Monitoring our 'Winners' performance in October 2016

Thursday, 27th October 2016 15:15 - by David Harbage

One year on from our initial ‘Identify and run with your winners’ blog, this article looks at both last month’s news and at significant developments affecting performance over the past year. With the US election taking centre stage, November 2016 is shaping up to be a critical month for financial markets and certainly a more interesting one for UK equities than in October, where most of our blue chips marked time in ahead of the Clinton v Trump vote.

As the spread sheet below shows, the average return from each constituent holding over the past year was positive and – if an investor placed a sum of money in each company stock based on its size (as the FTSE100 index is weighted) – a market capitalised weighted version of this portfolio of industry leaders would have outperformed the wider market.   

While assessing returns of equity investments over a twelve month period is far too short (most professional commentators would recommend a period of ten years as being more appropriate), this article takes a look back at the past year and wonders if the ‘industry leader’ descriptor was merited before leaving the reader to decide if good or poor performance has occurred by chance (being in the right or wrong place) or by design. Categorising the company stocks by reference to their returns over the past year, relative to the wider UK equity market – by comparison with the FTSE100 and the FTSE All Share indices – reveals

1. Industry leaders which outperformed the overall UK equity market by 20% or more: HSBC, Paysafe, Reckitt Benckiser, Rio Tinto, Royal Dutch Shell, Unilever and WPP Group

2. Industry leaders which outperformed the overall UK equity market by between 10% and 20%: Imperial Brands

3. Industry leaders which performed in-line with (producing returns within 10%) of the overall UK equity market: Aviva, British Telecom, Greene King, Persimmon, Smith & Nephew and Unite Group

4. Industry leaders which underperformed by between 10% and 20%: Sky and Whitbread

5. Industry leaders which underperformed by 20% or more: easyJet

The prime common factor found amongst the significant outperformers (the first and second groups) is that all feature high overseas earnings, whereas the underperforming companies tend to be domestic businesses. Much of this is simply currency translation – that is the prospect of revenue and profit being flattered in £ terms following the weakness in sterling – rather than an expectation of there being more robust growth beyond the United Kingdom. Three of the stronger performers also featured defensive, relatively recession-proof business activities (Imperial Brands’ tobacco, Reckitt Benckiser’s household & health products and Unilever’s food) – which seems logical against a backdrop of flat or slowing global economic activity. Although HSBC, Paysafe, Rio Tinto, Royal Dutch Petroleum and WPP Group have strong claims to economic sensitivity and being natural beneficiaries of higher global GDP.  

It is interesting to look at the outlook for earnings (primarily gleaned from brokers’ research, but also from the companies’ own guidance), and in particular the magnitude of up or down grades in those forecasts. There is a clear correlation between EPS (earnings per share) expectations and share prices, with an emphasis on looking as far forward as possible – rather than focusing on the current year’s trading. This is borne out when looking at whether earnings are set to grow or not over the next two years. Amongst the stocks we have been monitoring, the following are expected to deliver EPS growth in the current year and next: Aviva, Greene King, Imperial Brands, Paysafe, Reckitt Benckiser, Royal Dutch Shell, Unilever, Unite Group, Whitbread and WPP Group.

Five other companies, namely British Telecom, HSBC, Rio Tinto, Sky and Smith & Nephew are due to announce an EPS slippage this year, but a rebound or progress next. More concerning is the one instance of a firm likely to report an advance this year and a retreat the next: house builder Persimmon. However, the extent of the moves in consensual EPS forecasts is not great – up 10.3% in calendar 2016 and down 6.1% in 2017 – and the latest weekly data updates show upward revisions for both years. The final stock within the above list is easyJet, where analysts anticipate a drop in earnings in both the company year just ended, to 30 September 2016, and in the next. The magnitude of the forecast falls in the budget airline’s EPS is rather disconcerting: a 22% drop to 109p per share in the year just ended and a further 13% cut to 94.4p in 2017.

The nature of the airline industry necessarily makes it a higher risk-reward business venture, via its relatively low profit margins and a number of major influences that are often outside the control of its management. The price of fuel is one, exacerbated by the commodity being priced in dollars when most of easyJet’s ticket sales arise in sterling, and another external factor that can disrupt flights is weather or terrorist threat. Balance sheets feature aircraft on the Asset side and the debt required to finance such assets on the other; management of airlines will seek to own as modern a fleet as possible (new aircraft are significantly more fuel-efficient) and keep the cost of servicing its borrowings as low as possible. Competition from larger, better capitalised and perhaps foreign government assisted airlines is another near constant headwind. 

