We asked some of the managers who run IC Top 100 Funds to give their outlooks for the year ahead. They set out their expectations, concerns and views on where the opportunities lie.
UK equity income
Michael Clark (pictured above), portfolio manager, Fidelity Enhanced Income Fund (ISIN: GB00B3KB7799) says: "We can look forward to another year of positive real returns in 2014. There are encouraging signs of economic stabilisation and renewed growth.
The housing market continues to recover, and indus- try is doing well in many sectors.
"But economic growth has not yet fully returned to normal and consumer incomes continue to fall in real terms. Any disappointment on future gross domestic product growth (GDP) growth could pro- voke some turbulence in the markets. But as a result we are unlikely to see a destabilising move upwards in interest rates.
"Dividend payout ratios remain below 50 per cent of earnings, a very comfortable level. Companies are gen- erally cash-rich, and management policy generally tar- gets progressive dividends across all industry sectors.
"Valuations and the prospects for dividend growth will continue to support equity income in 2014, and if GDP growth is better than expected, it will support equity prices."
Kevin Murphy, co-manager, Schroder Income Maximiser (GB00B0HWHK75): "Sectors perceived as safe have become expensive, but banks and other cyclical areas remain attractively valued with signifi- cant potential for dividend growth. Opportunity also lies in slightly less cyclical areas such as telecoms and pharmaceuticals. The companies within these sectors have robust balance sheets, are highly cash generative, and yet continue to trade on reasonable valuations.
"We are avoiding many of the traditionally defen- sive high-yield stocks which are very highly valued, such as food and beverage companies, utilities and tobacco."
Charles Luke, manager, Murray Income Trust (MUT): "The pharmaceutical sector offers an attrac- tive yield and the potential for good growth over the long term, given more focused research and develop- ment expenditure, ageing populations and strong demand from emerging markets.
"In 2014, there is a risk that dividend growth will disappoint as company earnings fail to make pro- gress, in part due to the weakness in emerging market currencies as some companies generate revenues in those markets. I am cautious on companies whose share prices have raced ahead prospective earnings growth."
UK
Julian Fosh, co-manager, Liontrust Special Situations Fund (GB00B0N6YF70): "A risk to share prices in 2014 is that the expected EPS growth doesn’t materialise, despite the improvement thus far in the economy.
"A second risk is that the nascent UK economic recovery slows, or even goes into reverse. It's also important to remember that the average UK company derives around two-thirds of its sales from overseas. Therefore, slowing growth in emerging markets and China, a still struggling Europe, and a moderation in the rate of recovery in the US will have an impact and indeed are being reflected in still cautious outlook statements from many companies as they report results.
"Despite share price falls taking it to a sub-market price-earnings ratio rating, the mining sector's free cash flow yield remains poor, and it looks set to see returns fall below its cost of capital next year and further underperformance.
"A share that looks a good contrarian bet given such a background is AstraZeneca (AZN). Recent focus on the near-term expiry of key patents has driven the price down to very attractive valuation levels versus the market, and a lot of disappointment appears priced in. Companies with substantial intellectual property tend to be able to sustain higher returns than the average company, and for longer. The preoccupa- tion with short-term EPS overlooks the company's medium term prospects."
Nick Train (pictured above), investment manager of Finsbury Growth & Income Trust (FGT), says: "Technology, internet, media and healthcare will do best in 2014 because investors will pay up for genuine secular growth next year.
"The outlook for UK equities is pretty good, though not as exciting as for US stocks. The US is home to more, bigger and better technology companies. Nonetheless, the likely sharp falls in energy prices in 2014, precipi- tated by the opening up of new energy sources from the US, will act as a beneficial growth dividend for corporations worldwide, including the UK.
"Advances in digital technology mean that certain real estate companies will be pressurised, as more and more business is transacted in cyber-space, away from bricks and mortar. And high starting dividend yields have always been and will always remain potential value traps.
"The risks in investment markets are mostly rel- evant for nominal assets such as government and corporate bonds. Real assets such as equity should be relatively unaffected.
