Executive summary
The report is meant to select and analyse stocks to invest in among the FTSE 100 companies. This involves analysing the expected performance of the stock exchange and FTSE 100 companies for the next five years and the influence of the general economy on such. It analyses the past performance of three companies in different industries and predict their performances in the next five years. The report also applies the concepts of portfolio theory, diversification and risk-return trade-off to create a portfolio. Analysis of economic factors indicates that the LSE will experience growth in the next five years. The retail, pharmaceutical and telecommunication industries are expected to do well hence investing in such stocks will earn an investor greater returns. The stocks of GlaxoSmithKline, Sky and Sainsbury, are good buys since the companies show positive growth prospects. Creating a portfolio of these stocks will reduce the risk to an investor since the portfolio Beta is less than individual Betas.
Introduction
It is important for an investor to analyse the general economy as well the stock market and their influences on the performance of a given stock before investing in the stock. This report analyses the impact of the general economy on the performance of the London Stock Market and FTSE companies. It also identifies industries and companies in those industries that are likely to perform well in the next five years. It analyses the past and future performances of the companies and creates a portfolio from the using the identified stocks.
Justification of risk preference based on economic forecasting
Impact of the general economy on the stock market
The state of the general economy influences the performance of FTSE companies as well as the entire stock market. Commodity prices are one of the major variables affecting the performance of stock markets and the FTSE 100 companies. 2015 has been described as a tumultuous year for FTSE 100 companies. Commodity price rout has negatively impacted mining companies in the FTSE 100 thus lowering the market index. A fall in the price of copper, Brent Crude oil and iron ores led to a decline in profits for mining companies. The price of Brent crude oil slumped to a historical lowest in 11 years in December 2015 leading to a fall in the blue-chip index to a three-year low. Inflation also affects the stock performance. Higher inflation rates discourage consumer spending thus leading to low sales.
Events in foreign and global markets also affect the London Stock Market and FTSE 100 companies. FTSE 100 index suffered a major loss on August 24th, known as the Black Monday when the Chinese shares experienced an unprecedented fall. On just a single trading day, the FTSE 100 lost £91 billion. The problems facing some mining companies was also due to the fears of a decline in the demand for copper in the Chinese market as the Chinese economy was experiencing a slowdown.
The UK’s economy continues to grow and experiences a growth in GDP, fall in unemployment rates, among favourable movements. The government has increased its government to boost the economy since the 2008 financial crisis. George Osborne has announced that there should be fiscal policy changes to ensure that any government maintains a surplus budget in normal times. The growth in the economy is expected to continue over the next five years hence an investment in FTSE 100 companies will yield favourable returns. Besides, FTSE companies’ performance will improve in the next five years as the economy of China is expected to improve due to the fiscal and monetary measures the government undertook to restore economic growth and end the stock market crash. Besides, the government is keeping an eye on the inflation rate. Analysts expect that the interest rate will be increased in December 2016 if inflation rates go high. The Fed has already increased the US interest rate by 0.25%. This will ensure price stability thus guaranteeing greater returns in the next five years.
COMPANY AND INDUSTRY ANALYSIS
Industry analysis
After a careful evaluation of industries with positive prospects, I identified the telecommunication, pharmaceutical and retailing industries.
Telecommunication industry
The telecommunication industry, especially the pay TV sector is expected to growth at a favourable rate over the next five years. The number of subscribers to pay TV services have increased in the UK and globally over the last few years. The number of people watching movies, sports, documentaries, among other programmes on pay TV channels are increasing and is expected to continue increasing. The English Premier League and other European Leagues, the MLS, other sports such Test Cricket, Darts, among other sports, are increasingly becoming popular making this industry a good place to invest in. I have chosen to acquire the stock of Sky Plc. since the company is a leader in the pay-tv industry in UK and Ireland.
Pharmaceutical industry
The demand for pharmaceutical products such as drugs and medical equipment will increase over the next five years. It is due to the growth of population, especially in emerging markets. Medical care is essential hence pharmaceutical sales will increase as world’s population increases. Besides, the rising number of aging population in many countries will increase the demand for medical services since the aging population need more medical care than youthful population. Governments are also increasing medical spending, especially in emerging markets. Some governments provide medical insurance cover to low-income earners in their countries to enable them access medical care. One such country is the US, which enacted the Affordable Care Act. However, European Union member states reduced spending on social protection.
The above factors will contribute the growth of the pharmaceutical industry. The prices of these products are already increasing in countries like the US, among other countries. It is estimated that the global sales by pharmaceutical companies will be more than a trillion dollars by 2020 (Blogger, 2016). Therefore, investing in the stock of GlaxoSmithKline Plc. would be a sound decision.
