InterestingLeigh – Taking stock

Leigh Himsworth, head of UK equities at City Financial and manager of the City Financial UK Opportunities Fund, provides commentary for February

A belated happy new year and an apology for not writing sooner – I have no excuse other than to say I had little to write about earlier in the month.

As we have witnessed a degree of confidence creep back into the consumer, governments and even the press, the last bastion of nervousness appears to lie in corporate circles. Perhaps George Osborne was correct when at a recent speech in Davos he told big business to ‘stop apologizing’1, in that there is still an element of sheepishness, given the corporate ‘bashing’ that has taken place in recent years, with financial crises, bankers’ behaviour, mis-selling issues, the horsemeat scandal, and tax avoidance to name a few.

There is clear evidence that corporates are behaving cautiously. On the face of it, this is troublesome. Interest rates are low, we seem to have passed the worst economically, the policy makers continue their accommodative stance, and confidence is growing, yet we still have few transactions and only limited loan activity. According to JP Morgan, ‘Corporate capex outlays as a share of GDP remain at record lows in Europe. Consolidation activity is near 20-year low.’ (20/1/14) We are reminded also that PLCs are awash with cash and that net debt/EBITDA ratios are low at 1.112. So why should this be?

An issue for investors currently, and something that I touched on in November is the current rating of the market, on 13.5x forward PE ratio. This rating looks stretched without corporate activity and investment and importantly earnings growth. Most houses seem to be looking for UK growth in the region of 10% for 2014. A significant issue I have with this (using only basic mathematics and Peel Hunt numbers) is that the market has moved from a forward price to earnings ratio of 8.6x at the start of 2009 to 13.5x at 20 January 20143. The main UK index at the start of 2009 was 2,216 and it is now 3,660 – this would imply that we have had compound growth in earnings over the period substantially lower than 1%! You can all do the calculation in your spare time (those that are struggling, please email me for the method!). The point being that, if we have seen no real earnings growth in recent years, why should we suddenly see it now? Indeed, UK earnings revisions, again according to Peel Hunt, ‘remain in negative territory but are on a rising trend.’4

This point re lack of earnings may also explain the corporate reluctance to invest. It may also emphasise a point I have made repeatedly in the past, that corporates are not as strong as they appear, still frantically trying to repair their balance sheets. Further, using data from BofA Merrills5 in the chart below:

This shows that even directors are lacking in confidence, with director share buying at a recent low point.

There may be a point here that, overall, earnings have been subdued in recent years in large part because Mining & Banking earnings have gone seriously backwards. The response here is that if one strips out a handful of the very largest contributors to UK earnings and dividends, the market rating looks even more stretched.

We could perhaps see an improvement in the overall outlook for growth and also earnings especially if general confidence continues to grow and also inflation. Let’s face it, inflation is something that the authorities have been desperate to create in recent years, with vast quantities of monetary stimulus. Recent economic prints would suggest, though, that this too is proving elusive, at least in the traditional CPI/RPI meaning of the word. Asset price movements may suggest something different. For me, much of 2013 revolved around talk of a recovery and watching the US 10 year bond yield move generally higher; last year’s magical number was 3%, with the on-going and associated discussion of ‘Tapering.’ The interesting issue here is that when ‘tapering’ finally arrived, albeit only modestly in December, the US bond yield briefly flirted with 3% but has since drifted back to 2.716, along with weaker inflation prints. Perhaps now we have a greater risk of bond yields falling back through 2.5% rather than pushing on through 3%, 3.5%, 4% or higher as they move to ‘normalise,’ – whatever that means.

If yields did fall back, and inflation continues to be elusive, what then for the policy makers? More of the same medicine, or do they re-assess the diagnosis and find they got the wrong disease?

1 Times 24/1/14
2 Peel Hunt UK Market Valuations & weekly market moves: 20 Jan 2014
3 Peel Hunt, as above
4 Peel Hunt, as above
5 Bank of America Merrill Lynch European Investment Strategy Jan 2014.
6 Bloomberg 24/1/14.