The year 2000 was a roller coaster for investors and a testing time for fund managers, who had their...
The year 2000 was a roller coaster for investors and a testing time for fund managers, who had their convictions and strategy tested to the limit. It turned out to be a story of two halves: the first characterised by the growing bubble of telecoms, media and technology stocks and the sell-off of old economy stocks. The second half was marked by a welcome return to a more balanced, rational investing environment.
In the period from September 1999 to mid-March 2000, the market became almost obsessed with the telecoms, media and technology sectors and all but ignored any other businesses. Old economy companies were largely abandoned, despite offering proven management skills, strong balance sheets and healthy corporate earnings.
In March the market began to rotate, with a rapid deflation in some of the valuation excesses in tech stocks and something of a rally in the performance of many old economy stocks. However, the Perpetual UK Smaller Companies fund continued to buy and hold undervalued stocks in diverse sectors, such as housebuilding, construction, engineering, aerospace and defence, leisure, media and financials.
Our investment strategy remained consistent during 2000, despite the extremes tested by the market. We responded to changes but felt strongly that a clearly defined strategy needed to be allowed time to pay off.
We believed, however, that a soft landing was achievable for the UK, as confirmed by the Bank of England's Monetary Policy Committee (MPC) decision to keep interest rates on hold for most of the year. The economy remained remarkably stable, with moderate growth, low inflation and a strong currency. A heated housing market in the South of England, rising wage claims and an oil price rise could have prompted tighter monetary policy, but the MPC avoided over-reacting to short-term indicators and maintained interest rates at 6% from February through to December 2000.
Sterling remained strong against the euro, which posed a problem for manufacturing industries exporting into Europe. Towards the year-end, there were signs of a softening of the US dollar and firmer sentiment about the euro, both of which will assist UK-based exporters going forward.
We believe the UK outlook remains positive. Although a soft landing for the US economy is widely predicted, helped by the early and sharp interest rate cuts imposed by the US Federal Reserve, sentiment is still bearish on the prospects for corporate earnings growth. Leading technology stocks remain under pressure, while valuations in the rest of the market are still not high.
The Perpetual UK Smaller Companies fund has continued to invest in biotechnology stocks, where there is some degree of business protection via patents and intellectual property rights.
We believe that the UK smaller companies sector is particularly buoyant at the moment and is attracting fresh investor interest given the dominance of the main indices by a few highly valued stocks. The two key macroeconomic factors for smaller companies are real economic growth and interest rates. The sector tends to do best when there is reasonably strong domestic economic growth coupled with the expectation of falling interest rates.
This is currently the situation in the UK market. Interest rate-sensitive sectors, such as builders and contractors, have already benefited from the favourable environment. Some property groups and manufacturers have been largely discounted in relation to their net asset value a situation not experienced since the late 1960s. This situation has prompted a round of buyouts and take-overs, often involving US or continental European bidders.
In between bouts of activity, the UK smaller companies sector has been fairly subdued. At the moment, we have held a higher than usual cash position, waiting for further attractive investment opportunities. However, it is important to buy small companies at the right price and the right time. By definition, the sector is the bottom 10% of the market and always illiquid, making it difficult to exit in a hurry. But when it rises, everyone tends to chase the same stocks, and these can move very quickly.
The UK smaller companies sector index holds none of the major telecoms stocks but has a higher weighting in small technology and media companies. We are reasonably positive on media as a growth area, as people are learning to interact electronically in different ways. We see tremendous potential in intellectual property growth (patents) and undervalued stocks where there are specific barriers to entry.
Pockets of the technology sector have provided strong growth, although the fund has largely avoided the dot.coms. Technological advances will not only benefit the companies that develop them but also those who use them to cut business costs, automate back offices and manage customer relationships.
Elsewhere in the sector, biotechs have been high risk but the demographics underpinning the industry are undeniable and the medical developments often exciting.
The UK smaller companies sector has developed a far greater following in recent years as institutional investors appear more willing to take risks on start-ups. Venture capitalists are now behind over 40% of UK merger activity, so there is plenty of corporate activity ahead. There is also a new pool of companies run by people, often with a track record of business experience, working for themselves. Given a continuation of the benign economic environment, these companies offer exciting opportunities for careful investors.
Although the current outlook for the UK economy appears relatively benign, there are additional risks for the smaller company sector, which make us slightly more cautious than our colleagues managing funds investing in larger-capitalisation
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