There has been vigorous debate recently about what proportion of assets UK investors should alloca...
There has been vigorous debate recently about what proportion of assets UK investors should allocate to the domestic market and what should be earmarked for overseas investments.
Certainly, no one would argue with the conventional wisdom that, over the long term, overseas diversification can reduce risk and boost returns. However, as with any maxim, the truth is rather more complex.
Investors can be reassured that even if they maintain a hefty exposure to the UK stock market they are benefiting from developments abroad. This is because the earnings base of the UK market is relatively diverse. Witness the high proportion of overseas earners in the FTSE 100 Index.
About 50% of the earnings of the companies in the FTSE 100 Index come from overseas. So investors who opt for UK blue chips are automatically gaining a significant degree of exposure to the global economy, whether they know it or not.
Overseas exposure can obviously prove to be a double-edged sword and the UK market would certainly feel the effects of a pronounced slowdown elsewhere. To counterbalance this, the composition of the FTSE 100 Index gives the market a relatively defensive feel, heightening its attractiveness in the current environment. Oil firms, pharmaceuticals and banks dominate, together making up more than 40% of the FTSE 100.
The fact that these sectors are expected to have reasonably secure earnings in the coming months, even in the face of an economic slowdown, should provide some reassurance for nervous investors.
Against UK weakness
Furthermore, even if the technology sector continues to struggle, because of its small size, it has less impact on the index overall. These factors go some way towards explaining why, as the chart demonstrates, the UK market has held up relatively well in the face of US market weakness over the past six months
Despite these positives, investors continue to focus on developments on the other side of the Atlantic Wall Street has been battered amid fears that the US Federal Reserve may not be able to engineer the hoped for economic soft landing. A spate of profit warnings from the technology majors has exacerbated these fears.
In contrast, the UK results season has been a much more robust affair with most results coming in on target and the bulk of disappointments confined to second-line stocks. Nonetheless, the FTSE 100 Index has fallen below the psychologically important 6000 level and, at the time of writing, is labouring at 5600.
Brighter times are ahead
Despite recent gloom, there are reasons to be cheerful about the medium-term prospects for the UK stock market and, once the economic and earnings outlook in the US is clarified and Wall Street stabilises, a return to form is likely.
Although short-term periods of volatility are virtually a given, it looks as though the foundations of a stock market recovery are almost in place. A number of factors support this view. First, the interest rate cycle has turned; the Bank of England's Monetary Policy Committee (MPC) cut interest rates by a quarter percentage point to 5.75% in February.
Additional interest rate reductions are likely as the impact of lower inflation gives the MPC further room for manoeuvre. Our view is that the MPC will probably cut rates once or twice more, taking base rates to around 5.25% to 5.5%.
There could also be good news on the currency front, sterling might well continue to weaken relative to the euro, particularly if European economic growth continues to hold up well. This would certainly be a welcome development as far as the UK's beleaguered exporters are concerned. Another consequence of falling interest rates is that as 2001 progresses, the market will increasingly focus upon the result of these rate cuts, which should be a pick up in the economy in 2002.
Supportive share buy-backs
Supply considerations bode well. This year should see less share issuance compared with the recent past. When added to the trend for share buy-backs and ongoing widespread consolidation, this should prove supportive. Contrast this to continental Europe, where significant new issuance is still planned for the telecoms sector, and the relative attraction of the UK market increases.
Among the more technical indicators of the market's valuation, comparing the equity earnings yield and the government bond yield suggests the UK market appears cheap on an historical and relative basis. Similarly, the market's 12-month forward P/E ratio of about 20 times appears easily sustainable in the circumstances and looks likely to expand further as short-term rates fall.
From the fund manager's perspective, the market environment has undergone a fundamental change within 12 months. At the height of the mania for growth stocks, particularly in the technology, media and telecommunications sectors, an overweight position in these areas was the recipe for short-term performance.
The bursting of the technology bubble has ushered in a much more discriminating environment and big sector calls, either in the new or old economy are no longer the name of the game. Stock selection will prove crucial to superior performance going forward. The ability to pick winners as well as avoid losers, whatever the sector, is going to be essential.
So it is back to basics. We are targeting companies that display a blend of the following characteristics strong management, strong brand names, strong cashflow and pricing power. We are also extremely valuation and quality conscious.
To illustrate this, we prefer GlaxoSmithKline to AstraZeneca, Diageo to Unilever and Tesco is our preferred pick over
J Sainsbury. Among IT companies, ARM and Autonomy have the potential to deliver the goods over the long term.
Stick with core stocks
As long-term investors, we believe that provided the investment story is still intact we should stick with our core stocks in times of market uncertainty, rather than move substantially overweight in defensives. Our experience tells us that this is the best way to deliver the strong long-term returns our investors expect.
Clearly, the UK market cannot decouple from the US and until confidence about the economic and earnings outlook improves, UK investors will not be able to avoid a bumpy ride.
But after three years of mediocre returns and with the FTSE 100 Index well below its end 1999 level, the potential for a recovery, possibly in the second half of 2001, should not be ignored.
Charles Deptford is head of UK Equities with Rothschild Asset Management
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