In Looking closely, we explained why, even though the FTSE 100 has been flirting with levels not seen since April last year – and is not so very far from its November 2007 and January 2000 peaks either – that did not tell the whole story from a value perspective. We outlined why this analysis was leading us to look closely at basic materials and banking stocks and promised shortly to address the same argument from a different angle.
So let’s now do precisely that – after all, with those 2007 and 2000 booms soon followed by the painful busts of, respectively, the credit crunch and the bursting of the tech bubble, it is always worth considering what market highs could mean for future returns. In this context, the insight provided by one of our preferred metrics, the 10-year cyclically-adjusted price-earnings ratio – ‘CAPE’ for short – can be very helpful.
The CAPE encapsulates the average earnings generated by a market, adjusted for inflation, over the preceding 10 years, and helps explain why the FTSE 100 is looking much better value than, say, the FTSE 250 index of mid-sized stocks that itself reached an all-time high at the start of October. In Looking closely, we reminded you the total return from an equity investment or market is made up of three elements.
There is the dividend, which – whether you are looking at the FTSE 100, the FTSE 250 or indeed the FTSE SmallCap index – tends to average out over the longer term around 3.5% or 4%. Then there is any uplift that comes from earnings per share growth – or profits – and from any change in valuation. It is these two areas, as the following chart shows, where the real differences have occurred since the turn of the century.
As you can see, the FTSE 100 has seen some profits growth – though not nearly so much as the FTSE 250 – but the real kicker is the FTSE 100 has derated substantially. While the FTSE 100’s CAPE was 30x in 2000, it stands at 15x today; the respective figures for the FTSE 250 are 30x and 26x. In other words, while the FTSE 250 is almost as expensive as it was at the height of the tech bubble, the FTSE 100 is on half its valuation.
At this point, it is worth stressing that any market valuation is a simple average of the valuations of the individual stocks that comprise it, which means some sectors and businesses are going to be more attractively valued than others. The cheapest sectors in the UK today – banks and basic materials – also happen to contain some of the largest stocks in the market. Deep value can, in other words, be found in plain sight.
Now let’s consider the related topic of valuation spreads, which measure the difference in valuation between cheap stocks and the market average. Data from equity markets around the globe show that valuation spreads today are wide relative to history, thereby presenting an attractive opportunity for those pursuing a value investing strategy, as of course we do here on The Value Perspective.
In the past, periods with wide valuation spreads have seen investors all facing the same way and ignoring one set of stocks in favour of another – the dotcom bubble serving as a prime example of this. A decade and a half later, the stockmarket darlings may have changed but the market’s myopic focus on the so-called ‘bond proxy’ stocks, on which we have warned in articles such as No defence, has clear parallels with early 2000.
Yes, as Mark Twain apparently never actually said, history may not repeat itself but it often rhymes. And yet, while valuation spreads may be very wide between sectors in the UK, they are very narrow within them – or, to put it another way, all stocks within unloved sectors have been tarred with the same brush, irrespective of their individual characteristics.
It is at times such as these that the benefits of active stockpicking come to the fore. That is because those investors willing to do the hard work crunching corporate numbers should be able to find businesses within unloved sectors that not only trade at very attractive prices but also offer sufficient reassurance on account of the strength of their balance sheets.
Focusing on identifying good businesses in the cheapest parts of the market has historically offered value investors a premium return over and above the wider market. And, as we concluded last time, we are now looking very closely at commodity-related and banking-related businesses and you should not be too surprised to find significant weightings to both sectors in our portfolios.
- Get a weekly round-up of the best value ideas