Following the fall in equity markets, investors are having to concentrate more on survival than making profits
Investors bruised by the falls in markets over the past year may be wondering whether investing in equities is a worthwhile exercise. Negative returns for the market as a whole in 2000, and so far in 2001, have fuelled a climate of fear and shortened investors' time horizons to surviving the next quarter.
In this environment, investors, not surprisingly, tend to focus on preserving rather than increasing the value of their portfolios. However, the figures for market returns conceal a good deal of variation from individual companies and highlight the importance of stock selection in a difficult market.
In particular, many of the more traditional defensive and value plays have shown good performance in absolute and relative terms over the past year as the stars of the new economy have imploded one by one. This theme has been reinforced as the economic climate has deteriorated. The share prices of those companies exposed to the slowing international economy have weakened as profits estimates have been reduced. In the year to the end of July, for example, the overall market fell by 13% but the shares of BAT Industries rose in value by 62% and those of Safeway by 30%, while the value of Marconi fell by 91% and BT was down by 38%.
Observing this is all very well with the benefit of hindsight but what happens next? The background is moderately encouraging for UK investors. We expect UK GDP to grow by around 2.3% this year and around 2.5% next year. Rising government spending and robust consumer spending should combine to lead to earnings per share growth of about 6% per annum.
Alongside this, the valuation of the UK market, while not outstandingly cheap at current levels, gives room for upside as confidence recovers and investor appetite for risk increases. Furthermore, the time when the best opportunities arise for equity investors is when sentiment and share prices are depressed and expectations for future growth are low. However, this positive stance is tempered by our belief that, in a low inflation world, real growth will be more apparent, and more highly valued, than in a world where the general price level in the economy is regularly inflating at 5% per year or more.
Furthermore, investors are also likely to be more discerning as to what constitutes growth and, accordingly, less generous in the valuation they are prepared to give to companies that fail to meet these requirements.
So what kind of stocks will do well in this low growth, low inflation environment? The simplest answer to this is that the core of any portfolio should be businesses that can deliver capital growth. We believe successful, growing businesses often have common characteristics. They are frequently based upon a robust, high return business model with an attractive cashflow dynamic. They also have focused management and strong product and market positions, as well as the ability to exploit their potential, taking market share and increasing profitability.
Many of these are small and medium sized companies like Geest, Pizza Express and Marlborough Stirling. Larger companies, such as William Morrison and Wolseley, are also attractive in these terms.
Beyond this criteria, there are many opportunities for capital growth within a gently rising market. Examples include: recovery stocks like Reckitt Benckiser or Seton Scholl where returns are being improved by the actions of new management; and low-growth businesses where earnings stability or a revised strategy leads to a revaluation of the earnings base.
Of these latter businesses, many can deliver above-average growth but are currently overlooked by the market for not growing fast enough ' hence their earnings can be undervalued. The ports stocks and some of the brewing/leisure companies such as Greene King feature in this category.
These companies are traditionally regarded as value rather than growth stocks but in the low-growth world, there is scope for them to be revalued if they can achieve the growth we expect.
The past eighteen months have seen a renaissance of value investing as uncertainty about growth and the extreme low valuations created by the internet bubble combined to create a massive rotation into value stocks. Many value stocks are characterised by above average yields, hence the generally good performance of income funds over the same period. We expect this trend to continue while uncertainty about growth predominates.
Indeed, many of the steady growth stocks we consider likely to be attractive in the low growth/low inflation scenario are also companies with above market yields and dividend growth, reinforcing their appeal.
One of the key issues for investors is the sustainability of the earnings of the company into which they are buying, as a company that disappoints can inflict severe damage on a portfolio. To this end, we work hard at spotting situations that are deteriorating so we are early enough in forming our view to be able to exit cleanly.
If we are right, we have the option to reinvest in the company at lower levels and capture the recovery if we believe it is possible and can see the catalyst to trigger it. To do this, it is essential to have a knowledge of the fundamentals of each business as well as an awareness of the kind of things that can go wrong and an understanding of the cashflow and returns within a business.
In the past year, large companies like Marconi, Invensys and Hays have all disappointed and fallen sharply. Limiting investment in these companies has helped our performance.
Importantly, danger signals were flashing well in advance of the profit warnings issued by these companies in all three cases. Given the build-up of working capital and concern about vendor financing in Marconi, or the poor cashflow and deteriorating balance sheet at Invensys, the risks looked increasingly skewed to the downside, encouraging us to reduce our exposure.
We remain optimistic about the outlook for equity investors and are convinced the best opportunities arise when the market is beset by worries about the future. While overall market returns may look lacklustre in the context of the past, a carefully selected portfolio should still be able to deliver attractive returns over the coming years.
• Valuation of the UK market gives some room for upside.
• Best equity opportunities arise when sentiment and share prices are depressed.
• Real growth will be more apparent in a low-inflation world.
Industry Voice: Scottish Widows pension expert Robert Cochran and economist Andrew Scott discuss the future of employment and income, in episode three of Scottish Widows' podcast series.
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