Francis Brooke, manager of the Trojan Income Fund for Troy Asset Management tells MoneyWeek where he'd put his money now.
The UK stockmarket is shaping up to produce a modest positive return for the year. Strong dividend growth has supported valuations, but the fact that firms have been returning capital to shareholders also reflects the current scarcity of investment opportunities. That, in turn, has negative implications for future growth.
With energy and regulation costs on the increase, margins (which recently expanded, thanks to cost cutting) are under pressure again. As a result, the market may be disappointed by earnings and dividend growth next year.
This will be accentuated by the impact of the weak dollar, which I don't think has been fully factored into market forecasts. The UK market is disproportionately exposed to the dollar through big sectors such as oil, pharmaceuticals and mining, and the dividends paid by companies such as BP, HSBC and Rio Tinto are dollar-denominated.
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Our cautious outlook for next year hinges on the belief that inflation will remain low and investors need to adjust their expectations of nominal returns accordingly. Dividend income should represent a higher proportion of equity returns in the next few years than was the case in the 1980s and 1990s, when rising equity valuations boosted returns. Our choice of stocks is therefore predicated on the ability of companies to provide long-term dividend growth that will beat inflation and therefore preserve the real value of investors' capital.
We enjoy investing in companies that have recently fallen out of favour in the market, and Unilever (ULVR) is a good recent example. This global consumer goods manufacturer has lost market share to competitors such as Procter & Gamble and missed ambitious revenue targets. The recent restructuring programme has, however, reduced costs and the number of key brands to a more manageable number - 400.
The core franchise is still intact and the combined group generates £1.5bn of free cash flow after the payment of dividends. This means Unilever can invest in the advertising and promotion necessary to revitalise growth. At 489p, on a 2005 p/e of 11.5 times and offering a yield of more than 4%, the shares are attractive.
Davis Service (DVSG) is a good example of a medium-sized firm that fits our investment criteria. Capitalised at £800m, the company specialises in laundry, work-garment rental and other critical but unfashionable services. The shares trade on a prospective p/e of 12.8 times, yield more than 4%, and have a consistent dividend growth record. Rising wage costs will be offset by improved financing terms next year, and any proceeds from disposals are likely to be returned to shareholders.
Air Partner (AIP) is a very small company (its market capitalisation is only £40m). As the world's leading air charter broker, it has a unique franchise - matching the growing demand for the charter of aircraft with the global network of planes to which it has access. Air Partner does not operate or own aircraft, and has an ungeared balance sheet.
Although the forecast p/e of 17.5 times is relatively high, the shares yield more than 3.5% and there is a stated commitment to a progressive dividend policy that could see the dividend grow 10% a year. The shares are tightly held, the chairman has a 35% stake and there is no intention to diversify away from the core business. At 452p, we consider these shares to be an excellent long-term investment.
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