What Investment looks at the key issues that are driving the investment decisions of analysts and fund managers.

Investors are gradually coming to realise that some of the tried and tested rules of engagement that they have grown up with no longer apply. Dean Cheeseman, head of retail multi-management at F&C, argues that ‘It is no longer as simple as equities versus bonds. The market backdrop is changing the rules of the game when it comes to successful asset allocation. Although many believe that in turbulent times bonds are safer than equities, the current environment, and increased correlation across asset classes, means that selecting the right strategies within asset classes has become increasingly important.’

For example, he points out that ‘Surprisingly, large-cap stocks, which normally weather recessionary storms with relative resilience, have underperformed small-caps over the year to date. This has been driven by losses in Financials, currently a much bigger component of the FTSE 100 than of the FTSE 250’.

And Cheeseman adds, ‘Similarly, the gap between bond funds has widened to unprecedented levels. Corporate bond funds have displayed huge disparity in terms of performance, at some points as much as 15 per cent. The difference between a top-quartile and bottom-quartile fund is typically in the one to two per cent range over one year. It is 4.5 per cent so far in 2009. This anomaly can, again, be attributable to Financials, specifically subordinated bank positions. The decision over whether or not to hold these stocks has meant a vast difference in returns for bond managers.’

Getting the balance right
Chris Iggo, CIO for fixed income at AXA Investment Managers, takes up this theme, pointing out that ‘Investment is about securing an income stream and protecting capital (bonds) or giving up some security of income for the prospects of capital growth (equities). Asset markets have failed to fully live up to these expectations. The events of the past year or so have questioned the notion of capital preservation in bonds as defaults have risen. The past decade has seen two major bear markets in equities, and we are currently in a phase where there is not even much confidence that shareholders will get much in the way of income to offset the loss of capital they have endured.’

He adds, ‘We have looked at a lot of benchmark bond indices and stripped out the income return from the price return over the past few years. As you would expect, income return is stable but prices are volatile as interest rates change and the economic cycle evolves. The future has got to be all about managing the risks to income and the risks to capital and basing that risk management on a much more conservative and sensible approach to analysing the fundamentals.

‘For bonds, that means identifying that the risk to both the stability and value of the income stream and the protection of capital come from inflation, changes in interest rates and defaults. For equities, the risk is all about identifying the reliability of the business model and the competence of management. All of this requires active investment management, but in a way that emphasises optimising income generation and capital preservation and gets away from the over-complex leveraged risk taking that has not only done for the banks, but has also contributed to the wealth losses of recent years.’

The medicine takes effect
So how long is the pain going to last? Richard Jeffrey, chief investment officer at Cazenove Capital Management, takes the view that ‘While the severity of the downturn in activity currently being experienced cannot be questioned, developments in the second half of the year may be less treacherous than are widely expected. In effect, the banking crisis has brought forward some developments that would normally have taken place over a longer period during the recession.’

In essence, Jeffrey is arguing that the very severity of the crisis has forced governments
to act quickly enough to have a positive effect. He points out that ‘Alleviation of the financial pressure came through sufficiently early to ensure that households that might have found themselves in risk of default had the higher mortgage interest rate persisted suddenly found themselves in exactly the opposite situation. The unprecedented reductions in interest rates seen over the past six months have given many households with mortgages an equally unprecedented cash flow windfall.’

Jeffrey adds, ‘And it is worth emphasising the point that the monetary easing has
come through at a much earlier stage of the downturn in the economic cycle than is normal. The normal lag between interest rate changes and their impact on demand is between nine and 12 months. The implication is that, in the second half of this year, the improvement in household cash flows should begin to have a noticeable impact on demand.’

From small beginnings
Picking up on the technical outperformance of small-caps so far this year, Victoria Stewart, manager of the Royal London UK Smaller Companies Trust, says ‘A significant economic shock can precipitate a seismic shift in the competitive landscape of some industries, giving the survivors a much-improved position when the dust settles. We have seen this several times in very cyclical industries such as airlines and construction. Easyjet and Berkeley Group could well be beneficiaries of the current upheaval. But it is also possible to find excellent opportunities in less well known areas of consolidation.’

She also highlights several consumer-orientated areas. ‘In homewares, I think Dunelm will perform particularly well. Several competitors are wounded or exiting the sector (e.g. Woolworths), which is ripe for consolidation. Dunelm has net cash, excellent margin control and is well placed to take more market share through the cycle. In personal finance, Provident Financial is in a strong position with growth funding in place until 2011. The final demise of a major competitor, Cattles, will leave the market open for Provident to cherry pick the best customers and take market share.’

