Is it better to travel than arrive?

Tuesday, 17th July 2018 07:29 - by David Harbage

Although not the day that many of us England fans had been hoping for, yesterday’s World Cup final reflected the whole tournament’s capacity to outperform expectations: with plenty of goals and incidents to discuss. Warm temperatures added to a ‘feel good’ experience, even if many decided that they could not face watching a game which England so nearly graced.

Watching a national team or representative can be a very positive experience, bringing neighbours and families together to watch and support a sporting event which would not otherwise interest them. Heightened media interest inevitably ratchets up expectation levels and participants in sport can find such exposure a burden rather than a positive contributor to their performance. The emotive rollercoaster – ranging from euphoria emanating from positive surprise through to despondency when hopes are dashed – shared by England football fans over the past week can also be experienced by stock market investors.  

Financial markets opine that “It is better to travel than arrive” when referring to the prospect of looking forward in hope to a particular expectation, which in turn might fall short of the highest forecasts and therefore disappoint. Speculative investment situations such as drilling an oil well can generate high levels of emotive excitement or stress and company management endeavour to guide and manage such expectations with a view to maintaining an orderly market. A recent example of dramatic news flow surrounds Ocado the on-line logistics operator which distributes Waitrose groceries; recent success in winning potentially lucrative contracts with US retail stores has seen the shares rise from 239p last November to 1043p today and into the FTSE100 index. Travelling strongly, but the company is unlikely to break even until 2020 and some investors might decide to take profits before the company’s own profits arrive in two or three years’ time.

Certainly, Sell-side (brokers and corporate finance) analysts calculate equity valuations in a dispassionate way – as do the investing institutions (the Buy-side or share owning part of the market). However, these numbers surrounding future revenue, earnings and growth rates as well as their assessment of the risks & opportunities faced by the business are all forward-looking; essentially they are projections of future value, rather than a review of past achievements. History can be very useful in understanding how macro-economic factors or an industry cycle is likely to progress but there is usually some tweak required – especially where new technology or significant change in social demographics may occur.

Long term investors will endeavour to make prudent decisions – featuring a broad spread of asset types (diversification) and retaining cash for opportune moments in time, perhaps when an unexpected adverse event has led to an asset becoming anomalously cheap. Readers will no doubt recall instances of particular company shares which have come close to being worthless (fashion retailer Next and house builder Taylor Wimpey come to mind) before recovering strongly to feature as FTSE100 index constituents today. Professional asset managers will also be mindful of the normal pricing relationship between certain types of financial instrument. For example, a historical study of domestic cash versus corporate bonds versus company shares (looking at yields or returns, taking into account inflation) suggests that UK equity is undervalued but, of course, prudent investors will need to make a judgement about what the future holds for inflation & interest rates, profit & asset growth and corporate balance sheets.

At times of heightened geo-political tensions, changes in the economic cycle or other exceptional event, uncertainty becomes the order of the day. At such times, the prognosis of experts has often fallen short of the subsequent reality and the potential for emotional influences to impact share prices has risen. The short term trader will seek to amplfy fear or greed often gearing up, via the use of financial instruments, to push the downward or upward trend further – effectively, taking advantage of a highly charged emotive market environment before closing the ‘short’ or ‘long’ position. As a consequence of such activity, share prices will often move far away from academic analysts’ assumptions of ‘fair value’. In the same way, the football fan can easily become ‘carried away’ with the euphoria of victory or defeat (however narrow the margin).

Private clients who are investing for the long term (typically beyond economic or industry cycles) should seek to avoid being drawn into the emotive ‘knee-jerk’ response of trading too frequently, and in particular in response to a ‘fear of losing’ capital or ‘missing out’ on monetary gain. Too often, immature investors will capitulate in the face of a falling stock price rather than carry out a ‘head over heart’ review of what they own (and in what proportion). The serious fund manager will often use such times of ‘sell at whatever price’ despair to pick up equity at bargain basement levels. However, that same professional money manager will not hesitate to ‘top-slice’ or reduce the size of his or her fund’s exposure to a specific company stock, if good relative performance has exceeded the appropriate magnitude of benefit due from the news flow.   