On 6 October, easyJet provided the market with a trading update covering the quarter period ending 30 September 2016. Clearly, the underlying business is robust as evident in record passenger traffic (22m seats) and an impressive load factor (93.9% occupancy) despite a 6.1% increase in capacity (number of available seats in the fleet) as new planes have been delivered. However an 8.7% fall in ticket prices (at constant currency, compared to the same three months of 2015) is disappointing, when considering that cost per seat has decreased by just 1.1% and, when incorporating fuel expense, by 4.6%. The importance of the latter is emphasised by the company’s indication that its fuel bill fell by between £75m-£80m over the past half year, as compared to the six months ending 30 September 2015. Exchange rate movements have a similarly big impact on this company: in the trading year just ended, the CFO estimates that the pound’s weakness has cost the company £90m (compared to the previous year) and expects another £90m adverse impact in the current year (based on the cost of fuel being US$ priced, versus a weak £).

In the last quarter period post the EU referendum, the price of fuel in sterling terms has risen significantly and, as a consequence, analysts have been applying their ‘red pencils’ to next year’s profit expectations. The consensus (from 27 brokers) EPS for the year to September 2017 has fallen dramatically and consistently: from 170p six months ago, to 135p three months ago, to 114.6p a month ago to 94.4p at the time of writing. easyJet’s share price has fallen in line with these downgrades – typically remaining on a sub market price to earnings multiple of 10 times. Looking at the most recent news flow, there are reasons to be cheerful: the trend of strong demand for budget air travel from both holiday and business travellers, together with the issue of a further £0.5bn of 1.125% coupon investment grade 7 year bonds.

Locking into such cheap finance is commendable, but bears and critics of the management (such as the Haji-Ioannou family, who own 33% of the company) will point to the increase in the airline’s capacity - 8% more seats are planned for the year to September 2017 - as being too expansive and likely to dilute profitability. Certainly the consumer (notably those paying for their tickets in Euros) seems to be the most obvious beneficiary in the short term as there has been no shortage of European airlines promising to cut fares and add more seats. Last week the CEO of Europe’s largest budget airline Ryanair said he would slash prices by 15% and increase capacity by 1m seats per month over the winter, while Norwegian Air (the third largest, but fastest growing, budget airline) expects 18% growth in capacity this year and 30% in 2017.

The prime attraction of easyJet had been its dividend income; with investors expecting a 54p pay-out in respect of the year just ended, this equates to a yield of 5.8%. However, on the basis of management’s guidance of distributing one half of its profits (which followed pressure from the airline’s founder Sir Stelios Haji-Ioannou earlier this year), the dividend next year could fall back towards 45p (representing a yield closer to 5%). The chase for market share appears a race that no-one wins in the short term and, although easyJet may be one of the more prudent operators and a potential long term winner, investing in this industry is only for those prepared to take higher risk. With the immediate visibility on short term earnings appear worrying at worst and foggy at best, the stock is being removed from the List.                 

As regular readers of this blog will know, the writer places considerable store on dividend income. The prospect of procuring growth in dividend income – as companies share their profits – is a prime reason for owning a stake in successful businesses. If the decision to retain easyJet may be dependent on the perceived reliability of its dividend pay-outs, a review of the other constituents’ dividend yield and cover of such income (that is the extent, expressed as a multiple, to which the dividend payment is ‘covered’ by earnings or profits) would seem prudent. The prospective yield (the dividend income anticipated in 2017/18 expressed as a % of the current worth of the shares) is already shown in the extreme right hand column of the above spread sheet, but is reproduced here – along with dividend cover - for ease of reference: 

Company        Prospective Dividend Yield     Dividend Cover (by profits in 2017/18)

Royal Dutch Shell     7.0%                            1 time, that is EPS = dividend payment

Persimmon                6.4%                            1.6 times, that is EPS = 1.6 times dividend

Aviva                          5.9%                            2 times, that is dividend = half EPS

HSBC                         5.8%                            1.3 times, that is dividend = 1/1.3 EPS

easyJet                       5.0%                            2 times, that is EPS = double the dividend

Greene King              4.9%                            2 times

British Telecom        4.5%                            2 times

Imperial Brands        4.3%                            1.6 times

Sky                              4.2%                            2.8 times

Unite Group               3.6%                            1.5 times

Rio Tinto and WPP   3.5%                            2 times

Unilever                      3.3%                            1.6 times        

Whitbread                  2.7%                            2.5 times

Reckitt Benckiser     2.4%                            2 times

Smith & Nephew       2.1%                            2.8 times

Paysafe                      0%                               If half of EPS were paid out yield would be 3.8%

Clearly, per the Paysafe example, the dividend is not necessarily going to be a priority for some companies. Growth businesses will believe that they can best use the cash they generate to fuel more growth, for example via research & development in new products or the acquisition of complementary businesses. As far as the wider UK equity market is concerned, the prospective dividend yield based on forecast earnings in 2017 is likely to be 3.75% and such distributions would be covered 1.8 times. Therefore, as can be seen from the predictions above, our List of industry leaders are likely to pay above average dividends as well as feature higher cover on such income from earnings.      

 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.