Matthew Vincent: Great expectations need a reality check

Investors still have great expectations of equities – and of UK fund managers. In the first nine months of this year, retail fund sales reached a new record level. According to the latest quarterly data from the Investment Management Association (IMA), total sales in the first nine months of 2009 were higher than the total in the whole of 2000, when the dotcom boom fuelled what had been the highest annual sales on record. Then, as now, equities were the most popular asset class.

But investors still expect active fund managers to outperform index trackers. Tracker fund net retail sales in the three months to the end of September were down on the previous quarter’s level. By contrast, quarterly fund of funds sales were the highest on record, and the overall best selling sector in September was absolute return funds – whose managers make directional calls on individual shares.

All of this worries me, because expectations seem to be getting out of hand.

Fund managers point to the number of companies whose earnings have met or exceeded analysts’ expectations. Ashton Bradbury of Old Mutual recently pointed out that earnings growth was “unambiguously” rising, and the US results season had started well, with 70 per cent of results meeting or exceeding consensus forecasts.

However, this week I got two reminders of the dangers of relying on expected profits.

In an FT Masterclass on company reporting, Jane Fuller – former FT financial editor, companies editor and Lex writer – reiterated the old adage: “Sales are vanity, profits are sanity, cash is reality.” This made me think of an article by Nicholas Colas, chief market strategist at BNY Convergex, from a few months ago. He pointed out that while corporate earnings generally met or exceeded forecasts, many companies “chronically missed their revenue expectations”. If they can’t get the “vanity” part right, what does that say about the sanity of their earnings guidance or the reality of their cash flows?

At a breakfast meeting on absolute returns, James Inglis-Jones – co-manager of the Liontrust Continental European and First Income funds – restated the importance of cash flow in evaluating a company’s ability to deliver on its promises. In his latest fund commentary, he says: “Investor expectations for many stocks have risen significantly. We believe it will now be much more important for companies to justify higher investor expectations by meeting their profit expectations.”

He and co-manager Gary West believe they have found a way to predict expected – and unexpected – changes in company profits, which they call The Liontrust Cashflow Solution.

It starts with the premise that companies make mistakes in forecasting their profits. Investment decisions taken by company managers to support their forecasts create expectations in the market that are unsustainable. But these forecasting errors can be spotted by studying company cash flow. Strong cash flow, after investment spending, is a good indicator of strong growth in future reported profits. Conversely, weak cash flows often predict a collapse in reported profits.

So it provides an obvious long/short absolute return strategy: buy an equally weighted portfolio of cash-generative businesses with low analyst and investor expectations; and short-sell companies with optimistic managers who back aggressive forecasts with substantial investment.

Inglis-Jones and West have been pursuing this approach for institutional clients since December 2006. Over that period, their long/short fund has returned 47.4 per cent, meeting its objective of a 15 per cent return net of fees. Now, they have made the strategy available to retail investors through the Liontrust European Absolute Return fund. Since launch in July, it is down 1.55 per cent, having struggled in the sharp market rally. But as a non-directional fund, it is supposed to be uncorrelated to market surges. It was in the falling markets of 2007 and 2008 that the institutional fund made its money.

Crucially, the portfolio is selected using a simple cash-flow stock screening approach, and reviewed annually – keeping the turnover costs low. Which reminds me . . . 

My Fund Fees Manifesto has received strong support from readers – my thanks to all who have written in with suggestions. As a result, I am proposing some amendments to the version that I will present to the IMA next week:

● Show the impact of front-end and exit charges in the “what you might get” back figures in the Key Features document, calculated over various time periods, for lump sums and regular savings (thanks to Martin Earle).

● Calculate the average “total performance drag” for the sub funds of multimanager funds, and add it to the “performance drag” of the overall investment (thanks to Andy Lennard)

● Include retained dividends in a P&L showing funds’ additional sources of income (thanks to Ken Greenhill).

matthew.vincent@ft.com