Reality bites

Following the turmoil of the early part of the year, the prevailing mood across the UK equity market specifically – and in risk markets in general – has recently been positively serene.  After 2016 kicking off with two months, where changes from peak to trough levels of the FTSE100 in both months reached circa 10%, so far March has delivered a trading range of less than 3%.  All of this happened in the busiest month of the year for corporate news reporting.  Indeed, since the start of the year corporate earnings expectations in aggregate have been rebased downwards.  Current expectations are for profits for the market as a whole to fall again in 2016 as they had done in 2017.

How to reconcile this?  Well, there are a number of factors at play.  Firstly, like nature, markets abhor a vacuum – and the first two months of the year saw the majority of quoted companies enter “close period”, where they were limited as to what they could say about current trading ahead of formally announcing interim or final results.  In such circumstances (particularly when faced with an unsettling macro-economic backdrop), emotion – particularly fear – plays a much bigger part in the decision making process. Investment decisions are less rational; more irrational.

Yet, over the last half of February and into March, that information vacuum is filled.  And in general, the market’s worst fears were assuaged.  Yes, trading in some international markets – particularly in the developing world – is tough.  Much of the investment activity surrounding mineral and energy extraction is being ratcheted back in scale.  Where expenditure is taking place, those spending the money expect significant price cuts from those receiving it.  Even in North America, a retrenchment of oil and gas activity in Canada and the United States is impacting overall levels of capital expenditure in the economy.  However, the world is still a place where business can get done.  Yes, there were downgrades to expectations – but in the main forecasts were trimmed rather than slashed.  Similarly, in the UK domestic space, bellweather businesses like Next and Restaurant Group trimmed back the amount of growth that they expected to achieve in the current year.  By contrast, those exposed to UK housing related activity persisted with a pretty upbeat tone.  In financial services Lloyds was the only large bank to bounce on the back of a decent set of figures.  The other banks cut their forecasts for future dividends and refocused their efforts on cutting costs in the face of weak outlooks for income.  The life company sector, however, did get over the process of implementing Solvency II without any particular damage to perceived capital strength.

Taking all of this together, at the time of writing, the overall level of the UK equity market has barely changed since the start of the year.  In rough terms, the big oil companies and some of the big mining companies are up in share price terms over that period, whilst a broad range of other sectors are somewhat lower.

When we turned more cautious on the prospects for equity investment at the end of last summer, we were concerned about the level of equity valuations relative to what we thought was an over optimistic earnings/profits expectation.  Since that time, there has been a correction in both for many areas of the UK equity market.  Profit projections are more subdued, and as a result the valuation demanded by the sellers of equity is less onerous.  As we have noted in our last couple of factsheets, this has piqued our interest in putting the liquidity raised last year back to work in businesses where the risk/reward balance has moved to much more attractive levels.  In March we added two new investments to the portfolio – the first such move since September last year.

The two names that we added to the portfolio were Bovis Homes and Restaurant Group.  Both businesses are characterised by well invested asset bases, very strong cash flow and high returns on invested capital.  Both are also characterised by having valuations that have been decimated on the back of some positive momentum escaping from the trading picture in the latter part of 2015.  That is not to say that in any way these businesses are broken – both delivered record profits and dividends in 2015, and are forecast to increase both profits and dividends again in 2016.  Yet both stumbled in recent months.

In the case of Bovis, it failed to manage its cost profile adequately as it ramped up production to meet the UK’s continued demand for new housing, suffering more than others as its operations are almost exclusively in the south of England where labour shortages are at their most acute.  Its expected growth in production for this year is more controlled, and management has improved the business’s infrastructure to ensure delivery of its financial objectives.  Against this, the overall demand profile for new housing remains supportive, with the UK government announcing further measures to address affordability issues for first time buyers and first movers.  As for Restaurant Group, the start to 2016 has offered up a more challenging trading environment, which has been echoed by other consumer facing businesses.  We would accept that some recent menu changes at Frankie & Benny’s have not been helpful, and are likely to be reviewed, but in general a softer trading period does not make a bad business.  The internal financial dynamics of this business are very strong, and new restaurant openings will keep sales growth in positive territory.  The key variable for long term performance in this business – employment and wage growth trends in the UK – remain very supportive.

We have followed both of these businesses closely over almost two decades.  This is one of the best entry levels that we have seen in both over that time period.

This kind of investment is likely to typify the approach we will take when deploying the remaining liquidity we have in the coming months.  We are still wary of valuation risk, because as equity markets refocus their attention back to growth, the spectre of rising interest rates in the US and in the UK will need to be addressed once again.  So when the share prices of fundamentally strong businesses suffer from over-reaction to short term trading issues, we typically become interested.  We have a watchlist of current investment ideas – all are materially lower than the peak levels of valuation that they reached last year.  They are not sector, nor size, specific – reflecting the opportunities that have emerged across the whole market spectrum.

In recent days we have seen the latest set of earnings revisions data.  A picture that has been unrelentingly bleak for almost three years is starting to change.  With March’s data, we are close to an even balance of upgrades and downgrades.  This is an amber light in our traffic light parlance.  A weakening Sterling is providing a tailwind for overseas earners, partially removing the headwind of currency strength over the last two calendar years.

Across most of the market, equities are cheaper, profit forecasts are more realistic, and earnings momentum is on the turn.  That is a reality we can live with.