We are in the seventh year of a bull market, one of the longest in history. But bull markets don’t die of old age. So, what risks have developed during this run? 
Over the last six years, valuation has increased. The most widely used valuation tool is P/E ratio. This compares a company’s value with its profits; the share price divided by its annual earnings per share.
The lower the ratio the cheaper the share. On this measure the UK market stands at a P/E of 15x, above its long term average.
Given the global hunt for yield, equities offering growing income now sit on particularly high valuations, for example, consumer staple stocks are currently on a P/E 18x. This includes many well held shares such as Reckitt Benckiser, Unilever and SABMiller all trading on a P/E above 20x.
These shares are perceived as ‘safe’ yields. While the income may well be safe, one must not overlook the capital return. I am a value investor and I strongly believe risk must be viewed in the context of the price paid – expensive shares are risky shares no matter how ‘safe’ the dividend or how high quality the business model. Pockets of valuation risk have appeared in the market.
Another risk has emerged more recently. Dividend cover across the market has declined dramatically.
The dividend cover is calculated with reference to the profit a company makes. However, profit is an accounting term, it does not equal cash flow. Dividends are paid out of cash flow not profit. So the situation is even worse in cash flow terms.
In particular, many of the high yielding shares are paying their dividends out of debt not cash flow. These include all the utilities, large oil shares and some miners.
The following all yield over 6 per cent: Anglo American, Glencore, BP, Shell and SSE and are paying their dividends out of debt. Not all of these companies will cut their dividends, some can sustain increasing their debt for a while but it does present a risk.
Those most likely to come a cropper are those that have limited capital expenditure flexibility. Six FTSE 100 companies have cut their dividends this year and in high yield areas there is the threat of further cuts.
Bad balance sheets and expensive shares don't necessarily trigger bear markets. Historically, bear markets tend to be triggered by liquidity contraction, policy, inflation or external shocks. However, these issues can increase volatility.
Is there any good news?
Although it is difficult to tread between valuation and balance sheet risk in large capitalisation stocks, further down the market capitalisation spectrum there are still plenty of opportunities.
In particular, in many shares exposed to domestic UK consumer spending whose increased returns visibility has not been fully recognised. Also, with higher markets comes more M&A activity and a number of shares are making some sensational, value enhancing bolt-on deals.
There are lots of opportunities to make meaningful returns. However, stock by stock divergence could increase – make sure you are sitting on the hidden gems, not hidden horrors.
Georgina Hamilton is co-manager of the CF Miton UK Value Opportunities fund. The views expressed above are her own and should not be taken as investment advice.
The £378.1m fund, which see runs with FE Alpha Manager George Godber, is second out of 266 funds in the IA UK All Companies sector since launch in March 2013 with a 56.70 per cent total return, against its average peer’s gain of just 17.16 per cent.
Performance of fund vs sector since launch
Source: FE Analytics
It aims for long-term capital growth through investing mainly in stocks that the managers consider to be undervalued by the market. Its top holdings include Tullett Prebon, Bellway, Lookers, Barratt Developments and WS Atkins.