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David Harbage Blog


Review of the 'Focus on future profits' portfolio

Fri, 1st Dec 2017 - Author: David Harbage

It is a year since the author asserted that a prime driver of company share prices, over the appropriate longer term are those companies’ earnings or profit – with an expectation that distributed profits (dividend income) can be useful in combating inflation. Such income is not a bi-product but rather, for many investors, the prime reason for choosing equity investment to match long term liabilities.

To see how true that original statement might be, this blog has been monitoring the performance of a list of approximately 20 UK equities – featuring a number of industry leaders, together with a few ‘upstarts’, including a non-dividend payer - on a quarterly basis. Certainly, these company stocks are not intended to be a suggested portfolio, or indeed a recommendation of any sort.

The latest update of data is published below, showing each company’s size (market capitalisation or total worth of issued shares), future accounting year (being assessed as an indicator of the immediate outlook), forecast earnings per share (EPS, looking out as far as a reasonable number of brokers’ forecasts are available), comparing the pace of such earning growth to the share’s price-to-earnings multiple (PEG and PE ratio in that future year), the current share price, a summary of brokers’ recommendations along with the latest published price target of one of those research houses, broker consensus estimated dividend (based on the same year as the earnings), the extent to which that dividend is covered by those earnings, and the prospective dividend yield (calculated by comparing the forecast dividend to the current share price).

In addition to the ‘Sell side’ brokers detailed in the above schedule, fund management houses (who are more numerous and would normally have unbiased views) will have their own analysts (albeit typically carrying out secondary, rather than primary, research) on all the companies in their potential universe (from which they might choose to own). These fund managers make an assessment on future profits, incorporating a judgement on the best method of calculating those earning (or indeed other means of determining the current worth of future income or assets), as well as keenly monitoring the wider market’s opinions – to ensure that they do not have a ‘blind spot’ and miss a critical factor, be it a positive development or an additional risk. Often computer-facilitated, this exercise would be carried out on an intra-daily basis and, upon any significant development, potentially result in a change being effected in their portfolios.

At the end of this blog, the previous comparable spreadsheet of information – dated the 31 August 2017 – is reproduced for ease of reference. Looking at the past three months, a focus on European politics - as well as the prospects for the UK, post Brexit - has seen sterling stabilise and appreciate (the £ has moved from US$1.28 to US$1.34, and from EU1.08 to EU 1.13) over the quarter period. The UK equity market experienced a wider trading range than the previous quarter, with the FTSE100 ending the period 1.5% lower than where it started, but having ranged between 7,215.4 on the 15 September and 7,562.3 on 6 November. The mid cap (or medium sized companies of the FTSE250) index showed a similar pattern – barely 1% higher over the three months to 30 November, having slipped to 19,378.1 on 15 September before the index reached a record 20,491.4 on the 6 November 2017.

Looking beyond those headline indicators of the UK stock market’s valuation, there was, as always, plenty of movement amongst the individual constituents. Investors who choose to make company share selections, rather than own the whole market (via an index tracker), must expect to see laggards - as well as outperformers - amongst their portfolio. Put more brutally, such individuals must be able to accept the (perhaps temporary and if only on paper, unless realised by exiting a stock) emotional ‘pain’ of seeing losers as well as winners. Clearly investment in company shares should be viewed as longer term investment – over a number of years, rather than months – and the investor in specific company shares (rather than index-tracking funds) must be mindful of developments at those businesses. This blog will illustrate that point by taking a closer look at both the three month and the twelve months performance of the industry leading stocks selected a year ago.   

First of all we review the performance of the above ‘portfolio’ over the autumn months of September, October and November - which historically have seen some adverse turbulence. This time around, we saw outstanding (beating the wider market by 10% or more, a magnitude used in our previous quarterly reviews) share price performance from only two company stocks: GVC Holdings and Royal Dutch Shell. Shares in the online gaming operator rose 15.8% in response to an announcement of yet another encouraging trading and the prospect of management making an earnings-enhancing acquisition. The energy giant progressed 11.3% on the back of a stronger oil price and the Anglo-Dutch group’s estimates of medium term cash generation. Otherwise good (beating the wider market by between 5% and 10%) capital returns were seen in Unite Group (+3.8%) which announced further expansion of its nationwide student accommodation. 

