Australia in navigating the global financial crisis is now widely recognised.
In fact it follows several episodes where Australia seems to have escaped Houdini-like from a perilous situation – it also sailed relatively smoothly through both the Asian crisis of the late 1990s and the tech wreck earlier this decade.
It is the only major developed country not to have had a recession (defined as two consecutive negative quarters) since the early 1990s.
This owes to both good luck (sub-prime mortgages not having taken hold, exposure to China, etc) and good economic management (years of budget surpluses, sensible monetary policy and economic reform resulting in a more flexible economy).
But what does this mean for investors in shares?
Does it mean Australian shares are a better bet than global shares?
Or has it already been factored into share markets?
For example, over the last ten years Australian shares have dramatically outperformed global shares – returning 9.5% pa over the last 10 years versus a loss of 0.2% pa from global shares in local currency terms.
In fact, once allowance is made for the rise in the Australian dollar, global shares have lost 2.3% pa over the past 10 years. Can this outperformance continue?
The theoretical case to have more global shares
The standard arguments for Australians to have a greater exposure to global shares are as follows:
- Local shares are just 4% of the global sharemarket;
- Greater exposure to global equities and foreign currency provides ’diversification benefits’;
- The Australian share market doesn’t have much exposure to technology and consumer stocks and is over represented by financials and resources;
- Significant international exposure provides an offset to our high foreign liabilities and our high exposure to domestic assets via residential real estate; and
- Global shares offer more scope for fund managers to ’add value’.
The trouble is that such arguments are highly theoretical.
The benefits of global diversification are hard to explain given the poor returns from global shares over the last decade.
It is also debatable whether the extra opportunities offered by global equity investing have ever been consistently realised by fund managers, with similar or less value added relative to benchmark returns over time compared to Australian equity funds.
These arguments also ignore the actual return potential for Australian shares over a more relevant horizon of say five years.
…but strategic view still favours Australian shares
Despite the theoretical case to have more global shares, for many years I have favoured Australian shares over mainstream global shares and, even though Australian shares have outperformed for the last ten years, this remains the case for the following reasons.
Firstly, despite recent cuts in dividend payments Australian shares pay a higher dividend yield than mainstream global shares.
The average dividend yield on Australian shares is 4% versus 2.6% for global shares.
This is important because over long periods dividend payments constitute a significant component of the return an investor gets and so the higher the dividend yield the better (assuming it is not debt financed).
Moreover, high dividend yields augur well for future returns, because they signal corporate confidence about future earnings and excessive retained earnings are often wasted.
Secondly, the Australian economy offers higher growth potential than those underpinning traditional global share markets in the US, Europe and Japan.
Australia is experiencing much stronger population growth (more than double that of other developed countries), which is feeding through into much stronger labour force growth.
Australian households have not seen the same deterioration in their asset to debt ratios as has occurred elsewhere, public sector debt is very low compared to most other developed countries and we are heavily exposed to high growth Asia and strength in commodity prices.
All of these considerations are likely to translate into higher growth in earnings per share for Australian companies compared to earnings growth in traditional global share markets.
Reflecting the last two points, return projections (see below) based on current dividend yields and likely earnings growth tend to favour Australian shares.
Over the medium term (say, five years), a good starting point to project likely returns is to add current dividend yields to likely long term nominal GDP growth as a proxy for earnings growth and hence capital gains from shares.
Australian shares with a five year pre tax return projection of 9.5% pa come out well ahead of traditional global shares with a return projection of 7.3% (which will be even lower if as we expect the $A continues to rise).
Finally, franking credits should not be ignored because they add over 1% to the post tax return from Australian shares for Australian investors.
The hi
