Climbing the 'wall of worry'

Friday, 17th March 2017 14:47 - by David Harbage

It has been an interesting, as well as positive, week for UK equities with a number of critical pointers emerging to keep investors ‘on their toes’. As unseasonal warm temperatures arrived (London’s Kew gardens recorded 19 degrees centigrade), the market also seemed to have a spring in its step.

From a macro, ‘top down’ level, confidence was boosted by the American central bank decision to hike interest rates on Wednesday – by a quarter of one per cent to take its key overnight money rate range up to 0.75% to 1%. This represented the third 0.25% increase from the US Federal Reserve since rates bottomed, post the banking crisis nine years ago, and chair of the governors Janet Yellen indicated that two further hikes should be expected later in 2017. The market warmed to this policy of gradual and well flagged measures to address rising inflation, alongside raised targets for economic growth this year (GDP of 2.1%, versus previous forecast of 1.9%) with 2.1% also predicted for the following year and 1.9% in 2019. Against the backdrop of President Trump’s talk of 4% growth, investors had feared a less controlled, ‘knee jerk’ 0.5% hike.

Markets prefer a more cautious tone because the prospect of investors ‘travelling in hope’ (awaiting good news) for longer underpins current positive momentum – as well as reducing the possibility of an unwanted surprise (for instance: a ‘U’ turn by policymakers on any easing in economic activity) later on. Incidentally, while the US central bank has the same 2% inflation target that applies to rate setters in the Bank of England, a significant increase in domestic rates appears unlikely (despite continued news of economic health) while major Brexit-induced economic uncertainties overhang. On Thursday, the Monetary Policy Committee (MPC) voted 8-1 in favour of an unchanged 0.25% Bank rate in the UK – with the lone dissenter, Kristin Forbes (who is due to leave the Committee in three months’ time), calling for a pre-emptive rise in Base rate to 0.5%.

In the absence of the forthcoming Brexit - which received parliamentary approval this week – and, in particular, negotiations surrounding Britain’s terms of trade with the European Union – domestic interest rates would certainly be higher, based on current economic data. On Wednesday, the Office for National statistics (ONS) advised that unemployment had fallen by 31,000 to a rate of 4.7%, from 4.8%. Accompanying this, benign wage growth of 2.2% (as compared to 2.5% in December) limited concerns surrounding a new reflationary cycle. Last week’s Budget suggested that the Chancellor is prepared to accept higher government borrowing over the next year or so (to the extent of forgoing the proposed hike on NI contributions from the self-employed, per this week’s reversal) in order to maintain economic momentum while negotiations on EU trade continue.

In this environ - of UK rates being artificially restrained and US rates likely to follow a more orthodox route in the face of inflation - sterling appears set to remain under pressure against the greenback. Beyond the ‘carry’ trade (relative cash return on offer), the other prime influencer of a specific currency’s worth - of economic health - is likely to be overlooked in sterling’s case, because it is viewed as temporal and that the UK faces exceptional headwinds. The prospect of Scotland seeking a second referendum on independence from the United Kingdom – ostensibly in response to a wish to remain in the EU – represents another uncertainty, albeit more of a sideshow or irritant rather than a major negative. By contrast to the surprising political events of 2016, the re-election of Mark Rutte’s centre-right party in Holland on Wednesday provided comfort to those worried about further disruption to the EU. As ever boasting a minority, coalition-consensual government in the Netherlands but a ‘Drexit’ would have been sought by Geert Wilders if his nationalist party had become the largest in the Dutch parliament. Elections in France, Germany and Italy arise later this year.   

Previous blogs have highlighted the impact of a falling pound on the multinational businesses that dominate the UK equity market; suffice it to say that the £’s continued weakness helped to push the FTSE100 and FTSE250 indices to new highs this week. The headline grabbing FTSE100 comfortably went through the 7,400 level yesterday (despite a raft of ex-dividend deductions), encouraged by a number of trading results and further corporate activity.

Mergers or acquisitions are often announced to the market on a Monday, following frenetic activity in corporate departments of investment banks and company boardrooms over a week-end. Following ‘hot on the heels’ of the proposed merger of fund managers Standard Life and Aberdeen Asset Management, the Scottish M&A story continued as two FTSE250 businesses in the contracting cum engineering industry announced an all-paper tie-up on Monday. The Aberdeen-based, oil & marine services firm Wood Group announced that it had agreed to purchase its contracting peer in global natural resources, Amec Foster Wheeler. Placing a value on the latter of £2.2bn, investors in both companies welcomed the move which features greater diversification of business activities for the Wood Group (dependence on oil reduces from 85% to 60% of turnover), a more efficient balance sheet (Wood is undergeared, Amec carries £1bn of net debt), access to the more liquid FTSE100 index and synergy benefits can provide a spark to an otherwise uninspiring short term trading outlook.

