Some may think that the curtain is coming down on UK equities and the fat lady is about to start singing but we are still pretty confident over the medium term. There is no doubt that we have seen some very strong returns in the UK over the past four years but there are still a number of fundamentals underpinning the market.
There is, for instance, a relatively benign backdrop in terms of the global economy as the M&A frenzy continues, corporate health remains strong and valuations are still very attractive in certain parts of the market. In fact, one of the most notable trends to emerge over the past few years is a significant disparity between valuations and business quality – a trend that is providing a number of strong investment opportunities among UK large caps.
Bigger companies have been somewhat ignored over the past few years as investor risk appetite has risen. Rather than investing in these generally more stable, higher quality businesses, investors have been chasing returns from more cyclical companies and those that could be seen as potential bid targets.
At the same time, institutional investors have been cutting the equity exposure of their pension funds, leaving FTSE 100 companies worst hit. To compound the underperformance of large caps even further, the recent decline in the US dollar has raised concerns about companies with earnings heavily reliant on the US, many of which are in the FTSE 100. All these factors mean that you can now buy large caps at a 30 per cent discount to those further down the market. In 2003, you would have been paying a 30 per cent premium. Cheap does not necessarily mean good, of course, but if you consider that many large caps have powerful franchises, very strong balance sheets and limited debt, these stocks start to become increasingly attractive to investors. It is on the basis of these characteristics that we are now more heavily invested in FTSE 100 stocks than we have been for many years.
The only problem is that investors may need to be patient in order to reap the full benefits of such investments. Large caps are certainly undervalued but they may also stay that way for some time, given that merger & acquisition activity, as yet, shows no signs of slowing. In fact, with the recent bid by Premier Foods for RHM (which is to be funded mainly through shares rather than cash) driving up both the acquirer and the acquiree’s share prices, there could be yet another incentive for companies to prolong their buying spree.
On the positive side, it appears that being acquired is no longer just the preserve of the mid and small caps. A number of large caps (Gallaher, Legal & General and Barclays) have been buoyed by takeover speculation in the last few weeks.
It is also worth considering the large cap argument in light of the potential market risks next year. For instance, while the economic environment is generally favourable and corporate and government spending is strong, rising interest rates could increase the risk of earnings disappointments, particularly on the consumer side. To add to this, there could still be some stockmarket wobbles in the New Year, particularly if the market starts to question its assumption that US interest rates will decline in the first half of 2007. Indeed, it is on occasions like this that investors start to apply greater value to quality. So large caps can also be seen as an insurance policy, for which, at the moment, you are not paying any premium.
large cap investment may not necessarily deliver the hefty gains currently being seen among the mid caps but what you can be sure of is a reliable growth opportunity and a strong dividend for which, at the moment, you can be paying a minimal price. Not only that but should there be any shocks or surprises that change investors’ risk appetites in 2007, there is the potential for the cheapness of “quality” to be recognised once more. On that basis, (like the fat lady) we are overweight.
Richard Buxton is head of UK equities at Schroders