Owners of company stocks should keep a close eye on market trends and monitor updates on companies’ trading with a view to making good judgements about short term share performance. In particular if a stock ‘travelled’ too far, too quickly; this should be considered for both upward and downward moves – as wise investors will no doubt maintain a ‘Watch List’ of prospective investments (usually attractive businesses, which appear fully valued). However, the best returns usually accrue to the long term investor who identifies an industry leader with a product or service that cannot easily be replicated or bettered and which continues to deliver steady progressive returns to its shareholders (often in the form of a rising dividend pay-out, rather than a spectacular jump in profits).

An example of this might be the FTSE100 constituent Diageo – the £68bn market capitalised multinational spirits and brewing group, best known for Baileys, Guinness, Smirnoff and Johnny Walker, whose shares have risen by 50% over the past two years. 

Earnings growth has been far less spectacular (with 7% EPS anticipated in the year just ended and 10% in their accounting year to 30 June 2019), and offering a dividend yield of just 2.3%. With only one sell recommendation evident amongst the 20 brokers publishing an opinion on its equity, the company (which benefits from any weakness in sterling, as most of its turnover arises overseas) is viewed as a steady growth play rather than a racy performer. As a consequence the stock is highly rated as compared to the wider UK equity market (on a price-to-earnings ratio of 22 times’ next year’s earnings). However, by contrast with some of its international peers, Diageo appears fairly if not undervalued and is owned by most UK fund managers (including Capital Group which obsesses 2% of the group).

If Diageo represents an example of a UK company stock which appears fairly valued – with little evidence of emotional extremes impacting its share valuation (for better or worse) – and Ocado appears to have travelled ahead of events and normal fundamental valuation metrics, the writer would like to highlight a company which appears to have suffered unfairly from negative sentiment. Like many of its peers, FTSE250 constituent house builder Redrow has seen its stock price fall by 20% over the past two months as fears that profitability has peaked – with management unable to increase selling prices and 3-4% cost pressures. The shares current stand on a PE multiple of 6.1 times the earnings of 87.5p forecast for the year to 30 June 2019, and the anticipated (3 times covered by profits) 28.5p dividend for that year has the stock offering a prospective 5.3% income yield. There are 12 research houses covering this FTSE250 index constituent, but the consensual EPS forecast for the year just ended and next year has only increased – despite the adverse commentary on the residential property market.

Potential investors have to consider if the current near-moribund state of the overall or secondary housing market also applies to new build – which is currently benefiting from HMG support (low deposit Help to Buy scheme) and plentiful, well-priced land. In addition, a close eye is required to assess the perennial influences of interest rates and job security, as well as exceptional ones such as future political risk – could a change in government lead to a change in policy? Investors should consider, as this blog has before, if all house builders are the same – by reference to proposition (location, price point, build quality), end customer (private, social partnership, asset manager), balance sheet (cash or debt, length of land bank, level of creditors) and prospects.

More extreme adverse sentiment has been extended to other sector constituents – like the retirement homes specialist McCarthy & Stone, a business which relies on customers selling higher priced property – and, less appropriately, Crest Nicholson. In the case of the latter builder, which focuses on the south-east of England and necessarily more expensive homes than the nationwide volume operators, its equity has been in decline since reaching a peak of 632p in May 2017. A fall of 23% over the past two months has been ascribed to the company indicating that profit margins in the current year would come in at the bottom of its previously guided 18-20% range.

Prompted by concerns of the wider market’s stagnation holding back potential customers’ purchases, market commentators have extrapolated a continuation of such ‘bad news’ – notwithstanding management’s efforts to diversify geographically away from its core London commuter belt territory, and into a lower priced offering in general. For the record, the 10 brokers who analyse Crest Nicholson’s prospects anticipate a 2% fall in earnings in the current accounting year and an 8% hike in EPS in the year to 31 October 2019. Of those analysts, 7 suggest Buy, 3 say Hold and none recommend a Sell – dividend forecasts are 33p this year and a pay-out of 35.3p for 2019, twice covered by predicted profits.    

Euphoria can lead to ‘blind love’ and despondency can turn to capitulation – with a few less emotive descriptors sitting in between – but sensible private client investors can take advantage by choosing to buy when others sell (many because they are forced to do so, for example over-borrowed traders who run out of time or index trackers disposing of relegation candidates) and ideally, only disposing of stock for the best of reasons.

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.