…the market has blown ‘hot and cold’ over the past week with the only sure ‘call’ being its unpredictability. And, as we have commented before, investors in risk assets hate uncertainty and especially those which surround events or issues which are inherently ‘slow burn’ or protracted in nature. As flagged in previous blogs, there is no easy quick win or panacea for the Eurozone’s current woes, where - notwithstanding attention on Greece, post its second election, in very short order, at the weekend - Spain has long represented the ‘elephant in the room’ concern. Accordingly, investors should prepare for the long haul rather than expect (politicians, central bankers and markets) to encounter an imminent ‘Damascus road’ experience.
In the near absence of interesting trading results from leading listed companies and any remarkable economic indicators (having looked beyond the heightened ‘noise’ of political posturing), the writer is accelerating the promised assessment of the various business sectors within the UK equity market. In the week that Home Retail announced that its DIY subsidiary Homebase experienced an 8.1% fall in sales in the 13 week period to 2 June – blaming the wettest April in a hundred years – and Lloyds’ plans to hive off 632 branches (known as Verde, as demanded by the European Commission) may have moved in the direction of a flotation, we take a look at retailers and banks. Retailers, general and food, make up a relatively small portion of the overall UK equity market (approximately 5% in total), but the bank sector is considerably larger (circa 14%) and therefore makes a more significant impact on the likes of the FTSE100 or FTSE All Share indices. Sharing a high profile via the high street, and often stirring emotive feelings amongst customers and investors alike, the leading companies within both industries tend to feature as much in the wider media, as the financial news. This week was no exception as what was Boots the chemist appears set to become part of the larger US pharmacy cum supermarket group Walgreens, and the Royal Bank of Scotland (RBS) announced further delays in selling off 318 branches to Banco Santander (required as part of its acceptance of state aid).
Location, location, location is, Estate Agents agree, critical to assessing the value of property. The same can be said of businesses, with the polarised performance of individual countries being a key factor in determining the worth of (which in itself is largely due to an assessment of the outlook for) shares of stock exchange listed companies. Accordingly, banks and retailers whose assets are based, and whose revenue and profits arise, in healthy economies are typically performing well. For example Standard Chartered Bank is essentially an Asian enterprise, whereas HSBC is a truly global business and therefore features a mix of strong growth and flat performance.
Amongst UK listed retailers, Burberry’s upmarket proposition stands out as being relatively recession-proof and, perhaps not surprisingly, the group possesses a growing presence in emerging economies with burgeoning middle classes. Asia Pacific accounted for 37% of the group’s revenue last year and, partially in response to a further increase in Chinese outlets, two leading brokers raised their profit forecasts for the branded clothing (and a lot more) retailer this week. On Tuesday, Majestic Wines announced a 14% increase in pre-tax profits in the year to 2 April, enabling a 20% dividend hike, on a 2.6% increase in like-for-like sales. The latter, bucking an overall reduction in UK wine consumption last year, features strong growth in its higher value fine wine offering (defined by their management as that priced @£20+ per bottle). Aided by a weak domestic commercial property market, this out-of-town retailer plans to expand its current 181 warehouses to 330 over the next ten years.
Beyond the macro geography, a similar picture emerges when scanning the domestic landscape. The economy of London, and to a lesser extent, the south east of England has been considerably more resilient than the rest of Britain – perhaps most evident in the capital’s property (both commercial and residential, which has international appeal) market. The privately owned John Lewis partnership, which includes the supermarket chain Waitrose, is another example of how a business which traditionally appeals to England’s middle income segment has managed to withstand the wider economic malaise. Interestingly, the value fashion retailer Primark - which is owned by FTSE100 constituent Associated British Foods – has delivered an impressive performance (in both sales and profits) over the past three years, as it has increasingly taken market share from the longer established mid-priced proposition clothing retailers. Primark increased its selling space by 1m sq feet in the year to 3 March 2012, and promises further expansion – which may dilute earnings growth in the short term.
Clearly, in line with logical expectation, the stock market is pricing in these differing prospects for the leading, blue chip businesses in each sector. As an example Burberry shares are priced at a heady premium, both to their more domestic peers as well as to the wider UK equity market; currently offering a dividend of just 1.8% and standing on a PE ratio of 18.6x forecast earnings in the current year to March 2013, and 15.9 times the anticipated result in the following twelve month period. Perhaps reflecting that its business is domestically-based, Majestic Wine shares are valued on a less demanding rating – but nevertheless above the overall retail sector average – of 13.7, and 12.6, times broker consensual forecast earnings for the comparable periods, with a dividend yield equating to 3.8%.
