After five years of bull market conditions – despite corrections in early 2014 – investors are inevitably starting to ask how much further equities can rise.
For now, confidence remains high, with 40% of investors still positive on UK equities for example, according to the recent Lloyds Bank Private Banking Investor Sentiment survey. Last year was the strongest for the FTSE 100 since 2009 with a 14.4% return and we are clearly a world away from the depths of 2008, when the index lost 31% and suffered its worst period in three decades. But after such a run, concerns about stretched valuations are clearly starting to emerge.
Earnings growth needed
Among fund managers, many are expressing concerns about market vulnerability unless earnings growth starts to come through. Invesco Perpetual’s Mark Barnett, who recently inherited the multi-billion pound UK income franchise from the departing Neil Woodford, says a large portion of the market rise in recent years has come as a result of multiple expansion.
“Very little has come as a result of earnings growth and a key feature of the market move over the last few years has been the lack of profit growth,” he says. “With that in mind, my hunch is that we are looking on the expensive side of fair value.” Attractiveness versus bonds has long been an argument in favour of equities, but Barnett says the differential is much narrower than 12 months ago and any purchases now must have strong absolute valuation support.
“The one thing I know about this market is that valuations have risen to a level where, if we do not see earnings and profit growth coming through, there will be price vulnerability and scope to lose money,” he adds.
While acknowledging these concerns, Smith & Williamson UK Equity Income Trust manager Tineke Frikkee continues to see a strong outlook for UK equities in 2014, backed up by an improving economic backdrop.
“UK equities had a good 2013, anticipating strong GDP number to some extent,” she adds. “These have started to materialise – the IMF was predicting 1.8% GDP growth for the UK in 2014 last October and has already revised this upwards to 2.4%. Unemployment figures have also improved and with inflation looking under control and wage growth coming through, we are starting to see increases in real wealth.”
Keep on running
With market performance last year anticipating this improving backdrop, Frikkee agrees earnings growth is required to ensure the strong run continues – and believes this should happen in 2014. “Equity markets are linked to GDP growth in a way other assets are not, so we are confident the required earnings growth should come through,” she adds. ‘That said, we are unlikely to see another 20%-plus year from UK equities and volatility will continue. Against that backdrop, we believe it is sensible to choose a less volatile equity approach and decades of research show an income focus gives you that.”
Much of the concern about UK valuations focuses on the more defensive, mega-cap end of the market, where stocks have continued to catch the attention of yield-hungry investors. On her UK Equity Income Trust, for example, Frikkee is underweight income stalwart areas such as telecoms and pharmaceuticals, seeing little growth potential in names such as AstraZeneca.
Expensive defensives
Elsewhere, Cazenove UK Equity Income manager Matt Hudson is also avoiding expensive defensives, particularly so-called bond proxies. “These sectors are my major underweight position and our view is that many of the large-cap globally diversified companies – SABMiller and Diageo for example – are trading on multiples that are too high for this point in the cycle,” he adds.
“Many UK-focused defensive names, in sectors such as water, are also very expensive for the earnings growth they offer and we are not willing to pay up for their perceived safety. Our holdings such as DH Smith do not have the ‘quality’ tag, but have a good earnings stream and are much better value.”
With defensives broadly expensive, where are UK managers finding their opportunities at present? Threadneedle’s James Thorne, who runs the group’s UK Smaller Companies portfolio, is another stockpicker seeking businesses that can underpin higher valuations with solid earnings growth – and feels the UK offers a range of such opportunities.
“Ongoing recovery will not translate into a free ride for all,” he says. “Recent retailer results highlighted a two-speed UK high street and we expect similar wrangling over market share in other sectors. Investors will only reward companies that can meet or beat earnings expectations while the others will stay on the sidelines.”
Thorne sees a range of businesses that are not only more likely to benefit from economic recovery but also have a business strategy that should lure customers away from competitors. “In retailers and food for example, the multichannel strategy is working as savvy shoppers are shunning big-box supermarkets, preferring to order online or flocking to discounters such as Aldi and Lidl,” he adds.
“Elsewhere, Ted Baker has a strong brand, developing a distinctive and sustainable brand and investing heavily in taking it global.” Within housebuilders, he says an improving outlook should mean continued demand for construction materials and housing.
“Tyman is an international supplier of door and draft excluders set to benefit from new building while homeowners are also spending more on refurbishment,” he adds. “The business has restructured to cut costs and been boosted by a recent acquisition.”
Marshalls, the UK’s leading supplier of paving stones and patios, is another favoured name, where Thorne expects strong demand as a result of the renewed vigour of the UK housing market.
Retail therapy?
Thomas Moore, who runs the Standard Life Investments Income Unconstrained fund, also sees a good case for retail, highlighting improvements in household disposable income over recent months, aided by rising employment levels and lower inflation. “While life remains challenging for many consumers, with wage growth still below inflation, things are improving in terms of cashflow and sentiment and the general retail and travel and leisure sectors have seen the benefit of increased optimism,” he adds.
“Electrical retailers such as Dixons have seen some impact from improved confidence but more significant factors have included sales driven by newer technologies, such as tablets, a shorter TV replacement cycle and management actions to change sales processes and store formats.”
According to Moore, online sales is one area of retail that has enjoyed consistently strong growth, including throughout the downturn, running well ahead of sales in stores as website functionality, delivery options and security all improve.
“Many retailers’ websites now offer consumers a broader product offering compared with their local stores, making online a very appealing alternative,” he adds. “The result is that online sales have been growing at approximately 15% and look likely to continue at this rate.”
However, he acknowledges this online shift has been problematic for many retailers, reducing sales density in store and also enabling greater price transparency, particularly on branded items, as consumers can easily compare between retailers.
“Creating a truly multi-channel experience for customers has required significant investment in IT, logistics and changes to store configurations,” he adds. “It also raises questions over the optimum number and location of store networks, due to lower in-store sales and preference among consumers for online pick-up points. Many retailers will find they have too many stores and/or stores in the wrong locations as consumer habits change.”
One retailer that has not had such difficulties is ASOS, which Moore says has enjoyed the strong growth of online shopping in the UK, as well as successfully expanding overseas.
No place like home
While exposure to companies with heavily overseas sales – particularly in emerging markets – was a major theme a couple of years ago, the improving UK economy has enhanced the benefits of domestic focus once again. Frikkee, for example, now has 52% of her fund exposed to UK earnings and a further 35% across the EU, US and Australia.
Life insurance is currently the largest position, with Frikkee citing ongoing regulatory shifts such as auto-enrolment and the Retail Distribution Review (RDR), along with the ageing population, as key drivers. Holdings include Legal & General, Standard Life and St James’s Place.
“We also like the travel and leisure sector as a domestic play, via names such as EasyJet and TUI Travel, with consumers starting to feel slightly happier about life,” she adds. “Despite this, we currently have nothing in retailers as we feel the more old-fashioned high street names are struggling to compete with online rivals.
“Supermarkets are cheap at present but the sector needs to stabilise – and work out how more established names work alongside the newer discount operators – before we would consider buying.” Other domestic plays include housebuilders, media and asset management.
“While there are various philosophical arguments against the government’s rightto- buy scheme, there is clearly demand for more housing and we are playing that through housebuilders such as Berkeley Group and Telford Homes,” says Frikkee.
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