By contrast, double-digit negative returns (ignoring income) were seen in pub operator and brewer Greene King (-24.1%) as domestic consumers’ net disposable income came under further pressure. In addition, the shares of British Telecom (-9.8%) remain unloved as profits are squeezed by the industry regulator and its expensive excursion into broadcasting (notably football). The de-rating of GlaxoSmithKline (-16.9%), Reckitt Benckiser (-11.1%), Playtech (-11.4%) and WPP Group (-7.7%) continued in response to research houses cutting their forecasts of short term earnings in each case.

We turn now to look at share price performance over the past year to 30 November 2017 which, as one might expect, shows greater dispersion in return amongst the individual companies in this list and away from the wider market (as evidenced by the FTSE100 index, which stood at 6,783.8 at the close of business on 30 November 2016, and has appreciated by 8.1%. 

Of the 21 stocks in our list, 8 had outstanding (beating the wider UK equity market by 10% or more) capital outperformance, 7 produced disappointing negative returns and 6 delivered a respectable, positive performance. Turning to the first category, stellar returns were seen at the online payments group which was taken over mid-year Paysafe +51.0%, the national volume house builder Persimmon +50.3%, FTSE250 constituent GVC Holdings +38.7%, the household & food products group who have had a management cum strategic shakeup post Kraft Heinz’s unsuccessful bid at the beginning of 2017 Unilever +31.5%, investors warmed to good progress in growing its property assets Unite Group +29.9%, strong free cash flow prompted a £1.5bn share buyback in the summer at international drinks giant Diageo +28.6%, Sky +19.4% in response to Rupert Murdoch’s bid via Fox and, finally, a recovery in mineral prices and operational performance drove Rio Tinto +17.8%..

At the opposite end of the spectrum, there were a number of disappointments (with 10%+ underperformance), but three stand out: British Telecom -25.0% following the accounting scandal at its Italian division and dull trading closer to home, international advertising and media business WPP Group -22.8% which has lost its longstanding premium rating after announcing a profits warning in both March and September. Investors have also given the ‘barge pole’ treatment to domestic consumer stock Greene King -23.6%, negative sentiment gathering pace ahead of a disappointing update today.

Other areas of notable investor neglect over the past year were three mega cap international businesses: pharmaceutical GlaxoSmithKline -15.7%, tobacco giant Imperial Brands -10.6% and household product firm Reckitt Benckiser -3.7%, along with FTSE250 gaming software business Playtech -2.0%.

For the record, in the final ‘respectable’ category, two companies merit a mention as having delivered good capital returns (which we will view as stocks outperforming between +5% and +10%): the supplier of orthopaedic joints to an aging population Smith & Nephew +16.6% and the global bank HSBC +16.0%. Following them were life assurer Aviva +14.3% which announced an upgrade of its targets for earnings growth and dividends today, the FTSE100’s largest company Royal Dutch Shell +13.5%, the self-described Bank of Georgia +11.4% and coffee-to-budget hotel group Whitbread +3.6%.   

As mentioned in previous reviews, where brokers’ forecast EPS moves by more than 10% over a quarter-period a ‘sanity check’ - to ensure that the new estimated numbers are reasonable - is merited. This can best be done by reviewing the company’s announcements to investors; in particular by reading through trading results, updates, mergers and acquisitions to discover where the positive surprises or adverse news have emanated. It is also interesting to gauge the wider market’s mood by reference to overall trends in forward-looking EPS.

