Chasing the rally

So far this year the mid cap area of the UK equity market has risen strongly, ahead of the market as a whole and well in front of the FTSE 100.

Economically sensitive sectors have fared particularly well. Unsurprisingly, they performed poorly in the third quarter of last year when eurozone debt fears were heightened. In some cases, those stocks are pushing to all-time highs.

For our own part, while we welcome the change in sentiment, we continue to prefer a balanced approach. We have good exposure to the structural growth stocks, those we believe can grow in almost any economic environment. But we’ve also got exposure to economically sensitive stocks, companies exposed to the strongest end markets. As the rally has continued, we have added exposure to value stocks, those that are trading on cheap valuations but where the earnings outlook is actually not as bad as the market was fearing and therefore share prices could and should move higher.

Valuations are still historically low and we believe there are two factors likely to drive them higher. One is confidence – the continued-build up of positive data flowing into a further improvement in investor sentiment. The second is the perception of earnings growth. If the belief that earnings growth will start to accelerate becomes more widely accepted, that could really lead to a wide re-rating across the market.

Looking at sectors, we still like house-builders. This is a sector that has had a lot of negative perception, mainly due to the outlook for house prices. But this is not really the point. Builders have been able to replenish their landbanks at lower costs at the bottom of the cycle. As long as house prices stabilise, which is more or less where they are, then house-builder profits rise as houses built on the cheaper land comes into the equation. If you combine this with low share valuations, you have an attractive proposition.

Premier Oil is among the stocks we currently like. It is an oil producing company – as opposed to one supplying equipment or services to the sector. In my view it is trading cheaply when you look at the value of the oil it has in the ground. Currently the share price is factoring in oil at $85 (£53) per barrel, while the current price is around $125. That’s pretty cheap in my mind.

Debenhams is a stock we have liked for quite a while. As a UK retailer it is interesting in that it is outside our preferred themes. We originally bought into Debenhams as it was trading on an attractive valuation, so not really factoring in any kind of improvement on the UK high street. But in recent months we have seen a range of UK retailer stocks perform pretty well. I think what the market is trying to price in here is that the pressures on the UK consumer may get easier going forward. Higher rates of inflation last year squeezed consumers but I think we are moving through that process now. The Debenhams share price has responded favourably to that. There are also some stock-specific reasons, in particular the company’s strong balance sheet.

Richard Watts is manager of the Old Mutual UK Select Mid Cap fund.