The Case for Equities and How to Invest

“Quality is never an accident, it is always the result of intelligent effort” (Ruskin)

There appears to be at present a major discrepancy between quality and value – which reminds me of the Oscar Wilde quote that “a cynic knows the price of everything but the value of nothing”. As I highlighted in a prior post, What’s Driving the Markets and How Should I Invest?, investors have seemed to push up the price of lower quality companies, leaving an opportunity to invest in companies of higher value with upside potential of reversing its underperformance versus its index. I will now show how despite there being question marks over the value of the wider equity market versus its long-term average, against other asset classes the investment case looks strong – and there’s much cash waiting on the sidelines! Just remember – Quality, Quality, Quality!

Valuations may be unconvincing…

As you can see from the above chart it is arguable that relative to its long-run average, the equity market is fairly priced to slightly over-valued. To explain, using the same great blogger who sources the chart , the avid “Charter” of financial data, Doug Short: “The Q Ratio is a popular method of estimating the fair value of the stock market developed by Nobel Laureate James Tobin. The total price of the market divided by the replacement cost of all its companies. The mean-adjusted chart above indicate that the market remains significantly overvalued by historical standards” — 41% to 52% (depending the version of calculation you choose).

… But risk premium is stretched…

US Cyc-Adj Earnings Yield (Non-Fin) vs. US Real Return on Cash (%). Source: Capital Economics

Despite my point on valuation, the above chart shows how little all the cash sitting on the sidelines is earning their investor and in stark contrast to the earnings yield some equities could be providing instead – a mighty enticing motivation to invest.

… the Case for Equity versus Bonds Strengthens…

Ok, so what about bonds? Surely that would be an equally enticing move? Perhaps better on a risk return basis? Actually no. The superior yield equities can offer versus bonds is well- exemplified in the chart below, from Jesse Felder in his contribution to Seeking Alpha, By One Measure Stocks Are Cheapest in Over Half a Century.

This highlights not only the motivation for a move from cash to equities, but also a switch from government bonds to equities. When discussing earnings yield it is interesting to remember Warren Buffett’s quote that: “earnings can be pliable as putty when a charlatan heads the company reporting them”, lending support to my focus on quality companies which includes the requirement of good management.

I showed in my previous post, How to Play the Bond Markets, how the case for bonds is no longer a “broad-based trade” and investment grade spreads are now 63% narrower than at their 2008/9 peak and now below 2002 levels.

… And it’s Not the Time for High Yield

Moving on to high yield, credit appears to have recovered much more than equities. The below chart (which will be uploaded tomorrow – an exciting insight from Merrill Lynch) shows that the last time high yield (called high grade (HG) in this graph) spreads were near 200 bps, the S&P 500 was between 1,400 and 1,500, vs. only 1,181 currently (20/10/10). (To keep this post short and snappy, I will explore this in more detail later)…

INVESTMENT INSIGHT – How to Invest

As previously expressed, this has been a low quality rally, driven by low quality, high beta names (exemplified in my chart showing US Consumer Discretionary which should be the most affected in a recession driving increases in the wider market) – Therefore active management remains key – sector and stock divergence

This is a ‘stock-pickers’ market. Invest in high quality companies (strong balance sheets, cash flow rich) which have the upside potential to re-rate to their intrinsic value and having underperformed during the periods of market over-exuberance.

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