Published: Jun 15, 2015
Focus:
Insights
Robert Davies, Fund Manager
The UK equity bull market, that started when QE was announced in March 2009, is now well over 6 years old which is a long time by historical standards. That makes some investors nervous about committing new funds to the market and others have gone as far as to liquidate existing positions and go into cash.
Even renowned hedge fund manager Crispin Odey has complained that ultra-loose monetary policy has caused some company valuations to be detached from reality and says “Once a bubble forms it has an internal logic of its own and it will grow until it has outgrown all of its surroundings.”
This is most obvious in the disparity between the returns of the FTSE 100 and the FTSE 250. In the past year the mid-cap index has risen 14.6% while the FTSE 100 has only increased by 1.5% and over the past seven years the 250 has outperformed the 100 by 50%. Whilst it is true that some of this has been driven by higher earnings for domestic companies, such as house builders, a large element has been the revaluation of earnings that has resulted in the smaller companies standing on higher multiples than the large ones.
In terms of price-to-book ratios the average for the FTSE 250 is 2.6 compared with 1.9 for the FTSE 100 index. The story is the same for price-to-sales, with 1.3 compared to 1.1, price-to-earnings, with 18.3 compared to 16.5, and yield where 3.0% compares to 3.8%. On all measures the aggregate valuation of companies in the FTSE 250 is higher than for those in the FTSE 100.
Investors get little reassurance looking overseas, as the future of Greece in the Eurozone looks increasingly problematic and the Chinese stock market is charging ahead. Could problems there spill over into the UK?
So what to do, sit and wait for a correction or carry on investing?
As fund managers we cannot give advice and the FCA reminds us that past performance is no guide to future returns, but we can look at history for help and two things are clear.
One is that investing in companies with lower ratings give better returns than from those with higher ratings. The second is that, over the long term, the bulk of equity returns come from dividends and not from capital growth.
However, standing aside until the market drops can be a long, frustrating and not very exciting exercise, especially when returns on cash and bonds are so low. In this situation some investors might seek out funds that have a tilt to value and feed money in on a gradual basis to average out their entry price.
Many think that one of the simplest measures of the value tilt of a fund is its yield. Some comparative websites will also provide details of measures like the average price-to-book, price-to-sales and price-to-earnings for the constituents of the fund. Some will also indicate the bias in the fund to different parts of the market and, from the valuation evidence, it seems that the larger companies are cheaper than the smaller ones. So funds with more invested in the big caps should be less vulnerable.
None of this of course can deny the fact that if there is a correction all stocks will suffer. But provided that the time horizon is long enough, typically five years or more, the compounding effect of dividends, growth of dividends and reinvested dividends should give equity investors a better return than from cash or bonds.
