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Reasons to be cheerful

The outlook for UK equities is positive, particularly for investors who take a long-term view

Generally speaking, I would say that UK equities are attractively valued, both in absolute terms and particularly when compared with other assets such as Government and corporate bonds. Certainly, there are risks on the horizon for the global economy, with investors becoming increasingly concerned about what will happen to the US consumer in 2007. But I do think that these fears are to some extent already reflected in valuations.

We see many reasons to be positive about the outlook for UK equities, particularly for investors who have the long term in mind. Corporate balance sheets are in very good shape after several years of paying down debt. Companies do not seem to be pursuing the ambitious investment plans that often seem to mark this stage of the economic cycle.

Instead, we are seeing an encouraging discipline from firms in terms of returning capital to shareholders through higher dividends and share buybacks.

Many parts of the market are looking very attractive indeed. For instance, defensive sources of earnings from sectors such as utilities and telecoms look undervalued. We are seeing value among the large caps – the valuations placed on many of the UK’s biggest companies have become increasingly attractive as a result of what we view to be an overly pessimistic view by the market on the prospects of these companies.

At the same time, many institutional investors have in recent years been reducing their equity exposure in favour of other asset classes. This has manifested itself in a gradual depression of the prices of the biggest, most liquid stocks in the UK to the levels we see today.

The price/earnings ratio on the FTSE 100 index has fallen from a peak of over 30 times earnings at the turn of the century to just 12.2 times earnings now. During the bear market, such a de-rating was understandable if not inevitable but even since 2003, while the market has been rallying strongly, the p/e on the FTSE 100 has continued to decline.s

I believe that the gradual selling of UK equities by institutional investors has contributed to this continued de-rating of the UK’s biggest companies. Many of these companies such as Vodafone, HSBC and Royal Dutch Shell have dividend yields which are well above the market average, making them particularly attractive for investors seeking total returns.

One further consequence of the institutional selling of UK equities is that the ownership structure of the UK stockmarket is very different now to 20 years ago. In 1989, pension funds and insurance companies owned 50 per cent of UK stocks but by 2004, this had fallen to 33 per cent. In their place, we have seen a rise in prominence of overseas investors from 13 per cent to 33 per cent and other financial institutions such as hedge funds from 1 per cent to 11 per cent.

In the case of hedge funds, the use of leverage demands a more immediate investment horizon. These changes have contributed towards a significant rise in market turnover. In the early 1990s, annual turnover of the FTSE 100 was typically around 40-50 per cent but this has risen as high as 150 per cent in recent years. In other words, the implied holding period of a FTSE 100 stock has fallen from two-and-a-half years in 1990 to just nine months in 2006. Despite the market’s increasingly short-term focus, we have remained long-term investors.

Turnover on our main UK funds is low, with an implied holding period of nearly four years, in stark contrast to the market. The market’s short-term focus provides opportunities for long-term investors. Dividends drive equity performance over the long term but sentiment can be a key driver over shorter time periods. Short-term swings in sentiment can therefore cause share prices to move away from fundamentals.

Ed Burke is manager of the Invesco Perpetual UK growth fund


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