For the last year, most commentators have been unanimous in their view on the world’s major equity markets. Stocks are a sell, they say, thanks to the fact that p/e ratios are in the mid to high teens, which is too high. I’m not convinced they are right. Earlier this year, when the index was in the 4,800 range, I suggested that the FTSE would not only break above 5,000, but that a reasonable target was 6,000. Today the FTSE is at 5,425.1, and I still think it is going higher.
Why? First because p/es in the mid-teens aren’t expensive, at least not when you look at them relative to bond yields. Stocks are only really expensive or cheap relative to the cost of money, not in relation to where they’ve traded in the past. And with the cost of money (interest rates) at 50-year lows, the fact that p/es are at long-run average levels makes them more cheap than expensive, particularly given firms are making record profit margins and have huge amounts of cash on their balance sheets.
The press haven’t really cottoned on to this yet and nor have many traditional investors, but other buyers have. A huge number of publicly listed firms are being taken private this year. They’re being bought by other (often foreign) firms, by private equity firms, and even by their own managements. Foreign takeovers of UK firms reached a five-year high in the third quarter of £12.3bn. Then, a fortnight ago, Spanish telecoms giant Telefonica guaranteed the fourth quarter will set a new record when it made a £17.7bn cash offer for UK mobile-phone operator O2. But it’s not one-way traffic. Third-quarter acquisitions of foreign firms by UK ones totalled a huge £19bn too.
At the same time, secretive hedge funds, such as Och-Ziff and Perry Capital, are backing an increasing number of high-profile bids and management buyouts (MBOs), only the most recent of which is the £3.40-a-share cash offer MBO (worth £405m) of clothing retailer the Peacock Group. However, the biggest new players in the new leveraged buy-out (LBO) market are the private-equity funds now borrowing and raising record amounts to finance acquisitions.
Back to the 1980s?
The most interesting thing to note about all these deals is how they are being paid for. Most aren’t being backed by paper in the usual share-for-share swaps; no, they’re in the rather more old-fashioned form of cash, usually financed by cheap debt. It’s as if the days of Gordon Gecko and his corporate raiders are back. Back then, however, things were slightly different. Interest rates were relatively high, so the raiders’ cost of borrowing cash was expensive and as soon as a target company was acquired, the asset stripping had to begin. By the time the raider had sold enough assets to pay back the loans and interest, he’d own whatever was left outright. As long as he’d done his sums right, this residual value could still end up bigger than his original sum and his fortune was made.
Today, the game is different. It isn’t so much the assets that buyers are after, but the existing cash flow from those assets. All the acquirers in the game today share an appreciation that while credit is freely available and cheap, it’s not nearly as cheap as the equity you can buy with it: right now, the cost of debt is much lower than the earnings yield implied by p/es. The earnings yield indicates the annual return a stock would generate if all the profit was paid out in dividends. Instead, companies often retain some of the profit for reserves or reinvestment – but as long as that investment is at least of average efficiency, no value is lost, whether the whole lot is paid out or not. Over time, earnings yields tend to range between a similar level to long-dated gilts and about half gilt yields.
But the present extraordinary circumstances give us a stockmarket earnings yield of more than 7% this year, 8.3% next. Stocks yield nearly twice what bonds do – something virtually unheard of in market history. This means buyers can take over firms and then, rather than selling assets to pay off the debts incurred in the purchase, use the target’s cash flow to do so. It’s also worth noting that even the dividend yield of 3.5% (the portion of the earnings that really is paid out) is very nearly the same as current bond yields, despite the fact that, unlike bonds, equities are storing some profit for future, offering capital growth and, best of all, are – at least theoretically – inflation-adjusted. No wonder the mergers and acquisitions (M&A) market is so healthy.
A new bull market
With so many ‘real world’ participants finding listed stocks irresistibly cheap, you’d think, as Mike Foster points out in Financial News, that people would be beginning to believe in a new bull market. But most still don’t. Instead, the consensus view favours labelling 2005’s gains as a bear market rally. A recent survey of pension fund managers reveals, for example, that unlike last year, they no longer expect double-digit returns from equities over the next decade. The average expectation is now for just over 8% a year.
Yet with expectations for bond returns at an even less punchy 5.5%, that puts the pension funds in a tricky situation: they need to make a ten-year annual return on assets in excess of 10% if they don’t want to end up not being able to meet their obligations. No wonder then that they say they plan to try to bump up returns by putting more and more money into alternative strategies, such as private equity. The irony, of course, is that in the current environment, the private-equity funds the pension funds plan to invest in could well redirect those funds straight back into the same stockmarket that the pension fund had taken money out of. By not investing in equities, but instead putting their money into private equity, they are simply adding in a middle man. It’s time that they wised up.
What the bears say
In the bust after a big stockmarket bubble, such as the one we saw at the end of the last century, valuations usually overshoot to the downside. Most investors think that this means they should hit something like ten times (this is mainly because the average p/e fell to eight times in 1982, just before the start of the market’s longest-ever growth phase). So because the FTSE’s p/e has not fallen much further than 14 times since the excesses of the dotcom bubble, the bears think that the market has not yet completed its sell-off to sufficiently low multiples. That means, they say, that there must be further falls to come.
On top of that, argue the pessimists, profits margins are near record highs and can only come off from here. Worse still, with the world’s economic growth now looking like it could stumble, we could see the UK and most other major trading partners, including the US, revising economic growth down by 1%-2% soon. Also, rising oil prices will push inflation and bond yields up too. It will all, we are told, end in tears.
