Fund manager's comment/Mark Westwood
At LeggMason Investors, we believe that in the next decade, returns from equities are highly unlikely to equal the 20% annual gains that investors achieved for much of the 1990s.
According to the dividend discount economic model, the return from equities comes from the current dividend yield plus dividend growth. The current yield of the market is around 2.5%.
Over the long term, dividends are likely to grow at the same rate as the economy. If we assume that real GDP grows at 2.5% a year, and inflation averages 2.5%, then we can expect a return of roughly 7.5% before trading costs.
This low figure means active fund managers are likely to pay more attention to a company's dividend yield in the future. This is because the yield will represent a greater proportion of a shareholder's total annual return than in the last few years when most of the total return has been derived from a rising share price.
In terms of sectors, we are underweight telecoms and technology, as we believe both sectors are likely to underperform the market for the next few months. The technology sector is suffering from a freeze on IT expenditure after years of over-investment, while telecoms are being downgraded because of delays in the rollout of 3G mobile phones.
We have also moved away from defensive areas such as food retail and non-cyclical consumer goods, as we believe they offer poor value and have been pushed up to unsustainably high P/E ratios because of their safe haven status.
With the failure to break through the 6000 barrier, the FTSE 100 index has moved into reverse and the market retreated 10% in short order. It should not have come as any great surprise that the rally ended as it was driven by interest rates rather than profits and it was clear that we were still some way from an end to corporate profits warnings and company downgrades.
UK interest rates have been reduced to 5% and could fall further if growth does not pick up. However, the housing market remains strong and retail sales figures suggest retailers are seeing increases in prices and volumes and consumers are spending freely.
With lower stock market returns predicted and an absence of any discernable themes at the moment, we are increasingly looking at the market from a bottom-up perspective. We believe that over the coming months, the best returns will be achieved by finding well placed growth companies in growth sectors.
We would argue that the most likely scenario for the stock market is that investors will soon start to look for recovery in 2002 as rate cuts feed through to the economy. This recovery could happen as early as the fourth quarter and is likely to be led by the FTSE 100 large-cap stocks.
• Rate cuts will feed through to economy.
• Housing market remains strong.
• UK avoided US excess and stagnant Europe.
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