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Survivor instincts

As investors, we are accustomed to weighing risk and opportunity but the fluid economic and earnings’ environment means that the size and nature of the risks are changing, seemingly on a daily basis. By the same token, the shifting landscape is creating significant long-term opportunities.

Despite continuing negative newsflow, are we starting to see valuations so low that the rewards on a longer-term view are becoming clear? In general, our funds have done well this year from being conservatively positioned. We started to increase the defensive profile of funds a year ago by identifying the relative attractions and resilience of large-cap stocks, increasing, for example, healthcare, consumer staples and US blue chips.

Our funds are now positioned more extremely than at any time in the past five years, with significant overweights in large caps and the US market, underweights in Asia and emerging markets and a low beta.

Our conviction has, if anything, increased with the deteriorating economic environment. However, with the accelerated market falls of the past two months, the long-term value appeal of the cyclical, oversold stocks has undeniably improved.

A key challenge for 2009 will be gauging the emerging value in cyclical stocks. We have tentatively increased exposure to some minerals stocks but testing for post-recession recovery value will require the dusting off of some valuation tools that have not been used in recent years.

Emerging markets present a conundrum. These markets are very closely correlated with the fortunes of commodities and commodity stocks. We can often get similar sensitivities through developed market-listed stocks with equally appealing valuations but arguably less risk. Our approach through this crisis period has been to de-emphasise emerging market stocks, especially where developed market alternatives are available.

At some time in the next 12 months, it will be prudent to reverse this stance but when is not yet clear as it is impossible to say at this stage how long or deep the period of sub-trend global economic growth will be.

Investors must be prepared for something quite different from downturns of the past 20 years as one of the key features is likely to be a prolonged period of consumer retrenchment. The good news here is that this increases the implicit optionality of the strong survivors – a value that we have already seen recognised by the markets in the cases of JP Morgan and Exxon in recent months.

Given the above, we will have two particular areas of focus over the next few months – attractively valued survivors and undervalued cyclicals. There are many examples of stocks that are trading very cheaply v book and cash flow, with virtually no gearing.

Jeremy Podger is head of global equities at Threadneedle

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