Although it is extremely difficult to identify in general terms the bottom of the UK equity market, careful stock selection can build a portfolio that is particularly well suited to the recovery phase
The bull market days of 1999 seem long gone. The UK equity market recorded a dismal third quarter, losing a fifth of its value in the three months to the end of September, having almost halved from its peak.
The boundless optimism of three years ago has given way to doom and gloom among analysts, and investor sentiment is close to rock bottom.
We are clearly in a difficult investment environment, with investor confidence knocked by doubts about the sustainability of the US economic recovery, poor economic news from Germany, corporate profits warnings and the dark shadow of potential war with Iraq.
Company directors appear unwilling to give anything other than short-term guidance on earnings.
However, just as it was crucial not to be carried away by the hype surrounding the bull market back in 1999, we believe that it is important not to be too pessimistic about the prospects for the market now. All bull markets come to an end, typically when people are most optimistic about the future. They are followed by bear markets, which similarly come to a conclusion when sentiment is at its most negative.
Calling the bottom of the market is fraught with difficulty. Over the past two years there have been powerful rallies in equity markets that have proved short-lived and been quickly followed by new lows for share prices. The obvious question is whether the current run will have more longevity.
It is worth noting that, following the third-quarter sell-off, equity markets were looking reasonably valued on a yield basis. Although not quite at bargain-basement levels, we were not in the position of requiring an expensive market to be re-rated further to sustain the upward momentum in share prices, as has been the case in the past.
Government bonds on the other hand had became expensive as investors bid up prices in a flight to safety. There were other, anecdotal indications that sentiment toward equities had hit rock-bottom. Friends of mine that two-and-a-half years ago waxed lyrical about technology stocks have suddenly become experts on deflation.
In what is still an uncertain environment, careful stock selection will be crucial to achieving satisfactory returns ' more so than sector selection or style investing, which has proved so popular over the last couple of years.
Therefore, our focus is firmly on individual stock fundamentals. We believe those companies delivering on earnings expectations will continue to be favoured by investors, and that these good fundamentals will come in a variety of sectors.
Against this background we have continued to search for those companies that have some restructuring, reorganisation or acquisition benefits independent of economic activity. Following its rights issue we bought retail group Kingfisher, for example, which is using the proceeds to buy control of its quoted French DIY goods operation, Castorama.
With management control Kingfisher can now begin to make improvements to the operating performance of Castorama, bringing it more into line with market leader B&Q in the UK. Our holdings in Tomkins, Enterprise Inns and Imperial Tobacco are also examples of this theme.
Tomkins is a global engineering group, with strengths in automotive products, construction and industrial power systems. Following high-profile management changes there is potential for operational improvement. The new strategy will be to focus investment on fewer areas that offer growth and the potential for higher returns.
We are also expecting the new management to introduce more aggressive remuneration structures for senior managers and to encourage a more entrepreneurial culture. All this helps to align the interests of the management more closely with the interests of the shareholders, and should be positive for investors.
Enterprise Inns is another beneficiary of self help. The company is the UK's largest pub owner, and as such is effectively a property company with earnings coming from rental fees and sales of beer to captive (tenanted) customers. Earnings growth has historically come from attractively valued acquisitions as the company takes over smaller rival chains, and from the benefits of bulk buying and improving the estate.
Recently the opportunity arose for Enterprise to get involved in the management of the Nomura pub estate with the option of taking it over completely in 2005. This is an attractive deal that significantly increases earnings visibility for the group. We believe this is a strong and stable business model with excellent potential for meeting or exceeding earnings targets, and as such it now forms one of our core holdings in the Baring UK Growth fund.
Our third example of a favoured beneficiary of this theme is Imperial Tobacco. Imperial Tobacco is the largest cigarette manufacturer in the UK and the world's fourth-largest cigarette in terms of volumes. The company has gradually been increasing market share in the high-margin UK market and has an excellent record of managing the business and making value-creating acquisitions. The recent decision to purchase German rival Reemstma will boost earnings after efficiency savings and economies of scale are taken into account.
It will also give the group a stronger position in several important markets at a time when industry regulation is creating an increasing number of barriers to entry for established tobacco companies. Strong cashflow generation and a relatively high dividend yield also contribute to the attractiveness of this company.
In fact, looking for companies with an attractive dividend yield has been another theme in the fund in recent months. As the price of shares has come down, the yield on the UK market has risen, and in fact the yield on the FTSE All-Share is now 3.4%, a level last seen at the end of 1997. Dividend yields have been looking particularly attractive in the financial sector among some of the retail banks. The yield on Lloyds TSB touched 8.32% at the end of September, for example, before coming down again as the share price started to recover.
Again, this increases the size of the potential dividend return as a component of the total return available from the investment, and also increases the attractiveness of equities compared with bonds as an asset class.
Royal Bank of Scotland has been one of our favoured bank stocks for some time now. The company offers the prospect of good earnings growth from the reinvigoration of the old NatWest business combined with a highly regarded, efficient management team. The shares have performed strongly this year but we believe that there is still further to go and we remain confident in the prospects for the company.
The greatest uncertainty facing investors is the outlook for the global economy. Over the summer, forecasts for growth in the major economies for 2003 were scaled back, and this was a key contributor to the market sell-off in the third quarter.
We have recently reinvested in the more cyclical areas of the market such as the mining sector where our holding had been reduced earlier in the year. Though we do not expect a particularly strong economic performance next year, we do not expect the double-dip into recession that was being factored into share prices. Similarly we returned to the life assurance sector on valuation grounds having reduced our positions earlier in the year.
In conclusion, now is not a time to become more bearish on equity markets. At some point the process of downgrades to earnings and economic growth forecasts will have run its course and investors will be able to focus on those sectors and companies that can benefit from growth, albeit more modest growth than earlier forecasts suggested. In the meantime, though, value for money is likely to remain a feature of the UK equity market, with investors carefully calibrating growth prospects against share price valuation.
We have taken a fairly balanced position in the fund, favouring companies where we believe earnings are likely to prove resilient but still offer good potential for growth at a reasonable price.
In an uncertain environment, careful stock selection will be crucial for satisfactory returns.
Companies that have restructuring, reorganisation or acquisition benefits independent of economic activity are worth seeking out.
Companies with an attractive dividend yield has been a theme in the fund in recent months.
Paul Bruns and Elaine Parkes
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