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The above prices have been adjusted for share-splits (Vodafone) and mergers (BTR / Invensys).
If I were a betting man, I'd be somewhat foolishly plumping for the dogs of 1999 as the prospective winner in 2000. More than anything, that's my natural tendency to go against the crowd. Also, the ratings on some of the Top Dog companies are truly in the stratosphere, and I for one believe that at some stage in the not too distant future, there will have to be some sort of share price shake-out. For example, Logica (LSE: LOG) and Sage (LSE: SGE) are both excellent companies, but price-to-earnings ratios (P/E) of 135 and 143 respectively leave little room for error.
The reciprocal of the price-to-earnings ratio is the earnings yield. It is actually quite useful to measure the earnings yield against the risk-free rate of return. For the latter, I prefer to use base interest rates, which currently stand at 5.5%.
As a comparison...
One of the great things about investing in equities as opposed to leaving your money in the bank is that the earnings yield is only your initial rate of return. You are investing in a company which you think will grow, and hence, unlike interest rates (all things else being equal) the earnings yield will also expand as the years go by.
Last week, myself, Maynard and then Rob all expressed opinions about potential changes to the Qualiport. With PizzaExpress (LSE: PIZ) starting to look attractively priced, I first suggested that a sale of Rentokil Initial (LSE: RTO) and/or Unilever (LSE: ULVR) could provide the ammunition for a pizza top-up.
About this time last year, I wrote a couple of articles (links at the bottom of this piece) looking forward to 1999. One was entitled Top Dog vs Contraire, where I pitted the FTSE 100 companies with the highest and lowest share price relative strength over the preceding 12 months against each other in a race to the death.
Here's the results.
18/12/98 17/12/99 Change %
Top Dog
Colt Telecom 870p 2900p 233%
Orange 687p 2086p 204%
Vodafone 188p 311p 65%
Telewest 154p 335p 117%
BT 895p 1382p 54%
Average 135%
Contraire
BTR (now Invensys) 223p 328p 47%
ICI 547p 681p 24%
Marks & Spencer 399p 283p (29%)
Reed International 464p 438p (6%)
British Airways 368p 422p 15%
Average 10%
It's a no-contest! The top dogs of 1998 have again proven to be in a class of their own in 1999. The rise and rise in IT and telecoms shares has continued to astound me. A year ago, I wrote:
"All five Top Dog companies are in the high flying Telecommunications sector. Surely that can't outperform again. Can it?"
Well, we now know the answer. But will this outperformance continue into the new millennium? Again, from a year ago:
"Following the theory that winners will keep on winning, there must be a reasonable chance that Top Dog will win the 1999 race. "
What does this prove? Not a huge amount really, as the time period of 12 months is relatively insignificant. Also, without any backtesting, it's impossible to say whether this type of relative strength investing will be successful over the long term. I remember once seeing an article about simply buying and holding the 10 biggest companies by market capitalisation for 10 years. Over one test period, these collective companies outperformed the market.
I'd like to run the Top Dog vs Contraire competition again this year, just out of interest. If I keep running it for 10 years, we may well have some interesting back-tested data.
Here goes for this year's race.
Top Dog 2000 17/12/99
ARM Holdings 3970p
Sage 594p
Colt Telecom 870p
Billiton 377p
Logica 1478p
Contraire 2000
Rentokil Initial 228p
GUS 337p
Assoc British Food 324p
Boots 589p
Powergen 470p
Earnings Yield and ERP
Earnings Yield
Sage 0.7%
Logica 0.7%
Pizza Express 4.8%
Rentokil Initial 5.5%
Unilever 5.9%
In years past, many stock market investors thought that equities were the riskier form of investment, and so they demanded a premium. Not surprisingly, this is known as the equity risk premium, and is usually measured as the return of shares above bonds. Over the past 80-odd years, that outperformance in nominal terms has been about 6%.
So, what is the equity risk premium (ERP) today? I would calculate it as something like the dividend yield (2%) plus the expected growth in corporate profits (8%, although this may be a little high) less base interest rates (5.5%) = 4.5%. Others say the ERP is as low as 1%, or even negative, giving them the ammunition to pontificate about how over-valued the stock market is in general. However, given that history has shown shares to be much better performers than gilts, arguably the ERP should be zero.
