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UK All Companies Sector: Manager highlight sector opportunities

Derek Mitchell 300

Earnings-related pressure remains the dominant theme, both in the US, where the fiscal cliff does appear to be acting as a considerable drag on corporates, and in Europe, where politicians continue to put political issues far ahead of any genuine attempt to restore growth.

Shorter term respite may come with Spain asking for its bail-out or following the Chinese political handover, but the chief ripostes to earnings weakness remain the paucity of sensibly priced alternatives to equities and the financial strength of global corporates.

Buoyed by further cheap ammunition from the bond markets to add to already strong balance sheets, the de-equitisation theme that started in the early ‘noughties’ will undoubtedly continue. More interestingly, any clarity on US fiscal issues or the next stage in Europe could unleash significant corporate activity – with debt markets providing the funding and valuations undemanding, the ‘buy rather than build’ argument could become very persuasive once again.

If these ‘animal spirits’ are to re-emerge, they will be seen first in a post-fiscal cliff US as that economy begins to provide genuine grounds for optimism, led in turn by a recovering housing market.

Although the FTSE 250 has had a strong run, there are still plenty of good opportunities in this area of the market. Two stocks that I favour are equipment hire group Ashtead and food wholesaler Booker. Despite its outperformance, Ashtead is still the best way to play the housing recovery.

To date, it has benefitted from the shift to rental from direct ownership of equipment, but its end markets are only now starting to recover. There’s a lot to go for on volumes, and there’s still more to go for on pricing, providing another boost to the share price. Booker is the ideal defensive growth stock.

The recent acquisition of Makro has improved Booker’s position in its core UK market, driving strong sales growth, strengthening market share and helping to expand margins by widening its customer offering. Meanwhile there is the opportunity for further upside from its growth potential in the Indian market.

Derek Mitchell is manager of the Royal London UK Mid Cap Growth Fund

Anthony Cross new 300

We believe it is important to distinguish between the prospects for the UK economy – which are likely to be restricted to very modest growth as deleveraging continues – and those for the stockmarket, which are significantly brighter. In our opinion, there are substantial opportunities for investment in UK companies that have desirable business characteristics.

Many companies have strong balance sheets and are therefore well positioned to withstand the current economic environment. We are confident that companies which have high barriers to entry, through having significant recurring income, intellectual property and strong distribution networks, will continue to trade relatively well.

We have positions in a number of companies with high overseas sales exposure, especially to emerging markets. Diageo is a good example: the beverages manufacturer has a world class global distribution network established over many decades, generating 70 per cent of sales outside Europe and about 40 cent from developing markets. It has consistently earned a cash flow return which exceeds its cost of capital (every year since 1993). Catering group Compass is another company with an attractive international sales profile. Its shares look undervalued, on a free cash flow yield premium to the market, and it has a high level of recurring income deriving from multi-year contracts.

There are also opportunities to invest in strong UK-focused businesses, although we have very little exposure to “typical” UK consumer stocks, such as retailers. We do, however, expect good earnings growth from the likes of Domino’s Pizza. Domino’s is the UK’s largest pizza delivery business with over 750 outlets.

The UK pizza delivery market is growing at around 8 per cent per year and, through its network expansion, Domino’s has been able to capture over 90 per cent of this market growth* (Source: Numis Securities).

Anthony Cross is joint manager of the Liontrust Special Situations fund

Generally weak third quarter trading updates have given us the opportunity to increase exposure to industrial cyclicals such as Bodycote. If we are correct in our reading of the next phase of the business cycle, economic data ought to start surprising positively – so returns from this area of the market should start to improve.

However, we are mindful that overall this is a weak cycle for end demand and so the amplitude of the cyclical recovery in industrial production volumes will also be low. With industrial company profit margins at post-crisis highs we will be wary of staying too long here although weak commodity prices and energy costs may allow them to remain elevated for some time yet.

In addition we are sticking with our overweight in the consumer cyclicals style – although stocks like Debenhams and Easyjet have performed very well this year, valuations are supportive, margins are recovering and trading conditions are gently improving.

We continue to favour financials over commodities – both have proved to be a good source of beta in liquidity driven QE rallies but there are signs of improving fundamentals at the banks and margins are at a cyclical low point. At some point, bank stocks may return to trading on earnings rather than yield spreads with sovereign debt.

The combination of modest economic recovery and diminishing sovereign financial stress may challenge the very high ratings of some defensive growth stocks where earnings are now coming under pressure.

Julie Dean is fund manager on the Cazenove UK Opportunities Fund


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