Our year-end FTSE 100 forecast is 6800. Are we mad? Certainly equities are weighed down by a swathe of factors all of which we have commented on at various times over the past year or more. However, at prevailing levels we believe that equities offer outstanding value and that should any one of the equally well known catalysts for macro economic revival manifest themselves this should trigger a marked revival in risk assets.
This week sees the start of the Q2 / H1 reporting season in the UK in earnest. Ahead of the reporting season, sentiment is very depressed. Investors suspect, with some justification, that numbers will disappoint and that a series of downbeat outlook statements will act as the catalyst for sweeping earnings downgrades for 2008 and more pertinently, given the way they have held up to date, for 2009.
The UK equity market has fallen by 21% over the past 12-months and by 18.3% year to date. It hardly needs us to say that this represents bear market territory, both in terms of the extent of the index falls and their duration. Our equity view has, however, changed. We are looking at opportunities afforded by these falls to rebuild exposure to risk assets.
The starting point (and subject of this note) is to consider the question of base valuation. The first key point to remind readers is that in extreme conditions such as these, it is not a company’s profitability so much as its cash flow that becomes critical. Companies can still be reporting profits derived from operations over a historical period but their futures depend much more on the ability to keep generating cash. Therefore, we would argue that the cash flow statement is more critical in evaluating a company’s health, at the present time, than its profit & loss account. Secondly, the balance sheet will give a clear indication regarding a company’s tangible book value, another keystone to valuation support and a company’s ability to continue trading as a going concern.
Cash is king
Although there are a number of ways of assessing a company’s valuation in moments of severe strain such as these, investors would be well advised to check the relationship between a company’s enterprise value (market capitalisation + debt) against its ability to generate free cash-flow. According to Lehmans, this measure has served to put a floor under European equity markets over the past 20 years. On a number of occasions this valuation metric has fallen to around 20x, but has never fallen below that level. Over the past 20 years it has tended to average around 40x with two notable spikes, firstly between 1990 and 1994 and secondly 2000 and 2002. At present, the multiple has fallen to just 21.6x, its lowest level since 1988. Assuming that levels of free cash flow are sustained, this valuation metric is telling us that it would take 20 years for the market to pay off all outstanding debt and equity, leaving remaining assets as the terminal value.
Naturally, equity market analysis such as this results in valuation aggregation. Drilling down to the sector level it is possible to spot areas of extremes in which the EV/ FCF ratio is down to levels well below the long-term average. A couple of weeks ago we used our monthly Investment Handbook to highlight the close correlation between the performance of the short end of the bond yield curve and the Technology, Retail and Travel & Leisure sectors. Using this valuation methodology reveals these same sectors to be particularly beaten down. This suggests that investors expect that free cash-flows will come under severe pressure over the years ahead, although backtesting shows that the impact of recessions or periods of economic weakness on company cash flows has not been as severe as people imagine.
Generally, there has been some slippage as growth retrenches, but there has been no collapse and, just as importantly, the largest UK companies are not entering this downturn with particularly high levels of debt. As a consequence, companies had, in general, been reinvesting cash in their businesses, and as a result generally robust free cash generation has not been temporarily inflated by low levels of capital expenditure.
UK companies with EV/FCF of less than 10x
Stock – EV/FCF (x) – Recommendation
Reed Elsevier – 4.4 – Accumulate
Home Retail – 5.5 – Hold
Kesa Electricals – 5.7 – Hold
Antofagasta – 6.8
Wolseley – 7.3 – Hold
Centrica – 7.7 – Buy
Hays – 8.2 – Accumulate
Johnson Press – 8.5
Next – 8.6 – Hold
BAE Systems – 9.5 – Buy
Something tangible in the balance sheet
Although a company’s ability to generate free cash is a critical determinant of its ability to ride out a downturn, the base valuation ultimately depends upon the balance sheet. In distressed conditions when a company is wound up, all residual value following payments to debt holders and / or banks etc, is returned to shareholders. In such conditions one would not expect any company’s equity value to trade too far below the value of its tangible net assets for any prolonged period of time. If it did then investors would obviously be better off if the company went out of business and residual value were returned to them. Within our universe there are three companies currently trading below this critical threshold; Barratt Devs, Persimmon and Trinity Mirror! Furthermore, there are quite a number of companies from within our universe that are trading close to critical levels (see below). Assuming that many of these companies are generating significant free cash and that cash were included in balance sheet calculations then many of these companies would find themselves, perhaps unjustifiably, below this critical watershed.
UK equities with tangible NAV / FCF of less than 10
Stock, Tan NAV/FCF(x)
Trinity Mirror -25.98
Persimmon -8.81
Home Retail 0.85
Johnston Press 2.83
Reed Elsevier 3.06
Antofagasta 4.30
Kesa Electricals 4.73
Wolseley 4.93
Tomkins 5.28
Centrica 6.33
CRH 7.16
Hays 8.55
Next 9.00
Ryanair 9.52
Conclusion
What this analysis shows is that the equity market is close to base valuation using two key valuation metrics. This does not mean that share prices will rise aggressively, nor does it mean that there won’t be choppy periods between now and the year-end. What it does show is that unless global macro-economic conditions deteriorate markedly (and we are not sure that they will as the oil price is expected to subside and headline inflationary pressures ease as the year progresses), then equity market downside is fairly limited. Indeed, history shows that falling inflation pressure always results in an improvement in equity market sentiment and a recovery in ratings, which have reached very depressed levels at present. Naturally, markets will over-shoot on the downside just as they over-shoot on the upside from time to time, however, for longer term investors prevailing conditions do provide opportunities for those willing to live with a high risk / reward trade-off. We remain unconvinced by the banking sector, although its turn-around is likely to remain critical to our year-end target being achieved. Defensive sectors are popular at the moment, heading into a recession and a reporting season fraught with uncertainty and pot holes for the unwary. What this analysis does indicate is that when sentiment recovers there is deep value to be found in some of the more heavily bombed-out sectors of the market.
• This article is reproduced from the ‘Week in Preview’ newsletter published by Charles Stanley Stockbrokers