11/11/06

Fundamentals Article

At the moment, UK Investors are grappling with two sources of uncertainty. The main issue is the likely US economic slowdown in 2007, while the impact of UK monetary policy on the domestic economy also continues to play a part in investment decisions.

The extent to which events in the US are influencing company profits will not become evident until the end of the year. However, there are already signs that share prices of UK stocks with exposure to the consumer and the US dollar have already begun to adjust to the news.

Building materials companies like Wolseley, Carnival in the leisure sector, and aerospace stocks including Smiths Group and BAE Systems, have all seen their ratings contract to some extent. However, the share prices of equivalent US stocks, look as if they may be bottoming and we are confident that companies with strong fundamentals will recover.

Investors should be reassured by the fact that the earnings yield is significantly above the risk free yield represented by gilts - even more so when we are still seeing equity earnings move in a positive direction. We believe the valuation basis of the market will remain attractive provided inflation does not accelerate away from present levels. After all, dividends are growing at three times the rate of inflation.

Although dividends do not appear to be at risk in the immediate short term, there are some potential threats. The main area of likely concern would be any significant slowdown in the economy. There would also be problems if company profits were to fall, leaving dividend cover low. A further difficulty might arise if companies were to increase their capital expenditure significantly, as this would reduce the amount of cash available as dividend payments to investors. Having said that, average dividend growth is expected to remain in the 8-10% range for at least the next two years.

In terms of sector and stock valuations, there is something of a dichotomy. On the one hand, small and medium-sized companies are trading at historic rating premiums. In addition, defensive stocks - those deemed to have less gearing to the economic cycle - are commanding significant premiums. This leaves the large cap sectors such as resources and telecommunications looking fairly cheap. We believe that these stocks offer attractive opportunities for investors.

While economic growth will decelerate in the UK and globally, we still expect a positive return on capital. We are particularly keen on the banking sector, where our favoured holdings include Royal Bank of Scotland and HBOS. Similarly, the resources sector has continued to attract upgrades. We prefer mining stocks to oil companies due to their greater capital discipline and cost structures. Among the miners, we still believe there is value in companies such as Anglo American and Kazakhmys.

In the retail sector, we favour Marks & Spencer, due to a continuation of restructuring momentum, and WH Smith, where we expect further upgrades driven by cost savings. We have added to positions in British Airways, which is performing well, and believe the market is underestimating the potential for returns on capital to improve.

Conversely, we have limited exposure to defensive plays such as the beverage and food sectors. These are already looking expensive, and are now suffering significant individual downgrades to future earnings.

Karen Robertson, Fund Manager - UK Equity High Income Fund, Standard Life Investments

First published in The Herald on 11 November 2006.

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