I believe the fundamentals of equity investing remain unscathed and investors should learn eight key lessons.
By Kevin Murphy
Published: 7:31AM BST 26 May 2010
During the past 18 months we have seen unprecedented economic events, but I believe the fundamentals of equity investing remain unscathed and investors should learn eight key lessons.
LESSON ONE: PATIENCE IS A VIRTUE
Market sentiment can create exceptional opportunities for investors with patience. At times of market ''panic'', share prices fluctuate far more than underlying fundamentals of many businesses warrant. This creates great opportunities.
There have been many bargains over the past 18 months, Next is a particularly good example. The retailer saw share prices fall from £24 at the peak, to £8 at the trough.
This reflected investors' fears about global recession, but Next seemed a robust company with low net debt and unlikely to go bust. With shares seemingly trading at a low of four times normalised earnings this was a chance to acquire a quality business at a low price. Shares have shot back to more than £20.
LESSON TWO: IGNORE ECONOMISTS
While fund managers are frequently asked their economic views, macro-forecasting is notoriously difficult. The process relies on predicting a range of interrelated variables.
The number of economists proven wrong during this crisis highlights the scale of the challenge. There is little point forecasting economic outlook or using macro-forecasts to determine company values.
Economic growth often has an inverse relationship with subsequent stock market performance.
Research from the London Business School shows stock market returns are no higher in countries with high GDP growth and countries with low GDP growth can exhibit the best stock market performance.
This is an intuitive trend. Stock markets are discounting mechanisms that always look forward and equity markets can rally even while economic growth remains low.
LESSON THREE: CHEAP IS BEST
If macro trends are not the best indicator of stock market returns, valuation remains the surest guide to future investment performance and data illustrates that buying securities on low valuations gives the best opportunity for future returns.
Buying shares at around 5-10 times earnings, would usually see annualised returns for the next 10 years of more than 10pc. In contrast, buying shares on 25-30 times would see extremely disappointing future returns.
LESSON FOUR: GOOD COMPANIES ARE NOT ALWAYS A ''BUY''
Buying a ''good'' company at the wrong price can seriously affect overall returns.
GlaxoSmithKline, a very good company, generated earnings per share of about 50p in 1999-2000 and was trading at around £20 – equivalent to 40 times earnings.
Despite good earnings growth, it did not offer good value at that price. Ten years on, earnings have doubled while the share price has halved. The stock is more attractive now.
LESSON FIVE: IT IS THE AVERAGE THAT COUNTS
Peaks and troughs are part of operating and share price performance, but there is a tendency to revert to averages.
Companies with high profits are unlikely to generate that growth forever and companies with low profits are unlikely to be stuck in long-term ruts.
When valuing companies, strip out peaks and troughs and look at average long-term earnings potential – the intrinsic value or ''normalised'' profit potential.
Barclays' share price was about 700p in 2007, with earnings per share (EPS) of 70p. However, EPS looked unsustainably high given a ''normalised'' earnings estimate of 45p per share.
Mean reversion worked its magic and by April 2009 earnings forecasts dropped to 12p per share and shares to 50p.
Barclays faced obvious pressures, but this seemed a good company whose long-run earnings potential did not appear to have changed. The shares seemed to be trading at just one times normalised earnings – a low valuation that has corrected significantly in the past year.
LESSON SIX: DIVIDEND HISTORY IS KEY
As investors search hard for yield, it is important to note companies' long-term ability to pay dividends, rather than being swayed by short-term distributions.
Some utility companies need to increase their debt every year in order to maintain their dividend at its current level.
Conversely, a company such as AstraZeneca looks to be generating £8-9bn net cash each year, and is paying around £4bn in dividends. This is clearly sustainable and also gives the company flexibility.
LESSON SEVEN: SIZE DOESN'T MATTER
Tracking error (how different a fund looks from its benchmark index) is a widely used ''risk'' measure, but it is inappropriate to assess portfolios on this alone. Not owning a large FTSE All-Share constituent like British American Tobacco results in a higher tracking error and, theoretically, a higher 'risk'.
However, is it more or less 'risky' for investors to buy a company simply because it accounts for a large proportion of the index, and potentially overpay?
It is preferable to assess investments in terms of absolute risk, looking at
- valuation risk (the risk of overpaying),
- earnings risk (the risk earnings decline over time) and
- financial risk (the risk of insolvency).
If an investment's potential returns significantly outweigh the balance of risks, it should be viewed as an attractive long-term opportunity, regardless of index size.
LESSON EIGHT: DON'T FOLLOW THE HERD
Willingness to go against the crowd (and for your fund to look different to the index) is fundamental for generating superior long-term returns.
Given ongoing search for yield and the disappearance of the banks as major dividend payers, many income funds have been forced into a smaller set of high yielding stocks. In many cases, these are among the biggest stocks in the market – names like BP, Royal Dutch Shell, BHP Billiton and Tesco.
This trend has left many funds in the income sector clustered in just a handful of stocks. This is not the way to produce superior performance.
Kevin Murphy is the manager of the Schroder Income Fund