Consensus earnings’ forecasts have for some time appeared too optimistic but it is only recently that earnings’ downgrades have started to come through and the pace looks likely to quicken in the coming months.
The market is still assuming that the last three to five years are indicative of a company’s average profitability. This is too short-termist. Looking at a longer timeframe, average profitability is significantly lower and suggests that the returns of the last few years have been supernormal.
In addition, many companies are now heavily indebted and need to rebuild their balance sheets.
This bleak backdrop does not mean that compelling investment opportunities cannot be found by investors able to take short positions in their portfolio.
Share prices tend to be driven by earnings. If a company’s earnings fall by more than the market expects, then the share price is also likely to fall. By identifying companies that are heavily indebted, economically sensitive or likely to have to place stock from a position of weakness to shore up their balance sheet, investors can still generate strong positive returns in these tough times.
Perhaps more surprisingly, there are also now some interesting buying opportunities starting to emerge.
The overall valuation of the UK equity market has reached interesting levels. In the next six to 12 months, the market is likely to fall further, presenting extremely interesting opportunities. Indeed, valuations could well be at levels of “cheapness” that only present themselves once or twice in a lifetime.
As the stockmarket has sold off, opportunities have arisen to buy companies with classic defensive qualities, notably a resilient brand, strong balance sheet, the ability to generate cash and offer a secure dividend yield.
One example is the food retailer WM Morrison. People have to eat and therefore shop on a weekly basis so through companies such as Morrison’s, in which earnings are tied to essential spending and likely to therefore remain relatively robust, investors can mitigate risk.
Again, it is important to take a longer-term view. In the next year or so, many companies are likely to go out of business. Once the recession ends – which eventually it will, no matter how bad things currently appear – the survivors will be strongly placed with the competition markedly reduced.
In the current environment, therefore, successful investment is more about buying the likely survivors rather than simply picking up cheap stocks.
It is impossible to forecast exactly when the UK stockmarket will properly pick up again and investors should beware short-lived technical bounces, as have recently been experienced.
Normally, equities tend to move before economic data improves but, with the current levels of volatility, it is prudent to wait for clear signs that leading indicators are improving and government stimulus packages have laid solid foundations for global growth.
In the interim, however, the opportunities for investors with the right strategy remain strong.
While we at Cartesian are currently maintaining a defensive stance, the coming year should provide some of the most attractive opportunities in a generation to invest in sound companies at reduced prices.
Before then, there remain significant opportunities to make money from taking short positions in the many troubled stocks.
Jeremy Hall is manager of the Ignis Cartesian UK equity 130/30 fund