Is the bull market driven by fundamentals or QE?

New research from ‘The Share Centre’ monitoring both sales and profits of the 350 largest listed UK companies adds vigour to some who have warned the current bull market is more about on-going QE than market fundamentals.

•  UK Plc revenues up 2.1% in 2012 to £2.07 trillion, slowest rise in at least 5 years

•  Profits after tax fell 29.7% to £114.5 billion, down £48.4 billion compared to 2011

•  Pricing pressure and rising costs hit margins

• Squeeze broadly spread across sectors though larger companies saw bigger fall in profits

• Mining, oil and financial companies caused the most damage to the UK P&L

• UK index is heavily dominated by few sectors and companies – top ten firms make 50% of UK Plc sales and 57% of UK Plc profits

Sales from the UK’s top 350 companies rose at their slowest pace in at least five years in 2012, according to The Share Centre Profit Watch UK, a new quarterly report analysing the revenue and profit performance of the index of 350 leading companies.  The UK 350 made sales of £2.07 trillion in 2012, but this was only 2.1% (£42.6bn) more than in 2011, failing to keep pace even with inflation of 2.8%.

Even though sales inched ahead, profits after tax plunged 29.7% to £114.5 billion, a decline of £48.4 billion compared to 2011, the lowest profits from UK firms since the recession in 2009.  The net margin (profits as a percentage of sales) fell from 8% to 5.5%.

Profitability was squeezed at all levels of the UK Plc profit and loss account.  Gross profit (sales minus the cost of goods sold) fell 6.9% to £380.1 billion, while pre-tax profit declined by a quarter (-24.6%), a fall of £53.3bn.  This shows that companies failed to pass on rising costs of all kinds to their customers, both in terms of an increase in the purchase or production price of the items they sell, and in broader operating costs.

The squeeze was broadly spread. 23 sectors increased their revenues in 2012 while 14 saw them fall, worse even than during the recession in 2009 (when the ratio was 26:11). Only half saw their profits rise (19:18) with cyclical sectors falling furthest.  The previous low point was 2008 when only 3 sectors grew their profits.

The largest 100 firms (many of which are much more dependent on global conditions than the mid-cap 250 stocks, which are more UK focused) grew their sales by a lacklustre 2.3% to £1.83 trillion, compared to an even feebler 0.9% from the mid-cap 250, which reached a total £238.2 billion.  The mid-caps experienced a lesser squeeze on their margins, however. After tax profits from the large cap companies were £104.0 billion, a drop of 30.8% compared to 2011.  For the mid-caps, the decline was half the level of the large companies. Profits were £10.5 billion, 16.5% lower than the previous year.

Even though the squeeze was broadly spread, the UK index’s three biggest industries – financials, oil & gas, and basic materials (mostly miners) – were worst affected. Falling commodity and energy prices made revenue growth very hard to achieve, while the banking industry saw weak lending affect its top line.  Meanwhile, costs rose sharply, and there were sizeable asset writedowns by miners and banks.  Of the £48.4 billon fall in UK profits, £25.6 billion was from basic materials, £11.2 billion from oil & gas producers and £7.7 billion from financials.

Helal Miah, investment research analyst at The Share Centre, said:

“The weakness in 2012 reflects a perfect storm for UK listed firms as the three largest profit producing industries all suffered at the same time, a rather unusual coincidence of events. Firms selling commodities on world markets produced greater volumes, but had to accept lower prices for these raw materials, while a flat lining UK economy and the prolonged European recession made it very difficult for a whole range of companies to make any headway. Moreover, many firms were unable to offset lacklustre sales growth with cost cutting.

“Investors will be hoping 2013 will see some reversal.  Given the headwinds in the largest industries, revenues are likely to remain under pressure, but profitability should improve. At its current level, and based on typical valuations for the last four years, the market is implying profits will bounce back to £160 billion this year. That will be hard to achieve and suggests investors are prepared to pay a higher price for profit, particularly as equities are the best place to find income at present. This is underpinned by the strength of defensive sectors compared to cyclicals.”

The Profit Watch UK also reveals how hugely dependent investors in UK stocks are on a few big companies.  The top 10 firms by sales accounted for an astonishing 50% of all revenues in 2012 (£1.04 trillion), while the top ten by profit make up a staggering 57% of all after tax profits.  What’s more, there is a very strong concentration by industry.  Basic materials (mainly mining), oil & gas and financials collectively made up 86% of all UK Plc revenues in 2012, up from 59% in 2007.  Their share of profits was 37% in 2012 (compared to 69% in 2007 and 72% in 2011).  The Share Centre estimates that stocks outside the UK 350 would add less 2% to the revenue total and a smaller amount to the profit total.

Helal Miah concluded:

“The UK market is heavily skewed to a small number of big companies and big sectors.  Investors need to be careful when building their portfolio that they take account of this concentration as they select stocks.  Copying the UK index may not be the best way to diversify your risk.”

Appendix 

 

Methodology

The Share Centre analysed raw data from the financial reports of the UK’s largest 350 listed firms (provided by Factset, excluding equity investment trusts), cross referencing with additional data from the London Stock Exchange.  The researchers compiled the data for the whole market and analysed by sector and index.  For the first report, the current constituents of the FTSE 350 were analysed back to 2007, whether or not they were members of the index at that time.  Where possible, results for companies listed since 2007 (e.g. Glencore) have been included back to 2007.  Future reports will use the index as it evolves over time.

The first report analyses financial data for companies with year ends up to 31st December 2012 and who reported up to 31st March 2013.

Data Source: The Share Centre via FactSet Research Systems Inc.