In 2007, the UK equity market presents an attractive investment opportunity. It is cheaper than glob...
In 2007, the UK equity market presents an attractive investment opportunity. It is cheaper than global peers on both an earnings and dividend yield basis and, despite strong returns from the FTSE All-Share index for each of the past four years, the UK market has not become more expensive on an earnings basis, because the gains have been led by earnings growth rather than by multiple expansion.
With margin expansion and the strength of the global economic backdrop likely to fade next year, it may be difficult to achieve another double-digit return. However, with the forecast dividend yield on the FTSE 100 index at almost 3.5% and the market's large weightings in defensive sectors, UK equities should perform relatively well in a slowing global environment.
Our strategy for 2007 favours large-cap stocks over small caps. The latter have outperformed large caps for six consecutive years and we believe this trend may now be over. We expect the global economy to slow in 2007, which poses a significant risk to small-cap stocks, which are more cyclically orientated, have higher gearing and are more expensive on both an earnings and a cashflow basis. Should the economy slow, small caps may also be at risk of a more carefully considered risk appetite from investors, which would move their multiples from a premium to a discount compared to large caps.
The biggest risk to our view is the ongoing high level of M&A and private equity activity, which favours small-cap targets. However, with the abundance of cash on balance sheets and in private equity funds, the trend may actually move into large-cap acquisitions, given their valuations. Another risk is that we see a large depreciation in the US dollar against sterling, because large caps generate a much greater proportion of revenues and earnings in dollars. However, we believe these risks are more than reflected in the valuation discrepancies between small and large-cap stocks.
One call that is particularly difficult to make is on the strength of the UK housing market, which may prove to be a key factor in determining the path of interest rates, the health of the UK consumer and the state of the UK equity market.
However, despite rapid appreciation in recent years, it is easy to see a scenario where house prices are supported during the coming year by overseas investment and widely anticipated record City bonuses. Rapidly rising interest rates would be a significant risk but, with global growth slowing, we are not overly concerned at the moment.
There is not much in the value versus growth debate at the moment. Value stocks have been on a strong run compared to growth stocks over the past five years, but the valuation gap between the cheapest and most expensive stocks has narrowed significantly because of this outperformance. We believe quality companies that can defend their margins and are not cycle-dependent will be the best positioned in 2007.
The market should reward, and re-rate, true growth companies that can deliver above market-average growth, but we do not think the traditional growth indices will necessarily contain these types of companies. This may make stockpicking a key driver to returns, rather than the beta-driven returns that have dominated the market for several years.
Overall, we expect UK corporate profits to remain healthy during the coming year. The market should deliver a total return in line with earnings growth plus dividend yield - or just shy of 10% - in 2007.key points
UK equities should perform well in 2007
Slowing global economy will impact small caps
Corporate profits to remain healthy
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