Equities are unseasonably buoyant at the moment, despite the fact that the macro picture isn’t straightforward. The strength of economic activity and rising inflation, particularly in the UK and the US, has increased the likelihood of further monetary tightening in 2007. However, investors are optimistic as they are focusing on lower oil prices, abundant liquidity and fairly high earnings yields, along with the recent dovish statement from the US Fed. Monetary tightening is therefore yet to be reflected in equity indices. To us, this is worrying: most investors may be prepared to be cajoled by the data, but we feel more cautious and so are seeking out areas of defensive growth.
Utilities remain a key sector thanks to the slew of venture capitalist money and infrastructure funds looking to buy into firms with predictable cash flows. Valuations in the sector are no longer cheap, but we think momentum should keep it going for some time. Since May 2006 we have been buying International Power (IPR), a stock we see as a key beneficiary of high energy prices. The firm provides generation assets to Middle Eastern markets and builds desalination plants. It also has good free cash flow yield and the ability to ramp up its dividend.
In a slower growth environment, stocks such as Gilat Satcom (GLT) offer contra-cyclical or secular growth – they are able to drive earnings forward, regardless of the external climate, with their niche products. Earlier in the year Gilat, which provides international broadband satellite services, rose on the back of positive news flow and optimism over a new management team. But since the start of the year it has returned –5.1%. It is a new business and we expect to see short-term volatility in the wake of a new management strategy. Long term, we are optimistic about the firm’s exposure to the strong growth in Africa and the Middle East.
We have in the past concentrated on cash-generative firms that can offer yield during bearish periods. With this in mind, we have increased our allocation to property funds that provide high yields and good diversification. Puma Brandenburg (PUMA) plays on changes in the German residential property market, exploiting the difference between high rental yields and the historically low cost of borrowing. Should the German economy continue to improve, there is potential for substantial capital appreciation as well.
Despite a challenging trading environment, Halfords Group (HFD), the car parts and cycle retailer, continues to generate sales and cash. In October, it posted strong trading ahead of its November interims, as well as a confident outlook for the second half of 2006. Crucially, Halfords’ niche offerings mean margins can resist downward pressure from supermarkets.
Finally, we have no exposure to big pharmas due to long-term issues with patents, prices, legislation and competition from generics. We opted for a more lateral approach on the sector and bought a holding in Alliance Unichem in March 2006, having held Boots since 2002. The portfolio did well out of the subsequent merger – a deal that the market is now positive on – and holds the new entity Alliance Boots (AB/), which benefits from continued rationalisation and a strong position in wholesale drugs and toiletries.
The stocks Julian Chillingworth likes
12mth high 12mth low Now
International Power 352p 220p 335p
Gilat Satcom 125p 79p 90p
Puma Brandenburg 112p 102p 106p
Halfords Group 355p 271p 337.25p
Alliance Unichem 807p 609p 800p