The Road to Revulsion

Some people say they want to wait for a clearer view of the future. But when the future is again clear, the present bargains will have vanished. In fact, does anyone think that today’s prices will prevail once full confidence has been restored?

Dean Witter (May 1932)

In a recent strategy note, James Montier of Societe Generale and the author of Behavioural Investing (compulsory reading for anyone in my office) identifies equities and bonds, in aggregate terms, as being priced at exceptionally attractive levels. For instance, the yields on BAA-rated bonds are now the highest since the 1930s; and senior secured debt is available for 50c-70c on the dollar. In the case of equities, the US is trading on a Graham and Dodd price-earnings ratio of 15 times, against an average of 18 times since 1871; the UK is trading on 12 times such a measure against an average of 16 times since 1927.

From a bottom-up perspective, Montier argues, opportunities are compelling. In Europe and the UK nearly one in ten stocks passes an augmented Ben Graham screen. In Japan and Asia one in five stocks passes the screen. Even 15 stocks within the S&P500 are shown up as deep-value opportunities. For long-range investors, times such as the present are few and far between.

Somewhat more critically, the current market state is not ‘unprecedented’, despite the desire on the part of analysts and the media to convince people that we are in virgin territory. Indeed, investors who follow a value philosophy recognise the extraordinary opportunity: great companies are available at bargain basement prices. This is the end result of a market that has gone from losing its head at the top to losing its nerve at the bottom.

Can prices go lower from here? Almost certainly, yes. But as Jeremy Grantham noted recently, ‘If stocks are attractive and you don’t buy and they run away, you don’t just look like an idiot, you are an idiot’. Further, it is worth reminding ourselves that whilst valuations may not matter for short-run returns (this is normally just a momentum effect), they are a primary determinant of long-run returns. On this score, markets are cheap regardless of near-term direction.

Whilst Montier’s article focuses on advanced markets, the case for investors in South African equities is no different. As evidence of this, the domestic market trades on a trailing price-earnings ratio of 8.8 times. Using our 50-year regression model, a trailing price-earnings ratio of around 9 times translates into an expected five-year average annual return of 25 percent to which can be added a dividend stream of five percent per annum.

Cheapness in the South African equity market is evident via other metrics. More than 70 percent of stocks listed on the South African exchange trade on a single digit price-earnings ratio; better than 45 percent of stocks offer a dividend yield greater than five percent; and 110 of the largest 250 stocks trade at less than net asset value. Finally, if these metrics require reinforcement, it is noteworthy that the domestic market trades on a Graham and Dodd price-earnings ratio of 13 – cheap by domestic and global standards.