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The era of free money—now 100 months of interest rates at emergency levels of 0.5% or lower—has helped fuel the FTSE 100’s rally to 7500, according to Thomas Moore, manager of Standard Life Investments UK Equity Income Unconstrained fund.
What is more, high valuations are pervading many different sectors – not just defensive sectors with stable revenue streams, but also cyclical sectors (meaning those more linked to the economic cycle), with far more volatile revenue streams.
“If you believe that the starting valuation you pay for an investment will turn out to be an important determinant of its ultimate return, then this should make you nervous, particularly if you believe that interest rates are heading higher,” says Thomas. “Just as the era of free money has driven valuations up, so the unwinding of this era can be expected to drive valuations down.
“The good news is that there is lots of valuation dispersion between loved stocks and spurned stocks and despite the momentum in headline market levels, there are still plenty of opportunities to be found.”
“The characteristics I look for in companies are strong operational trends and market position, strong cash flow generation, robust balance sheets, rapid dividend growth underpinned by all of the above, and an attractive valuation.” continues Thomas.
“Examples of companies exhibiting these characteristics at the moment include Dunelm, Glencore, Direct Line and Saga.”
Thomas outlines the strengths he sees in these underlying businesses, despite challenges in the macro environment posed by Brexit and exacerbated by the election result.
“Dunelm is a business with very strong cash generation, so much so that they need to pay regular special dividends to avoid excessive de-gearing. Near-term sentiment towards the stock is negative due to real wage concerns following last year’s [and the post-election] sterling devaluation. However, we expect Dunelm to outperform its peer group thanks to a superior product offering, new and refurbished space and their strategic move into online through an acquisition.
“Glencore has transformed its prospects since the nadir of the commodity cycle in 2015. Investor perceptions are changing as Glencore reassures the market about the quality of its assets, the performance of its marketing division and its balance sheet risk. Glencore’s earnings mix is highly diversified, with broadly equal contribution to earnings from copper, thermal coal, zinc and marketing. The industry backdrop is now far more benign, as all the big mining companies have committed themselves to a more cautious approach to capital expenditure, which will be supportive of commodity prices. Management has reinstated the dividend, having deleveraged aggressively since 2015.
“Direct Line has a leading market position in the UK motor insurance market. Their strategy is inherently higher quality than the price-led strategy adopted by newer entrants who are reliant on price comparison websites. Management is confident enough to commit to a consistent level of profitability driven by their superior customer stickiness resulting from their proposition and service. This could be a virtuous circle as their better stickiness means lower acquisition costs (lower reliance on price comparison websites than the others), allowing them to reinvest in customer proposition.
“Saga has a leading position with over-50s, with a huge database of customers and very high brand awareness. They use this database to cross-sell products and reward loyalty, typically starting with a motor insurance product and cross-selling travel, investments and home care.
In the year since the Brexit vote, investors could be forgiven for becoming somewhat complacent. After all, markets have reached all-time highs and sterling had started to rebound slightly. Even the trigger of after Article 50 had little impact.
The election result (or lack thereof, depending on how you look at things!) on 9 June served to remind everyone that macroeconomic issues will continue to occupy headline space in the foreseeable future. But markets, on the other hand, have carried on regardless. At the time of writing, 3pm the day after the election, the FTSE 100 was up about 0.8% for the day and still sitting well above 7,500.
More important going forward will be how strongly company fundamentals are able to shine in this environment. This will be particularly pertinent in the mid-cap space, which, as per the day after the Brexit vote, was sold off after the hung parliament. This happens because many of these medium-sized companies rely on a strong domestic economy to boost their earnings – a potentially weaker Brexit negotiating position threatens our economy.
Yet Thomas is more positive about valuation opportunities among mid-cap stocks. Conversely, high valuations among large caps (i.e. the FTSE 100) may restrict the performance of sectors that have become much loved and highly consensual.
“While there are valuation opportunities among overseas earners, the bulk of the opportunities reside among UK domestic companies in my view … Throughout this period of change, the key is to retain an anchor. This anchor is a focus on the cash flows that are used to pay dividends. Regardless of the latest macro noise, it is cash flow and dividend announcements at the company level that will provide the ultimate anchor for share prices. As these announcements continue to beat market expectations, it is this anchor that gives me confidence in the performance of the fund in the months and years ahead.”