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Calling off the search for blue-chips

Created:
22 July 2008
Written by:
David Stevenson

I've stopped recommending shares in the blue chip FTSE 100 for one reason. I think it's quite possible that we're moving from a rather nasty, but short-lived, equity sell off into a rather more scary deep bear market. I wouldn't go so far as to agree with uber-bear Albert Edwards, who's suggested that the benchmark index could sink to 3,000, but I don't think another 20-25 per cent downward lurch is out of the question.

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Why? One possibility is that as the credit crunch unwinds, it'll inflict horrible damage on the real economy, dragging down earnings growth or pushing it into reverse. Falling profits would put many indebted companies in breach of banking covenants, triggering rescue fundraisings and big write-offs.

More theoretical, but also more important, is the idea that the risk premium for shares - the reward that investors effectively demand for buying shares, as opposed to less risky assets - is pushed upwards. Low interest rates and low inflation over the past decade have made for low returns on other asset classes like cash and bonds. That's meant investors have been content to accept PE ratios of between ten and 20 for solid, growing companies.

But with bond yields and savings rates now higher, equities need to be cheaper to compensate for the higher risks entailed in holding them. That would suggest multiples of between four and eight times forward earnings.

This kind of structural change has happened before, especially during periods of heightened risk to share prices, and a model has been developed for understanding what a 'base line' share price valuation could look like. Decades ago, Ben Graham devised a term called "cyclically adjusted underling PE" to describe what the core earnings of a company could look like over the long term. Basically, this exercise involves taking a rough 10-year average of earnings and then working forward to establish a sensible or average PE ratio.

Over the long term, cyclically adjusted PE ratios have only really looked cheap in the UK when they're below 10 - which they aren't now. Many of the top companies in the FTSE have a cyclically adjusted figure that’s way above that level.

To understand just how bad it could get, I ran a test on some of the leading components of the FTSE 100. Here's what I did:

• I took the top company from a number of different sectors

• I worked out underlying earnings per share by taking a simple arithmetic average of EPS figures over the last ten years.

• I looked at the current dividend cover and applied it to the underlying EPS figure, to get a core dividend.

• Then I estimated what a baseline forward looking PE ratio for such a company could be. This ranged from as low as 4 for very defensive companies (builders) through to 8 for companies perceived as safer and faster growing (such as BAE Systems). Obviously, this is arbitary, but it helps set a 'floor price' for the shares.

• I also calculated the likely resulting dividend yield and the potential drop in the share price from its current levels.

Here's what the calculations showed:

Company Price now Mean EPS Core dividend Baseline PE Floor price Est'd yield % Implied price fall (%)
Persimmon 258 78 29 4 312 9 21
BSkyB 432 25 13 8 200 7 -54
Aviva 485 34 22 6 204 11 -58
BT 195 15 11 8 120 9 -38
BAE 436 21 10 8 168 6 -61
Reckitt Benckiser 2454 70 30 8 640 5 -74
Unilever 1411 80 44 8 640 7 -55
Diageo 884 36 21 8 288 7 -67
RBS 165 40 17 4 160 11 -3
Tesco 375 16 6.7 8 128 5 -66
BAT 1708 53 33 8 424 8 -75
HSBC 728 67 36 6 402 9 -45
GSK 1167 72 40 8 576 7 -51

What strikes me from this table is that many, many blue chips – Tesco, BAE, Diageo, Reckitt to name but a few – are priced to perfection. If they foul up, and don't produce the growth the market expects (remember they're mostly valued at over 15 times current earnings) they could theoretically fall by more than 65 per cent.

Only Persimmon, RBS, and to a lesser degree BT and HSBC, look like they're anywhere faintly near their theoretical bottoms. Now, I'm not suggesting that carnage on this scale is inevitable, or that Reckitt Benckiser is going to lose three-quarters of its value, but it's certainly possible. And that, in a nutshell, is why I've stopped adding blue-chip shares to my screens. I just need more reassurance that we aren't heading into a big bear market.

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