With 2008 set to be one of the worst years for investment returns on record, investors will be hoping for some improvement in 2009. However, the message from the fund management community is that, while sharp falls in investment markets should have created some opportunities to buy in at cheap valuations, it may take some time for that value to be realised.

More of the same
The key problem is, most commentators agree, that we are in for a long and painful economic downturn. Robert Talbut, CIO at Royal London Asset Management, comments, ‘I fully expect next year to be as eventful as this year in the policy, economic and corporate fields, but with financial markets at some stage making marked upward progress. However, I don’t expect any material retreat from recent volatility.’

He adds, ‘Overall, I believe the real economic news will reach its worst in the spring of next year and will be closely followed by very poor corporate earnings reports and expectations, as companies take an increasingly cautious view on the outlook. This lack of confidence will be replicated in the consumer part of the economy. However, none of this should really come as a surprise to investors who are becoming increasingly conditioned to expect a deteriorating backdrop.’
However, Simon Edwards, chief executive at Midas Capital is keen to remind investors of the cyclical nature of investment markets. He suggests that ‘In our view, while news-flow from the real economy will continue to be bad for some time, many assets are now fundamentally cheap, discounting not just a slowdown but a full-blown recession. Valuations are now extremely attractive across a range of assets and, just as they have fallen in a correlated way, there is a prospect that many assets will recover together.’

He adds, ‘There are significant opportunities in equities, corporate bonds, property and a range of other asset classes. Remember, we are now seeing massive levels of central bank and government support globally and a reduction in counterparty risk. We expect further falls in interest rates soon, together with improving market confidence as we go through 2009.’

Survival of the fittest
Sarah Arkle, CIO at Threadneedle Investments, argues that ‘The real key is what is priced into the market. In many ways, the economic outlook is clearer than the outlook for markets. We prefer companies with strong balance sheets. These companies that survive will have pricing power and will be in an excellent position to get stronger in the future.’

She adds, ‘Sterling will continue to come under pressure, which is a positive for global funds. Given the outlook, we are recommending a diversified portfolio, slightly underweight cash, given the relatively low returns you are getting from cash. On equities, we would be pretty close to the benchmark for global equity markets, having previously been underweight the US.’

However, Carl Stick, manager of Rathbone Income cautions that ‘It is important that investors keep a close eye on their chosen and focused basket of stocks. Rather than over-diversifying, a strategy that has failed in 2008, investors are better off with a basket of high-quality value stocks. Concentration on barriers to entry, pricing power, longevity of earnings streams and quality of management continue to be key to successful stock selection. Balance sheet structure in terms of leverage, internal cash generation and working capital are also very important.’

And some managers are continuing to steer clear of the equity markets. Tom Caddick, head of the multi-manager division at LV= (formerly Liverpool Victoria), reports that ‘We have been short equities for most of 2008 and are still in that position. Our key underweight has been Europe and that has been right. However, we are marginally increasing our exposure and would expect our portfolios to be broadly neutral by the end of the year.’

He adds, ‘However, if we are looking at the bigger picture, there is still a lot of bad news to come. It doesn’t necessarily mean that there will be continued falls in the stock market, just because there are problems with the economy. Given that markets tend to move six to nine months ahead of the economy, next year could be better than anticipated. Our broad house view is that 2009 will begin negatively but will end much more positively.’

Caddick feels that ‘Corporate bonds will be first out of the trough, followed by gilts, although that might be tempered by the sheer volume of gilts issuance that will have to take place. But we are sure that bonds will lead and we are reflecting that in our portfolios, with a weighting towards investment grade. At the same time, we are underweight equities and it is right to maintain that stance.’

Value is appearing
What is clear is that investment professionals do see value in current market levels. Edward Bonham-Carter, CIO at Jupiter Asset Management, observes that ‘Investors who do not currently need cash may wish to look to the long term, as we ourselves at Jupiter are doing. I believe we will see higher equity values from these depressed levels. I am not saying the market will not go lower: it may well do so. But if one is confident that the capitalist system will re-emerge – albeit with a need to reduce consumer borrowing and increasing state expenditure and regulation – then equities present good opportunities for investors taking a long-term view. Being able to buy the shares of large, well-managed companies that will be able to grow their dividends on high yields, looks significantly more attractive than the returns investors can get from other asset classes.’

Which should come as good news to fund managers who follow a “value” approach. Nick Purves, co-manager of the Schroder Income Fund, emphasises that ‘Market declines are often followed by strong returns. Low-valued shares have already made up some ground in the recent economic environment and share prices often improve before earnings recover from a downturn.’

Clive Beagles, senior fund manager of the UK Equity Income Fund at J O Hambro Capital Management adds that ‘Value does outperform over time and there are great opportunities at the moment, for example with well-run companies profiting from the demise of their competitors. What’s more, UK equities currently look as cheap relative to bonds as they have at any time since the 1950s and are yielding more than government bonds.’

However, it is important to remember that some dividends will be more robust than others, Jason Britton, co-fund manager at fund of funds specialist T. Bailey, points out that ‘With cash returns falling, the risk-free returns that investors can obtain are also coming down. Indeed, in 2008 we saw examples of why cash is not risk free. Equity income meets the needs, not only of those investors who have seen their cash returns fall, but also those looking for a slightly more defensive return to the market.’

He adds, ‘UK Equity Income funds provide a cautious exposure to the equity market, partly because of their bias towards large, more stable and defensive companies, and partly because the FTSE 100 has a great diversification of its income, indeed over half the FTSE 100 dividends come from overseas earnings.’

