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Ratings risk - an emerging trend

Keeping a share price at above-average ratings requires near perfect execution, and with economic conditions looking tougher, that’s becoming harder.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

Since the financial crisis, high quality companies with scope to steadily increase earnings, and high growth smaller companies have been very much in vogue.

That’s helped quality-focused fund managers like Nick Train and Terry Smith, who favour these sorts of companies, and they’ve proved popular.

However, the strong run means the price to earnings ratios

A common valuation measure that divides the share price by profits per share, so will rise if prices increase or expected profits decrease. Ratios should not be looked at in isolation.

of lots of these companies have increased quite a bit. Keeping a share price at those ratings requires near perfect execution, and with economic conditions looking tougher, that’s becoming harder.

We think that creates risks investors need to be aware of. This article is not personal advice. Ratios shouldn’t be used in isolation to make an investment decision. If you’re not sure, please ask for advice. All investments rise and fall in value, so you could get back less than you invest.

How has ratings risk increased?

The best way to help understand ratings risk is to look at an example.

Diageo is a well-run business, with reliable revenues, high margins and a portfolio of brands that would be the envy of many of its competitors. In short it is a very high quality and attractive business. But investment isn’t just about finding attractive businesses, it’s also about attractive prices.

As companies like Diageo become more popular with investors, the price increases, but recently earnings haven’t been keeping pace and past performance shouldn’t be seen as guide to the future.

Change in share price vs earnings per share

Scroll across to see the full chart.

Past performance isn’t a guide to the future. Source: Thomson Reuters 05/08/19

You can see this best by looking at a price to earnings ratio.

Diageo - Trailing price to earnings ratio

Scroll across to see the full chart.

Source: Thomson Reuters 05/08/19

What does it mean?

The key question investors need to ask themselves is whether Diageo’s earnings are worth more today than they were 10 years ago. That’s certainly possible – earnings could have become more reliable or prospects for future growth could have improved. But the price increase could be a symptom of investor sentiment alone, and that can change quickly.

If Diageo’s earnings were to stay stable, but the P/E ratio returns to where it was ten years ago, that would mean the share price falling by around 45%. If the company were to run into trouble, the result might be even more painful.

The combination of falling earnings and a fall in rating is truly toxic for share prices – since a lower multiple of a lower level of profits enhances the fall. In the below example, which is only for illustration, we assume that earnings expectations fall 10% and rating halves. The shares fall 55%.

Earnings per share Price/earnings ratio Share price
Pre-fall 10 20 200
Post-fall 9 10 90

How can I reduce the risk?

The most obvious way to manage ratings risk is to constantly monitor the value of your investments and sell shares where the rating has become ‘toppy’. That’s time consuming though, and assessing when a company has become ‘expensive’ is difficult even for professional fund managers.

An easier way to manage rating risk is to avoid being over-exposed to more popular stocks. Taking a more value centric approach with some of your investments might involve investing in individual stocks that are out of favour at the moment. We think that sectors like financial services, tobacco, oil & gas or housebuilders are particularly unloved right now – largely because of economic and regulatory challenges.

Alternatively you could think about investing in a wider range of companies through a value-focused fund. In either case you can help shelter some of your portfolio from the painful falls that are possible when good companies fall out of favour.

Unless otherwise stated estimates are a consensus of analyst forecasts provided by Thomson Reuters. These estimates are not a reliable indicator of future performance. Past performance is not a guide to the future. Investments rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.

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    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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