EPS forecasts, dividend growth, Chris Boxall and factor performance
The best investment research, blogs and podcasts this week
Hello everyone - Happy Easter / Passover / Ramadan and anything else you happen to be celebrating this week. Here’s my weekly round up of things I’ve read, watched and listened to in an effort to make sense of investing and markets…
Have a great weekend,
Ben
Are EPS forecasts too optimistic? Yes, they are…
It’s probably best to ignore the title of this note from Franklin Templeton because I’m not sure it really does much to answer that question. But what it does do is have a good crack at trying to understand which way corporate earnings are trending.
Valuations or earnings: Which is most important for equity returns in 2023?
For months there has been a sense that analysts have been way too optimistic on the outlook for earnings, given the pressure on margins and prospect of a recession. This definitely matters a lot when it comes to valuations and whether the market pricing-in the future appropriately.
Here’s a summary of the research, which focuses on the US but rings true this side of the Atlantic:
Coming out of Covid, earnings-per-share recovered in a positive stepwise fashion (see the chart below) but they now seems to have reached the top (or at least run out of steps)
Since March 1991, the market consensus has expected positive earnings growth 74% of the time. Currently the consensus expects a 2% EPS drop over the next 12 months - so it’s a big, negative signal
Weak EPS consensus like this tends to precede bear phases (happened in 2008, 2015/16 and 2020)
Franklin Templeton’s own leading EPS indicator suggests a 6% drop in EPS over the next year - so larger than the consensus
Pressure on profit margins is to blame. Margins hit a cyclical peak in April 2022 but are now down 23% from there
Profit margins tend to decline for extended periods of time — 20 months on average — before troughing. We are about to hit the 12-month mark
In the last seven periods of extended peak-to-trough margin declines (since 1990) EPS fell in five of those periods at an average of -14%. Consensus expectations are currently -2%. That seems too optimistic
Paradox of thrift = corporate cost cutting (redundancies) leaves consumers with less money to spend, which weakens demand for goods. Growth is preferable - but it needs a catalyst (which isn’t coming from central banks)
In summary, investors should prefer defensive positioning (cash and fixed income, in FT’s view) or look for growth in Asian economies
Dividend growth you can’t count on
Here’s an interesting take on dividends from Slater Investments: Progress ain’t what it used to be… Income is a core theme of one of Mark Slater’s main funds, so there is certainly a vested interest here. The article riffs on a similar idea picked up a couple of years back by another fund manager, Terry Smith (Never let a good crisis go to waste).
With “progressive” dividend growth policies widely ditched when payouts were slashed during the Covid pandemic, there was a healthy rebasing of dividend cover. This offered the possibility for dividends to grow sustainably for many years
But when companies recovered many shied away from up-ing their payouts. Fewer now talk of progressive dividend policies anymore
With earnings forecast to fall across the market, the read-across is that payouts will fall too. Directors are ducking the issue
Dividends remain an important support of share prices. If they are automatically allowed to re-rate downwards in line with earnings, it could be a problem
Balance sheets are solid and companies could defend their payouts if they wanted to. Bizarrely, this means there could be cases of companies cutting dividends while simultaneously buying back shares on the back of their strong finances
Slater, of course, recommends taking a pooled approach to dividends
Small-cap investing and how to find AIM shares
“We’re all looking for growth at the end of the day.”
Nobody could really argue with Chris Boxall on that point. The boss of specialist small-cap investment firm Fundamental Asset Management pushes back against the over-categorisation of different investment styles. And you can sort of see his point.
Fund Your Retirement Podcast - Fundamental Asset Management’s Chris Boxall interviewed by Fund Your Retirement
This is an interesting podcast with someone who knows AIM (the Alternative Investment Market) and AIM shares better than most. It’s strange to think that it wasn’t until 2013 that you could hold AIM shares in ISAs. That year stamp duty on AIM shares was also abolished.
In the intervening years, the index has drifted higher (from around 700 points then to 800 points today) and the number of companies quoted on it has drifted lower. In early 2013 it was about 1,100 companies, but today it’s 727. The upside is that the quality has arguably improved, and so has the average company size. Some of the biggest-cap stocks on AIM have at times been big enough to scrape into the FTSE 100.
Among the highlights here:
Taking advantage of the inheritance tax relief on AIM shares, why that relief exists and whether it will ever go away. Chris says (talking his own book) that rather than potentially removing this tax break, the government should probably enhance it to help smaller companies.
Small company investing is perceived as riskier, which on one hand you could argue is a great reason why most people should stay away from it. But as Chris says, it’s a great place for individual investors to add value and outperform the big boys. With patchy professional research, there is greater scope for DIY-ers to find an edge.
On the quality of AIM over time (since he started investing in 2004) - AIM peaked at about 1,700 companies in 2007. Fast forward we’ve still got a market cap of just under £100bn, the average company is worth £118m [although there is a very long tail of very small shares]. You’ve seen a lot of the rubbish go, a lot of the international stock go, a lot of the questionable companies go and now you have a junior market full of more substantial businesses. It’s probably too safe... AIM is in desperate need of a few good new entrants.
Companies he talks about: AB Dynamics, Tracsis. He likes small companies that are founder-led with proven business models that grow well organically and then do some bolt-on deals. These days, though, larger companies are coming through and going on acquisition sprees [or at least they have been].
Interesting companies: Fonix Mobile, H&T Group, Somero Enterprises
Things to watch out for: I’ve never heard a bad tale from a CEO - you only hear what they want to tell you. We prefer reading the facts and looking at outside industry sources if necessary. Anyone looking at an AIM share should look at its AIM admission document, it’s full of useful information. The one section that most people don’t look at is the risk section, and that’s got the most valuable information in it.
Advice for private investors:
Don’t be overly exposed to a single stock
With AIM, take profits as you go
For IHT-conscious investors, make sure your holdings continue to qualify
Keep an audit trail for IHT purposes
The flexibility is why PIs in small, quoted companies can massively outperform
Factors underwater in Q1
Nicolas Rabener is awesome on the subject of factor performance. His Factor Olympics Q1 summary shows that everything was underwater in the first three months of the year:
Size (small beats big) did the best while low volatility did the worst in Q1
As the table shows, there is a lot of rotation when it comes to performance over time
In 2022, value was easily the best returning factor, followed by momentum and a multi-factor approach. But in Q1, value slipped down the performance standings
Nicholas reckons the underperformance in Q1 mostly all happened in March. He says resurgent interest in growth is a potential reason for it
Another take on factor performance in Q1 comes from MSCI in Markets in Focus: Factor Valuations and the New Rate Regime. Their data shows a similar story, with most factors underperforming indices in the first three months of the year. Although they suggest that the quality factor had a good run:
On their data, momentum was the worst performing factor in Q1, together with low volatility. Growth, value and size fared better, relatively.
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