The oil services industry inevitably sees cancelled orders and margin pressure when a weak oil price adversely impacts its prime customers – most obviously the upstream exploration companies. A pick-up in global economic activity (this month China announced a GDP growth target of ‘around 6.5% or higher’ in 2017 – a little higher than most commentators had anticipated), should see the oil price continue its climb from the US$30 per barrel seen in December 2015. The share price of Wood Group has been closely co-related to the commodity – rising from 552p to reach 894p in January this year, before slipping back to a pre-bid price of 716p. While the immediate outlook is difficult (profits are due to fall 15% this calendar year), a rebound in merger-adjusted earnings is anticipated in 2018 which should provide support. Nevertheless the combined group appear to be valued very close to the median earnings multiple for the wider market and is set to pay no more than a market average, twice covered by EPS, 3.7% income yield.

Owning a business whose future prospects are so closely tied to a particular commodity or product price – which will rise or fall according to the magnitude of supply, demand or other external, exceptional factor (notably geo-political concerns in the case of oil & gas) - represents a significant threat or opportunity. Looking beyond the oil price, domestic house prices command equal levels of media attention – and it is for the reader to assess the extent of potential volatility in price on that consumer product, and therefore the impact on the profitability of the industry’s listed companies. Bovis announced on Monday that it had received expressions of interest from two of its competitors over the past two weeks: Galliford Try and Redrow. These were almost certainly prompted by recent operational difficulties (being slow to complete homes and therefore miss financial targets) and the appearance of a tiller-less business (the chief executive resigned over the afore mentioned difficulties). Both bids were rejected as being inadequate and undervaluing Bovis’ potential, but the predators could return with a higher offer over the next four weeks (within the Takeover panel rules).

This predatory interest – albeit with little or no cash consideration in the offer – has resulted in Bovis advising that its efforts to resolve its recent profitability problem and find a new CEO were progressing well. The FTSE250 stock has risen 12% this week, but hopes of any higher offer must be tempered by the widely appreciated knowledge that buying land (to replenish that built on and sold) – the traditional reason to acquire another builder - is currently not a problem. Yes, economies of scale come into play, but synergy benefits are less obvious than in most manufacturing industries. Bovis shares are currently fairly, or even fully, valued when comparing their book value and earning multiple with peers: after discounting a probable 7% slippage in EPS in the current calendar year, a 10% advance in 2018 to 91.3p would put the stock on a multiple of 10 times.

Whilst commenting on the construction sector, an important steer was provided by upmarket builder Berkeley Group today, who indicated that trading in its geography of London & south east England had stabilised, after the EU referendum-induced weakness (completions were subsequently down 16% on the previous year) and that profits in the current year to 30 April 2017 were likely to be at the top of analysts’ expectations. Rather like reputation-damaged Bovis, the valuation placed on Berkeley Group had taken a ‘hit’ over the past nine months (albeit for something outside of its control: location of its sites). For those interested in the numbers, the stock is priced on a PE ratio of 9.3 times the April 2019 consensual forecast (of 13 brokers), who had anticipated slippage in EPS towards 318p before today’s announcement - which could prompt upgrades.

More assured prospects reside elsewhere within the sector, but potential investors must be careful that house builders do not represent a classic ‘value trap’ – essentially an equity investment offering an attractive earnings multiple, but perhaps hiding the possibility of a fall in future profits. Equity investments are primarily valued by reference to their future profit stream. Rather like the oil companies, belief in the sustainability of current new (rather than the overall stock of second hand) house prices and future progress is required.

Finally, amongst too many other corporate trading announcements to comment upon, a brief mention to two smaller AIM listed companies which have merited comment in previous blogs: Telit Communications who reported full year results for calendar 2016 on Monday, and Purplebricks, where board directors sold 2.9% of the online estate agents stock on Wednesday. The former is a technology business, which has been focusing on building up its ‘Internet of Things’ (IoT) products & services - essentially where wifi facilitates device-to-device communication and controls - announced City-beating numbers. With demand from both industrial users and consumers appearing to take a significant step forward, the company represents an interesting exposure to web-facilitated growing robotic technology. Telit stock has risen from 225p to 295p over the past year and accelerated another 10% on the last update; the shares are rated on an earnings multiple of 11 times 2018’s EPS (forecast by 4 research institutions), based on a 10% and 28% advance in profits this year and next.

By contrast the online estate agent Purplebricks is unlikely to become profitable this year, but this embryonic company which seeks to dislocate the existing commission-based estate agency model is expanding its reach into Australia and the United States. EPS of 8.4p are predicted (by the 3 brokers that monitor the company) in the year to 30 April 2019 putting the shares on a heady rating of 36 times the current £3 share price. The shares have trebled over the past three months, reaching a market capitalisation of £830m. Neil Woodford’s Patient Capital trust owns 25% of the company, but it remains a higher risk-reward stock (consider the low ‘barriers to entry’) and, as flagged when highlighting the business previously “not one for widows and orphans”. Taking some profit out of an investment that has risen so strongly, so quickly, makes eminent sense – whether you be a director with inside knowledge or a more distant longer term investor.                        

Signing off and looking forward to another week as this market tries to maintain its ‘climb up a wall of worry’ ahead of the ISA season. That allowance became more important than ever, incidentally, post last week’s Budget as dividends are set to be taxed more heavily – for basic as well as higher rate tax payers - in the year beginning 6 April 2018.

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.