Market Ratings & Sell Discipline

As I mentioned in yesterday's post about Reckitt Benckiser which I feel is expensive, I have had a few questions about low medium & high PE valuations and my sell discipline which is based on 20x PE and 2% dividend yield. I have written about this before and you can see my original post here.

So I thought I would expand on the thinking behind those metrics and why they were chosen as they were not simply plucked out of the air. They are based on years of experience and knowledge of financial market history. This suggests that it is usually not a good idea to buy markets / equities when ratings go over 20x, think back to the dot com peak in 1999. While this seemed like an exciting time to invest, the overall index in the UK which was on well over 20x at the time and has gone sideways since then, only offering the dividend yield by way of return in the subsequent 15 years as the overvaluation has been worked off.

That's not to say you couldn't have made decent returns over that period as I did by focussing on value stocks in the early 2000's when the highly rated technology stocks were collapsing. But it did mean that if you bought an index fund your returns have been disappointing and probably well below the long term expected real (after inflation) return of 5 to 6% from equities. Which just goes to show the importance of the starting valuation when you are buying stocks / the market.

At the other end of the scale it is usually a good idea to get more exposure to equity markets when valuations reach single figures as they did back in the UK in 2009 after the financial crisis. Any one who was brave / wise enough to have bought shares in that period will have in all probability done very well and earned above average returns versus the long term average, as the market has recovered its poise and ratings have increased again. As a result the FTSE 100 for example has nearly doubled as it has recovered from around 3500 back towards its 1999 peak close to 7000.

Thus when the market is priced around the mid teens in between these two extremes you could say that the market is fairly valued and should provide average real returns although in the long term this will depend on whether the market re-rates upwards or downwards from there. So lets look at some evidence of what these types of rating mean for returns.

I'm going to cheat a bit here and stand on the shoulders of a giant John Mauldin, who I have mentioned before. Below are four key graphics from a post he featured back in 2010 looking at this which you can read here via the Market Oracle site. These show the forward 10 year real returns based on different PE & Yield ranges.

These show that as you would expect as you go up the valuation scale in terms of PE and down in terms of yield the average real returns tend to decline with the >20x and <2% returns falling below the average long term 5 to 6% real returns.

Now while this is US data a similar pattern would be seen in the UK. Indeed it used to be that whenever the yield on the UK market went below 3% in seemed to signal a reversal in the market, although in recent years the market has on occasions been prepared to run with lower yields. The other reason that markets have perhaps been prepared to entertain lower yields on some occasions is not only the falls we have seen in interest rates and inflation but also the increasing use of share buy backs (SBB). Indeed some suggest that Total Shareholder Yield which includes not only dividends but SBB's and in some cases debt repayments, but I'll have more on that for you soon.

The markets propensity to accept lower yields can be more prevalent for individual stocks but nevertheless I tend to try and use a 3% minimum yield for new purchases. This is why I then use a lower 2% threshold as selling trigger to allow for re-ratings and the benefit of the Company trading well and growing its dividend strongly. However once it goes below a 2% yield I tend to look to exit, although I will judge each stock on its merits and some may warrant a sale before they reach that level if, the fundamentals of the business or the facts change as not every stock will be able to justify a 2% yield.

I therefore think in general if the 2% & 20x ratings signal poor returns for an index it seems sensible to apply the same thinking to individual stocks, although obviously some can go onto much higher PE's and have little or no yield, but as a value investor I'm not interested in playing those types of stocks myself and would rather rotate into better value stocks.
Of course some businesses may never be successful or robust enough to justify such lofty valuations in the first place.

Meanwhile in the piece I referenced earlier John Mauldin mentioned secular bull and bear markets and the roughly 17 year cycle, there is some great research on this and the importance of avoiding the downside if you can in secular bear markets. This come from Crestmont Research website.

In the UK we have been going sideways since 1999 on the back of the extended valuations back then and the start of secular bear market. Since then I have had pencilled in my calendar 2016 as the year to look out for the start of a new 17 year secular bull market. But I guess you can never be that precise about these long term cycles but here's to hoping 2016 might be the year that FTSE finally breaks above 7,000 if it doesn't manage it this year. However it does seem as though we might still need one more big sell off at some point to take valuations back down again before the next secular bull market can begin - I guess time will tell.

Finally if you want to read more about the long term real returns you might expect from equities see the Global Returns Year Book from Credit Suisse.