A strong pound, failing oil prices and slowing global growth mean UK businesses have posted their most lacklustre profits since the financial crisis, prompting questions over which funds are positioned to avoid further weakness through the rest of the year.
The latest Profit Watch UK report from The Share Centre focuses on the FTSE 350 companies that reported their full-year results up to the end of December 2014 and shows the weakest sales and profits performance in years.
The cohort of companies covered by the report is an important one for the UK stock market, as it includes two-fifths of FTSE 350-listed firms and accounts for about 75 per cent of the index’s total revenues.
Performance of indices over 2yrs
Source: FE Analytics
Revenues among these companies dropped 7.5 per cent over 2014 to a combined £1.44trn, meaning the weakest sales performance from the group since 2010. Some 21 sectors witnessed a decline in revenues, while 16 saw a gain.
Helal Miah, investment research analyst at The Share Centre, said: “Falling oil prices, languishing commodity prices and weak global economic growth all hit the UK stock market’s three largest sectors – oil, mining and banking.”
Furthermore, sterling was an average of 5 per cent stronger against the dollar and the euro over the course of the year and this damaged the figures of companies that report earnings in these currencies.
The oil sector was the principal contributor to the revenue decline with the companies here seeing sales fall by £63bn. Shell and BP’s combined revenues dropped more than £60bn – together they account for a quarter of FTSE 350 revenues.
Looking at net profits, which represent the return left for shareholders after all other costs have been accounted for, paints another downbeat picture. Net profits for the fourth-quarter cohort amounted to £64.3bn, which is the worst performance from these companies since 2008.
Leading the 8.8 per cent fall in net profits were companies in the oil, pharmaceutical, gas utilities, aerospace and tobacco sectors. Positive contributions came from miners, financials especially banks, travel and leisure, housebuilders and technology hardware.
Miah adds: “2014 was characterised by healthy recoveries in the US and the UK but contrasting with languishing eurozone and emerging economies. This culminated in the announcement of quantitative easing in the eurozone in January 2015.”
“These factors drove the US dollar and sterling higher against most other currencies, and had an impact on corporate income and balance sheets.”
“On top of this, major structural changes within individual sectors such as food retailers, oil & gas, mining, banks have also played a, mostly negative, part and will continue to be a major factor in the short to medium term.”
Looking over the next year, the analyst says there are reasons to be optimistic as monetary policy is expected to remain supportive, investors continue to channel money into equities and there are signs of improvement in the eurozone.
So how should investors be positioned for the coming year?
Miah argues that the financial sector is expected to fare well, with profits rising as real household income strengthen and the economic recovery continues.
Performance of indices over 5yrs
Source: FE Analytics
FE Analytics shows there are 22 funds in the IA UK All Companies and IA UK Equity Income sectors that have a higher weighting to financials than the FTSE All Share and hold five FE Crowns.
These include Fidelity Special Situations, Invesco Perpetual UK Strategic Income, R&M UK Equity Unconstrained and Schroder Income funds. All these are headed by FE Alpha Managers.
Of the 22 funds, Stephen Message’s Old Mutual UK Equity Income has the highest weighting to financials at 42.30 per cent. Message recently told FE Trustnet: “With the banking sector, it’s not all going to be plain sailing - it hasn’t been for the past four or five years. But I think the trend is one of gradual improvement in terms of falling regulatory burdens and greater confidence in their balance sheets.”
The Share Centre also argues that “the worst of the falling profitability in the mining sector should … be behind us now”, which could make these companies more attractive to investors with a contrarian mindset.
Miners have been very much out-of-favour over recent years, not least because of the end of the so-called commodity super-cycle ushered in depressed prices for the materials they produce. As the graph below shows, miners have significantly underperformed the wider FTSE All Share.
Performance of indices over 5yrs
Source: FE Analytics
However, some investors are tipping the sector for a rebound on the back of attractive valuations and the better capital discipline that has been shown by the new management teams in place at some of the biggest players in the industry.
According to FE Analytics, just eight five FE Crown-rated funds are overweight basic materials companies in the IA UK All Companies and IA UK Equity Income sectors.
Only three of these are headed by an FE Alpha Manager: Martin Walker’s Invesco Perpetual UK Growth and Invesco Perpetual Childrens funds and Chris Reid’s Majedie UK Income, which also features Yuri Khodjamirian as co-manager.
More generally, Miah says investors should take active exposure to the UK rather than seeking to replicate the overall market through a tracker or ETF.
“The UK stock market is unusually concentrated in global oil, mining and banking stocks, so the UK index actually provides far less diversification than some other major countries,” he explained.
“That means that index trackers are, contrary to conventional wisdom, actually rather riskier than a better diversified portfolio of shares.”
