FE Analytics shows the FTSE All Share has risen 60.16 per cent over the past five years, while the blue-chip FTSE 100 has gained 55.19 per cent and is currently around the 6,660 mark following a sell-off.
Several investors expect the FTSE 100 to break the psychologically important 7,000 point barrier by the end of the year.
But not all are convinced that UK equities face a continued uphill march, with FE Alpha Manager Mark Slater saying that the market could be hit by a 10 per cent correction over the coming six months or so while Rathbones’ David Coombs, also an FE Alpha Manager, expects markets to have a “shake-up” in the next couple of months.
Performance of indices over 5yrs
Source: FE Analytics
Murphy, co-manager on the £1.5bn Schroder Income and £630.3m Schroder Recovery funds, says concerns such as these are leading clients to ask how the funds’ value-driven approach can find new stock ideas.
He says the short answer to this question is “the same way as ever”, adding that using the cyclically-adjusted price/earnings (CAPE) ratio is a good place to start.
The CAPE ratio makes use of a 10-year rolling average earnings series to smooth out the peaks and troughs of the corporate earnings cycle and Murphy says it supports the argument that what an investor pays for an asset is the the biggest driver of future returns, not the growth that follows.
“A near-century of data is telling us is that, if you buy the market when it is cheap, history suggest you will make some very attractive returns – for example, 11 per cent a year for the decade after buying in at a valuation of 7x or less. As the market grows more and more expensively valued, however, the returns indicated by history become lower and lower and eventually negative,” he explained.
10yr annualised return by starting CAPE
Source: Global Financial Data and Thomson Datastream, as at 30 June.
Based on UK equity market since 1927
Murphy added: “We are not suggesting for one moment there is any great science or magic involved here – after all, the chart is only saying that when the market is cheap you should buy and when the market is expensive you should sell. The trouble is, there is always someone who will come up with a plausible reason why the chart should be ignored – why ‘this time it’s different’.”
“So when the cyclically-adjusted P/E ratio of a market, sector, region or stock has it sitting on the left-hand side of the chart, there will always be some very scary reason why you should not venture there – just as there will always be a new paradigm, dynamic or whatever that means you should become super-excited about a particular investment even though it is valued towards the right-hand side.”
So where should investors be looking now? The manager notes that the FTSE 100’s CAPE ratio is currently around the 14x mark, as seven years of profit growth has offset the fact it is approaching record highs.
This valuation is a far cry from 27.1x that was seen when the index reached its all-time high in December 1999.
The historical CAPE data cited above suggests investors could make a reasonable real return from here of about 5 per cent a year over the next decade, after inflation, from the current valuation, Murphy says.
It must be noted that past performance is no guaranteed indicator of future returns, however.
Murphy also points out that the market has a spread of valuations from which investors can pick, following the market distortions created by the loose monetary policy of the US Federal Reserve, the Bank of England and other central banks.
This has pushed the valuations of lower-beta equities and ‘bond proxies’ to expensive levels.
On the other hand, the manager added: “There are companies that are not paying a dividend and in which the market has little or no confidence – with the banking sector ‘public enemy number one’. Standing alone in our left-hand sub-7x valuation bucket, banks remain by some distance the cheapest sector in the UK market – cheaper even than tobacco stocks were in 2000 – even though, to our minds, they are decent businesses.”
The five FE Crown-rated Schroder Income fund, which Murphy manages with Nick Kirrage, has two banks in its top 10 holdings – HSBC and Barclays.
Barclays also appears in the managers’ Schroder Recovery fund, alongside Royal Bank of Scotland (RBS).
Performance of stocks vs index over 7yrs
Source: FE Analytics
Barclays is a well regarded banking stock, with brokers such as Investec, Deutsche Bank and Numis placing a buy rating on the stock.
Although some analysts have a neutral rating on the bank, none of the majors view it as a sell.
Despite this, the stock has underperformed the FTSE 100 over the most recent market cycle after investors fled the sector in the aftermath of the financial crisis and proved wary to return because of ongoing risk from regulatory crackdowns.
Over seven years Barclays is down 50.32 per cent, according to FE Analytics.
Shore Capital Stockbrokers says the valuation case for the bank looks attractive and says it is making steps in the right direction to turn its business around, although “there is still plenty more work to do”.
RBS, which had to be bailed out during the financial crisis and is 81 per cent owned by the taxpayer, has fallen 91.43 per cent over the market cycle while HSBC is the best performer of the group with a decline of just 1.61 per cent.
Other fund managers have argued that HSBC’s relatively better performance means that it doesn’t offer the value it once did.
Income veteran Neil Woodford recently sold HSBC from his £2.6bn CF Woodford Equity Income fund, suggesting that the growing size of regulatory fines hitting the industry could start to impact banks’ ability to grow their dividends.
“I’m not suggesting that HSBC is a bad investment but in the light of this growing risk, I now view the shares as broadly fair value,” the FE Alpha Manager concluded.
