A good start to the year
Share
As political direction in the eurozone seems to improve, the outlook in equity markets appears to be turning more positive.
UK small cap equities have made a good start to 2012. In the first four weeks the RBS Hoare Govett Smaller Companies (ex-investment trusts) index made up everything it lost in 2011, with a little to spare. The change in direction is reflected in a sector-level rotation, which began in the fourth quarter, with higher risk areas of the market tending to outperform. The best returns have generally been from more globally orientated sectors such as technology, engineering, mining and chemicals, though some of the more neglected domestic sectors have also been coming back, including general retailers and travel and leisure.
One of the many frustrating issues of 2011 was that the market was governed by a tug-of-war. On one side, were macro issues, pulling toward a negative view and lowering appetite for risk assets. On the other side were what might be classed as fundamentals, including equity valuations, which have been at historic lows, and modestly positive data for the global economy, including the world’s two largest and most influential economies, the US and China. The US economy grew 2.8% in the fourth quarter, up from 1.8% in the third, with exports, employment, business confidence and retail sales generally positive and helping to dispel fears of a contraction in 2012. In China, signs of inflation moderating and a cut in bank reserve requirements provided another more positive influence on markets.
Although unrest in the Middle East can impact the price of oil and thus inhibit global recovery, the real macro risk is the euro and an end to the uncertainty over the eurozone debt crisis is key to restoring market confidence. Eurozone politicians and policymakers have given an object lesson in ‘how not to do it’ over the last six months. In spite of this, yields on Italian and Spanish bonds have fallen materially, suggesting that confidence around the sustainability of their debt is gradually being restored.
Without arguing that recently-improved risk appetite across equity markets is definitively here to stay, a lot of bad news is already priced in to a UK market trading on a p/e ratio of around ten. Within the smaller indices, the valuations of cheap and expensive stocks are certainly currently very polarised. and as macroeconomic newsflow gradually stabilises, it is likely that valuations will begin to converge again. Tactically, we have been building small positions in a range of very cheap smaller companies in order to capture part of this value rally, while maintaining our core, strategic positioning around the themes of structural growth and higher quality cyclicality focussed on the pockets of growth within the global economy.
Technology remains our most favoured sector as we believe the industry provides access to a range of strong, globally exposed growth stories. TeleCity and Anite are our preferred stocks. Among our key active positions at a stock level are Fenner and Ashtead. The former is a leading player in the manufacture, installation and (increasingly) servicing of heavy duty conveyor equipment used in mining, an area for which demand remains strong. The latter, which saw outstanding performance in the fourth quarter, is a top-three player in the US construction equipment rental market, performing strongly as operating companies increasingly opt to hire rather than buy.
As the macro outlook continues to clarify, we expect to return to a more directional stance, either defensive or cyclical. In the meantime, good stock selection remains paramount in delivering outperformance.
Dan Nickols is manager of the Old Mutual UK Select Smaller Companies fund.
To receive more relevant articles like this one, why not sign up to our briefings and breaking alerts by clicking here and Follow @fundweb
