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Water skiing definitely isn’t for the faint hearted.
You are yanked to the surface like a cork released under water and then you have to hold on for dear life.
As a spectator, it’s quite an amusing sight. Sometimes the skiers fall far behind the boat, and other times they slingshot around and overtake the boat. Whatever happens, however, the boat will always remain the most important factor in this sport.
The skier can fully relax an entire rope length behind the boat, but as soon as the boat moves forward, so will the skier.
In the same way the skier may move past the boat, but without the boat’s towing action the skier will lose momentum.
The boat will eventually catch up and as soon as it moves past the skier, the rope will tighten behind it.
We can apply the same principle to share profits, or more specifically, earnings. Share prices are determined in a variety of ways, of which the most important is their ability to generate future profits.
Investors’ emotions also play a vital role. When prices are based on emotions rather than ability to generate profits, it either creates a good investment opportunity, or a massive warning when share prices grow faster than earnings.
When we take a look at the bull market between April 2003 and June 2008, we will see that the FTSE/JSE All Share Index grew by a staggering 374%.
This was one of the best times for investors. Share earnings, however, grew by “only” 127% (I hope you can appreciate the irony, as the growth was still remarkable).
By applying the water-skiing analogy, this definitely qualified as the time when the skier passed the boat on the water at top speed. As we are well aware, the skier lost momentum in 2008 and was overtaken by the boat.
Fifteen years down the line, we find ourselves in a reversed situation, where the skier has been sprinting in front of the boat for quite some time, something that should always serve as a warning to investors to be careful going forward.
I feel that this is exactly why we haven’t seen much growth in the local stock market over the past three years.
Many will disagree with me in saying that the FTSE/JSE All Share Index still generated 25% growth over this period (or 8% per year), but if we take Naspers* out of the equation, the market’s total growth for the full period was a measly 1%.
The earnings per share (EPS) model below gives us an indication of how share prices compared to earnings on a historical level (which serves as no guarantee for future performance whatsoever).
These levels are then multiplied by the average historical price-to-earnings ratio (P/E) of the underlying asset (in this case, the FTSE/JSE All Share Index).
The average P/E since 1995 is 15.5 times. When we multiply this by the Index’s EPS, we get the same results: the skier in front of the boat, with the boat that’s starting to catch up. In the period following the 2008 crash, share prices ended up far behind earnings (or the proverbial boat) in 2011-2012.
This provided the emotionless investor with the perfect opportunity to buy.
According to this model, it appears as though the Index will be better priced around levels of 47 000 points (20% below current levels).
But before you panic and start to sell in fear of a 20% drop, we can also see how earnings have caught up with prices over the last year, and if this can be kept up for another year, we may be able to see the boat and skier come together eventually.
Finally, and the most important point of all, is that share prices reflect more of what’s to come in the future, while current earnings depict the last 12 months’ (historical) earnings.
The only warning I would like to give to investors is that in 2002 and 2008 when investors’ forecasts took a more negative turn, prices corrected sharply and quickly, so make sure that your risks are well diversified and that all your eggs aren’t in one basket.
Schalk Louw is a portfolio manager at PSG Wealth.
*finweek is a publication of Media24, a subsidiary of Naspers.
