Interactive Investor

The Big Picture: The stock-picking dilemma

27th January 2017 12:46

Edmond Jackson from interactive investor

Is the next leg of the equities bull market underway? Donald Trump has certainly restored the faith that he will deliver on his business-boosting pledges, after signing a volley of executive orders within his first week as President.

He has filled key government commerce posts with business leaders, immediately asking heavyweight chief executives to draw up trade recommendations. As "turkeys don't vote for Christmas", these proposals should favour business - but we shall see.

Trump was expected to mellow on his campaigning issues once in office, but instead he appears invigorated. Republicans don't seem to be clipping his bristling ideas down, either.

There are obviously big issues at stake. Can the President re-rate annual GDP growth from 2% to 4% through tax cuts and fiscal spending, while avoiding another major rise in public debt? Constraints of modest productivity and an older population are  limiting.

Trump wants to boost US oil and coal industries, but this could have a detrimental impact

The US economy has been in an up-cycle for some eight years, resulting in a tight labour market, and Federal Reserve Board members have already cautioned that interest rate rises could happen sooner and faster if fiscal expansion boosts inflation.

And as Trump continues to try and pick a fight with China, we are reminded that it's the Chinese with the leverage as the main buyers of US Treasury bills.

Trump is enthusiastic about boosting the US oil and coal industries, but this could have a detrimental effect on prices. Oil and coal prices have strengthened following recent production cuts from OPEC and China, taking the exposed equities up with them, but an increase in US shale oil production and mining output could offset this progress.

A flip in sentiment this week from selling the inauguration into a rush to the US equities party shows how edgy it is. Interestingly, a director of Ashtead Group, a favoured play on US infrastructure spending, hedged his bets and sold 62% of his holding - £4 million worth - at 1,585p. Ashtead's price has since advanced to 1,650p.

Credit ratings agencies have warned again on well-established themes: Moody has highlighted that state-owned companies owe the equivalent of 115% of Chinese GDP, which Fitch says will weigh on the GDP growth rate over the next two years.This story has existed for a few years, mainly burning short-sellers' fingers.

We will wait to see what Trump does to Chinese tariffs and how the region then responds; the major risk being economic melding with political/relational issues, such as control over the South China Sea and the status of Taiwan.

But how long would it be before China tests Trump's "America First" rhetoric, as regards to protecting such territories?

UK: Trouble ahead?

2017 starts with further obsessing over Brexit, which is liable to check consumer confidence and corporate budgets.

Volatile retail sales were at a 14-year high last October, supported by November's unsecured consumer borrowing reaching a 12-year high in November, before falling 1.9% in December - the fastest monthly drop in nearly five years.

A pre-Christmas rush for food treats then boosted supermarkets. It's all looking exposed though, especially versus higher import costs and rising inflation against sticky wages.

Meanwhile, online retailing and digital marketing flourish, the stocks boosted to tropical ratings amid scarce value. I've drawn attention to online retailers like Boohoo.com and Gear4music, which continue to perform strongly, albeit nowadays on lofty ratings.

The stocks to own in a rising price environment are those with pricing power and consumer loyalty

Online market researcher Brainjuicer Group and digital marketing servicer Next Fifteen Communications have reported strong trading, but there are signs of corporate budgets generally getting pressured. For example, a profit warning from St Ives' strategic marketing arm appears to mirror telecoms group BT.

Showing how polarised the current market is, the former two market research groups enjoy high ratings, while St Ives is rated lowly after blowing cold on prospects in April 2016 and then turning hot in August.

I said to look out for a January trading update that could tilt the stock sharply from 116p, underpinned by its macro relevance. But, instead, St Ives reverted back to its April outlook and the AIM-listed stock has consequently revisited lows of around 80p.

I did stress that marketing services involve limited visibility, but it's nevertheless a harsh message. It helps explain why BT shares were savaged 20% on 24 January after the Italian scandal and warning its international corporate business was slowing, amid pressure on its UK public sector work - relevant also for support services stocks.

