The key to operating an investment trust in the current volatile market is shrewd bottom-up stock selection, focusing on either a particular sector, region or country opportunity, rather than the top-down approach of the previous bull market
How times change. Emerging from a savage bear market, asset allocators find things very different. Now, the wise allow stock selection largely to determine asset allocation.
That is to say, an over or underweight country, and regional or sectoral position stems from bottom-up and not, as in the roaring bull market, from top-down. The UK stock market had another strong month in September, led by sectors like steel, mining and construction. Oil and materials stocks also continue to do well.
Corporate earnings have been mixed, but disappointments have in some cases been severely punished. For example, Compass, a food services company, fell by 29% last month. Certain sectors, including food manufacturers, are struggling. They face cost pressures and are unable to pass on higher prices.
We recently bought European steel company Arcelor. Price differentials between US and European steel are unsustainably high, and Arcelor should benefit from any narrowing. In the UK we have bought stockbroking firm Collins Stewart Tullett, and switched US energy stocks, selling Pioneer Natural Resources and buying EOG Resources.
Stock selection will continue to have a macro overlay. Subject to the over-riding issue of stock selection, two questions remain the same for asset allocators. The first of these concerns Japan. Against the MSCI All Countries World index's 9.3% weighting, what is the right thing to do?
We continue to believe that the outlook for the Japanese market is encouraging. This is based on what is occurring at Japanese corporates. Not only are earnings growing through cost reductions but companies are buying back more shares and increasing dividend payments. We continue to hold a large weighting in companies which are capable of doing much more for shareholders.
In 2004 the supply of stock from domestic institutions should fall considerably - they have already cut their equity weightings.
The risks to our positive view are overseas' stock markets falling (as this could cause foreigners to sell) and a sharp appreciation of the yen. The latter is something the Japanese authorities have been resisting for most of 2003.
Japanese valuations still look attractive, both on an absolute basis and relative to other markets in the developed world. During 2003 there were more corporate transactions. These will be the driving force for further reductions in costs, which we would expect to see in 2004. Increasingly the effect on profitability will be company specific.
The second big asset allocation call is emerging markets. We are, in short, very positive. Emerging markets are always first to recover from the trough of economic decline. In five of the last six economic cycles, Asian markets have been harbingers of recovery.
We think they will be again, as this seventh cycle turns. We expect the convergence of China and emerging Europe with the EU to be key drivers of the emerging markets' continuing outperformance this year, as at least for the next couple of years. Growth in China may not be front-page news, but the country's 1.3bn population and economic dynamism are propelling it towards the global arena and creating opportunities for investment. Since its accession to the WTO together with infrastructure development continuing apace, demand for commodities and metals in China has reached critical mass.
China is the third largest consumer of metals, after the US and Europe, and accounts for 15% of global demand. It should push Europe into second place soon. It already consumes more steel and copper than the US, and accounts for well over 50% of the growth of several commodities.
In terms of regional bets, we like Asia. But we are underweight Latin America, due mainly to rising global risk aversion. And while we find Brazil attractive, we see better opportunities in Asia. We favour emerging Europe for reasons of convergence. On emerging markets as a whole, we are very bullish and expect an absolute and relative outperformance from this asset class for the next couple of years at least.
For alpha, the return above the market return, investors will use specialist niche managers to run high conviction concentrated portfolios which aim to achieve long-term capital growth from UK and international stock markets.
And what of private equity? It offers strong historic returns with limited correlation to stock markets, and is seeing growing interest from investors in alternative assets, including private equity.
Access to that is normally very difficult for private investors. But around 13% of the trust I manage invests in a private equity fund of funds. So, within the structure of a generalist international trust, investors can access the advantages of smaller specialist trusts.
Tom Walker manages the Martin Currie Portfolio Investment Trust
Japanese valuations are attractive compared to other developed countries.
The convergence of China and emerging Europe with the EU will be key drivers of the emerging markets.
UK stocks are doing well in steel, mining, construction, oil and materials.