Shelter from earnings shocks
Colin Morton, manager of the Rensburg UK Equity Income and UK Blue Chip Growth Trusts, tells MoneyWeek where he’d put his money now.
There are unprecedented things happening in today's markets. The collapse in conventional and index-linked Government bond yields, particularly at the very long end of the market, has left many commentators astonished. However, it has also provided strong valuation support for the UK equity market given that the real yield on long-dated paper is a benchmark for the cost of capital across the financial markets. Ten-year yields are now just over 4% and the earnings yield on equities is still around 6.5%, which should lead to further takeover activity in 2006.
Investors have also taken heart from the encouraging news on inflation there are still few signs of effects from the sharp rise in energy costs spilling over into the broader economy and wage growth remains within acceptable limits. All this means that it will be possible for the Bank of England to cut interest rates, should it prove necessary. It would, of course, be preferable if the recent stability in consumer spending and gentle improvement in the housing market was maintained instead, but that the flexibility to act exists has to be good news.
The downside of keeping a lid on inflation in the face of rising input costs is that earnings in many areas will be under pressure and we have already seen several examples of this in trading statements. The results season in the US has thrown up several high-profile disappointments, which has introduced a degree of caution ahead of the UK reporting season, which gets into full swing next week.
Given this uncertainty, my current favoured stocks are in areas of the economy that should be reasonably well sheltered from any earnings shocks. Scottish & Southern Energy (SSE) generates, transmits, distributes and supplies electricity to industrial, commercial and domestic customers in England, Scotland and Wales. It also provides electrical and utility contracting services and supplies natural gas. The company is extremely well positioned to benefit from the long-term growth in these markets. The management aims to grow the dividend in real terms and, with the shares currently offering a prospective yield of 4.2%, we believe they are attractive.
The next stock, Imperial Tobacco (IMT), was tipped by my colleague, Mark Hall, in this column in October. The attraction here is the strength of the underlying cash flows and the potential for excess cash to be returned to investors. The shares have already performed well, but we would argue that there is more to come. The management has a good track record in terms of delivering for shareholders, and the free cash yield of 7.5% is attractive in the current low-interest-rate environment. The firm has recently announced plans to return £600m by means of a share buyback programme. This equates to 5% of the current market value and is in addition to the current forecast dividend yield of 3.7%.
My final tip is National Grid (NG/). The company owns and operates electricity transmission and gas distribution networks, which are located throughout the United Kingdom and in the northeast of the United States. The firm also owns liquefied natural-gas storage facilities in Britain. The group's shares offer a dividend yield in excess of 4.0%, which National Grid plans to grow at around 7% a year over the medium term.
The stocks Colin Morton likes
12mth high 12mth low Now Scottish & Southern 1,115p 853p 1,115pImperial Tobacco 1,790p 1,366p 1,683pNational Grid 597p 480p 588p