Bargains in the blue chips

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The Independent Online

Most investors will have realised by now that current market conditions are hardly typical on any historical perspective. What is still not widely appreciated is how unusual and extravagant the divergence from normal experience has become, although there are some small but telling indications of how naïve and inexperienced many new-breed private investors can be.

Most investors will have realised by now that current market conditions are hardly typical on any historical perspective. What is still not widely appreciated is how unusual and extravagant the divergence from normal experience has become, although there are some small but telling indications of how naïve and inexperienced many new-breed private investors can be.

One good example is the aggrieved reaction of many investors who failed to get shares in the recent successful dot.com flotation, Interactive Investor.

Because of the flood of applications from wannabe Net investors, most private investor applications were heavily scaled back, meaning that the average e-punter received less than 200 shares, which even if the mania continues is hardly going to make anyone as wealthy as they probably dreamed of becoming when they first applied.

Something similar happened with the privatisation programme in its early days. It is a telltale reminder that in market conditions like today's, the seller is in a strong position to dictate terms.

As has been mentioned here many times before, the overall valuation of the market continues to hover in largely uncharted territory. Despite the hefty fall in the market so far this year, aggregate dividend yield and equity risk premium remain close to record low levels. Volatility in share prices is also at high levels in historical terms, with some of the largest companies jumping around by 15 per cent or 20 per cent in a day.

Only the rising yields in the bond market are preventing stock markets from breaking loose from gravity. There are few, if any, occasions in the history of financial markets when bond and equity yields have marched in opposite directions for any length of time - rising bond yields are a good leading indicator of trouble ahead in the equity market - and it is good to see this now seems to be taken on board by most professional investors.

What is equally remarkable about the current market, apart from the gullibility and overblown expectations of first-time investors, is that while valuations generally are unnaturally high, this disguises huge disparities between different sectors of the market. With nearly all the action being concentrated in just two or three sectors (telecoms and IT well to the fore), other sectors have suffered what in other times would have been considered calamitous falls in value.

Anyone sitting on a portfolio of blue chip equities will know exactly what is meant by this. Whether you look at the retail sector or traditional cyclical industries, there are scores of household names which have experienced price falls of 40 to 50 per cent in the past 18 months, prompting many professionals to say we have actually been living through a hidden bear market in the majority of shares since 1998.

Another way of looking at this is to look at the divergent performance between high and low yielding shares in the FTSE 350 index (which itself accounts for around 80 per cent of the value of the All-Share index). As the chart suggests, the difference in performance has not been as marked as it is now at any time since 1985, when this data series was first recorded.

The graph is derived by taking the performance of the highest-yielding shares and dividing it by that of the shares of the lowest-dividend yields. It illustrates a market mentality which favours future hope over current earnings and proven dividend capacity. It is this phenomenon which has given so much difficulty to traditional value investors and those who manage income funds.

Part of this is down to genuine differences in prospects between the old and new economies. In a month which has seen Courtaulds Textiles, once one of the largest companies in the market, fighting off a bid at a price which values the business at less than a fifth of the current market value of the aforementioned Interactive Investor, only a fool would deny we are living through a period of real and intense change in technological leadership.

Most telling of all, as an indicator of the market mood is that the media has turned so sharply against many former gurus whose style of investing has fallen out of fashion.

None more so than in the case of Warren Buffett, with even the mighty Financial Times suggesting recently that it might be time the great man went into retirement, given the way his BerkshireHathaway shares have underperformed the market by more than 50 per cent in recent months. (This is about as daft as suggesting that the Test selectors in Australia should have dropped Donald Bradman because he scored single figures for three innings in a row.)

It is a matter of choice whether you choose to see these indicators as proof of the fact that we now live in a new and very different world, or whether you take them as yet more telling symbols of the mania which has gripped the market and lured thousands of neophyte investors Klondyke-like into the market.

That experience suggests while the latter view is the right one, there is no advantage in being too judgemental at this stage, better to focus instead on the many new (and unsung) investment opportunities created by the extreme conditions.

For example, why is there is such a fundamental mismatch between oil prices and the values placed on leading oil companies? It is hard to look much further than the obsession with more fashionable sectors, and the institutions' desperate and built-in need to keep up with the Joneses.

The one constant that has run through all decades of the stock market's history is that the lowest medium- and long-term returns derive from buying the most fashionable shares in the market at or close to their peak in popularity. For conservative investors with genuine medium- to long-term horizons, fortunately, the counterpoint is also true. Buying a portfolio of quality blue chip stocks at prices which are half their earlier peak is a very safe and reliable way to book yourself a comfortable retirement.

The good news is that such opportunities are presenting themselves in numbers as a result of market mayhem. It is a matter of time before the markets return to their collective senses and correct the absurd imbalance in valuations.

As the wise old American professional investment consultant Charles Ellis said: "Attempting to beat the market - to do better than other investors - will distract you from the fairly simple and interesting and productive task of designing a long-term programme of investing that will succeed in providing the best possible results for you."

He added: "Las Vegas is busy every day so we know not everyone is rational. If you, like Walter Mitty, still fantasise that you can and will beat the pros, you will need both luck and prayer."

Is that relevant today? You bet.

davisbiz@aol.com

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