In All in the price, we argued it is not the growth you see but the price you pay that is the biggest driver of future investment returns, illustrating the correlation with a chart based on almost 100 years of data. This time we will adopt a similar approach to analyse the returns the UK market saw in the years after it peaked in 2000 and think what that might imply now it has finally climbed back to those levels.
The chart below takes the market’s individual industries and places them in different valuation ‘buckets’, according to how cheap or expensive they were on 1 January 2000. As you might imagine from what were the last days of the tech boom, the most expensive sectors were technology, media and telecoms. Oil and gas was up there too while, at the other extreme, languished tobacco.
Source: Schroders, as at 1 January 2000. DataStream.
It may be hard to imagine now but, 15 years ago, investors steered well clear of tobacco stocks. All they could see were huge litigations threats and companies that killed their customers, which felt like a poor business model. It still is a poor business model but what investors now understand is that tobacco companies enjoy, among other things, considerable pricing power and huge barriers to entry.
Now investors love these businesses and their share prices have … no, let’s not get too far ahead of ourselves. Instead, let’s remember that January 2000 was a very, very bad time indeed to be entering the stockmarket. Ahead of you lay the so-called ‘decade of lost returns’ – 10 years where you were about to make no money from investing in equities.
But of course that is not quite true. If you had let valuation – the price you pay – be your guide as to where to invest, you could have made some extraordinary returns over the 10 years that followed. Again, as we saw in All in the price, there is a 100% correlation between price and returns and, as we also saw, whatever helped you to justify paying a higher price was irrelevant.
The reasons why you thought tech would be a great investment – that it would grow faster, say, or that it would change the world – were irrelevant. Tech did grow faster and it did change the world but it did not matter – you made bad returns. On average, those sectors that were valued on a cyclically-adjusted price/earnings ratio of 35x or more on 1 January 2000 fell 46% over the next 10 years.
At the same time, those sectors in the 21x to 28x range averaged a 38% rise while those in the 14x to 21x range averaged a 156% rise. And the almost friendless tobacco sector? It would have made you 763%. At a company level, one of the best investments you could have made in the early 2000s was British American Tobacco, a £6bn FTSE 100 business that was right in front of everyone’s face.
Its low valuation was right in front of everyone’s face too but people used to shrug and say: “Yes – but how cheap is it really?” The answer turned out to be it was 1,000% cheap – the proverbial ’10-bagger’. Today, British American Tobacco is still one of the biggest companies on the UK stockmarket – not to mention the dictionary definition of ‘deep value hiding in plain sight’.
So what does this all mean for investors in 2015? Today, despite the recent market falls, we are still up around the levels of early 2000. In some ways, somewhat depressingly, we have spent 15 years going nowhere. To our minds, however, there is an opportunity here because it is actually quite lazy to think of the market as being on a par with 2000.
For the reality is that, over the last 15 years, profits have grown and so valuations have in fact come down. UK businesses have moved on since 2000 and so the market is not as expensive as it was back then. That is not to say it is cheap – in the context of history, we would say it was slightly expensive – but, back in 2000, the UK was the most expensive it had ever been. That makes a big difference.
As we look ahead, here on The Value Perspective, we expect neither another ‘decade of lost returns’ nor a stellar showing from the market as a whole. Within it, however, we believe there will be stellar sectors and stellar performers and the 2015 equivalent of our ‘valuation bucket’ chart below would suggest these will be in areas such as banks and food and drug retail.
Source: Schroders, as at 30 June 2015