Retail industry
There has been a tremendous growth in the retail market since the 2008 recession. This has been boosted by economic recovery with UK’s GDP increasing. Consumer spending has also increased due to increased access to borrowing facilities, falling oil prices that reduces the costs of products, and a rise in the real wage. Real wages have been increasing in the UK although it is yet to reach the pre-recession level. Retailers are expected to expand their markets with the focus shifting to online retail business. There is, however, cut-throat competition in the retail industry and the established retailers such as Tesco and Sainsbury have been forced to cut their prices to deal with competition from discount sellers such as Aldi. Sainsbury is the second largest retailer in the UK, and its growth prospects are promising hence it will be a good buy.
Company analysis
Sky Plc.
It is a British broadcasting company operating a portfolio of pay TV channels providing entertainment, sports, 24-hour news and movies. It operates in the United Kingdom, Italy, Ireland, Germany and Austria. It has about 21 million subscribers in the above countries. It recently renewed rights to broadcast LALIGA and MLS matches in the UK, among other leagues.
Sky Plc. revenues have increased steadily for the last five financial years ended 30th June 2015. This period also saw a steady growth in net income except for the year ended June 2014. The company’s net profit margin increased from 12.14% in 2011 to 13.34% in 2012 then rose to 13.53% in 2013. The year 2014 saw a decline in net profit margin to 11.61%, but it increased to 19.59% in 2015. In the trailing 12 months period, Sky Plc had a net profit margin of 13.33%. This was higher than the sector’s average of 9.33% in the same period. The average net profit margin for the last five-year period is 12.60% compared to the sector’s average of 10.64%. Its return on equity (TTM) was 63.11%, higher than the sector’s average of 14.79%. Its return on assets (TTM) is 12.22%, and this is higher than the sector’s average of 6.92%. It has also outperformed the sector’s average in the last five years with a five-year average return on assets of 14.21% compared to the sector’s 4.90%. Its earnings per share has also increased in the last financial years. It has also consistently paid dividends in the last five financial years. Dividend per share increased from 23.28p in 2011 to 25.4p in 2012, 30p in 2013, 32.00p in 2014 and 32.80p in 2014.
In the most recent quarter, the company’s quick ratio was 0.88, and the current ratio was 1.08. These were less than the sector’s averages of 1.34 and 5.75 respectively. This shows that the firm’s current assets are adequate to settle its current liabilities although its liquidity is lower than the industry’s average. It has more debt than equity in its capital structure. The total debt to equity and long-term debt to equity ratios in the most recent quarter were 234.38 and 249.98 respectively. This implies that Sky Plc. has a lower solvency. Its interest cover in the same period was 13.97 implying that its earnings are adequate to meet its debt interest obligations hence it is unlikely to default on its debt obligations. The high debt ratio should not be a big issue so long as the firm’s return on assets is positive. The DuPont analysis indicates that a firm’s return on equity will increase with an increase in leverage as long as its return on assets is positive.
The above analysis indicates that the firm has performed well in the last five years. This stellar performance is expected to continue in next five years. Analysts at Routers estimate that the 5-year growth rate in the firm’s revenues will be 11.84% while EPS will grow at 8.87%, and dividends will increase at a rate of about 5%.
Valuation of stock (Dividend Growth Model)
Last dividend = 32.8p Expected growth rate = 5%
WACC = 7.1%
Intrinsic value of the stock = 32.8 (1.05)0.071-0.05 = 1,640p
The closing price on 31st December 2015 was 1,112p implying that the stock is undervalued hence it is a good buy.
Sainsbury Plc.
The firm’s revenues have increased in each of the last financial years except for the year ended March 2015 when there was a decline in total revenues. Revenues declined from £23,949 million in 2014 to £23,775 million in 2015. However, its sales are expected to grow in the next five years at an average rate of 3.56%. Net income also increased during the period except for 2015 when the firm made a net loss. It has paid dividends in each of the last five financial years. It paid 15.10p in 2011, 16.10p in 2012, 16.70p in 2013 and 17.30p in 2014. The dividend per share decline to 13.20p in 2015. Despite reporting a net loss in 2015, it managed to pay annual dividends. Its dividend yield for 2015 was 4.71% compared to the sector’s average of 2.50%. In the trailing 12 months, the firms had a positive gross and net margins of 6.23% and 1.88% respectively. The return on equity during this period was also positive at 7.5%, and its return on assets was 2.64%.
In the trailing twelve months period, the firm’s quick ratio was 0.52, and its current ratio was 0.67 compared to the sector’s averages of 0.6 and 1.09 respectively. This implies that its current assets were not adequate to settle its short-term obligations and that its liquidity was lower than the sector’s average liquidity.
