Investors who had a tough time in 2001 are advised to turn their attention towards companies with a strong business franchise, good management, positive cashflow and a sustainable competitive advantage
In common with the previous year, 2001 proved extremely challenging for investors in the UK equity market. Growing pessimism over the state of the global economy and a marked deterioration in the earnings background have been the principal factors behind equity market weakness.
Indeed, interest rate reductions in the US, UK and Europe failed to provide much of a reprieve, as these were taken as renewed evidence of the severity of the downturn. Even prior to September's terrorist attacks on the US, the risk of recession in the US appeared to be growing and following the attacks, the consensus moved rapidly to the view that a US recession was all but inevitable, as confidence among US consumers is likely to be seriously undermined.
In the UK, economic growth has slowed, although apart from the manufacturing sector, this has not been anything like as pronounced as the slowdown in the US. Indeed, preliminary third-quarter GDP figures showed the economy expanding by 2.2% on an annualised basis, which was broadly in line with the long-term trend rate of growth.
Nevertheless, as the UK is a relatively open economy, the US slowdown has had a significant impact on exports, particularly in the manufacturing sector where output has weakened sharply. In contrast, the domestic economy, and in particular the consumer sector, has remained relatively buoyant.
While the deterioration in the global economy is likely to result in a period of sub-trend growth in the UK, Gartmore believes that the economy should avoid a recession. There are no major structural imbalances in the UK economy, the public finances are in good shape, inflation is subdued and unemployment is at its lowest level since 1975.
Furthermore, we believe this cyclical downturn may prove to be relatively mild in a historical context as the Bank of England has brought the UK base rate down to its lowest level since 1964 in a pre-emptive attempt to head off the threat of recession.
Looking at the UK equity market, the immediate earnings outlook is far from encouraging, however. Gartmore expects the spate of profit warnings to continue on the back of the ensuing uncertainty post-11 September and earnings downgrades. Research from HSBC indicates the previous peak in the number of profit warnings was 136 during the first quarter of 2001. The fourth quarter is likely to show a new record of over 150.
However, one of the most interesting trends in the last few weeks is that investors have begun to look beyond the bad news on earnings and towards a recovery during the second half of 2002. This is in anticipation that interest rate reductions, together with an increase in government spending, will feed through into underlying economic activity. Indeed, companies that have recently issued disappointing trading statements, such as media group Informa and aerospace and auto components group GKN, have seen their share price marked up as investors have drawn the conclusion that the worst is over on the earnings front.
Interestingly, sectors such as IT hardware, software services and electronics, which have previously borne the brunt of concerns about the deteriorating earnings background, were among the best performing areas of the UK equity market in October as investors rediscovered an appetite for risk. Nevertheless, the market may have become somewhat over-optimistic on the earnings outlook and the share prices of some stocks that rallied strongly in October leave no scope for any further disappointments.
In this environment, some investors may be inclined to follow a more balanced approach on sector weightings, taking a less aggressive stance relative to a standard benchmark such as the FTSE All-Share Index, given the uncertain economic and market background. It is worth pointing out that in the more volatile market conditions that we have experienced in recent months, with a wide divergence in returns between sectors, reducing the scope of any sector bets can still result in sizeable outperformance in relative terms.
Reducing exposure to the more defensive, non-cyclical consumer sectors such as beverages and tobacco and increasing investment in more cyclical areas of the market certainly appears tempting given the strong run that the former have had when, as noted earlier, the earnings cycle may be bottoming out. Nevertheless, it may be some time before we see a recovery in some of the more cyclical industries and in the near-term, there may be further disappointing news on earnings. An example would be media stocks, where advertising revenues are deteriorating and traditionally lag turning points in the economic cycle.
In a low growth, low inflation environment, pricing power has become a rare commodity. Margins across a range of industries have been squeezed as competition has intensified. Naturally, companies will have greater pricing power in cases where they have a dominant market position and there is a comparative lack of major competitors. However, even in competitive industries pricing power can still be an important factor. In the food retailing sector for example, Tesco has pursued an aggressive pricing strategy through the introduction of its value range of own-branded goods.
Aside from pricing power, we believe companies that have a strong business franchise, good management, positive cashflow, and a sustainable competitive advantage offer the greatest potential for unexpected earnings growth. Such companies need not necessarily be located in industries that may immediately be thought of as high growth areas, or glamour stocks, and can often be overlooked by investors.
One example is Chubb, demerged from the old Williams conglomerate. The company focuses on security services, specialising in electronics-based security systems. It has a sizeable market share in a high margin business, and through concerted expansion it has developed a true international presence. In the retail sector, Kingfisher has consolidated its business following the sale of Superdrug and Woolworths and refocused on its more profitable electronics and DIY businesses.
In the former market, it owns the Comet chain while in DIY it is represented through market leader B&Q in the expanding home improvement sector, where it has also established a strong presence in Continental Europe.
Among financials, ICAP offers potential for positive earnings surprises. The company is one of the largest foreign exchange, derivative and securities brokers in the world, delivering its offering through traditional voice and electronic broking platforms. It operates in secular growth markets such as interest rate swaps and other over-the-counter derivatives, where increased volatility and interest rate changes drive trading volumes higher. Meanwhile, the company has been a successful consolidator following the mergers with Exco and Garban. The latter deal in particular, announced in July 1999, has significantly enhanced the company's product offering as well as offering scope for cost cutting.
While it is important to establish key buy criteria when selecting stocks, sell disciplines are just as important in more volatile markets. Investors should always have a price target in mind for each stock, closely monitor performance relative to the market and take early decisive action if a stock is not performing.
Our overall view of the outlook for UK equities in 2002 is a reasonably optimistic one. We believe that with the prevailing macroeconomic environment of lower growth and low inflation, companies that have a sustainable competitive advantage in their marketplace offer more potential for positive earnings surprises and should outperform as investors begin to see a recovery in the profits cycle.
The cyclical downturn in the UK may prove to be relatively mild in a historical context.
In a low growth, low inflation environment, pricing power becomes a rare commodity.
Companies with a sustainable competitive advantage in their marketplace offer more potential for positive earnings
To promote 'long-term investment'
Switching 'hard and expensive'
Smaller funds still packing a punch
To drive progress