Price and value are not the same

There is a difference between price and value. An asset may have a high price but be at fair value. In other words it is not necessarily expensive. Similarly another asset may have a low price. Its price may have even fallen in recent times but that does not necessarily mean it is cheap. Terry Smith, the highly respected manager of the Fundsmith Equity fund warns against the potential perils of so called “value investing” – buying stocks whose intrinsic values do not seem to be recognised by the market. Value investors buy expecting an upward revaluation. However if and when this occurs depends on market sentiment and unpredictable events. The risk is that low growth companies remain just that or their values deteriorate over time. In other words they were cheap for a reason and should have been avoided. Similarly Smith points out investors can confuse highly rated with expensive. The conclusion is that understanding price and value is essential when buying and selling as investors may make wrong calls if decisions are based on price alone.

The fact that S&P 500 recently reached a new high and technology stocks have made stellar gains have led some to conclude that the US equity markets are overvalued and prices could correct. This may be a misunderstanding as suggested below but even so I have some sympathy with the conclusion, albeit from a different perspective. It is about banking profits while you can. Take an investment of £10,000 that grows by 50% and is valued at £15,000 a year later. That £5,000 is a paper profit only. If markets fall by 20% the investment drops to £12,000. The profits fall from £5,000 to £2,000 a decline of 60% from their peak. It is not unreasonable to want to take risk off the table and crystallise paper gains by partial sales. What I advise my clients do depends on a variety of factors including their risk profile, their financial objectives, whether they need a cash injection now and their investment timescales. Sometimes it is better to do nothing and retain the profits to compound capital growth over the long term, ignoring the short term market noise and price fluctuations. There is a lot to be said for a buy and hold strategy, providing the fund manager hasn’t lost the plot.

In this blog I want to explore current equity valuations. A number of fund managers I have listened to and read recently have shed some light on the matter for me. One source was JP Morgan who produce an excellent quarterly guide to the markets, the latest was a 99 page document packed with charts and tables about the global economy and stock markets. One chart shows global forward price to earnings ratios. P/E ratios are a commonly used measure of valuations. The higher the ratio the higher the stock or index is valued. There are several measures of earnings that can be used. Arguably the use of projected forward earnings for a company or a market is more useful than historic data.

What the chart surprisingly showed was that at 30/9/18 forward P/E ratios were higher in the US, Europe (excluding the UK), Japan, the UK and emerging markets than they were a year ago and for all bar the US, valuations are below their long term average since 1990. Moreover US valuations were not excessively high. The long term average is 15.8x whilst at 30/9/18 the S&P 500 had a P/E ratio of 16.9x. (Source: JP Morgan citing FactSet, IBES, Robert Shiller and Standard & Poors). This means prices are 16.9 x earnings per share. I conclude the US is not cheap nor especially expensive whilst the fact that forward P/E ratios have declined in the last 12 months across the board means that earnings growth has accelerated faster than prices, therefore supporting the gains in prices. However JP Morgan did observe that global economic growth is less synchronised than a year ago.

The cheapest market based on a comparison of the long term average is Japan which is trading at a P/E ratio of less than 50% of its long term average. A word of caution though. The long term average in Japan is much higher than other markets I suspect due to a bubble in property and equities. Very high P/E ratios have skewed the long term average.

Finally turning to technology. You know you are advancing in years when fund managers look no older than your children. At a recent seminar I listened to Richard Clode, one of the fund managers of the Janus Henderson Global Technology fund who presented a compelling case for the tech sector. He was an impressive young man who clearly knew his stuff and communicated it very well. There is a lot going for technology. It is dynamic and innovative; technology companies lead the way in research and development, an attribute Terry Smith thinks is very important in stock selection. The terrific performance of tech stocks in recent years* has been driven by superior earnings growth whilst valuations are in line with the long term average. Large cap technology stocks have huge amounts of net cash estimated to be in excess of $285 billion at the end of July whilst non-technology large cap companies (I think in the US) had net debt of more than $60 billion (Source: Bloomberg, cited by Janus Henderson). That said Clode thought some technology companies are overpriced meaning stock selection is important. I conclude as long as tech stocks are cash generative and are growing their earnings then this sector has further to run.

Those who follow the markets know the FTSE 100 index has lagged the S&P 500 across the pond. In the last five years data from BBC News online show the FTSE 100 rose 12.8% (from 11/10/13 to 5/10/18). In contrast the S&P 500 rose 73.9% over the same period. This lesser known index is more representative of the US economy than the more famous Dow Jones Industrial Average. These return figures exclude dividends.

I had always thought the poor performance of the FTSE 100 was due to its heavy weighting in banks, oil majors and miners. These stocks have had massive headwinds since the great financial crisis and have delivered awful returns in the last 10 years. Whilst this is true what I hadn’t taken into account was that at 30/6/18 just 0.6% of the FTSE 100 index was represented by technology stocks (Source: Bloomberg, cited by Janus Henderson). According to CNBC in an online article on 6/8/18 26% of the S&P 500 was in technology. No wonder the S&P 500 has done so well whilst the FTSE 100 has been as exciting as a wet blanket on a cold January day. It is a lesson for UK investors who are too UK centric in their portfolios. Their home preference or bias, in part due to thinking Sterling was the place to be, to mitigate currency risk, fell victim to the unintended consequences of being underweight in technology.

*The average IA Technology & Telecoms fund has delivered a total return of 121.2% in the last five years whilst the average IA Global fund gained 67.3% (FE Trustnet, 10/10/18). Bear in mind funds IA Global sector include some technology stocks meaning if the non-tech returns could be stripped out the disparity would have been greater.

The content of this blog is intended for general commentary only and is based on my understanding of stock market valuations. Nothing in this article should be construed as personal investment advice. You should seek individual advice based on your own financial circumstances before making investment decisions.