"Everyone thinks consumer branded goods com- panies are expensive because they have performed well for a few years. But the inflation protection and growth opportunities in emerging markets offered by companies such as Diageo (DGE) and Unilever (ULVR) still make their shares a bargain."
Harry Nimmo, manager, Standard Life UK Smaller Companies Trust (SLS): "The spectacular perfor- mance of smaller companies equities in recent years is likely to soften and return nearer long term averages. We also see smaller company investors favouring higher quality, lower risk more sustainable businesses with visible growth.
"The key risk is sustained low interest rates coming to an end. This has contributed significantly to stock market strength, particularly at the smaller end of the market. The second significant risk is a challenge to the stability of the euro which could mean more vola- tile market conditions.
"Major corporations in sectors that are mature or susceptible to the loss of business through competitor online trading could be value traps, as could compa- nies over-distributing dividends. Food retailing, old- fashioned big retailers, big pharma, big oil, tobacco, and traditional betting and gaming could be affected.
"We see value in branded retailers with interna- tional reach, examples being SuperGroup (SGP) and Ted Baker (TED); and secondary but high quality real estate with focused models that are benefitting from the vibrancy of London economy and property mar- kets such as Workspace (WKP), Big Yellow (BYG) and Shaftesbury (SHB).
"Predictable growth stocks with good market posi- tions and strong cash flows include PayPoint (PAY) and Emis (EMIS)."
Mike Prentis, manager of BlackRock Smaller Companies Trust (BRSC), says: "The housing market is strong and this should continue to be good for shares in house builders, which traditionally perform well in the first calendar quarter, and estate agents. This housing strength seems to have had a positive effect on retailers, leisure and other consumer stocks.
London, in particular, seems to be achieving strong economic growth and this bodes well for shares in some of the property investment companies and pub companies with a clear London focus, although these have already performed well.
"Many UK-listed shares are international busi- nesses, for example, in electronics and software. The structural growth being achieved by these companies will be assisted by the strength of the global rather than UK economy. We prefer ones with exceptional management, world leading products or services, pre- dictable revenues, and good margins and cash flows, such as Oxford Instruments (OXIG) and Xaar (XAR).
"We are wary of companies supplying customers who are fighting aggressively for better value. This encourages us to avoid suppliers to the government - for instance, many outsourcing and defence companies, and food producers, which typically supply the UK supermarkets. Shares in some of these companies do not look expensive, but they have still been long- term losers.
"The worst performing sectors over the last year have been resources and might provide some con- trarian surprises in 2014. Well run companies within these sectors include Petra Diamonds (PDL) and Faroe Petroleum (FPM).”
Global equity income
Patrick Ryan (pictured), manager of Lazard Global Equity Income Fund: "The best opportunities are in Europe and emerging markets. Valuations in Europe are attractive at roughly 16 times earnings and remain 30 per cent below their 2007 peak, in contrast to the US where earnings have reached new highs. This implies European earnings have more cyclical rebound potential should the stabilisation in those economies persist.
"However, the truly compelling valuation opportunity is in emerging markets, which trade at just over 12 times earnings, a discount of over 30 per cent to the US.
"We are avoiding very large cap, defensive income stocks from developed markets as they trade at unap- pealing valuations both relative to the broad market and in absolute terms.
"Rising rates are a clear headwind for income stocks as investors will shift capital to bonds if rates become more appealing. However, cyclical income stocks perform much better in a rising rate environ- ment as they are less of a substitute for bonds, and their earnings will see an uplift driven by the cyclical rebound that is pushing interest rates higher."
James Harries (pictured), manager of Newton Global Higher Income Fund (GB00B5VNWP12), says: "We have been concentrating on the US equity market in particular, and within that technology. Attractive valuations and more recently dividends have become a feature. We have been able to invest in some great businesses with durable franchises which offer decent dividends and longer-term capital growth.
"We remain relatively keen on the US dollar and relative vibrancy of the US economy. Equities denomi- nated in US dollars with bond-like characteristics should do well in a more difficult environment, which we expect. We have to be selective, however, as the US market is fully valued in absolute terms and relative to others.
