The FTSE/JSE All Share Index is currently trading on a price-to-earnings (PE) multiple of close to 23. This is the highest level it has been since early 1969, just before a crash that saw the market lose over 60% in two years.
The current valuation is also well above the 50-year average PE of around 13. This historical average would usually be a measure of what could be considered “fair value”.
Some market watchers might argue that at these kind of stretched multiples, the market is in extremely dangerous territory. When it is this far from the mean, bad things tend to happen.
However, others question whether this long term average is really an appropriate guide. For a number of reasons, comparing the current market with its past manifestations is problematic.
“One should be wary of saying that this time it’s different, but I do think it is slightly different,” says Rhynhardt Roodt, portfolio manager at Investec Asset Management. “Fund managers can come up with all sorts of reasons why things are cheap or expensive and you can slice it many different ways, but the structure of the market has changed.”
Fund manager at Ashburton Investments, Wayne McCurrie, points out that the first thing to consider is that historical averages were set in a very different interest rate environment.
“As an investor, you have alternatives,” McCurrie explains. “You can buy shares, or you can put your money in the bank. If interest rates at the bank are at 3%, it makes more sense to buy the market, but if they are at 15% you’ll say that’s a very good return and I’ll rather go to the bank.”
What this means is that when interest rates are high, bonds and cash become more attractive and so markets tend to be lower. When, however, they are lower, as they are now, the market will be higher as the alternatives are less attractive.
“From 1969 to 1998 local bond rates averaged around 15%, and over that time the PE ratio of the JSE was 13,” McCurrie says. “But now bonds are averaging 8% or 9%, so the PE of the market should be higher because the alternative investment or discount rate to buying shares has dropped quite materially.”
On top of this, the nature of the JSE has also changed significantly over the past two decades. Most earnings generated by listed companies now come from outside of the country.
“Our market is no longer a South African share market, whereas in the 90s it was,” McCurrie explains. “That means that you can’t use our long bond rates to compare all of our shares against. You have to use some combination of local rates, and the long bond rates in the US, which are currently at around 2%.”
That further pushes up what might be considered “fair value”.
The JSE is not what it was
One also has to consider the other impacts of this structural change.
“Up until the 90s we were in isolation,” says Roodt. “The JSE was a small regional market that no one wanted to invest in. But once capital markets opened up and the market received increased investor attention, multiples expanded.”
This was because local stocks were now being compared to those in other markets, but also because local companies were themselves able to access global opportunities.
“If you go back many years, the South African market was very dominated by a number of resources companies that, theoretically, should trade on lower multiples because they offer lower returns, are very cyclical, and very capital intensive,” Roodt argues. “Our local companies also didn’t really have opportunities to expand.
“But the composition of the market now is very different,” he explains. “Many companies have gone out and become globally-dominant businesses like Naspers, SABMiller and British American Tobacco, and these companies have a lower cost of capital. The composition of the market is now higher quality, and that means that it should trade at slightly higher multiple.”
When all of these factors are considered, McCurrie argues that you have to be able to look at the current valuation beyond just how it differs from the long term average.
“I don’t think that the outlook for shares is particular good, but I don’t think we are on the brink of an almighty collapse,” he says. “When you just look at the PE and see that in 1969 it hit 20, in 1987 it hit 20, in 1994 it hit 20, in 1998 it hit 20, and in 2008 it got close to 20, and on each of those occasions the market collapsed, you might automatically think that now that it’s at 23 the market is going to halve. But I don’t think that’s the correct assumption.”
Roodt agrees that while the market is still expensive, it is not as over-valued as it may superficially appear.
“There are various dimensions to valuation,” he says. “You can consider absolute valuations, valuations relative to history, and valuations relative to other asset classes.
“In absolute terms, the market is probably on the more expensive side. Relative to history, pretty much all metrics will point to equities as an asset class globally is certainly expensive. But if you look at relative valuation, I would say that equities would stack up as being much cheaper than asset classes like developed market bonds.
“So the historical average is just one metric,” Roodt concludes. “But if you throw in the other ones, especially relative valuation, since money will always try to find a home, we would say that the local equity market is mildly expensive and therefore lower investment returns lie ahead.”
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