View from City Road: Be wary of high profit forecasts

IS HOPE triumphing over adversity? Stockbrokers are forecasting a rise in profits of 20 per cent or so for next year even though most of them expect the economy to grow by 1 per cent or less. At first sight the gap looks hard to justify.

Some brokers are especially optimistic. For example, Nomura's Nick Knight expects profits to rise by 30 to 50 per cent over the next two years. Towards the other end of the spectrum, Kleinwort Benson expects growth in industrial profits of 10 per cent next year. The consensus is for about 13 per cent growth in industrial companies and more than 15 per cent for the whole market.

Some fund managers regard even this as far too high. Legal & General, which is keener than many on bonds, reckons industrial profits will grow by only 6 per cent.

Four factors stand out when considering next year's profit rise. The first is the devaluation of sterling by about 12 per cent since Black Wednesday. As overseas profits account for about 40 per cent of the total, the translation benefits alone should add about 5 per cent. Exports should also benefit but they remain a small factor in the overall make-up of quoted companies' profits.

Lower interest rates will also be helpful but far less important than might appear. This is because a large number of companies have borrowed at fixed rates or in the US where rates are already lower than in the UK.

Productivity, the third factor, will be far more important. Although companies have been shedding jobs at an enormous rate this has merely allowed them to keep their costs in line with falling demand. With a real prospect of stable or even rising volumes, the financial benefits of huge redundancies should now boost profits. Phillips & Drew reckons this will add 10 per cent to domestic profits - which translates into about 6 per cent to the total.

The fourth and most variable factor is economic growth. Nomura's more optimistic projections are based on increases in gross domestic product of 1.7 per cent, well above average in the UK whereas others are far more cautious. Gains in the US, however substantial, could be partly offset by downturns on the Continent, particularly in Germany.

On this basis it is easy to see that profits of quoted companies might grow by 12 per cent or so next year. But forecasts much higher than that must be relying on guesswork, which is hardly a reliable basis for investment. Caution is in order.