"We are avoiding businesses that have been the beneficiaries of the boom in China which we think is in the process of coming to an end. Meanwhile, cyclical businesses such as mining companies have fallen to a level that makes them look cheap, but that does not yet fully reflect fully the slow-down in China which we believe to be structural rather than cyclical, and look like value traps to us."
Global
Bruce Stout, manager of Murray International Trust (MYI), says: "Certain companies will perform well regardless of the economy they are situated in, so I'm not avoiding any regions, even the US and Europe, where I have grave concerns about the side-effects of the Federal Reserve's QE programme and the European Central Bank's monetary policy. Despite their economic woes, the US and Europe are home to some good quality companies such as Johnson & Johnson and Nestle that are performing well regard- less of the backdrop.
"If current trends continue, certain stocks within emerging markets may become even more attractive, given the whole asset class has been so out of favour recently even though the long term story remains compelling."
Peter Walls, manager, Unicorn Mastertrust (GB0031218018): "The UK equity market should continue to perform well given relatively undemand- ing fundamental ratings and its exposure to over- seas earnings which should benefit from a further recovery in global GDP growth. UK smaller companies are likely to continue to make solid progress in the short-term but there is a danger that investors become over exuberant.
"The year 2014 should be a more rewarding one for emerg- ing markets. In addition to a pick-up in global GDP growth, their valuations are attractive by international comparisons. Russia, and in particular JPMorgan Russian Securities (JRS), could be a good contrarian bet for 2014. This country's equities are very cheap and it is relatively immune from QE considera- tions, though has a different variety of political risk.
"Risks include the US recovery stalling or the shadow banking system in China going into tailspin. Other risks include heightened volatility, overconfi- dence and political risk, later in the year, and interest rate risk."
Europe
Sam Morse (pictured), portfolio man- ager of Fidelity European Values (FEV), says: "Recent share price move- ments can only be justified by a return to the sort of growth seen pre-crisis. This may well lead to disappointment, given that some of the longer-term impediments to global growth remain, such as high consumer and government debt levels. Economic improvement is already discounted in share prices and the recent seeking out of higher risk opportuni- ties - seen as the last remnants of value - suggest that the market may be about to lose steam.
"Shares have re-rated from a low base in the last 18 months, but earnings and dividends have grown little during that time. Aggregate valuations do not look extreme relative to history as they have risen from a low base, but on a bottom-up basis it is increasingly hard to find attractively valued opportunities where fundamentals are robust.
"Consistent dividend growers are no longer selling at such a premium to the market. Calculations sug- gest a 20 per cent premium against a 60 per cent high, and, although they have lagged in the recent surge, consistent dividend growers have not been de-rated in absolute terms."
US
Clare Hart, manager of JPM US Equity Income Fund, says: "Our largest absolute and relative weight is financials, which have been dealing with greater regulation and high capital requirements for several years. But these are manageable and many parts of the financial sector are looking forward to higher interest rates from a lending perspective. In general, financials are going to be a decent place to be in the next couple of years.
"Overall, we are optimistic for the US equity market and think it will go higher. On an absolute basis, valuations are reasonable. At 15 times earn- ings, they are more typical of the levels we've seen longer term.
"We are less optimistic on telecoms because of structural challenges such as increased competition and creative destruction.
"We are also worried about the small pockets of excess, particularly in sectors where companies usu- ally pay high dividends, such as utilities, real estate investment trusts (Reits), consumer staples and tel- ecoms. Investors have just focused on the dividend and have driven stock prices up to levels where they don't make sense."
Don San Jose, manager, JPMorgan US Smaller Companies Investment Trust (JUSC), says: "As the US equity market flirts with new highs, we continue to believe that equities can go higher. Stocks look fairly valued to us and we expect investors will still earn a reasonable return from these levels.
"The relative valuation gap between equities and fixed income remains intact and could be a key catalyst for equity performance from some asset class rotation. Additionally, there is enough growth in the US to keep earnings moving ahead.
"A continuation of the economic recovery with many of the domestic headwinds becoming tailwinds is a positive. Companies, governments and consumers are all being more prudent and disciplined with their cash, suggesting this recovery still has more legs.
