Quality of FTSE 100 earnings improves even as the index struggles

As the FTSE 100 remains in the grip of a global bout of ‘risk-off’ sentiment, investors can at least draw some reassurance from how the quantity and quality of UK plc’s earnings seem to be improving.

Two weeks ago this column noted how aggregate pre-tax profit forecasts for the FTSE 100 have continued to rise. Pre-tax profit forecasts for 2018 now stand at a total of £225.8 billion, some 6% higher than they were a year ago, while estimates for 2019 are also showing positive momentum with a second straight increase to £242.9 billion.

Advisers and clients may also feel they can draw some reassurance from how the quality as well as the quantity of UK plc’s earnings seems to be improving.

The gap between statutory earnings and companies’ preferred profit metrics (which can – cynically – be described as ‘earnings before bad stuff, or ‘EBBS’) closed dramatically in 2017 from 2016’s decade high to the lowest level since 2011.

Gap between stated and adjusted operating earnings at FTSE 100 firms is (thankfully) closing

Source: FTSE 100 companies’ Annual Report and Accounts in aggregate, 2008-2017

There are two, conflicting, possible interpretations for this:

  • Companies are simply being more transparent, providing greater clarity to shareholders on the many moving parts which make up their business and enabling investors to get a better view of what is really going on under the bonnet.
  • Those companies which had perhaps been intentionally muddying the waters ran out of tricks to pull, relating to acquisitions or restructuring charges, or even felt a lesser need to do so as underlying trading improved. Some firms still present sales figures in multiple formats of actual, underlying and underlying in constant currencies. Others continue to point to underlying metrics of their own choosing and publish those figures first in regulatory announcements (while at least flagging that they are not based on generally accepted accounting principles, or GAAP). In both cases the goal is to put a positive gloss on their figures. But for all of that, the gap between stated and adjusted numbers has closed, which would suggest that the underlying quality of FTSE 100 earnings in 2017 improved relative to 2016, even as overall profits rose nicely.

Close the gap

It is interesting to note that the gap between stated and adjusted earnings shrank last year as inflation began to increase a little, hopes grew that the UK economy could gather traction and the Bank of England finally felt confident enough to raise interest rates for the first time in a decade.

The gap between stated and adjusted net profits also fell sharply from an unusually high level. The earnings gap seen in 2016 had been exceeded in only the Financial Crisis-stricken year of 2008, 2012 and 2015 over the previous 10 years, while only 2013 has seen a lower gap between the stated and adjusted versions of the bottom line than 2017.

Gap between stated and adjusted earnings at FTSE 100 firms is closing at the net level, too

Source: FTSE 100 companies’ Annual Report and Accounts in aggregate, 2007-2016

This apparent improvement in earnings quality may ease some fears that a deterioration in the standards of reporting and accounting could be a pointer that a market top is imminent.

The economist J.K. Galbraith’s concept of ‘The Bezzle’, outlined in his book The Great Crash 1929, explains that market participants tend to become less wary, and companies more aggressive, as a stock market cycle moves on, as rising share prices dull the senses of the former and encourage the latter. Galbraith wrote:

At any given time there exists an inventory of undiscovered embezzlement in – or more precisely not in – the country’s business and banks. This inventory – perhaps it should be called the bezzle – amounts at any moment to many millions of dollars. It also varies in size with the business cycle.

In good times it is plentiful, there are always people who need more. Under these circumstances the rate of embezzlement grows, the rate of discovery falls off and the bezzle increases rapidly. In depression, all of this is reversed. Money is watched with a narrow, suspicious eye. The man who handles it is assumed to be dishonest unless he proves himself otherwise. Audits are penetrating and meticulous. Commercial morality is enormously improved. The bezzle shrinks.”

Galbraith’s words are particularly strong and the gap between stated and adjusted earnings flagged by AJ Bell research in no way implies that any FTSE 100 management team is doing anything illegal.

But the collapse of FTSE 250 member Carillion and the launch of the Kingman inquiry show that issues over auditing, accounting and reporting standards and transparency remain as important as ever.

Action plan

A big gap between stated and adjusted earnings does not necessarily mean a company is inherently a poor investment while a small gap may not automatically mean it is a good one.

But advisers and clients will want to make sure that their chosen fund managers are on top of this issue as a means of protecting the downside at a time when some signs of nerves are creeping in, just as a huge wave of central bank liquidity starts to ebb. As legendary investor Warren Buffett once asserted: “Only when the tide goes out do you discover who’s been swimming naked.”

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.