Interactive Investor

Why equities are at their cheapest in 100 years

23rd January 2015 14:01

Harriet Mann from interactive investor

In absolute terms, UK equities look neither cheap nor expensive on a range of valuations metrics like price/earnings ratios, dividend yield, price-to-book and enterprise value-to-cash profits. Compared to fixed-income, however, London-listed stocks are looking extremely cheap, reckon the analysts at Citi.

As investors continue to favour income through low-risk asset classes, the popularity of government bonds has risen, pushing prices up and yields down. And due to that inverse relationship between a bond's price and its yield, the return on gilts has collapsed to historically low 10-year returns of 1.5%. Dividend yields on UK equities, however, are now at a 100-year high.

"UK equities have never been cheaper in the last c100 years relative to UK gilt yields, surpassing previous valuation extremes in 1940, 2008 and 2012," says Citi.

But it's not just UK equities that are enjoying an impressive yield run. As you can see from the chart below, all of the regions shown by Citi boast dividend yields way above bond yields.

"This means that equities have rarely, if ever, looked cheaper relative to bonds," says the broker. "Equities have replaced bonds as the 'default' yield asset class. In turn, this should attract more marginal buyers to equity, e.g. bond market, multi-asset, quant/low risk."

"With absolute valuations generally around long-term average levels, this suggests that flat to growing dividends should also support positive returns in the coming 12-18 months," adds Citi.

But with a disappointing season of earnings and downgrades from Citi's oil & gas team, could wide-spread dividend cuts be on the cards? They doubt it. In fact, the analysts claim that since the historic lows of the financial crisis, UK companies have been more than happy to pay out higher dividends over the last three years (see chart below). And they expect this to continue.

"This would suggest that UK plc will honour, and even grow, total dividend commitments. Citi analysts have 10% dividend growth still pencilled in for 2015E, for example, although we suspect that risks probably lie to the downside."

It may seem sensationalist, but Citi finds it hard to adopt a bearish view, as it doubts there will be any widespread dividend cuts, global recession/deflation or a sudden rise in interest rates.

Citi uses three strategies to identify securities with investment potential; high dividend yield and surplus free-cash-flow, high dividend yield growth and decent dividend cover, and high dividend yield and strong balance sheets.

For the first strategy, the mining and pharma sector looks attractive, with consumer goods company Unilever, broadcaster BskyB (SKY) and retailers Kingfisher and Marks and Spencer featuring.

For the second plan, financials and miners dominate with HSBC, Barclays and Rio Tinto taking the lead. Commodity and financial stocks dominate the third strategy, too, with Royal Dutch Shell, HSBC and BP among the favourites.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.