Up to the end of the third quarter in 2005, companies with strong visible cash flow, structural grow...
Up to the end of the third quarter in 2005, companies with strong visible cash flow, structural growth and a good starting yield proved to be the correct positions to have.
Staying clear of the UK consumer and pure cyclical companies also proved correct except for the oil and mining sectors.
However, all this changed in the fourth quarter as the market turned on its head, beginning to believe the end to rising interest rates and that inflation was not an issue. With global Gross Domestic Product (GDP) growth surprisingly on the upside, the market pushed ahead with cyclicals, banks and consumer stocks all leading.
Newton's performance, along with the Income fund, suffered in quarter four, but our view of the world has not changed. We continue to believe the UK consumer has accumulated too much debt to fuel the last few years of consumption. Much of this has been funded by the housing market gains, but this has now come to an end for the foreseeable future. Signs of any meaningful slowdown in the housing market has yet to materialise and therefore interest rate cuts will be unlikely. Added to this, the consumer faces rising utility bills to reflect energy prices and local tax increases in the New Year. Therefore, the Christmas spending surge fuelled by heavy discounts from retailers, will not be sustainable and again the slowing consumer trend will re-assert itself.
With the consumer weak and world GDP slowing, companies are finding it difficult to achieve price inflation. This comes at a time when their own costs are rising due to commodity inflation and so we expect to see corporate profit margins come under pressure during 2006. The positive for companies is that debt is still relatively cheap, and looks set to remain that way. Therefore many will be tempted to use this to either supplement returns via buy-backs or buy in growth through acquisitions.
The valuation of the UK equity market, along with many of the world markets is not expensive. Both the price earnings ratio of 13 times* and a yield of 3%* for this year compares favourably with historic levels and a 10-year bond yield below 4%. Many companies have strong cash-flow and low levels of gearing, meaning their dividends will continue to grow making this income stream far more favourable than the static bond income. Within the market, many yields are materially higher than 4% and still growing.
Therefore, in this low return world, Newton continues to focus upon those stocks that demonstrate a strong cash flow, attractive total returns and structural growth, independent of the economic cycle.
* Source Reuters and Financial Times as of 18/01/06
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