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Financial Times: Investors cautious as index gains ground: “BP and Shell, for example, make up 14 per cent of the market's total capitalisation and are expected to have made bumper profits from oil at more than $40 a barrel.” (


By Henry Tricks

Published: October 5 2004


With the FTSE 100 at a 27-month high, it is tempting to think investors are as excited about corporate profitability as the Office for National Statistics.


They are not. Profit warnings have flown thick and fast this summer and some equity specialists say corporate earnings among the bulk of listed companies may have peaked.


Khuram Chaudhry, equity strategist at Merrill Lynch, said: "Consensus profit expectations for UK companies had risen for 18 consecutive months until May. In May the data reached a peak."


The rally is being driven by several factors, mostly connected to the weighting of the biggest stocks on the index. BP and Shell, for example, make up 14 per cent of the market's total capitalisation and are expected to have made bumper profits from oil at more than $40 a barrel. The financial sector - the largest in the index - has also benefited from upward revisions in earnings forecasts.


Further down the index, however, it is not such a simple story. Manufacturing companies, such as Rolls Royce, are also expected to increase profits, owing to the surge in global demand for capital goods.


But the service sector - loosely geared to UK consumer confidence and the buoyant housing market - has begun to suffer. Profit forecasts for the largest retail companies, such as Tesco and Next, are powering ahead, while their smaller competitors, such as J Sainsbury and Marks and Spencer, are shrinking in size and profitability.


In the past month alarm bells on profits have sounded from a host of consumer-related stocks: from Sainsbury, Unilever and Compass, the caterer, to MFI, the furniture retailer, and Ultraframe, designer of conservatory roofs. warned that profits for its all-important summer quarter would come in lower than expected because of "challenging trading conditions" in the travel industry this summer.


Uncertainty in the high street has also helped decimate the number of publicly traded companies. Debenhams and Selfridge's have been taken private, while M&S and WH Smith only narrowly avoided the same outcome this summer. Several housebuilders are expected to move into private hands in the next few years as the market slows.


In an indication that confidence is increasingly strained, Mr Chaudhry noted that only three directors were buying shares in their companies at present for every one that was selling. In February 2003, when the stock market was near a trough ahead of the Iraq war and the market was considered seriously undervalued, the ratio was 10:1.


The shake-out, he believed, was largely in response to higher interest rates and raw material costs and dwindling economic confidence.


"With a backdrop of interest rates rising and higher input costs . . . there is a likelihood that profits are going to be slightly softer in the next 12 months than they were in the last 12 months," he said.


That would spell bad news for corporate UK, not just the publicly listed sector. That is because more of the downgrades are in the service sector, home to the bulk of businesses, than in manufacturing, which is more the domain of listed stocks with higher capital requirements.


According to the ONS, part of the reason for the high profitability is low capital investment. If that grows, and earnings do not, profitability will weaken.


Akber Khan, of European Equity Focus at Deutsche Bank, said the index was still at least a third short of its level the last time corporate profits, as measured by the ONS, were at this level. Price/earnings ratios were also in the mid-teens, compared with levels above 20 back then. That suggested there was not the "comfort level" about growth as there was then, he added.

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