By Mark Westwood,a fund manager at LeggMason Investors Over the next decade, returns from equiti...
By Mark Westwood,a fund manager at LeggMason Investors
Over the next decade, returns from equities are unlikely to equal the annual gains of 20% or so 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 about 3.3%.
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%, then in future we can expect a return of roughly 7.5% before trading costs.
This depressingly low figure means that active fund managers should now focus on companies paying sustainable, high dividends. This is because the yield will become more important to the shareholder's total annual return in contrast to the past few years, when a larger percentage of return was derived from a rising share price. In this period of prolonged low growth and low inflation, genuine growth firms will attract an increased premium relative to the market and it is therefore important to. So seeking out growth stocks on sensible valuations.
Adding some special situation stocks should prosper in this environment ' these are companies which are boosting returns by cutting costs, restructuring or perhaps appointing a new management team to turn around a poorly performing business.
As an example of a high yielding firm, this can be illustrated by the following company case studies that form part of the Legg Mason Investors UK funds holdings. The high yielding Scottish Power announced figures that beat analyst forecasts with a sharp profit improvement led by a recovery from last year's US power crisis at its Oregon-based Pacificorp arm. It has reduced its debt burden by selling its Southern Water business and, in spite of its well-flagged dividend cut, shares still offer a dividend yield in excess of 7%, which will strongly underpin the share price.
As a growth firm, BSkyB should be able to grow, regardless of economic conditions. It now has a virtual monopoly in the UK pay-TV market following the demise of ITV Digital. Sky should comfortably hit its targets of seven million subscribers and average revenue per user of £400, as 75% of new subscribers are taking the top-tier package. Sport and film rights are now cheaper and this will improve margins. The stock overhang has now been cleared and Sky has turned free cashflow positive.
In summary, with lower stock market returns predicted in the future, good stock picking will be the key for many active fund managers, and there will be sectors of the stock market that should generate strong returns.
Turning more generally to the UK stock market, 2002 has been an extraordinary period in which investor sentiment has weakened considerably in response to concerns about global economic growth, accounting scandals and the outlook for corporate profits ' all factors that have led to a large fall in stock prices. Investors will start to look for recovery in 2003, as further rate cuts in the US and the UK revive these economies.
This is likely to be led by the highly liquid FTSE 100 large cap stocks. and so we are positioned accordingly.
UK valuations now attractive.
Interest rates and inflation remain low.
Focused active funds may outperform.
Lower stock market returns in the future.
Company profits remain under pressure.
Weak investor sentiment.
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