The value rally is being powered by ratings change not earnings
Another week, another push forward for the UK stock market. We’ve waited for a long time for this to happen and it’s very satisfying to see the FTSE 100 and FTSE 250 finally get some winds in their sails.
The key question is whether the rally has legs. Some companies look like they’ve already priced in a significant amount of potential future growth so that they a) no longer look good value and b) stand to experience a big share price correction if the earnings growth doesn’t materialise.
There are stocks still priced attractively versus their prospects, four of which we featured in this recent article. However, it does feel as if we are approaching the stage where parts of the market may find it harder to keep rising without stronger earnings upgrades.
Shares has looked at the performance data since 1 November 2020 which is roughly when the market rotated towards value-style shares. In theory, the vaccine rollout has improved value stocks’ chance of growing earnings and investors suddenly found they no longer needed to pay top price to access growth.
For the past five months, these value stocks have principally risen because investors have been prepared to pay a higher rating for them. For example, if a company was trading on 10 times forecast earnings for 2021 and enjoyed a 50% rise in its share price, it would be trading on 15 times – assuming no change to earnings estimates.
Cleaning provider Mitie (MTO) has seen its 2022 earnings per share forecast increase by 5% since the start of November 2020, according to Stockopedia data. Its share price has risen by 129% over that period, meaning the gains are almost entirely down to the rating change.
Mitie now trades on 13.1 times 2022’s expected earnings. Investors need to ask – is that now a fair rating, whereas previously it was on a depressed rating? Or is that rating too high for this type of low margin business?
Wagamama owner Restaurant Group (RTN) has risen by 204% since 1 November yet its 2022 earnings per share forecasts have fallen by 28% over that period, putting it on a price to earnings ratio of 24.9 – not the sort of rating you’d associate with a leisure company.
Since 1 November, 315 stocks from the FTSE 350 – which combines both the FTSE 100 and FTSE 250 indices – have increased in price, 16 of which by more than 100% and 97 delivering more than 50% return, according to SharePad. The ones delivering negative returns have seen an average share price decline of 4.2% over that period.
Shares is certainly not calling the top of the value rally, merely highlighting the need to be more selective with stock picking at this stage.
It’s also worth looking at the ones that haven’t rallied as there could be some decent companies trading on lower ratings than their historical average.
This group is likely to include some quality names with a long track record of delivering good returns, but which are temporarily out of favour because investors can find potential growth stories on a cheaper rating. As we explain in this article, now could be a good time to load up on quality names.