However, David Clark, manager of the Ignis Asset Management UK Smaller Companies Fund, warns investors not to read too much into low valuations and market rallies during the coming months. Indeed, he expects the March reporting season to be a particularly ‘grim’ time for markets, with companies likely to significantly undershoot analysts’ earnings forecasts and little evidence of a sustained recovery until much later in the year.

Clark observes that ‘There seems to be a consensus that a recovery is round the corner but I’m not sure that the second half of 2009 is going to be that much better than the first half. I suspect that, in the short term, we will see more efforts to improve the banking sector and that will briefly boost markets, but I would be very surprised if we didn’t see further dips in the second and third quarters. Only after that do I think we could see signs of a more solid recovery.’

He adds, ‘On a valuation level, I do not believe the small-cap market is currently “raging cheap” as a whole. The average p/e ratio of around seven is not quite as inexpensive as it looks. You really have to question the numbers you are on and the value of the stock. It is not as cut and dried as it seems. I believe the actual p/e ratio is more likely 12 times 2009 earnings.’

However, Clark does see benefits in exposure to small-caps when a sustained recovery does appear. He argues that ‘Large-caps will react first to any good news, followed by mid-caps and then small-caps. When there is a little more conviction that the recovery is here, I have total faith that small-caps will outperform, with some stocks liable to grow four or more times. Large caps will be left behind.’

Cycling through Europe
Cédric de Fonclare, manager of the Jupiter European Special Situations Unit Trust, sees selective opportunities appearing in Europe’s larger cyclical companies, having switched out of cyclicals and into defensives in 2007. He points out that ‘European cyclicals were very strong in 2006 and this had proved positive for the fund. However, going into 2007 we became increasingly concerned about valuations in this area and felt that cyclical companies would be less able to produce the reliable profits growth I look for in a deteriorating economic environment.

‘So, we reduced exposure to sectors such as chemicals and engineering and switched into more defensive growth areas such as healthcare. While this move, together with our long-maintained underweight position in banks and other financials, was a bit early, it was beneficial as growth slowed, particularly during last year.’

But now, de Fonclare reports that ‘Looking ahead, my central view is that Europe’s economies will continue to contract during the year. Against this backdrop, we have initiated positions in consumer-facing businesses, technology and capital goods companies where we feel share price declines already discount a significant part of the bad news. The common characteristics of the businesses we are selecting are: quality franchises and/or brand, the ability to grow faster than the broader sector, market leadership and strong balance sheets. We believe these characteristics will help these businesses emerge stronger from the current downturn.’

Feeling the pain
Richard Pease, manager of the New Star European Growth Fund, also sees selective opportunities in continental Europe. He notes that European investors have felt the pain more than most, suggesting that ‘the sharper correction reflects fears that European companies are more “late cycle”. This refers to Europe’s strong presence in the manufacture and export of capital goods, which tend to be ordered late in the economic cycle as companies, buoyed by strong demand and excited by consecutive years of profits, seek to boost their capacity.’

He feels that ‘The trick is to identify companies that are likely to have good managements and sensible enough business models to get through the current malaise and be in a position to take advantage of the recovery when it arrives. This does not just mean hiding in traditionally defensive stocks, but also those areas that are overlooked because of supposed cyclical sector classifications. For example, Wolters Kluwer is a media company, yet the majority of its earnings come from professional subscription-based information services that lawyers, accountants and healthcare professionals consider almost part of the tools of their trade.’

Pease argues that ‘several factors point to potential European relative strength, rather than weakness, in the year ahead. First, most European governments are in a stronger position than their US or UK counterparts. Germany is projected to borrow 2.9 per cent of its gross domestic product (GDP) in 2009, far less than the burgeoning 7.2 per cent the UK is expected to borrow.

‘Secondly, the European Central Bank (ECB) was criticised for moving too slowly in cutting rates, but in so doing it has been left with more ammunition than its Anglo-Saxon counterparts to stimulate the economy.

‘Thirdly, a strong euro acted as a brake on earnings in 2008. As the ECB cuts interest rates, the relative yield attraction with other currencies will diminish. A weaker euro would improve the profitability of those companies with overseas earnings and further support valuations.’