Britton argues, ‘Provided good managers are chosen, who can successfully avoid those companies cutting their dividends in 2009, investors have the opportunity to buy dividend earnings at unusually low valuations, thanks to the 2008 bear market. We see this as a compelling buying opportunity for the UK equity income sector.’

Leading the recovery
Jane Coffey, head of equities at Royal London Asset Management, also insists that there is value to be found in some sectors of the market. She reports that ‘My favourite sector last year was pharmaceuticals and although share prices are slightly lower than they were at the start of 2008, they have proved to be a good defensive bet while the rest of the market lost over 30 per cent. I think 2009 will be another comparatively good year for the sector, with GlaxoSmithKline and AstraZeneca continuing to deliver good dividend growth and benefiting from the continued weakness in sterling, through strong US sales.

Coffey points out that ‘With interest rates coming down rapidly, the five per cent yield offered by both companies will look increasingly attractive. Elsewhere, companies with low debt and visible earnings are likely to outperform the broader market. Vodafone, Cable and Wireless, Croda, 888 and Playtech fit these criteria and look attractive at current prices.’

She adds, ‘Looking further into the year however, the best opportunities will come from those areas of the economy that will either lead the recovery or have been worst hit so far. Only companies with the strongest balance sheets and most competitive positions will survive the current turmoil, but those that do will emerge far stronger than before the recession. Lloyds/HBOS would be my choice in the banking sector, as they will have a dominant position in UK retail banking which should return to being a higher margin, but less leveraged, business than it has been this century.’

Coffey concludes, ‘Within the consumer field, I believe the holiday companies will also benefit from renewed pricing power as capacity is removed from the sector. Thomas Cook and Tui Travel have an effective duopoly in the tour operator market, while excess airline capacity will have been removed and small independent operators will suffer from their perceived lack of security and buying power.’

Much of the focus is on larger-cap stocks, that could have the resilience to weather the coming economic storms. And while there is also value emerging among the small-caps, it may take more time to appear. Mark Niznik, co-manager of the Artemis UK Smaller Companies Fund, is confident of the prospects of the UK small-cap sector, but on a three- to five-year view. He says, ‘We feel that investors have anticipated a more difficult trading environment, with the small-cap index having more than halved since last summer putting valuations on a 30-year low. Meanwhile falling interest rates tend to be good for small-caps and we note that smaller company directors are showing confidence by actively buying their own shares. We saw a similar situation in late 1998 and 2002. We also believe that the effects of the recession have been priced into the market and that investors will benefit from an increase in merger and acquisition activity in the sector, once the current bank lending blockage eases.’

Looking further afield
What about overseas equity markets? Oliver Russ, manager of the Argonaut European Income fund, feels that ‘Europe offers once in a lifetime value. Recent market moves have left European equity as cheap as it ever has been within recent memory. As regards potential dividend cuts, Europe will prove to be more robust than the UK, where up to a third of yield may be at risk. The lesson of history, one from which investors should take comfort, is that dividends are much more resilient than earnings. In fact, dividends have risen this year, in contrast to an earnings decline in Europe.’

However, this does not mean he is predicting an imminent bull market in Europe. ‘Confidence has been shattered to an extent we would not have believed possible a year ago, and so any recovery will probably be tentative for a good while, and punctuated with sell-offs. However, the time has come to look at recovery stocks, and to begin to position for the ultimate upturn – retail and consumer stocks are beginning to look quite compelling.’

Japan has been a perennial harbinger of recovery, only to disappoint investors that have ventured back into its stock market. However, Michael Wood-Martin, Japanese equities fund manager at Henderson Global Investors, reports that ‘Despite a weakening economy, it has been encouraging to see Japanese companies willing to indulge in corporate activity overseas. Such activity has not been high on the corporate agenda until now and should be construed as a sign of confidence among management.’

He adds, ‘Foreign investors in Japanese equities have cut and run over the last few months and the export market remains an area of concern. But overall the country is not too badly positioned. If the US can drag itself up and off the canvas, and persuade its nation of consumers to keep consuming, then Japan’s exports would spring back into life and the economy would be handily placed for a recovery. The stock market would respond very favourably to such an outcome.’    

Emerging strengths
Even better value could be found in the emerging markets. Kim Catechis, head of global emerging markets, at SWIP, suggests, ‘From a valuation perspective, emerging markets have become much more attractively priced. Towards the end of last year, this discount had all but disappeared and some of the more highly valued markets, such as China, were actually trading at a premium to developed markets.’

He adds, ‘Now, emerging markets equities are trading at a discount to their developed counterparts. Investors with a longer term outlook have the opportunity to access world class premium growth companies, offering the potential of superior earnings growth and significant returns on investment.’

Catechis admits that ‘In the short term, volatility is likely to persist and investors are still very risk-averse. However, in the medium to long term, emerging market equities are well-placed. Compared with prior financial crises, developing countries are in a much stronger position. This time round the world is relying on the likes of China and India for growth. This is actually an excellent opportunity for longer-term investors.’

Perhaps less surprising is the degree of bullishness among managers of funds investing in the US, given the assumption that, having been first into the recession, the American economy will also be first out. However, Simon Moss, fund manager of US equities, at SWIP, suggests that investors in the US concentrate on large cap stocks. ‘Bigger is better when looking at a US market recovery. We are currently analysing large global companies which have exposure to emerging market economies such as China. We are expecting these companies to do better relative to the market over the next year and recover quicker as markets improve. Over the longer term, we see growth in mega-caps as a key driver to performance.’

He adds, ‘We expect the dollar to remain strong relative to sterling and the euro. The dollar is still seen as a reserve currency enabling the Fed to raise more capital and provide further stimuli to the market, more so than we will see in European markets.’