Another surprise for markets as May opts for June

Thursday, 20th April 2017 13:58 - by David Harbage

The surprises continue: an escalation in global tensions (Syria, North Korea) prompted our last blog - writing about alternative investments (gold, commodities, private equity) – and the domestic financial markets, at least, now have a UK General Election on June 8^th to contend with.

In fact, like it or not, political elections are going to capture much of the media over the next few days as the French election process begins on Sunday, ending on Sunday 7 May, with the German Federal election due later in the year – on 24 September.

The rationale for Mrs Teresa May’s call – which Parliament endorsed yesterday – is clear enough: to increase the Conservatives’ majority to ease the path for, and the eventual vote to seal, Brexit. That it represented a ‘U’ turn on her previous statements and is opportunistic cannot be denied or be denigrated. The answer is always ‘No’ (not now) until it is ‘Yes’, and the prime opposition - in England, at least – probably appears weaker than at any time in living memory.

Notwithstanding that the EU referendum is now an event in history, the biggest factor in this election is undoubtedly set to be Brexit - providing the opportunity for individuals to reiterate or change the position they took back in June 2016. On the face of it, those that wish to leave the EU are likely to vote Conservative or UKIP, while those more sympathetic to our remaining in the EU are set to vote Green, Labour, Liberal, Plaid Cymru or SNP.     

As sterling strengthened, to just north of US$1.29 and EU1.19, commentators agreed that the most likely outcome - of the current administration being re-elected with a higher majority, based on current polls – would be a major positive for the British pound. A larger majority would provide Teresa May’s government with a stronger negotiating position in agreeing Brexit terms with our European neighbours. More pertinently, the prospect of an increased Conservative presence in the House of Commons is likely to dilute the hard line Brexit position and progress a better trade deal with the EU. Insofar as the foreign exchange markets are concerned, a softer Brexit outcome would undoubtedly be welcomed by holders of sterling.

By contrast, the UK equity market has fallen by 3% (FTSE100 index retreating from 7,340 to 7,110) since Monday’s announcement, in the face of the sterling strength – unwinding the previous year’s currency translation benefit for the multinationals who dominate the prime indices. The other big factor that has prompted a markdown in valuations, if not sentiment, is uncertainty. At the risk of repeating previous truisms:”the markets hate uncertainty, even more than bad news”. However unlikely, one can “never say never” (for instance to seeing a non-Conservative government in power on June 9^th) – but to the confident investor, a ‘wobble’ in the market can provide an opportunity to buy assets at a lower price.

Severe markdowns in share prices can arise from natural disasters (think of the impact on the Japanese markets of the Kobe earthquake in 1995 or the Fukushima nuclear power explosions in 2011 which were prompted by an earthquake and tsunami), from wars (recall Middle East conflicts, since the 1990 invasion into Kuwait) or terrorist atrocity (September 11 2001) to political events (elections or referendums). History is also littered with company specific, exceptional events – ranging from accounting irregularities to product issues, through to management scandals – which have adversely impacted the largest companies. Too numerous to mention but, while recent issues at British businesses British Telecom, Sports Direct and Tesco come to mind, further afield Enron, Volkswagen and WorldCom incurred much greater financial loss.

Existing owners and prospective buyers of stock have to consider and decide if the incident prompting the wider market, or individual stock, selloff is likely to be a temporary factor or a longer lasting one. In addition, making a judgement on the magnitude of the drawdown: is the fall an appropriate adjustment (to reflect the changed circumstances, and based on the cost of rectification) or is the markdown in valuation grossly wrong? History suggests that an over-reaction on the downside, exacerbated by an emotional response (fear), is the most likely outcome in the short term when considering such events – with one particular exception.

