Basic maths – If an industry has a longer economic cycle, valuation metrics should reflect this
Why might an investor look at a business trading at the top of its historic price range and think it cheap yet, on a different date, look at the same business trading near its lows and think it expensive? It should not really be possible but it can happen if the investor is using a one-year earnings number – be that forward-looking or historic – to arrive at their valuation metric for a business.
The inherent problem with this approach is that a business’s earnings can vary very significantly from year to year. As such, a single year’s figures may be good, bad or indifferent and, unless you have studied the history of the business, you are not going to know which it is. Far better, we would argue, to use a valuation metric that better takes account of the economic cycle.
Long-term visitors to The Value Perspective will by now have guessed we are warming up to an article on our preferred valuation metric, the cyclically adjusted price/earnings ratio. Known for short as the ‘CAPE’, this effectively smooths out the peaks and troughs of an economic cycle by dividing a business’s current share price by its average profits over a number of years, adjusted for inflation.
The idea of the CAPE was originated in the 1930s by value gurus Ben Graham and David Dodd, who suggested that seven or, better still, 10 years was enough to reflect the earnings cycle of a business or market. We, however, are no longer sure that universally holds true and since that may sound close to sacrilege – especially coming from a site dedicated to value investing – we should quickly explain why.
Over the last 12 months or so, basic materials businesses – in other words, mining shares – have been showing up as increasingly cheap on a CAPE basis. Until recently, however, we have held back from investing and the reason we have done so is because we do not believe that even 10 years comes close to encompassing a full economic cycle for a mining company.
From the initial discovery of iron ore, copper or whatever it may be – through obtaining planning permission to develop the site as well the necessary permits to operate it to sorting the transportation network, buying plant and machinery, hiring workers and so on – it will perhaps takes a mining company five years just to bring a mine up to speed. In short, these are long-cycle businesses.
So while we could just set up our computers to screen the market for Graham and Dodd profits, we believe it makes more sense to get to the bottom of what the CAPE metric is aiming to do, which of course is to arrive at an average. And if we believe seven or 10 years is not a long enough time period to generate a meaningful valuation for this sector, the answer is obvious – use a longer period.
The past 18 months notwithstanding, the last decade has broadly been a very good one for miners. Go back 20 years, however, and commodity prices were much lower than they are now – as, by extension, were mining company profits. Averaging out these two contrasting decades should thus offer a much more holistic view of the profitability of the basic materials sector – so that is what we have done.
Source: Schroders Datastream, 2015
As you can see, the sector currently stands on a 20-year CAPE valuation of 10x, which is very close to every other trough over the period. What particularly catches our eye is the way the sector has tended to bounce each time it has approached those lows while the potential upside, should valuations revert towards their long-term mean of 16.2x, helps to explain why almost every stock we have been looking at over the course of the last month has been in this space.
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.
The views and opinions displayed are those of Nick Kirrage, Andrew Lyddon, Kevin Murphy, Andrew Williams, Andrew Evans, Simon Adler, Juan Torres Rodriguez, Liam Nunn, Vera German and Roberta Barr, members of the Schroder Global Value Equity Team (the Value Perspective Team), and other independent commentators where stated.
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