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Key ratios for bear market investing

FEATURE: Is the market close to bottom? Here, we explain six key ratios that will help you decide when to re-enter the market
December 29, 2008

Credit-induced recessions and the bear markets that accompany them don't come along that often. So investors need the perspective of history to decide whether or not it is too risky to invest in equities. And it's worth bearing in mind that today's commonly used disciplines, such as value investing and discounted cash flow analysis, either originated in or flowed from the deep bear market of the 1930s.

Here, we look at the ways in which you can work out whether or not the market is cheap – and how to find companies that will survive the recession.

First, let's take the state of the market. There are two or three interesting ratios to look at: the 'yield gap', and Tobin's Q and Schiller's CAPE.

Yield gap

One common yardstick that is used in the UK as a supposed signifier that the market is cheap is the yield on the equity market compared to the yield on gilts. This goes to the heart of the relative riskiness of bonds and equities.

In the 1930s - in fact, at any time prior to the 1950s - it was the norm for equities to yield significantly more than gilts. This reflected the fact that shares were perceived as inherently riskier than government bonds. Hence the yields on shares should be significantly higher to compensate investors for the extra risks they were running.

Only when the economy entered its post-war growth phase and inflation began to increase did equities begin to be viewed as inherently better investments than bonds (whose fixed coupons were eroded by inflation).

From the late 1950s onwards, yields on shares began to dip below those of gilts, creating what became known as the 'reverse yield gap'.

The issue for investors now is whether we are returning to a point where the yield gap - with equities yielding more than bonds - again becomes the norm for the time being, or whether the market can be expected quickly to return to a 'reverse yield gap'.

Depending on which index you use, the equity market stands on a yield of about 5.6 per cent, roughly twice covered by profits. The yield on a 10-year gilt is 4.1 per cent. That gives a yield gap of 1.5 percentage points. Is that wide enough, and when might it narrow? And should we be looking more at how equities stack up against a basket of arguably more directly comparable corporate bonds?

There is data covering the US that shows what could happen. In the early 1930s, yields on the S&P Industrials peaked at around 8 per cent at a time when AAA-rated bond yields were 5 per cent and falling. Between 1936 and 1958, equity yields fluctuated between 4 per cent and 7 per cent, while bond yields moved in a range from 2.5 per cent to 3.5 per cent. At no time during that 22-year period did equities yield less than bonds. The only reason that equities yielded less than corporate bonds at times in the 1933 to 1936 period was because of massive dividend cuts on many leading shares. It all sounds depressingly familiar.

The upshot is that we can't say with any conviction that the yield gap will switch back to a reverse yield gap any time soon. It may even need to widen some more before equities get as cheap as they are going to get. Yields on corporate bond exchange-traded funds (ETFs) - which mainly invest in high-quality bonds - range from 5 per cent to 7.3 per cent, depending on which currency denomination you choose, suggesting that equities have more backtracking to do before they get convincingly cheap.

Tobin's Q

The second, rather testing macro indicator of the market's value is known by the single letter Q. It is often known as Tobin's Q, after the economist James Tobin who devised it in 1969. The theory behind Q is that listed companies should be valued at their underlying net worth, that is, the value of their accounting net asset value (NAV), with some defining this more strictly as the replacement cost of net assets.

The best source for data about 'Q' is at Smithers & Co's website (www.smithers.co.uk). This has graphs giving values for Q and the underlying data going back to the early years of the century. Andrew Smithers was the co-author of Valuing Wall Street, the definitive work on Q and how it has varied over the years.

The current data for Q shows the ratio standing (as of early October 2008) at almost exactly its long-term average, but substantially below the peak level reached when the equity market was at its most manic. Q is a basic measure of whether stock markets are in touch with reality. And very often they aren't. Smithers describes it as being like a piece of elastic that will pull any deviation from the long-term average back to it in the fullness of time, as indeed has happened. This follows the classic statistical phenomenon of 'reversion to the mean'.

Moreover, Q's history seems to demonstrate that just as the ratio overshoots on the upside when markets are frothy, the reverse happens when markets are depressed. The period between the mid 1930s and late 1950s, and from the early 1970s to 1990 were periods that Q spent below its long-term average for an extended period of time. Significantly perhaps, these periods followed violent bear markets that, in the case of the 1930s, were credit-induced.

Critics of Q, although there are fewer of them than there used to be, point to the increasing role of intellectual capital rather than physical capital in today's economy. But even intellectual capital that is genuinely created by one company or industry, rather than simply transferred from one owner to another, will be to the detriment of the value of the intellectual capital of another industry or company.

The invention of the word processor decimated typewriter sales, personal computer sales hit mainframe computer sales, and the launch of one type of software will affect sales of a competitor. The overall economy, and the value of Q, will be unaffected.

