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 announces some positive results for the previous year, including rapid growth in Asia and, hey presto, the market value of the company increases 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 though 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, have 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 then 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 which 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 10 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 10 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 the Prudential has earned an average of 43p each year. The price in the chart above is 763p, so that 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 the 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 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 stock of an individual company are more risky than an index tracker. The risk of things going badly are 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 the 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.