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How reliable are forecasts of a FTSE 100 earnings rebound?

1 week ago

No one can agree upon the origins of the quote, “Hope is not a strategy”. This column cannot be sure and a trawl of the internet sees commentators attribute it to everyone from former US President Barack Obama, to film director James Cameron, to former New York City Mayor Rudi Giuliani, to one-time Green Bay Packers American football coach Vince Lombardi.

One thing is certain, however: hope is not a strategy when it comes to investment. Any selection should be made with downside protection in mind first, followed by a clear assessment of potential returns, with a set target for the overall gain, to ensure that possible rewards more than compensate for the possible dangers.

“It seems as if fears of an extended economic downturn thanks to a prolonged pandemic are being offset by markets’ hopes for more fiscal and monetary stimulus, which they feel in turn will stoke a sharp recovery in profits, dividends, share prices and asset valuations in 2021 and beyond.”

At the moment, it seems as if fears of an extended economic downturn thanks to a prolonged pandemic are being offset by investors’ hopes for more fiscal and monetary stimulus, which they feel in turn will stoke a sharp recovery in profits and dividends – and presumably share prices and asset valuations – in 2021 and beyond.

This scenario could yet pan out and it is unlikely that central banks and governments will stop running quantitative easing (QE) schemes, racking up budget deficits or even experimenting with new ideas such as Modern Monetary Theory or Universal Basic Income if the economic outlook becomes any more uncertain.

What any of those will do over time to faith in fiat currency is a question for another time, but they do seem to be underpinning hopes for a rapid recovery in UK plcs’ earnings power, at least if trends in FTSE 100 earnings forecasts are any guide.

Trio of tests

Taking an aggregate of the bottom-up forecasts for all 100 members of the UK’s premier index, analysts are currently expecting a sharp rebound in pre-tax profit, to £174.2 billion in 2021, from 2020’s £122.2 billion.

Analysts are forecasting a big bounce in FTSE 100 earnings in 2021

Source: Company accounts, Sharecast, analysts’ consensus forecasts

To test the reliability of such an estimate – and whether it is a safe assumption upon which to base an assessment of the valuation of the UK market (since the FTSE 100 represents over 80% of its market cap and earnings power) – investors can look at three barometers.

“An outcome of £174.2 billion in 2021 would take next year’s pre-tax profit total for the FTSE 100 to a level 5% above that of 2019 and one just 10% below 2018’s all-time high.”

  • The first is how the 2021 forecast compares to recent history. An outcome of £174.2 billion in 2021 would take next year’s pre-tax profit total for the FTSE 100 to a level 5% above that of 2019 and one just 10% below 2018’s all-time high. Investors must weigh the effects of the pandemic, the efficacy of policy response and how corporate and consumer behaviour may (or may not) change as part of their analysis here.
  • The second is to gauge analysts’ confidence in their own forecasts. This can be done by tracking momentum in the estimated aggregate profit totals. The bad news is that estimates for 2020 are still sliding lower, as the pandemic refuses to go away and the Government juggles policies designed to protect the public’s physical health with the need to manage its financial health. The good news is that estimates for 2021 have started to creep higher. A 6% upgrade in analysts’ earnings forecasts since July offers some encouragement.

Consensus FTSE 100 earnings estimates for 2021 are creeping higher

Source: Company accounts, Sharecast, analysts’ consensus forecasts

  • The third is to look at the mix of the earnings recovery, by sector and stock, to judge just what needs to drop right – and how likely this might be.

“In terms of sectors, Oil & Gas is expected to generate nearly a third of the FTSE 100’s £52 billion jump in pre-tax profits on its own. Another quarter of the increase is seen coming from Financials (banks and insurers) and another quarter from consumer discretionary and industrial stocks.”

In terms of sectors, Oil & Gas is expected to generate nearly a third of the FTSE 100’s £52 billion jump in pre-tax profits on its own. Another quarter of the increase is seen coming from Financials (banks and insurers) and another quarter from consumer discretionary and industrial stocks.

Oils, financials and cyclicals are seen spearheading the FTSE 100’s earnings recovery in 2021

Source: Sharecast, analysts’ consensus forecasts

This picture is confirmed by the company-by-company breakdown of forecast FTSE 100 profit growth. Oil majors BP and Royal Dutch Shell top the list, with four banks also in the top 10, alongside two miners – Glencore and Anglo American – as well as British Airways owner International Consolidated Airlines and aerospace supplier Rolls-Royce.

Analysing the finer details of each individual company may be beyond the resources of advisers but these are the names which their chosen UK equity fund managers must understand – and upon which they must have a clear view – if they are to generate the sort of performance that helps clients meet their financial goals and the managers justify their fees.

Just 20 firms are forecast to generate more than 80% of the FTSE 100’s profits growth in 2021

Source: Sharecast, analysts’ consensus forecasts

“It seems fair to say that this is high-octane mix. If there is a strong global economic recovery – thanks to a vaccine, fiscal and monetary stimulus or the virus simply becoming less potent – then the UK could well be a very interesting place to invest.”

It seems fair to say that this is high-octane mix. If there is a strong global economic recovery – thanks to a vaccine, fiscal and monetary stimulus or the virus simply becoming less potent – then the UK could well be a very interesting place to invest, especially as consensus forecasts put the FTSE 100 on 13.6 times earnings for 2020 with a prospective yield of 4.2% with sentiment on cyclicals, and especially oils and banks, well and truly washed out.

However, if the opposite happens, and the pandemic lingers and drags the economy down, it would be unwise to put too much faith in forecasts of a rip-roaring earnings recovery, or that 4.2% dividend yield for that matter (although that still comes in at 3.7% if you assume the banks pay nothing again, thanks to regulatory or economic pressures). The drive away from hydrocarbons and toward renewable energy could also hold back BP and Shell, and thus the FTSE 100, in the near term, which is a further factor that investors must consider.

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Russ Mould
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Russ Mould

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AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.

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