The UK stock market is cheap.
That’s the surprising conclusion of the latest ‘Popular Delusions’ note from Soc Gen strategist Dylan Grice.
He has been using an updated version of Ben Graham’s Appraisal Method, to identify stocks worth at least 50 per cent more than their market value.
It has thrown up just 11 names, which suggests the market is pricey, according to Grice. But three of the companies on the list are British: Aviva, AstraZeneca and Standard Chartered — leading Grice to conclude that the UK is the only market trading below its intrinsic value.
Here’s the Soc Gen man’s thinking, his methodology and some pretty pictures.
Ben Graham defined ‘bargain issues’ as being those with an “indicated value at least 50% more than the price.” Over the last few decades, such bargain issues have returned around 20% per annum, yet today, there are as few of them around as there were in Q2 2007, the eve of the global credit crisis (see chart below).
Methodology:
I’m going to depart from the arithmetic of Graham’s valuation method2 – though not the spirit – and go with Stephen Penman’s Residual Income Model, which tells me which stocks are likely to offer a return above my hurdle rate.3 This model starts with a company’s book value and its RoE and takes consensus earnings forecasts to project future book values and RoEs.4 But for each forward period, earnings are charged in order to account for the opportunity cost of capital employed. The income left after taking this charge is the ‘residual income’ and only this residual income is capitalized onto current book value per share. The model does two things which I like:
1) By focusing on both book value and RoE it anchors valuation firmly around the earnings power of the company’s assets. Book value isn’t to everyone’s liking because it’s an accounting estimate that misses much of a business’s true worth. The varying nature of ‘intangibles’ across industries and even within them also hinders comparability. But when book value is understated by accountants, then RoE (and therefore capitalized residual income) must be commensurately overstated; so by focusing on the actual earnings generated by imprecisely measured assets, we circumvent that problem.
By taking a charge against the opportunity cost of capital we’re guarding ourselves against overpaying for growth. If a company I’m looking at invests its profits instead of paying dividends it will grow earnings. But it won’t necessarily grow value. I can get mere growth by putting £100 into a bank account and reinvesting the 5% interest rate each year indefinitely. But I’m not adding any value. The account today is still only worth £100 and I shouldn’t pay a premium to book just because it’s growing. By charging a hurdle rate equivalent to the return I’d hope to find elsewhere (I’ve set it at 10% in the work which follows), I’m improving my chances of buying value creation and not just growth.
Results:
And why the UK is cheap.
And finally, as far as aggregate valuation is concerned, the chart below shows that only the UK market has an estimated intrinsic value higher than that currently priced by the market. In contrast, the average IVP ratio across developed markets is around 0.7, implying stock markets are worth only 70% of what they are currently trading for.
Related links:
‘Deep down, even the fiercest equity bulls must be doubting themselves – FT Alphaville
A Minskian roadmap to the next gold mania – FT Alphaville