Shares: Why projected returns paint a less than rosy picture

The week ahead

WHAT next for the Footsie? That's the question most investors are asking themselves after a manic first quarter in which the index of 100 leading shares rose by almost a fifth. The rise has surprised even the most optimistic of market observers, who had pencilled in year-end targets of 6,000 for the Footsie but never expected the market to get there in less than three months.

The first trick is explaining the reasons for the rise. According to Mark Brown and Gareth Williams, equity strategists at ABN AMRO, the investment bank, the re-rating of global equities in recent years can be explained by measuring Economic Value Added (EVA) - the difference between a company's return on capital and the cost of that capital. They show that, since the early 1980s, the world's 11 largest industrialised countries have been producing a positive EVA. What's more, the level of EVA is forecast to hit a new high in 1998.

So far, so good. But since the stock market is effectively a way of discounting future expectations, the current level of EVA matters less than what is likely to happen in the future. And here the picture becomes less rosy. Because if returns on investment are high, companies are likely to invest more, thereby dragging down returns.

Another threat comes from pay rates. Although companies have been successful in increasing the share of economic cake gobbled up by profits - at the expense of workers' pay - this is unlikely to last. Private-sector pay rates are already rising by an average of more than 5 per cent a year. If this is sustained, profits will come under pressure.

This analysis leads Brown and Williams to argue that the quoted sector, excluding financial stocks, has gone ex-growth. Although company analysts are still forecasting earnings growth of about 7 per cent for non-financial stocks, a top-down analysis suggests this is more likely to be 3 per cent.

They argue that investors should take refuge in financial and services companies, which offer some protection from this trend. If you're not a fund manager with a large portfolio to invest, however, it may be better to stay out of the market altogether.

The coming week is dominated by results from companies in the building & construction sector. By Friday, investors should have a good idea of whether recent reports of a slowdown in the sector are accurate or not.

Shares in Blue Circle, which reports full-year results on Monday, have staged a recovery this year after being pummelled by sterling and the Asian crisis.

The cement company is generally viewed as one of the best-run firms in the sector. But given its exposure to economic turmoil in Malaysia and increasing price competition in Chile, analysts will be carefully scrutinising its overseas activities. NatWest Markets expects profits to rise to pounds 340m from pounds 297.6m.

Also in cement is Rugby Group, which reports the following day. Investors will be looking for evidence that recent cost savings are coming through in the bottom line. Confirmation that the new pounds 120m cement kiln, due to be up and running in August, is on schedule will also be welcomed. The new plant will allow Rugby to close down smaller, less efficient kilns. Finally, analysts will also be trying to gauge the exposure of the group's Australian division to turmoil in the Far East. Pre-tax profits are expected to be pounds 74m (pounds 60m).

On Wednesday, construction group Alfred Macalpine should produce full- year profits of pounds 21m, up from pounds 9.4m on the back of a booming construction sector. The company will also face questions about its enlarged homes division.

Life is tougher at RMC, the building materials group which is struggling to cope with the depressed German construction market. Although profits from the country probably rose by about 4 per cent in local currency, this turns into a 15 per cent drop once translated into sterling. Overall, profits expected up 4 per cent at pounds 306m (pounds 295.3m).

Manchester United kicks off the week with six month results on Monday, fresh from a vital victory over Wimbledon in the Premier League. The Reds have had a terrible month. They were knocked out of the European Champion's League by Monaco and have Arsenal breathing down their necks in the Premiership. But that won't be reflected in the results, which are expected to show that profit before tax and transfers increased from pounds 15.7m to pounds 17.4m. Analysts will be looking for details of a new shirt sponsorship deal. United's long-standing agreement with Sharp runs out this year and will not be renewed. Names including Ford are believed to be chasing the contract, which will set the benchmark for other football clubs.

Motor components group LucasVarity reports results tomorrow. Investors are still unconvinced that the transatlantic merger, now almost two years old, has delivered the promised benefits in the key braking systems division. With all the cost-cutting out of the way analysts will be looking for an improvement in margins.

Chief executive Victor Rice will also face questions about acquisitions. Following the sale of its heavy duty braking division to Caterpillar last December, LucasVarity could easily splash out more than pounds 1bn on an acquisition. However, it may instead beef up its rolling programme of share buy-backs.