FOOL'S EYE VIEW
Why Trackers Beat Cash

By Maynard Paton (TMFMayn)
September 5, 2002

At the Motley Fool, we've often written about the long-term benefits of investing in shares. Taken from the Ten Steps To Foolish Investing, regular readers will find this sort of statement quite familiar:

"All the evidence shows that over long periods, the stock market has produced returns that far outweigh those offered by a mere building society. The CSFB Equity-Gilt Study tells us that over the last 80 years or so, the London Stock Market has returned an average annual rate of 12.3% (about 8.2% after inflation is accounted for). It has far outperformed cash in a deposit account (which made 5.5% per year or 1.6% after inflation) or gilts (which are Government bonds and made 6.2% per year or 2.3% after inflation)."

So why should long-term investors put their faith in index trackers over and above the building society? Sure, history has shown the stock market beating the returns from cash in the past. But as they say, an investment fund's past performance is no guide to the future. And given that the stock market has effectively gone sideways for the past five years or so, with plenty of market pundits suggesting a further downturn on the cards too, there must be numerous investors who must doubting the merit of the index tracker.

Back to basics

To understand the long-term virtues of an index tracker, as opposed to cash in the bank, we have to go back to basics.

The leading index on the London Stock Exchange (LSE: LSE) is the FTSE 100. This index represents the 100 top companies listed on the London exchange. So, when you contribute to a FTSE 100 index tracker, your money buys you slices of each company within the index.

But importantly, you buy in proportion to each company's market worth. So, the greater the value of the company, the more your money gets spent buying that company's shares. Today, for instance, a £1,000 contribution into a FTSE 100 tracker would buy you £107.16 of BP (LSE: BP.) shares, £74.91 of GlaxoSmithKline (LSE: GSK) shares and £66.75 of Vodafone (LSE: VOD) shares.

But how are BP and the rest valued by the stock market? Although the subject of share valuation can be a complex one, it essentially all boils down to this: A company's value is based upon the expectation of its future profits. In short, the more profit the stock market thinks the company will make down the line, the greater its market value will be today.

However, to generate those greater profits of tomorrow, companies have to reinvest present day profits back into their business. Thus, BP will plough back its profits to fund new oil exploration projects, Glaxo will retain profits to develop new drugs, and Vodafone will reinvest its profits to finance its new 3G telecom network.

Now, these three developments, alongside those of the 97 other FTSE 100 members, will all have differing long-term returns. Some of the projects will beat the return from cash hands down, while others will do rather worse.

Good examples at either extreme of the reinvestment spectrum are Glaxo and Marconi (LSE: MONI). Aided by patent protection, blockbuster drugs (such as Zantac) have historically generated 20%-plus annual returns on the company's investment. Marconi, on the other hand, recently spent £6b of shareholders' money on acquisitions, most of which was effectively poured down the drain.

But while there are many differing outcomes within the reinvestment spectrum, one thing's for sure: Shareholders of a business don't put up with their profits being reinvested at sub-standard levels for long.

Thus, if a company is continually reinvesting its profits for a return equal to that from a building society account, shareholders will eventually demand changes. They'll either ask the company to distribute those profits as a dividend, ask for the company to alter it's corporate strategy, or ask for the company to alter its management. There's no point in companies reinvesting their profits in "risky" business projects when the same return is available risk-free elsewhere.

Summary

In business, it is very much the survival of the fittest. Over time, the companies that will endure and prosper are the ones that can continually reinvest their profits well above the rate available from cash. Obviously, the fitter the business, the greater the profits it will make and the higher its valuation will be. And that being the case, contributions into a FTSE 100 tracker will therefore be weighted towards the strongest of UK businesses.

Sure, some businesses will falter in the future. Witness the decline of the textile, motor and brewing industries, all key components of the UK stock market of decades gone by. But over the years, far more rewarding industries have always appeared. For instance, software, pharmaceutical and outsourcing firms are all great examples of relatively new businesses generating high returns with shareholders' money.

To have long-term faith in a tracker, you have to believe that the majority of companies will continue to reinvest their profits at rates greater than cash. You have to believe that, as has regularly happened in the past, the stock market will not suffer companies reinvesting their profits at sub-standard returns. Furthermore, you have to believe that, while certain companies and industries will fall from FTSE 100 grace, there'll be new companies and new industries that will more than replace their predecessors in the stock market's top flight.

Over the long-term, share prices generally run in tandem with company profit growth. And as explained above, long-term profit growth should run ahead of the growth expected from cash. To believe that cash will beat a tracker over the long-term, you must assume major companies will no longer find ways of successfully investing money in their businesses, and that the long line of innovative and creative businessmen seen throughout the ages will suddenly come to an end.

More:  Visit the Motley Fool's Index Tracker Centre |  Index Tracker discussion board

This article was originally published in October 2001.