Such examples highlight a dilemma for stock-picking: the few strong growth situations are "priced for perfection" thus exposed to any adverse change in the story. Meanwhile, there is a growing risk of "value traps", especially among cyclicals on low price/earnings (PE) multiples and attractive yields.

If the UK business cycle is turning down after a long ride from 2009, cyclicals in relatively traditional sectors are most exposed to adverse news. The few that are industry leaders will become potential bid targets, especially for US firms empowered by the strong dollar, as is St Ives, but its cold/hot/cold reporting shows limited visibility. In other words, look before touching out-of-favour stocks.

BT's problems

The challenges range more widely than Italy and its under pressure contracts. Last April I said BT was over-priced at 470p, staking that it was the "end of the line for this blue chip". As telecoms become more competitive, they have less pricing freedom, I argued, and BT's shares were left exposed because a yield of over 3% was needed to compensate for rising risks - including its expansion into costly sports coverage.

BT might never break even on its ambitious move into sports, which will dilute earnings. Such a bid for market domination of consumer services, including the £12.5 billion acquisition of EE, puts the Italian accounting fiasco in the context of corporate aggrandisement and hubris - of head office losing control.

Various conflating factors compromise a 10% annual dividend growth policy, which is why BT's share price has fallen to exact a higher yield as compensation for the risks. All-considered, I wouldn't read too much into BT's shocker as regards to the wider economy; it has its own reasons for an underlying flat outlook.

Unilever disproves

As wisdom comes under strain, Unilever has warned that volatile currencies and a slowdown in its refreshments and homecare businesses weighed on sales in 2016. It's had a difficult start to 2017, too. This counters the argument that global consumer groups add strong defensive elements to portfolios and hedge against sterling.

Unilever dropped nearly 5% on the news, briefly falling below 3,200p. The stock has fundamentally scared me, given an annual average PE of 20-26 in recent years. Before this update, the shares were trading on a forward PE of 20 at 3,350p.

Stocks are vulnerable to profit warnings when rated highly against underlying growth

But it has risen from 2,300p in 2014 over 3,50p last summer, when manager of the highly successful £9 billion Fundsmith Equity Fund Terry Smith argued that investors shouldn't be concerned about the Unilever's valuation. The same could be said of other global companies like Imperial Brands' tobacco products, he said, which is also down from about 4,140p to 3,650p.

Smith's argument is partly inflation-linked: the stocks you want to own in a rising price environment are those with pricing power and consumer loyalty.

But the current situation shows these stocks are vulnerable to warnings when rated highly against underlying growth. They have also risen on a technical basis, as bond investors switched into perceived "safe" equities, while bond yields fell with interest rates.

Presently, there's a mismatch in global interest rates, where Europe and Asia remain low but the US has switched to rate rising.

If the Fed warning I cited earlier is born out, faster US rate rises might further hurt the bond proxy shares as conservative investors sell. Nick Train, the respected manager of Finsbury Growth and Income Trust, has also been positive on Unilever.

Events are possibly showing that even the best brains can get out-witted in these uncertain times, especially if departing from a basic sense of price versus underlying earnings.

Sage drop

It's not just consumer staples that are finding it tough. Business software group Sage's organic earnings rose 5.1% in the first quarter, against consensus forecast for 6.7% growth in the current year to end-September and 6.6% for 2018.

This FTSE 100-listed stock has enjoyed an annual average PE of 22-25 times and yields a modest 2.6%. It's also been another favourite of Smith and Train, whether or not they sold down as the price fell from 756p to 600p, at the same time as Unilever and Imperial Brands peaked.

Two Sage directors have piled in at around 599p, buying 25,000 shares and 10,000 shares each. The hope is that Sage's heavy investment in cloud products will reinvigorate growth, although this looks speculative as competition increases. Cash conversion is also reducing.

So while equity strategists enthuse over The Icarus Trade as Trump revives bullish sentiment and recent UK GDP figures appear resilient, it's worth noting the various company warnings now clipping feathers.

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