Analysis for the Telegraph highlights the cheapest stock markets - and shows how to back them
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Buy low, sell high. It is a simple formula for investment success, but with so many ways to measure a market, and with conflicting results, following it can be difficult.
To help, we today highlight three closely watched valuation measures, and others that are growing in popularity.
Price-to-earnings ratio
We start with the most widely used calculation. The p/e ratio compares a company’s value with its profits. To work it out you take the share price and divide it by the annual earnings per share figure. Another way to look at it is that if the company is valued at £10bn and makes £1bn in annual profits, its p/e ratio is 10.
The lower the figure the better. With stock markets, you would compare the p/e with other countries, or with its own long-term average. With shares, you compare it with rivals. For instance, if the average p/e for all bank stocks is 15 and your bank stock is at 10, you may have a bargain.
Cape ratio
It has a daunting title – “cyclically adjusted price to earnings” – but the Cape is growing in popularity. Essentially, it is the p/e ratio with a twist. Instead of using earnings over 12 months, this valuation measure takes the average earnings figure over the previous 10 years.
In doing so the Cape ratio strips out short-term anomalies. One of the main criticisms aimed at the p/e, the more basic measure, is that a market could be deemed “cheap” because earnings have just reached their peak in the economic cycle and are about to fall. By taking the average for 10 years, the ups and downs of the cycle are evened out. It was first dreamt up a generation ago by investment gurus Benjamin Graham and David Dodd and refined by US academic Robert Shiller in the Nineties.
This measure, though, does have critics. Richard Troue of Hargreaves Lansdown, the fund shop, said: “It can be slow to acknowledge genuine stock market shifts. For instance, Japan’s collapse into deflation and stagnation took years to be fully acknowledged.”
Price-to-book ratio
Rather than focusing on earnings the price-to-book ratio examines how a company’s market value compares with the value of its underlying assets – the value of all the buildings, machinery and intangible assets if sold today.
To calculate the price-to-book ratio for the whole index you need the value for each share. A low score signals that a stock market or share is undervalued. A figure of less than one is viewed as a bargain, as it means investors are buying at a discount to the value of a firm’s assets. But bear in mind it could be cheap for a reason.
According to Miles Standish, managing director of Fisher Investments UK, this measure is more useful because some firms manipulate their earnings figures, which can distort the average valuation for the entire stock market.
“The book value cannot be manipulated, but there are plenty of ways for earnings figures to be fudged or glossed over,” said Mr Standish.
Best of the rest
Perhaps the most basic way to gauge the value of the stock market is to look at the dividend yield.
This is the income investors receive from shares, expressed as a percentage of the share price. As a rule of thumb, if the stock market yield is higher than a country’s government bond yield then investors should buy. This has been the case in Britain for five years (today it’s 2.7pc for 10-year bonds versus 3.5pc for the FTSE 100), although critics point to the distortion created by the Bank of England’s stimulus efforts.
A lesser known measure that is gaining more prominence is the “Q ratio”. This compares the market value of a stock with the company’s replacement cost, in other words what it would cost to recreate its business.
Mr Troue said this was useful for markets such as Britain and the US where there is plenty of data available, but for emerging market nations such as China and India, where data is not as widely available, it does not work so well.
Another less familiar ratio that some experts use is the inverse p/e ratio or “earnings yield”. Flip the normal p/e calculation upside down and divide the earnings by the share price. This serves as a useful comparison with government bond yields as it assesses whether investors are being compensated for holding shares as opposed to bonds.
Warren Buffett has his own favourite. He values the market by comparing its total value with the country’s economic output to assess whether it is time to buy more shares or cash in.
The countries and markets where it’s currently best to invest
Experts all have their own favourite valuation methods. Rather than getting too involved in the endless debate, Your Money looked at the three main measures of value – the normal price-to-earnings ratio, the cyclically adjusted price-to-earnings (or Cape) ratio and the price-to-book ratio – to work out whether a stock market was cheap or expensive.
We looked at 34 countries and assessed whether they were currently trading above or below their historic average, using all three valuation metrics.
The cheap stock markets
To be named “cheap”, markets had to be trading below their own historic valuation across all three measures. As the map to the left shows, only a handful of stock markets managed to achieve this feat – Greece, China, Hong Kong, India, Japan, Russia and Turkey.
Some stock markets will be cheap because the countries are in the midst of economic turmoil – this certainly rings true for Greece and Turkey, which both have fragile economies. Highly indebted Greece, in particular, has been trying to get its house in order.
The risks are great but investors could make big returns given that the valuations are so cheap. The Argonaut European Alpha fund is heavily invested in Greece while an HSBC ETF tracks Turkey at a cost of 0.6pc a year.
Sometimes markets are cheap because of political uncertainty. Russia certainly falls into this category. This is not new, as Russian shares have been prone to political tensions for years. But the dispute with Ukraine means they are the cheapest in the world on the price-to-book measure.
Long-term fans of emerging market nations – China and India, for example – may be tempted to invest more money. Both nations scored well. The First State Asia Pacific Leaders and Newton Emerging Income funds are favoured by brokers. Among investment trusts, JP Morgan Global Emerging Markets Income is highly regarded.
The expensive stock markets
In red are the countries that scored badly on all three metrics. America, Sri Lanka, Pakistan and Indonesia are all trading on valuations that are higher than their historic averages across each of the measures. Investors are buying high.
The main reason for the lofty valuations is that these stock markets have performed well in recent years. This pulled in other investors and has left these markets substantially overpriced.
In America, for instance, the two main stock market indices – the S&P 500 and the Dow Jones – have set new record highs on several occasions over the past year.
Whether or not a correction is imminent is anyone’s guess, but given these valuation investors who want to net big returns are probably better off shopping elsewhere.
For many, seeing a fast-growing Asian nation with favourable demographics such as Indonesia in the expensive list will be a surprise.
But again this is because its stock market has performed so well recently, having gained 17pc so far in 2014.
Those in the middle ground
Those countries in the middle ground, such as Germany and Austria, highlighted in amber, scored well on either one or two of the valuation measures. These countries are considered neither cheap nor expensive relative to their history.
Given that the FTSE 100 is trading within reach of its all-time high, British investors will be comforted by the neutral valuation rating.
On both price-to-earnings and price-to-book, UK shares are trading at expensive levels. But the Cape measure indicates that there is still plenty of value. The British stock market has a Cape score of 15.28, below its historic average of 18.79.
This suggests the strong performance that British investors have enjoyed over the past three years could continue for a little while longer.
Source: www.telegraph.co.uk
Source: www.telegraph.co.uk
