Something strange has happened in UK financial markets
Market savvy investors frequently refer to the Price Earnings multiple as a means of gauging fair or unfair value for a given company listed on the stock market and, in the aggregate, as a means of assessing whether a market is generally under-priced or overvalued.
On the face of things, aside from mounting political concerns in both UK and mainland European financial markets, there is good evidence to suggest that aggregate investor behaviour has led to significant distortions in the pricing mechanism for market tradeable equities. There are a number of ways of describing this and possibly the most striking is the distribution of PE ratios.
Share price divided by earnings per share gives rise to a number called the Price Earnings ratio, or “PE” for short, and its use pervades all markets because of the high information value its number contains. It’s a crude but effective basic indicator of value. If the PE is very high you will need to become convinced the company is excellently managed with a bright earnings future before buying. If the PE is very low, you will want to check there is no bad news evident or coming around the corner before committing to purchase.
As with most things to do with markets driven by supply and demand, sentiment and other spurious influences, there are no hard and fast rules on what aggregate market PE is high and vice versa. But, most spectators agree aggregate PE’s below 15 imply shares are generally trading cheaply and a PE significantly above 20 implies shares are relatively expensive.
Now, lets look at the market distribution of PEs comprising the aggregate figure. Normally, we would expect to see a bell-shaped curve of individual PE values – a clustering of companies around the average figure with only a few instances of extreme values. Today though we have nothing remotely like a bell curve distribution of PE values as shown in the chart below.
Even odder is the fact that the cluster of companies with PEs of less that 10 includes a large proportion which regularly pay annual dividends of 5% or more and are expected to continue to do so. So, what can we make of all this oddity?
Its tempting to conclude that market values of many large and boring UK companies are significantly undervalued and the most likely explanation for this is a general aversion of non-European investors to invest in UK or mainland equity markets. Its seems international investors are, for the time being, preferring to invest in similar staple industries outside Europe in more politically stable environments.
Will that change after the Brexit question is resolved? All other things being equal, it appears it will. It is likely we will experience a reversion to the mean bell shaped curve soon after the relationship between the UK and the EU is clarified.