October 25, 2013 6:07 pm

Look no further than home for value shares

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UK shares have doubled since their low, says Dominic Picarda

The hunt for good value is getting tougher. I discussed here recently how the number of robust, high dividend yield opportunities had dwindled markedly, and how this has cast something of a pall over the outlook for shares in general.

In developed stock markets, the situation is probably worst for US large-cap shares. However, this is not to say that there aren’t decent value national equity markets around. Indeed, I believe that we need look no further than our own doorstep in this regard.

The UK, in the shape of the FTSE 100, is still a pretty attractively valued market, despite having risen by as much as 98 per cent from its early 2009 lows. But while the likes of the US have got the better of UK large-cap stocks in performance terms over this period – the S&P 500 set another all-time high this week – there is a good chance that the situation will be reversed in the years ahead.

History shows that the FTSE’s dividend yield is a decent guide to where it may be heading over the next year and beyond. The best capital gains have generally come when the FTSE has yielded more than 4 per cent. However, the present yield of 3.5 per cent is still consistent with a rise of about 6 per cent over the coming 12 months.

A more sophisticated view is offered by ShareMaestro, a purpose-built valuation model whose back-tested results have thoroughly beaten the market over time.

If we gloomily assume dividends don’t grow above inflation over the next five years, ShareMaestro says that the FTSE is still worth 7,747, some 16 per cent above where it is today. The model points to a less than one-in-five chance of the market going down over the next year.

I also think that the state of corporate profitability also leaves room for UK shares to go up. The accompanying chart looks at earnings per share for the DS Total Market UK index, a lookalike of the FTSE All-Share index, which itself is dominated by the FTSE 100. Specifically, it shows that earnings are below their rolling average of the last 10 years.

At first blush, this may not sound like especially great news. However, a look back over the last 40 years shows that times such as these have given way to the some of the strongest gains in equities. When earnings are below average levels, they tend to bounce back. By the same token, when earnings are well above the trend of recent years, shares often struggle thereafter.

In this respect, the situation in the UK is a bit like that in continental Europe, but very different to that in the US, where earnings are above trend. To me, this makes a more compelling case for betting on UK and European shares over the medium term. I would not be at all surprised if UK equities produced double-digit annualised returns over the coming five years.

Of course, there are risks to my fairly optimistic outlook. Aside from a renewal of the crisis in Europe, I am nervous about the effects of the US Federal Reserve’s plan to cut back on its money-printing bonanza. Also, were sterling to strengthen further, this could also be bad news for the FTSE 100’s performance.

I also understand that many investors might be uncomfortable about buying into a bull market that has already seen the FTSE nearly double from its lows. With retail investors getting increasingly confident and London property prices booming, I hear comparisons being drawn with the go-go days of early 2007, just before the crisis struck.

The FTSE 100 has reached the sort of price levels where it peaked in 2000 and 2007. The bull market is also the same sort of age the last one was when it expired. To those who believe in patterns or cycles, we are at an obvious point for things to take a decisive turn for the worse.

My response to this is that the FTSE is neither as stretched in terms of price, nor as richly valued as it was at the great peaks of 2000 and 2007.

The monthly relative strength index is one of the most effective gauges of whether a market’s price action has become overstretched. Today, this indicator is well short of its extremes of the past couple of decades.

While the FTSE is currently good value according to the ShareMaestro model, it was somewhat dear in 2007 and eye-wateringly so in 2000.

All in all, I remain fairly confident about the outlook for UK equities. The FTSE 100 offers decent value by past standards, and excellent value compared to developed government bonds. The bull market has further to run.

Dominic Picarda CFA, is associate editor of Investors Chronicle, and author of its Market Tactics report.

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