Adrian Saville, CIO of Cannon Asset Managers, recalls in this distillation of a research paper he authored the wisdom of investment gurus Benjamin Graham and David Dodd, and what this implies for South African equities.

In the wake of the 1929 stock market crash, Benjamin Graham and David Dodd of Columbia University argued that long term historical trends are far more significant for making investment decisions than any short-term moves.

Specifically, Graham and Dodd argued that price-earnings (p:e) ratios should not be based on only one year's worth of earnings, saying investors should look at profits for 'not less than five years, preferably seven or ten years'. To calculate this ratio, earnings for the previous 10 years are inflated to current prices using the consumer price index and an average earnings figure is calculated. The current price is divided by average real earnings to give a ratio with a more sensible perspective on value.

Graham and Dodd recommend that future earnings should not be considered as there is no proof that the market or analysts are able to forecast. Also, short term trends can confuse the real issues so only long term performance should be used. They argued that a price-earnings ratio based on one year of data would say more about what the economy was doing at a particular moment than about a company's long-term prospects.

Today, based on average profits over the last 10 years, the Graham and Dodd price-earnings ratio in the US has fallen to 15 times versus the average of 16.4 times recorded since 1881, as shown in Figure 1 (click on the grey arrows underneath the image). In the past 25 years the ratio has averaged around 23.3. Given this backdrop, using Graham and Dodd's long-term valuation tool, equities in the US are at their cheapest level in a generation.

However, just because equities are cheap, it does not mean they will not get cheaper. Prices or earnings (or both) could fall from current levels, despite the concerted policy efforts being undertaken. It must be stressed, however, that while valuations do not really matter for short-run returns, they are a primary determinant of long-run returns. Figure 2 (click on the grey arrows underneath the image) shows the average 10-year real returns achieved in the case of the S&P500 over the past 125 years depending on the starting Graham and Dodd price-earnings ratio.

The current p:e ratio of 15 in the US puts the market in the third column from the left — the second cheapest quartile. This suggests that over the next 10 years investors in the S&P500 can expect above-average returns (although not the bargain basement ones of the cheapest quartile), which belies the extremely cautious stance currently being taken by investors with regard to US equities.

Valuations in South Africa are compelling

In South Africa, with less data available, we have used a seven-year Graham and Dodd price-earnings for our analysis. The average Graham and Dodd price-earnings ratio for the SA market since 1980 is 16.7 times.

The current SA reading of 13.2 times is well-below recent peaks and about 20 percent below the long-term average, suggesting that, despite the gloomy mood, the domestic equity market is attractively priced.

Figure 4 (click on the grey arrows underneath the image) shows the average one-year, five-year and seven-year real returns achieved in the case of the JSE over the past 20 years, depending on the starting Graham and Dodd price-earnings ratio. Quartiles are used to sort the starting ratio, with quartile one capturing the highest price-earnings ratios (expensive markets) and quartile four capturing the lowest price-earnings ratios (cheap markets).

The current ratio of 13.2 puts the South African market in the set of columns furthest to the right, or the fourth quartile, representing a cheap market. Based on historical performances, a starting Graham and Dodd price-earnings ratio in this quartile correlates with an average annual real return of 20 percent over the next year, 13.1 percent per annum over the next five years and 31.6 percent per annum over seven years. In short, from a future returns perspective, there is no better starting point.

The sky is not falling

Despite these potentially highly attractive returns, investors continue to shun SA equities. While equities may get cheaper yet, potential returns are so attractive that it would still be beneficial to buy at these levels. For instance, when the Graham and Dodd ratio has been in the cheapest quartile, the average real return over five years is 13.1 percent whilst the minimum is 1.2 percent and the maximum is 44.4 percent. Under this scenario, the likelihood of earning negative real returns is so low that investors face a less than five percent chance.

South African equities are in bargain-basement territory and represent compelling value for investors who have the temerity to push aside the gloomy forecasts for 2009 and look beyond the noise of today.

Adrian Saville is CIO of Cannon Asset Managers and he holds a Visiting Professorship in Economics and Finance at the Gordon Institute of Business Science. Visit Adrian's blog at http://adriansaville.blogspot.com/

We all know the 'buy low, sell high' maxim. Having said that, are you as optimistic as Adrian Saville that the market is so cheap you can almost not lose? Leave a comment below...

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