In what was a very difficult quarter for equity investment, the FTSE All-Share Index delivered a total return of -13.5%. Investors increasingly fretted about the eurozone sovereign debt crisis and questioned whether politicians would be able to find an acceptable solution to the problem, thereby avoiding contagion to the broader European and global economy through the banking sector. With the environment being very much one of ‘risk off', economically sensitive companies were sold as investors sought refuge in those sectors perceived to be defensive or resilient. Corporate updates generally remained relatively benign, with a limited number of profit warnings, typically company specific in nature. Economic data suggested a typical mid-cycle slowdown rather than anything more serious, which is consistent with recently issued IMF forecasts for anaemic global economic growth. This serves to reinforce our view that the key focus for stock selection must be on quality and balance sheet strength.
During the quarter performance benefited from positive stock contributions from Northumbrian Water, Dunelm, IG Group, Holidaybreak and Pennon, as well as from a lack of exposure to mining and banks. Northumbrian Water and Holidaybreak received agreed cash takeover bids, with both holdings sold at a small discount to the bid price. Our preference remains for companies with strong market positions and robust balance sheets that we expect to be the longer term winners. New holdings were initiated in United Utilities and WH Smith. United Utilities trades at close to its regulated asset value, in contrast to recent bid activity in the sector at a premium of more than 25% to asset value. WH smith offers a dividend yield of almost 5% (and growing), a solid balance sheet and predictable cashflow, with an airport travel business that is expanding internationally.
Looking ahead, the eurozone debt crisis is likely to remain centre stage for a while yet, with the forthcoming G20 meeting in Cannes at the beginning of November expected to be a key focus. Investors are currently overlooking the overall strength of corporate balance sheets and ongoing cashflow, which should encourage M&A activity in due course and will be supportive of the market. This underpins our preference for mid cap shares over mega cap companies, which are typically bid-proof and far more likely to be acquiring their smaller brethren. Our central economic view remains one of ‘muddle through', with growth in developed economies expected to remain anaemic for a number of years. Although politics remains a key risk, we believe that any resolution of the sovereign debt crisis would be a positive catalyst for the stockmarket. With interest rates low and inflation in the UK still rising, we believe that equity income offers an attractive source of growing income in a difficult environment.
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