Wednesday, 04 May 2016 - 20:00

 

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Seed Weekly - Local Equities - Expensive or Not?

An important part of Seed’s multi management process is performing monthly asset class valuations using in-house quantitative models. This process covers all of the local and global asset classes that are suitable for inclusion in our multi asset class funds and model portfolios. The output of these models guide our tactical asset allocation decisions, where we under- or overweight certain asset classes in the short term, compared to our longer term target weights.

Local equities form the core of our multi asset class products, and determining whether this asset class is cheap or expensive is crucial. One of the inputs of our valuation model is the Price/Earnings (PE) ratio, which is the multiple of annual earnings investors are willing to pay for a certain company, sector or the market as a whole. We have found that the total market PE is not a great leading indicator of stock market returns over the short to medium term, but does give a good indication of what to expect over the long term.

Practically, this means that a high current PE ratio (expensive market) results in lower than average returns over the next five years, while a low PE ratio predicts above average subsequent returns. Of course, with many factors other than PE ratios at play, the model does not have a perfect statistical fit. In the past, during periods of exuberance, expensive markets have continued to perform well, and during times of pessimism, cheap markets have continued to lag.

A potential shortcoming of the PE ratio, when applied to a specific company, is that it fails to allow for potential growth in earnings. This means that it might appear that investors are overpaying for the current level of company earnings, but if reported earnings grow strongly the ratio can quickly come down to more normalised levels.

The graph below illustrates the model graphically, with the total market PE on the x-axis and the resultant 5-year nominal annualised return on the y-axis. With the current market PE at nearly 22 times, the model indicates that we can expect muted returns over the next 5 years, assuming that the modelled historical relationship continues to hold. It is clear from the graph that the PE is very high compared to the historical observations.

Although the market in total might be expensive, there is always the possibility that there are pockets of value that might be overlooked. When applying the valuation model on a super sector basis, it is clear that Financials still offer some value at the moment, while Industrials appear very overvalued.

At Seed, we have been viewing the local equity market as expensive for about 3 years, and therefore have remained underweight local equity in the Seed Balanced Fund. However, the volatility of equities has provided us with some good opportunities to add exposure in some months or to take profit in others. In addition, our equity exposure remains tilted towards Financials.

Kind regards,

Cor van Deventer

Tel +27 21 914 4966
Fax +27 21 914 4912
Email info@seedinvestments.co.za

Seed is hiring: Visit the Seed Analytics LinkedIn profile to view vacancies.

www.seedinvestments.co.za

Wed, 04 May 2016

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