By Daniel Nickols
The year has started strongly for UK equity indices, but we shouldn’t be particularly surprised by this. Markets are rallying not because corporate earnings growth is surprising to the upside but because a majority of market participants are persuaded that the world is becoming a less, not more risky place: fears around the big questions of 2012 – would the fiscal cliff provoke a US recession? Would the Chinese economy experience a hard landing and would the euro currency bloc begin to break apart? – have begun, rightly in my view, to dissipate.
US data has not been uniformly strong, but the overall picture is one where economic traction is beginning to reassert itself and where the US housing market in particular, after years of torpor, has begun to grow again. With US consumer debt service cost as a percentage of disposable income at its lowest since records began in 1980 and interest rates likely to remain at current levels into 2015 we expect the housing market recovery has much further to run. This has profound implications for US consumer confidence and spending. In addition, we expect the discovery of huge US shale oil and gas reserves to be very positive for growth in the longer term. Much reduced energy costs will significantly improve US industrial competitiveness.
First quarter growth data for China may have disappointed slightly, but growth of 7-8% for that economy, particularly if it is increasingly driven by consumption rather than production, should provide a useful impetus for the global economy. Finally, while the eurozone as a whole looks unlikely to grow, the serene performance of equity and bond markets in the face of the collapse and bailout of the Cypriot banking system and protracted formation of a new Italian government is testament to the success that the eurozone authorities have had in persuading the market that their ‘lender of last resort’ message is more than just rhetoric.
In this environment, our focus has been primarily on stock selection rather than on major shifts in sector allocation. We have reduced our exposure to mining and oils, reflecting the weakness of commodities prices generally, and have taken profits amongst some of the industrial names where ratings have expanded materially, but have increased our weightings to financials in response to positive prospects for asset managers and an improving environment for specialist lenders. Our thematic biases have remained essentially unchanged – we continue to look for structural growth opportunities, for strong total return stories and for a range of special situations.
By structural growers, we mean businesses which we believe have the opportunity to deliver above average rates of growth over an extended time horizon, driven by dynamics which are either intrinsic to the company itself (a compelling and differentiated product or service) or through exposure to a strongly growing niche market, rather than being a function of wider economic growth. In this basket, we continue to like Telecom Plus, a multi-utility reseller with significant headroom for growth arising from its currently low market share and Perform Group, which monetises sports rights across a range of web-based channels and Rightmove, the dominant property portal.
Total return stories are companies delivering good if unspectacular rates of earnings growth accompanied by a high and rising dividend yield. In a still uncertain world where high but dependable yields are hard to access, companies that can deliver, within their total return (earnings growth plus rating expansion plus dividend) a high proportion of that return through the relative certainty of the dividend component will continue to perform well. Holdings with these characteristics include Greene King and Talk Talk.
Looking ahead, we remain optimistic. While a near term correction in markets cannot be ruled out, particularly given the strength seen in recent months, we would expect markets to grind higher over the balance of this year.
Daniel Nickols is manager of the Old Mutual UK Smaller Companies fund
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