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The acquisition trail

The market is cheaply rated, there are good profit expectations and M&A activity looks like picking up

Looking at the UK equity market over the next 12 months, we remain positive. There are a number of factors supporting our view globally.

Economic conditions are likely to be encouraging, with growth reasonable and infla-tion manageable. Valuations are relatively low and profit forecasts look achievable. Finally, with companies in a good financial position, it seems fair to expect merger and acquisition activity to remain buoyant.

In our view, expectations for US growth are too low. The consensus number is currently around 2.6 per cent. We think that number should be over 3 per cent, suggesting fore-casts will continue to rise. That may not be very high growth in a historical context but it is a lot better than people were thinking might be the case just six months ago when there was talk of a double dip.

Growth in the UK may be lower than the US but globally it is expected to be higher. The current view on global growth for this year is around 4 per cent.

Globally, inflation will be well controlled, particularly in the US and continental Europe. In the UK, it is becoming an issue and it is worrying that inflation expectations are starting to rise. But, given the relative weakness of the UK economy, unless those expectations move a lot higher, the Bank of England will most probably be prepared to allow inflation to continue to run above target levels.

Interest rates should then rise only modestly this year. That might create an inter-esting conundrum for the Bank but it is not a reason to be concerned about the overall levels of the UK equity market. What it does tell me is to be careful where you are positioned within the market.

At a company level, cashflows are generally strong both in the UK and globally. Given the broadly positive picture on the global economy, this would indicate that an ongoing rise in profits is achievable this year and probably next year.

Against that background, the UK equity market has a current price/earnings ratio of around 10.5 times prospective earnings. That looks good value.

We continue to like com- panies with international earnings. There are a number of economies that are recov-ering strongly, such as the US and Germany, or which cont-inue to grow fast, such as the emerging markets. We would rather buy those businesses which have a meaningful overseas exposure rather than a purely domestic position.

We do not have strong views on market-cap ranges at the moment. Mid-caps are trading at a small premium to the FTSE 100, which might look a bit stretched. But mid-caps provide good exposure to economic sensitivity and to merger and acquisition activity, suggesting that the current premium is justifiable.

As we see it, given current and prospective cashflows, gearing levels are going to fall to very low levels through normal trading activities. Companies will not just sit on that cash. They will deploy it, either through increased investment or through acquisitive spend.

There are currently a whole range of acquisition opportunities. Included in these are businesses that are privately owned or where private equity investors are looking for an exit. As a rule of thumb, the valuation of private companies tends to take its lead from the quoted market and this would suggest transactions at sensible levels. For the businesses we are invested in, I would far rather they were using their cash to make acquisitions today than waiting two or three years, when valuations are likely to be higher.

The one thing that makes me nervous is that the rest of the market has started to catch up with our views. I have about half a dozen market strategy papers on my desk, all of which are bullish. This makes me think there will be some short-term wobbles along the way, as is the case when expectations get ahead of themselves.

However, the crux of our argument comes down to three core factors – the market is cheaply rated, profit expectations are well founded and we will see a pick-up in mergers and acquisitions. If you put those three together, then, on any reasonable timeframe, you have a strong case for a rising market.

Ashton Bradbury is head of equities at Old Mutual Asset Managers


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