Two years into the current bear market, after a plethora of profit warnings and negative trading statements, investors should avoid sectors based on corporate investments
At the present time, the UK market is not only having to grapple with the current crisis in the Middle East but there is also a high degree of uncertainty over the economic outlook, warns Geoff Miller, head of Exeter's equities team.
Recent US economic data has been weak and suggests there is a possibility the economy may slip back into recession.
Our view is that the interests of investors are best served by sticking with companies with sound finances and non-cyclical growth prospects. Companies with low levels of debt, preferably with a high degree of asset backing, and strong cashflow should be favoured during uncertain times.
Andrew Hobson, a member of Miller's team, adds: 'It does not necessarily mean an investor's portfolio should consist of conventional defensive stocks, such as food manufacturers, tobacco and drinks companies. There are many companies with sound finances and strong growth prospects, unrelated to the economic cycle, which are currently undervalued by the market.'
Hobson cites an example of just such a company, namely mid-cap pharmaceutical stock ' Galen Holdings. Here, growth prospects have been unaffected by the downturn in the global economy and the market in the shares is liquid enough to accommodate buyers and sellers.
Almost two years into the current bear market and there has still been a plethora of profits warnings and negative trading statements. Hobson feels investors should avoid sectors dependent on corporate investment, such as software specialists or those dependent upon the oil price like chemicals.
One area of concern in Hobson's view is smaller companies where fund managers have been selling shares regardless of their prospects, preferring instead the ability to liquidate holdings quickly if necessary.
Despite this flight to quality, Nick Brind, Exeter's specialist in smaller companies, says: 'Although this is generally true, there are smaller companies that offer exposure that should prove defensive in the current environment, including specialist operators in property and construction. I believe certain healthcare support services will prove to be strong performers, although I accept that some companies in the broader health sector are suffering, particularly in biotech, where it is difficult to assess value.' He holds the view that smaller companies offer better earnings growth prospects than their larger counterparts yet trade on a discount to them and many contrarian investors are already invested in the sector.
Exeter's core multi-thematic approach features five core and enduring themes: financials, energy, outsourcing, health and technology.
Miller says: 'We are very overweight in financials and have recently increased our weightings in fund management and life companies. Such companies offer both geared exposure to market recovery and dividend yields of typically 5%-6% irrespective of whether the recovery materialises. Within financials, we are also overweight in insurance and have holdings in three banks which offer reasonable value with solid blue chip credentials.'
Shares in oil companies have been robust as the oil price hovers around $30 per barrel. This is as a result of the fear of war in Iraq rather than the key driver of the oil price, namely global demand, which remains subdued. We feel the US government, particularly given the state of its economy, will not tolerate this oil price for a sustained period.
Ultimately, we feel that in the event of a war against Iraq, American political pressure will prevail and Opec will increase production. If a war does not occur, then the oil price could fall sharply. Hence we are underweight in energy.
In outsourcing, Hobson feels there are a number of issues. He says: 'A great deal of outsourcing companies are involved in recruitment and this is obviously unattractive at this stage in the cycle. Some large companies involved in public-private partnerships have had serious doubts raised over their accounting procedures ' such as capitalisation of costs associated with bidding for government projects. In general, in weak economic environments I think there is a tendency for companies to batten down the hatches and maintain control over company functions, rather than outsource them, so in outsourcing we are underweight.'
In technology, our major play is Comeleon ' a very specific call that is more intellectual property than technology. We approach technology from a broad perspective. Comeleon has a new product and process with the potential to unlock vast latent demand, with significant barriers to entry and potentially high returns for shareholders.
We reject the traditional software/hardware straitjacket and many companies in these sectors would not fit our criteria in the first place, given the intense level of competition and overcapacity in those industries.
On health, we are overweight as valuations are undemanding while fundamentals remain robust. In addition, if over the next few years economic growth is unexciting, then we feel companies such as these will regain a sizeable valuation premium to the market. Within healthcare, we prefer mid caps as large-cap pharmaceuticals have been suffering from a number of concerns ' large number of patent expiries over the next few years, product failures, and driving the top-line from such a high base in general. We think the current bear market has increased the attractiveness of health and pharmaceutical companies that has led us to increase the weighting here.
Miller points out that the bear market has affected the weightings of these themes. Depressed market levels have driven the prices of financials to attractive levels in our view. Fundamentally, due to the weak global economy, we are underweight oil. We have maintained an overweight stance in our chosen technology companies but have resisted adding to holdings (even though prices are attractive) given negative investor sentiment towards such companies and small caps in general.
On whether one sector stands out in terms of potential earnings growth in the current environment, we are keen on insurance stocks, particularly the smaller insurers of Lloyd's of London. The impact of the WTC disaster ' the highest insurance claim on record ' on top of an already poor 2001, together with dramatic falls in equity markets, has left much of the industry severely short of capital. Munich Re recently posted its first ever loss. The very nature of the WTC disaster has pushed insurance premiums sharply higher and, together with capital constraints, the rises are now quite dramatic. In addition, demand for insurance for terrorism, kidnapping and property has exploded in popularity.
Here, given their specialist expertise, relatively small size individually, and access to capital markets, Lloyd's of London is extremely well placed to reap the rewards of higher underwriting profits. Indeed, industry insiders find it hard to remember such a good market for them. We are overweight in Insurance, focusing on Lloyd's vehicles, such as Chaucer and Ockham, and will remain so for the foreseeable future.
Looking ahead, Richard Scott, Exeter's International investment specialist, says: 'Recent US data has shown that economic activity decelerated to a crawl over the summer. If the data does not improve soon, it is likely that Alan Greenspan will conclude that interest rates will have to be reduced further to stimulate the economy.'
Our house view on the UK with the FTSE 100 at around 3800 is that the market is fundamentally good value. The question is quantifying the upside. Our base case scenario is one of a muted profits recovery in 2003. This, together with the investor confidence that even a moderate recovery should engender, means that the market has significant upside potential over the next 12 months.
Our team thinks that for the UK market to recover it must first fall to a level that offers good value to the investor. However, with the FTSE at circa 3800, we believe this condition has been met. We consider UK equities to be cheap in absolute terms, relative to recent market history and relative to bonds.
Nevertheless, as Hobson observes: 'Equities being cheap is not enough ' the market requires a catalyst to realise that value and drive the market higher. The catalyst could take several forms: a sustained run of economic data pointing to higher growth in the US economy, presaging global recovery; a sustained run of corporate results pointing to economic recovery; or a sudden rash of merger and acquisition activity. The market is waiting for the former two to kick-in but could be surprised by the latter.'
There are certainly a number of sectors ripe for consolidation such as biotechnology and engineering. In the meantime we expect several niche insurance companies to be among the leading lights in terms of profit growth.
Valuations remain undemanding in healthcare sector.
Share in oil prices have been robust as the oil price hovers around $30 per barrel.
For the market to recover, it must first fall to a level that offers good value to the investor.
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