Valuation of Sainsbury’s stock (Dividend Growth Model)
Last dividend = 13.2p
Expected growth rate = 1.45%
WACC = 6%
Intrinsic value of the stock = 13.2 (1.0145)0.06-0.0145 = 294.32p
The closing price on the last day of trading (31st December, 2015) was 258.80p implying that the stock is undervalued hence it is a good buy.
GlaxoSmithKline Plc.
The firm has experienced mixed changes in total revenues in the last five financial years. Total revenues increased in the year ended December 2013 but declined in 2014. However, the last financial years have seen a growth in the firm’s dividend per share from 65p in 2010 to 80p in 2014. Its gross margin (TTM) was 67.49%, and this was higher than the sector’s average of 56.17%. Its net profit margin in the same period was 41.24% compared to the sector’s average of 0.69%. The return on assets and the return on equity during the same period were 21.03% and 187.3% respectively. These were higher than sector’s averages of 10.87% and 15.73% respectively. This indicates that the firm performed better the than sector’s average performance in the trailing twelve months period. Its performance is predicted to improve in future with sales and dividends growing at 5% and 3% respectively in the next five years.
Valuation of stock (Dividend Growth Model)
Last dividend = 80p
Expected growth rate = 3%
WACC = 9%
Intrinsic value of the stock = 80 (1.03)0.09-0.03 = 1,373.33p
The closing price on the last day of trading (31st December, 2015) was 1,373p implying that the stock is correctly valued. The intrinsic value is slightly more than the actual market price hence it is a good buy.
EVALUATION OF THE PORTFOLIO
Portfolio theory provides that investors can reduce the risk involved in stocks by creating a well-diversified portfolio (Brigham and Ehrhardt, 2013, p. 1003). Investors face both systematic and unsystematic risks. Systematic risk is the variability of stock returns caused by market-wide factors. Systematic risk is inherent in the market and affects the entire market hence it cannot be eliminated or reduced through diversification. Unsystematic risk is that which is asset specific and affects only the stock or stocks in the same industry (Brigham and Ehrhardt, 2013). Therefore, it can be eliminated through diversification. For instance, the retail industry and the telecommunication industry experience different risks. If the retail industry is falling, an investor who invests in both the retail and the telecommunication industry can offset the losses in the retail stock by high returns on the telecommunication stock.
The beta of a stock is the measure of its specific risk relative to the entire market risk. The Beta for Sky Plc.’s stock is 0.65 implying that its returns are 35% less volatile than the market returns. Sainsbury’s Beta is 0.71 showing that its returns are less volatile than the market return. The stock of GlaxoSmithKline is also less volatile than the market return since its Beta is 0.75. A Beta of more than one would imply that the return on the stock is more volatile than the market return.
Portfolio Beta = (0.5 × 0.65) + (0.2 × 0.71) + (0.3 × 0.75) = 0.692
Portfolio P/E = (0.5 × 14.23) + (0.2 × 11.82) + (0.3 × 6.75) = 11.504
If a portfolio is created with 50% of Sky Plc, 20% Sainsbury and 30% GlaxoSmithKline, the portfolio Beta will be 0.692. The portfolio Beta is lower than the individual Betas for Sainsbury and GlaxoSmithKline. This further indicates that diversification can reduce the risk if the portfolio is well diversified. The portfolio suits the risk-averse profile since it reduces the risk involved.
In creating a portfolio, an investor should consider the correlation between different stocks. A well-diversified portfolio is created if the portfolio stocks are negatively correlated or if the correlation coefficient between them is low (Megginson and Smart, 2010). As shown below, the correlation coefficient between the stocks of Sky and GlaxoSmithKline is low hence the combination is good for diversification. However, the correlation coefficient between GlaxoSmithKline and Sainsbury is high hence the combination is not good for creating a well-diversified portfolio.
Correlation coefficients
Conclusion
Analysis of the general economy indicates an improvement in the UK’s economy. The GDP and other economic variables are expected to improve in the coming years. Consequently, the performance of the London Stock Exchange as well FTSE 100 companies will improve. GlaxoSmithKline, Sky Plc. and Sainsbury shows positive growth prospects hence are good stocks to invest in. The intrinsic values of these stocks are more than their current market prices hence they are good buys. Creating a diversified portfolio using the three stocks will reduce the portfolio risk as shown above.
Bibliography
Blogger, G. (2016). Pharma Report Predicts Trillion Dollar Global Industry by 2020. [online] Pharmexec.com. Available at: http://www.pharmexec.com/pharma-report-predicts-trillion-dollar-global-industry-2020 [Accessed 2 Jan. 2016].
Brigham, E. and Ehrhardt, M. (2013). Financial Management: Theory & Practice. 14th ed. New York: Cengage Learning.
Megginson, W. and Smart, S. (2010). Introduction to corporate finance. Southbank, Vic.: Thomson/South-Western.
