Activate | February 2008 | Issue 11

The bears are coming

Robert Waugh, Head of UK equities at Scottish Widows Investment Partnership (SWIP), explains why a combination of factors means that the long period of sustained growth in the UK stock market is likely to come to an end in 2008

Are bulls turning into bears on UK financial markets? Fears of a slowdown in the UK economy, the continued fallout from the US lending crisis and a more muted outlook for global economic growth are all contributing to a growing level of pessimism among investors. As a result, the upward trajectory that stocks have traced over the past few years has hit a bumpy patch. The UK market in 2008 got off to one of its worst starts in recent memory and on 16 January, the FTSE 100 fell below the 6,000 level to its lowest point since the middle of August.

The period since 2004 has seen the strongest period of sustained growth since the late 1960s and early 1970s. Certainly, the UK economy has had a lot more steam in it than most anticipated. But there is now clear evidence that it is starting to slow. December’s interest rate cut from 5.75% to 5.50% was the first in two years and is unlikely to be the last. By the middle of the year, we expect two further 0.25 percentage point reductions, with the possibility of further cuts in 2009.

The risk this year is that the fallout from the credit crunch could lead to a US recession, with a corresponding impact on global growth prospects. Another key uncertainty for 2008 is likely to be the state of the housing market. The Nationwide Building Society reported a 0.5% drop in house prices for December, taking the annual growth rate down to 4.8% per cent – the lowest since May 2006. With lenders, not surprisingly, tightening their loan criteria in the wake of the credit squeeze, it seems clear that the market is now cooling. Reflecting this anticipated housing weakness and the slower growth of financial services as the impact from the credit crunch lingers, SWIP expects growth in the UK to slow in 2008. Generally speaking, companies in the developed world have benefited over recent years from high levels of profitability and low debt. Under the scenario of a slowing economy, however, their high profit margins are likely to come under pressure. Already, the sell-off seen across a range of economically sensitive stocks in the UK is reflecting some of these concerns.

The UK market in 2007 saw a divergence of performance at sector level. At one extreme, strength in demand from emerging markets fuelled significant upgrades to profits in the mining sector. The added impetus of mergers and acquisitions within the sector led it to strongly outperform the wider market.

This year, the mining companies are likely to face a major headwind in the form of declining metals prices. At the other end, the banks spent the latter half of 2007 reeling from the impact of turmoil in financial markets. It is difficult to see how the financial sector will grow its earnings in 2008 as banks continue to reduce the amount of debt on their balance sheets.

With a number of sectors facing challenges, at best the UK market is likely to deliver only low single-digit earnings growth. The months ahead, then, appear to present us with a challenging investment environment. But there will be opportunities, particularly for longer-term investors.

A view from the top: mining perspectives

Despite the current credit squeeze, the share prices of mining companies have been trading at record highs. Cherry Reynard explores the reasons for such top performance and whether the momentum is a one-off or likely to continue

Mining stocks were the star performers of 2007, beating every other sector by roughly 20%. The industrialisation of China, India and other emerging markets has created consistently strong demand for commodities, pushing up prices and generating higher profits for mining companies. But, following the credit crunch, global growth is weakening. Can the sector continue to generate strong returns for investors in this climate?

The FTSE All-World mining sector index returned 61.7% over the course of 2007. Its nearest rival has been the basic materials sector, which returned 47.5% over the same period. This compares with a return of just 3.8% from the wider FTSE 100 index.

The big picture

Mining was certainly the right sector last year, but investors also needed to be in the right stocks. An investment in Lonmin, for example, would only have delivered 1.1% over the year. The platinum mining company issued a profits warning in July, after production problems left it unable to take advantage of the high platinum price. In contrast, investing in BHP Billiton or Rio Tinto – both the subject of bid activity during the year – would have returned 66% and 97% respectively.

What has driven these surging prices? Demand for commodities has remained strong, much of it coming from emerging markets. Chinese GDP growth rose 11.9% in the second quarter of 2007, while India grew 9.2% in the third quarter.

John Payne, partner at Hexam Capital fund company, says: “The big picture is the industrialisation in high population countries like India and China. They need infrastructure to accommodate this change, which is pushing demand for materials. The numbers are huge and, as GDP increases, they will need more and more.”

"Mining was certainly the right sector last year..."

