Valuing the market: A first step beyond passive investing

“Investments may be soundly made with either of two alternative intentions: (a) to carry them determinedly through the fluctuations that are reasonably to be expected in the future; or (b) to take advantage of such fluctuations by buying when confidence and prices are low and by selling when both are high” - Ben Graham

For the investor who wishes to receive reasonable returns and is willing to see some fluctuation in the value of their funds but does not wish to put out too much effort, a simple portfolio which tracks both the FTSE100 and government or corporate bond indices is perhaps a good place to start.  One question which will then arise is how much to allocate to each asset class when annually rebalancing the portfolio? 

There is no definite answer but the usual suggestion is 40% to bonds or your age as a percentage in bonds.  Another way is compare the current level of the market to its past level in order to determine whether the future may be brighter than normal, or not. Currently the FTSE100 is around the 6,000 mark which is about 14 times its inflation adjusted earnings over the last decade.  This number is sometimes known as the PE10 and the ratio of the current PE10 to its long run average has been shown to be helpful when determining whether an equity index’s price is high or low and therefore whether future returns will be higher or lower than average¹.

The current level is lower than the long run average and historically the lower the level the higher the future returns, at least in the long term.  In a passive index tracking stock/bond fund the target allocation for shares should perhaps be higher than normal to take advantage of this situation.

Using a formula to set target allocations based on the ratio between the current PE10 and its long run average is one way to remove emotion, and possibly poor judgement, from this process.  My own asset allocation formula currently gives the following allocations:

This approach to asset allocation would have held only 20% in shares at the peak of the dot com boom and 90% at the bottom of the bear market in 2009.  In a model portfolio the returns have beaten a typical 60/40 stock/bond strategy² by about ¾% a year.  An equally important improvement is the reduction of risk of loss.  The biggest loss since 1993 for the model portfolio was 17% compared to over 40% for the FTSE100 and 24% for the 60/40 split portfolio. This approach appears to give the passive investor, with only a small output of energy, a way to generate slightly better returns with noticeably lower risk of loss than the typical 60/40 split.

Investment grade companies: For both the defensive and enterprising investor

“Each company selected should be large, prominent and conservatively financed.  Indefinite as these adjectives must be, their general sense is clear” - Ben Graham

For those investors who wish to pick individual companies, the table below lists 10 with a high dividend yield and a low price to earnings ratio (as at May 23^rd).  All of these companies have a track record of consistent revenue, earnings and dividend growth going back over the last decade.  They are, on first glance at least, solid, stable and growing and may therefore have a fair chance of growing in the future.

When a company with a high dividend yield continues to increase the dividend then there is a limit to how low the share price will go.  Over time the increasing dividend will become so attractive that new investors are likely to buy the shares and push up the price to a point where the yield is less attractive.  The dividend effectively sets a ‘floor’ under the share price.

Compare that to the situation where a company grows its earnings and dividends but because the initial price paid was too high the investor still manages to lose out.  Vodafone is a good example of this.  The company’s earnings have gone from around 5p to 15p per share in the last decade, with the dividend going from around 1p to 9p.  Unfortunately for the investor buying around the turn of the millennium, even with these gains in the underlying company the share price has gone from over 200p to around 170p now. In this case paying 40 times earnings, or an earnings yield of 2.5%, with a dividend yield of less than 1% left a lot of room for the share price to drop, no matter how well the company did.

High yield shares are not for the faint hearted though.  As with any type of value investment there is likely to be some kind of problem - either in the short term or perhaps the longer term - which means that investors require a higher yield before they’re willing to invest in the company.  When looking at high yielders it may be best to look for strong, stable, growing companies where the risks are short term and survivable, or non-existent.

For further analysis on these companies leading to price targets, click here.