Retaining belief in the FTSE100 and House-builders

Wednesday, 17th June 2015 14:08 - by David Harbage

The mega cap end of the UK equity market, as measured by the FTSE100 index, has given up much of the gains made in the year to date as concerns surrounding Greece and the prospect of higher interest rates in the US have dampened our local post-election euphoria. By contrast, the mid cap FTSE250 index has retained most of its 2015 advance, reflecting in part superior earnings growth and, more pertinently perhaps, an inherent higher exposure to the domestic economy.

Sell-side analysts have been paring back earnings forecasts for 2015 and 2016 in the face of growing doubts about top line growth and US dollar strength. Lower consumer confidence and consumption in Europe, and weaker than anticipated investment by the corporate and public sectors elsewhere, is likely to restrain sales. Translation of dollar revenues into sterling - or euros for that matter – is set to have a pronounced adverse impact on second quarter numbers (as it did on calendar 2015’s results).  

But this appears to be ‘in the price’, with the FTSE100 back down to 6680 at the time of writing. While the writer would not encourage too much belief in seasonal influences, the two prime periods of traditional folklore are weakness in the summer (“Sell in May…….”) and an advance in the winter (the Santa or year-end rally). Historic evidence barely gives credence to such theories, but taking a prudent view about investing monies into equity – including the idea of ‘drip feeding’ money into the market – suggests investors can take advantage of apparent weakness to finesse a portfolio.

The FTSE100 often appears to trade within a range and, in the current clime whereby the headwinds of bad news or uncertainty do not appear to be significantly greater than the norm, the index appears to have moved into attractive valuation territory. Although a short term trader would be looking through a very different lens, a 5% retracement from the 7,100 level reached in late April seems to offer value to this observer and a natural opportunity to invest (taking the longer term view, of course, appropriate to the asset class). Essentially driven by the relative merit of its income production capability (considering both the generation of free cash flow and the return of cash to investors, via both dividends and share buybacks), which is likely to retain its attraction as cash rates and both government bond & real estate yields remain low for the foreseeable future.

That management are more inclined to seek earnings growth from non-trading opportunities in a sluggish or below-trend economic environ, is logical. Perhaps in the form of returning excess profits, in the form of a special dividend or a one-off return of capital, or carrying out exceptional action such as to acquire a more lowly valued (competitor or complimentary) business, which could favourably re-engineer the combined balance sheet or enhance profit or asset value (per share), to drive a positive re-rating of the company’s stock.

An example of the relative strength seen in the share prices of medium sized FTSE250 index businesses and a UK-focused industry sector is house builders. It also provides evidence of management which is seeking to enhance shareholder value by focusing on the returns achieved on its invested capital – being prepared to return monies when re-investment hurdles demand. Today’s corporate announcements, by FTSE250 constituent Berkeley Group and AIM listed Inland Homes bear testimony to this. London-oriented builder Berkeley announced full year results which comfortably exceeded broker expectations and, featuring a net cash balance of £430.9m as at its 30 April 2015 year end, is paying a 90p interim dividend as final part of a promised 434p of cash return. The highly regarded management (of whom chairman Tony Pidgeley is best known for his reading of the industry’s cycle) confidently anticipates making further exceptional payments of 433p by September 2018 and another 433p by September 2021; indicating almost £3bn of cash due from forward sales in support.

Moreover, £99.8m receipts from the sale of a portfolio of ground rents evidences management’s keen focus on cash – which investors have long appreciated, and represents a key differentiating factor within this homogenous sector. By contrast, while the company has a long land bank (37,473 plots represent 11 years’ work, based on last year’s completions), its net asset value of 1199p per share lags the peer group and is almost a sideshow.

By contrast, brown land developer Inland Homes is a very different business in terms of both size and strategy. Acquiring urban sites in the south and south-east of England for residential development, typically from the public sector (such as the Ministry of Defence), procuring planning permission and then selling the consented land onto house builders or (as allowed more recently by the group’s improving finances) building on the sites itself. Today’s announcement, of the disposal of 205 consented plots for £19m to a house builder (an institutional investor had also made a bid, incidentally), was accompanied by an encouraging trading statement indicating that profits for the current year to 30 June would be significantly above market consensus expectation. Inland Homes stock is not cheap relative to its more liquid, volume house builder peers but its net asset worth – stated to be 33.47pence as at 31 December 2014 – almost certainly understates its true worth (as land is valued at cost, not re-valued upon achieving consent) to investors or potential predators. Readers with long memories will recall that this management team, led by CEO and 8% stakeholder Stephen Wicks, have created successful similar businesses before engineering an exit to the benefit of its management and shareholders. Certainly, there is no shortage of natural buyers (trade or institutional investors) for land.

Bottom line, dear reader, consider opportunities to finesse equity investment – by adding a little when prices appear attractive and, if braver, top-slicing when valuations appear stretched (perhaps when the market has performed very strongly without obvious reason) – if the risk-reward profile of the asset class fits your needs and comfort zone. Secondly, if considering investment into individual business segments or individual company stocks, endeavour to focus on those whose business model (the drivers and risks) you can better understand and believe have shareholder’s interests uppermost.    

David Harbage                     

17 June 2015