You could not have failed to notice that the FTSE 100 index has pushed past its previous all-time high of 6,930 in December 1999. As I write this morning it is trading at 6,952 up on the back of news that the date of US interest rate rises is likely to be pushed back. With equities doing well investors may well be asking if what followed 15 years ago could happen again. It is the wall of worry syndrome, as equities climb higher investors increasingly fear the drop. You will recall back in the early noughties the technology bubble burst, a recession followed and the FTSE 100 index collapsed to around 3,600 in February 2003. It would be fair to argue however that this time it is different.
Will 2015 repeat 1999?
I think not for several reasons. Firstly the UK equity market today is not subject to excessively unjustified valuations from a technology or other sector with no earnings as it was at the end of 1999 and in early 2000.
Secondly the valuation of the FTSE 100 index as a whole is close to its long term average. You may recall that the Price to Earnings (P/E) ratio is an oft quoted measure of the value of a stock or a market. It is calculated by dividing the share price by the earnings per share, typically trailing earnings in the last year. The higher the P/E, the more the market values a stock or index. During the technology bubble the FTSE 100 P/E ratio peaked at just over 30. Today it trades at around 16. The key conclusion is that the largest UK companies are not expensive because earnings have grown significantly since 1999.
The third reason for optimism is that the global economic cycle is still in the recovery phase. We are emerging from the worst financial and debt crisis in a generation. The UK economy is not overheating from excessive growth nor rampant inflation of wages or prices. It is not unreasonable to expect further expansion of equity prices as earnings grow. These will come from the UK as well as recovery in key overseas markets such as Europe, which is further behind the economic curve.
This broad based assessment of the valuation of UK equity market above does not account for differences in valuations between different sectors or stocks. There is considerable disparity as explained below. Before I do I need to explain a major style of fund management called value investing. Schroders define this as:
Value investing is the art of buying stocks which trade at a significant discount to their intrinsic value. Value investors achieve this by looking for companies on cheap valuation metrics, typically low multiples of their profits or assets, for reasons which are not justified over the longer term. This approach requires a contrarian mind set and a long term investment horizon. Over the last 100 years a value investment strategy has a consistent history of outperforming index returns across multiple equity markets. (Schroders – The Value Perspective).
The CAPE Crusader
To understand value investing we need to consider a more sophisticated measure of stock market valuation. I refer to CAPE, the Cyclically Adjusted Price to Earnings ratio. This measure is also called the Shiller P/E after the economist Robert Shiller who popularised its use and shared a Nobel Prize in 2013 for his work on asset prices. The standard P/E ratio is limited as it takes into account one year earnings only and these can be distorted by an atypical trading period or they are a function of the current phase of the economic cycle. Earnings may be depressed if there has been a recession or if a company had a particularly bad year, but one which is unlikely to be repeated. This may lead to a distorted P/E. CAPE is calculated taking into account the previous 10 year earnings which irons out the anomalies of market cycles or one off company factors.
The Use of CAPE in Investment Decisions
A few weeks ago I listened to an excellent presentation from a manager of the Schroder Recovery fund. This fund adopts a value investment style. The principal learning point about value investing was the stark relationship between CAPE and future returns. The following link supplied courtesy of Schroders illustrates this very clearly.
The chart shows rolling 10 year annualised returns from UK equities since 1927 based on the CAPE valuations at the start of the 10 year period. Companies that started with the lowest CAPEs i.e. in the 0-7 range had the highest 10 year investment returns with lower returns achieved as the CAPE ranges increased. Although there will be variations within each “bucket” so that not all companies with CAPEs between 0-7 returned more than 10% p.a. the conclusion is clear. Valuations matter and are a primary driver of future returns. This is not to suggest that stock specific issues do not need to be taken in account. Some companies are value traps; they are cheap for good reasons and should be avoided. That is why value investors are typically bottom up stockpickers who seek to identify stocks with attractive valuations that the market has not recognised. In contrast passive index tracking strategies will be required to buy the basket cases.
Schroders demonstrated in the webinar that CAPEs vary between sectors of the market. Back in 2000, tobacco companies had CAPEs between 7-14, whilst the oil and gas, media and technology sectors had CAPEs in excess of 35 (Source: Schroders. From Datastream. Data at 1/1/00). Over the next 10 years stocks in the 7-14 bucket returned 763% whereas those with CAPEs of 35+ lost 46% (Source: as above). Those sectors in the 14-21 bucket returned 156% and whilst those with CAPEs of 21-28, 38%. This inverse relationship between CAPE and 10 year performance reflects a tendency for valuations to revert to mean.
Today Schroders consider banks to be very attractively valued with CAPEs up to seven (at 31/12/14). They argue that bank balance sheets have vastly improved yet valuations are still depressed. This sector is a prime candidate for value investors albeit with the stock picking due diligence that is needed.
Basic resources, food and general retailers, insurance, oil and gas fall have CAPEs between 7-14. Technology and chemicals are examples of more highly valued sectors.
Investors should not assume the whole of the UK equity market is expensive based on the performance of stockmarket indices. Headline record figures for an index like the FTSE 100 mask good investment opportunities. This is because there is a wide disparity of valuations within sectors and stocks.
CAPEs are an excellent tool that can be used by investors to assess value and for asset allocation purposes not-withstanding the requirement for good stock picking.
With UK equities riding high a value investment style is an entirely appropriate strategy for investors.
This blog is intended as general investment commentary and reflects my own views. It is not an invitation to invest in the areas highlighted as these may not be suitable for you. You should seek individual advice before making investment decisions.