In the second of a seven-part series for Master Investor, Glenn Martin, author of 7 Successful Stock Market Strategies, discusses long-term investment in the FTSE 100.
This is the second in a series of seven articles drawn from my new book, 7 Successful Stock Market Strategies. My first article provided an overview of the book. This article concentrates on Strategy 1, long-term investment in the FTSE 100. This is the simplest strategy because you buy a cost-effective FTSE 100 tracker fund and then continue to hold the investment whilst reinvesting dividends. You can make periodic fund top-ups, if you have further money to invest. However both for the initial investment and for any subsequent top-ups, it is essential that you do not invest when the FTSE 100 price is very expensive. For example, if you had invested at the end of 1999 in the dot.com boom, when the market was hugely overpriced, it would have taken you 7 years to recover the original value of your investment, including reinvested dividends.
This is where the unique Market Valuation System in my book comes into play. This system provides a current intrinsic value for the FTSE 100. The system projects the investment value in 5 years time which an investor will gain from investing in the FTSE 100 today – namely the FTSE 100 price in 5 years time together with the value of reinvested dividends. This future investment value is then reduced by two factors to obtain the current value of the FTSE 100:
– The FTSE 100 Risk Premium, which investors require for investing in equities rather than in safer cash-based alternatives. My extensive research over the last 30 years has shown the value of this Risk Premium to be around 10% for the whole five-year investment period.
– The gross redemption yield on 5-year gilts. This yield is used to reduce the future investment value, as adjusted by the Risk Premium, to today’s value since UK gilts held to redemption are regarded as risk-free. The technique to reduce a future value to today’s value using a given yield is know as discounting. It is the opposite of compounding whereby a current value is projected to a future value according to the investment yield and the period invested.
Having obtained the current value of the FTSE 100, you can express this as a percentage of the current market price to determine whether the price is expensive or cheap. For example at the end of 1999, the system indicated that the FTSE 100 was only worth 56% of the market price. These percentage valuations can be used as market entry and exit signals. A proven system has been to buy the FTSE 100 when the valuation is at least 105% and sell when the valuation falls to 95%. Since 1984 every FTSE 100 buy signal has produced a capital gain on the subsequent sell signal. Strategies 3 and 4 use these market timing signals to boost returns further.
The factors required to produce the FTSE 100 valuation are:
– the current FTSE 100 dividend
– the projected real FTSE 100 dividend growth rate over the next 5 years
– the average inflation rate over the next 5 years
– the actual inflation rate in 5 years time
– the FTSE 100 Risk Premium
– the current redemption yield on five-year gilts
My book provides sources to obtain values for each of these factors and explains how to build a spreadsheet to produce a FTSE 100 valuation using the factors. Alternatively investors can subscribe to ShareMaestro software (sharemaestro.co.uk) which provides weekly valuations for the FTSE 100 and for individual UK shares in the FTSE All-Share index.
For Strategy 1, you would only invest in the FTSE 100 if the current valuation were at least 105%. Once invested, you would instruct your broker to reinvest all dividends. The book provides details of brokers who charge nominal fees for dividend reinvestment. You should invest in a cost-effective FTSE 100 Exchange-traded tracker fund (ETF) rather than in a FTSE 100 unit trust tracker, since the latter will attract broker platform fees of up to 0.45% annually.
The returns of this buy and hold FTSE 100 tracker fund strategy have been very strong. From the start of 1984 to the end of September 2014, the compound annual return, including reinvested dividends after the basic rate of UK tax, has been 9.2%. This return includes dividend reinvestment costs and the prevailing management fees for the i-Shares FTSE 100 ETF. These fees have recently been reduced.
I would expect future returns for Strategy 1 to be lower than in the past since the FTSE 100 real dividend growth rate has reduced in recent years. However I would still expect the returns to be substantially higher than the highest returns available from cash deposits.