A Brighter Decade for Equities?

 

The fog is slowly lifting in the Investment World and the future is starting to look clearer. However, there are still those who believe this is just a lull and the storm will return. Personally I think it is still misty but with a good level head and understanding of the Markets it will be possible to navigate a profitable path forward.

 

What should investors be doing?   Of course, there is no specific answer and everyone's individual circumstances are different.  But if we consider the outlook for various asset classes it may be that the next ten years will be very different to the last.

 

Cash  -  Everyone should hold some cash.  How much you should have will depend on the level and security of your other income.  You should always have some cash available for emergencies because you do not want to be forced to sell other investments at a time when they may not realise their full value.

 

Currently returns on Cash are exceptionally low.  The Bank Base Rate is 0.5% and unlikely to rise before 2011.  However, the Retail Price Index is 3.7% so unless you can earn more than this after tax, you are seeing your purchasing power fall.  There are some term accounts giving a higher return if you are prepared to lock your money away for 3 to 5 years.  Do not expect Rates to rise much even when the Bank of England decides to start tightening.  The UK Banking system (and the US) requires assistance in recapitalising itself.  They achieve this profitability by being able to borrow money from the Government and Money Markets very cheaply and then lend it out at a much higher margin to their customers.  This can be seen in the Government Bond Markets where both US and UK short term Rates are below 1% but 30 year Rates are over 4.5%.  Future economic growth will be reliant on a sound Banking system so do not expect Rates to go up soon.

 

Property is an asset class that investors have traditionally liked.  Residential property prices have held up well but prices remain well above the long term average, especially when compared to average income.  My concern is that at the bottom end of the Market it is still difficult for first time buyers to get on the housing ladder.  The affordability of property is still about 50% above its long term trend for first time buyers.  What happens when Interest Rates eventually rise and, in the Rental Market Landlords are struggling to maintain rental rates?  After a tripling in values since 1996 I think property will, at best, track inflation.

 

The Commercial Property Market is likely to produce better returns than cash but, although prices fell a lot, I do not see a great opportunity for big capital gains whilst there is still a weak economy and a lot of empty office and retail space.  However, rental yields are now back around 7% so as long as capital values do not fall reasonable returns should be achieved.  If anything I think there is a danger that too much money will flow into the traditional Property Funds and this will drive up values in the short term but only to cause another setback as valuations become unattractive again.

 

Last year was a year of two totally different returns for Bond investors.  If you were invested in a Fund that invested in Government Bonds you lost money as Gilt yields rose and prices fell.  The future performance of Government Bonds will depend on many factors, particularly inflation.  The higher inflation is, the more Rates will have to rise and so will Gilt yields, dragging down prices.

 

Even more important though is the projected issuance by the UK Government which is likely to be nearly £200 billion next year.  In order to attract buyers higher yields may be required.

 

Last year was the year of the Corporate Bond as fears of companies going bust receded.  In particular, Funds investing in Financial and High Yield Bonds saw gains of over 50% in some cases.  In general, Corporate Bonds are fairly valued now but there is still some scope for gains from some of the better managed High Yield Funds, especially as they still offer attractive income rates of over 6%.

 

Equities, I believe, selectively offer the best potential returns but I think there is a certain type of Share that offers exceptional value and could produce excellent returns over the next five years.

 

Over the last twelve months Equity Funds produced good returns after an abysmal 2008.  The best returns last year came from Emerging Markets and in the UK from cyclical stocks which fell the most in the previous year.  Currently I see great potential in Shares of multinational companies that produce a high level of earnings from the Developing Markets.

 

The World has split economically since the Credit Crisis of 2008.  As Western economies have struggled, Emerging Markets have boomed, returning to previous peaks.  In the West, consumers are going to face higher taxes and are more reluctant to borrow money.  Paying off debts is now a popular strategy.  However, in Emerging Markets consumers are seeing their income rise and have traditionally been savers so they have the potential to increase borrowings to fund their new found consumer desires.

 

Whilst Emerging Market Indices have rebounded very strongly, there is better value to be found in multinational companies that generate a high level of revenue from these countries.  As the consumers look to spend they are attracted to Global brands.  The rise of the Emerging Market consumer is so spectacular that by 2030 there will be over two billion middle class people in the World.  This is a massive Market to be exploited.

 

Companies of great diversity are expanding into these Markets.  They are, in general, household names such as Unilever, Shell, Coca Cola and Diageo.  A good example I like is a company called 'Yum Brands' which was brought to my attention several years ago by Graham French, an excellent Fund Manager at M&G.  Graham manages their Global Basics Fund which I have held in the Active Growth Fund for the last five years.  I noticed in the Financial Times recently that its Share price had risen significantly as earnings had exceeded expectation by some margin.  Out of interest I had a further look at this company's website which told how it was expanding in China, for instance.  Yum Brands is the Parent Company of Pizza Hut, Taco Bell and KFC.  In China there are already 2,870 KFC restaurants and they are opening a new one at least every day.

 

Other Western companies are selling luxury watches, clothing, cars, mobile phones, medicines and financial services.    British companies feature strongly, with 30% of the FTSE 100 companies revenue coming from East Asia.  Companies such as SAB Miller (Drinks), BAT (Tobacco), Rolls Royce (Aero Engines), Burberry (Clothing), HSBC (Finance), Vodafone (Telecoms), and Anglo American (Mining) all have a high level of earnings from these Markets.   In the Active Growth Fund I am therefore increasing weightings in Funds that invest in these companies.

 

The other area I like is more defensive but also very attractive.  This is UK companies with steady cash flows, modest earnings growth and strong finances.  Many of these pay out very attractive levels of dividend with companies such as Vodafone, SSE, BP and Shell all paying over 5%.  I am not optimistic for the UK economy but I believe that the attractions of these companies will eventually lead to a re-rating of their Share prices but all the time we are waiting we are still receiving high dividends.

 

Of course, we have a General Election coming up but this is going to have more effect on domestic companies than those with international earnings.  In fact, with the Pound likely to remain weak this is likely to boost overseas earnings even further.  Yes, Equities have underperformed other assets over the last decade but do not be surprised if they become the best performing asset of the next decade.

 

In my next article I will look at some of the Overseas Markets which I think will remain attractive options for investors.

 

Please note; this blog contains the personal views of David Stephenson as at March 22nd 2010, and does not constitute financial advice.