Listed UK companies issued 312 profit warnings over the last 12 months, according to the latest EY Profit Warning report. That’s more than during any 12-month period since the financial crisis peaked in 2008.
Even more worrying is that almost half of the 76 companies that issued profit warnings in Q1 had already issued a warning in the last year. When a company issues multiple profit warnings, it usually means that forward visibility of earnings is very poor.
Does this mean that January’s market correction was a warning of a worse crash to come?
Here’s the real problem
It’s been clear for some time that many companies are struggling to maintain profit growth. The main problem areas seem to stocks with exposure to commodity prices, and retailers.
Last year we saw most of the big mining and oil firms downgrade expectations. We’re now seeing the effect of big spending cuts by these firms trickle down. Profit forecasts for service and engineering firms, which depend on the big producers, have been falling.
Retail is also another area of concern. So far this week, BHS and Austin Reed have both gone into administration. Recent months have seen profit warnings from Next and N Brown Group among others. Sales growth is poor on the high street but costs are rising, thanks to the impact of the National Living Wage.
Is the FTSE 100 safer?
Profit warnings seem to be spread fairly evenly across companies of all sizes. During the first quarter, 20 FTSE 350 companies issued profit warnings. It’s clear that the FTSE 100 and FTSE 250 aren’t necessarily safe havens for investors.
Indeed, I’d argue that the FTSE 100 is looking increasingly risky. The index currently has a dividend yield of 3.95%, which seems appealing. However, this is only covered 0.95 times by the collective earnings of FTSE 100 companies.
At the moment, I’d argue that the FTSE 100 is priced on the expectation that earnings will soon start to recover. According to the latest official index data, the FTSE 100 is currently trading on a P/E of 26.
In my view, the FTSE’s high P/E and uncovered dividend yield suggest that the big-cap index could see another sharp correction later this year, if earnings don’t start to firm up.
A better alternative?
The FTSE 250 looks better value and safer to me. The mid-cap index currently trades on a P/E of 17 and has a yield of 2.7%, covered 2.2 times by earnings.
However, I believe that the best approach in uncertain and fragmented markets is to focus on selecting a portfolio of high quality stocks. By looking for firms with defensive profits and well-funded dividends, you should be able to enjoy a reliable dividend income and have a chance of beating the market.
Companies such as National Grid, Unilever and British American Tobacco have been largely unaffected by the commodity crash and indeed the financial crisis. High-quality and defensive businesses like these have delivered market-beating gains for investors in recent years. Housebuilders have also performed superbly, and there have been other winners among smaller stocks.
