Are valuations offsetting the risk?

In these extremely volatile markets where the full extent of the financial crisis is still to be understood, it is time to go back to basics, says Mark Appleton, Chief Investment Officer at BJM Private Client Services.

“It is important not to be tempted to try and time the market, it is impossible to get it right and investors should rather look at valuations’” says Appleton who explains that if something is inexpensive, it offers a buying opportunity, even if you are not sure when the market will stabilise. Over time a quality company bought for less than it is worth will provide decent returns.

Appleton says that BJM Private Client Services focuses on the implied risk premium of the equity market. This is the return one would expect to receive from the equity market over and above the long bond yield - which is the long term risk free return. In other words, are you being compensated for the risk you are taking by investing in equities rather than bonds over the longer term? This measure is calculated based on dividend yields forecast dividend growth and long bond yields. “When you invest in an asset you are investing in the income generated by that asset which is why yields are the best measure of value,” says Appleton.

Appleton says the recent reduction in the long bond yields from 10.5% to 9.7% reduced the risk free rate and therefore increased the implied risk premium received from financial and industrial shares to some 4%. Appleton explains that premiums in excess of 4%, means that shares are approaching good value.

Appleton says bond yields need to fall further to support further upside in interest rate sensitive counters. While bond yields could bounce up after such a strong fall in the short term, as inflation comes back into the target range and confidence builds around a interest rate cut, bond yields will fall and the implied risk premium will increase. “If the long bond yield trends down, then the equity market will respond positively”. However Appleton believes that financial and industrial shares are unlikely to fall dramatically from current share prices and is cautiously accumulating equities in expectation of a re-rating of the bond market in the medium term. “Short term rates are close to topping out,” says Appleton who adds that listed property will also benefit from lower bond yields . “Listed property yields traded lower than the risk free rate up until recently and currently forward yields from property are higher than the long bonds. We expect to see reasonable growth in distributions from this sector as supply constraints, such as the electricity crisis and a general slowdown in the construction industry creates upward pressure on rentals”.