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Shield yield or go for growth in UK

After many years of successful Isa seasons with investors committing money to the UK market, investor psychology is a major factor for 2003. Despite the dramatic falls in markets and the perception that many UK stocks are at very attractive levels, investors are still unwilling to commit money to the UK market. If people were to invest now, what are the prospects?

The list of possible negatives has been well documented – the threat of war, solvency levels for life insurance companies and the imbalances in the economy. The consumer is still propping up the UK economy as the manufacturing sector continues to struggle. With interest rates unlikely to go higher in the short term, the consumer and the property market are key indicators of the economic outlook on a month by month basis.

However the over-borrowed consumer must eventually be reined in and another sector take up the lead in the economy and it is in this adjustment that we see opportunities emerging.

Equity income funds look likely to be the best-performing UK equity funds as the market goes through this period of transition. Growth stocks previously commanded a premium valuation but old economy and yield stocks have valuation support and, often, better earnings&#39 visibility, allowing them scope to continue to outperform.

The ability of UK comp-anies to generate cash and increase dividends is likely to be a major attraction for equity investors in a low-growth, low-inflation economy. As the yield on equity income funds is at a level that is more or less equal to that on cash and bonds, equity investors have a rare opportunity to buy dividend yield which is ahead of inflation and is at least as attractive as the traditional safety asset classes of bonds and cash. For these reasons, equity income funds look likely to continue their period of outperformance.

For growth funds and smaller companies funds, the story is more focused on stock selection than on big themes. As most growth stocks have little or no yield, investors will be less likely to seek them out for their abilities to return cash to shareholders. Investors will instead look at each growth company – big or small – and make a judgement on their ability to grow. Successful companies are likely to generate high returns through being market leaders with pricing power in areas where there are high barriers to entry.

A select portfolio of growth stocks could outperform the market and there are a number of focus and special situations funds on the market which will look to deliver capital appreciation for investors in a challenging environment.

These growth stocks will not have the advantage of yield for safety but that is not to say that some experienced fund managers cannot produce outperformance from this area.

For the Isa season, investors will have two choices – where to commit new money and what to do with the existing list of funds that are contained in previous years Peps and Isas.

With the UK market at these levels and investor confidence still fearful, we expect to see equity income funds and corporate bond funds being the best sellers but with some growth and smaller companies funds being included in the general refocusing of old portfolios.

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