Misplaced optimism has led financial markets to regard UK recovery as normal, warns leading fund manager

News - Banking

Written by Ray Clancy

Thursday, 22 April 2010 12:00

The financial markets are wrong to believe there is a normal recovery underway in the UK and the commodity sector is showing classic signs of an investment bubble, it is clamed.

In reality the recovery far from normal, despite stock market behaviour, and fund managers seeking to move up the quality scale may struggle with rising valuations, says fund manager, David Stevenson of the Ignis Cartesian UK Opportunities Fund.

Stevenson, who has outperformed his peer group in nine out of the past 10 years, but lagged the cyclical rally in 2009, says the performance of the FTSE All Share since its nadir in 2009 has fostered a false sense of confidence, pointing out that the rally was fuelled by unprecedented intervention and a realisation that the broader economic environment was less dire than previously feared.

‘The progress of the market over the past year or so has given rise to misplaced optimism. The recovery in the UK is still tentative with notable hurdles remaining, including a weak currency, high national debt and the potential for a hung parliament,’ he explained.

‘So while the stock market may be behaving as if this is a normal recovery, we believe it is definitely not. Indeed many weak companies, while given a temporary reprieve in the risk rally, will come under renewed pressure in 2010 as risk appetite moves sharply lower,’ he added.

While debt-laden companies with poor fundamentals have been at the vanguard of the market resurgence, Stevenson says it will be quality companies, those with a record of generating free cash flows and paying dividends, rather than those reliant on stimulus or debt finance, that drive market progress during the remainder of the year.

‘What we are likely to see now is a welcome return to rationality. Companies we expect to do well will be those able to demonstrate attainable recovery targets, value creation, undervalued growth and a secure yield, preferably with an international bias. Those we are avoiding tend to exhibit recovery risk, value destruction, strained balance sheets and a heavy reliance on domestic discretionary spending,’ he pointed out.

As investors begin to fortify portfolios against potential headwinds later in the year, Stevenson believes asset managers may struggle to gain exposure to quality names at attractive valuations. ‘Quality is in growing demand but it may not prove easy for fund managers to move up the quality scale. As sentiment shifts further, the prices of the more resilient UK listed companies, and the portfolios in which these are already held, such as our own, have the potential to rise sharply,’ said Stevenson.

Stevenson currently favours companies generating overseas earnings. From a domestic standpoint Stevenson says it is still possible to find companies that have established a niche in the market and are therefore able to remain profitable in leaner times. A key example is Halfords, a recent addition to the portfolio.

‘Halfords recently announced the acquisition of Nationwide Autocentres, which will provide the opportunity for sales and cost synergies through the dual rollout of operations, with Halfords capable of double digit earnings growth for the next two years. The stock is currently trading on a cheap valuation and offers an attractive dividend yield,’ he explained.

Stocks Stevenson is particularly keen to avoid, on the other hand, are those in the commodity sector. ‘This is an area of the market demonstrating classic signs of an investment bubble. In the last year, much of the demand has been artificial, with the injections of liquidity and rising appetite for risk leading to commodity reflation. When the liquidity tap is turned off, as is currently occurring, demand is likely to evaporate and there could be a sharp retraction of gains,’ he added.