Jonathan Davis: No, it isn't the death of equities

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The Independent Online

The bear market might be squeezing the life out of the life companies, but a glance through the ratings of stocks on Thursday shows quite how radically the most recent leg of the downturn is starting to put renewed vigour into valuations. It is a long time since something like half the stocks in the Footsie were sitting on a prospective dividend yield of more than 5 per cent, or since an almost identical number of stocks in the large-cap index could boast p/e ratios in single figures.

The bear market might be squeezing the life out of the life companies, but a glance through the ratings of stocks on Thursday shows quite how radically the most recent leg of the downturn is starting to put renewed vigour into valuations. It is a long time since something like half the stocks in the Footsie were sitting on a prospective dividend yield of more than 5 per cent, or since an almost identical number of stocks in the large-cap index could boast p/e ratios in single figures.

As has been noted before, in several cases the market is working on the assumption that dividends are going to be cut – the Lloyds TSB prospective yield is now up to11 per cent, for example – and there are also plenty of companies whose earnings are still likely to disappoint.

Everyone also needs to be wary of what psychologists like to call "anchoring", the natural mental habit we have of judging share prices by reference to a recent experience rather than to more fundamental valuation basis. (This could also be known as the Marconi effect, after all those who said Marconi "just had" to be cheap when it fell below 100p en route to oblivion.)

That there are now real pockets of value in the equity universe is not in doubt. One small piece of evidence is that the list of large-cap stocks that meet the "safetyfirst" portfolio criteria mentioned here over the past few months had grown from six to 20 by the middle of this week. The list now includes a swath of retailing heavyweights, GUS, Sainsbury, Boots, Matalan, Dixons Group and Next, along with one or two less appealing industrial suspects, such as Rolls-Royce. (There will always be one or two that qualify for what the fund manager John Carrington liked to call his OMDB – over my dead body – list).

Whichever way the Iraqi endgame now plays out, technical analysis suggests it clearly possible after its latest declines for the market to fall below 3000 before long, though in the short term it looks oversold.

I noticed this week, for example, that Ian Rushbrook, the Edinburgh fund manager whose views have been mentioned here more than once before, was quoted as saying 2750 was not an impossible level, and we had yet to find the bottom of this phase of the market. Given how volatile the market has been, falling by 5 per cent on Wednesday alone and bouncing back the following day, the trading opportunities many pundits have been predicting are certainly there for the nimble-footed.

Although bearishness is beginning to creep inexorably and more deeply into the psychology of investors, which is the necessary precondition of any sustained turnround in sentiment, it is probably fair to say we are still a long way from seeing the kind of total capitulation a real bear market requires before it can reverse. While it is helpful to hear ultra-bearish fund managers such as Hugh Hendry of Odey Asset Management say that it may take 20 years for share prices to regain their March 2000 peak, you need a lot more saying and believing that, before we can be confident the real bottom has been reached. To that extent, valuation is no longer the key driver of market behaviour.

The more one looks at the figures for institutional activity, the more evident it becomes that many big investment institutions are still not actively deserting equities on the scale you might expect from merely reading the headlines.

Most of the fall in their published equity weightings seems to be the result of falling prices, rather than active disinvestment. A few are taking out insurance against rising and falling prices through the futures market, but it is a mistake to describe what we are seeing as "the death of equities".

With the overlay of uncertainty caused by the Iraq diplomatic endgame, valuation considerations are going to continue to struggle to make their voice heard above more pressing short-term concerns. Only in retrospect will we know for certain where the real value in today's market lies.

There is still no reason I can see to abandon the view that well-run companies with strong market positions, low gearing and secure yields are the first place for medium- to long-term investors to look. This is becoming noticeably more of a consensus view than it was a year ago, and its wisdom may well be tested by further bouts of market weakness, because the present phase of post-bubble workout could take several years to unfold completely.

Two further footnotes on long-run returns. One, prompted by a reader, is to reiterate that all comparisons between gilts and equities do need to take account of the baleful impact of taxation and costs. These can have a quite significant impact on eventual fund values, because of compounding. Gilts are, in general, cheaper to own and trade than equities, while an expensive equity fund can easily take up to 3 per cent or more per annum out of your potential returns in hidden and explicit costs. Tax can have an important impact on the value of both types of asset.

The second is an interesting statistic highlighted by Ned Riley, of State Street Global Advisers, in a recent presentation. During the bull market years of 1982-1999, the US equity market produced a breathtaking annual compound return of 17.9 per cent. The average equity mutual fund returned 14.2 per cent per annum. Yet the average equity mutual fund investor still only secured an annual return of 7 per cent, or less than half the market's return.

The reason? Buying and selling funds at the wrong time, usually on the basis of overweighting recent past performance. A useful reminder as we approach the end of the annual Isa season.

davisbiz@aol.com

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