Hamish McRae: Time for the brave investor to seek value in the stock market

Worrying about what is value makes a change from fretting about the bottom. No one can know where the bottom is until well after the event and we have had two false bottoms to the market since the peak. But we can say something sensible about value – whether shares are sensibly priced or not. If they are reasonably priced, then on a long-term view it must be wise to start buying now. Much better to be a bit early for the bus and have to wait a short while rather than miss it and have to hang around for ages until the next one comes.

We know now that there was not much value in shares a year or two ago, though it would have been more helpful if more of the investment banking community had told us that at the time. But now?

Perhaps the bravest of the mainstream financial institutions this cycle has been HSBC. I keep on my desk its economic team's paper Bubble trouble – the US bubble and how it will burst published in July 1999, more than six months before the markets turned down and more than 18 months before the US economy went into recession. So its judgement deserves attention today.

HSBC feels that there is real deep value in the UK market now in a way that there has not been for the best part of a decade. Thus 30 per cent of the Footsie stocks yield more than gilts and 20 per cent of the market is on a price-book ratio of less than one.

That sounds great – the best value for a decade – but there are two problems applying this principle. One is that all methods of valuation have their limits, even the most basic one of price-earnings ratios. The other is that you buy individual stocks, not the market. So HSBC has drawn up a set of eight old-fashioned valuations and seen which companies come towards the top on several of these.

Perhaps the best place to start this quest for value is to acknowledge the extent to which the market has been distorted by the collapse of the so-called TMT sector (technology, media and telecommunications). As the first graph shows if you take out TMT the market basically went sideways between the peak at the beginning of 2000 and this May. It was only in the past couple of months that it has really fallen away – and so only in the past couple of months has it become good value.

But how good? The next two graphs show two of the most basic measures of value, the price-earnings ratio and the dividend yield. On a prospective p/e (ie the current price against what companies are predicted to be earning at the current moment) the ratio is between 12 and 13, which as you can see is a typical level of the first half of the 1990s.

The dividend yield at 3.25 per cent (next graph) is also not far from the typical early 1980s level. The latter, it is true, might still be a touch thin but remember that this is a lower interest rate and inflation environment now than then, so you might expect slightly lower dividend yields.

But all this assumes that profits will rise decently in the next year or so. Insofar as the collapse of the market since May has been warning us of a double-dip in the world economy, is this assumption still valid?

Well, the final graph suggests that earnings per share are likely to move sharply upwards. This projection is based on a simple model, developed by HSBC, of UK, US and EU GDP (weighted towards the UK), plus the share of corporate profits within GDP, and with an allowance for interest rate changes. Models are only models but as you can see there has been a decent fit in the past. Looking at it you have to be of a fairly gloomy disposition not to expect some recovery of profits in the months ahead.

The HSBC team looks at other influences, such as the US market and the shift by many British pension funds from equities to fixed-interest securities. It concludes that the US market is a lot more overvalued than the UK one, so for London to go forward it would have to de-couple more from the US. That is possible but the US market may well remain a drag on the UK. As for the switch to bonds, the HSBC team thinks it will continue, capping any rise in the market. Looked at one way that might seem bad news, but it also means that UK shares will remain good value for some time.

And which shares? Which companies jump most easily through the various valuation hoops that are held out?

For a start house-builders and construction companies do well, as do insurance companies after the crash of recent weeks. Retailers and some other financial service companies also appear cheap. Of course if companies are particularly cheap on any one measure there is usually a good reason for that. Nevertheless there are some odd-ball situations that make you wonder whether the market is really right.

For example, some companies have huge amounts of cash relative to their price: Cable & Wireless cash holdings are 56 per cent of its market capitalisation. Others are cheap in relation to fixed assets (ie not counting goodwill as an asset). You might want to exclude the telecoms companies for obvious reasons, but British Airways and House of Fraser both pop up towards the top of the list.

Finally if you look at those two classic measures of value, dividend yield and p/e ratio, there are some surprising examples. Thus Royal & SunAlliance is now on a yield of 10.8 per cent and a p/e of 4.2. Abbey National is on 7.5 per cent and 9.0. Old Mutual is on 6.6 per cent and 4.6. Of course there are always reasons why any particular share is cheap: people are worried about the company for some reason. But you have to think of the flip side: there were reasons why shares used to be so expensive: people had high expectations of its prospects. Just as investors were over-confident then it is perfectly reasonable of them to be over-depressed now.

And the bottom? The key point is that whatever happens to the market as a whole, for some shares the bottom will already be passed. The various indices bottom on particular days but the shares that comprise these indices bottom on a cluster of dates, some months apart. The HSBC view is that while in the short term the UK market could be dragged down by the US, by the end of the year it should have turned and be back up to 5000.

That feels right. It really would be very odd for the market to go down three years running. The second leg of the double-dip (if that happens) may already be priced into the market. And at last there is real value in shares. The more people feel they should not be in the market at all and instead put their money in gilts, the greater the opportunities for the brave.