You are here: cherry > Press releases for December 2010 > A huge degree of uncertainty remains - but so do stock picking opportunities, says RCM’s Jeremy Thomas

13 December 2010

Jeremy Thomas, CIO UK Equities at RCM, shares his outlook for 2011: “The UK market has risen 65% from its low on 3 March 2009. Much has improved since then with the banking system stabilised, a return to growth for most economies and corporate profits rebounding rapidly. However, in many other respects little has changed. Central banks in developed markets have kept monetary policy extremely loose and quantitative easing has been necessary to ward off deflation and give a further boost to growth that has been tepid relative to previous periods of economic recovery. Global imbalances on trade, uncertainty over the long term viability of the Euro, and tensions over commodity prices and exchange rates remain to the fore. There is still too much debt in many parts of the world and a long period of deleveraging lies ahead.” Volatility in growth, inflation and asset prices ahead “The long term impacts of these challenges are highly uncertain, but it seems likely that the will of the US Federal Reserve will ultimately prevail and this will lead to a more inflationary outcome. The key questions of how much inflation, and when it will be evident, are near impossible to answer, but will be critical to financial markets. As a result we expect an extended period of volatility in growth, inflation and asset prices ahead.” Equities look fairly priced “The valuation of UK equity markets now appears fair in absolute terms, particularly if adjusted for the now high level of profit margins. It is more difficult to see the long term case for investing in cash or bonds at current yields making equities more attractive in relative terms. Equity markets in the UK and Europe are somewhat cheaper than in the US and dividend yields are more appealing, particularly given the potential for dividend growth. The UK market is international by nature, with only around one third of sales directly related to the UK economy, and a rise in merger and acquisition activity is likely. With liquidity pouring into markets from quantitative easing, generally positive economic data and continued strong announcements on corporate profits, the market should be well supported at current levels.” Periods of fear and greed “The immediate focus will be the sovereign debt crisis in Europe and the risk of a bubble in emerging markets. Commodity prices which have the potential to be destabilising as credit conditions need to be tightened in some regions and the rising price of oil, food and other raw materials pressure corporate margins and consumers’ disposable income. In short, the foundations do not yet appear to be in place for the start of the next long running bull market. We expect the market to move between periods of greed and fear and this forms the basis for our approach to managing portfolios. The key, we believe, is to be very selective in choosing which shares to own. We believe that our relatively concentrated, valuation driven, and fundamental approach to stock picking should prove well suited to the current environment.” Many high quality companies are currently at a discount “High quality companies, especially large capitalisation stocks such as GlaxoSmithKline, Diageo, Unilever, BAE Systems or Reed Elsevier are materially undervalued and this is an unusual opportunity. In uncertain economic times, these companies typically move to a valuation premium, yet in many cases they currently sit on a discount. These companies have high return on capital, sustainable competitive positions, and below average levels of economic cyclicality often with free cash flow yields approaching 10%, which is attractive when compared to government bonds on 3% or cash deposits on 1%. As a result of their cash generation they also have the scope to payout significant dividends to shareholders. In an environment of low interest rates and volatile equity markets these dividends will represent a large proportion of investor’s total return.” “A disciplined, valuation focused, approach will reward investors over the longer term. In contrast, in an uncertain and treacherous macro-economic environment, buying popular growth companies on high valuation multiples is an unwise strategy – any disappointment leads to rapid de-rating and loss of capital. Historical evidence from prior periods of range-bound and volatile stock markets, for example, the 1970s supports this view.” Wary of highly cyclical industries “Although macroeconomic developments are important for equity markets, as far as possible we avoid taking extreme bets on a single potential economic outcome. Highly cyclical industries such as mining or banks are hard enough to analyse in normal economic times. In the current uncertain environment the range of possible outcomes for many of these industries and companies is so wide that they become difficult to value sufficiently accurately to have a sensible margin of safety and we are wary of these sectors looking into 2011. Our preference is to seek out specific opportunities at the stock level. With the falls in volume and liquidity, the number of interesting equity investments off the usual beaten track for many investors has risen considerably. Often these occur in mid or small cap companies where there can be a material undervaluation combined with a potential change or event that may serve to realise value. We are finding an increasing number of these opportunities in stocks such as Henry Boot, N Brown, or Phoenix Holdings. We expect to add value here in the coming year.”

Click below to download the full press release