For individual companies, the trick has been to maintain production at high levels to take advantage of increased demand, generating huge amounts of cash. In turn, with this free cash flow, companies have returned it to shareholders through dividends or share buy-backs and used it to invest in further production.

Merger and acquisition activity has also given support to share prices in the sector. BHP Billiton recently attempted a bold $67bn (£33bn) takeover of Rio Tinto, which was rebuffed on the grounds that it undervalued Rio Tinto’s existing business and its prospects. Rio Tinto in turn was rumoured to be considering a tie-up with Companhia Vale do Rio Doce of Brazil. Lonmin’s poor run of performance left it vulnerable to further takeover bids.

But can this strength be sustained? Payne believes that demand will hold up, even in the face of a slowdown in the US. For instance, Russia plans to spend $1trn on infrastructure over the next five years and China and India are showing few signs of slowing.

Dr Graham Birch, head of BlackRock’s natural resources team, believes that the commodities ‘supercycle’ is one of only six in the past 250 years, equivalent to the European industrial revolution. He explains: “Investing in mining stocks, which are set to benefit from growth in demand, potential merger activity as well as rising profits, is an excellent way for volatility-tolerant investors to take advantage of this trend.”

In the offing

Market experts continue to be bullish on the outlook for mining stocks for 2008, arguing that despite the deterioration of credit market conditions and ensuing volatility, fast-growing emerging markets have decoupled from the US economy, giving them a leg up. Meanwhile, expectations of more corporate activity to come in the year will also help to drive stock prices. Yet, some market watchers point out that, although high stock prices will continue, costs, including energy and labour, are rising and profit margins may be squeezed. Taking this into consideration, it’s worthwhile to look at the individual company’s performance when making your stock picks to ensure that you reap the benefits when the next mining company clinches the next big deal.

Global round-up: the year that was

As 2007 passes and we head into 2008, what lessons can investors learn from last year's turbulent markets? Simoney Girard reports

On 16 June 2007, the FTSE 100 hit its highest level for nearly seven years: 6732.4. A month later, the US subprime collapse sparked a frenzy of stock selling, even in markets as far afield as China. The credit crunch ensued and UK mortgage lender Northern Rock racked up £30bn of debt to taxpayers by December.

As we start 2008, the positive mood of January 2007 has been replaced by the cold shadow of the credit crunch and there’s no room for complacency.

Chinese chequers

No prize for guessing which country raced ahead in 2007 and is on course for strong gains in 2008. China’s climb into positive territory is evident; if you had invested £1,000 in the Chinese A-Shares market in December 2006, by December 2007 you would have gained nearly 27%. The Chinese growth theme is still one that expert investors are keen to play, although Iain Fulton, manager of the Scottish Widows Global Growth fund, said the team has been top-slicing investments in China, such as selling CINOOC, one of the year’s top stocks, to invest in undervalued stocks elsewhere.

Fulton explains: “China is still a strong secular play, although we think there is a little bit of a bubble in the stock market, so we are rotating some of the profits into other stocks.”

Japan

Three years ago, Japan was the Land of the Rising Sun for investors, with double-digit returns on your investments.

Top 5 performing sectors 2007
Mining	+55.27%
Industrial Met	+49.5%
Chemicals	+44.26%
Mobile T/Cm	+40.96%
Oil/Eq Svs/Dst	+33.99%
Bottom 5 performing sectors 2007
Real Estate	-1.56%
Gen Retailers	-1.93%
Household Gds	-2.66%
Banks	-5.03%
Media	-5.7%
Source: Thomson Financial

But if you had invested straight into the Nikkei 225 at the start of 2007, your investment would have been down 6.91% by December 2007, as Japan was the worst performing market last year – a situation experts claim is unlikely to change significantly in 2008.

The US

The world’s most diverse economy ended 2007 with a grumble, but even with the credit crunch and the subprime market collapse, the S&P 500 finished higher than the Nikkei 225, up 1.5%. The US is still shaky, despite having some top-notch stocks that are reporting strong profits. But 2008 may prove a better year for investors. Ian Vose, manager of the £21.3m Scottish Widows Investment Partnership (SWIP) Global SRI fund, says: “We have been moving our weighting in the US up gradually. We will look for stock opportunities in the US this year, driven by valuations.”

