While UK equities remain at depressed levels, there are good opportunities, particularly for small and mid-cap stocks which are less exposed to geopolitical problems
Last year was a very difficult and painful one for UK investors, with the FTSE mar- ket experiencing its biggest fall since 1974. In fact, this is now the most severe bear market to hit the UK for more than 70 years.
Not surprisingly, investor confidence has been shaken and sentiment is at a low ebb. In such an environment, convincing investors during the current Isa season that equities still make sense is becoming more and more difficult. Some of the current weakness is due to geopolitical worries, with uncertainty over the timing and outcome of a US-led attack on Iraq the main concern, along with fears about possible terrorist attacks.
Forecasts for economic growth have also been reduced, house prices are high, manufacturing is in decline and companies will clearly find it difficult to grow profits against a background of low inflation and increasing labour, pension and insurance costs.
However, none of these concerns is new and, because of the prevailing gloom, UK equities now offer good value. Indeed, the FTSE All-Share Index has fallen below its 1969 value in real terms and to its lowest level since 1967 relative to gilts.
Compellingly, the UK gilt/equity yield ratio now shows that equity investors are receiving a dividend income ' which should grow over the long term ' roughly equal to the fixed income available from gilts.
Ignoring equities at these depressed levels could prove costly for investors. Instead, they should be looking to take advantage of the current stock market weakness and using this year's Isa allowance to invest in UK equities.
This argument looks especially valid as none of the alternatives is particularly appealing at the moment.
Bond yields are at record lows, cash deposits are paying less than 4% gross and property price rises are generally expected to slow significantly over the next few years. For investors willing to look through the current uncertainties, we believe that there is some particularly good value to be found outside of the blue-chip names, with smaller and mid-cap UK stocks now offering excellent opportunities.
Our research suggests that companies below the FTSE 100, in the Mid 250 and small cap indices, are currently trading on lower P/E ratios than larger stocks, yet are receiving higher earnings forecasts and are expected to enjoy faster future dividend growth.
Admittedly, smaller companies would be expected to lag behind larger companies in any future stock market recovery, as money usually initially finds its way into the bigger, more liquid stocks when investor confidence picks up. However, once investor attention turns to smaller stocks, their lower valuations and good growth potential suggest that they could offer attractive returns in the long run.
Our strategy for finding the best small-cap and mid-cap companies involves the use of a proprietary multi-factor model. This focuses on four characteristics that we believe lead to consistent outperformance of portfolios: value, growth, estimate revisions and price momentum. The aim is to find companies that are both cheaper and growing faster than the rest of the market.
Although our model suggests the best stocks to hold from a quantitative perspective, it is no substitute for common sense. It is particularly important with stocks of smaller companies that we get to evaluate a company's management, explore its balance sheet in detail and discuss cashflow prospects. This is why we overlay our quantitative research with an intensive programme of company meetings, in order to take a management health check and ensure that growth targets are realistic, while making certain that real opportunities exist regardless of sectors or sentiment.
We find that properly targeted company meetings also help us to explore the industry dynamics and competitive landscape, as well as enabling us to resolve issues and help us place news flow in context. This is especially important when researching companies that are not well known in the stock market.
In the prevailing difficult market environment, our focus has been on companies with strong cashflows, solid balance sheets and strong earnings growth potential.
We also retain a large spread of stocks across a wide range of sectors to diversify risk. But, as always, we are on the lookout for catalysts in the market, which will enable us to lock in value for investors early on. In the past, for example, we have invested in cyclical and secular themes, such as the growth of technology stocks in the late 1990s and utilities before that.
By investing in these themes early on, investors can capitalise on the success of companies as they make their way into the FTSE 100.
On the other hand, companies that are in danger of falling from the FTSE 100 into the mid-cap universe can also represent a good investment opportunity, and we therefore also devote a large amount of time to analysing the most promising of these demotion candidates. EMI and British Airways, for example, have both recently been demoted from the large-cap index (British Airways has since re-entered the FTSE 100 after performing strongly following its relegation to the FTSE 250).
For those convinced that equities, and particularly mid-cap and small cap stocks, still make sense for their Isa choice, a good way to gain exposure is through an investment trust. At the moment, with the market offering good value, trusts can borrow money to buy more stocks and leverage the potential returns once the market begins to rally. Of course, the use of gearing can amplify losses if the market continues to fall. But we believe that the stock market offers real opportunities at its current depressed levels.
Despite the poor geopolitical backdrop, the economy actually remains in relatively good shape, which is good news for smaller and medium-size companies, whose fortunes are more closely linked to the domestic economy than their larger counterparts. Consumer spending is still strong and, although the growth rate has fallen, it is now at more sensible levels. House prices remain firm but growth has moderated and overall debt service costs appear manageable, provided interest rates do not rise substantially, which looks unlikely. Meanwhile, public sector spending is growing strongly in an attempt to improve the UK's creaking transport and health infrastructure, which will boost future economic growth.
Additionally, valuations, earnings growth expectations and dividend growth forecasts in the small-cap and mid-cap areas of the market are also currently looking more attractive than for larger companies. Granted, returns in the future may not be as high as investors were used to in the bull market of the late 1990s. But, over a five to 10-year investment horizon, we should expect returns to more than match potential returns from cash and bonds. If exposure is achieved through an investment trust, the ability to gear can potentially further enhance returns. And, as history has taught us, when confidence eventually returns investors will not want to be left out of the market.
UK equities offer good value, especially small and medium caps.
Small caps may lag larger caps in the initial recovery but should outperform later.
Geared investment trusts can benefit strongly from a market recovery.
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