Earnings component is too easy to manipulate, believes BWD fund manager colin morton
The earnings component of the price/earnings ratio is so easy to manipulate it has become an unreliable valuation method for stock selection, according to BWD UK Equity Income manager Colin Morton.
He tends to use the lesser known enterprise value to earnings before interest and taxes (EV/EBIT) to give a clearer indication of a company's underlying profitability and whether it is trading at a premium or discount to the market.
With a minimum target FTSE 100 weighting of 70%, BWD Rensburg's UK Equity Income fund is designed to be a core holding in client portfolios. With the FTSE 100 making up around 85% of the UK index, however, the fund still has scope to double-weight mid and small-cap companies relative to the market. In contrast to the other fund Morton runs for the group, BWD UK Blue Chip Growth, UK Equity Income has enough flexibility to exploit opportunities down the market scale for what is very much a core portfolio, he said.
'If I like engineering stocks, for example, I might well have to compromise to some extent on the Blue Chip fund as many of the better companies in this sector are small and mid caps,' Morton added. 'With the capacity to go down the market cap scale on UK Equity Income, I should avoid such issues.'
When building the portfolio, Morton starts by analysing the current stage of the economic cycle and identifying wider themes to inform his sector over and underweights, such as the long-term savings theme of the 1990s.
At company level, the key factor is free cashflow rather than headline yield, with Morton looking to find companies capable of growing their dividend and avoid stocks that are guilty of overdistribution.
With a stock such as Vodafone, for example, the headline yield on the stock is low, at around 1%-1.5%, the company has free cashflow of around £7bn and it is predicted to be cash positive in two years time.
Morton believes the company has used its free cashflow sensibly by paying down debt rather than giving huge amounts away as a dividend, which has put it in a much stronger position for the future.
That said, he still has to achieve the target yield of 110% of the All-Share for the fund to remain within the equity income sector, so has to find higher headline yielding stocks to meet this.
Although expected equity returns in the high single digits over the coming years are low compared to the recent bull market, Morton feels such gains are acceptable in light of base rates of 3.75% and 10-year bonds yielding around 4%.
'It is certainly difficult to see equity market returns any higher than that in the foreseeable future,' he said. 'Consumer spending, which makes up more than half the economy, is likely to be down on last year, as is government spending, while business spending looks unlikely to escalate despite pockets of pent-up demand developing in some sectors of the market.
'So with GDP at around 2%, inflation at 2% and earnings growth expected to be in the region of 4%-5%, single-digit returns look to be the best the equity market can hope for, unless we see a major uplift in consumer or business spending.'
Current positions in the portfolio include an underweighting in pharmaceuticals, driven by underweight positions in sector giants such as AstraZeneca and GlaxoSmithKline.
The sum of market capitalisation, preferred equity and short- and long-term interest-bearing debt, less cash and equivalents. Used as a proxy for the takeover value of a firm. Often used in conjunction with EBIT (earnings before interest and taxes) as an alternative to price/earnings ratio.
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