The euro zone crisis has intensified. Renewed concerns around Greece exiting the single currency have had a dramatic impact on financial markets as investors have pulled out of riskier assets and reinvested into government bonds. This has led to German and UK ten-year bond yields reaching record lows, while the yield on the ten-year US Treasury is at its lowest point since 1946.
David Lis, Head of Equities at Aviva Investors looks at investment opportunities in the UK equity space against this backdrop of low yields. He says:
“It’s a tough market out there. Given the lack of a decisive response from policy-makers to the prevailing issues in the euro zone, uncertainty is likely to persist. This of course has an effect on companies and the overall economy, with earnings expectations likely to suffer and the UK facing years of lacklustre growth.
“For investors this begs the question of where to invest their money. We believe UK equities look attractive relative to both risk-free assets and other equity markets. They currently yield considerably more than cash and gilts, and also provide the possibility of a rising income stream, versus a static income stream from bonds.
“We have identified three investment themes which drive the positioning of our equity portfolios. They are company re-ratings, M&A activity and what we call ‘self-help’. These themes provide investment opportunities that we believe can deliver value to our clients.”
In detail:
1. Re-ratings: High-quality franchises are likely to be positively re-rated, so companies which are able to grow revenues and cash flow in subdued economic conditions will be highly prized. Our holdings in this category include Booker, the primarily UK-based cash-and-carry wholesaler and Compass, the international catering and support services business.
2. M&A: M&A activity will accelerate as companies with strong balance sheets take advantage of weak share prices to strengthen their competitive position. The euro zone crisis is creating M&A opportunities because the shares of many UK-listed companies which derive a significant proportion of their profits from the region have collapsed. Valuations are so attractive they are proving irresistible to corporate bidders. Canada’s CGI Group recently bid for UK and European IT services company Logica at a substantial premium to the pre-bid share price. We expect bargain-hungry bidders to start emerging for other companies, too, with Aegis being another recent example where an overseas bidder has proposed a substantial premium to acquire the company.
3. Self-help: ‘Self-help’ potential is where management is taking action to improve how the business is run. Despite economic headwinds, many companies can still perform satisfactorily and prosper provided they become more efficient and keep bearing down on costs. Examples include Kingfisher, the DIY business which owns B&Q and Castorama in France. Recent results have been disappointing with first-quarter sales dropping sharply as wet weather hit sales of barbecues and garden furniture. But the company’s move to streamline its supply chain could generate substantial cost savings in the medium and longer term.
On a sector basis, our latest weightings and views include:
• Underweight oil & gas: The major oil companies face a challenging future, with existing productive assets in decline and access to new resources proving both difficult and expensive. But following recent falls, valuations are attractive. BP shares have fallen since the start of 2012 and look good value especially given a dividend yield of more than 4%.
• Underweight banks: Banks will continue to trim the size of their balance sheets for some years yet, and this will weigh on profits. Harsher regulation, including greater capital adequacy requirements, will lower returns permanently. We expect our underweight stance to stay in place for the foreseeable future.
• Overweight media: Valuations appear attractive, given many media companies have more robust cash-flows than the market perceives. Pearson, Reed, DMGT and United Business Media all have strong market positions and exposure to more resilient B2B expenditure. We are also exposed to a recovery in advertising expenditure through our holding in ITV, whilst Aegis has benefitted from a takeover approach.
• Underweight mining and overweight industrials: Aggressive earnings forecasts in the industrial sector need to be cut further, but we remain upbeat on the long-term prospects of key holdings such as Melrose and BBA Aviation. Following a series of value destroying and poorly-timed acquisitions at the peak of the cycle, we have been focusing on miners which have been employing their capital in a more disciplined manner. Major iron-ore producers can extract iron ore more cheaply so returns will be higher than we previously assumed. Our preferred play in this space is Rio Tinto.
• Overweight support services: Two companies that have proved extremely resilient through the global economic downturn are Compass and Experian. Their track record of delivering on their targets, and their future growth prospects, both organic and through acquisition, are underappreciated.
• Smaller companies: Smaller companies are attractively valued with steady M&A activity at the smaller end of the market. We are finally seeing an increase in public sector outsourcing and a number of companies should benefit from this trend.
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