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Taking stock

The first four months of this year have offered little respite from the bear market. The FTSE100 stands at about half the level of its peak in December 1999. But it provides a good background for discerning investors to start looking at the value of holding equities.

Despite the uncertain economic outlook, investors should not ignore the opportunity to pick up quality stocks cheaply.

In terms of research and information, general sector analyses are less useful during a sustained market downturn. Company resilience to difficult trading is stock-specific, not sector-specific.

Investors need to undertake a close inspection of individual companies relative to key investment objectives. With the comprehensive company and market information published during the results&#39 season, spring is a good time to make these decisions.

Companies are reporting results after the second full year of economic downturn in the UK. This is making it easier to pick out the winners from the losers. Only those businesses able to report a robust performance in the third year of difficult markets can offer much reassurance for risk-averse investors. But the wise investor will look beyond last year&#39s performance, which is no guide to the future.

In a depressed market, it is important to keep a close eye on forecasts and concentrate on results&#39 information on future earnings and dividends. Forward statements and guidance given by management during announcements and annual general meetings should demand investor attention.

The last few weeks have seen investors increasingly buying into companies that have reported solid performance for 2002 and remain cautiously confident for 2003. It is the strong recognisable brands that are seeing most of the renewed investor interest.

Stocks such as Diageo, Rentokil and Unilever have increased dividends following result announcements and have seen upward movements in their share prices.

Another factor currently favouring equities is that interest rates are languishing at 3.75 per cent, the lowest level since 1955. The recent fall through 4 per cent breaks another psychological barrier for the markets and has highlighted that dividends now offer more attractive returns in comparison with bonds and cash. Consequently, income stocks are now firmly back in fashion.

Using dividend guidance gleaned from results, investors can base their decisions on up-to-date dividend expectations and invest in an equity portfolio with the potential to provide a higher income than is currently available from bonds.

Investors keen on dividend income should also favour more cash-generative businesses and sectors. Firms holding a lot of cash should be able to sustain dividends even if they face depressed trading in the short term.

For example, the retailer French Connection recently announced a 50 per cent increase in dividend. On the same day, the FTSE 100 fell by 5 per cent while French Connection shares rose by 6 per cent.

But a word of caution on retail stocks – consumer spending is not expected to continue at the high levels seen in 2002, so some retailers&#39 earnings for 2003 are looking increasingly risky.

Businesses with long contracts are also worth considering in terms of earnings&#39 visibility. These industries are able to minimise earnings&#39 volatility and tend to function in sectors such as support services, defence and construction. Investors can expect lower earnings&#39 growth in return for a level of certainty in terms of income.

The relaxation of solvency requirements for life funds could also be significant in providing a better market for equity investment. Life insurance companies have been under intense pressure to sell equities as markets have fallen to meet their solvency requirements. Since the FSA indicated it would be willing to relax this regime in January, pressure for further selling has been reduced.

Life insurers and investors should benefit from this development and see an end to the downward pressure caused by life funds selling shares into a falling market.

Investing purely for capital growth in the share price is now a distant memory of the bull market but it should remain a factor, if a less significant one, than income and stability of earnings. With the stockmarket at seven-year lows, investors could stand to benefit from potentially huge gains in capital values.

However, there is no way to avoid the fact that the market is fully capable of falling further. Exposure to this risk can only be reduced through a careful diversification of stocks within a portfolio.

So spring offers a good foundation to form, if not execute, equity investment decisions. This is partly because of the level of information released into the market in this part of the year.

Also, in the current economic climate, it is likely that interest rates will remain low and perhaps drop further, causing an exodus from low-yielding assets and making dividend yields increasingly important. This trend should put a premium on the share price of those companies able to sustain dividend yields.

There is still a worrying level of bad news and uncertainty in the market that is continuing to depress equity valuations. Nevertheless, investors should still be encouraged at least to review the information available to them.

Investors who are brave enough to get back into equities need to focus on specific “safe” criteria such as good earnings&#39 visibility, high sustainable dividend yields and confident predictions of a solid future performance.

In making investment decisions now, investors can confidently re-enter the market once short-term concerns have been addressed. In the long term, this market could provide investors with significant returns if they choose to hold quality stocks purchased at the right price.

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