In the three months to 30 November 2017, only two constituents of our list recorded a double-digit move in consensus EPS forecasts for the coming year (which analysts term FY1 or forward year one): whereas Rio Tinto saw estimates for 2018 EPS rise from 272p to 309.6p, Playtech received analysts’ ‘red pen’ treatment as next year’s prospective EPS was marked down from 84.2p to 74.1p. It is interesting to see that broker recommendations on the latter have not been adversely impacted, perhaps indicating belief in the company’s longer term prospects or taking account of the reduced price.    

Looking at the past quarter and our diverse list of companies, there have been more downgrades to EPS forecasts – rather than increases. The relative strength of sterling might account for some currency-translation easing in profit expectation, but the company stocks that have enjoyed such positive EPS upgrade treatment from brokers are: Rio Tinto, as mentioned, plus Aviva, Diageo, HSBC, Paysafe, Persimmon, Royal Dutch Shell and Unite Group.   

More interesting is to look at the twelve month move in forward-looking EPS estimates - in terms of assessing the rigour of our belief that the trend in future earnings will determine the worth, and therefore direction, of equity prices. Amongst our list of leaders in various industries, only two companies have had double-digit (i.e. 10% or more) reductions in brokers’ forecasts of future earnings: British Telecom’s EPS for the year to March 2019 has fallen 32p to 28.1p and Greene King’s EPS for the year to April 2019 has retreated from 75.8p to 67.1p. These two firms were amongst the three worst performers; the other, WPP Group, also saw a fall in EPS for calendar 2018 (from 126.2p to 125.9p, after having been as high as 139.3p in March 2017).

The same picture emerges amongst the portfolio’s ‘winners’, with the biggest upward jumps in future earnings also proving to be the company shares which performed best. In particular, the biggest moves in EPS over the past year were seen in: Persimmon (184.6p to 255.4p), Rio Tinto (227.5p to 309.6p), Paysafe (36p to 43.6p), Unilever (175.5p to 214.6p), GVC Holdings (50.9p to 60.7p) and Aviva (47.5p to 55.7p). Double-digit hikes in forward-looking EPS were also seen in Diageo (103.7p to 116.7p), HSBC (50.3p to 55.4p), Sky (57.3p to 64.2p) and Unite Group (30p to 34.7p).               

Overall single digit increases in EPS consensus forecasts over the past year have also been recorded at Bank of Georgia (367.7p to 38.9p), Playtech (71.7p to74.1p), Reckitt Benckiser (339.4p to 359p), Royal Dutch Shell (147.1p to 152.5p) and Whitbread (255.5p to 272.7p). By contrast, overall single digit decreases in EPS consensus forecasts over those twelve months were seen at GlaxoSmithKline (108.9p to 108p) and Smith & Nephew (72.7p to 70.7p).

It should be noted that all the % returns mentioned in this blog – be it for companies or indices – relate to capital only; income returns from dividends would, of course, increase total shareholder return in every case. The prospective yield shown in the right-hand column of the schedules refers to just that – future income – and, for the most part, is based on the consensus of brokers’ estimates for dividends to be paid in respect of 2018/19’s earnings, rather than a reflection of what was paid over the past year. Paysafe-excepted as a non-dividend payer, investors will have benefited from dividend income over the past year from these companies - and the share price, in theory at least, would have been adjusted lower to reflect the dividend on the entitlement date. 

It can be seen over the past three and twelve months that the directional trend in profit forecasts has clearly been a key driver of short term stock performance – with dividend pay-out expectations rising by a similar magnitude when higher earnings are anticipated. When estimates of future profits have been reduced, typically the amount of anticipated dividend – if well covered by earnings – has remained unchanged. The only exception to this being companies with an explicit policy of distributing a specific proportion of its earnings. Accordingly, although indicating some slowing in profit growth across much of the UK equity market over the next twelve months (and in domestic consumer stocks in particular), this has not appeared to jeopardise anticipated dividend pay-outs from almost every one of the portfolio’s constituents.  

Finally, for ease of reference, please see the previous (31 August 2017) uplift of data.

 

 

 



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