The price you pay is the most important driver of equity returns, says Nick Kirrage of Schroders.
As the last few weeks in global markets have again proved, one of the more inconvenient truths of investing in equities is that we cannot know the future. Yet we can be certain of at least one thing, according to Schroders’ fund manager Nick Kirrage. As a ‘value’ investor, he maintains that the single most important factor in whether or not investors make money is not the growth they achieve, but the price they paid for the stock. With that in mind, he believes today’s best investment opportunities could be lying in the banking, food retail and drug retail sectors.
Schroders has analysed the best part of a century’s worth of returns in the UK equity market, from 1927 to the present, comparing them with their starting price/earnings (P/E) ratios. (P/E ratios tell us about the costliness of a share or the market as a whole – the lower the number, the cheaper they are.) The result is shown in the chart below. Every time the market fell to a P/E ratio of between zero and 7x, investors would have made, on average and after inflation, 11% a year, every year for a decade. “The small print, of course, is every time the market was at those levels, there was something so apocalyptic, so death-of-equities going on, you would have had to force yourself to buy in,” Kirrage acknowledges. “But, if you did, you saw a fantastic real return.”
1927-2015 – 10-year annualised return by starting price/earnings ratio
Source: Global Financial Data and Thomson Datastream, as at 30 June 2015; based on the UK equity market since 1927
Whenever you paid a higher price, however, you would have seen a correspondingly worse return. More to the point, Kirrage insists, whatever helped you to justify paying a higher price was irrelevant, whether it was a better business, a stronger economic environment or world-changing new technology. It did not matter. What makes the chart so powerful is that while everything else has changed over nearly 90 years, one thing has stayed the same: people. Human beings are the constant – markets are cheap when they are fearful, and expensive when they are greedy.
Kirrage then uses a similar approach to analyse the returns in the UK market in the years after it peaked in 2000. The second chart takes the market’s individual sectors and places them in different valuation buckets, according to how cheap or expensive they were on 1 January 2000. As you might imagine from what were the last days of the tech boom, the most expensive sectors were technology, media and telecoms. Oil & gas was up there too, while tobacco languished at the other extreme.
Today, 15 years later, we see that the starting valuation rule is again applicable. Tech grew and changed the world, as investors predicted, but it still generated bad returns. On average, those sectors that were valued on a cyclically adjusted P/E ratio of 35x or more on 1 January 2000 fell 46% over the next 10 years. At the same time, those sectors in the 21–28x range averaged a 38% rise while those in the 14–21x range averaged a 156% rise. And the almost friendless tobacco sector? It would have returned 763%.
UK sectors grouped by starting price-earnings ratio in 2000 – 10-year annualised return
Source: Schroders, as at 30 June 2015
So what does this mean for investors in 2015? Today, despite the recent falls, markets are within reach of the levels of early 2000. But profits have grown since then and so valuations have in fact come down. Back in 2000, the UK market was the most expensive it had ever been. Today it’s not cheap but, in the context of history, Kirrage reckons it is only “slightly expensive”.
Sectors such as banks, food retail and drug retail are now in the low-valuation buckets. Kirrage does not expect the next decade to be stellar for the market as a whole. “Within it, however, we believe there will be stellar sectors and stellar performers from these sectors,” he says.
Please be aware that past performance is not indicative of future performance. The value of an investment with St. James’s Place may fall as well as rise. You may get back less than you invested. Returns on equities cannot be guaranteed.
This material is for information only and is not a recommendation or intended to be relied upon as a forecast, research or advice. The opinions expressed are those of Nick Kirrage and are subject to market or economic changes. The views are not necessarily shared by other investment managers or by St. James’s Place Wealth Management.