Time to be canny in earnings hunt

With corporate earnings appearing to be at their peak, investors will need to seek out funds focused on companies that diversify and are not reliant on consumers in developed markets

FS Tomas Hirst byline 160

Despite all of the economic gloom over the past few years, corporate earnings have repeated provided encouragement for crisis-fatigued investors. With central bank support for markets looking set to come to an end soon, however, there is now a significant question mark over whether the good news can be sustained.

While Prime Minister David Cameron gleefully greeted news last week that the UK economy grew 1 per cent over the third quarter, according to the Office for National Statistics preliminary estimate, markets remained relatively unmoved. In part this reflected a mixed earnings picture as Unilever beat expectations to post a 5.9 per cent increase in sales while WPP, the world’s largest advertising company, cut its forecast for the second time in two months.

“Corporate earnings appear to be around their peak and while that does not mean they won’t improve from here, they are more likely to fall,” says Darius McDermott, managing director at Chelsea Financial Services.

This poses a problem for investors. Central bank action has already driven yields on traditional safe-havens, such as government bonds, below inflation so that in real terms investors are seeing their capital eroded. Equities, however, have also benefiting from the Bank of England’s asset purchases through the portfolio rebalance effect.

Unfortunately these gains look set to be coming to an end in the near future. The Bank has already spent £368bn of the £375bn it is currently allowed to spend on the scheme and at the current rate it looks set to reach its limit in under a month.

Speaking at the Cardiff Chamber of Commerce last week Mervyn King, the governor of the Bank, said the Monetary Policy Committee would have to think long and hard about whether to extend it further.

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“Printing money is not, however, simply manna from heaven,” he said. “There are no shortcuts to the necessary adjustment in our economy.”

So faced with a sluggish economy and the potential withdrawal of support through quantitative easing, corporates are going to have to rely on canny management and strong market positions to protect earnings streams. For those that are unable to achieve these the outlook is getting increasingly dim.

“The corporate sector, particularly in the US, has significantly de-risked over the last few years,” says Toby Vaughan, senior fund manager at Santander Asset Management. “Cash flow generation in some areas is at all time highs, so I think that is positive for high quality companies. Earnings forecasts still look aggressive though, and we expect them to moderate as upwards support to revenues is scarce.”

In these markets the key will be identifying businesses that enjoy a diversified revenue stream and are not overly reliant on stretched domestic consumers in developed markets. Although slowing growth in emerging markets, particularly in Asia, is a cause for concern they are still looking far more dynamic than their western counterparts.

Indeed despite the positive news that the UK could have escaped recession in the third quarter, the path to economic recovery is still pockmarked with potential risks.

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“If you look at the medium-term pressures being faced by markets, with deleveraging and fewer policy tools to help manage growth, any recovery we do see is likely to be fragile. We expect to see a fat trading-range environment, which should still provide some opportunities,” says Vaughan.

One way in which those concerned about preserving capital over the short term can look to position themselves is to focus on investments with a strong yield component or products that look to limit downside risks.

“People could look at absolute return funds in this type of environment,” McDermott says. “We added the Standard Life GARS fund to our AFI Cautious portfolio at the last rebalancing, for example. We also like dividends as if earnings are falling and prices are volatile then getting 4-5 per cent a year in income gives you some comfort.”

The Standard Life GARS fund, managed by the group’s multi-asset team, aims to produce returns by exploiting market inefficiencies using a range of asset classes and strategies. Over the past year it has returned 6.86 per cent compared with an IMA Absolute Return sector average of 2.92 per cent.

It is certainly the case that absolute return funds hit their stride and garnered a large chunk of retail capital during the peak of market uncertainly following the collapse of Lehman Brothers. Subsequently, however, many of them have struggled to achieve the returns promised to investors.

Investors will no doubt be watching closely to see how they perform in a range-trading environment.