Observations on markets & trading updates

Thursday, 26th January 2017 14:51 - by David Harbage

Against a backdrop of seeing sterling rally further – post PM Theresa May’s advice that she would produce a Brexit paper outlining plans for leaving the European Union…..

and evidence that the British economy has performed more strongly post the EU referendum, than in the first half of 2016 – gross domestic product (GDP) exceeded expectations as it grew 0.6% in the final quarter of 2016, per figures released by the Office for National Statistics (ONS) this morning…...

sentiment towards domestic risk assets, such as real estate, corporate debt and equities remains intact. A view supported by a plethora of survey evidence (on asset allocation and price targets) from fund managers and financial commentators. Although there remains some appetite to retain cash, this appears driven by the wish to retain opportunistic ammunition (to pick up a bargain or meet an unexpected liability) rather than benefit from rising interest rates or a pickup on yields on credit.

Further afield, the newly installed President Trump is capturing most of the headlines – notably on job-creating, if controversial, projects (oil pipelines and border walls) – with corporates seeming to respond to his efforts to repatriate US jobs and in anticipation of lower taxation. Against this backdrop, the Dow Jones Industrial Average (DJIA) index of 30 major US equities finally broke through, and finished above, the 20,000 mark. While it may be psychologically significant as the best known (dating back to the nineteenth century) indicator of the health of Wall Street stocks, the DJIA index is far from being the best guide to US equity progress – representing only 30 companies, which are not the largest in stock market worth terms, and not on a market valuation weighted basis. That honour goes to the much more diversified (albeit determined by Committee) Standard & Poors (S&P) 500 index which, at 2,300, also reached a new critical high yesterday

Following on from last week’s blog highlighting the dispersion in rating between UK equities focused on the domestic economy and those with a global profile or reach, this article features two rather different businesses which today provided the market with an update of their most recent trading. The multinational alcoholic drinks business Diageo reported their interim results for the six months to 31 December 2016, and one of the UK’s leading greeting card retailers Card Factory provided an eleven month update on trading again to the year-end. The ONS numbers this morning highlighted the strength in Britain’s service sector (at +0.8% in the final quarter of 2016, this dominates national output) and, in particular, the retail industry. While undoubtedly a fiercely competitive sector, and making reasonable returns on invested capital difficult to achieve (reader should take a look at profit margins of the leading stock exchange listed food and general merchandise retailers), consumer spending in the run up to Christmas appears to have been resilient.

Diageo shares rose by 4.5% (or almost £1, to get within touching distance of their all-time high of 2268p reached last October) as they delivered results which beat the market’s forecasts. The City has long been admirers of this well-managed business, with 16 research houses on the Sell side currently putting forward a Buy recommendation, 10 a hold and only 1 analyst suggesting a Sell on the maker of a leading range of spirits and the brewer of Guinness. Essentially delivering a 28% jump in operating profit, on a 14.5% hike in net sales, the group have once again delivered organic top line growth (management target is 6%) and improved productivity (aim to enhance operating margins by 1% over the 3 years to June 2019).

Critically, the impact of sterling’s weakness cannot be over-emphasised: be it over the past half year or its future influence. Diageo’s accounts department anticipate (based on exchange rates of £1=US$1.24 and £1=E1.16) that for their full year to 30 June 2017, the company’s net sales will benefit by £1.4bn and operating profit will be favourably impacted to the tune of £460m. To put those numbers in perspective, the consensus of the previously mentioned broker analysts anticipate profits of £2,620m in the current trading year to June 2017. While investors may remain comfortable with owning international consumer industry leaders like Diageo, they should be mindful that exchange rates can (or, rather, will) fluctuate and that the shares’ current heady rating – the price-to-earnings multiple for the current year is 20.5x, with a likely dividend yield of 2.9% - could contract if the pound were to regain some of its lost ground.       

By contrast with the maker of Bailey’s, Johnny Walker & Smirnoff which can trace its origins back to the 1700’s and has a current equity market value in excess of £56bn, Card Factory is little known beyond the UK’s secondary high streets. Beginning as one store in 1997 and fully listed on the London stock exchange since May 2014, the company’s shares are worth £860m in total and investors’ experience can be summarised by envisaging a hill shaped graph: rising from 200p in May 2014, to briefly touch 400p in September 2015, before retracing to 236p a week ago. While principally a ‘bricks ‘n mortar’ retailer through its 850 shops, the company runs two websites for its low price proposition of cards, related wrappings and gifts. Differentiated from its competitors by having an in-house design and printing capability (often described as a vertical operation), management are seeking to roll out more stores (51 opened since 1 February 2016) as well as progress its online offering via complimentary products.

The latest results may mark the ‘low water’ point for the shares, as trading was good over Christmas (relative to a strong 2015) and negative ‘like-for-like’ (that is only comparing the stores opened over both periods) sales came back into positive territory of +0.4% in the period Feb 1^st to Dec 31^st 2016. Once established, new stores typically deliver higher revenue and profitability, resulting in total year to date sales rising 4.3%. CEO Karen Hubbard, who only joined a year ago, spoke optimistically of 2017, suggesting further market share gain, as well as reiterating guidance on analysts’ forecasts for the current accounting year which ends on 31 January. Card Factory shares rose 3% on today’s update and, at 252p, currently stand on a PE multiple of 11.9 times forecast earnings for the year to 31 January 2019, supported by an anticipated (twice covered by profits) dividend of 4%. The latter is expected to be boosted by special dividends which could double its pay-out ratio.

However, this FTSE250 index constituent will rightly be regarded by many – including several fund managers known to the author – as a low quality investment, depending on weaker peers leaving the industry as much as the company’s own product and business model succeeding. This is certainly the case compared to a company, which owns well-established branded products and sells into almost 180 countries, like Diageo. Over the past half year, the CEO has invested £120,000 of her own money in Card Factory, at an average price of close to 300p, and a number of leading UK fund managers (like Invesco, Artemis, Old Mutual and JP Morgan) have faith in the business.

“You pays your money and takes your choice” or give both of the above mentioned companies a ‘wide berth’ (this blogger makes no recommendations). One is an investment in a confident consumer in the United States & Europe and a growing middle class in Asia and emerging economies (Diageo). The other is a play on the price-sensitive domestic consumer (and one who typically likes to see the product before buying – a High Street presence is beneficial), and a company who can continue to gain market share from the more expensive greeting card retail competition.     

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.