Best to stay true to first principles

In an equity market that has suffered from too much complexity and too much debt, focusing on cash-generative companies with robust business models should produce good opportunities.

Britain’s economic environment has worsened over 2008. As the impact of the British economic slowdown makes itself felt in various parts of the economy – retail sales data, for example, declined by 2.2% year-on-year in October, and the latest survey by the Royal Institution of Chartered Surveyors revealed that home sales fell to their lowest since the survey began in 1978 – there appears to be little prospect of a near-term recovery.

In fact, it is likely that the economic slowdown will be deep, and meaningful signs of recovery should not be expected before 2010. In this environment, corporate profitability will continue to come under pressure, particularly in sectors that depend on consumers.

Against this sombre backdrop, the British equity market, as measured by the FTSE All-Share index, has lost a third of its value so far this year – down 33.6%, in terms of capital returns, between January 1 and October 31.

In response to the financial crisis and the deteriorating prospects for the British economy, the government and the Bank of England’s Monetary Policy Committee, to their credit, appear to be willing to fight with every tool in their box to lessen the impact of the slowdown.

Measures taken to revive the economy have included a partial nationalisation of clearing banks, a one-and-a-half-point interest rate cut to 3% and cash injections into the financial system. These appear to have saved us from the worst outcome – financial meltdown – but the implications of the credit crisis for the global economy remain overwhelmingly negative.

Turning our attention to British equity investing, the asset class appears generally inexpensive, which in itself should ultimately prove to be a source of support. In fact, most measures of valuation are lower now than they have been for decades.

In terms of valuation, we have been in a bear market since 2000. The de-rating that has occurred suggests the market did not believe that the earnings growth of recent years, which was built on financial leverage and consumer debt, was sustainable. Events of the past 18 months suggest that the market was right to view this earnings growth with suspicion, as it is now evaporating.

However, valuation measures that attempt to account for the cyclicality of earnings also appear low. The British market Shiller price/earnings ratio (P/E), using 10-year average earnings in its calculation, stands at its lowest level since 1982.

While parts of the market will suffer as leveraged and cyclical earnings disappear, many other investment opportunities are available where earnings, profits and dividends are sustainable and could grow, even in the challenging economic environment.

In these times of uncertainty and volatility, and in a world that has suffered from too much complexity and too much debt, it is important to remain true to principles and processes that have worked well in the past. To this end, investors should remain focused on companies that have robust business models, are cash generative and are able to use this cash to develop their businesses or return it to shareholders in the form of dividend payments.

In terms of sectors, some areas of the equity market provide interesting investment opportunities. These companies typically fall within the more defensive parts of the market, such as tobacco, telecommunications, pharmaceuticals, oil and utilities, and almost all are found in the large-cap end of the market.

Companies in these sectors are usually non-economically sensitive, and are likely to have less financial risk, thanks to their proven cash-generative business models and strong balance sheets. They also possess attractive valuations, with dividend yields above the market average and less risk of dividend cuts.

In addition – since many of the companies in these sectors are internationally diversified, such as the pharmaceutical groups GlaxoSmithKline and AstraZeneca and oil majors BP and Royal Dutch Shell – they should also be prime beneficiaries of sterling’s weakness on the currency markets. Sterling’s depreciation, particularly against the dollar and the euro, will persist for some time and act as a tailwind for British companies that trade internationally.

While there are still real concerns over the problems facing the economy, valuations and long-term opportunities in the British equity market remain compelling.

However, investors should tread carefully. Many businesses will struggle in this environment and some will fail. The need to be selective is as great as ever.