Stocks may be pricey, but they have further to go – canny investors should continue to buy the least-bad asset class, says Jonathan Compton.
Type “equities are expensive” into your browser. You’ll get 1.28 million articles – from investment analysts setting out historical proof, to “shock jocks” advising the purchase of a shotgun and a bunker for the coming crash. This urge to forecast a crash was particularly evident last month, as the yield on ten-year German government bonds “soared” from 0.05% to a high of 0.78%.
The reality (apart from the yield going from nothing to almost nothing) is that this mirrored a bounce in the oil price, which should be temporary – the world is producing about 2.5 million barrels a day more than it needs.
There is certainly a good case to be made that equities are overvalued. But my hunch – and there is much evidence to back it – is that the pundits will again be proved wrong. We do not live in normal times. Since 2008, financial rectitude has been thrown to the winds, amid money printing, currency manipulation and interest-rate suppression. As a result, equity-market dynamics have changed dramatically. Funds flowing into equities overall are rising, while supply is shrinking. So prices can only go one way.
Seemingly dry technical factors are key here. Take share buybacks. Company balance sheets groan with cash. Globally, from 2010 to 2014 the amount of cash held rose by 25% to $1.6trn. Because global growth (and thus demand) has been relatively weak, there has been little need for new investment. So bored finance directors are playing the stockmarket via huge buyback schemes, driving up share prices – in America, firms with big buyback plans have beaten the index by 6.5 percentage points over the last year. UK companies have around £60bn – nearly 4% of GDP.
Their finance directors have joined the party too. These buybacks reduce the total number of shares in issue, a shrinkage compounded by a surge in takeovers. In 2014 global mergers and acquisitions grew by 47% to $3.3trn. Some were all-paper bids, swapping shares in the bidder for the target, but many more were a mix of shares and cash, such as the current bid by Shell for BG. Others are all cash. The last two reduce the shares in issue.
Stockmarkets contain self-correcting mechanisms. As investors become cheerier and share prices rise, firms take the opportunity to issue new shares. Private-equity groups also sell out to take advantage of high valuations. As this flood of ever-more expensive paper swamps demand, share prices fall. And so far we’re following the script – globally, equity issuance has surged with high equity prices. In the first quarter of 2015, new issuance rose by 20% to $232bn.
In 2014 it rose by 66% to $625bn for the eurozone, Japan, the UK and America – the highest ever, save for the peak of the technology boom. So doomsters are right to flag this – when companies dump their own shares in unprecedented quantities, caution is advisable.
Yet this ignores a crucial point: these figures are on a gross basis. In 2014 buybacks amounted to an unprecedented $950bn. So at the net level, the paper in issue on this measure alone shrank by $325bn – the frenzy of share issuance has been more than offset by buyback mania. Also, another once-vast source of supply has dried up – privatisations. After BT listed in 1984, governments globally sold utilities, roads, banks and any other assets they could find behind the sofa. Today there is not much left.
Other factors steadily cause the number of shares in issue to be locked up or to diminish. One is the desire by many shareholders to reinvest dividends. Corporate dividend reinvestment plans have a net-zero effect because firms issue new shares in lieu of dividends. But investors seeking capital growth will reinvest this income, providing a constant flow of new money.
Bankruptcy is another factor. When a listed firm disappears, the number of shares in issue shrinks. Ultra-low interest rates have kept many otherwise doomed businesses alive (hence the moniker, “zombie companies”). Yet listed firms continue to expire, especially smaller ones.
Just look at Aim – littered with twitching corpses due to bad management and a high percentage of over-borrowed miners and tech stocks. The result is further shrinkage. Measuring the extent of growth or contraction in the number of shares in a given market can be remarkably useful for predicting turning points.
Between 2008 and 2012, China’s new issue market was on fire. The amount of new paper rose by an average of 9.7% a year. Over the same period, the amount in Germany shrank by 3.4% a year. Although just one of several causes, it is no surprise that, during those five years, China’s stockmarket performance was dire, while the German market trundled higher.
What else is driving this bull market?
