One consequence of the financial crisis and resulting economic downturn has been the unprecedented easing of monetary policy. This has depressed the returns on cash and government bonds. So investors looking for more than just capital preservation are being forced to consider riskier assets, such as corporate bonds and equities. We at Killik hope the downturn in equities will provide a floor from which the market can build through 2009. But we doubt the recovery will be all one way. Instead, we expect to see more of the wild price swings of the past couple of years.
During the last few weeks we have seen a marked rotation into higher-risk assets, such as financials and cyclicals, many of which suffered spectacular collapses in 2008. However, after such a strong rally we believe this theme has run far enough for now. After all, the sharp deterioration in trading conditions experienced by many companies only really got going in the fourth quarter of last year. Although many firms have cut costs to protect profits, the pressure on sales remains intense and we would expect further downgrades to earnings forecasts as we go through the year.
We would therefore suggest switching back into those stocks with resilient earnings, which have lagged in the recent rally. We would include companies such as Capita (LSE:CPI) and Compass Group (LSE:CPG) that benefit from the stability of long-term contracts. We also like firms such as Imperial Tobacco (LSE:IMT) and BAT (LSE:BATS) that sell products that are used regardless of the state of the economy.
In the long term, dividends have contributed a large part of the return from equities. Although the average expected yield from the UK market is currently well above cash and government bonds, we would caution investors against just buying stocks on high yields, as it’s likely that many may cut their dividends at this stage in the cycle. We would target companies that have the financial capacity or business resilience to maintain or grow their payout. In particular, we like the oil majors BP (LSE:BP) and Royal Dutch Shell (LSE:RDSB), the pharmaceutical majors GlaxoSmithKline (LSE:GSK) and AstraZeneca (LSE:AZN), and Vodafone (LSE:VOD).
Meanwhile, the majority of dividend-paying UK equity investment trusts look expensive. Their dividend levels are unsustainably high and flattered by the positive impact of cheap debt and a reliance on revenue reserves stored during the good years. This is one reason we favour open-ended UK equity funds, such as Invesco Perpetual Income (020-7065 4000). It offers a sustainable 4.8% yield.
Finally, we would not chase stocks with a high exposure to the British economy, and in particular to consumer spending. The level of disposable income has increased for many following a collapse in the cost of living, with the cost of food, mortgage and utility bills all falling. But we believe that unemployment, or the fear of it, will remain the main driver of consumer sentiment and, therefore, of spending. So avoid the retail sector.
The stocks Jonathan Jackson likes
| 12-month high | 12-month low | Now | |
|---|---|---|---|
| Capita | 773.5p | 550p | 642.50p |
| Compass Group | 396.25p | 235.50p | 331p |
| Imperial Tobacco | 2,292p | 1,368p | 1,512p |
| British American Tobacco | 2,043p | 1,350p | 1,573p |
| BP | 657.25p | 370p | 441.75p |
| Royal Dutch Shell | 2,245p | 1,223p | 1,421p |
| GlaxoSmithKline | 1,339p | 984.50p | 1,021p |
| AstraZeneca | 2,966p | 2,015p | 2,294p |
| Vodafone | 169.50p | 96.40p | 128.35p |