UK Equity Market Commentary

Friday, 4th May 2012 14:17 - by David Harbage

This is the first in a series of weekly briefing; call it a blog if you wish, on the domestic equity market. Written by a fund manager with almost 40 years' experience of the rollercoaster ride - and continues to aim at the moving target - which is share prices. We will endeavour to provide an insight into the professional investor's world, by assessing the risks facing UK companies while gauging the fundamentals and sentiment surrounding industry sectors. Finally, while not making any personal recommendations, we will be commenting on major corporate actions and expressing views on both large and smaller listed stocks. Calendar 2012 to date has been something of a non-event. The rally in share prices which has traditionally accompanied a new year was in evidence in the first quarter, as the FTSE100 index progressed from 5572.3 on the last working day of 2011 to 5965.6 on the 16th of March. But since then, and replicating our weather, the early promise and brightness seems to have faded away as further bouts of uncertainty, surrounding dull economic performance and political stability, overshadowed decent corporate news flow. Based on historic measures, the UK equity market appears to offer exceptional value - an assertion best evidenced by the 2% bond yield being dwarfed by the 4% dividend yield, (never mind the more important earnings, or profit, yield) comparator. But perhaps fundamental assessments of appropriate longer term worth go out of the window when fund managers' time horizon is just three months. As always, there are storm clouds on that horizon and current opinion is that there is more than enough to worry about. In particular: the difficulty of calling the strength of economic activity, within an increasingly interdependent trading world, against a backdrop of imminent change in political leadership. The Chinese economy is slowing - as it must from an exceptionally high pace of growth over the past 20 years. Lower than forecast GDP growth of 8.1% in Q1 2012 (down from 8.9% in the previous quarter) has prompted fears of a 'hard' disruptive landing, rather than a softer well-controlled deceleration in the world's second largest economy. In a country featuring such a big population and an undemocratic opaque structure, it is difficult to make confident judgements. However, 'top-down' world trade and 'bottom-up' company specific reports would suggest that China, as well as many other emerging economies (especially in Asia), continues to thrive. Economic progress in the developed world is patchy, and clearly below trend, with the normal recovery process restrained by collateral damage to the financial system. In particular the inability of banks to play their usual lending role following an economic downturn (as they are required by regulators to build up their capital reserves) remains evident. The US is set to perform better than Europe, but both are set to experience considerable political change and uncertainty in 2012 which could impair fragile economic progress. Moreover, any lack of unity in Europe (noting French politicians' recent parochial posturing) could jeopardise the ECB's plans to restructure Europe's finances. So perhaps a number of the big institutional short term and absolute return investors have chosen to keep their powder dry until some of these political uncertainties ease. And perhaps some would assert that if the bond/earnings yield relationship is out of kilter, it may be that gilt yields - rather than equity prices - have to rise in order to achieve a more normal historic position. More bearish yet, a smaller body would opine that earnings are set to fall by a double-digit magnitude - notably commentators who anticipate a more protracted economic downturn - as a means of reverting to a more typical rating. Investors adopting a more optimistic perspective on the global economy, anticipating slow but positive growth - probably via a pragmatic 'muddle through', rather than dramatic or decisive solutions devised by policy makers - will surely view current equity valuations as attractive. The prospect of pedestrian GDP growth in most of the major developed countries is set to keep a lid on interest rates, inflation and bond yields. The current cost of borrowing for big corporate PLC's is exceptionally low, mindful that medium term 5-15 year gilts yield just 2%. Listed UK plc, by reference to the FTSE All Share index is valued on a price/earnings multiple of 11x, which equates to an interest rate of 9%. Think of this as cost of capital, and an encouragement for companies to use their typically cash-rich or under geared balance sheets to buy-back their own equity with a consequent enhancement of earnings per share. A similar result could be achieved by using cash to acquire a competitor or perhaps a complimentary business. When top line sales growth is difficult to achieve, because of a flat economy, many of the biggest listed companies are likely to adopt such corporate activity as a prime means of delivering value to shareholders. Such purchases of stock and wholesale acquisitions can also shrink the equity base or supply, which in turn would drive up the price of the remaining issues. While a marked pick-up in Merger & Acquisition activity or other forms of financial engineering probably awaits greater confidence in the boardroom, strong cash generation remains a key measure of corporate success. We suggest cash is more important than headline profit, and would look closely at a company's business model, Profit & Loss account and balance sheet to assess the sustainability of future positive cash flow. Over the past week, two of the biggest cash generators within the FTSE100 index, BP and Royal Dutch Shell, announced their trading results. Both of these fully integrated companies (possessing both exploration upstream and refining & marketing operations) feature very strong, lightly indebted balance sheets. However, most analysts agree that the immediate outlook for these global giants of the oil and gas industry is very different. In next week's article we will begin to take a closer look at individual industries, and the major UK listed stocks within each sector, commencing with natural resources. It is an exciting area and one that appeals to investors seeking scarce limited assets, as well as to others who anticipate higher oil prices - albeit probably as a result of heightened political tensions in the Middle East, rather than a pick-up in economic activity. The Writer's view are their own, not a representation of London South East's.