The stock market can be a funny old place. One day (last week actually), you might look at the price of Prudential, the FTSE 100 listed, multi-billion pound global insurance and financial services giant, and see that it’s valued at £17.8 billion.
Then a few days later, it announced some positive results for the previous year, including rapid growth in Asia and, hey presto, the market value of the company increased by some £2.2 billion, or 12%.
Okay, so some of that gain came before the latest results in anticipation, but a change in value of £2.2 billion in a week? That’s a pretty big swing.
So were investors right to jump in on the back of these results?
We all enjoy a good news story, but it’s another thing entirely to base investment decisions on such short-term and potentially short-lived results. So let’s step back a bit and look at how existing shareholders have faired in the last decade.
That’s one seriously bumpy ride, especially if you thought you were buying a boring and safe blue chip. As you can see, those investors who were brave enough to jump in when everyone thought it was the end of the world (early 2009) have made a colossal amount of money. They may be tired old clichés, but “being greedy when others are fearful” and “buy when there’s blood in the streets” are as close to Newton’s Laws as investors are ever likely to get.
Over this 10-year period, the share price, despite the massive swings in value, has gone precisely nowhere. So the next question is;
Can the investors who are piling in today expect anything better?
Of course, I do not have a crystal ball, but neither does anyone else. The next best thing is to understand what drives investment returns in the long term and to have the discipline to avoid getting caught up in the random noise that the financial media generates every day.
Returns driver #1: Growth
The first driver of long-term returns is growth. Unsurprisingly, those companies that can continue to grow for years and even decades will tend to have better share price growth in the long term than those that can’t.
Growth can be measured in various ways, but I prefer plain old earnings growth, and a little dividend growth doesn’t hurt either. The table below shows both Prudential’s earnings and dividends over the last ten years:
These results show a fairly typical history, with peaks and troughs in earnings and dividends. Overall the trend does seem to be upward, although the earnings growth figure over these ten years comes out at something like 17% a year, which is skewed upward by the poor results near the start of the period. This was a difficult period for many insurance companies as the previous easy money from equity investments evaporated once the dot com bubble burst.
If I look back just a couple more years to the previous peak earnings in 2000, then the growth rate since then is nearer 7%. The median growth rate for the companies I track is 7.5%, so it looks like the growth rate is about average in the long term.
Returns driver #2: Valuation
Finding a good company is only half the battle. To really beat the market, you have to buy low, and that’s where valuation comes in. Although looking at today’s PE ratio can be helpful, a much more useful measure is PE10, the price relative to the company’s 10-year earnings average.
The general guideline is to avoid paying more than 20 times the earnings average. In the past decade, Prudential has earned an average of 43p each year. The price in the chart above is 763p, so at that price, investors are paying almost 18 times the 10-year average earnings.
That’s pretty much bang on the median value that I have for the almost 200 medium and large-cap stocks that I track. So in terms of valuation, the Pru is once again Mr Average.
Of course, if you’d bought in around 700p in the week before the price explosion, then you would have been paying just over 16 times the earnings average, and while that’s not spectacularly cheap, it’s always better to pay less.
Returns driver #3: Dividend Yield
The yield at 763p is about 3.3% which, much like the PE10 value of 18, is very average. It’s about the same as the median value of the stocks that I track, and it’s also about the same as the FTSE 100.
Investors who are looking purely for yield would probably find more attractive opportunities elsewhere. And speaking of looking elsewhere:
How does Prudential stack up against other large caps?
By now, you probably won’t be surprised if I say that I think this one is very average. The valuation is average, the yield is average and the growth is average for medium and large-cap companies.
My watch list has the company down in position 73 out of 192, which is skewed slightly by that misleading 17% growth figure, but even then, it certainly wouldn’t be on my ‘hot’ list, it’s on more of a ‘warm’ list, waiting for the share price to drop to give a better entry point.
Would an index tracker be better?
As a stock picker, I have to think that every investment I make is going to turn out better than the index tracking alternative, otherwise why should I both with all the work and the additional risk of investing in individual shares?