CAPE

What lends weight to Q is that the cyclically-adjusted PE ratio on the market (CAPE) shows a virtually identical picture, the current value being almost at its long-term average and arguably poised to undershoot. CAPE, devised by the economist Robert Schiller, looks at the PE on the market using a long-term average of real earnings, ideally over the past 30 years. Value investing guru Ben Graham advocated, as far back as the 1930s, using a 10-year average of earnings to determine whether or not individual shares were cheap.

The yield gap, Q and CAPE suggest that the market is at best at 'fair value' at present and may possibly weaken further in the coming year or two. The cyclically adjusted PE ratio for the S&P 500 was six times earnings in 1982, before the start of the long 1980s and 1990s bull market. It is currently more than double that figure.

That does not mean, however, that equity investment is completely ruled out, but simply that we need to be exceptionally careful about the shares we invest in. So here are a few ratios to bear in mind when picking individual shares in this difficult climate.

Yield to PE ratio

Ask any investor or market analyst who was active in the early 1970s what the defining ratio was at that time, and it's a fair bet they will comment that good companies often sold on PE ratios less than their percentage dividend yields. A few months ago, finding sound companies that satisfied this criterion would have been a tricky exercise: now it is much less difficult.

A simple screen on shares with a market capitalisation greater than £250m, with a prospective yield greater than 8 per cent, dividend cover greater than 2.5 times and a prospective PE ratio less than seven times produces nine companies, including Ladbrokes, Greene King, Enterprise Inns and Drax Group. With brewers, pub owners and betting shops, which take cash from the public and own physical property, it’s a fair bet that the dividend yields will be sustainable and earnings remain relatively stable. Nothing is certain, of course, but it’s a good starting point for further investigation.

Free cash flow ratios

One very important feature of bear market investing is to look at cash flow rather than profit. Cash is the lifeblood of any company, and measuring it is much more important than calculating arbitrary profits. Cash flow takes operating profits and adds back book entries such as depreciation and amortisation and adjusts for changes in debtors, creditors and stocks.

Free cash flow takes this process one stage further, by deducting tax and interest paid. This is on the grounds that a company will not stay in business for long if it neglects to pay these items. A further deduction is sufficient capital spending to maintain the company's existing fixed assets in a reasonable state of repair.

The point about the free cash flow calculation is that it represents the amount of cash left over after all essential deductions have been made.

Companies then have a choice about how free cash flow is spent. It can be paid to shareholders in the form of dividends; used for acquisitions, used for share buy-backs, and used for straightforward 'organic' capital investment in the business, or simply retained.

Whatever choice companies make, free cash flow can be used to determine whether a company's shares are good value or not. At its simplest, this is typically done by comparing market value with free cash flow to arrive at a 'free cash flow multiple' or, by turning the calculation on its head and multiplying by 100, a percentage free cash flow yield.

In bear markets, some of the best companies will stand on multiples of free cash flow well down into single digits. By implication, this gives free cash flow yields well above 10 per cent or even higher than 15 per cent. If the nature of the business means that free cash flow can be guaranteed to be stable, stocks like this arguably represent outstanding value on a long-term basis.

The Z Score

Companies go bust in bear markets. So an essential part of any investor's toolkit should be a means of measuring whether or not a company is truly solvent and whether or not its financial position is deteriorating.

Research claims that the Z score can predict 70-80 per cent of potentially bankrupt public companies. The most famous prediction of bankruptcy that employed Z-score analysis was Maxwell Communications, but there have been other instances where it has come into its own to give investors advance warning of potential problems.

It works by taking a number of key ratios - partly from the profit and loss (P&L) account and partly from the balance sheet - and combining them in a specific formula. While this looks complicated, calculating it can be semi-automated using a spreadsheet. The individual Z-score measurements are used because they are based on the most common reasons for a company getting into dire straits.

In turn, they examine: the degree to which cash is flowing out of the business; whether the company is reinvesting sufficient amounts; the return it gets on its assets ignoring the quirks of the tax system or its capital structure; and the extent to which the company's stock market value can decline before the figure drops below the company's liabilities. The final ratio measures the effectiveness with which the company's assets are being used to generate sales and produce cash.

Weighted in the correct proportions and then combined, these measures provide a test of financial solidity that has proved over the years to be reliable. A financially sound company should have a Z-score of at least 3; one at risk of bankruptcy would have a score of 1.8 or less.

One disadvantage of the measurement is that it can't be used to assess the financial viability of banks, insurers, other financial companies and utilities. It will also be defeated by fraud and even relatively modest massaging of the key numbers will affect the outcome.

Where it really scores, however, is in pointing to deterioration in financial solidity. Conservative investors looking to buy shares in a bear market environment need to use it as a sieve to filter out the riskier investment prospects.

Companies and sectors with poor Z-score ratings tend to underperform during bear markets, only perking up when the economy starts to recover. Conversely, household and personal care, healthcare and some technology sectors have high Z-scores and look set to perform rather better for the time being.

Macro indicators still show the market as a whole looking likely to get cheaper before it recovers, but there are some key ratios that can point to likely candidates for safety-first share investing, if you feel the need to have a presence in the market. But go carefully.