August is typically a quiet month for the UK equity market but, as many of our investors are acutely aware, the relative calm of the holiday season was disrupted by a significant profit warning from Provident Financial and a general mood of market antipathy towards much of the rest of the portfolio.
The profit warning from Provident Financial, which came hard on the heels of its warning in June, has been an obvious headwind to performance. This arose from continued and worsening problems for its consumer credit division, which Neil has comprehensively explained in his blog post and our recent video, which also provides some context about what’s been happening in markets recently more broadly. Broadly half of the portfolio’s underperformance in August came from Provident Financial – much of the rest, in our view, is the result of the stock market’s current preferences, which have become extreme.
As the summer has progressed, global stock markets have become increasingly narrowly focused, returning to the themes that drove behaviour in the second half of 2016. Markets have appeared singularly fixated on stocks that are seen as proxies for Chinese credit growth – in the UK that basically means mining and consumer goods companies – with the rest of the market languishing behind. We do not believe this behaviour is fully justified by fundamentals – nor do we believe it is sustainable. Nevertheless, it has been a considerable further headwind to performance in recent weeks.
Furthermore, we would argue that this behaviour has introduced more risk to certain parts of the market. To demonstrate this, let’s look at what’s happened to Diageo1 – a stock we don’t own – over the course of the last eighteen months. Diageo’s share price has risen 48% from its near-term low of £17.48 in June 2016, to end August at £25.92 (much of that share price rise has come in the last few weeks). In June 2016, the company was expected to deliver £1.02 of earnings per share in the current financial year (which ends on 30 June 2018), putting the shares on a prospective price / earnings ratio (PE) of 17.1x earnings.
We have previously made the point on this blog that starting valuation (the price you pay when you buy an asset) has a strong bearing on the long-term return that you get from that asset. This applies as much for single stocks as it does for broader asset classes, such as the UK stock market as a whole. Diageo has many attractive characteristics as an investment but, from our perspective, valuation is not one of them, particularly when you consider that this is a business that has been growing earnings at an average rate of 3.3% per annum over the last five years.
Part of the share price performance we have seen since June last year has been justified by fundamentals – forecasts for earnings in the current financial year have risen by 15% (albeit currency fluctuations explain part of that increase), so that at the end of August, the consensus forecast for this year’s earnings per share is £1.17. If Diageo’s share price had also risen by 15%, its PE would have remained the same – but the share price has of course risen by much more, to £25.92 so the PE has increased in the space of 15 months from 17.1x prospective earnings to 22.1x. That is why we say the market’s behaviour has introduced more risk. Diageo’s shares now trade in valuation territory which suggests the prospective return over the next ten years will be low.
Now, there are many other factors at play here, and other things could have changed to justify Diageo’s share price rise. Perhaps it’s forecast growth rate has increased – in which case, it could grow into that valuation in the years ahead. Indeed, according to Bloomberg Diageo’s anticipated earnings growth rate has improved from about 4% per annum in mid 2016, to about 10% per annum now. So the investment community, it would appear, has become considerably more upbeat about Diageo’s future growth prospects. Perhaps it will grow at 10% per annum over the next few years – in which case its current valuation is almost justifiable. But perhaps it will continue to deliver growth of 3-4% going forward, as it has done in the recent past. Either way, we have a situation here in which the starting valuation is high and expectations are high. In our view, that is not an attractive combination. We would rather invest in stocks where valuations are low and expectations are low – which is one of the reasons we remain attracted to the healthcare industry, and have grown increasingly attracted to UK domestic cyclicals in recent months (more on that another time…).