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Picking over the value prospects

Matt Goodburn says stock selection looks like getting tougher

Despite the sharp correction to the UK market in May and June, UK equities have enjoyed a fourth consecutive year of solid growth but stockpicking is likely to get more difficult.

F&C UK growth and income manager Ted Scott considers the current low cost of debt, positive profit and earnings’ numbers will ensure 10 per cent growth in the first quarter of 2007 but he fears that there may be more testing times ahead.

He believes the US slowdown may be worse than the soft landing that many people are expecting and stocks with high dollar exposure could suffer.

Scott says: “A mid-cycle correction is almost inevitable, presenting a major downside risk to equity markets. The dollar has weakened and if the consensus view that the interest rate cycle in the US has peaked is correct, any fall in interest rates could see the dollar weaken further.

“This could also destabilise equity markets if it proved to be a sharp sell-off, as it would reflect a lack of confidence in the US economy and also less attractive returns in widely held dollar-denominated assets, especially in the Far East.”

Scottish Widows Investment Partnership head of UK equities Robert Waugh expects the UK economy to moderate as part of the US-led economic slowdown but is still optimistic for the UK, particularly in the second half of the year.

He says: “Company valuations look fair on their own merit and particularly when compared with gilts and equities in other regions. We expect the UK market to perform in line with profits growth in 2007, with gains of between 5 per cent to 8 per cent.”

Waugh believes the best opportunities for returns will come from careful stockpicking and detailed analysis of individual stocks.

“This approach brought us winners such as the London Stock Exchange, Persimmon, Intercontinental Hotels and Drax in 2006,” he says.

Credit Suisse co-head of multi-manager Gary Potter also believes fund managers will have to work hard on stockpicking to achieve decent UK equity returns.

He says: “The outlook for UK equities next year will be more challenging. They have been better this year than international equities but I do not think this will be repeated.”

Potter believes corporate profits will struggle and the FTSE 250 will struggle to match its 2006 performance.

He says: “Having seen a dramatic improvement in the 250 this year, we are now favouring bigger companies for their stronger balance sheets and defensive qualities.”

Neptune UK equity fund manager Jeremy Smith also considers that large-cap stocks will offer the best investment prospects and particularly stocks with big global franchises such as HSBC and GSK.

But he believes that oil stocks may not do quite so well next year.

He says: “Our sector analysis has led to a negative view on integrated oil companies, which are suffering from their failure to invest adequately in exploration.

“Investing in oil services companies would be a good way to take advantage of the rush to find and exploit new reserves, but in the UK there is a lack of good opportunities in that area.”

Mining is another area to be avoided in 2007, according to New Star UK special situations fund manager James Ridgewell. He also believes that tobacco and utilities will struggle to keep up with their recent strong performance but he tips UK life companies to do well.

He says: “The mining sector has outperformed for some time and is showing signs of creaking as some commodity prices start to come under pressure. It is hard to see how much longer tobacco and utilities can continue to perform.”

Ridgewell also believes the FTSE 250 will struggle to maintain its recent strong performance as it becomes harder to find value stocks but he feels that selective picking of financial stocks could yield good results.

He says: “The support services sector can be a great hunting ground for little gems, given the trend towards outsourcing and efficiencies.”

Another wary note is sounded on the prospects for UK equities by Invesco Perpetual’s UK growth fund manager Ed Burke.

He says: “Our cautious stance stems from our concern that the favourable economic conditions, which have been prevalent over the past few years, for example, low interest rates, strong consumer spending and supportive Government expenditure, will not play such a major part in boosting the UK economy.”

But he believes that there are still some grounds for optimism for the UK equity market.

He cites recent upbeat corporate trading statements and the fact that numerous companies are continuing to buy back their own stock and return cash to shareholders.

This, together with continuing merger and acquisition activity, leaves him convinced that UK equities can continue to make progress in 2007, although at a more modest pace than in 2006.

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