Mega-cap earnings 'almost wholly dependent' on weak sterling
The effect of the sharp fall in sterling post the referendum against a range of currencies had some initially predictable effects on UK equity markets.
Large-cap stocks, with on average 70 per cent of earnings overseas, were mechanically rerated to take account of 'cheaper' valuations. For the first year since the financial crisis mid caps saw significant underperformance, a direct correlation of the much lower percentage of lower overseas earnings and lower commodity exposure.
The post-crisis premium to large caps has now disappeared. Now that these effects have washed through there are a number of important follow-on aspects for investors to appreciate in asset allocation and sector preferences.
The rerating of large-cap stocks driven by weak sterling and rising commodity prices has thus for the first time since the crisis given large-cap stocks a similar rating to mid caps.
However it is important to note that earnings growth forecasts for this year and next, showing continuing strong growth for mega caps, are almost wholly dependent on continued weak levels of sterling.
For stocks such as Unilever or Diageo, underlying organic growth rates of 2-3 per cent could just as easily be wiped out by even a modest rally in sterling.
20 times price/earnings stocks that will then show no or even negative earnings growth will then look significantly structurallyn overvalued.
In contrast mid caps' earnings growth is based much more on secular growth trends and is therefore far higher quality than that as a result of one-off currency effects. We therefore expect mid-cap stocks to begin to re-establish their premium rating as sterling stabilises or rallies.
As the initial hedging strategies of corporates, especially retailers, wears off over the early course of the year, the inflation implications of passing through costs has significant implications for a number of stocks and sectors.
Headlines suggest many suppliers and retailers are looking to pass through significant price increases (the Marmite-gate spate between Unilever and Tesco for example) to consumers, but the history of significant devaluations suggests a more nuanced response will be necessary.
Despite intentions it is more likely that there will be a pain-sharing approach between suppliers, retailers and the end consumers. The final mix effect will be critical for corporate profitability, and the effect on consumer spending will be the key driver for the economy.
AVOID LEGACY ASSETS
Sectors at risk include domestically oriented retailers and legacy restaurant and pub groups, as cost inflation will be joined by rises in the Living Wage and business rate increases to create a potentially lethal cocktail for profitability.
For the average restaurant or pub group, growth of at least 3 per cent in like-for-like sales will be necessary to merely maintain profits - levels that few have reached or sustained in the last few years.
Growth stocks in these sectors, however, should largely avoid these issues as greater buying power should allow supplier renegotiations. Hotel Chocolat, for example, is expecting to hold prices as it reinvests considerable synergies from its factory automation into maintaining prices.
Patisserie Valerie, retailer of the eponymous cakes, also believes that cost inflation this year will be very manageable as the estate expands rapidly. The clear message is thus buy growth in these sectors, and avoid 'legacy' assets.
Weak sterling will make the UK a particularly attractive destination for M&A as overseas bidders seek cheap assets.
Corporate balance sheets remain robust, ease of equity raising is good (and valuations reasonably high) plus cost of funding continues to stay low (but starting to rise) giving a favourable backdrop also on the funding side.
We have already seen several approaches for formerly unloved industrials and support services stocks such as Lavendon and Brammer at the end of the year. We expect much broader M&A activity in mid and small-cap stocks as 2017 progresses.
The major currency devaluation thus offers investors an interesting and more complex menu of asset and sector allocation opportunities now that the initial devaluation rerating of mega caps has been priced in.
Phil Harris is manager of the UK Equity Growth Fund at EdenTree Investment Management.