Equity markets look expensive on almost any measure of valuation, according to Ian Lance and Nick Purves, who manage the RWC Enhanced Income fund.

"Equities are priced for roughly 5 per cent nominal returns, which is better than bonds at the moment but below the long-run average return and not fantastic given the amount of volatility that you are likely to see," said Lance.


The comments are surprising given that fund managers are often charged with championing the asset classes they manage.

Lance continued: "The first component of equity market returns is dividend yield. Yields on both UK and US equities are currently lower than [4 per cent] average."

"The second component of your returns is earnings growth, which comes from the market. Clearly we know that an awful lot of debt has been added to the global economic system over the last few years."

"This suggests we are going to go through a period of deleveraging which is likely to lead to lower-than-average growth in earnings."

"The final component of your returns is the shift in valuation over time. At the moment valuations are above average. You often hear people say how one-year forward P/Es look cheap relative to their long-term average."

"What that tends to ignore is the fact that earnings are very elevated. Shiller P/E, a more stable measure of valuations, shows that the US and UK are trading above their long-term averages."

Data from FE Analytics shows that RWC Enhanced Income has returned 2.79 per cent since it was launched, in October 2010, compared with a return of 7.42 per cent from the FTSE All Share.

The fund’s defensive characteristics aided performance in 2011 and it lost only 2.57 per cent during this time, compared with 3.46 per cent from the benchmark.

Performance of fund vs benchmark in 2011



Source: FE Analytics

Despite the low expectations for equity markets, Lance says there is little choice for investors since few other asset classes are likely to offer strong returns.

"We’ve just been through a period where interest rates have been cut to virtually nothing, money is being printed all round the world and you shouldn’t be surprised that lots of different asset classes are being pushed up at the same time."

Against this backdrop, and up against wider risks from the eurozone, China and beyond, Purves says that cheap stocks are hard, but not impossible, to find.

"Whilst we think there is some value out there in some areas, we’re not going to pretend for one second that that under-valuation is particularly widely spread. These are challenging times no doubt."

"Not withstanding the environment, investors are still entitled to expect a high single-digit return from the shares that they hold, with a reasonable level of volatility."

"We look for companies with a dividend yield of around 4 per cent where that yield is well covered and there is a degree of stability."

"We think there is value in areas such as pharmaceuticals, telecoms, some of the big oil companies, technology companies and also insurers."