Wednesday, 21 November 2012 - 20:00

 

Charts

Value in the Local Market

Long term value investors will appreciate the importance of the starting PE ratio when making an investment. Low PE investments typically outperform high PE investments when looking over a 5 year period. While the relationship is true on an individual stock level, the same also holds when looking at the market as a whole and also different market sectors.

The charts below show how this relationship holds over various periods. We have taken market data over the past 15 years or so, and for each starting PE have looked at the subsequent 5 year return (annualised) that an investor would have received from the relevant index. For example in the first chart (looking at the ALSI – overall market) we can see that when the starting PE was around 20, the subsequent 5 year return was just short of 5% pa, while starting PE’s of under 10 have delivered in excess of 30% pa over the following 5 years. The market’s current PE is just above 14, and by this measure the ALSI should deliver just over 15% pa over the next 5 years, which is a bit below the long term average.

On average the market looks fairly valued, but when looking a bit closer we can see some major discrepancies between the various sectors. The Resource sector has been hard hit in relation to the Industrials and Financials; particularly this year as the global economy (and especially China) has slowed and locally has been exacerbated by the numerous strikes across the industry costing not only production, but also lives. On the other side, Industrials have been driven by the ‘flight to quality’ both locally and abroad, where investors have bid up the prices of those companies with stable earning profiles. Locally the retailers have been major beneficiaries and also ‘sin’ companies like British American Tobacco and SABMiller.

While the performance of the Resource index has been poor, the sector is now showing good value with a PE of just over 10, and a dividend yield in excess of 3%. This is compared to the Industrial index’s PE of nearly 20, and dividend yield of 2.5%.

The three charts below show the history of starting PE versus subsequent 5 year return (annualised). The large yellow dots indicate the current PE and expected 5 year return from here for the three sectors.

This method is by no means full proof. There will always be anomalies, but if this approach is consistently applied investors should be able to generate above average returns over rolling 5 year periods. Another caveat is that returns never come in a straight line. Investors must realise that while Industrial companies are expensive, they can continue getting more expensive (i.e. continue to go up). At the same time, while Resource companies are cheap, this doesn’t mean they’re going to instantly deliver returns to investors, they could even continue to fall over the short term. Investors need to be patient and have a time horizon of at least 5 years for this strategy to work.

Investing is neither an art, nor a science, but by consistently using valuations to assist in the investment process investors will increase their probability of generating satisfying returns.

Take care,

Mike Browne

www.seedinvestments.co.za
info@seedinvestments.co.za
021 914 4966

Wed, 21 Nov 2012

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