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The road to recovery

After a volatile first quarter, investors could be forgiven for thinking that the R-word spells recession.

From almost whatever angle you slice the economic pie – the heavy writedowns from the banks, to dull consumer spending, property prices, or sharply reined in economic forecasts – the health of the markets and economy at large is showing severe strain.

But the point is emerging where the market and investors themselves are looking to that much more bullish R of recovery.

In the current investment climate, it is worth pausing for a moment and thinking about what recovery, and specifically recovery investing, really means. A typical strategy would see investors now piling into distressed housebuilders and retailers, yet it remains unclear when credit conditions will ease to allow any kind of recovery to be staged. No one wants to catch a falling knife.

Moreover, reading the market in the current climate is very difficult. Little has been said from a market perspective about the changes to capital gains tax but its impact over the next few months should not be underestimated.

Where investors have previously been locked into their equity holdings by a penal rate of CGT, the new 18 per cent rate gives them much greater ability to free up their existing investments.

This will boost liquidity by encouraging more trading but we may see some investors look to crystallise their gains and escape the market’s current volatility in the more immediate term, contributing to a downward pressure on prices.

Similarly, some fund managers may feel driven to pursue more liquid holdings in present market conditions, pushing down the smaller caps which receive a lot less attention from institutions.

In this climate, those investors drawn to recovery should focus on exactly the kind of stocks that have been dragged down by sentiment but where the fundamentals are still sound rather than try and play out a conventional recovery strategy.

For example, commodities have enjoyed an impressive run but we have witnessed a defensive retreat, particularly among the smaller shares. With the price of oil soaring, the valuation of assets from quality firms such as Northern Petroleum look highly conservative – often calculated at only around $70 a barrel.

Continued global industrialisation and diminishing reserves among the major players could also spark consol-idation in the sector. In short, we could see some “recovery” from a sector that has in fact borne up well in recent times. This is recovery, but not as we know it.

Where the current market may most sharply counter inherited wisdom is over the role of the consumer.

In previous downturns, central monetary policy has seen rates relaxed, inducing a consumer-led recovery. However, at present, not only is the Bank of England taking a much more conservative stance, locked in a stagflationary threat of weak growth at home combined with protracted upward pricing pressure, but external factors are also conspiring against the consumer.

Unusually high prices in relation to raw materials and commodities, neither of which look set to ease, are translating into significantly less disposable income for buyers.

It will take much more radical action than the quarter-point interest rate cuts we have seen (and the market has anticipated) to turn this situation round.

Investors should consider the prospect of an export-led recovery from companies well positioned to benefit from the weakness of sterling and neatly providing diversification away from the domestic UK slowdown.

Meanwhile, more traditional recovery targets – housebuilders, retailers, financials – need to be viewed on a stock-specific basis and with a high degree of caution.

Retailers such as Marks & Spencer, Blacks and Kingfisher, have demonstrated the value of store refurbishments and will continue to commit capital to these programmes but they can only go so far, particularly while buyers remain stretched.

For housebuilders, cautious financial markets and unattractive lending conditions remain worrying, such that their volume-driven models and high level of gearing may mean prices have further to fall unless corporate activity emerges.

Property shares, although heavily discounted, may still be very exposed if property prices drop. Their gearing could mean an 8 per cent fall in property in real terms translates into anything up to a 20 per cent fall in property shares themselves.

Arguably, the most interesting recovery play is from financials. Where companies such as HSBC have been more insulated to date by their geographic interests, others, such as Lloyds and Barclays, may see an uplift and promise a higher yield.

Encouraging first-quarter results and the hiking of dividends suggest that value is starting to emerge on a stock-bystock basis.

Dividend yields will also help offset the timeframe in which share prices themselves recover.

However, the sector needs to overcome jittery sentiment and the stubbornly high Libor rates, which undermine the hope that the worst of the crisis is over.

More removed from the financial crisis, insurers are also providing attractive yields and value is being added by the raising of premiums following last year’s flooding. The JC Flowers/Friends Provident saga may also encourage the beleaguered sector to court a little more action.

In this volatile market, it is important that investors undertaking a recovery strategy are prepared to back their investments over a longer timeframe, choose companies on a stock-specific basis and build a heavily diversified portfolio to help mitigate risk.

This should span both the number and sectors of companies held within the portfolio, to the diversity of business models and key mar-kets of individual stocks.

For many who prefer to closet-track the index, the prospect of longer-term recovery is unappealing. Funds that chart a steadily defensive course are fine but a sudden switch into cautious stocks – some of which are expensive – could come at a price if the market should fall while the benefit of recovery has been sacrificed.

All in all, investors should not feel they need to desert equities, become overly defensive or engage in risky recovery strategies at all cost.

Now is not a repeat of the painful recovery, correcting vastly inflated prices.

It is simply the case that the classically rising market of recent years has been replaced by much more divergent performance – both good and bad, allowing valuable individual buying opportunities to emerge.


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