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By Alec Hogg
Investing in shares is not rocket science. But it isn’t easy to do successfully. Because, like the unfortunate novice at the racetrack, when everyone around offers advice it’s terribly easy to turn into a confused fool. And on the stock exchange, a fool and his money have always been very easily parted.
The rational approach is to only invest in shares when the odds are in your favour, and hold back or even lighten your stake when conditions are unfavourable. Among the best ways to gauge the relative level of share prices is by comparing their return in terms of the profit they’re generating.
We do this through monitoring the Price:Earnings ratio which tracks the share price as a multiple of the most recent year’s earnings (profit).
The average PE ratio of JSE listed companies since 1989. Produced from data provided by TimBukOne.com
The higher this P:E ratio, the longer it will take for the company to earn back profits to cover today’s entry cost. Put differently, a P:E ratio of 15 translates into a price equivalent of 15 years of the most recent 12 months of profit. So the lower the P:E ratio, the more appealing the investment prospect.
The chart above, produced from data supplied by TimBukOne.com, tracks the average P:E ratio for all JSE-listed shares over the past quarter century. At a glance it shows the current P:E ratio of 19.88 times is very much at the top of the long-term range – the level at which share prices are expensive.
Indeed. the current average P:E could be termed dangerously high. Even more so when loss-making companies are eliminated from the calculation. Doing so pushes the average P:E ratio of JSE-listed companies that are actually generating a profit to a stratospheric 32 times.
The last time PE ratios were at such elevated levels was back in 1994, after which share prices fell back significantly. They also approached the level in 2008 before another substantial retraction returned the market to normality.
The reason for this is twofold.
Share prices around the world were buoyed by Quantitative Easing – the US and Europe’s money-creating answer to the threat of returning to the 1930s Depression. A lot of the freshly minted cash sloshing around the system found its way into listed equities, driving share prices to abnormally high levels.
The second stimulant for local shares has been the slide in the local exchange rate. With a big chunk of the profits generated by the JSE’s biggest listings now coming from abroad, South African stock prices have also been stimulated by the depreciating Rand.
Long-term investors warn that over time, share prices always revert to the mean. Our chart suggests that with the JSE’s P:E ratio deep into the “expensive” zone, there is limited upside from current levels, but a high risk of a significant correction.
So is the level of share prices on the JSE expensive? You betcha. When will share prices revert to the mean? Unfortunately, nobody rings a bell at the top. But history would suggest a substantial correction is a matter of when, not if.
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