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Blind spot 1 - Why investors must not underestimate the significance of a change in valuation

10/05/2016

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

The novelist Julian Barnes may have provided A History of the World in 10½ Chapters but, here on The Value Perspective, we reckon we can offer a history of investment in 23 words – ‘A low valuation tends to lead to good future returns for investors while a high valuation tends to lead to poor future returns’. Too long-winded? OK – how about ‘Valuation is the best guide to future returns’? 

The odd thing is, while this idea is simple enough in theory, even professional investors seem to find it tough to put into practice – and especially so once figures are introduced into the mix. 

After some three decades of bond bull market, for example, experienced investors understand they may expect better future capital returns if they buy a bond when it yields 15% rather than when it yields 1.5%. Put forward almost the exact same example from the equity arena, however – the difference, say, between buying a business on a price/earnings (P/E) ratio of 6.6x, and buying one on a P/E ratio of 66x – and, for whatever reason, some of those same experienced investors are unable to make the same sort of intellectual leap, apparently missing the distinction between what is essentially the same valuation. 

A failure to understand the importance of value when buying and selling equities is a significant blind spot for investors – the consequences of which are starkly illustrated by events around the turn of the last century. As Rob Arnott of Research Affiliates points out in his paper, How can ‘smart beta’ go horribly wrong?, over the 50 years to 1999, stocks outperformed bonds by some 7.5% a year. 

“The investing industry embraced these historical returns as gospel in setting future return expectations – at the top of the tech bubble, pension fund discount rates and return assumptions were the highest ever, before or since, for stocks and balanced portfolios,” he adds. “In the late 1990s, many proclaimed a ‘new paradigm’ [where] profits were no longer needed, and equity valuations could rise relentlessly.” 

As Arnott goes on to observe, the problem with such an outlook is it failed to take into account how nearly half the real return over that 50-year period “came from rising valuations as the dividend yield tumbled from 8% to 1.2%”. He continues: “If we subtract non-recurring capital gains (for stocks) and losses (for bonds) from market returns, the adjusted historical excess return falls to 2.5%.” 

Thus the true equity premium over what Arnott calls “this stupendous half-century for stocks” was 2.5%, with the new paradigm-promising 7.5% gap between stocks and bonds merely “an unsustainable change in relative values”. That may have all happened more than a decade ago but, as we discuss in Blind spot 2, the implications for investments – and investors – today are every bit as far-reaching.

 

Author

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

I joined Schroders in 2000 as an equity analyst with a focus on construction and building materials.  In 2006, Nick Kirrage and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Nick and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.

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