That’s why every time I pick a stock, I compare it to the index. In this case, the comparison comes out like this:
If I put 7% in the growth column above, then you’d see that the Pru is really very similar to the FTSE 100 in terms of potential.
The key difference is that, as usual, the shares of an individual company are more risky than an index tracker. The risk of things going badly is higher, but the higher share price volatility also gives the opportunity for better medium-term results if you can time it right.
So, in summary, I wouldn’t personally bother with Prudential at the moment, Asian growth story or not. It’s a good company, and so a fall in the share price might change that, but at current levels, there are more attractive fish in the sea.
Very interesting the way you end each article with a comparison with the index. I don’t think I’ve ever seen that done proactively (as opposed to looking at the results after some period of time).
Of course, a pure passive investing believer might argue you’re trying to judge two things — your share and the fair value of the index — which is even more fraught with danger, risk (and they would say delusion) than just the stock picking.
But I like the idea. Too often stock picks are presented in a vacuum.
I guess occasionally people compare a stock’s yield to the index, or PE or something. I certainly haven’t seen anyone else make it such a core part of any evaluation, but to me it makes perfect sense. Why am I stock picking if not to beat the market? Therefore each stock I pick has to look more attractive than the market.
Regarding the point about the passive investor – from my point of view I’m not comparing a stock and an index; I’m comparing two stock, one of which (the FTSE 100) is a super-sized conglomerate with 100 wholly owned subsidiaries. To me the index is no different to any other company. It has earnings, it pays a dividend, it has ups and downs, and it has a ‘share’ price which moves all over the place, often with no relation to the underlying business.
I know a passive investor would say this is all a waste of time, and that’s fair enough; they can say what they like!
I’m actually a big fan of passive investing for people who can’t pick stocks effectively or don’t want to.
And your point about a vacuum is spot on. All investments are relative. There’s no point saying company X is attractive because it might return 20% a year for the next decade, because it isn’t attractive if company Y can return 30% a year for the same level of risk.
That’s why I’ve moved away from the idea of an intrinsic value, even an uncertain one. There is no such thing as intrinsic value, only relative value. Although saying that, given that most things mean revert, you could say that the intrinsic value is the value we’re most likely to see at some point in the future.
For me Prudential is something I can’t comprehend. I should, because they operate in the same field with me – financial services, but I can’t. It is clear that they have lost market share in UK, US and Europe. It is clear there are some gains from Emerging Markets and so on.
It is very hard to get to understand how much is gained comparing with how much is lost.
Will I invest in Prudential, the answer is simple: I don’t invest in something I don’t understand. There are plenty of companies I can understand so I will spend my time researching them.
When I look at large companies like Prudential, SSE or Vodafone I find it hard to believe that any investor really understands the business and the economic ecosystem in which it exists.
Just think about the millions of factors that affect Vodafone. The management, the other staff, their competitors, other disruptive technologies, the economy, consumer tastes and so on. And each of these factors have many layers. All of these things also interact with each other so it’s a hell of a job to disentangle it all.
My basic assumption is that Prudential will continue much as it has in the past with some amount of variation which I nor anyone else can possibly define.
So I’m willing to invest in what I don’t understand because I don’t think it’s possible to understand any complex business, which is why Buffett buys Coke, Gillette and Wrigley’s; businesses which are as simple as simple can be.
But I don’t think investors need to limit themselves so severely. As long as a business has a long stable history that may indicate some intrinsic stability in the business which has a better than average chance of persisting, and it’s that stable base which allows me to make a half-sensible attempt at valuing the things.
John
I can understand Coke business and its pricing power, they put the price of the sirop up every year and they spend (invest) lots of money in marketing. I can suppose this will continue to happen, it will remain profitable and even increase its profits.
I can also understand Vodafone business with the good and the bad of it. I am not happy with the bad, the fact that it treats new clients better than the old ones. The good is that it has better infrastruture which is important when chosing a provider for 3G services. People will need wide and fast mobile broadband and this should give a bit of pricing power. Not enough to make in into my portfolio yet.