UK equities delivered a fourth consecutive year of double-digit returns in 2006. The FTSE All-Share index rose by 17 per cent last year and is now up by 100 per cent from its March 2003 low. Can investors expect more of the same this year? Although corporate profitability remains robust and M&A activity underpins valuations, the major anomalies have disappeared and 2007 will be a stockpicker’s market.
Earnings’ momentum has been a key driver of the market’s stellar return. Having been excessively bullish during the post-bubble downturn, analysts subsequently proved excessively bearish. These extremities have dissipated. Earnings’ forecasts currently reflect a modest global economic slowdown, a scenario under which corporate profitability remains healthy.
We are relatively relaxed about the macro outlook although wary of the often discussed risks to stability such as a collapse in the dollar, terrorism or global pandemics. There is clear evidence that US economic growth is slowing but, in today’s more globalised world, a US slowdown is not necessarily cause for doom and despondency. The rise of China and India, signs of recovery in Japan and recent benign news from the eurozone suggest a world economy firing on several cylinders simultaneously. Under this scenario, earnings’ forecasts do not, in aggregate, look unrealistic.
If earnings’ momentum is unlikely to be a key driver of market returns in 2007, what about valuation? The strong rise in the stockmarket since March 2003 has left valuations looking more demanding. Mid-cap shares have strongly outperformed larger-cap stocks but this has not left the FTSE 100 looking particularly cheap. A prospective mean price/ earnings ratio of 12 for the blue-chip index looks compelling but this is distorted by the heavy weighting of lowly valued mega caps. If you exclude the biggest 15 stocks (accounting for around 50 per cent of the FTSE All-Share’s market cap), then the FTSE 100 trades on a p/e of 14. This does not look inconsistent with the faster-growing FTSE 250 trading on 15.
Valuations have been inflated by a frenzy of M&A activity which is likely to continue as global liquidity remains extremely high. If there is not a compelling valuation argument for the market as a whole, what about these lowly valued mega caps? Support from dividend yields limits the downside in many cases but that does not mean that they are necessarily great investment opportunities. We see strong value in commercial banks but many so-called defensive shares look expensive relative to their low growth prospects.
It seems odd to us that Barclays yields 20 per cent more than British American Tobacco this year (4.3 per cent v 3.6 per cent). Five years ago, investors could expect a 3.7 per cent yield from Barclays and 5.6 per cent from BAT. How have the two businesses performed over the intervening years? BAT has grown its dividend by a very creditable 60 per cent but Barclays has managed 80 per cent.
We can find numerous similar examples of companies growing strongly but trading on historically low valuations. We find it interesting that even in industries which are struggling to maintain returns, we can still find pockets of value. In the oil sector, we hold Venture Production which trades at a 30 per cent discount to BP and Shell despite faster growth and superior execution. In media, a sector which, in our view, continues to destroy value, we hold Informa, whose organic growth continues to surprise positively. We see little value in the retail sector as valuations generally fail to reflect the tougher trading environment and rapidly accelerating refurbishment cycles. Next is, however, one our biggest holdings as we believe that the market has fixated upon current trading to the detriment of its longterm franchise value.
It is this rigorous bottom-up analysis which underpins our confidence in generating strong returns for our clients in 2007. We do not think that investors can depend upon market-wide earnings’ momentum, aggregate valuation support, a macro-economic framework or indeed size biases for another year of double-digit returns.
A stockpicking approach is essential. The market is full of anomalies and while its prospects as a whole now appear less compelling, we remain excited by the number of undervalued opportunities that remain.
Rachel Durkin is co-manager of Bramdean specialist UK equity fund