What some observers have called a ‘great rotation’ had begun as supposedly ‘defensive’ value style stocks outperformed more growth-orientated companies.
This effect reached its nadir in mid-May and some commentators believe these events mark a new phase of the market cycle.
With the end of quantitative easing (QE) and interest rate rises in sight in the US and UK, investors may have been rotating into defensive and value stocks. But one view is that this episode can be viewed as a short, sharp correction.
Little has changed at a macro level to warrant a ‘great rotation’ and it can be expected that the prevailing market and economic backdrop, which had favoured certain holdings in the preceding quarters, will now begin to reassert itself.
Following Bank of England Governor Mark Carney’s Mansion House speech on June 12, UK interest rates may begin rising towards the end of this year, but rises are likely to be slow and incremental to avoid jeopardising recovery and are arguably already priced in.
There are of course risks and widespread deflation is a concern. But rather than take a dogmatic stance on this, the focus should be on where investors can readily identify pockets of inflation and deflation, and link these directly to the prospects for shares.
It can be suggested that UK-listed companies exposed to downward global pricing pressures and currency fluctuations are better avoided in favour of companies that have pricing power and are able to benefit from the domestic UK recovery.
Tesco amply serves to demonstrate the characteristics to avoid. Its UK profits are declining amid fierce competition at the high and low ends of the market.
Meanwhile, its experience in hitherto high growth overseas markets is chastening, as evidenced by a meagre 0.5 per cent rise in like-for-like sales in Q1, which fell to -8 per cent with the effects of currency factored in.
Back at home, prospects are favourable for certain domestically focused businesses. Barratt Developments and related companies such as Howden Joinery Group are positioned to benefit from long-term structural factors, such as a chronic housing shortage, coupled with policy support in the form of the government’s Help to Buy and related initiatives.
Both of these companies sold-off heavily in the recent ‘great rotation’. While they have recovered some ground, Barratt remains some 21 per cent off its March high and Howden is down 20 per cent from its peak in the same month.
Barratt now looks very attractive on a price/earnings ratio of 8.8x. Its forecast dividend is 3.8 per cent, growth of 43 per cent on the previous year’s payout.
Howden’s dividend is forecast to grow by 18 per cent next year. Other high conviction holdings include Ashtead Group, which is currently down 9 per cent from its April high, and easyJet, which is some 10 per cent off its April price but remains one of the most attractive shares in the market.
Due to their projected earnings and free cashflow growth, businesses such as these are often in a position to grow their dividends faster than the market.
Markets went up last year but earnings forecasts went down on average, resulting in a general rerating of the market.
Nevertheless, this does not always mean the types of businesses in favour require a rerating in order to generate an attractive total return over the next year, owing to their growth in earnings and healthy dividend yield.
In spite of the temporary shift in market sentiment in recent months, there is not necessarily a case for migrating from stocks with the potential to grow their earnings above forecast expectations to what could be considered the illusory security of value and defensive businesses, many of which arguably offer little upside and considerable downside.
David Urch is fund manager at EEA
