MARKET COMMENT
Shares Are Too Cheap

By James Carlisle
June 27, 2002

It's been a long way down since the market peaked back in December 1999 and some of the technology shares, that are so hard to value, might have further to go. Who knows? But there are beginning to be some clear signs that the more reliable end of the market is just too cheap. Take these FTSE 100 companies for example.

Company                          Prospective
                                   Yield (%)

United Utilites (LSE: UU.)               8.0
Abbey National (LSE: ANL)                7.4
Lloyds TSB (LSE: LLOY)                   6.0
Six Continents (LSE: SXC)                5.4
Alliance & Leicester (LSE: AL.)          5.2
British American Tobacco (LSE: BAT)      5.1
Rolls Royce (LSE: RR.)                   5.1
HSBC (LSE: HSBA)                         5.1
Scottish & Newcastle (LSE: SCTN)         4.9
Boots (LSE: BOOT)                        4.7

These are solid businesses, as far as I can tell, with reliable cash flows and dividends that you'd expect to grow at least in line with average earnings growth over the long term. Yet they have dividend yields that match or beat the 4.7% yield on long-dated gilts (which, of course, doesn't offer the potential for growth). Perhaps the market is factoring in some hefty dividend cuts, but I can't find much sign of that for the above companies.

If we look further down the list, there are some attractive-looking growth companies (at least that's how they've been considered in the past), with yields above 3%:

Company                          Prospective
                                   Yield (%)

Sainsbury (LSE: SBRY)                    4.6
Pearson (LSE: PSON)                      3.7
Hays (LSE: HAS)                          3.5
Shell T&T (LSE: SHEL)                    3.3
Allied Domecq (LSE: ALLD)                3.3
Smiths Group (LSE: SMIN)                 3.3
Reuters (LSE: RTR)                       3.1
Diageo (LSE: DGE)                        3.1
BP (LSE: BP)                             3.0
GlaxoSmithKline (LSE: GSK)               3.0

Overall, the FTSE 100 has a dividend yield of 3.0%, while the 30-year gilt yields 4.7% giving a 'yield ratio' of 1.6. Traditionally, it's stood at closer to 2, to reflect the growth prospects offered by shares.

To me it seems that something's not right here. Assuming there isn't going to be a bloodbath for dividends, and there's no reason to suppose that there will be, then either gilts are too expensive or shares are too cheap.

It's tempting to think that gilts are overpriced on the basis that yields have been a lot higher recently. After all, back in the seventies, the long bond yield was up in the mid teens. Going back further, though, it looks like it was the inflationary 1970s and 1980s that were exceptional. Since 1869, cash and gilts have returned, on average, 4.7% per year and inflation has averaged 2.9% per year. So the current long bond yield of 4.7% hardly looks out of place. If anything, you might say it could go lower if the Bank of England continues to keep inflation down at 2.5% (or below).

One way or another, it seems hard to justify the yields on a lot of shares right now. That doesn't mean the market can't fall lower, much stranger things have happened, but for long-term investors there are plenty of attractive opportunities.