UK and Europe

Closer to home, things were better. The European Central Bank and the Bank of England are responding to the economic crisis with calculated interest rate cuts, relieving pressure on consumers. Markets have been strong – the FTSE World Europe ex UK was the best performing developed market over 2007, while the UK finished fairly robustly at 6456.9, compared with its 17 July low of 5,858.9. This is despite some shocking performances from European and UK stocks – notably Northern Rock. (Source for all data: Morningstar & FT, as at 31/12/07).

Banks

While the SWIP managers do not make sector bets, being purely stock-pickers, they are selective about financials. They are investing instead in insurers, asset managers and other financials; banks were the fourth worst performers in 2007.

Commodities

Investors in commodities, mining and natural resources will have been smiling during 2007 after another great year for oil prices, mining and gold-related companies. Mining was the best-performing global stock. Although SWIP’s managers believe that commodities companies are fairly priced now, they may still prove to be decent performers in 2008.

Top 5 Global Stocks in 2007
Casa On (Bra)	+7,751.85%
Timmingo (CAN)	+7,216.67%
Mongolia (HK)	+5,983.24%
Parmalat (BRA)	+2,133.92%
Telefonica (PERU)	+1,920%
Bottom 5 Global Stocks in 2007
Northern Rock (UK)	-92.87%
BIF (HUN)	-87.69%
Astroc (SPAIN)	-87.43%
Soars (PORT)	-80%
IKB Deutsche (GER)	-78.99%
Source: Thomson Financial, 31/12/2007

Consumer stocks

Vose says: “With the subprime difficulties in the credit markets, we are avoiding domestic-related industries such as selected retailers and consumer discretionary stocks in the UK , US and parts of Europe.”

Food, glorious food

Food stocks such as European retailer Nestlé are a good defensive play for 2008, according to SWIP, as valuations look attractive and stocks are less exposed to market volatility.

Industrials

Industrials, such as German company Merck and some UK exporters, are still trading on positive fundamentals and are less correlated to the consumer crisis.

Three learnings

Be smart, stay focused, think global. These are three key learnings to take away from 2007. Ensure your portfolio is diverse enough to withstand whatever the year may bring and avoid being overexposed to any one country or sector.

Stellar returns: how to invest like a private equity player

Private equity firms have been a dominant force in driving up the UK market. Here, Simon Evans explores how you can invest like the experts

Private equity has come far since its modest beginnings in the late 1970s. Last year saw a plethora of deals completed globally at sometimes staggering valuations, with many of the world’s best-known companies leaving the public arena for a life in the private shade.

In Britain, names such as Boots, the AA, Saga and Bird’s Eye have all been targeted by private equity firms, while further down the capitalisation spectrum many previously unheralded names have gone private, including the UK’s biggest estate agency chain, Countrywide. No less than eight private equity groups have been linked to ailing bank Northern Rock since its collapse, proving that the ‘masters of the universe’, as they have been dubbed, are here to stay.

"Private investors can plug into some of the opportunities created by the buy-out boys"

For the man on the street, gaining access to the returns linked to private equity isn’t at first glance easy. Private equity firms stipulate minimum investments of sometimes millions of pounds to gain access to investment portfolios. With a little savvy, however, the private investor can plug into some of the opportunities and spiralling share prices created by the buy-out boys.

Private equity firms often look for companies that have large cash positions on their books, for example, while others look to invest in firms that enjoy positions of market dominance that aren’t easy to copy. They set their sights on companies that have strong brand recognition or seek out those whose once strong brands are not being fully exploited.

They also aim to invest in markets where significant barriers to entry are apparent, such as patents and high start-up costs, thus reducing the chances of new firms entering and gaining market share.

Quality, not quantity

The quality of a company’s management is often key to a private equity group investing in a firm. If management is strong, then private equity companies will provide them with growth capital to build the business, while poor management teams will find themselves booted out by buyout firms looking to turn around a business. For example, the chief executive of EMI, the poorly performing British music group, didn’t last long after the company fell to a private equity bid tabled by the Terra Firma buy-out house. Private equity firms have also bought stakes in companies where a founding family or management wants to realise their stake and exit the business. Moreover, companies in certain sectors have proved themselves more susceptible to private equity offers. In this climate, where debt financing is getting harder and more expensive to come by, many private equity firms are looking at smaller listed companies.

