An independent professional's take on the latest news and trends in global financial markets

Woodford and McLean Q and A

Colin McLean founded his fund management business, SVM Asset Management, 20 years ago in Edinburgh. He is one of the professional investors who was featured in my book Money Makers. An experienced stockpicker, he summarises his market views and how he is positioning his portfolios in the latest Independent Investor Q and A, which has been posted to the Independent Investor website today.

Here is a short extract:

How generally do you see the equity markets at the moment?

The global economy will slow next year, but still deliver robust growth.  Many companies have yet to get back to peak margins, but are cutting costs sufficiently to do so.  Quantitative easing will drive the US Dollar lower, and continue to boost most asset classes; emerging markets in particular. Equities are not over-valued, and more M&A activity is possible given the low returns on cash held in corporate balance sheets.  I see an analogy with the period post the initial recovery in 2003, when it was followed by a good further three years for equity markets and a lot of UK M&A in 2004 and 2005.  I am not sure if the rally will last three years, but I do think we are still in the recovery stage for many businesses.

This is a link to the whole interview. All Independent Investor Q and As are currently free to view. As expected gold has corrected this week after its recent strong run and the dollar has also paused from its previous oversold condition. However the long term prognosis – bullish for the former, bearish for the latter – remains unchanged. The case for owning large cap equities with strong cash flow and balance sheets is however clearly now becoming more widely held than it was earlier this year.

Neil Woodford of Invesco Perpetual has been arguing this case for months now. In the Financial Times this week, he noted that shares in some of the UK’s most dependable businesses currently trade at “unusually low valuations”.

AstraZeneca, Vodafone and BAE Systems all trade on single-digit price/earnings multiples, representing a substantial discount to the market as a whole. GlaxoSmithKline, Imperial Tobacco and Scottish and Southern Energy also trade at p/e discounts to the market. Dividends from these businesses look safe, are likely to grow, and provide an attractive income yield that is very difficult to replicate from any other asset class – unusually these businesses’ own corporate bonds provide a yield substantially less than their dividend yield.

The asset class as a whole is now cheap but, despite obvious dependable characteristics – operating in resilient, non-cyclical industries, with proven records of consistent growth in earnings and dividends – these shares are cheaper than the market and are inexpensive compared to historic valuations. These businesses face challenges but they can influence their own destiny in a way that companies more vulnerable to the economic cycle cannot.

The economic outlook is fraught with uncertainty, so to me it is inexplicable that the stock market is not embracing certainty or dependability where it can find it. Perhaps it is because investment horizons appear to be getting shorter and shorter, encouraging brief bursts of risk on/risk off activity that seem to characterise current markets, stimulated by the latest batch of economic data. Or maybe the whole asset class is out of favour – the current yield on UK equities relative to other asset classes suggests this is so. Whatever the reason, fundamentals are being ignored.

In time, I believe companies with dependable characteristics will be valued more sensibly. A valuation premium for dependability is normal and justified. In difficult economic times, the quality premium deserves to be even bigger than usual and I strongly believe that, ultimately, the premium will be restored. Patience is required, but in the meantime, the combination of dividend yield and dividend growth from dependable growth companies should result in very satisfactory returns for investors, even without the implicit re-rating.

My only comment is that you can often wait a long time for sensible things to happen on valuation grounds. Patience is an undervalued commodity in investment.

Written by Jonathan Davis

October 22, 2010 at 2:17 PM