The market's most recent embrace of cyclicals is nothing new. In fact, key industrial stocks began o...
The market's most recent embrace of cyclicals is nothing new. In fact, key industrial stocks began outperforming the index on both sides of the Atlantic during the slowdown phase of the world economy in late 2000 and have continued as the concept of recovery has gained credence with every passing set of economic data.
In stock market terms, we could already be in the second phase of the recovery. The first phase, and the sharpest rally, occurs as sentiment extremes are corrected and liquidity comes back to the system. The second comes as confidence improves and companies take advantage to repair balance sheets and rekindle M&A activity.
This would all appear to be good news for the market if it was not so naggingly obvious. I find it hard to believe much of this is not already priced in, given the flag-bearing nature and sheer transparency of this recovery. The consensus supporting it is overwhelming ' when did you last meet a fund manager whose portfolio was not well placed to benefit from an improvement in economic conditions?
I think we have seen the best of the gains from cyclical stocks. The time to sell economically sensitive situations is when there is nothing but blue sky ahead and right now there are very few clouds on the horizon. Valuations suggest the scope for multiple expansion is limited however ' what is needed now are meaningful profit upgrades to justify and support share prices.
This may well happen but the risk/reward ratio is starting to look asymmetric. Recoveries do not happen in a vacuum, things go wrong along the way. A steadily rising oil price, liquidity induced inflationary pressures, and dwindling government finances are all potential dampeners.
From a stock selection perspective, I prefer instead to focus on quality, well-managed companies that are capable of meaningful profits progression irrespective of economic conditions. A key criterion is consistency of delivery and businesses that are run not as director's lifestyle support vehicles, but whose managers are clearly incentivised to create shareholder value.
In the large-cap market, I like Marks & Spencers. Still the overwhelming clothing market leader, this business is a long way short of its peak earnings potential. Management are doing all the right things, selling or closing peripheral businesses, returning surplus capital to shareholders and focusing on its core ranges.
Analysts are reassuring behind the curve and UK fund managers are still substantially underweight. More fundamentally, I believe the momentum in this company will drive strong profit upgrades and further share price outperformance.
In the mid-cap sector, PHS stands out as a tremendous value creator. This company possesses outstanding returns on capital with considerable expansion opportunities both in the UK and overseas.
On the small-cap side, one stock that catches the eye is Mears Group. This local authority outsourcing company has been winning an impressive array of contracts.
Economic data suggests recovery.
Pick up in M&A and IPO activity on the way.
Plenty of attractive stock picking openings.
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