Although the UK stock market is set to recover this year, the improvement is unlikely to be significant, which reinforces the importance of finding companies with long-term growth potential
While there will be a resurgence in the UK economy this year, it will not be a sharp bounce or V-shaped recovery, but slow and steady.
Although we do expect the UK stock market to advance this year, the improvement will not be significant ' at the absolute maximum, I expect that the All-Share will move ahead by 8%-10% by the end of 2002.
The biggest risks to the market are more Enron-type shocks, which would undermine investor confidence, or further terrorist attacks. Providing these do not occur, the outlook for the UK stock market is reasonably positive.
The main contributor to the resilience of the UK economy during the global slowdown has been the strong consumer. Because of low interest rates, repayment on debt has become a lot easier and the consumer is in a far stronger position compared to that of the late 1980s and early 1990s recession. It would take interest rates in excess of 8% to put the consumer back into a similar difficult financial position and this is highly unlikely.
A small rise in interest rates in the second half of the year is probable but this will not be significant enough to undermine confidence in the economy or markets.
Although I expect consumer confidence to ebb slightly ' we are still unwinding slightly in terms of the labour force and companies continuing to focus on productivity ' a strong consumer will continue to fare well for the UK economy.
However, despite our confidence in the economy, this is not going to be reflected in a huge bounce back in corporate profits and some companies will continue to struggle. At the same time, dividend growth is becoming far less important to companies and to many investors. Rather than demanding dividend increases, there is now a far greater trend toward dividend cuts.
This reinforces the importance of focusing on companies that display potential for long-term growth rather than relying on a cyclical upswing or where total return is predicated on companies not cutting their dividends. I do want exposure to an economic upturn but because we are cautious on the extent of the economic recovery, many of the overtly cyclical companies may not achieve the profits that many investors are anticipating. Many of our overweight positions are therefore not highly cyclical.
For example, I am not chasing the classical cyclical stocks such as advertising. Valuations of advertising companies are expensive and I expect the advertising cycle to pick up much later than the market has discounted. Instead, I prefer to focus on companies with good long-term growth potential because of structural factors, rather than those relying on an economic upswing.
Within the Framlington UK Growth fund, one of the big overweight positions is the housebuilders. For example, companies within this sector are trading on low valuations, yet there is a strong structural demand for housebuilding in the UK. We are building a fraction of the number of new homes compared with the peak of the housing boom of the late 1980s. There is demand for 200,000 new homes a year, yet only about 140,000 new homes are being built each year.
Another area that is presenting opportunities within the UK market is the life assurance sector and we have been adding to this area within the UK Growth fund. Although there have been concerns about the financial and liquidity positions of life companies, there has been strong growth in new business.
With the rapid trend toward axing final salary pension schemes, the need to provide for long-term wealth is becoming increasingly important and these businesses will benefit as a result. The likes of Prudential and Legal & General are therefore still good long-term stories.
The transport sector is also interesting. Budget airlines such as easyjet are the future of short journeys and will continue to enjoy strong business growth. There is no need to fly first or business class for a 40-minute flight to Edinburgh, for example.
The slowdown in the economy has had little affect on these companies. Because the consumer has remained strong, demand has not tailed off significantly. Meanwhile, when companies want to cut costs, they turn to the low-cost airlines, but when conditions improve they do not necessarily trade back up.
We are also positive on mining companies, mainly because there are big barriers to entry and they should also benefit from cyclical factors. The UK pharmaceutical sector is less attractive: AstraZeneca is overvalued and GlaxoSmithKline has generally disappointed on new products, but, to be fair, its price is undemanding at the moment.
The outlook remains tough for telecoms. They are simply too dependent on the next generation of mobile phones and WAP. Meanwhile, there are new entrants such as Hutchison and the only way they can compete is on price. I remain negative on technology as companies are still overvalued. Meanwhile, there has been over-investment in many areas and there is also a lack of visibility.
Our three most overweight stock positions are Persimmon, Taylor Nelson and Compass Group.
Persimmon, the housebuilder, is benefiting from the structural demand for new housing. At a bottom-up level, this business has a broad national spread of housing and a diversified range in pricing. Meanwhile, management is focusing on cost-cutting, following several acquisitions last year.
There are two reasons to expect growth from Taylor Nelson, the market researcher. First, companies are realising that in a competitive world, they need good information to give them a small advantage over the competition and so are seeking out better quality market research. Second, many businesses are deciding that they do not need their own market research department and are contracting out to companies such as Taylor Nelson. This is a mid-teens growth business.
Compass Group is also benefiting from the trend toward outsourcing. Although what it does is not very glamourous ' it makes shepherd's pie and sandwiches ' it saves customers money and management time. It is continuing to win new business and we expect this company's earnings to grow strongly.
We have a multi-stage process when constructing the UK Growth portfolio. The first stage is to identify global trends or themes, such as the ageing population, globalisation, technology and outsourcing. These themes do change ' we are now looking at different military threats, for example.
We had the peace dividend from the end of the Cold War, but following the 11 September terrorist attacks, we now have a different military threat that cannot be ignored. We have seen US President George Bush accelerating defence expenditure. That continues to drive a trend in global defence spending and companies will make money as a result.
Once we have identified the relevant themes and trends, we look to find companies that will benefit from these. At a company level we conduct intensive research to determine whether we believe certain companies can achieve their goals, make profits and create value for shareholders.
Of course, we also look for quality companies outside these themes. There are many good quality niche players out there that do not necessarily fit into the macro process.
Within our company screening process, it is vital to be objective. Over the past couple of years, there has been the trend for fund managers to become theme obsessed and lose objectivity. We want to remain objective ' to be able to say that the theme is great, but the competitive risk is so high that this company is not worth investing in.
The company research process involves both a quantitative and qualitative screen. The qualitative side involves looking closely at management. If management claims it is launching a new product, do they do it on time? If they say they are going to win greater market share, do they actually do this?
At a quantitative level, we look at whether there are better run businesses, whether they use their working capital better, and whether they generate more cash than the competition?
That screen should provide a pool of interesting companies but fundamentally important to me is valuation. It is pointless doing all the work and research on themes, trends and companies if you then pay the wrong price for the company. Companies will be overvalued and undervalued for certain periods, but in the end they will come back to what they are worth. If you overpay you will, in the end, lose money.
To achieve good consistent returns, it is not necessary to chase out-and-out growth. A business that is growing ahead of the market and ahead of inflation will deliver attractive real returns. For example, a company that is growing at 8% a year over five years, while inflation is 2%, will deliver 30% compound real returns over that period. It is not just about just chasing companies with 20 or 30% annual growth.
Important to focus on companies with good long-term growth potential based on structural factors rather than those merely relying on a cyclical upswing.
While confidence might fall off slightly, strong consumer demand will continue to buoy the UK market.
Post-11 September, there is a military threat that cannot be ignored.
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