If the ERP is 4.5%, based on the above one would expect that the market should be trading on a P/E of just 10. That is calculated by taking risk-free base interest rates (5.5%) and adding the ERP (4.5%), and taking the reciprocal (1/10%). With the FTSE 100 trading on a P/E of 29, something doesn't quite look right. If on the other hand you assume the ERP is zero, that brings the assumed P/E down to 18 (1/5.5%). All these theories and numbers can be debated until the cows come home, but certainly give food for thought.
Rather than look at the level of the stock market in general, I prefer to look at individual companies, and use the earnings yield to put some perspective into valuations. Take Sage and Logica for example. It will take them 8 years of 30% earnings growth before their earnings yield hits today's risk free rate. In that 8 years, a hell of a lot can happen to the company, both positive and negative. Investors at these prices should make sure they are aware of the risks.
Qualiport Developments
Maynard's excellent column of last Wednesday suggested selling both Unilever and Rentokil, bemoaning their lack of sales growth, a predicament which will still be adversely affecting those two companies a year from now. At the same time, Maynard suggested a more focussed portfolio, narrowing down the number of companies to those which offer the very best long-term growth prospects. Do Unilever and Rentokil fit that bill? Arguably not.
Because the Qualiport is fully invested, we are forced to sell in order to buy. However, I believe investing decisions should be made in isolation, and on a case by case basis. If I don't think the future's particularly bright for Rentokil, I should sell them regardless of whether I need the cash now. Otherwise, you risk making a poor investment decision.
These days I just can't get excited about Rentokil. But, I'm reluctant to sell at around 225p, given the initial earnings yield and their past growth record. Yet, when you compare an investment in Rentokil to one in PizzaExpress, the latter has the better growth prospects.
I'm going to keep sitting on the fence on this one, feeling somewhat undecided at this stage. Comments, suggestions and cures for procrastination all welcomed to the Qualiport message board. I've not mentioned this company for a while now, but my indecision is compounded by a potential investment opportunity in Berkshire Hathaway, chaired by none other than Warren Buffett.
Related Links
Company Change Bid DELL(US)+0.70 45.50 EMA -0.14 13.16 IIG +0.02 2.60 MSY -0.29 8.28 PIZ 0.00 7.00 RTO -0.04 2.22 ULVR +0.09 4.34 LLOY +0.11 7.35 Qualiport Stocks Last Rec'd Total # Company Buy Current Change 22/04/99 542 Misys 5.57 8.28 48.5% 17/04/98 301 Emap 10.20 13.16 29.0% 27/01/99 74 Dell (US) 44.63 45.50 2.0% 27/10/98 1133 Indep Ins 2.60 2.60 0.0% 29/09/99 356 Lloyds TSB 7.56 7.35 (2.7%) 19/12/97 783 Rentokil 2.55 2.22 (12.9%) 04/11/98 245 Pizza Exp 7.93 7.00 (11.7%) 17/07/98 266 Unilever 7.53 4.34 (42.3%) Last Rec'd Total # Company In At Value Change 22/04/99 542 Misys 3065.85 4487.76 1421.92 17/04/98 301 Emap 3139.85 3961.16 821.32 27/01/99 74 Dell (US) 2007.42 2040.61 33.19 27/10/98 1133 Indep Ins 2990.63 2945.80 (44.75) 29/09/99 356 Lloyds TSB 2723.20 2616.60 (106.60) 04/11/98 245 Pizza Exp 1966.34 1715.00 (251.34) 19/12/97 783 Rentokil 2046.53 1738.26 (308.27) 17/07/98 266 Unilever 2052.00 1154.44 (897.56) Cash: £ 38.91 Current Total : £20,698.54 Total Invested: £20,184.62 Profit/(Loss) : £ 513.92 Value Per Share Day Month Year Qualiport 0.98% 3.93% -1.99% FTSE 100 0.10% 2.03% 14.43% FTSE All Share 0.11% 2.17% 17.95%