Daily Equity Report

We looked at 10 lessons that investment strategist James Montier put out in a paper issued by US fund managers, GMO. I mentioned that I would spend a bit more time on some of the lessons that he highlighted.

His lesson number 4 was – Valuation matters.

He noted that while most everyone agrees with the assertion that “value investing tells us to buy when assets are cheap and avoid purchasing expensive assets.” He has repeatedly come across investors willing to “undergo mental contortions” to avoid the valuation reality.

He highlights the Graham and Dodd methodology of calculating the price to earnings ratio by dividing the current price over the 10 year average earnings. He cites past examples when investors rejected this methodology because it is too backward looking and does not take growth into account. This was especially the case in the IT boom period when different valuation metrics were being invented.

He also cites that during the latest crisis, investors were making arguments that this methodology was overstating earnings.

However over an extended period of time, buying when the PE is low (using a 10 year smoothed earnings) generates significantly better returns than buying when markets are expensive.

The graph above reflects the compounded real return over a subsequent 10 year period, based on different starting valuations. What is clear is that when the PE ranges between 5-13, the 10 year real return is far higher than when the PE ranges from 20-48.

We have done a similar study of the real returns on the JSE at different starting valuations – modelling this, drives our basic equity asset allocation decision.

If you have any questions on your investment returns, strategy and would like to find out how Seed can assist, please don’t hesitate to give us a call.

Kind regards

Ian de Lange
info@seedinvestments.co.za
www.seedinvestments.co.za
021 9144 966