While no one is predicting we are on the edge of a bull market after three years of negative returns, uncertain markets should allow stockpickers to buy attractive stocks cheaper than in the past
There has been a comparative advantage in being an income fund manager in recent years. Income funds have offered risk-averse investors some stability at a time when the UK stock market is down around 25% over 2002.
It could be argued it has been relatively easy to play the value game up to this point. Defensive areas of the market such as beverages and tobacco have performed well at a time when stock markets have been continuing to address technology issues. I expect it will be more difficult in future and individual stock selection will be key as the policymakers reflate the global economy.
Until midway through 2002, our equity income funds had produced positive returns against a background of an index falling by almost 10% (between 1 January and 1 July 2002, the FTSE All- Share returned -8.92%).
However, fortunes changed as the markets fell sharply in the third quarter, the largest quarterly correction in 18 years. European markets fell by almost 30% and London performed more poorly than Wall Street.
In the latter half of 2002, the stock market endured a stream of profit warnings with no sector escaping. Companies to announce problems included Cable & Wireless, Brambles, Corus, Barclays, Abbey National, JD Wetherspoon, British Aerospace and Invensys.
In November, chancellor Gordon Brown announced Britain would miss its growth forecast. This came as no surprise since it seemed unlikely the forecast of 3.5% growth for 2003 would ever be achieved.
There are still economists out there who believe we will get lower levels of growth than the consensus 2.6% forecast for 2003 and the 2.9% predicted for 2004. I believe it will be around the 2% mark but, whatever the outcome, there is little doubt growth will be modest going forward and we can therefore only expect a modest recovery in the FTSE All-Share. This creates a problem for investors closely benchmarked to the FTSE's main indices, with the FTSE 100 constituting some 85% of the All-Share.
The returns from these indices are determined by the large, mature companies in the oil, pharmaceutical and telecom sectors.
These sectors operate in increasingly competitive environments. The major pharmaceutical companies are having to deal with expiring patents and substantial increases in patent challenges while the production profile of the big oil companies has fallen short of expectations.
The sector is, of course, dogged by the ongoing crisis in the Middle East. I have less than 1% in oil stocks at the moment, which is a big call against the market but one I am prepared to make at this juncture.
The oil price is too high given supply and demand factors and while it may spike over any military conflict, I believe the price will come back later in 2003.
It would be foolish to presume any war will resolve the issue of global terrorism and the instability in the Middle East in one fell swoop. In itself, it is a factor that will put a ceiling on stock market levels until such time as a short-term resolution can be found.
Going forward, I am choosing to focus on stability, deliverability and defensiveness. I do not mind if sectors are failing to show signs of strong underlying growth as long as the companies within them are lowly rated. This includes stocks within the financial sector.
There are some attractive property stocks. A number of these companies have matured since the recessionary experiences of the early 1990s and do not have the overstretched balance sheets of that period. Their shares can be acquired at discounts of some 30% of their value.
For example, Liberty International has an outstanding portfolio of almost unique property assets. I also hold Helical Bar, which has proved that, as a developer, it can be profitable throughout the cycle. The group came through the early 1990s and has returned cash to shareholders in a meaningful way.
It is important to be selective with property stocks because there is clear evidence the downturn is under way in certain areas of the commercial property market, particularly the office sector in London.
The housebuilding sector is also interesting. The stocks have a return on capital employed in excess of 20%, they have good dividend yield and dividend growth yet many are on multiples of just six or seven times.
For example, one of the UK's biggest house builders, Bovis Homes, has cast doubt on recent speculation of a housing market crash by revealing a strong forward order book. Bovis said its cumulative sales reservations are more than 10% higher than last year and it is still in a good position to deliver another positive set of results in 2003. This message was echoed recently by Persimmon and Wimpey.
Fears house builders remain at the mercy of the economic cycle have led analysts to the sector the worst rating in the market. Even if house prices do fall and profitability halves, the builders would still be on multiples of around 12 times earnings. However, that aside, I believe house prices will not crash but are already slowing of their own volition.
Unlike some commentators, I am not hugely bearish on the banks. To invest in the UK and be completely out of the banking sector is, in my opinion, too bearish. They are flat, unexciting companies yet have contributed to about 40% of the dividend growth of the market. The sector should prove resilient to any rise in bad debts and the yields and returns that UK banks should generate justify holding them.
Northern Rock, for example, has done well. The company simply packages up and securitises its mortgage book. It is budgeting for 15% growth per year over the next three years. It may not achieve that target but the market has already taken a downbeat view of its outlook and that view is now in the share price. If we do not see sharply rising unemployment, outside of the Southeast, the demand for mortgages may still be strong.
Elsewhere in the financial sector, I also favour some of the Lloyd and ex-Lloyd's insurance vehicles. It is important to be discerning with the banks because some appear to have made mistakes. There are concerns with the wholesale bank at Abbey National and with boardroom politics at Lloyds TSB.
If Lloyds cuts its dividend, I fear it will have the problems ICI had in the early 1980s when it cut its dividend and its share price weakened to a degree that shocked the management.
The uncertainty and volatility in the markets is opening up selective investment opportunities. If you can lock some blue-chip stocks into your portfolio while they are temporarily on their backs, so to speak, you will get better income growth than the market going forward and some capital return.
For instance, I recently bought media and publishing group Pearson recently and its share price has since shot up more than 20%. The price has fallen back a little since but if it falls back further from today's levels, I will buy more. Its education and training businesses should offset the continued slide in advertising at the Financial Times newspaper; meanwhile, it has been yielding almost 5%.
Equities have suffered three years of negative returns. As we enter 2003, no one is kidding themselves we are on the edge of a raging bull market. But returns in the mid-single figures are achievable, although half of those returns may be made up of dividend yields.
I am broadly positive on an 18-month view. Unlike the sceptics, I believe Britain will achieve higher economic growth in 2004 than this year and by then a number of the better companies in the UK will have emerged in a strong position.
I am focusing on finding assets that are under-priced and for which the rating is not a true reflection of the company's future. The uncertain markets should enable me to pick up these assets cheaply. For example, Centrica, which owns the British Gas name and the AA motoring services group, is not a business in which I have previously invested.
It was too highly rated and there were questions over its business model but I have pursued the company over the past six months because it has nearly halved in value and been de-rated. I have bought it aggressively because I think it can get back to a higher rating.
If I can pick up just half a dozen stocks such as Centrica during the next year or two it should go a long way to helping me deliver both absolute returns and strong relative returns once again.
Returns from the FTSE indices are determined by large companies in the oil, pharmaceutical and telecom sectors
Uncertainty and volatility in the markets is opening up selective investment opportunities
Defensive areas of the market have performed well at a time when the rest of the market has been continuing to address technology issues
60+ £300bn ISA savings
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What made financial headlines over the weekend?
Q2 net sales dropped almost 50%