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Only fools and bourses – The ‘CAPE’ ratio can be useful but do not take it at face value

20/03/2015

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

The British girl group Sugababes may not seem an obvious starting point for any discussion on the merits of value investing but please do bear with us. Sugababes started life in 1998 with a founding line-up of Keisha Buchanan, Mutya Buena and Siobhán Donaghy but one by one, over the course of the next 11 years, all three left the group – each time to be replaced by a new singer. 

Go to a Sugababes concert now and you would hear the group’s repertoire being performed by Amelle Berrabah, Jade Ewen and Heidi Range while, curiously enough, the original three members have reconvened under the eponymous banner of Mutya Keisha Siobhan, which Wikipedia helpfully informs us “is often shortened to MKS”. So – which would you consider to be the real ‘Sugababes experience’? 

Keen students of popular culture may recognise a similar philosophical conundrum cropping up in an episode of ‘Only Fools and Horses’ where the road-sweeper Trigger wins an award from the council for having owned the same broom for 20 years. He goes on to reveal it has had 17 new heads and 14 new handles, but insists it is still the same broom. Does Trigger have a point? 

Genius that he was, Plutarch foreshadowed both these vexing questions with his ‘Ship of Theseus’ paradox. Can a ship that is restored by replacing every single one of its wooden parts, the First Century historian and philosopher asked, remain the same ship? At the same time, we sense you asking, what has any of this to do with value investing? 

Well, here on The Value Perspective, we often refer to a metric known as the cyclically adjusted price/earnings ratio – ‘CAPE’ for short – which encapsulates the average earnings generated by a business, sector or market over the preceding 10 years, adjusted for inflation. And of course, over time, the constituents of sectors and markets can and do change. 

The peripheral eurozone is a topical enough example, with many companies that would have featured in the benchmark indices of Greece, Ireland, Italy, Portugal and Spain before the 2008 financial crisis now no longer with us due to insolvency. As it happens, at the start of 2015, all five markets featured among the cheapest in the world on a CAPE basis in a chart we ran in Cape of good hope.

Focusing in on Greece then, a comparison of the constituents of the Athens Composite index in 2006 and 2015 reveals just three of the 10 largest companies from nine years ago can still make that claim today. At a sectoral level, meanwhile, financial companies make up just a third of the Athens Composite at present, compared with half the index back in 2006. 

However, even though they may no longer exist, the constituents of the Athens Composite in 2006 are frozen in time as the profits or earnings power of Greece. Of course, given some of those stocks are no longer in the index, it would be foolish to work on the basis that that level of profits or earnings power is likely to come back any time in the near future. 

What this means for us as investors is that, when we are valuing stockmarkets, we need to recognise there are reasons those markets may not necessarily end up performing as strongly as the superficial headline ratio would suggest. Indeed, when we dig deeper, it can quickly become apparent there are nowhere near the number of opportunities within ‘cheap’ markets as the headline ratios might suggest. 

Here at The Value Perspective, we feel pretty well protected from the pitfalls of the headline CAPE because our investment approach is very much stock-specific. Even so, when we talk about sector valuations and, for example, suggest that banks are the cheapest businesses in the UK, we need to be cognisant of the fact they are very different beasts now compared with nine or 10 years ago and that share issuance flatters the headline ratios. 

The point of our Ship of Theseus analogy (and the two shamelessly more populist variations on the theme) is that markets and sectors change and evolve. As a result, investors need to be careful about taking headline ratios at face value and so being fooled into buying an index that may not necessarily provide the returns that history would suggest. 

Of course there will be selected opportunities for long-term holders in out-of-favour markets such as Greece, Ireland or Spain, but investors need to do the work at the stock-specific level before they, as one incarnation of the Sugababes once sang ‘Push the button’. Or indeed pull the Trigger.

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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