An adjustment caused by the wider market or a particular share being significantly overvalued on fundamental considerations. In the case of a listed company (which, of course, goes to make up an index), this would feature its balance sheet, trading prospects and a SWOT (assessment of the businesses’ Strengths, Weaknesses, Opportunities & Threats) analysis. The catalyst to recognising such over-valuation could arise via a shock (perhaps a bank collapse) or may be less dramatic (computer-based traders initiating big Sell orders, having determined that their valuation targets had been reached, causing other investors to ‘book profits’ or make for the exit). Unhelpful, if inevitable, media headlines will often refer to such stock market falls as ‘crashes’ as they will appear unexpected – consider the dramatic 20%+ falls in global equity markets in the month of October 1987 (FTSE100 index still finished 2% higher to close that year at 1,713) and the more gradual, but greater falls at the turn of the millennium (FTSE100 fell from 6,930 on January 1^st 2000 to 3,940 on 31^st December 2002).

Readers can make a judgement for themselves, but this writer would contend that the overall UK equity market is not overvalued – in particular by reference to the earnings and dividend yield on offer, compared to history and relative to the most obvious cash alternatives. By contrast, a case can be made that US equity appears expensive, particularly as interest rates appear on a clear upward trajectory, and the old saying of “When Wall Street sneezes, the rest of the world catches a cold” contains a real truth: that leading global equity valuations are co-related.

More pertinently, as regards the UK equity market, this blog’s previous suggestion that sterling has found a base is reinforced by the prospect of a domestic election that could provide greater clarity on our political direction. Intra-market, a reversal in the polarised call - on overseas versus domestic stocks of the past year - would appear to be a reasonable assumption. Both the Conservative and Labour parties can be expected to promise further support for infrastructure and housing, which offers further support for the domestic building material and construction industry.

Evidence of this being in investor thinking has already surfaced with sector leading businesses like Ibstock, the brick maker, and Kier Group, the civil engineering contractor, attracting broker mention and fund manager attention (as well as the new home builders). Both of these FTSE250 index constituents possess strong market positions in their particular business activity and their equity is similarly valued by the stock market – based on broker forecasts into 2018:

Ibstock has a market capitalisation of £900m and, based on the consensus of 10 brokers’ estimates, 20.2p of earnings per share (EPS) for calendar 2018 which equates to an undemanding (wider UK market is on a PE of 13x forecast 2018’s profits) Price-to-Earnings multiple (PE ratio) of 10.9. The shares are set to yield an above market 4.4%, based on next year’s likely dividend distribution and, for your information, 8 of those brokers view the stock as a Buy, and 2 have Hold recommendations.    

Kier Group’s market worth is £1,280m, has 6 published broker views (all say Buy) suggesting EPS of 119.6p in their accounting year which ends 30 June 2018; this also equates to a PE of 10.9 times those estimated earnings. Some readers might find it helpful to invert the PE ratio into an earning yield (10.9x becomes an earnings or profit yield of 9.17%) and, Kier’s higher pay-out ratio suggests a 5.3% income yield.

To complete the construction sector with a house builder of similar market size, here are the comparable valuation metrics for FTSE250 constituent Redrow: £2,055m market cap, 13 brokers consensus forecast 72.1p EPS for the year to June 2018 equating to a PE of 7.7x (earnings yield of 13%) and, with a quarter of earnings typically being distributed, a dividend yield of 3.25%. Current broker views break down to 10 Buyers, 2 Holders and 1 Seller. 

Bottom line expectations for this observer is that the market’s current weakness will be a short-lived period – lasting until the 8 June uncertainty is removed – and that the Conservatives will return with a higher majority, which will aid foreign investors view of the United Kingdom’s currency. As a consequence of the latter, the current stretched dispersion of equity valuation will contract to more normal, trend levels – as investors regain appetite for domestic stocks, funded by reducing exposure to international firms whose valuations appear stretched. Such a premise is based on valuations measured by earnings ratio, preferably using EV/EBITDA (Enterprise Value compared to Earnings before Interest, Taxation, Depreciation & Amortisation) rather than the more simplistic PE ratio – which ignores a business’ other capital sources (of either net debt or net cash) beyond equity, as well as the purity of sustainable profits (after stripping out interest, tax charge and asset depreciation/amortisation).