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Viewpoint
July 2012
Navigating a slow-growth world: UK Equities
Mark Westwood
UK Equity Fund
Manager
Q: Deleveraging is a major theme in all markets. How long do you think the
process will take?
It certainly is a major theme and it‟s one that is likely to persist for a number of years. If
you look back, debt levels throughout the Western world have been building up since the
1980s. The UK is not alone here, debt levels have spiralled in the US and most of Europe
as well. This has been a long process, fuelled by low interest rates and poor regulation,
and it will be a long process to bring debt back under control. Exactly how long it takes
depends on a number of factors, including growth and inflation. But with both of these
factors forecast to remain lacklustre, we are looking at several more years.
Q: So should we expect volatility to remain high over that period?
Yes, I think volatility is likely to remain a feature in all markets, simply because there are
so many uncertainties. But we should remember that volatility is not unusual for equity
markets. In fact, volatility is the norm and the period of the 1980s and 1990s was the
anomaly. Volatility fell to unusually low levels in these decades, helped by a relatively
benign economic and geopolitical background. However, history shows that, since 1900,
there have been as many +25% years as there have been -15% years in the UK stock
market, and there have been more of both of these than there have been flat years. The
most recent decade has seen a more typical pattern re-established, and we certainly don‟t
expect a return to the unusually calm conditions of the „80s and „90s any time soon.
Q: What else can we expect in the continued deleveraging phase?
We can already see the effect that deleveraging is having on the economy, with the
current recovery proving significantly weaker than previous cycles. This is partly because
banks are seeking to repair their balance sheets, which means that they are less willing to
lend to companies and consumers. At the same time, the government is also trying to
deleverage. As part of this process taxes have risen and benefits have fallen, which of
course is placing further pressure on the consumer. The UK economy has dipped back
into recession in the past two quarters and we are likely to continue to flirt with recession
over the next year.
“We are likely
to continue to
flirt with
recession over
the next year”
Q: Why should investors consider UK equities against this backdrop?
First of all, it is worth remembering that the stock market and the economy are two
different things. UK companies are not reliant on UK economic growth. In fact, less than
30% of UK corporate earnings come from the domestic market and more than 50% come
from outside Europe. So there is plenty of exposure to faster-growing markets in areas
such as the US and Asia. Secondly, valuations are supportive. The price to earnings
ratio is low relative to the past 20 years and, while it could be argued that it was artificially
boosted in that period by rising leverage, even comparing to longer time frames the PE
ratio looks reasonable.
Q: How confident are you in the earnings forecasts that underpin that PE ratio?
The PE ratio can move around a lot as earnings expectations change and it is fair to say
that there is a lot of uncertainty about the path of earnings at the moment. That‟s why it‟s
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“Experienced
management
teams will use
cash in the
right way for
the business”
important to use a range of valuation measures. We look at price to book value, price to
cash flow and the dividend yield, both in absolute terms and relative to yields on other
assets. On all of these measures, UK equities look cheap. I suppose this is not surprising
given the level of uncertainty out there, but if you manage to look beyond the daily news
and consider the long-term cash flows that many businesses are generating, I think the
market is good value. To put it another way, I am finding plenty of individual companies
that I am very happy to invest in at these levels.
Q: What is the best approach in times of market volatility?
Some people try to time the market, but in practice this is very difficult to do with
consistent success and it can also be expensive in terms of dealing costs even if you do
get it right. We prefer to take a more measured approach. We do lots of detailed
research into companies and, once we invest, we tend to invest for the long term because
we have a high level of confidence in the business model, the quality of the management
team and the state of the company finances. So we would normally just use market
weakness to top up our holdings in those high conviction stocks where we are confident
that they are long-term winners. We will also take advantage of setbacks in individual
companies to increase our holdings if we think the market has over-reacted to short-term
news flow. We did that successfully with Tesco and Carnival earlier this year. As long as
nothing has changed in the overall story, we are happy to take a long view and we try not
to get swept away in the ebb and flow of market sentiment.
Q: How important is the quality of company management in times like this?
It‟s always important, but it is particularly crucial in tough economic times. It is worth
pointing out, though, that many companies are in better financial shape than the
government or consumers. There are lots of companies with very strong balance sheets
that are generating significant cash flows and are also able to raise money at very low
rates of interest. This cash can be used in a variety of ways: it could just be kept on the
balance sheet; it could be used to increase dividends, buy back shares, invest in new
capacity or undertake M&A activity. We have seen lots of our holdings, from BAT to
Morrisons to Centrica, raising their dividends in recent months. We have also seen
companies like the house builder Persimmon announce significant share buybacks.
Experienced management teams will be perceptive enough to use cash in the right way
for their business and that is good news for investors.
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