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An eye for earnings

Aslowing UK economy is leading to an increasingly polarised equity market. At one end of the spectrum, despite valuations becoming more attractive, consumer-related firms are facing an earnings’ squeeze over the next 12-18 months as consumer confidence ebbs away.

At the other end of the spectrum are the mining, oil, and commodity companies. These are the areas of the market that will most likely see earnings upgrades despite the fact that the valuations of these firms are not as compelling.

What do we prefer? Cheap companies or those that we think will have the chance of being upgraded?

For us, the bottom line is earnings’ security. If we are confident that a company can deliver earnings in these tough market conditions, it is more important to us than cheap valuations.

It is more than likely that house prices in the UK will see a double-digit fall in 2008 and this will have a knock-on effect on consumer confidence. These combined factors will act as a constraint on the profit growth of UK companies as they do not have the sufficient pricing power to be able to pass on the higher costs of inflation caused by the current high oil price.

As such, unless we see aggressive cuts in interest rates by the Bank of England, we could see GDP growth in the UK going negative. However, while we see the possibility of another two 25 basis points cuts to 4.5 per cent, we cannot see rates dropping as low as 4 per cent.

The reason for this is the structural issues that would follow, namely the threat of inflation. The last producer price index data showed a 20.6 per cent year on year rise. It is also conceivable that the consumer price index may hit 3 per cent this quarter, prompting a letter from the governor of the Bank of England to the Chancellor. It is this high level of inflation that will curtail the BoE’s ability to aggressively cut rates.

Against this backdrop, we are currently avoiding consumer-related companies. Banks, property, housebuilders and general retailers will all be likely to see a real earnings’ squeeze.

The banking sector is an interesting theme. The rights issue announced by the Royal Bank of Scotland indicates that banks are starting to rehabilitate and recapitalise. However, at this stage, there still remain too many issues for us to revisit the sector and as such we are currently underweight. An economic slowdown would also negatively affect the chances of any earnings’ upgrades.

So, where will be the areas that see upgrades and subsequently outperform? Companies that are exposed to the high price of oil is one area we are overweight in. It is our opinion that oil prices will remain at current levels for a number of months yet.

However, companies that will see upgrades do go beyond just oil and mining shares. If you look hard enough, there are a number of areas where you can find likely upgrades such as support services and oil services.

The support services companies we like are those exposed to infrastructure projects. Examples of high-value capital projects that companies can get exposure to are the 2012 Olympic Games and the widening of the M25. There has been under-investment in a lot of oil infrastructure and subsequently there are a number of specialist oil services companies that have started to be upgraded by the market. These upgrades are backed by strong outlook statements and active M&A.

Indeed, despite the oncoming economic slowdown, we believe we will continue to see M&A activity in the FTSE 100 but not so much in the FTSE 250. This follows the theme of 2007, which was the first year since 2002 when the value of M&A in the FTSE 100 was more than the value of the FTSE 250. There may not be the same level of knockout bids but activity has been focused on mining and specific franchises where valuations are reaching a sustained level of earnings” distress.

Brian Gallagher is manager of the UBS UK equity income fund

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