Monitoring our 'Winners' performance in August 2016

Thursday, 1st September 2016 10:50 - by David Harbage

The summer is often a quieter time for financial markets and, after the dramatic political events of the past couple of months, August has focused on assessing domestic economic news and digesting company results for the first half of 2016.

 The UK economy grew 0.6% in the second quarter period (as compared to 0.4% in the first three months) of 2016, driven by a 0.9% increase in household consumption (versus 0.7% in the previous quarter period). Against a backdrop of benign data featuring a 0.6% rise in consumer inflation in July (a slight rise, ahead of expectations), higher employment (31.75m people in work, and the highest rate, at 74.5%, since records began in 1971) accompanied by lower unemployment to the end of June (at 4.9%, the lowest rate since 2005 and, at 1.64m, the lowest number since 2008), Bank rate was halved to 0.25%.

Corporate profits showed a slight overall beat on analysts’ expectations, with forecasts for the full year largely driven by Brexit-driven, currency influence: notably overseas earners’ profits set to be flattered. Heartened by an absence of major profit warnings (relative to previous reporting periods), the UK equity market made a little progress in August with the headline FTSE100 index reaching 6,940 midway through the month before succumbing to weakness from overseas bourses. By contrast with the 1% advance in the wider market (reflecting a number of stocks being marked lower, as they traded ex-dividend), the company stocks on our list of businesses - which this writer identified as being industry leaders – showed polarised returns over the past month. Leaving aside a ‘steady as she goes’ group of Greene King, Imperial Brands, Reckitt Benckiser, Smith & Nephew, Unilever and Unite Group  which produced low single digit performance, we witnessed 5.5% to 6% share price weakness in the communications-to-broadcasting giants British Telecom and Sky. This was countered by relative share price strength, often of 10% plus, in the remainder of the list detailed below, which typically features more cyclical or economically sensitive businesses – where HSBC, despite its size, showed itself to possess the ‘fleetest of feet’ with a 15%+ rise in its equity worth in August.     

Looking at brokers’ research on these companies, it is noticeable that the above mentioned group of six – from Greene King to Unite Group - saw analysts upgrading their earnings’ forecasts for the next year. Profit estimates for BT Group and Sky in 2017 remained unchanged whereas EPS expectations for the remaining nine companies (with the exception of WPP Group) were lowered. This bears testimony to the forward-looking nature of the stock market and the fact that share prices move ahead of, but in anticipation of, future expectations or developments. The first group of often relatively economically-resilient stocks, who have enjoyed investor favour, had already anticipated or ‘priced in’ earnings upgrades as their share prices simply marked time when the higher profits were announced and ‘blue pencilled in’ for next year. By contrast share prices of the second group rose, despite lowered profit projections – essentially because the announced results and commentary surrounding the trading outlook were not as bad as some feared.

Sentiment towards BT and Sky, who both announced their last set of numbers on 28 July, seemed to suffer through the month of August as a number of fund managers lightened their exposures – although consensus profit and dividend forecasts of ‘Sell side’ analysts remained unchanged. Having commented on BT, Sky and HSBC in last month’s blog reviewing July’s performance, further mention of their respective merits or shortcomings can await a later blog – beyond saying that investor sentiment towards both telecommunications and broadcasters remains positive, but could be waning, while the long-term inhabitants of the ‘dog house’ sector of banking could be on an improving trend.

Different investors will have differing objectives and therefore make very different investment choices. For example, the shares of Next will appeal to some institutions and individuals, and the equity of Paysafe to others. In a month that has sadly witnessed the demise of British Home Stores, there has been considerable attention focused on the clothing retail sector – debating the competitive ex-BHS landscape of online versus High Street (in particular the impact of overheads, such as business rates) and the impact of more expensive imports (in response to sterling’s weakness). Fund managers with a positive view on the domestic economy will often seek to capture that expectation by owning general retailers, as they represent prime beneficiaries of anticipated higher consumer spending. Next is clearly a leader within the industry and, by contrast with many of its fashion peers, has historically delivered respectable trading results. Its shares appear fairly valued, being close to a market average earnings rating (of 12.3 times forecast profits in the year to 31 January 2018). A relatively safe choice within a low growth (as recently guided by the industry and the company itself) higher risk sector; in the month of August, Next stock rallied 11% to recover some of the ground it has lost since the £80 high reached in December 2015.

Another stock to advance by the same magnitude last month was a lesser-known, but also exposed to the consumer, business Paysafe. But, by contrast with the fashion retailer, this uplift has taken the shares to a new all-time high. Does this make the equity of this financial payments company expensive? A look at the respective PEG ratios, for this year and next, suggests not - as double-digit growth in underlying earnings is confidently expected by the near-universally bullish broking (and institutional investing) community over the next three years. Trading results on 10 August beat forecasts and Paysafe management guided analysts (something Next is also good at doing) to ‘raise their sights’ for earnings in the second half of this year and 2017. The performance of the recently acquired European Skrill business has been encouraging and, now that the integration has been completed, analysts are pondering the prospect of further earnings-enhancing acquisitions. Unlike Next, shareholders in Paysafe have yet to enjoy a dividend; but whether a maiden payment is declared following the calendar 2018 results may well depend on corporate action in the interim.

As the second smallest company (with only student accommodation group Unite being its junior), by reference to market capitalisation, in this list Paysafe barely qualifies in the eyes of some as an industry leader. Certainly, oil behemoths BP, Royal Dutch Shell or mining giants BHP Billiton, Rio Tinto would represent more obvious, better known industry leaders, but the wish to own businesses in technology and a specialised area of commercial property persuaded for their inclusion. Paysafe appears to have the ability to be nimble in a fast moving high growth industry, as well as large enough to possess the capital to reach and develop in new markets and countries.

If some belief in market efficiency can be held and is reflected in current equity valuations, the critical determinant of share price movement (relative to the overall market) surrounds the trend in earnings expectations over the next year or so. The all-important question is: have the recent EPS downgrades (for example seen in house builder Persimmon and the leisure firm Whitbread) now come to an end, can the series of EPS upgrades (as seen in the likes of tobacco business Imperial Brands and household goods manufacturer Unilever) continue? Looking across the various industries and businesses represented on the above List, a lot (of above average profit performance) is expected from those stocks boasting a price-to-earnings multiple of say 16 or above – while much less is anticipated from those with a PE ratio of less than 12. This in itself is far too simplistic as a much longer term view of a company’s prospects (10 years plus) should be assessed, as well as a raft of other measures (to include asset worth), and caveats surrounding a range of industry or company specific developments which could impact equity valuation. Those stocks valued in between 12-16 may better represent the average – viewed in terms of the pace of immediate profit and dividend progression, and the stock market’s valuation of its current worth and prospects - UK listed company.              

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.