It's time to get defensive

published 25 October 2006

A professional investor tells MoneyWeek where he'd put his money now. This week: Ted Scott, manager of the Stewardship Income, Stewardship Growth and F&C Growth & Income funds

The market is close to levels last seen in early May and seems fully valued. Bid fever is partly to blame (recent targets have included steel group Corus and utilities firm Veridian), and falling oil prices have also helped investor sentiment. But perhaps the main factor supporting equities has been the realisation that US interest rates have almost certainly peaked; this has traditionally resulted in equity markets outperforming.

Yet all these supporting factors rely on a soft landing for the US economy. I believe the market is being complacent, mainly because it thinks the Federal Reserve will be able to cut interest rates in 2007, allowing the Goldilocks' economy (not too hot, not too cold) to resume. But the slowdown may be faster than expected the price of oil is dropping because markets expect demand to fall. The million dollar question is: just how soft or hard will the landing be? If it is harder than the market expects, then equities are likely to decline. Given this, we favour investing defensively at the moment.

Many defensive firms have been performing well, but some still look reasonably cheap. In August, we increased our exposure to Vodafone (VOD), notably in the Stewardship Income fund. The share price had fallen to 110p, which seemed to discount all the bad news. It also had a yield of around 6%, while its p/e was at a 30% discount to the market. The share price has since risen to 130p after a positive update at an investor conference.

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We have also added to our position in GlaxoSmithKline (GSK). Defensive drug stocks have underperformed the market over the last two years, particularly mega caps such as Glaxo, which is on its lowest rating in 15 years and has an attractive yield too. We recently bought into international business travel group Hogg Robinson's (HRG) initial public offering (IPO). Original plans for a £380m float were pulled, and it eventually listed this month at less than 75% of what private equity group Permira, which controlled almost 90% of the firm, had wanted. We bought in because of the fire-sale price and attractive yield. We also participated in the IPO of European media company Mecom (MEC).

A smaller theme has been our increasing exposure to publishing within the Stewardship funds. Advertising-related media stocks have generally been weak over the last few years. This is partly caused both by the shift towards internet-related products and the cyclical advertising downturn. Some of our holdings, such as the Daily Mail (DMGT) and local newspaper publisher Johnston Press (JPR), have been massively de-rated as a result. We believe the bad news has now been discounted. Both firms have seen improvements in September, so if the cyclical element is starting to tick up then share prices should respond positively.

We have also been selling out of certain areas. In Stewardship Growth, we've sold our holding in water group Severn Trent (SVT), whose share price jumped after the bids for Veridian and water services group AWG. Unless Severn Trent is bid for, it is extremely expensive, priced at a significant premium to its regulated asset value. On top of this, it does not have much yield support, which is what has traditionally attracted us to utilities in the first place.

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