"The housing theme has been a strong performer for most of the year, and as smaller companies tend to have a high correlation to this they are a good way to play both the housing and domestic economic recov- ery. We expect in the next year to see the benefits of a slightly faster economic recovery in the profits of many consumer and financial companies as well.
"A good contrarian bet for 2014 could be consumer shares such as retailers or restaurant names, particu- larly casual diners. We like Brinker International (US: EAT), which owns the restaurant chain Chili’s. Brinker has changed its menu to bring people in who might have gone to a cheaper option, and has a great management that is very shareholder-friendly.
"We are seeing some pockets of excess in the quest for yield and stability. Utilities, consumer staples, real estate investment trusts and telecoms look expensive."
Emerging markets
Slim Feriani (pictured), manager, Advance Developing Markets Fund and Advance Frontier Markets Fund, says: "Comfort can be taken from the continuation of accommo- dative monetary policy in the west for longer than expected, as the delay buys time for a number of emerging markets to address fiscal and trade deficits. It can also be taken from attractive valuations, sentiment towards the asset class being at a nadir and the continued pick-up in economic data from China, the most important economy for the asset class.
"Emerging markets as a whole now trade on 10.1 times next year's earnings, a level that has his- torically proven an attractive entry point. From this level, there is again scope for returns to be driven by a re-rating of the PE, even in the absence of a recovery in earnings.
"While we are bullish on the medium term, we are cautious about being too aggressive too early in countries running twin deficits, the so-called fragile five of India, Indonesia, Turkey, South Africa and Brazil. Policy makers in those countries have limited flexibility when tapering concerns resume.
"It is probably too early to take large bets on more cyclically exposed stock markets, but on the back of a stronger economic data we have gradually been adding to China and Korea, at the expense of Indonesia and Thailand. We have also added to Mexico, where we like the strong macro situation, linkages to the recov- ering US and the government's reform agenda.
"In Russia, we retain a large overweight based on cheap valuations and the country's robust sovereign balance sheet supported by high oil prices, as well as attractive and rapidly growing companies in the consumer sector."
James Donald, manager of Lazard Emerging Markets Fund (GB00B24F1P65), says: "Given existing, reasonable valuations and generally strong fun- damentals, the prospects in many emerging markets countries are very positive.
"If economic growth in the US, Europe and Japan decreases significantly, or if credit growth in China is left unchecked, this would be likely to cause prob- lems for emerging markets.
"Current value traps include high quality, defensive stocks, particularly in areas like Asian consumption, which currently trade at inordinately high ratings.
"The strongest contrarian bets for 2014 are in economy-sensitive shares and sectors, as well as Russian equities. Specifically, many stocks in the industrials, energy and particularly the materials sectors have, until recently, performed relatively poorly and are unloved by investors. Russian shares are also selling at generally low valuations.
"As long as the global economic situation is stable, we would be surprised if such growth equi- ties in emerging markets do not perform strongly."
Richard Titherington, manager of JPMorgan Global Emerging Markets Income Trust (JEMI), says: "South Africa is our largest country overweight. Companies there tend to be very profitable, operate in consolidated markets with management teams that have a culture of paying dividends, and have some of the best corporate governance standards in the world. We own everything from retailers to industrials.
"We are overweight Taiwan, where we have been finding some interesting technology com- panies. Cash dividends are much higher up their list of priorities than they used to be, led by chip manufacturer TSMC. But much of the pure PC supply chain is in decline as the market for tablets and smart phones evolves, so we need to be aware of value traps among Taiwanese tech companies.
"There are also good yield opportunities in the Middle East, where we have exposure in Qatar and Saudi Arabia, and we have added recently to Turkish industrials and finan- cials in Brazil, because the dividend yield has improved and growth still looks solid.
"We are underweight Mexico, where yields on companies we like have come down as the valuations have moved up. Korea, our largest country underweight, historically has had value trap characteristics, and does not offer many interesting income opportunities.
"High yield, low growth strategies could be under pressure in a rising rate environment. We can find high yield opportunities in cyclical sectors, and these types of stocks should be better placed than those offering high yield but low growth. But high yielding stocks in emerging markets are cur- rently at attractive valuations compared with their developed market counterparts."
