Please note that tax, investment, pension and ISA rules can change and the information and any views contained in this article may now be inaccurate.
Quality of FTSE 100 earnings improves even as the index struggles
As the FTSE 100 remains in the grip of a global bout of ‘risk-off’ sentiment, investors can at least draw some reassurance from how the quantity and quality of UK plc’s earnings seem to be improving.
Two weeks ago this column noted how aggregate pre-tax profit forecasts for the FTSE 100 have continued to rise. Pre-tax profit forecasts for 2018 now stand at total of £225.8bn, some 6% higher than they were a year ago, while estimates for 2019 are also showing positive momentum with a second straight increase to £242.9bn.
The gap between statutory earnings and companies’ preferred profit metrics (which can – cynically – be described as ‘earnings before bad stuff, or ‘EBBS’) closed dramatically in 2017 from 2016’s decade high to the lowest level since 2011.
There are two, conflicting, possible interpretations for this:
– Companies are simply being more transparent, providing greater clarity to shareholders on the many moving parts which make up their business and enabling investors to get a better view of what is really going on under the bonnet.
– Those companies which had perhaps been intentionally muddying the waters ran out of tricks to pull, relating to acquisitions or restructuring charges, or even felt a lesser need to do so as underlying trading improved. Some firms still present sales figures in multiple formats of actual, underlying and underlying in constant currencies.
Others continue to point to underlying metrics of their own choosing and publish those figures first in regulatory announcements (while at least flagging that they are not based on generally accepted accounting principles, or GAAP).
In both cases the goal is to put a positive gloss on their figures. But for all of that, the gap between stated and adjusted numbers has closed which would suggest that the underlying quality of FTSE 100 earnings in 2017 improved relative to 2016, even as overall profits rose nicely.
A big gap between stated and adjusted earnings does not necessarily mean a company is inherently a poor investment while a small gap may not automatically mean it is a good one.
But to protect themselves, and their portfolios, investors can apply the following checks:
– Watch out for frequent ‘exceptional’ items (an oxymoron if ever there was one) or a growing gap between stated and adjusted earnings.
Companies which in 2017 added to a trend of a growing gap between stated and adjusted operating profit include AstraZeneca (AZN), GlaxoSmithKline (GSK), Imperial Brands (IMB), ITV (ITV) and Marks & Spencer (MKS) once more.
– Watch out for restated numbers, unclear numbers or unintelligible commentary.
As an equity investor, your time horizon should be five to 10 years at least, as this is when the power of dividend reinvestment really makes itself felt. Yet depressingly few firms provide a clear 10-year history of their numbers in the Report and Accounts (British Land (BLND) and Hammerson (HMSO) deserve praise here).
Make sure you know what triggers management bonuses, share awards and stock options.
As Warren Buffett’s long-time business partner Charlie Munger once noted: ‘Show me the incentive and I will show you the outcome.’
Investors therefore need to check these triggers, particularly if they are changed and particularly if they are structured so that they are based on underlying or adjusted profit figures, as a management team may be tempted to start gaming the system and focus on short-term pay triggers (‘managing the numbers’) rather than doing what they should be, which is deepening a company’s competitive position (‘managing the assets’).
– Go by the book.
Net asset value (NAV) measures what investors collectively own through their shareholdings – it is the total assets of a company minus its liabilities and represents what would be left if the firm were wound up today. Companies that consistently grow earnings should grow NAV over time. Those which conjure profits from accounting manoeuvres, or frequently take asset write-downs to cover restructuring operations, especially after acquisitions, may not.
CLARITY IS KING
If these ‘scratch-and-sniff’ tests mean the investor is not satisfied at the end, then the investor can either:
Avoid the shares altogether (or sell them if they own them);
Pay a discount valuation, relative to sector peers or the wider stock market, until their qualitative doubts are soothed.
Clarity and consistency of reporting standards are a good sign. Restatements and obfuscation are not. To leave the final words to master investor Warren Buffett:
‘Bad terminology is the enemy of good thinking. When companies or investment professionals use terms such as EBITDA or pro forma they want you to unthinkingly accept concepts that are dangerously flawed.
‘In golf my score is frequently below par on a pro forma basis. I have firm plans to “restructure” my putting stroke and therefore only count the swings I take before reaching the green.’
By Russ Mould, investment director, AJ Bell