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• Rally set to continue into 4Q. Stocks look set to rally further as a steady improvement in economic newsflow should prompt earnings upgrades – we
have recently raised our forecast for 2010 profit growth to 23%. While trailing PE multiples are gradually moving back toward longer-term averages equity
valuations remain attractive relative to other asset classes, M&A appears to be picking up and sentiment toward stocks is not excessive. Although serious
long-term fundamental concerns are likely to see equities move within a wide trading range for some years, we think investors should keep a reasonably
high beta portfolio in the near term as risk appetite picks up and broadens out. Significant downside is unlikely until interest rate and inflation fears pick up.
•Investment strategy. For the next few months we recommend investors run a reasonable degree of beta in their portfolios and we recommend an
overweight in areas such as Energy, Mining, Industrials, Life Assurance and Asset Managers. We would be underweight Consumer cyclicals, Staples and
Utilities. On a 12-month view we believe there is outstanding value on offer from quality growth stocks (e.g. a basket of our reliable growth stocks trades
at an all-time relative valuation low vs the market) and would look to increase weightings in these names over the next quarter ready for 2010.
Companies that meet such criteria include: BAE Systems, Compass, Reckitt Benckiser, Vodafone, Burberry, First Group and Imperial Tobacco.
• Current Investment Themes:
(1) Reliable growth – A volatile and uncertain macro environment should favour stocks that have a good track record of producing consistent profit
growth. Overweight rated stocks in our reliable growth screen (P49-51) include: Reckitt Benckiser, Imperial Tobacco, BAE Systems, BAT, TUI, Vodafone,
Rolls Royce, Diageo, Balfour Beatty, SABMiller, Scot. & Southern Energy, Xstrata, Compass Group.
(2) Overweight Resources – We are OW Energy and Materials in the European Model Portfolio due to: 1) Play on recovering Chinese economy and
possible bubble in Chinese equities; 2) Steep yield curve; 3) Earnings momentum to surprise on the upside; 4) Sentiment survey suggests investors are
underweight sector.
(3) Take profits in consumer cyclicals – Consumer cyclicals have performed strongly as befits their early cycle characteristics. Valuations are
becoming stretched and we prefer Capital Goods to General Retail.
(4) Yield curve – The yield curve is unlikely to steepen much further, in our view; however, with short-term policy rates likely to remain low for longer, the
curve may stay steep for a while. This should be favourable for commodity and industrial stocks and delay renewed defensive outperformance.
(5) Re-equitisation - Re-equitisation remains a key feature of this cycle as companies look to repair and strengthen balance sheets – we expect further
rights issuance, dividend cuts and debt-to-equity swaps, and screen for companies with weak balance sheets.
(6) The importance of dividends – With interest rates set to remain low for some time, stocks with a solid dividend profile should perform well.
(7) Mid250 vs FTSE100 – Mid250 has enjoyed a record 6m outperformance over FTSE100; however, valuations are not as extended as is often
perceived and its greater cyclical composition means that significant FTSE100 outperformance is delayed until we get closer to first rate hike .
Regular Stock screens:
(1) Low Fixed Charge Cover (P41) – Underweight-rated stocks include: Punch Tavern, Rank, Go-Ahead, HMV, Enterprise Inns, Kingfisher, Severn
Trent.
(2) Private Equity (P42) – New entrants incl: Qinetiq Group, FirstGroup, Sainsbury’s.
(3) 3 U’s and 3 O’s (P43-46) – New entrants to 3 Us this month: Qinetiq Group, FirstGroup, Sainsbury’s.
(4-5) Director Deals & Buybacks (P49) – No significant buybacks.
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