What is a Reasonable Rate of Return?

There has been a lot of debate lately about the expected long term performance of equity markets. It comes down to a simple question; what is a reasonable rate of return? To paraphrase Bob Dylan, the numbers; they are a changing!

Ask most investors and they will tell you that double digit returns are possible, if not probable. And while that view may turn out to be correct it is certainly not supported by return data since the turn of the century.

For example, the iShares S&P/TSX 60 Index Fund (TMX, symbol XIU) has, on a price basis, returned approximately 0.791% per annum from its high in early September 2000. If you add back dividends the numbers are better with an approximate compound return of 3.15% over the same period.

With all due respect to the industry wide caveat that historical performance is not necessarily indicative of future performance, one cannot ignore long term trends if doing so results in unrealistic expectations. And the previous 16+ years of data comes nowhere close to investor expectations about future growth!

So… what’s reasonable?

Reasonable assessments begin with an assessment of the economy in terms of its potential and pitfalls. Because the Canadian economy is influenced by exports to the US the potential and pitfalls are one in the same. The performance of the US economy goes to our benefit and detriment. And while the US economy may be the best house on a bad street, it is certainly not a pretty picture.

I am not suggesting the Canadian economy is bed ridden. Quite the opposite as the numbers are pointing to stronger growth. However we cannot escape the fact that we operate between a rock (central bank largesse) and a hard place (a tepid global recovery). The implication is tepid growth for Canadian GDP likely between 1.0% to 2.0% rather than the 2.5% to 3.5% range that approximates historical norms.

The objective is to build an investment thesis that mimics toned down growth expectations. To that point investors might want to re-think the role dividends play in a portfolios’ total return. I suspect dividends will become ever more important in terms of total return. And if you believe as I do, that a more realistic return assessment is somewhere in the mid-single digits, then mature blue chip dividend paying stocks should anchor the portfolio.

If we add option writing to this discussion the combination of dividends and premium income should deliver returns in the mid-single digits while at the same time reducing portfolio risk.

Case in point is the Enbridge Income Fund Holdings Inc.* (TMX, symbol ENF, Friday’s close $29.49). ENF operates pipelines on behalf of Enbridge Inc. (TMX; symbol ENB) who owns 50% of the fund. Think of ENF as a toll road for oil and natural gas. The fund distributes monthly income to unitholders based on the tariffs to transport gas through the pipeline. It currently pays 15.6 cents per unit per month which equates to a 6.33% yield that we believe is sustainable.

ENF also has options. The ENF October 30 calls are trading around $1.10. If you write the October 30 calls at $1.10 the six month return if exercised is 5.4%. Add back six monthly distributions and the return pops to 8.6%. Return if unchanged is 3.72%, ex-distributions, and 6.9% including distributions. Downside breakeven taking into account the dividends is $27.46.

In this case we have an example of a company where there is a high probability of ending up with a return in the mid-single digits without requiring a larger than life upside move.

In my view… a reasonable rate of return!

* Full disclosure, clients of Croft Financial Group own positions in the Enbridge Income Fund.