Valuation holds the key

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Mitchell Fraser-Jones 10 June 2014 Est. reading: 3 min read

With stock markets near their peaks, will you be able to find value for investors?

The UK stock market is close to its all-time high. In its own right, that is not necessarily a cause for concern. What really matters is the valuation on which the market is trading, not its overall level – it’s the classic difference between price and value.

In terms of the price / earnings ratio (PE), it’s difficult to argue that the market is overwhelmingly cheap anymore. The FTSE All Share Index has been rising at a time when its earnings have been falling, causing a “double-whammy” impact on valuation. The PE of the FTSE All Share Index has risen from about 9x earnings towards the end of 2011 to over 14x earnings at present. Even so, the UK stock market’s valuation, in PE terms, is only marginally higher than its long-term average, as the chart below illustrates. We would not argue, therefore, that the market was overwhelmingly expensive, as it was in the late nineties.

Source: Longview Economics to 6 June 2014.

In yield terms, though, the market seems to have more valuation support. The forecast dividend yield for the FTSE All Share Index is 3.68% at the time of writing, according to Bloomberg. UK Equity Income funds are expected to deliver a yield in excess of that of the market and we believe we can build a portfolio that can deliver a sustainable yield of about 4% at inception. That is an attractive return in its own right, particularly when compared to the income available on cash, Gilts or high quality corporate bonds.

The real attraction of equities, however, is in the growth that dividends can provide. Equities are real assets – companies operate in the real economy and, as such, they are typically able to increase prices over time in line with or slightly ahead of inflation. In turn, this means dividends rise over time to protect investors against the eroding effect of inflation. Ultimately, it is this “real” quality that has allowed UK equities to deliver superior long-term returns to other asset classes.

 

REAL INVESTMENT RETURNS BY ASSET CLASS (% PA)
2013 10 years 20 years 50 years 114 years
Equities 17.4 5.0 4.1 5.5 5.1
Gilts -9.6 2.5 3.5 2.5 1.2
Corporate Bonds -1.0 1.8
Index-Linked -3.9 2.7 3.2
Cash -2.3 -0.5 1.3 1.5 0.8

Source: Barclays Equity Gilt Study 2014

Clearly, in the current challenging economic environment, some companies may struggle to grow their dividends, others may struggle to pay a dividend at all. It is important to be selective. We need to be convinced that the companies that we invest in will not only pay a decent dividend but also have the ability to grow that dividend sustainably over time.

Admittedly there are fewer companies than a few years ago that are in this position but, crucially, there are enough to build a diversified portfolio. And we are very confident that such a portfolio can deliver a very attractive long-term return.

In its simplest form, the total return from an equity investment will be a product of dividend yield + dividend growth. Theoretically speaking, if an equity yields 4% and provides dividend growth of 4% per annum, all else being equal, its total return will be 8% per annum. Of course, in the real world, all else isn’t equal – valuation changes can significantly disrupt this simple theoretical model, particularly in the short term. Nevertheless, in the long term, fundamentals like dividend growth matter and that is why we focus on them.

This is why we are optimistic that we can find value for investors. We believe we can build a portfolio that can deliver a yield of c. 4% per annum. We believe this portfolio will be capable of delivering modest, mid-single-digit dividend growth per annum. According to our simplistic, fundamental view of the world, this should result in a high-single-digit annualised total return. That is our long-term expectation and we are confident we can deliver. In a low-growth, low-return world, we believe a high-single-digit return will be a very attractive outcome for investors.


This article forms part of our Your Questions Answered series. If you haven’t already done so, we would encourage you to subscribe to our blog using the “Subscribe to articles” link above, to be alerted when a new post is added. If you would like to pose a question, please leave a comment below.

What are the risks?

  • The value of the fund and any income from it may go down as well as up, so you may get back less than you invested
  • Past performance cannot be relied upon as a guide to future performance
  • The ongoing charges figure is charged to capital, so the income of the fund may be higher but capital growth may be restricted or capital may be eroded
  • The fund may invest in other transferable securities, money market instruments, warrants, collective investment schemes and deposits – some of these security types could increase the fund′s volatility and increase the level of indirect charges to which the fund is exposed
  • The fund may invest in overseas securities and be exposed to currencies other than pound sterling – as a result, exchange rate movements may cause the sterling value of investments to decrease or increase
  • The fund may invest in unquoted securities, which may be less liquid and more difficult to value, because they are generally not publicly traded – the lack of an open market may also make it more difficult to establish fair value

Important information

Before investing, you should read the Key Investor Information Document (KIID) for the fund, and the Prospectus which, along with our terms and conditions, can be obtained from the downloads page or from our registered office. If you have a financial adviser, you should seek their advice before investing. Woodford Investment Management Ltd is not authorised to provide investment advice.

The Woodford Funds (Ireland) ICAV (the “Fund”) has appointed as Swiss Representative Oligo Swiss Fund Services SA, Av. Villamont 17, 1005 Lausanne, Switzerland. The Fund′s Swiss paying agent is Neue Helvetische Bank AG. All fund documentation including, Prospectus, Key Investor Information Documents, Instrument of Incorporation and financial reports may be obtained free of charge from the Swiss Representative in Lausanne. The place of performance and jurisdiction for all shares distributed in or from Switzerland is at the registered office of the Swiss Representative. Fund prices can be found at www.fundinfo.com.

Woodford Investment Management Ltd is authorised and regulated by the Financial Conduct Authority (firm reference number 745433). Incorporated in England and Wales, company number 10118169. Registered address 9400 Garsington Road, Oxford OX4 2HN.

Woodford Patient Capital Trust plc is incorporated in England and Wales, company number 09405653. Registered as an investment company under section 833 of the Companies Act 2006. Registered address Beaufort House, 51 New North Road, Exeter, EX4 4EP.

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