Soon after share prices hit rock bottom in early March, hopes of a swift recovery in the economy and in corporate profits prompted a two-month shopping frenzy. As investors rushed to scoop up bargains, the UK market enjoyed one of the best quarters in its history. From its mid-March lows, the FTSE All-Share rose by around 25%. During this rally, investors did the exact opposite of what they normally do: they bought stocks whose trading conditions were still deteriorating. Companies for whom the profit outlook was improving, meanwhile, underperformed. Astonishingly, between March and May, shares in companies with the rosiest profit outlooks underperformed the companies with the worst outlooks for profits by more than 30%.
As we head into the second half of 2009, however, some of those "buyers for recovery" are starting to re-examine their purchases in the cold light of day and questioning whether they are the bargains they appeared to be during the spring sales.
Some of the companies that were the biggest beneficiaries of the "dash for trash" are now facing a plaintive demand from worried investors: "Show us the money."
In trying to gauge how much companies are worth at a cyclical low point, I find it useful to look at a company's enterprise-value-to-sales (EV/sales) ratio, a valuation tool that looks through the business cycle.
At the moment, EV/sales tells me something interesting: shares in a number of companies whose earnings depend on the UK economic cycle are now more expensive than their historic norms. Or, to put it another way, despite the still-fragile state of the UK and global economies, buying the right to a slice of these companies' sales is more expensive now than it has been over the past 10 years.
That seems dangerously over-optimistic. Earnings forecasts for many of the companies whose shares have risen furthest since the spring are still falling. Take housebuilders, where profit forecasts continue to be cut. It may seem unlikely, but homeowners (and, by extension, housebuilders) have actually been enjoying a "sweet spot" in recent months. Falling interest rates have driven the cost of monthly mortgage repayments lower and, while the private sector has started laying off staff, the public sector hasn't - not yet, at least.
Furthermore, in the early part of this year, energy prices were falling, driving petrol prices and utility bills lower. That boosted households' spending power. Unfortunately, however, those benign trends won't last. So, the pressing question becomes this: how can the rally in the shares of housebuilders since the spring be justified?
I should, however, emphasise that this stands in contrast to some of the well-merited gains made elsewhere. For some companies, things really are getting better. Take, for example, Barclays. Profits at its investment banking division have been rising fast and keep beating the market's expectations. Elsewhere, earnings forecasts for copper miners such as Kazakhmys and Antofagasta are also rising. Given that the market for copper is relatively tight and China has been buying vast quantities of copper, gains in this part of the market seem far easier to understand.
Elsewhere, however, where the hoped-for improvements in earnings have yet to come through, share prices are beginning to wobble. The indiscriminate greed of March and April is fading. While the market has already priced in a return to normal profitability, for some companies, that happy day still is a long way down the road.
A company's share price must, in the final analysis, depend on the profits attributable to its shareholders. That's why, in looking at companies that have rallied so far from their March lows, I make one simple demand: "Show me the money." Jeff Saunders is a UK portfolio manager with Martin Currie
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