With the JSE on a P:E (price to earnings ratio) of 9.5 times, based on historical relationships, investors can expect a return of about 23 percent per year for the next five years.

Since the middle of last year financial markets have been washed over by waves of anxiety relating to the global economic slowdown, massive increases (followed by the recent collapse) in commodity prices (especially oil and platinum), rising price inflation, beleaguered consumers, frozen credit markets and, related to this, an increased incidence of distress or failure amongst banks and financial firms.

This backdrop has resulted in investors panicking about business prospects which have caused stocks to be widely — and wildly — sold off. As evidence of this the 49 markets that make up the MSCI World Index have experienced declines ranging between 28 percent (in the case of Switzerland) and 67 percent (China) in the year to date, measured in US dollar terms, with the much vaunted BRIC countries of Brazil, Russia, India and China having experienced an average decline of 61 percent.

The extent of depression about world equity markets is further evidenced by the fact that the nine country indices that have produced gains in the past twelve months belong to exceptionally small countries (examples include Malawi, Palestine and Costa Rica) that collectively account for less than one-tenth of one percent of the capital value of world equity markets. In US dollar terms the South African equity market, measured by the FTSE-JSE All Share Index, is off more than 40 percent in the year to date.

Expected return of 23% for next five years

As Dr Adrian Saville, CIO of Cannon Asset Managers, has stressed in the past: "Crisis gives birth to opportunity and the current situation is no exception. This probably represents one of the best buying opportunities that equity investors have faced for some time. On a trailing P:E ratio of 9.6 times, the expected average return from the market is about 23 percent per year for the next five years."

Incidentally, the last time the South African market traded on a price-earnings ratio of less than 10 times was in mid-2003, around the time of the start of the most recent strong bull run in equities. Coincidentally, the mood at that time was not dissimilar to the current mood: exceptionally poor sentiment relating to equities.

That aside, an average annual return of 23 percent translates into a doubling of capital in just over three years. Further, if one allows for growth in earnings, the market is priced on a forward P:E of 8 times. This result suggests that equities look even more attractive on a forward basis. However, the only way one can capture this powerful force of compound returns is to remain invested.

Saville's argument finds support in research conducted by Citadel. Using monthly data since 1960, the study finds strong evidence of an inverse relationship between the P:E of the All Share Index and the realised annual return over the subsequent five years. Actual P:Es and the subsequent returns are plotted and fitted to produce an expected return curve (see the second image; click on the grey arrow underneath the image to scroll between images).

The cheaper shares are in terms of their P:E ratio, the better profit prospects become

Significantly, the lower the P:E, the greater the upside potential in the subsequent period, reinforcing the appeal of the JSE at current levels. To put the point differently, the cheaper shares are in terms of their P:E ratio, the better an investor's profit prospects become, as can be seen in the third image.

Relying on the relationship that low P:E ratios translate into higher future returns, value managers, such as Cannon Asset Managers, focus on a search for value in the form of low P:E ratios in underlying equities. Extrapolating from the relationship between P:Es and market returns, an investor who buys into a fund on an eight times P:E can anticipate a mouth-watering annual average return of 26.6 percent over the next five years.

Of course, building a portfolio with a P:E ratio well below the market average is not a simple task. It requires a dedicated hunt for exceptionally priced opportunities and, by definition, a willingness to buy stocks that the market has ignored, neglected or treated too harshly and that carry fantastic recovery potential with an ability to meaningfully beat the market.

Saville says that examples of such opportunities are ABSA, Metropolitan Holdings, Lewis and Iliad, each of which is a good example of exceptional value being born out of distress. In each case, these companies trade on undemanding single-digit P:E ratios, offer high dividend yields and are supported by strong cash flow, sound balance sheets and attractive earnings prospects. These companies are held in Saville's Cannon Equity Fund, which has an implied forward P:E of less than 7.0 times.