Puncturing Deflation Myths

¹²Investors: Get Set For The Double Dip Recession Ride
Fund Managers Are Buying Defensive Shares To Counter A Downturn.

By Paul Farrow, Personal Finance Editor | 20 September 2010

According to the latest Bank of America Merrill Lynch survey, professional investors have returned from their summer breaks in a less than buoyant mood. Many are approaching the fourth quarter with a heightened sense of caution, increasing their cash positions and buying shares that have defensive characteristics. Fund managers are building up defensive positions in their investment portfolios because of fears of a double-dip recession in many economies.

The survey coincides with pessimistic views from Neil Woodford, one of the most listened-to fund managers in Britain. He said life was going to be very tough and that the chances of the country falling back into recession next year had increased. Mr Woodford's concerns echo those of British businesses, many of which said in a survey last week that they also thought that Britain was heading for a recession.

"It's almost certain we will see recession in places like Greece and other places where they are cutting budget deficits very aggressively," he said. "Frankly, I've been surprised at how well house prices have held up. [But] with a lag, we are beginning to see some weakness as more supply is coming on to the market. I expect house prices to continue to fall… and that will put pressure on consumer confidence."

But investors are not discounting shares despite this pessimistic outlook. Many reckon that equities are a better bet than bonds at this juncture— and it all boils down to yield. The yield on equities is currently higher than on bonds, something that rarely happens. But when it does, it often suggests that equities are a bargain.

Put simply, a yield is the income from an investment, expressed as a percentage of the price. The higher the income in relation to the price, the better the value of the underlying investment— and vice versa. Analysts and fund managers study the relationship between the gilt yield and the equity yield religiously to examine how cheap or expensive shares are compared with government bonds. The closer they are to each other, the better value equities are reckoned to be.

Stock market bulls ask: what would you rather get— a 1.7% fixed return on five-year gilts, for instance, or a 3.3% return on equities, with growth thrown in, over the long term? Before 1959, equities continually yielded more than gilts because they were perceived as more risky. But in the Fifties and Sixties the perception began to change as the major pension funds started to invest in shares.

The pioneer of this new direction is considered to be George Ross Goobey— often called the father of the equity cult— who started to take the Imperial Tobacco pension fund into equities in the Fifties. In 2003, when equities also yielded more than gilts, it turned out to be a defining moment. The FTSE 100 had fallen to 3,487 but within days it started to reverse its fall and never looked back until the financial crisis hit in 2007, by which time it had climbed to 6,725.

Although many analysts are in no doubt that equities offer great value, they advise investors to expect a rocky ride— the past few years have been unprecedented. Equities may be cheap, but not all shares and sectors will deliver. The global economy is slowing again, while corporate and consumer debt is still at worryingly high levels.

"The current yield available on selected stocks, combined with dividend growth, can provide decent returns," continued Mr Woodford. "If you can invest at very low valuations, returns could be even more meaningful. Equity markets offer an attractive yield for investors looking for a better return on capital. This return is not risk free, but a selective and patient approach helps to mitigate risks. In my view, present valuations suggest the risk is worth taking."

Mr Woodford said there were many industries, including pharmaceuticals and tobacco, that were partly insulated from the downturn and would continue to be able to increase revenues, profits, cash and dividends.

"Some of the most interesting opportunities are in companies where the prospects for dividend growth are the strongest. Take AstraZeneca: at a price-to-earnings ratio of just over eight times, it is trading around its historic low and a long way below the FTSE All Share's average of 15 times. The company is also yielding 4.7% and is committed to growing its dividend. This is an example of a quality business where the negatives are fully priced into the stock."

Bill Mott, the highly regarded income manager at Psigma, said: "I cannot recall a time when the defensive sectors have offered such attractive yields relative to 10-year government bonds". But what should an investor buy? The Bank of America survey showed that falling bond yields encouraged investors to embark on a yield hunt [[usually sufficient warning not to do the same! : normxxx]], with the largest moves into telecoms, energy and pharmaceuticals. A glance at the graph shows what is proving irresistible to fund managers.

Mr Mott has built his Income fund with a heavy bias towards large companies with strong cash flows that he hopes will do very well in a 'bracing' environment. His fund is full of stocks in the pharmaceutical, utilities, telecoms, tobacco and food retail areas. "These same companies should cope successfully in the event of a double-dip recession thanks to their defensive qualities," he said. "Such companies will also have pricing power in an inflationary environment."

Outside the FTSE 100, Mr Mott holds Booker, Dairy Crest, Premier Farnell and Rotork.

Fund management groups have tried to capitalise on investor nerves with new funds. M&G recently launched a corporate bond fund that aims to keep pace with inflation. Many financial advisers welcomed the fund, but few said they would be recommending it to clients because it was untried.

Last week Fidelity launched its Equity Growth Defender, which sets out to protect 80% of the highest value the fund reaches without the use of derivatives, although it offers no guarantees. If the fund price moves up, driven by higher share prices and effective stock selection, equity exposure will be increased. If the fund price falls, its equity exposure will be reduced and cash increased.

Darius McDermott of Chelsea Financial Services said:

"The most glaring concern with this fund is that capital is not protected. And while the FTSE falling by 20% in one day might appear an unlikely prospect, if the last three years in the markets have taught us anything, it is that you must expect the unexpected. My other gripe is that, should the market take a fall, the manager will begin selling equity positions, which is the exact opposite of what most good active managers do."

[ Normxxx Here:  And there we have it: Finally, a fund which mimics the strategy of the "little" investor: sell at the bottom and buy at the tops!  ]

Adrian Lowcock of Bestinvest said it was the quality large-cap companies that looked most interesting on valuation and yield grounds. He tipped fund managers such as Tony Nutt (Jupiter Income), Nigel Thomas (Axa Framlington UK Select Opportunities) and Colin Morton (Rensburg UK Equity Income). "They have been investing in high-yielding large-cap stocks with strong cash flows. And Bill Miller of Legg Mason US Equity has gone as far as saying that US blue chips are the bargain of a lifetime," he said.

It Is Not All Defensive

Amid all the talk of going defensive, fund managers in the Merrill Lynch survey expected stronger growth in China over the next year, a sharp reversal from the pessimism of recent times. A net 11% of the managers surveyed expected China's economy to strengthen, which marks a 30% swing and the biggest positive move since May 2009. [[Which means that it's probably about time to get out of China stocks.: normxxx]] If it's China you're interested in, advisers' favourites include funds from Jupiter, Neptune and Gartmore.