View from the UK equity desk
David Lis, Head of Equities, is upbeat on prospects for the UK equity market.
- We expect UK equities to rise after initial period of consolidation in 2014.
- Equities should weather the US central bank’s withdrawal of exceptional monetary stimulus this year better than most asset classes.
- Industrials look a better cyclical play on improving global growth than miners.
- We prefer general retailers to food retailers with many large supermarket groups facing challenges.
After a strong year for the UK stock market we expect a more muted performance in 2014. Nonetheless, we still believe equities remain appealing relative to other asset classes given low interest rates and an improving economic outlook. We also believe equities should weather the US central bank’s withdrawal of exceptional monetary stimulus this year better than most asset classes.
In terms of valuation, UK equities no longer look as compelling as say 12 months ago. However, with a yield of 3.3% and a price to earnings (p/e) ratio of 15.1x1,1 equities are still trading below their historic averages while interest rates remain at historically low levels. So, we believe shares are still attractive. Indeed, many defensives, like healthcare stocks, offer income levels double those of UK government bonds. Furthermore, many of these defensives have strong balance sheets and healthy growth prospects which will allow for future dividend growth.
Turning to the economic outlook, the UK has been one of the strongest in the developed world over the last year; there's been a sharp rise in employment and a surge in business and consumer confidence. The outlook for US and European economies is also encouraging. This is reflected in the US Federal Reserve’s planned withdrawal of its exceptional stimulus measures in 2014 due to the improving economy. By contrast, emerging-market prospects are worrying with weaker Chinese growth and geopolitical tensions representing two headwinds potentially buffeting the global economy.
Notwithstanding the benign economic backdrop, the UK equity market has struggled to build on last year’s gains so far in 2014. Sentiment has not been helped by company earnings growth largely trailing domestic economic growth over the last year, sparking many earnings downgrades of late. With the equity market looking more fairly valued at the end of 2013, we expect a period of consolidation before the market heads higher, supported by improving business spending, confidence and earnings.
Three investment themes are driving the positioning of our equity portfolios. First, we expect high-quality franchises to continue to be positively re-rated. So companies that can grow revenues and cash flow, regardless of economic conditions, will be highly prized. Holdings in this category include BTG, the niche pharmaceutical business with a strong product portfolio and promising pipeline of new products. Two others are Booker, the leading UK-based cash-and-carry wholesaler, and Restaurant Group, owner of strong eating franchises like Frankie & Benny's and Garfunkel's.
Mergers and acquisitions (M&A) is the second theme influencing our portfolio allocations. We expect increased M&A activity and a buoyant initial public offering (IPO) market this year. Meanwhile, Vodafone concluded the third largest corporate deal in history during February with Verizon’s $78.8 billion buyout of Vodafone’s stake in the US telecoms group, reflecting the growing enthusiasm for deals.
We expect healthy M&A volumes to support the market this year and companies with strong balance sheets will remain alert to opportunities to strengthen their competitive position.
Despite the large number of IPOs coming to the market, many have very high valuations and so finding attractive investment propositions can be difficult. As ever, we remain extremely selective in this area, looking for business models we cannot already buy through existing quoted companies.
Finally, we target “self-help” opportunities where management is taking action to improve their businesses. Whatever the state of the economy, companies can still prosper if they become more efficient and cut costs. Aviva is an example of this. The group is simplifying its operating model, focusing on its best-performing businesses to drive growth and target higher cash flow.
Oil & gas (underweight)
We believe the oil majors face big challenges, with existing productive assets in decline and access to new resources proving both difficult and expensive. However, after a dire year of underperformance by the oil-exploration sector, investment opportunities should emerge with some explorers’ share prices seemingly undervaluing their assets.
Financials (underweight banks, overweight insurance and other financials)
We continue to favour the non-bank sector within financials. Banks still struggle to cover their cost of equity. The scale of political and regulatory interference they face is also a worry that many underestimate. We prefer the growth opportunities offered by wealth managers like Brewin Dolphin and Rathbones.
Prudential is our favourite insurance stock, as it benefits from a strong Asian franchise and has a global flavour to its earnings. We also like Aviva, as mentioned earlier.
Valuations appear attractive given we believe many media companies have more robust cash flows than the market realises. Reed Elsevier, Daily Mail & General Trust and ITV all have strong market positions and exposure to the more resilient business-to-business advertising market. Furthermore, ITV has self-help potential. The broadcaster is in the fourth year of a five-year restructuring programme which is delivering efficiency savings. At the same time the company is repositioning its business to exploit opportunities in digital media and overseas markets.
General retailers (overweight)/Food retailers (underweight)
We prefer general retailers to food retailers. Many large supermarket groups, such as Sainsbury’s and Morrisons, are seeing profits eroded as discount chains eat into their market share. Sporting-goods retailer Sports Direct, and fashion brand Ted Baker, are among our preferred general retailers. Sports Direct has an attractive business model with a competitive online platform and plans to grow the business with further expansion in Europe. Ted Baker’s strong brand helped the company report annual profit growth of 26.7% in March, despite the increasing pressure on many retailers’ margins. We expect expansion in Europe, the US and Asia to help drive growth.
Mining (underweight)/industrials (overweight)
We prefer industrials over miners as a cyclical play on improving global growth. Our holdings in engineering-turnaround specialist Melrose, and aviation-services provider BBA Aviation, continue to perform well. For instance, BBA Aviation offers a quality franchise with cash flow generation that is under appreciated by investors.
In the mining sector, we target companies that employ their capital in a disciplined manner. The sector has underperformed the market in the last year with commodity prices under pressure amid signs of weaker Chinese economic growth. The fall in metal prices has prompted increased focus on capital discipline. As a result valuations in the mining sector are beginning to look attractive enough for us to consider increasing our holdings in the sector. Rio Tinto and BHP Billiton are among our favoured mining stocks with their strong focus on cutting capital spending and efficiency savings.
We are optimistic about the prospects for smaller companies over the medium term, despite the FTSE Small Cap index returning 20.4% in the twelve months to 31 March 2014. By contrast, the FTSE All Share added 8.8% over the same period.2 Despite more stretched small-cap valuations, we believe they remain attractive. For instance, strong growth and M&A activity in the mid and small-cap universe should support valuations over the next 12 months. Our portfolios are well-positioned for such trends, being built around investments in businesses benefiting from structural growth or self-help initiatives.
1. Source: Financial Times, 7 April 2014
2. Source: Deutsche Bank Equity Market Commentary, 1 April 2014