Trading Strategies: economy boosts this popular FTSE 100 share

Inflation’s fall to 2.3% in April was met with disappointment by many investors. Although it represented a 0.9 percentage point decline versus March’s figure, and inflation is now 6.4 percentage points lower than it was a year ago, investors were expecting an even greater drop to 2.1%.

According to them, the prospect of an interest rate cut at the Bank of England’s next Monetary Policy Committee meeting, scheduled for 20 June, is now far less likely.

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An upbeat economic outlook

However, the reality is that the UK economy’s performance is improving more rapidly than many investors currently realise. Certainly, inflation is slightly above the Bank of England’s 2% target, but its sustained fall to a level that is very close to the central bank’s objective, means that the cost-of-living crisis is coming to an end. It could even be argued that at just 0.3 percentage points above the Bank’s goal, and with wage growth having been ahead of inflation since April last year, pressure on disposable incomes from price rises is now minimal.

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Furthermore, a persistent fall in inflation to around 2% means that interest rate cuts are now imminent. Whether they begin on 20 June or not, they are set to have a positive impact on the UK economy’s performance once time lags have passed. And with GDP growth amounting to 0.6% in the first quarter of the year, which is its fastest rate of growth since the final quarter of 2021, the outlook for consumer-related companies that are among those most reliant on the UK economy’s performance, is particularly encouraging.

Improving investor sentiment

Indeed, the International Monetary Fund (IMF) recently upgraded its GDP growth forecasts for the UK. It now expects the economy to expand by 0.7% this year versus a previous estimate of 0.5%, and for it to grow by a further 1.5% next year. This could have a positive impact not only on the financial performance of consumer-related firms operating in the UK, thereby boosting their top and bottom-line growth prospects, but also on investor sentiment towards the wider FTSE 350 index.

It has been repeatedly derided by many investors over the past couple of years. While this is somewhat understandable, since it has posted a paltry 15% gain in the past five years versus a 61% rise for Germany’s DAX index and a 93% surge for the S&P 500 index, the UK economy’s growth rate is set to roughly match that of the eurozone both this year and next year. It is also forecast to be within 0.4 percentage points of the US economy’s 1.9% expected growth rate in 2025. Therefore, UK-listed stocks could become far more popular among investors as the argument for avoiding them due to the country’s relatively downbeat economic prospects fails to hold sway.

A favourable risk/reward opportunity

Investor sentiment towards consumer-focused stocks could be subject to notable improvement as interest rates fall. A looser monetary policy that boosts the economy’s prospects is likely to have a disproportionately positive impact on their financial performance due to the cyclicality of their earnings.

Investors may determine that consumer-related firms offer the most appealing risk/reward opportunity in the FTSE 350 index, with their valuations currently being highly attractive both on a standalone and relative basis in many cases.

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In addition, a variety of UK-focused companies in the consumer realm have solid balance sheets and strong market positions to complement their wide margins of safety. This suggests that while many investors are currently preoccupied with inflation being slightly higher than expected, a buying opportunity exists for long-term investors who can instead look at the bigger economic picture.

Impressive results

For example, Marks & Spencer Group (LSE:MKS) offers significant investment appeal. The FTSE 100-listed retailer’s share price has risen by 11% since the start of the year, which is slightly ahead of the 6% return of the FTSE 350 index over the same period. However, investors still appear to be overlooking the company’s capacity to rapidly grow sales and profits amid improving economic conditions.

Indeed, the firm’s recently released full-year results showed that it is making encouraging progress implementing its growth strategy. Sales rose by over 9% versus the prior year, while adjusted earnings per share moved nearly 46% higher. This means that despite its recent share price rise, the company trades on a price/earnings ratio of under 12. This suggests that it offers a wide margin of safety, which could equate to substantial share price growth over the coming years.

Source: SharePad as at 29 May 2024.

A sound competitive position

The company’s financial performance is likely to benefit to a greater extent than many of its retail peers due to its status as a mid-tier operator. With the cost-of-living crisis now either approaching, or at, its end and wage growth being consistently ahead of inflation, consumers are likely to become less price conscious as pressure on disposable incomes alleviates. This means that they are set to increasingly prioritise factors such as quality, customer service and convenience rather than the prices of various products. Given that M&S is not a budget retailer, with it historically having sought to compete on non-price metrics, this should play into its strengths and negatively impact no-frills rivals.

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The company’s latest results showed that it continues to seek profit margin improvements via efficiency gains. Previously, it was aiming to deliver structural cost savings of £400 million over a five-year period. It has now raised that target to £500 million over the same time frame, with £180 million of structural cost savings having been delivered in its latest financial year.

Alongside this, it continues to invest in the quality and range of its products. This contributed to market-leading volume growth in its food segment and a market-leading share increase in its clothing & home division. This increasingly strong competitive position means it is well placed to capitalise on an improving economic performance as interest rates are cut. And with return on equity rising from 13% in the 2023 financial year to 15% in its latest annual results, its competitive advantage over sector peers appears to be growing.

Solid fundamentals

The return of a dividend in its latest financial year after a four-year hiatus does not mean that M&S has suddenly become a worthwhile income holding. A yield of 1% is evidence that income seekers should look elsewhere in the FTSE 350 for an attractive dividend stream. However, a returning dividend highlights growing confidence among the firm’s management team that its financial performance is on the up.

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The dividend also indicates that the firm’s financial standing is sufficiently sound to enable it to both reward shareholders via regular payouts and reinvest for future growth. Indeed, its net gearing ratio now stands at a relatively modest 75%, down from 96% last year, while net interest payments were covered over 17 times by operating profits in its most recent full year. These figures show that the company’s overall risk has declined, which further improves its risk/reward opportunity from a long-term investment perspective.

A long-term buying opportunity

Certainly, the company’s share price could prove to be volatile in the short run amid heightened political uncertainty. Meanwhile, many investors may continue to overlook the investment potential of M&S as they focus on inflation being slightly ahead of the Bank of England’s 2% target.

But as the cost-of-living crisis fades, interest rates are cut and the economy’s performance improves, the company is well placed to take advantage of stronger operating conditions. Trading on a relatively low valuation and benefitting from an improving financial and competitive position, it offers clear long-term investment appeal.

Robert Stephens is a freelance contributor and not a direct employee of interactive investor.