If we look at the immediate earnings’ growth forecasts for pharmaceutical giant GlaxoSmithKline (LSE: GSK) (NYSE: GSK.US), it’s easy to conclude that the firm isn’t much of a promising capital-growth investment. Easy, but top-of-the-head analysis might be too simple.
City forecasters following the firm expect earnings to fall 15% in the current year to December followed by a 6% recovery during 2015. Those figures come on top of virtually flat earnings in 2012 and 2013 to paint an uninspiring picture on growth.
In fact, earnings were 20% higher in 2009 than they are likely to be in 2015, so we see real decline over the medium term, not growth of any kind at all.
But the share price has risen
However, GlaxoSmithKline shares were trading at about 1000p at the beginning of 2009 before rising to just under 1800p during 2013 and then falling back to today’s 1382p. So, the shares have indeed provided investors with capital growth over the period despite the decline in the business. So why does the share-price and business performance disagree?
I think that three factors might have conspired to produce this, perhaps, baffling outcome, but it is the third factor that might confound investor expectations on capital growth the most, going forward.
Three share-price drivers
Firstly, the firm has kept up dividend progression over the period, regardless of its lacklustre performance on earnings’ and cash generation:
| Year to December | 2009 | 2010 | 2011 | 2012 | 2013 |
| Dividend per share | 61p | 65p | 70p | 74p | 78p |
Those valuing the business by reference to dividend yield might have been happy to keep buying. Even now, the shares yield about 6.1% on a forward basis.
Secondly, speculation has likely driven the share price. The thinking maybe goes ‘earnings’ recovery follows earnings’ decline’. GlaxoSmithKline often talks about the next generation of drugs and treatments it is developing to fill the earnings’ hole left as existing formulations lose their exclusivity. Then there’s the takeover fever swirling around the industry that Pfizer‘s pitch at AstraZeneca has whipped up to frenzied proportions.
Thirdly, and perhaps worthy of most focus right now, the valuations of traditionally defensive shares such as GlaxoSmithKline tend to move counter to the wider economic cycle. Companies seen as defensive, with reliable income streams whatever the financial weather, are most appealing to investors in volatile economic times, such as recently. When that happens, investors tend to buy and the valuation of the defensives rises.
However, it’s another cycle. So, when economic conditions seem more benign, investors switch to risk-on thinking and abandon stodgy old defensives in favour of more exciting investments, which causes the valuations of the defensives to fall.
Naturally, that’s an imperfect model, but it is an effect to watch that could drag on forward investor capital gains. There’s some evidence that valuation compression might be taking place right now, as the P/E rating was running at around 16 last year, which compares to about 14.5 today. Although it’s unclear how much of that effect results from reduced earnings’ expectations and bid speculation, and how much relates to valuation-cyclicality.
Growth is growth
Whatever the behaviour of shares, underlying business growth is growth. For a decent growth investment, we want to see forward earnings rising steadily. If the business is growing, the shares will take care of investors’ capital growth in the end.
With GlaxoSmithKline, we don’t have anyone forecasting growth figures, but we have a lot of jam-tomorrow talk. So, I think I’d better place my capital-growth money elsewhere.