Charles Robertson: Price is right for a return to stock market investment

Published on Saturday 19 December 2009 18:23

THE stock-market recovery has been rapid and dramatic, particularly when you look back to the levels of pessimism around in March when prices bottomed.

The FTSE 100 Index closed last week at 5,196.81, giving a rise over all but the final weeks of 2009. Many overseas equity markets have done even better. So 2009 will be seen as the year of recovery for both the global economy and risk assets in general. But this does not answer the $64,000 question: will the rally continue and do those sectors that have performed well over the past seven months have the underlying strengths to keep improving in 2010?

From the spring, as equity markets began to appreciate that the global financial system was not about to collapse and confidence increased, the UK equity market responded positively.

Not surprisingly, it was the previously hardest hit areas of the market (with the exception of the state-owned banks, Royal Bank of Scotland and Lloyds Banking Group) that led the charge with constituents in, for example, the mining sector – including Fresnillo, Vedanta Resources and Kazakhmys – more than doubling in value.

Conversely, those areas that proved more resilient in the downturn, the so-called "defensives", have not performed as well and so companies such as United Utilities, National Grid, AstraZeneca and Imperial Tobacco have either seen their share prices stagnate or move lower this year.

Using as a valuation measure the 12-month forward Price Earnings Ratio, it is now possible to buy a basket of these defensive shares at a significant discount to the wider market, and at levels not seen for many years. Typically, they offer relatively stable and growing earnings, a yield premium to the market, with dividends that are relatively secure. Many investors consider the market may begin to appraise the merits of certain defensive shares, given they include those of GlaxoSmithKline, Tesco and Royal Dutch Shell. But I worry this is becoming a "consensus view" and that investors should also be looking elsewhere in the UK market.

Despite the strong rally in cyclical share prices, valuations do not appear expensive at this stage of the recovery. Careful consideration should be given to the earnings number used in valuations, though, as peak, trough or trend/average earnings give very different figures.

Similarly, analysts tend to undervalue the rate of earnings per share early in a recovery.

A feature of the credit crunch was the speed with which companies addressed their cost base in a bid to improve efficiency. If sales grow, this should feed straight through to profits even if prices remain weak. This category of stocks could include Balfour Beatty, Marston's and Interserve.

A word of caution, however, is needed in that the "ultra loose" monetary policy has probably caused a sharp rally in the share prices of a number of companies that are financially constrained or lacking a structural growth agenda.

Companies where the share price has already recovered strongly in anticipation of a rebound in earnings will need to deliver, leading us to believe that in 2010 the market will become more selective and a theme may emerge of the "strong getting stronger".

Another interesting theme is companies who may benefit from "emerging market" growth. Again, this is perhaps a consensus view and a careful distinction should be made between a company with exposure to this growth and another that is able to profitably exploit and develop that exposure.Examples of companies we consider to be well positioned in this respect are SAB Miller and Prudential. Similarly, having exposure to companies which provide the building blocks or fuel the growth of emerging markets, also appears sensible, so we are maintaining many of our holdings in the resources sector.

Many investors seem concerned that they have missed the boat and that the "equity party" is largely over.

Maintaining a risk-averse stance would be the correct one for anyone who fears a "double dip" recession, but we are more optimistic because a number of valuation measures show the market as not looking particularly expensive just now.

Yes, the bounce back from recession will take a long time and there are many potential minefields, such as a currency or sovereign debt crisis, or a "bubble" developing in China that could derail the fragile recovery. However, spared any serious policy error, the monetary backdrop is likely to remain relatively benign while interest rates are unlikely to revert to a more normal level in 2010.

We have really only concentrated on possible negative surprises and perhaps, as Bill Jamieson wrote in last week's Scotland on Sunday, ("It's recovery but not as we know it"), new engines of growth will emerge to support the next phase of the business cycle.

Therefore, with 2010 clearly on the horizon, the total return offered by UK equities looks like being attractive in comparison with cash over the coming 12 months.

&#149 Charles Robertson is senior investment manager with Murray Asset Management