Can investors still find value in current equity markets?
With many global markets nearing or surpassing all-time highs in recent months, investors might question whether now is a good time to invest in equities. Of course, the question needs to be set in the context of the current shortage of alternatives, with cash and many areas of the bond market continuing to provide derisory returns. However, the fact remains that equity markets have surged in recent years on a wave of liquidity created by quantitative easing and central bank policy.
The market rally has been driven by momentum, not by the fundamental attributes of companies. “Over the last five years, the rising tide of QE has lifted all boats. It has been an unusually indiscriminate rally with the individual strengths and operational performance of companies largely being ignored,” observes Neil Woodford.
However, as the stimulus of QE is withdrawn, the expectation is that markets will become more discriminate, with fundamentals playing a much more significant role in determining the performance of individual stocks. But for now, the challenge facing value investors – those who seek shares that they believe the market has undervalued – is to spot opportunities to invest in companies that have been overlooked in the market euphoria. After all, for those value investors, the price they pay for a company has proven to be the key determinant of future returns.
As Kevin Murphy of Schroders explains, “The market is not a single entity: it offers us a choice of businesses and valuations. Our job is to scour the investment universe to find interesting ideas – albeit they are somewhat thinner on the ground today than they have been in recent years.”
Measure of value
Clearly no one has a crystal ball to foresee the future; but if we look into the past, what can history tell us about the potential for returns from here? Does today’s market offer good value for investors?
The starting point for this conundrum is how to value the market. The price/earnings (P/E) ratio – the company’s share price divided by its earnings per share – is a widely recognised measure of the value of equities. A high P/E suggests investors are paying more for the earnings the company will achieve, whereas a lower multiple suggests there is greater value for investors (i.e. they are paying less for the prospect of those future earnings).
The chart below shows the annualised 10-year returns from the UK stock market based on various starting valuation levels over the last 50 years. The current P/E of the UK market is illustrated by the grey bar, above the long-term average of 14 but below previous highs seen in periods such as the peak of the technology boom in December 1999 and prior to the global financial crisis in June 2007. The chart illustrates that the higher the price paid, the lower the future returns have been, and that currently we are somewhere in the mid-range.
The importance of starting valuation
Source: Thompson Reuters. Monthly data to 1 April 2015. UK equities and price-earnings ratios from 1 January 1965.
The important difference between now and the dotcom boom is that, whilst markets have reached similar levels, the values of many technology companies were then vastly inflated, with little or no earnings to support such enthusiasm. Earnings may not have risen significantly in recent years, but they are much healthier than has been the case in the past when markets were high.
There remain a number of economic and geopolitical uncertainties which may check the progress of markets, which no one can predict. However, valuations are not too stretched by historic measures. There are still attractive returns to be made if you find those companies that have been mispriced.
The value of an investment with St. James's Place will be directly linked to the performance of the funds you select and the value can therefore go down as well as up. You may get back less than you invested. Past performance is not indicative of future performance. Equities do not have the security of capital which is characteristic of a deposit with a bank or building society, as the value and income may fall as well as rise.
The information contained above, does not constitute investment advice. Full advice should be taken to evaluate risks, consequences and suitability of any prospective fund or investment. Where the opinions of third parties are offered, these may not necessarily reflect those of St. James's Place.
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