This week has marked the start of the “belly” of the reporting season, where analysts and investors pore over a raft of statements on a daily basis; reading the tea leaves to work out what it is likely to mean for profits and dividends in the years ahead. So far in this process, it is fair to say that it has been less than plain sailing for many companies. Over recent years, stockmarkets have appeared to become less tolerant of short term “misses” to financial objectives. Small retrenchments of profit expectations often lead to much more severe corrections in company valuations. The last few days and weeks have seen many such share price reactions. The questions that exercise our minds at the moment, are “are markets behaving rationally?”, and “if not, does this present an opportunity for us?”.
For those who like to see the world in black and white, our answers may disappoint. In essence, we would respond to both questions with the default position of the economist; “that depends”.
Let’s deal with the question over rational markets first. Should small changes to a company’s expected profitability lead to much larger changes in its valuation? Clearly the major factors in making that decision are the valuation levels prevailing before the change in profit forecasts, and the likelihood of more downgrades hitting further down the line. Talking in general about equity markets as a whole, then arguably the current moves in UK equities are perfectly rational. We know that overall valuation levels are higher than historic norms, and that they are being increasingly pressured by the drift upwards in bond yields. Equally, we know that the stockmarket maxim that profit warnings normally come in threes is not to be taken literally, but does exist because experience tells us that genuine “one-off impacts” are very rare indeed.
All of this suggests that there is not some quick turn, or arbitrage, to be made out of this volatility. Markets assimilate new information very quickly, and tend not to systematically leave easy profits in their wake.
However, it does not mean that there isn’t an upside to this turbulence. Two of the central planks of our investment philosophy are that markets have a habit of extrapolating trends, rather than analysing them, and that they are systematically predisposed to interpret cyclical trends as structural trends. We would argue that some of this is taking place just know. Whilst it is unlikely that we can exploit these conditions for short term gain, share price weakness can make for an attractive entry point for medium term investment decisions.
One of our primary bugbears with current investment orthodoxy is the assumption that share price volatility and risk are the same thing. They are not. Volatility is exactly that; share prices rise – share prices fall. It is the job of a fund manager to utilise that to his or her advantage. Risk is about the permanent destruction of value; through structural changes in industry conditions, the deployment of shareholder funds in low (or negative) return assets, or frequently the impact of financial gearing biting at the wrong point in an economic cycle. And whilst we are fairly sanguine about the current investment climate, we do have concerns about the impact financial gearing will have on long term returns for investors in many companies.
The world of easy access to cheap debt is not over, but it is definitely getting less easy and less cheap. Bond investors are increasingly demanding a higher return on their invested capital, and this will eventually feed through into borrowing costs for all debtors. The next stage will be to demand greater covenant protection and higher equity backing. Companies who operate with the forbearance of their lenders run the risk of having to tap shareholders for more cash. That is the point at which the damage to equity values is permanent.
The most recent, high profile examples of this have been related to the outsourcing industry, and particularly in the aftermath of the Carillion debacle. However, it is also noticeable that many businesses that have a private equity history (and typically, therefore, higher gearing levels) are some of the most harshly treated in the event of a profit slip.
The fashions for balance sheet security and balance sheet efficiency tend to wax and wane in a negatively correlated fashion. For the reasons set out above, we prefer the former.