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Nailing the floor

Created:
22 July 2008
Written by:
Mr Bearbull

The IC's share recommendations have become increasingly bearish of late. For one as cynical as Bearbull, it simply has to transmit as a buy signal - the IC's share recommendations are more bearish than ever, so prices simply can't fall any lower. Ho, ho. Flippancy aside, it would help if we could establish where the floor for share prices lies, and at what level share prices would obviously be cheap.

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First, we are getting some encouraging signals from various sources. The price of oil - the swing factor on which the global economy still hangs - may be faltering. That would be the logical consequence of declining demand, rising production (if it is true that Saudi Arabia is pumping more oil than at any time in the past 20 years) and easing worries about future supplies (stimulated by a tentative dialogue between the US and Iran).

Next, politicians and business leaders have moved from phase 1 in their Crisis Response Manual - where the gist of all responses is: "Don't be silly. Everything is fine." - to phase 2. This requires calmly acknowledging the depths of difficulties - but don't call it a crisis - and warning that recovery is still some years away. When Alistair Darling, the UK's invisible chancellor, does it, it's as convincing as Mr Bean. When Win Bischoff likens the scale of the credit crunch to that of the secondary banking crisis of the mid-1970s, it prompts the thought: okay, we got through that one (though many banks didn't), so we'll scramble through this one. But Sir Win has rather more credibility - 42 years in investment banking; seen it, done it, and catapulted into the hot seat at Citigroup to sort out the mess left by Chuck Prince.

Then there are quantitative signs that UK share prices are cheap - well, getting that way. My favoured touchstone is the inflation-adjusted dividend yield on UK equities. Currently this is 3.9 per cent, compared with its 3.6 per cent average since the beginning of 1982. That start date is important. It approximately marks the transformation of the UK economy from its inflation-ridden, demand-driven, inflexible post-War model to the supply-driven, flexible version that has helped to give most middle-aged Britons the sort of affluence that their grandparents could not have dreamt of. In other words, drag back the start date to before 1982 and we are no longer making a sensible comparison.

On that basis, shares are moving into bargain territory and, if London's All-Share index dipped another 8 per cent, they would be firmly planted in that land. At that level - 2530 on the All-Share index - the real yield would be 4.4 per cent, which is one standard deviation above its 1982-2008 average. Statistically speaking, this is a level it reaches only one-sixth of the time and from which share prices tend to bounce.

That said, no inescapable law says they must. Besides, there is still plenty to be bearish about. In particular, for shares to be cheap at current levels implies that investors are willing to accept a risk premium for holding equities that is low compared with the actual premium realised from UK shares over the past 30 years or so. The nominal dividend yield on equities is 4.3 per cent, a bit less than the 4.9 per cent redemption yield on 10-year government bonds. Implicitly, therefore, all the premium must come from growth in dividends. That's normal enough. Yet, for investors to make the 6 per cent risk premium that UK shares have returned over the long haul, we have to make heroic assumptions about future growth rates in dividends. The conventional way out of this impasse is to suggest that investors will be willing to accept a lower risk premium in the future than in the past. That explanation worked well for some years, but now it's coming up against capitalism's biggest crisis in 35 years and that, sort of, adjusts the benchmark.

Still, for what it's worth, I feel more confident about share values than I did six months ago. Although there is a nagging voice within that dredges up a quote from A-level English and King Lear: "The worst is not, so long as we can say: This is the worst."

• I was talking a few weeks ago (27 June 2008) about takeover situations offering easy pickings. In case any of you are in doubt, I should stress that I was being ironic. However, takeover situations, both actual and likely, are worth tracking - especially in times like these, where agreed deals can offer nice returns with minimal risks.

Take the 328p-a-share cash offer for food equipment maker Enodis from US-based Manitowoc. I have bought 22,000 Enodis shares at a fraction below 315p each for the Bearbull Speculative Portfolio. Assuming that the deal completes - and there is a touch of execution risk - then in four months time (or a bit less, if I am lucky) I get the proceeds and pocket a 10.8 per cent annualised return net of costs. That's worth having. Put it this way - if someone permanently offered me that scale of return on my whole capital with the same level of risk, I'd give up the stock-picking game altogether. No question.

MORE FROM MR BEARBULL...

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