Is Tellworth British flop a contrarian buy signal for UK stocks?

“The postponement of the proposed listing of the Tellworth British Growth & Recovery investment trust is an indication of the lack of interest from investors in the UK stock market and British firms, as the pandemic refuses to go away, the economy looks fragile and Brexit approaches – but it is precisely this lack of interest which will appeal to wilful contrarians, who will assert that this means there are bargains to be had,” says Russ Mould, AJ Bell Investment Director.

“The ideal stock selection offers the combination of downside protection and upside potential and that comes from paying a lowly valuation and usually by buying when no-one else is interested. 

“It seems pretty fair to surmise that no-one is interested in buying UK stocks right now, given Tellworth British’s failure to raise the funds it was seeking and the turgid performance of the FTSE 100, which continues to underperform its global peers and still languishes 12% below its pre-financial crisis peak of 2007 and 16% below its 1999 high

“However, bids for G4S, William Hill, Hastings and TalkTalk suggests that someone somewhere thinks there is value to be had in the UK stock market, but the question is what will change perception of UK equities and make investors want to add to their exposure.

“In theory a rapid rebound in earnings and dividends from 2020’s trough of despondency could help and an aggregation of the bottom-up forecasts for all 100 members of the UK’s premier index shows that analysts are currently expecting a sharp rebound in pre-tax profit, to £174.2 billion in 2021, from 2020’s £122.2 billion.

 
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.

•    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.

 
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. 

 
Source: Sharecast, analysts’ consensus forecasts

This picture is confirmed by the company-by-company breakdown of forecast FTSE 100 profit growth. 

BP and 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.

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, especially as FTSE 100 looks good value on an earnings, book value and dividend yield basis – plus sentiment toward cyclicals, and especially oils and banks, is well-and-truly washed out as investors fall over themselves to pay ever-higher multiples for growth names like the big US tech stocks.

“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 a forecast 4.1% dividend yield for 2021 for that matter. 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, is a further factor which investors must consider.”