Simon Edwards, Chief Executive of Midas Capital Partners, an investment management company, believes that the opportunities for the traditional player to cash in on private equity strategy are obvious: “We look for a number of characteristics in our investments that many private equity investors would find familiar,” he says. “An excellent example is AJ Bell, the Manchester-based SIPP provider. It has a strong management team, an excellent market position, strong growth prospects and cash flows.”

Special Situations

Investors wishing to cash in on the investment tactics employed by the private equity world can do this when buying funds through Lloyds TSB Share Dealing. Made famous by fund management guru Anthony Bolton, so-called Special Situations funds have long ploughed a similar furrow to private equity, yielding great returns. As the name Special Situations suggests, the managers of such funds put their cash to work in what they perceive to be unique opportunities. Although a minority investor, Bolton was instrumental in the sacking of Michael Green, Chief Executive of Carlton, after the merger with Granada, which created ITV – a private equity-style approach to investing. Bolton’s success has spawned a whole sector of Special Situations funds whose investments would not look out of place in a private equity house.

Artemis’s fund, run by Derek Stuart, uses a similar approach. He says: “The key is to find companies that went wrong because of bad management or too much debt. These are problems that can be straightened out. But if a company loses its franchise, there’s no hope.”

Whether it be investing directly in shares with the right characteristics or through specialist funds, the stellar returns gleaned by private equity players might not be as remote as private investors may think.

Investment Matters

Financial journalist Tim Cooper looks at what you need to know about tax to make the most out of your investments

What the taxman gives with one hand he seems to take away with the other. So it is with investing in shares. While there are some good breaks available to investors, there are also pitfalls and hidden tax costs of which you should be aware.

Tax-efficient vehicles?

One of the most popular tax-efficient savings vehicles is the Individual Savings Account (ISA), which you can use to save cash or invest in stocks and shares. The maximum you can put into an ISA is currently £7,000 in each tax year, but this limit is set to rise to £7,200 from 6 April 2008. If a married couple both use their ISA entitlements, together they can invest £14,000 a year tax-efficiently, and £14,400 from 6 April 2008. Those who have used all their entitlement to invest in ISAs and their forerunner, Personal Equity Plans (PEPs), should have built up sizeable tax-efficient portfolios. (Don’t forget that all PEP accounts will automatically become stocks and shares ISAs on 6 April 2008, thus becoming subject to ISA rules). You pay no tax on interest and bonuses you receive from your ISA savings and investments. What’s more, you pay no tax on capital gains arising on your ISA investments, you can take your money out at any time without losing tax relief and you don’t have to declare income and capital gains from ISA savings and investments, or even tell your HMRC office you have an ISA.

Taxing matters: UK shares

When you buy UK shares, you pay tax on the transaction. This is called stamp duty reserve tax (SDRT) for paperless transactions and stamp duty for transactions using a stock transfer form. SDRT is currently paid at 0.5% on UK shares. Stamp duty on paper transactions is also 0.5% but is rounded up to the nearest £5 above.

Being mindful: income tax & CGT

The two most important taxes for share investors are income tax and Capital Gains Tax (CGT). Income tax is charged at the marginal rate on any dividends or distributions received. CGT can be complicated and you should take advice from an accountant if you are unsure of your liabilities. CGT is liable at the marginal rate on any gains realised during the tax year, in excess of the annual exemption. In the current tax year, this exemption is £9,200 a year for individuals. Married couples have separate exemptions.

Any capital losses taken during the year may be offset against capital gains to reduce the potential tax bill. Overall losses may be carried forward, but if the exemption remains unused it is lost. Making full use of the annual exemption is sensible tax planning as this is one of the few tax breaks available to investors in which gains can mount to a significant level over time.

Capital gains on shares can attract taper relief if the investment has been held long enough. Maximum business assets taper relief is available if it has been held for two years, and the maximum non-business asset taper relief is available if the asset is held for 10 years.

However, in his pre-budget report in October 2007, Chancellor Alistair Darling proposed to withdraw taper relief from 6 April 2008, even if assets were held before this date. Under this plan, the chargeable gain would be liable to tax at the new rate of 18%, subject to the deduction of allowable losses, any other reliefs and the annual exempt amount.

Your personal tax position

Because of these and other fiscal permutations, you can alter your personal tax position by investing in shares. We will send you tax vouchers for stocks held in your Nominee account with your annual statement pack in April, which you will need to retain to complete your tax returns.