Monitoring our Winners' performance in September 2016

Friday, 30th September 2016 15:18 - by David Harbage

September proved to be a sunny month for London, both in weather and stock market terms, recording the highest temperature (34 degrees centigrade on the 13^th) of the year and UK equities within 3% of its all-time high (FTSE100 index reached 7,103 in April 2015). Benign geo-political, economic and corporate news has represented a fair tailwind, encouraging followers of momentum to talk bullishly of further progress in the final quarter of the year.

The prospect of firmer commodity prices, and in particular oil - post this week’s OPEC meeting which agreed to cut production for the first time since 2008 – represented a positive for the UK’s big natural resource stocks. This move was significant enough to warrant bringing an oil & gas along with a mining company back onto our radar, via Royal Dutch Shell and Rio Tinto respectively, introduced at the expense of withdrawing Capita and Next from our List.  Seeing the price of a barrel of Brent crude get back towards US$50 will help combat global deflationary concerns, although at a cost to the greater corporate and consumer population.

However, looking forward to prospects for the equity market, the US election represents a major uncertainty – not just for America but, as the prime driver of global economic growth, on stock markets around the world. Historically, the year featuring US elections have tended to be good ones for equities and, in 2016 to date, Wall Street has enjoyed a double-digit advance reaching a new high last month. Economic data has surprised on the upside over the past year, which encouraged the Federal Reserve to raise interest rates last December (to 0.25%) and put the markets on notice to expect further hikes in 2016 – which, of course, have yet to materialise. Certainly, based on the current valuation of the immediate profit stream (using consensual forecasts for earnings in the current year and calendar 2017) relative to its longer term mean, the US equity market appears overvalued.          

This week’s lively debate between Donald Trump and Mrs Hilary Clinton confirms US politics are deeply polarised; but, while both candidates appear unloved by many within their own parties, a victory for Mr Trump would represent a significant surprise for financial markets. Even more so than the Brexit result within our referendum on European Union membership. It could be argued that the American two house political system is likely to provide the desired stability, but markets could yet encounter a bout of nervousness if opinion polls register further evidence of Donald Trump’s popularity. October has historically been a stormy month and, after stock markets have also enjoyed something of an ‘Indian summer’, it may not just be the leaves that take a fall.  

A useful exercise which a number of fund managers carry out on a regular basis, and which might also lend credence to the view that equities appear dear, is to re-assess a Watch List. These are company stocks or potential investments which are not currently owned or are perhaps under owned (by comparison with normal index weight or typical exposure in a portfolio). A case of ‘like the story’, but perhaps not until a particular issue is resolved or being unwilling to pay the current price. Carrying out a similar exercise on the universe of London stock exchange listed businesses (FTSE All Share index constituents, plus AIM), by applying filters on valuation (notably PE ratio and earnings growth), balance sheet strength (gearing), shareholder return - and all relative to company size, geographic profile and business, supported by availability of credible research – did not instil this prospective buyer with much enthusiasm. Another filter was applied to assess shorter term momentum: an inspection of brokers’ changes in their forecasts of corporate earnings for the next two years. Some broad brush trends could be envisaged, such as the impact a weakening in sterling versus the US dollar would have on immediate profits or significant moves in specific commodity prices, but others could not be anticipated. Trying to exclude those, over the month of September there has been a small but noticeable reduction in projected earnings which may or may not represent the beginning of a trend, perhaps a slowdown in top-line growth or downward pressure on profit margins 

To satisfy readers’ curiosity, the following firms were amongst those that merited closer interest or scrutiny: of those over £10bn in market capitalisation, life assurer Legal & General; for those between £3bn and £10bn, the oil services group Petrofac and in the £1bn and £3bn segment, Carillion. Thereafter, and capitalised between £100m and £1bn: Cape, Connect, Forterra, Ithaca, NAHL Group, Petra Diamonds, OPG Power, Redefine, Telit Communications, 32Red and Utilitywise merited attention, as did the following businesses, worth less than £100m Avation, Fairpoint, GLI Finance and Stadium Group. For one reason or another, the fund manager operating a Watch List or a prospective private client investor could also decide that the current price was not compelling and that there would be a better opportunity to buy. If this view rolled out more widely across the buy side, then investors might decide that a lack of attractive investment opportunities implied that the overall UK equity market was overvalued. This, of course, is simply one and perhaps an erroneous perspective – whatever might currently be inhibiting sentiment (ranging from pedestrian profit progress to difficulty in procuring the means to finance the growth potential) could evaporate very quickly - perhaps via new contract ‘wins’ or the emergence of new backers. 

Turning to the above List of long term winners, a number demand special attention or merit a mention. Starting with the weakest performer, Capita, this is a company that has benefitted from a well-established trend of both the public and corporate sector outsourcing many of their routine functions. On the 29^th September, they unexpectedly announced a trading update which indicated that their internal growth had slowed in the second half of 2016. By contrast with the 4% organic (i.e. achieved from existing operations, not from acquisitions) revenue growth expected, this was likely to fall to just 1% - meaning 2016 profits in the range of £535m-£555m, as compared to the pre-announcement consensus level of £614m. A fall in earnings of this, double-digit magnitude was not well-received (the share price fell 27%, below £7, on the day) and the market is unlikely to offer speedy forgiveness. For that reason and notwithstanding the undoubted, continuing trend in outsourcing by big organisations, Capita stock is removed from our List of Winners to make way for one of those huge multinational natural resource corporations. The likes of Rio Tinto, and Royal Dutch Shell, in particular, offer a high dividend yield to compensate investors for the leaner years.

Another company to report disappointing trading results in September was Next, on the 15^th. In the half year ending 31 July 2016, the clothing retailer announced a 1.3% fall in pre-tax profits on a 2.6% increase in turnover – confirming that the domestic consumer has, however temporarily, not got fashion towards the top of their priorities. The numbers were a little shy of analysts’ expectations, leading several brokers to lower their forecasts for the full year to the end of January 2017 were lowered, again. More critically, for the year ended 2018, consensual EPS expectations were cut from 461p to 446p (having been 476p in March) per share. While the clothing retailers will air the perennial excuses surrounding the weather (“too hot, not hot enough”) to explain unexpected fluctuations in demand, clearly 2016 is turning out to be an ‘annus horribilis’ as, even pre-Brexit (with its resultant weaker £, more expensive import of cloth, impact), the likes of Marks & Spencer were warning of a marked slowdown in fashion sales. With too many expense factors (including overhead business rates) being outside of their control – and necessarily having to take thinner profit margins, this business proposition lacks appeal.

By contrast in the last week of September, the equity worth of Sky received a welcome boost as a number of brokers, including long term supporter Exane BNP Paribas (who have a price target of 1075p) and Kepler Capital initiating coverage (placing a fair value of £11 on the stock), suggested the broadcaster’s shares had been unfairly neglected. This is undoubtedly and necessarily a fast moving company, in an industry which is renowned for its pace of technical development, and Sky has made a number of small value investments into innovative start-up companies in various forms of relevant technology. This was evidenced by three small acquisitions in September: Molotov, a French video platform, The Drone Racing League and Ginx TV, a 24 hour eSports television channel. Finally, in the month of September, investors continued to warm to the defensive, global attractions of Unilever who, earlier in the month had announced plans to expand its household products business by acquiring Seventh Generation – a US-based soap and detergent manufacturer.