|Summary: While the market appears to have run ahead of valuations, expectations of further earnings upgrades will drive intrinsic values higher and spur share price gains for high-quality companies.|
|Key take-out: The market for quality companies is now more expensive than it has been at any time since the GFC.|
|Key beneficiaries: General investors. Category: Portfolio management.|
So is the market really cheap or expensive?
I have seen a great deal of research explaining whether the market is currently cheap or expensive. In most instances the research is price based.
For example, using average price to earnings ratios (PE), some investors claim the market is about fair value. Some analysts use historical PEs and others use forecast PEs, and others point to the very popular statistical S&P 500 valuations based on the Shiller PE Ratio calculation known as CAPE. This model uses earnings calculated as a 10-year average.
The problem I have with many of these ‘valuation’ approaches is not the same criticism held by those who criticise the Schiller PE, for example. My issue relates to the fact that a valuation must be completely independent of the price. A valuation should be used to compare the price. If the valuation has price as an input, you are simply comparing price to some other form of price.
This is possible in the supermarket, where the price in one store can be compared to the price in another store. But in the stockmarket there is only one price. Therefore, it must be compared to something else, and I propose comparing it to ‘value’ or ‘worth’.
It follows then that the least informative commentary about whether the market is expensive or cheap is the commentary that observes the stockmarket is well down from its highs. Not only could profits have changed since then, but so could the components of the index and even their weighting.
Now, to be clear, I don’t see much need to forecast the stockmarket and you won’t ever find me publicly suggesting the S&P/ASX 200 will be at such and such level by December 31.
You can be a successful investor in the long run without being a successful market or economic forecaster. Instead, what I do is estimate future intrinsic values based on company profitability justified by fundamental values. Unlike forecasting the entire market, and all the possible influences including sentiment, it is possible and practical to assess an individual business. Then, from the compilation of facts, an estimate of past, present and future valuations is possible – something I introduced to Australia. Obviously, it is not possible to be precise – by its very nature intrinsic value is an estimate – but it is possible to produce a reasonable range of probabilities that are rational.
With that in mind, one can immediately see how challenging it might be to not only estimate the collective results of a large group of companies such as the ASX/S&P 300 but also to try and predict how investors might react to the various factors that influence both the short and long-term direction of the market.
For today’s article I thought it worthwhile to aggregate individual company valuations in such a way as to produce two independent assessments of whether or not the market is cheap.
In the first example (Fig.1.), I simply appropriately weight and aggregate the valuations of the biggest 200 companies. The aggregated valuation is then plotted against the S&P/ASX 200.
The market appears to have run ahead of valuations. Any further price gains must be supported by further earnings upgrades, which flow into valuation upgrades. If price gains occur and valuations don’t correspondingly rise, the risk of a setback is heightened.
Figure 1 reveals that the stockmarket, as reflected by the largest 200 companies, looks to be a little expensive compared to the level that bargain hunters might desire. Intrinsic value is rising but prices appear to have moved a little ahead of valuations. For any further gains in aggregate share prices to be sustained and supported, intrinsic values would also need to rise. For this to occur, we would need to see further earnings upgrades.
Speaking with visiting analysts earlier today I realised that it is a common theme in the stockbroking community that the big caps are now expensive. Their conclusion is to start scouring the smaller companies.
Having significantly outperformed the market over the last two years, by investing in smaller high-quality companies I can assure you that market prices do not appear in aggregate to be cheap. Indeed, in my experience the smaller companies rallied in advance of the big caps – the latter being fuelled by the chase for yield.
I don’t buy all companies. I don’t invest in the biggest and I don’t invest in the smallest. I invest in the best irrespective of their size. So I decided to split out the very highest-quality companies and compare their valuations to market prices. Figure 2 is an inverted margin of safety chart for the best quality companies I follow.
When the red dashed line is above zero, the margin of safety is negative. When the red dashed indicator is below zero, a positive safety margin exists for the group of very high-quality companies that I track.
What the chart shows is that the market for quality companies is now more expensive than it has been at any time since the GFC. If, however, you look further back, then the results reveal the extent of ‘expensiveness’ can become a lot more irrational. Prior to March 2008, market prices for these stocks were significantly higher than their respective valuations.
In essence what I believe is that the higher-quality companies that I follow are likely to upgrade their earnings in coming months. As a result, their intrinsic values will rise and further share price gains for these very highest-quality companies are likely. This view is also supported by the very low collective level of share exposure that superannuation funds and households currently have to shares.