Despite the short-term volatility prevalent in the UK market so far this year, value can be found in the media, telecom and life assurance sectors
This week's debate focuses on the UK equity market. Present were Jeremy Smith, manager of the Neptune UK Equity fund, and Ben Russon, who heads up Newton's UK Opportunities portfolio.
Is the outperformance of smaller companies sustainable and is your portfolio geared towards that area of the market?
Jeremy Smith (JS): It is interesting that at the start of the year, we once again had this debate among market forecasters as to which segment of the market would outperform. And for the third year running, everyone pointed to the top 10 stocks in the market and said how cheap they were and they would obviously do a lot better. As we got to the end of the first quarter, interestingly, they continue to do quite poorly.
One of the smaller company sectors where I have not been invested in for many years but have started to find good ideas is the technology area, IT services in particular, where the sector has moved to nearly a 50% yield premium to its 20-year average.
Are there any clear sectoral themes or biases that you are currently pursuing?
JS: At Neptune, our investment philosophy is to analyse sectors from a global perspective. What we are trying to do is to position our country portfolios for the right point in the business cycle. We have the capacity to have zero positions in the very largest sectors of the market and very large exposure to some of the smaller ones, driven by our analysis of the structural factors underpinning each of those sectors and where we are today in the global economy.
The biggest sector exposures I have today are the media sector where we are trading at five-year relative lows and there are increasingly positive signs that the advertising cycle may be beginning to turn slightly upwards.
Life assurance is another key sector, where our analysis of the savings industry has highlighted the UK as one of the most exciting areas for growth in personal savings and investment.
Ben Russon (BR): Netwon UK Opportunities fund has strong positions in the media sector, as we see a lot of attractive opportunities and value there. We also have big positions in the life assurance sector, again trying to play the growth in savings on a global basis. We also have strong representation in the telecom sector where we think there are some attractive opportunities.
What is your view on the oil sector?
JS: The oil industry is a good example of the way we approach our sector analysis. Neptune was quite early into the integrated oils, about three and a half or four years ago, when they were deeply unpopular with the oil price quite low. These came out of 2000, 2001 and sat there with a degree of underperformance for a number of months before finally benefiting from very strong outperformance as the oil price accelerated in 2004.
We then moved through the integrated into the oil service sector where the cost inflation that the former are currently suffering from is benefiting services companies for about the first time in 20 years.
But within the sub sectors in the oil services, we are beginning to see some signs of overheating and oversupply. The lead times for example to build a seismic vessel for sub sea research is only about six to nine months. And so the windows to invest are quite small in these industries, which are highly capital intensive and where supply can exceed demand quite rapidly.
From a global perspective, we favour the national companies and not the western based integrated stocks. So in our Global Equity fund for example, we have no western based companies at all, they include Chinese and Russian companies.
BR: As a house, we have a positive view on the oil sector, primarily based on the big picture that the Opec cartel can maintain the supply discipline in order to maintain oil prices around these levels.
That is primarily based on the view that field depletion rates are increasing as companies find it harder and harder to get the oil out of the ground from their existing resources, which has affected the spare capacity of the industry.
So the supply and demand dynamics should maintain oil prices at these higher levels.
The larger integrated stocks, BP and Shell, did have a difficult year last year but we feel now that BP should be able to turn the corner into 2007 and 2008 and start to produce some production growth and an element of earnings growth.
Are you expecting market volatility in the coming months?
JS: We have certainly experienced a lot of volatility in the UK market so far this year. The M&A boom and frenzy has been exacerbated by the profusion of short-term investors, whether they be trading desks or event driven hedge funds, creating a lot of liquidity in individual names.
The frenzy for individual stocks is approaching the same sort of levels as we saw back in the dark days of early 2000 when the market began to move away from investment and towards pure speculation. And I feel we are in that kind of gamblers' paradise at the moment where the fundamentals of individual businesses are largely being ignored, due to the dominance of very short-term investment horizons.
My personal opinion is that this year will not be a dazzling year for UK equities, mainly because of the exposure of profitability that the biggest companies in the index have towards a slowing growth environment in the US economy and obviously a more challenging consumer spending environment in the UK.
BR: We have now had four years of double-digit market returns and the last two years of that has been based on genuine earnings growth. And so this year, looking forward, you are going to need to see earnings growing again in order to drive stock prices forward.
In essence, there is no reason why that cannot happen. I am not suggesting we are going to see anything like the returns that we have seen in recent years but in the absence of any shocks, there is no reason why the earnings and indeed the UK market will not make some steady progress this year.
Are you tied to growth or value in your portfolio?
BR: We would not like to pigeonhole ourselves in the growth or the value camp. We are seeking investments in companies with sustainable growth profiles and valuation is always going to be a central tenet of our investment approach. On the growth angle, in this environment, we are really seeking out stable, sustainable growth opportunities and trying to avoid the cyclical areas that have been performing quite strongly in recent years.
JS: Neptune's philosophy is very much the same, to have a pragmatic style driven by business cycles and relative value. What we have seen over the last six years as value has outperformed growth decisively is a huge de-rating of what were perceived to be growth industries, whether they be the media sector, technology, telecoms or pharmaceuticals. Stocks like Glaxo and Astra have effectively seen a halving of their ratings.
Within banks, you have seen HSBC go from 16 or 17 times down to a much lower double digit p/e ratio. All these businesses that were perceived as being global titans operating in growth industries producing steady growth have been hugely de-rated in this rush for smaller mid-cap companies.
So in summary, most of the ideas that we are picking up now are actually in sectors I never would have imagined investing in five years ago because they were too highly valued against the rest of the market.
What are your concerns for the rest of the year?
JS: We are in a highly speculative market and there are a lot of short-term funds that are not looking at any fundamentals or valuations or relative valuations of individual businesses. They are purely speculating on where the next bid target is and as long as we are in that very volatile, very speculative environment, it is difficult for the fundamental investor with a longer-term investment horizon to product short-term performance.
I feel very confident that I have got the right portfolio to outperform over the next 12 to 24 months but on a month by month basis, it is down really to the individual stocks and how they are performing with regard to sentiment.
BR: Newton UK Opportunities fund is really there to offer investors exposure to the whole Newton process, including the strongest ideas coming from our team of analysts. As Jeremy says, in this M&A liquidity driven market, there is an element of luck as to whether you are involved in the latest bid or rumoured bid or whatever, which will affect short-term performance.
But over the longer term, it is really a case of continuing to do what we do and pick the right stocks that we feel will be well positioned to perform over the longer term. My main concerns really would be macro and it is the risk that the problems in the US sub-prime arena either worsen or spread wider and cause more global repercussions.
Closer to home, the biggest risk is probably wage inflation and such wage pressures could put the MPC in a very difficult position if you have the inflation statistics pushing forward. But fundamentally, I think as long as you are happy with your portfolio and the stocks you have got for the longer term, you can ride out any short-term volatility.