Gearing Down

April should be a time of reflection for those interested in UK equities. The month offers a lull between the avalanche of information that comes with the corporate reporting season, and the subsequent pick up in activity for Q1 reports and AGM statements. It also offers the space to take a more reflective look at what has gone past. The first reactions to full year reporting are normally set in relation to the individual equities themselves; normally assessing what outlook statements suggest about the short and medium term prospects for the companies involved. With time, however, one starts to pull together a clearer picture of the overall corporate landscape, which helpfully draws out one or two strands of information to further inform our decision making going forward.

Looking initially at the company level considerations of the reporting season, we assess that it has been a decent run of results, particularly given the potential banana skins in the form of geopolitical risks that have been around for the last six months.

In general, we would describe the reporting season as solid, if uninspiring. Across the majority of the market, results have largely been in line with expectations. Virtually every outlook statement has made reference to the heightened level of political risk, but most management teams have noted that they are “mindful” of political uncertainty, rather than it being an impediment to current business activity. That said, expectations for ongoing progress in 2019 is, in general, to be described as muted rather than exciting.

It hasn’t been all plain sailing in the first quarter of the year. There have been some significant declines in the share prices of some big companies. However, there are two major themes that have driven many of these moves.

The first is the exposure to UK retail. The headlines have invariably been grabbed by the demise into administration of high profile chains; Debenhams and Patisserie Valerie have hurt quoted investors the most, but several private business have also taken this route. LK Bennett, Better Bathrooms and Oddbins are amongst the most notable. Shareholders in other retailers like Carpetright, Moss Bros and Ted Baker are nursing substantial losses, even if they are still trading viably.

However, it has not been a one-way street. The first quarter has seen strong share price performances from other parts of the retail spectrum; Next and JD Sports have delivered share price returns in excess of 40% since the turn of the year. Tesco’s shares have risen by 30%.

As ever, there is no single factor that allows us to reconcile these two trends, but there are a couple of themes that can be drawn out. The first is that, in general, UK retail specifically (and UK domestic exposure in general) was oversold at the end of last year. As the threat of a calamitous no-deal Brexit receded, so the discount to this exposure unwound. Those companies that demonstrated some ability to deliver results in line with expectations were rewarded handsomely. Those that didn’t, weren’t.

On top of this was a general overlay of debt aversion. Specifically, retailers who were likely to be financial constrained remained unloved. Those with the potential to turn better trading conditions into higher dividends were lauded.

This concern over company gearing has been a theme across the whole market, not just in the retail sector. The other trend identifiable over the past three months has been the exaggerated impact on the equity values of those companies who have committed the twin sins of disappointing on trading, and carrying heightened balance sheet debt. This has been seen in the construction, support services, and leisure sectors, alongside the impact on retailers. Even the management teams of businesses trading well have commented that shareholders are urging them to be less, rather than more, inclined to increase balance sheet gearing.

To our mind, this is entirely rational. This economic cycle is getting long in the tooth. At the time of writing, we are only a couple of months away from the US economy experiencing its longest ever post-War period of continuous economic expansion. It won’t last for ever. On top of this, whilst the geopolitical risks are waning at the moment, they haven’t gone away. Brexit, in particular, remains a serious risk to the smooth functioning of the UK economy.

Lastly – and it is not getting a huge amount of airplay at the moment – this year will see the introduction of IFRS 16 into statutory accounts. This accounting standard forces companies to recognise the long-term financial liabilities associated with many operating leases, and will substantially increase balance sheet gearing for many companies. At the current time, the received wisdom is that investment decisions will carry on as normal as most affected companies will present two sets of financial statements – one including the IFRS 16 impact, and one adjusted to exclude it. It is believed by most that the adjusted numbers will be used to inform investment decisions. We would concur with this over the short term, but history suggests that reasonably quickly these adjustments stop being made, and investors will start to allocate capital on the new statutory basis. Companies that are already carrying high levels of gearing may suffer by comparison.

We could discuss in much more detail the issues surrounding the progression of the UK economy over the remainder of this year, and the long term implications of the introduction of IFRS 16. However, at this juncture we will leave them for future newsletters.

The message from the reporting season is, largely, one of business as usual. Our current refrain – that businesses and economies would be in good shape if politics could get out of the way – is one we have issued almost persistently over the last ten years. But the last ten years has equally shown that we cannot wish away the political risks to equity investment.

UK equities remain the ugly duckling in the global equity pond. They are likely to remain so until some kind of Brexit agreement is reached and businesses know what the rules of engagement are going forward. When that will happen is not a question we can answer at this point. But when it does, additional upside will come from the transformation of ugly duckling into swan. In the meantime, strong cash generation should support attractive dividend payments, keeping investor interest piqued.