Why you should avoid the stocks everyone loves

published 25 May 2006

Charles Glass, investment adviser to the Close Finsbury Continental European Equity fund, tells MoneyWeek where he'd put his money now.

We expect European stockmarkets to remain buoyant over the rest of 2006, helped by an improvement in consumer confidence and plenty of takeover activity. And, after a long absence, the European investor is once again dipping his toe into the equity market.

The eurozone recovery has been led by Germany, with its country's exporters benefiting from the global boom in industrial goods. In recent years German consumers have been big savers, feeling uneasy about their job prospects as firms have moved production to eastern Europe and Asia. However, we think that much of this hollowing out' has now run its course, given that the proportion of the German workforce in manufacturing has fallen to around 22%.

Italy, by contrast, is having a tough time, but there are still opportunities for investors. Banks, for example, offer good prospects (we are 9% invested in this sector). Following the first round of banking consolidation in the mid to late 1990s, when returns on equity improved from around zero to about 12%, the central bank governor blocked all corporate activity and so the sector went back to sleep. He has now gone and foreign banks are queueing up to enter the market, so we felt it was right to hold three Italian banks, all of which have high single-digit net-interest income growth.

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For us, the biggest risks are in areas everyone loves. If you'd invested in the 25% of stocks with the lowest price-to-book ratio (evidence of unpopularity) since March 2000, you would have doubled your money. We've now had three years of energy stocks and small-caps doing well, for example, and it's time to look for other things. We like to sell firms when their share prices are strong. We then move into areas where the mood may be worse, but where there's better value.

Oil-service firms are a good example. We started buying into this sector when the major oil firms weren't investing, which meant service companies were suffering from weak order books and low profits. Companies such as Saipen and Bouygue Offshore responded by merging, which took capacity out of the industry. We bought them because we considered it an industry ripe for improvement. Our view was that the customers would have to come back eventually, and that's exactly what happened.

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