Earnings clarity now the main focus

By David Stevenson, manager of SVM UK Opportunities

Following a steady stream of profit warnings and corporate failures, the stock market has become entirely focused on earnings clarity. Previous attempts to call recovery on the basis of a broad macro view have quickly collapsed in the face of such poor, company-specific, newsflow.

More than ever, investment success depends on detailed analysis of individual business models, to pinpoint those that offer the best earnings visibility. Small and medium-sized companies still represent an area of the stock market where such research can produce the greatest leverage to investment returns. Current corporate distress is a reflection of the low-growth environment.

In more buoyant times, companies could be aggressive with their borrowings, as well as the accounting policies they used to measure their growth, such as early recognition of sales. As top-line growth has slowed, however, many companies find themselves with weakened balance sheets. Others have had to restate revenues.

To assess the financial condition of a company, research must now extend beyond the indebtedness disclosed within the balance sheet. Any discount at which bonds are trading must also be monitored, as well as the changes to credit ratings made by agencies.

The condition of company pension funds is also key, with some deficits so large they represent a significant proportion of market capitalisation.

Sale and leaseback deals on property can be another indicator of a cash-hungry business. For the weakest companies, the overall cost of capital can actually be increasing despite the benign interest rate environment.

Companies doing best in current conditions are those that do not require access to capital markets. Their organic growth is being self-funded from cashflow, with any surplus used to increase dividend payouts, buy back shares or pay back debt.

Against a backdrop of low growth for the economy, businesses will, on average, do well to achieve 5%-10% growth in earnings. If P/E multiples are sufficiently low, however, as is the case with many mid and small-cap stocks, there should still be scope for upwards revaluation.

Indeed, share prices might only rise in line with earnings growth, with no expansion required in the multiple. If such companies can also offer dividend yields of 4%-5%, there is the solid prospect of double-digit gains. Modest, but realistic, investment expectations should be the order of the day in the current stock market.

Looking ahead, fears about structural low inflation within the UK economy may prompt further interest rate cuts. This has traditionally been good news for smaller and medium-sized companies, with their proportionally greater exposure to domestic markets.

Rate cuts may encourage further acquisition activity, with some small and mid-cap deals in the property and motor distribution sectors showing market valuations are now attractive to trade buyers. For those prepared to carry out detailed research and pick companies selectively, there are still plenty of investment opportunities on offer.

Bull points

Detailed company research is rewarded.

Best research leverage in small/mid-caps.

Still many investment opportunities.

Bear points

Macro market views not working.

Risk lies entirely within companies.

Risks cut across sectors.

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