The 25% rally in the UK stock market since the EU referendum last June has got investors worrying whether share valuations are too high given the mixed outlook for the economy.
AXA Framlington fund manager Chris St John believes he has some arguments to reassure investors in his part of the market, the FTSE 250, which lists the medium-sized or ‘mid cap’ companies in the UK.
Mid cap stocks were hit harder by the Brexit vote than larger companies in the FTSE 100 because they were seen as having greater exposure to a potentially weakening UK economy.
Since the end of last year, however, the FTSE 250 index has caught up with the FTSE 100, with both indices now showing a total return of just over 25% since 24 June last year, as some of the gloomier economic forecasts have been ignored.
He flagged the change in the price/earnings (PE) ratio which measures share prices against their 12-month earnings, or profits, forecasts.
St John said that currently the PE ratio on the FTSE 250 was ‘at a premium to the long run average as the market is pricing in an acceleration in underlying earnings’ and ‘certainly if recent history is anything to go buy we are seeing that’.
However, he said if you go back to year ending December 2001, the FTSE 250 produced £5.5 billion of profit and in the year to October 2015 produced £18.6 billion, over a three-fold increase.
‘In terms of 12-months forward PE [at the year ending December 2001]… it was 18.9 and you would be forgiven for saying I’m not going to buy the FTSE 250 because it’s too expensive, which is an ongoing issue I have when I talk to people about the FTSE 250 space,’ said St John.
‘If you roll the clock forward to the year ending October 2015 earnings more than trebled and index valued at 16.1 and so between the two points it has de-rated but bought at start and held to the end you would have made significant returns, over 300%.’
Earnings growth is also a ‘critical influence’ on equity returns and St John said a company ‘compounding earnings can compound dividends’.
‘To get those returns as an equity holder, which is crucial is the balance sheet is appropriately strong and the companies need to be appropriately financed,’ he said.