All of the UK indices have largely been range-bound since the beginning of the year – at present, the FTSE 100, All Share and small cap indices are just in positive territory.
In the first half of the year we have seen earnings momentum falter due to businesses entering a period of more difficult like-for-like comparisons, the one-off benefits of a bounce back from trough earnings having diminished and analyst forecasts starting to reflect an improved outlook. We are seeing an increasing number of profit warnings across a number of sectors, for reasons such as the declining UK high street environment, raw material inflation and the change in the competitive environment since 2008.
Corporate balance sheets
Earlier this year, we expected M&A (buy), capex (build) and buybacks to become increasingly important in the mid and small cap space in 2011 due to improving corporate balance sheets pushing management to spend their improving cash flows on acquiring other businesses, spending on growth projects and improving shareholder returns through share buy backs.
However, the increase in M&A expected at the beginning of the year has yet to arrive. In fact, a series of deals in the small cap universe have failed due to unrealistic price expectations from the buyers or sellers. Despite this lack of pick up, a recent survey of CFOs suggested M&A is set to increase over the next 12 months and that they are more comfortable with higher gearing. The success or failure of recent approaches for Laird, Misys and Microfocus (all UK mid caps) may set the agenda for M&A over the near future.
If uncertainty on the global economic outlook was the key to disappointing levels of M&A, we might have expected low levels of capital expenditure as businesses batten down the hatches for a slower period of growth, particularly in the oil & gas and mining sectors.
Meanwhile, buybacks and positive dividend surprises seem to be increasing. The underlining drivers are the same as those driving increasing capex and M&A – improving balance sheets have enabled stronger income returns to shareholders. KCOM (UK telecoms business) is a prime example: two years of successful restructuring has resulted in a falling pension deficit and improving balance sheet, enabling the business to announce a significant improvement in dividend yield.
IPOs and equity raisings
As markets returned from the precipice of November 2008, it was inevitable that investment banks would eventually get back on the IPO trail. However, so far, these have largely provided disappointing returns for shareholders. At the top end of the market, Glencore is trading at a discount to its IPO price, as are several of the leading mid cap IPOs.
A number of the high profile issues from 2010 have also struggled in 2011, including Betfair, Supergroup and Flybe. The problem seems to be most acute where a number of investment banks have been involved during the process, resulting in unrealistic pricing expectations and subsequent disappointing outcomes for shareholders, as well as a few failed IPO attempts.
A series of secondary equity raisings by existing plc’s to fund acquisitions have been more profitable in terms of outcomes for shareholders. Plastic business, RPC, for example has raised cash to fund acquisitions that should strengthen their market positions.
Implications for investors
What really matters about all of this for investors is the implications, if any, for the next 12 months and beyond. It seems to be coming clearer that the economic recovery is not yet fully entrenched, and a bumpy extended U- and not a V- shaped recovery is the most likely outcome.
With a backdrop of mixed economic signals, a diversified portfolio and focus on quality structural growth and restructuring stories would seem to be a sensible approach. It will also be important to avoid weaker business models which are more exposed to profits warnings in weak economic conditions. Though this article is more cautious in tone, the mid and small cap universe always has opportunities that fit into this sweet spot. Finding them always proves the problem.
