Equity Investors Not As Revolted As They Were


“I've seen your revulsion and it looks real good on you...”
Courney Love


In a recent research note titled History: The Greatest Teacher published in April of this year by Cannon Asset Managers (and published on this blog alongside), I built an argument to arrive at the conclusion that South African equities were cheap. This result reflected the global sentiment amongst investors of revulsion towards equities given the sharp fall that had taken place in equity prices since the second half of 2007. One of the key aspects of the argument was that the best time to build exposure to an investment is during the darkest hour when investors generally want nothing to do with the specific asset class. This certainly was the mood at the time.

Since then, however, equities have enjoyed an extraordinarily strong run in prices, with the FTSE All World Index up 45 percent over the past three months measured in terms of US$. Emerging market equities, however, have been particularly rampant, with the FTSE Emerging Market Index climbing 70

percent in US$ terms, and the Claymore Frontier Markets Index up 61 percent. South African equities listed on the Johannesburg Stock Exchange (JSE) have participated in this recovery, having climbed 28 percent in Rand terms from the low reached in early March by the FTSE-JSE All Share Index of just over 18 000 points to the current levels of just over 23 000 points at the start of June. Interestingly, if converted into US$ performance, the return hikes to just shy of 70 percent over the three months, reflecting the double whammy brought by the recovery in appetite for emerging market currency exposure with the South African currency strengthening from 10.59 Rand per US$ to 8.00 Rand per US$.

IS THERE STILL VALUE?

This exceptional recovery in equity prices has caused some to label the move a false rally in a deep bear market. Others have used the equity price recovery as evidence that the dramatic turbulence of the last two years is drawing to an end and that economic recovery and a restoration of financial market stability are in sight. Based on the evidence, it is hard to know which view is right. Further, while much faith is placed in the ability of analysts to gather up arguments and evidence to develop sensible forecasts, all the evidence that I have says that forecasting generally is a widely inaccurate pastime. This makes forecasting a potentially dangerous input into any serious investment process. Further, regardless of whether we have experience a false rally or a recovery rally, the sharp rise in prices pushes a key question to the front of investors’ minds: ‘With the benefit of hindsight, equities now appear to have been exceptionally cheap earlier this year. Are they still cheap?’

  • Usefully, this question can be answered by revisiting the facts, with no need for forecasting. To consider the facts, the evidence below is based on the key metrics that were used in my previous note to assess the relative cheapness of equities, namely:
    trailing price-earnings ratio;
  • dividend yield;
  • equity yield versus bond yield;
  • price-to-book ratio for the market and for individual counters; and
  • Graham and Dodd price earnings ratio for the market and for individual counters.
THE EVIDENCE: PRICE-EARNINGS AND YIELD RATIOS

Considering these metrics, as the figure below shows, despite the recent rally in equity prices, the JSE remains cheap trading on a single-digit trailing price-earnings ratio.

Similarly, using trailing dividend yield as a basis for assessing value, equities continue to offer an attractive yield. Interestingly, financials, which remain the most shunned of the equity super sectors, are priced on a trailing dividend yield of 6.3 percent versus the yields of 4.0 percent and 4.9 percent offered by resources and industrials. Regardless, the metric suggests that equities are still relatively cheap.

This stance is supported by evidence drawn from comparing the dividend yield on equities to the yield on government bonds. As suggested above, whilst the equity rally hints at loss of value in the asset class, the equity-bond yield ratio shown below points to relative value in the riskier asset class, equities, versus the lower risk asset class, government bonds.

FURTHER EVIDENCE: PRICE-TO-BOOK

Cut another way, valuation analysis shows that despite the strong recent price rally, 43 percent of the 250 largest companies listed on the JSE still trade at less than net asset value. Two months ago the figure was 45 percent.

Further, the price-to-book ratio for the market has moved modestly higher, moving the market’s price-to-book ratio from quintile five into the high ranges of quintile four. As shown in the figure below, whilst quintile four price-to-book ratios are less compelling than quintile five ratios, they remain competitive from an investment return perspective.

WHAT ABOUT GRAHAM AND DODD?

Finally, considering the Graham-and-Dodd price-earnings ratio, the recent market rally has raised the figure from a local low of 11.7 in March 2009 to the current 13.7.

This reading moves the Graham-and-Dodd price-earnings ratio from quintile five (cheapest) to quintile four, highlighting that some value has been taken off the table. Still, drawing from history, equity markets located in quintile four have delivered competitive returns, although not as compelling as when the market is price in quintile five – which tends to be the ‘priced for disaster’ bin.

Measuring the Graham-and-Dodd price-earnings ratio at the stock specific level, it is notable that 75 percent of stocks trade on ratios of less than 16 times. Recalling Graham and Dodd’s yardstick that ‘the maximum one should be willing to pay for an investment is 16’, it follows that three-quarters of the JSE by headcount is attractive from this perspective.

ALL TOGETHER NOW

In summary, whilst great attention in the recent price rally has been given to the matter of sustainability, evidence from forecasters’ track records suggests that this is a fool’s errand. There is a simpler and easier to answer question: ‘Are equities still cheap?’ On this score, the evidence demonstrates that whilst some value has been lifted, much remains to be harnessed by patient, far-sighted investors who are willing to look past the blow-by-blow real-time commentary that pervades.