Yet there is far more to this prolonged bull market than technical factors. A key issue is interest rates. For all the brouhaha about rising German yields, rates are likely to be suppressed by central banks for far longer than expected. When bond yields are zero, logically the multiple on equity markets should be infinite. While theory ignores reality, the principle holds true that markets should be trading at record multiples and valuations. They are not.
Then consider the flow of funds and cash levels. Despite rising markets, equity fund inflows have been muted over the last two years – large-cap domestic funds in America have even seen net outflows. This suggests many investors have missed out on the bull market – inevitably they will join in higher up. Cash levels are also high. In 2014 institutional and hedge-fund returns were the worst in eight years relative to the indices and their own history. Many have been holding cash, expecting a steep correction. This has not happened – they too will be “forced” to buy.
Professional investors and analysts have been wrong-footed because of poor earnings forecasts. In 2014 the published forecasts by investment banks were the most inaccurate – overly cautious – for the last 20 years. For 2015 they are also cautious – estimates are being lowered further. Maybe they are right, but companies are proving adept at squeezing costs and maintaining profit margins.
Any effort to guess where markets are going inevitably circles back to quantitative easing(QE) and interest rates. Commentators have long obsessed over when US rates would rise, given a stronger economy – yet the signs are that this is fading. Federal Reserve boss Janet Yellen has been forecasting a rise since she took office and may even announce one. Yet it would be reversed quickly, given that it would hit economic growth – especially before a presidential election year. QE will continue in the eurozone – after all, it only just started last year.
As in America, the economic effects will be muted, but it will be significant for equity and house prices. Japan has no realistic choice but to keep it going, while the government-induced stockmarket surge in China will do nothing to halt financial implosion from the property market – it too will pursue easing policies (it already is). QE is like the Hotel California in The Eagles’ 1970s hit – “you can check out anytime you like, but you can never leave”. And the citizenry likes it – seemingly, it has no cost and it makes borrowing cheap. So the taps may stay open for several years.
Every ageing bull market such as this one produces commentators best remembered for forecasting blue skies just before the lightning strikes – so I pray to St Warren de Buffett that it hits someone else. Corrections are inevitable. Yet overall, the ingredients remain appealing: incontinent central banks, QE and suppressed interest rates; the vast sums of money sloshing around the system; incredible shrinking markets in terms of the number of shares facing rising walls of cash; fruity but not extreme valuations; and excessive pessimism.
Finally, what are the alternatives? Zero-yielding government bonds? Often surreally priced residential and commercial property? Cash deposits paying nothing? Or commodities, most of which will remain in a prolonged bear market? I will continue to buy the best – or least-bad – asset class. Stay long.
Four stocks to buy now
It’s unfashionable, but a key principle of investment is that, when you buy shares, you lend a company’s management your capital, so you should expect an annual rent – or dividend. The yield does not need to be particularly high – often a very high yield is a sign that a company is about to cut its dividend.
But a steady or preferably progressive dividend policy is a sign that management recognises that it exists to provide not just an ephemeral capital gain, but the certainty and discipline of rent for shareholders’ capital.
Moreover, as dividends can only be paid from real taxable profits in most countries, they are a sign of financial health. So my tips below combine a yield of above 2.5%, covered at least 1.5 times by earnings in a business that is unlikely to vanish because of new technologies, or a sudden move in exchange or interest rates. In the UK, there are two companies (which I own) that fit these criteria. The first is Direct Line Insurance Group (LSE: DLG), which specialises in domestic motor and home insurance.
The current 4.1% yield is covered 1.8 times. The other is ITV (LSE: ITV), which still yields over 3.5% and I believe will eventually be absorbed by another media group. Overseas, I would like to own the largest North American soft drinks company you have never heard of – Canada-listed Cott Corporation (TSE: BCB). It is number three by volume after Coke and Pepsi. The management has tended to overhype its average performance, but it should be able to raise margins from the derisory current sub-1%. The yield is 2.7%.
I remain a happy holder of Australia’s Treasury Wine Estates (ASX: TWE), which rejected a takeover bid last year then announced overstocking problems and weaker-than-expected sales to China. But a declining Australian dollar and climatic advantages make it an interesting growth story. It yields 2.6%.
• Jonathan Compton spent 30 years in senior positions in fund management and stockbroking.