Investors might be interested to see - as benchmark indicators, rather than strictly comparable businesses - the current equivalent earnings-based valuations for Marks & Spencer (PE of 9.3x & 8.5x, same March year end) and Tesco (PE of 8.7x & 8.2x, albeit with a February 2013 & 2014 year end) stock. Incidentally, M&S are endeavouring to expand overseas (targeting 100 new international stores per annum), via multichannel (new websites in France & Ireland will take total to 10 by year-end) and broader product (in-store banking, via HSBC); while Tesco announced more of its plans to exit Japan (a flat economy with a mature food retail market), to focus on faster growth opportunities this week.
Turning to the banking sector, the valuation differences are perhaps not as great as their polarised business activities or locations might suggest. Standard Chartered stock is currently valued on a price/earnings multiple of 10.1x calendar 2012’s earnings (based on a consensus of 35 analysts), and 9.1 times next year’s with a current dividend yield of 3.5%; whereas HSBC is valued on 9.3x & 8.3x for comparable years’ earnings, and yields 4.8%. By contrast, Barclays’ shares are priced on a PE measured ratio of 7.0 and 5.4 times 2012 & 2013’s earnings, respectively. The recently announced injection of £100bn+ to support UK banks, by the Bank of England, should be beneficial for the big domestic clearers, but will have limited impact on the overall HSBC group and no direct effect on Standard Chartered.
Notwithstanding the HM Government’s large stakes, placing a realistic valuation on the equity of the Lloyds Banking Group and the Royal Bank of Scotland is a particularly demanding task – as small changes in the outlook for a number of factors (for example UK residential property values, in the case of Lloyds, and commercial asset values on prospective disposals for RBS) could combine, in various mixes, to dramatically change the outcomes for these banking giants. The equity of both appear significantly undervalued, based on banking industry analysts’ traditional assessment - primarily book value, thereafter earnings – but these companies desperately need to reduce the size (and improve the quality) of their respective balance sheets; something not helped by an unappealing prognosis for the domestic economy (impacting bad debt provisioning, in particular). While upside potential almost certainly exceeds the downside for Lloyds and RBS, this represents a long-term call; pending structural changes in the banking industry are likely to mean that the visibility on future earnings and balance sheet worth will not improve any time soon.
Perhaps we can conclude this brief look at these two often controversial industry segments, by a reminder that the two facets - per the example of a coin - particularly apply to any consideration of stock and share investment: the fundamentals of a company’s business and, secondly, the current price of its equity. Investors have to determine whether to pay the higher price for what appears to be more assured growth, or to anticipate some reversal of fortunes for the more beleaguered. Home Retail was an example this week of an ailing retailer whose stock rose 23% on Tuesday’s announcement of ‘better than feared’ trading results. Essentially, beside the 8% fall in sales at Homebase, its other prime operation Argos recorded a sales decline of just 0.2%. Kesa Electricals (owns Comet in the UK, but is changing its name to Darty to reflect its prime continental European brand) is another example of a retailer which is having a hard time, but managed to produce better sales numbers on Wednesday – albeit a fall of 2% - than had been expected.
Existing and prospective investors must investigate and decide if these businesses are in structural decline, or have merely been temporarily impacted by short term economic storms. Some firms, weakened during the sustained economic downturn, may lack a compelling future strategy and market position but do possess useful assets (for example property or brand worth) which could attract a predator. Albeit in a different industry, Vodafone’s acquisition of the struggling Cable & Wireless Worldwide group this week was a prime example of such a ‘rescue’. Investors should expect cash-rich businesses to take advantage of the current environ – which features difficulties in procuring finance or renewing debt obligations, as well as a lack of confidence in the economic outlook – by making trade purchases and other complimentary (typically earnings enhancing) acquisitions. AstraZeneca’s US$1.2bn spend on American biotech business (best known for a potential treatment for gout) Ardea, which completed this week, represents a case in point.
At this point in time, it is not surprising to see domestic cyclical stocks such as banks and retailers come under the proverbial ‘cosh’. The emotive factor will often exacerbate the depths to which an ‘unloved’ equity may fall, but the number of well-known high street names falling into liquidation is evidence that many will not recover. For those that do survive the current near-recessionary conditions in the UK, the future has to look brighter as the number of competing franchises will have diminished. Be you a retailer or bank – on the High Street or distributing to customers via the internet - subject to being financially strong (by reference to balance sheet), the biggest clearly have something of a natural advantage.
The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.
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