Why buy equities?

An alternative view can save your clients considerable pain and result in a much better market entry point. As opposed to thinking about growth consider the view of accessing underlying corporate earnings of companies. This perspective leads me to ask what is the right price at which to gain such access (where is value) and one simple indicator is the price earnings ratio (PE).

A simple example is an investor paying £1 for a company that has earnings of £1 will recoup the initial investment in one year, PE of 1. However, as the price increases so does the time it takes to recoup the initial investment and the risk of some disruption to the company’s earnings increase, would you want to wait 30 years to recoup your investment?.

Now the irony is that as PE’s decrease, much quicker than any contraction in corporate earnings and effective value increases typical private investor’s fear of investing in equities increases. I suspect a large contributor to the fear is a lack of understanding or more likely just a lack of thought of the link between growth and the corporate earnings.

Current PE ratios of major world indices

Major world equity indexes and price earnings (PE) ratios
Equity Index	Average PE last 5 years	Est. current year PE	Projected next years PE
Dow Jones	16.89	11.99	10.76
S&P 500	19.57	13.08	10.36
FTSE 100	16.41	9.75	8.58
DJ Euro Stoxx 50	13.48	8.40	7.38
Nikkei 225	22.39	79.13	27.11
Hang Seng	14.43	10.66	9.35

Source: Bloomberg, 13 February 2009

The table identifies current PE’s are lower than the average of the last five years and simplistically offer better value for money over the historic levels, but I suspect you found it easier to persuade clients to invest when PE’s were double the current levels, when risk was significantly greater.

I’m not suggesting this is the bottom of the market as I’ll leave that to the gamblers and there are many ways to reduce the risk of markets decreasing further before they rise but that’s for another article, what I am suggesting is you consider value for money.

By the way, to believe equity markets are not going to rebound over the long term is to believe that companies will not make future profits and if that occurs there is no reason for them to exist and no earnings to honour corporate bonds or pay wages which in turn drive other investments such as housing and art.

Wayne Ellis is sales director at Merchant Securities. The view expressed here is his own.