Why 2012 could be a vintage year

Fund Strategy - 20 Feb 2012 | By Patrick Collinson

Unemployment is at its worst for 14 years. Economic growth is virtually invisible. Inflation, though falling, is still high. Yet the London stockmarket has in recent weeks enjoyed its best run for years.

The reason? British companies are cheap. Maybe when we look back in 10 years’ time, we’ll see that 2011 and 2012 were among the best years ever to invest.

Neptune Investment Management has a fascinating graph mapping the year when someone invests with the returns they receive over the next 10 years. 1974 was the best year ever to invest, with annual real returns averaging more than 17% for the next decade. The years 1976, 1979, 1981 and 1983 were all pretty hot, too. What unites them - apart from the fact that the country was either heading into recession or deeply stuck in one - was that the price/earnings (p/e) ratio on the market was between eight and 12. And the worst years to invest? 1971, 1972, 1998 and 1999, when p/e ratios were between 17 and an astonishing 25 (that was 1999).

So what does that say about 2012? The market is on a p/e of just over 10, and that puts us, potentially, in the gaggle of “good” years. The last “good” year to invest - when future real returns averaged more than 10% - was 1985, so we’ve been waiting for this opportunity for rather a long time. (Collinson continues below)

Mark Martin, the manager of Neptune’s UK Mid Cap fund, uses the graph to underline how undervalued he sees British equities to be. But he’s no super-bull. He sees at times extreme volatility in the market, as fear and optimism over Greece and Europe swing around in equal measure.

He’s fascinated by the psychology of markets, and when “stone age” brain takes over from “rational” brain. There has been a lot of “stone age” activity since the start of the financial crisis, but now he detects a different psychological force emerging - that being out of the market might represent too much of an opportunity cost.

”Valuations are low and, from a sentiment perspective, everyone is very aware of, and sensitised to, the European debt crisis”

His central position is that British-listed companies have stronger balance sheets than in previous years and are well-placed to weather volatility. “Generally, we are more positive now than we were this time last year, as investors now appreciate the severity of the crisis. For example, Greece leaving the eurozone is being openly discussed. I continue to expect markets to be volatile, but any sell-offs should offer good entry points in coming weeks and months.”

“Valuations are low (which is critical) and, from a sentiment perspective, everyone is very aware of, and sensitised to, the European debt crisis. Although the euro crisis is certainly a worry, the fact the subprime crisis is such a recent and traumatic memory means people are likely, at the margin, to over-react in fear.”

Martin, a relatively youthful graduate from Oxford in 2002 who joined Neptune only three years ago, has produced terrific performance with the Mid Cap fund. The portfolio is in absolute first place out of the 322 funds in the IMA UK All Companies sector over one year, with a return of 12.7% compared with the average loss of 2.3% by its peers. Over three years it generated a gain of 109% compared with the 57% for the sector, again putting it in top decile position.

The biggest surprise with this fund is how small it is. It has only £8m under management at present, but now that it has a three-year track record and the Neptune badge on it, my guess is that the money will start flooding in.

Industrials and healthcare helped the fund climb to the top of the tables in 2011. Remember that old adage, “don’t catch a falling knife”? Well, it’s not always true. Martin bought Bunzl, the distribution and packaging firm, when it was demoted from the FTSE 100 in March. It left the blue-chip index at the same time as Hargreaves Lansdown entered it. But Martin sees Bunzl as a “classic compounder, consistently growing dividends, growing profits and beating its cost of capital”. “It has exposure to global growth and sells consumable, largely non-discretionary products so it is a steady-state business. That kind of stability is harder to come by in the FTSE 250 than in the FTSE 100.”

It was a great call. Since March, Bunzl has gone from about 725p to 922p, and has re-entered the FTSE 100. March, meanwhile, was a dreadful time to buy Hargreaves - it was touching 650p and is now closer to 450p.

“In healthcare, we owned BTG, which is like a mini-Shire and offers growth in a growth-deprived sector,” says Martin. “Although the biotech sector is largely forgotten in Europe (unlike the US), innovation and technology are alive and well at BTG.” Its shares have risen from about 220p a year ago to above 340p today.

But even though Martin is number one in his sector, he doesn’t walk on water. Holdings in Millennium & Copthorne and UBM have been a drag on performance. But he’s not selling out yet. “We continue to own these, and added to them on weakness as they are exposed to global growth, especially in emerging markets, and to rising corporate profits.” M&C remains one of his biggest positions; he reckons hotels are an attractive, supply-constrained business and M&C has plenty of emerging markets exposure

Financials are perhaps Martin’s big idea for 2012. Pessimism is overdone, and valuations are attractive, he says. He expects banks to remain constrained by capital problems for some time, but that opens the door to other players. “In a capital-constrained world, where banks are fearful to lend, those who do have the ability to lend should be able to charge high prices for the provision of capital.” Martin likes Intermediate Capital and Close Brothers.

He is also keen on housebuilders, particularly Redrow. He reckons the government’s new-build strategy - which will underwrite 95% mortgages - will transfer risk from the builders to the Treasury, and could really take off.

Neptune’s economist, James Dowey, reminds us that between 1932 and 1935 the economy grew by 20%, fuelled largely by a private housebuilding boom. Maybe it will be housing that lifts Britain out of the economic quagmire.

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