Interactive Investor

Earnings surge predicted as firms splash cash

18th July 2014 14:36

Lee Wild from interactive investor

Capital spending is back with a bang in developed economies after a five-year hiatus. Companies, previously unwilling to pump money back into their business are finally beefing up capacity and buying new equipment. And, if forecasts are correct, corporate earnings among the engineering sector could surge by an incredible 20% this year, twice as fast as current consensus forecasts.

"With business confidence approaching all-time highs, and with interest rates being near all-time lows, we find the lack of significant capital expenditure (capex) startling," said Barclays recently, claiming a "dearth" of capex was holding back economic growth. Indeed, capex-to-sales ratios at about 8% have changed little since the downturn.

It's clear to see why spending must increase. Equipment owned by private US companies is currently at its oldest levels since the 1950s, and spare capacity is quickly disappearing. And there are clear incentives to get spending, too, not least, as Deutsche Bank points out, the 60 basis-point drop in the market-implied cost of capital for global companies over the past two years.

"Capex is making a comeback," Barclays says, and leading indicators certainly suggest that is the case. Many are sitting near record highs, and the Philly Fed Survey - historically one of the best pointers to future behaviour - suggests US capital spending is growing at the fastest rate since 2000.

In Europe, where one might expect companies to be more tight-fisted than elsewhere, transportation capex is growing faster than any time in the past 18 years. That initial investment in trucks, typically at the cheaper end of the capex scale, is usually a reliable precursor to more significant spending on more expensive heavy machinery further down the line.

And here in the UK, capacity utilisation rates are near all-time highs, which means businesses must invest in extra capacity to meet the inevitable pick-up in demand. Indeed, Barclays' predicts growth in UK fixed investment of 10.7% this year and 8.8% in 2015, easily outpacing consumption at 1.7% and 2%, respectively.

Best entry point for four years?

But which companies are most likely to benefit in a more free-spending corporate world?

"Traditionally the sector to access a recovery in capital spending has been industrials,” says Barclays, certainly since 1996. And OECD forecasts for Gross Fixed Capital Formation (GFCF), which measures the value of net additions to fixed assets, imply that annual growth in earnings for the industrials sector could be as much as 20% for each of the next three years - consensus estimates currently point to more modest growth of 10%, 12% and 10%.

"This suggests that consensus estimates for earnings may not fully factor in a recovery in capital spending," reckons Barclays.

It appears not. Use those consensus numbers and the 12-month forward price/earnings (P/E) ratio for the industrials sector relative to the market is well below the levels seen during the capex recovery cycle of 2004-2007. Ramp up earnings growth to 20% and the sector would trade on 20-year lows.

Mark Fielding and Robbie Capp at UBS agree. "The UK engineers have been caught up in a combination of the general UK mid-cap sell off and currency worries," they say. "However, ex-currency we think EPS [earnings per share] momentum is solid and 2015 forecasts not ambitious."

The pair point out that the sector PE relative is at or close to four to five year lows versus the FTSE All Share, FTSE 250 and the US and European engineering peer groups. Indeed, the sector's premium to the FTSE All Share has more than halved so far this year to 12%. And it now trades at a 5% discount to its European peers compared with a 10% premium at the beginning of the year, despite growing twice as fast as both the UK and European markets over the past decade.

"We see this as a buying opportunity in what remains a high quality group," writes UBS, preferring more global engineers like "top picks" Bodycote, Fenner, Spirax-Sarco and Tyman (TYMN).

Barclays' analysts go further, picking 60 stocks they think will benefit most from the capital spending theme. Among them is scientific instruments maker Spectris, highly-rated precision tool firm Renishaw, building supplies outfit Wolseley, real estate firm Segro, rental equipment business Ashtead, product tester Intertek and high street lender Lloyds Banking Group.

Of course, the timing of any significant upturn - certainly enough to generate the huge uptick in earnings growth predicted by Barclays - is uncertain. But the signs now are as good as at any period in the past few years. Companies know they must invest to stay ahead of the competition, and replacing old kit is essential. As confidence grows the money will flow.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.