At the beginning of this year, there were two principal investment themes within the UK: the underva...
At the beginning of this year, there were two principal investment themes within the UK: the undervaluation of smaller and mid-cap companies relative to the main market and the UK market's overly bearish view of both UK and global economic prospects
Higher interest rates and sterling strength had created difficulties for industrial, engineering, and other manufacturing companies, a disproportionate number of which occupy the UK smaller and mid-cap companies sectors. Institutions also neglected smaller and mid-cap company stocks due to disappointing performance and limited liquidity.
In the meantime, strong money flows into retail FTSE-100 index-tracking funds, and quasi-indexation by active managers, had contributed to premium valuations of FTSE-100 stocks.
Market turbulence during 1998 had provoked a flight to the safe havens of large companies, which were seen as offering financial substance, more broadly diversified business bases, better established brand names, greater resilience to economic shocks and more liquid and tradable stock.
It was our opinion that, despite gloomy trading statements and an environment of general pessimism, falling interest rates, declining inflation and historically low home ownership costs implied increased consumer spending power. We also thought that the pessimism surrounding many consumer cyclical stocks had been overdone.
In this case, the global economic environment was likely to prove more positive than markets appeared to be expecting. With this assessment in mind, there were several consumer cyclical companies that appeared to present potentially attractive investment opportunities. They were Dixons, Debenhams, DFS Furniture and Greenalls, as well as some commodity-related and economically sensitive stocks with international activities, such as ICI, P&O and Rio Tinto.
Our economic interpretation has remained consistent through-out the first six months of 1999, as indeed has our investment strategy. Additional investments have been made in the property and house construction sectors, as well as in ancillary activities such as building materials and plant hire companies. Exposure to the global economy has been expanded through investment in carefully identified international trading companies, such as Diageo and Unilever.
During the first six months of 1999 we have remained of the opinion that the prices of telecom stocks, while clearly reflecting expectations of substantial growth in traffic, do not fully reflect the likely negative impact on future earnings of increasingly aggressive price competition. We have therefore remained largely uninvested in this sector.
The strategy outlined above has proved positive for our fund performance during the first half of 1999, with those sectors more sensitive to economic cyclicality generally outperforming the FTSE All-Share Index, and the more defensive sectors either matching or underperforming. At the same time, the depressed valuations within the UK small- and mid-cap companies sectors have encouraged increasing levels of corporate activity, such as acquisitions, mergers, management buyouts and share buy-backs.
The growing level of takeover activity has contributed to outperformance by the smaller and mid-cap companies sectors and this, combined with a belated recognition of the value available, has encouraged a resurgence of institutional interest.
At present, with inflation in the UK still benign, sterling interest rates unlikely to rise in the near future, and the global economic outlook improving, valuations within the UK equity market still appear relatively modest. Smaller and mid-cap stocks remain underpinned by low interest rates, signs of recovery in the industrial, engineering and manufacturing sectors, rapid pick-up in the UK housing market and continued takeover and merger activity.
Barring unforeseen shocks to global equity markets, such as a large rise in US interest rates or major US stock market correction, we see continuing opportunities for positive investment returns during the coming year.
Stephen Whittaker is head of UK investment at Perpetual
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