Hobson: The Danger of Following Indices

THE WEEK: Don’t get bamboozled by market data, make sure you drill down into figures for individual companies

Rodney Hobson 17 June, 2016 | 11:10AM
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One of the recurring problems with using the FTSE 100 index as a yardstick is that it often seems to be dominated by one sector or another – at various times IT, banking and more recently oil and commodities – so it can give a distorted view of the state of the stock market.

I was reminded of this when reader Peter Hood alerted me to a sharp rise in the average price/earnings (PE) ratio in the blue chip index since the end of January, when it stood at just under 17. He says the ratio was 27 by the end of February and topped 30 early in May, distorted by some companies hitting a PE as high as 80.

He also points out that some yields have also been bloated, in some cases to 8% or more. Shouldn’t the two figures, as a general rule, move in the opposite direction?

I reckon that, as a general rule, larger companies should trade on a P/E of about 13-14 on an historic basis, perhaps a little higher when the economy is growing and certainly a little higher on a prospective basis.

I also regard 3.5% as the norm for judging yields, perhaps a little higher in times of doubt and a little lower if there are genuine reasons to expect dividends to rise sharply in the next year or two. Where a yield falls below 2% I am reluctant to invest; above 6% I am suspicious because the market is presumably factoring in a reduction in the dividend.

It is true that a rise in a share price will raise the P/E ratio and reduce the yield. To have both figures at a higher level is a warning sign. Something will have to give, and it will probably be the dividend.

I think some distortion has arisen in the Footsie because of the sharp fall in oil and commodities shares and some investors are starting to factor in a recovery in those sectors. Also banks, particularly Lloyds (LLOY), are seen as recovering as previous misdeeds are (we hope) going to fade into the past. This week a time limit was agreed with the Financial Conduct Authority for PPI (payment protection insurance) mis-selling claims.
 
I do not, however, look at P/Es and yields for a whole index. In fact, I wouldn’t know where to find such figures and I’ve never looked for them. I prefer to look at these figures, plus dividend cover, for individual companies and would urge all investors to do likewise. You invest in a company, not an index, unless you are buying a tracker fund and I always encourage investors to build their own share portfolio.

Berkeley Squared 

Even if you narrow your perspective down to sectors, you still need to assess individual companies. Regular readers know that I have invested in three housebuilders and have seen the sector as an essential ingredient in any portfolio for the past five years or so.

However, I would avoid Berkeley Group (BKG), the housebuilder that is most geared up to the London market – a great position in the recent past but not where I would want to be right now as London comes off the boil and other regions play catch-up.

Berkeley reported a 20% fall in reservations following the rise in stamp duty and Chancellor George Osborne’s moves to curb buy-to-let. The shares are already down by a fifth this year. I’m not tempted to call the bottom.

Brexit is the New Weather

Clothing seller N Brown (BWNG), which issued two profit warnings last year, blamed the Brexit debate for a decline in revenue in March-May. Unfortunately, on the very same day the Office for National Statistics revealed a 6% rise in retail sales in May and an upward revision to 5.2% in April. While retail sales were boosted by price reductions, there was an improvement in volumes as well.

Brown shares gained because investors had expected worse. I would not chase them any higher. After next Thursday’s vote, retailers will go back to blaming the weather.

Rodney Hobson is a long-term investor commenting on his own portfolio; his comments are for informational purposes only and should not be construed as investment advice.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Rating
Berkeley Group Holdings (The) PLC4,433.00 GBX-0.45
Brown (N) Group PLC40.50 GBX-2.17
Lloyds Banking Group PLC52.32 GBX-2.90Rating

About Author

Rodney Hobson

Rodney Hobson  is a columnist for Morningstar.co.uk and author of several investing books, including The Dividend Investor and How to Build a Share Portfolio.