All investors want to buy cheap shares that will deliver great medium-to-long-term returns, but how do we determine whether a share is a bargain buy or expensive?
Chief economist for AMP Investments, Dr Shane Oliver, says it comes down to valuation — based on a stock's price-to-earnings (P/E) ratio — and the best time to buy shares is on single-digit P/Es.
Let's explore this further.
Cheap shares mean single-digit P/Es
A single stock has its own P/E, and the market as a whole can be measured on an overall P/E.
In a recent article, Oliver said shares produce higher returns when they are bought on low P/Es.
Oliver referred to the mid-1970s when ASX shares were trading on a P/E of just 5.4 times.
The AMP economist wrote:
… at the end of the mid-1970s bear market in September 1974 the PE was just 5.4 times which was a great time to buy as Australian shares returned 21.8% pa over the next decade.
The key is that the starting point matters – put simply the higher the yield and the lower the price to earnings ratio (for shares) relative to their history the better for an asset's medium term return potential.
Human nature gets in the way of trading decisions
Oliver says the importance of starting point valuations "is often forgotten".
He explains:
Behavioural finance tells us that it's natural for investors to pay too much attention to recent performance, so after a run of strong years investors expect it will continue.
This leads many to buy only after good times, only to find they have bought when shares are overvalued and therefore find themselves locked into poor returns. And vice versa after a run of poor returns.
So, when valuations matter the most, they often get ignored. But of course, valuations can have their own pitfalls.
The valuation pitfalls
Oliver points out that sometimes shares are cheap for a reason. He explains:
First, you need to allow for risk as sometimes assets are cheap for a reason. This can be an issue with individual shares, eg, a tobacco company subject to lawsuits even though current earnings are fine.
Second, valuation is a poor guide to market timing, often being out by years.
Third, there is a huge array of valuation measures when it comes to shares. For example, the "earnings" in the PE can be actual historic earnings as reported for the last 12 months, consensus earnings for the year ahead or earnings that have been smoothed to remove cyclical distortions. All have pros and cons.
What does inflation and interest rates have to do with it?
Oliver explains the relationship between inflation and P/Es:
The shift from the high inflation of the 1970s and 1980s to the low inflation last decade was very positive for shares. But if inflation rises resulting in higher interest rates, then shares should trade on lower PEs as investors find shares less attractive, uncertainty rises and earnings quality falls.
This of course was a major factor weighing on share markets last year.
And what about interest rates?
Oliver says shares should trade on higher P/Es when interest rates fall and vice versa when they rise.
So, what's the verdict? Are shares today cheap?
Oliver concludes that current P/E ratios for shares point to a medium-term return potential of about 10% for ASX shares and 5% for US shares.
US shares have been performing much more strongly than ASX shares since May, as we cover here.
Oliver says:
… US and Australian shares now offer a reduced return premium over bonds of around 0.8% in the US and 2% in Australia. For the US this is the lowest risk premium over bonds since after the tech wreck …
But ideally bond yields need to fall to improve the prospects for shares. If we are right and inflation continues to fall over the year ahead, then this should allow lower bond yields and provide some support to shares.
Oliver says there is still a risk that global markets will further correct, led by US shares, due to a deterioration in US stock valuations.
He points out that US technology stocks are especially sensitive to bond yields.
