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Rising to the challenge

While the high hopes of the New Year may be floundering, with a little digging there is still value to be found


After the fears that rattled the markets in 2008 and then at the start of 2009, investors entered 2010 feeling much more hopeful.

At the start of the year, there was a common expectation of 20 per cent-plus earnings’ growth for the UK in 2010 against a consensus GDP
expectation of 1.3 per cent, up from the 1.1 per cent forecast in the fourth quarter of the previous year.

But given the fiscal outlook, burgeoning public and private sector debt and a continuing lack of sales growth from the corporate sector, this will be challenging.

Of course, foreign economies offer higher growth rates and many companies we own have substantial overseas earnings. Eurozone economies are expected to do little better, however, and even America is predicted to grow by just 2.7 per cent. This is a far cry from the 4 per cent-plus rate for the US being touted earlier last year as justifying a level on the S&P 500 considerably lower than that at which it stands today.

Even if expected earnings’ growth is delivered, perhaps with help from the East, other risks remain, most notably that of derating as the tightening cycle continues in China to moderate its credit expansion, and the rollback of quantitative easing in the West.

Given this macroeconomic background, how are our portfolios positioned? All stocks in our funds must have at least one tier-one economic advantage characteristic, which comprises intellectual property, strong distribution channels and significant recurring business. Other economic advantage characteristics include licences and franchises, brand, customer databases and relationships, procedures and formats, and culture.

In addition, we use three quantitative screens to gauge market sentiment and valuation levels – positive revisions to earnings’ forecasts, undervalued (high) return on capital and cyclically adjusted price-to-earnings’ ratios. Changes in the range and extent of each screen give us
strong clues about the state of the market and the current stage of the stockmarket cycle.

The level of competitor corporate activity enjoyed by the fund in the last quarter of 2009 clearly demonstrates the value available

Currently, there are many more stocks experiencing positive earnings’ revisions than 12 months ago. Positive revisions are also more likely to be rewarded by the market in 2010, unlike last year. Stocks undergoing such revisions include Aggreko, Rightmove, Domino’s Pizza, Pearson
and Michael Page.

There are several companies with undervalued return on capital sitting on attractive valuations. These include Royal Dutch Shell, Unilever and AstraZeneca.

The cyclically adjusted p/e screen, however, is very bare in comparison to the other two.

This screen is used primarily to aid stockpicking during those generally short periods where explosive market performance discounts recovery before it is evident in company profitability, such as in 2009. It is yesterday’s story therefore, and we do not have any holdings on the strength of this measure.

This does not mean we do not own any cyclical stocks but those companies we hold that are characteristically highly cyclical or late cycle appear in the positive earnings’ revisions section of the portfolios.

While it is easy to continue to be pessimistic about Western economies, and the UK in particular, the level of competitor corporate activity enjoyed by the fund in the last quarter of 2009 clearly demonstrates the value available.

We would expect further takeovers during the year ahead. Furthermore, most of our companies have a strong international focus and this diversity helps offset any particular geographic weakness.

Anthony Cross is co-manager of the Liontrust first opportunities fund


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