Those of you who follow my reports on a regular basis, will know that I often use the analogy of the water skier to illustrate how share prices (and ultimately, indices) sometimes find themselves in front of the proverbial boat, or earnings. Without the pulling action from the boat, the skier will lose momentum, but once the boat catches up and moves past the skier, the rope will tighten behind it, pulling the skier forward.
When applying this principle to share earnings, we also have to consider that the value of a share can be calculated in a variety of ways. The most important will probably be its ability to generate future earnings. Investors’ emotions, however, also play a vital role in price movements. When prices are based on investors’ emotions rather than a company’s ability to generate future income, it either creates a good investment opportunity or serves as a crucial warning to investors when prices rise faster than earnings.
In March 2018, I warned investors to make sure that their risks are well diversified, due to the fact that the FTSE/JSE All Share Index (based on its fair value at that point) as the water skier, was roughly 20% ahead of the boat (earnings growth). The earnings per share (EPS) model that we use to determine the fair value, gives us an indication of how share prices performed when compared to their earnings on a historical level (which does not guarantee future movements). These levels are then multiplied by the average historical price earnings ratio (P/E) of the underlying asset (in this case, the FTSE/JSE All Share Index).
This is all now history, and 18 months down the line, our index is trading around 5% lower and the EPS around 15% higher. It would appear that these two have finally caught up with each other.
Please note that this model does not indicate that the FTSE/JSE All Share Index is now cheaply priced, but rather that the Index, in growth-terms, is priced more fairly. Over the past 25 years or so, we have seen that the “boat” can stay ahead of the “skier” for long periods of time.
In order to determine whether current prices are cheap or expensive, I use a model that adds the price earnings ratio (P/E), inverse dividend yield and price to book ratio (P/B) together, and then normalises the data.
The P/E indicates the relationship between the share price and its earnings (profit), and it also shows us how cheap or expensive a company’s share is. Dividend yield simply indicates the percentage of dividends paid by a company to its investors, relative to its current share price. There are analysts that may argue that a P/B may be an even better way to determine if a share is cheap or expensive. The P/B ratio compares a share’s market value to its book value. The lower the P/B, the more undervalued the share.
When combining these valuation methods, you can clearly see that the best times to buy, was just after the 2008 market collapse, as well as between 2011 and 2012, just after the global recession. For the first time since then, our local market is now priced at the same levels as these post-recession levels.
I can still remember the negativity that followed the 2008 Great Correction, and also the 2011 recession, with emotions at an all-time high. Investors who were invested in cash wouldn’t even consider BUYING anything, and those who were already invested in local shares, wanted to SELL at those all-time-lows. Those who acted on their emotions in both situations, will tell you today that it was a huge mistake.
In conclusion, I would like to make it clear that I am not saying that the FTSE/JSE All Share Index cannot see further declines, because it can. Based on historical movements, it has moved even deeper into value levels before. What I am saying is that the market isn’t that expensive anymore and that it now presents a buying opportunity.
The opinions expressed in this blog are the opinions of the writer and not necessarily those of PSG. These opinions do not constitute advice. This is intended as general information and does not form part of any financial, tax, legal or investment related advice. Although the utmost care has been taken in the research and preparation of this blog, no responsibility can be taken for actions taken based on the information contained in this blog. Since individual needs and risk profiles differ, it is always advisable to consult a qualified financial adviser before taking action.