Equity Returns in the Long Run

Dear Friends,

                   When I had made a conservative assumption of 16% Returns from Equity Mutual Funds for the next 20 years in PenguWINs SIgaram page (https://penguwin.com/sigaramsip-kodeeswaran/ ), many people were curious to know the basis for the same and I thought I will try and explain the same.

To be able to articulate the basis of 16% ROI, I need to explain a few jargons including GDP, Real and Nominal Rate, Corporate Earnings and Alpha.

GDP (Gross Domestic Product) is the aggregate of all goods and services in the country including Agriculture, Industries and Services. India GDP growth projected for the Financial Year 2014-15 is 7.4% (Vs 6.9% in FY 2014 and 5.1% in FY 2013). These are the based on the new/revised logic of GDP calculation where GDP is estimated at market prices, which includes indirect taxes but excludes subsidies. Earlier, GDP growth was estimated at factor cost, which excludes indirect taxes but includes subsidies. The GDP is expected to grow by atleast 1% or more from the current levels once the current policy measures are fully implemented including the GST implementation and by 2017, the estimates for GDP is about 8.5%. 

GDP is represented as a Real Rate, excluding the impact of Inflation. The inflation rates vary by country and to get a clear picture of a country’s growth, only the real rate is considered so that they are comparable. If we add inflation to the Real Rate of GDP then we get the nominal value of GDP. The expected Inflation in the medium to long term would be in the range of 4 to 6%. If we assume a median number of 5% as the inflation, then the Nominal Rate of Indian GDP is 13.5%. If I have to quote a similar example, today the 1 year SBI Bank Fixed Deposit rate is 8.5%. This is what we call as Nominal Rate. If we deduct the Inflation Rate of 6.5% (Last 1 year Average) then the Real Rate of Bank FD is 2% (I have not considered the taxation in this, which if considered will make it negative for someone with 10L plus income).

During the 10 year rule of Dr. Manmohan Singh, UPA, between 22 May 2004 and 26 May 2014, where there were several unfavorable events like the US economy crashing due Sub-Prime crisis, rampant corruption including 2G, CWG, Coal, policy paralysis etc. can you guess as how much did the GDP of India grow?

Yes, you will be pleasantly surprised that the Average GDP growth during the 10 Year period was 7%. The Average Inflation during the same period was 6.5% which means the Nominal GDP growth rate was 13.5% which is phenomenal. Please remember that this is based on the old method of GDP calculation and would be higher if the current approach were used.

GDP forecast is 13.5% for the next 10 years plus period as explained earlier. The Corporate Earnings is estimated to be atleast 3% higher than this resulting in a number of 16.5% on the lower side. Markets – Sensex and Nifty are slaves of corporate earnings and their growth will be on similar lines. There could be periods where Markets are ahead of Corporate Earnings like the current situation (Feb 2015) and there are other times where the Markets lag the Corporate Earnings like in 2013, when the markets were considered cheap. But over long term, Markets will rise or fall in proportion to the corporate performance and they can’t be divergent for long. The Sensex and Nifty returned 17% between May 2004 and May 2014 (10 year UPA regime) when the Nominal GDP was 13.5%, which is in line with the explanation provided above.

Equity Mutual Funds have been able to generate an Alpha (excess returns over Markets (Sensex/Nifty) through Fund Managers Active Investment Strategy) of 3-5% over the long term which means a return of 20% is quite achievable (Corporate Earnings plus Alpha). I had toned down this realistic number and tried to project a more conservative number of 16% in my calculations (I am sure every investor will be happy to experience a positive surprise rather than have high expectations now and get disappointed later).

To summarize:

• Real GDP Forecast for the next 10+ years is 8.5%
• Nominal GDP is Real GDP plus Inflation. Inflation is expected to be around 5% which means Nominal GDP would be 13.5%
• Corporate Earnings is expected to be atleast 3% over GDP and assuming 3%, the number would be 16.5%. This is what the Markets/Index (Sensex, Nifty) is expected to deliver.
• Mutual Funds have been able to comfortably generate an Alpha of 3 to 5% and hence the Returns from Equity Mutual Funds is expected to be about 20% over 10+ year horizon.
• To put it simply, the GDP and Inflation numbers will be able to tell you how much the Equity Investments will be able to deliver in the long term.

Please remember that India is a growing Economy with a lot of positive factors like a young population (demographic advantage) and world over all Financial Pundits predict a great Indian growth story. This run is expected to be there for the next 20 years before we move to the league of developed nation when the growth rates are expected to plummet by atleast 8 to 10%. So, please make use of this golden opportunity that exists in the next 20 years and maximize your wealth.

Please feel free to write to me or call me if you have any questions or suggestions.

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