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Expect disappointment as values become stretched

It has been a good year in the Australian equity market. As we come to the end of the September 2013 quarter, the ASX300 Accumulation Index has increased by 24% over 12 months - a rate that is more than double the long term annual average of about 11%.

A natural response for many investors is to feel that they should allocate more capital to the market, to avoid missing out on the gains others are enjoying, and this is certainly a mindset that we have noticed recently. With short-term interest rates at record lows, there is no shortage of people who have become frustrated with the returns on cash, and are electing to move money into equities as their term deposits mature.

Don't abandon a disciplined approach

However, this line of thought often leads to decisions that are contrary to those a disciplined investment process would follow. When share prices are rising faster than corporate earnings, it is almost certain that the value available in the market is declining, and ultimately, value is a crucial driver of long term investment performance.

Not surprisingly, an analysis of historical returns shows that when the ASX Index has an unusually good year, the following year is more likely to be below average. This doesn’t always happen of course, but a good run last year is usually a sign that the odds have shifted against you. Our analyses suggest that when the market has performed as well as it has over the past year, the prospects for the year ahead are perhaps 1% dimmer than the 11% average.

When quickly-rising share prices get ahead of underlying values, we may be able to improve our assessment of future prospects if we ignore the share price and try to understand where underlying value sits. If the valuations were very good to begin with, then a year of rising prices may be no cause for alarm.

There are a couple of simple measures that we can look to in assessing value for the market as a whole. In the Australian market, historical analysis indicates that average P/E multiples and dividend yields have provided a useful aggregate value benchmark and an indicator of future return prospects. Let’s consider each of these.

In the case of dividend yields, the average for the All Ordinaries over several decades is around 4%, based on IRESS data. Currently the market sits quite close to this level, at around 4.1%, so on this measure, prospects for the year ahead are no less favourable than they might normally be. However, recall that investors have been demanding yield in recent times, and in many cases boards of directors have responded with increased payout ratios. Dividend yield may not be an accurate reflection of the underlying earnings capacity of the businesses, and it may be wise to be cautious in using it as a yardstick for value.

Potential for disappoinment

Turning to P/E ratios, the long run average for the All Ordinaries (again, based on IRESS data) lies at around 15x. Currently, the market sits at 17x, some 10-15% higher. This suggests that following the strong run recently, the market may now have moved to the slightly expensive side. At this level, our analysis indicates that the prospects for the year ahead may be around 2% less favourable than the 11% norm.

These reductions of 1-2% per year may seem small, and well worth accepting in the context of cash rates that are sitting close to the rate of inflation – and we’d probably have to agree with that. The real question is whether equities offer a sufficient risk premium. If the market offered reasonable value at the start of the recent run, it may have some way to go before pricing becomes a significant issue.

However, if the market continues to perform strongly, it will almost certainly be sowing the seeds for disappointment some way down the track, and investors need to guard against becoming ever more positive as valuations become increasingly tenuous.

Investors tend to manage their exposure to equities with one eye in the rear view mirror, and this has a significant impact on their investment returns over the long run. The effect of systematically investing more when the market has become expensive, and less when the market has become cheap, can bake in a level of underperformance that compounds over time.

Having a disciplined approach to valuation, and selling shares when the crowd is cheering them on can be very difficult to do – but in the long run the benefits are real.

Roger Montgomery is the founder and Chief Investment Officer at The Montgomery Fund, and author of the bestseller, ‘Value.able‘.

 


 

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