Why the bears are wrong
Price/earnings ratios are not too high. And this isn’t only the case for interest-rate adjusted p/es, it’s also the case for straight p/es. In fact, the FTSE is cheaper in terms of its multiple than at any time since 1991 (just after the fall-out from the 1987 crash). The average p/e for the last 12 years or so has been about 20 times. Today it’s just 14 times. Indeed, looking out over the next 12 months, the multiple drops to just 12 times. The market hasn’t seen multiples consistently below 12 times since the late 1980s, when ten-year gilt yields were above 10% and short-term interest rates went to 15%, making shares with their much lower yields look pretty unattractive. It seems preposterous at first blush that equities cost no more now than they did then. We can therefore say with impunity that stocks, compared to their past valuations at least, are cheap.
That, however, is not the same as saying they will go up. Note that in a completely efficient market, all stocks would be at their very cheapest at the top of their earnings cycle. Savvy investors start to sell in anticipation of profits turning down and the p/e falls even as the earnings per share (EPS) rises. With profit margins at near-record highs, there’s every reason to suspect that profits can’t rise much faster than the rate of economic growth from here. And unfortunately, economic growth is stalling and already looks as though it might come in a full two percentage points below Gordon Brown’s target of 3.5%.
Still, economic growth is not the same thing as stockmarket growth. Warren Buffet argues that if you split the last 100 years in the US between those periods that saw strong growth and those that saw flat growth, all the market gains are actually to be found during the latter periods, thanks to the fact that interest rates tend to fall in periods of low growth. This is supported by recent studies from ABN Amro that show that low-growth, developed economies’ stockmarkets give better returns over time than high growth, developing nations’ stockmarkets.
Look at it like this and it is clear that the swing factor for the market at the moment is not the economy or profit growth, but interest rates. Currently, there are concerns in the market regarding imported and late-cycle inflation pressures, but if the economy continues to perform badly (as it no doubt will) bond markets will soon start pushing long rates down, despite the fact that they are already at record lows. And, as we have shown, falling rates (and hence bond yields) are good for equity valuations.
The long view
Finally, I want to look at where today’s stockmarket sits in relation to its own past. The market has had a good 60% run-up since its 2003 lows. Such moves make people nervous, as they make them think that there will now be plenty of scope for profit-taking. But they forget that the market isn’t even back to the level where the sell off started. When the oil shock hit in 1974, it took stocks five years to get back to the previous peak. When the 1987 crash hit, it took two years. So far, since the really rather localised and relatively insignificant dotcom bubble peaks, the market has already taken six years and still needs to rise another 18% before it’s back at those highs. In other words, in classic bull-market terms, we’re climbing a wall of worry. Everyone feels nervous about the market, despite the fact that all factors look about as good as they get.
Look at a 44-year chart of the FTSE All Share. By its 2000 peak, the All Share hadn’t even hit a very long-term overbought peak (not like it was in 1987, for example). Two thousand was only one standard deviation above the trend. But by the 2003 lows, the market had been sold down to levels well below its trend. Precious wonder it bounced from there.
What’s really interesting now though is that because the market had sold so low back in 2003, and because the trend over time is always rising too, the rally since 2003’s lows has still not taken the market even back to the trend (which, incidentally, is a good 40% above here). It would appear that the LBO experts have the right idea about the stockmarket after all. Even though stock prices are a good deal higher in nominal terms than they were three years ago, in so many other respects they haven’t been this cheap for decades. Don’t let anyone tell you otherwise.
A mania for mergers and acquisitions
With his catchphrase “greed is good”, Gordon Gecko, the character in the 1980s film Wall Street, would be drooling over the profits to be made in the current mergers and acquisition frenzy. This year in Britain alone over £67bn worth of deals have been completed. Since January, 512 deals targeting UK firms have been announced – the highest figure for the time period since the glory days of 2000. And on 31 October alone takeover bids for four British firms with a combined market capitalisation of more than £23bn were launched. It all adds up to a phenomenal level of activity and some huge profits. And relatively easily made profits too. Back in the 1980s, borrowing money was an expensive business, so raiders had to strip assets fast to pay back debt borrowed at double-digit rates. This worked – the fortunes of tycoons such as Lord Hanson and Sir James Goldsmith were made in the process – but as asset stripping tends to come with business closures and large-scale redundancies, it didn’t make the raiders popular. But this time round, with rates at 4% in the US, 4.5% in the UK and 2% in the eurozone, the nature of the deals has changed. The corporate world has been restructuring and cost cutting for several years and is now awash with cash: today’s raiders just look to pay off their debts with their target’s cash flows.
The very fact that the market knows that there are bidders about in the market is supportive, but there is more to it than that. When a company is taken private, the supply of shares available to investors falls, but at the same time demand rises as investors look to reinvest money they have been paid for their shares in firms that have disappeared from the market.
The stocks to buy
In a bull market, most stocks tend to rise, but that doesn’t mean investors should be entirely indiscriminate in their buying. At the moment, larger companies look better value than smaller firms, so it’s worth looking around at the top end of the market. Globally, I’m still keen on the companies that provide the heavy plant employed by the big mining firms. Deere & Co, Caterpillar, Bucyrus International and Tokyo-listed Komatsu all seem like good buys. The big pharmaceutical companies also look reasonably valued, as do Shell and BP – I’ve said it before, but it remains true that while you can get such good value from these large caps, there is little point in buying into riskier oil tiddlers. Otherwise, in the retail sector I’d point to both Tesco and M&S as still having the potential to make further gains, and to the reinsurance sector, where premiums are bound to increase in the wake of Hurricane Katrina. Both Swiss Re and Munich Re look good to me.
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