Cautious UK equity selections

Monday, 17th September 2012 12:40 - by David Harbage

A focus on individual stocks

Last week’s blog focused on constructing a portfolio of stock exchange investments, in which collective vehicles (featuring low cost index-tracking exchange traded funds and an actively managed investment trust) dominated. But several readers, probably reflecting a large portion of the LSE.co.uk audience, requested further detail on the individual UK company share selections. Accordingly, always seeking to oblige, we are suggesting two lists of domestic equity names. The first, detailed in this week’s blog, is biased towards defensive, economically resilient businesses, while the second one (to be published next week) incorporates a higher level of growth and a fair smattering of cyclical company stocks.

Cautious or Aggressive (economically-resilient versus economically sensitive)

In more benign times, when local and global economic performance would be closer to the norm (assessed as UK & World GDP being close to trend growth, of say 2.25% and 3.5% respectively), one would expect cautious, slower growth, stocks to be more attractively valued while a portfolio of the most obvious beneficiaries of strong economic activity – essentially, higher growth companies - would be more expensive. However, as one might anticipate after a number of years of below par growth in the world’s major developed economies, non-cyclical defensive equities are not cheap relative to the overall universe of stocks - as investors have recognised their more reliable earnings or asset worth.

If it is already ‘in the price’, where do we go from here?

Listed businesses which intuitively feature slower growth via a more resilient lower risk-reward corporate persona may be enjoying a premium rating, as history shows us that investors are happy to ‘pay up’ for more assured growth at this point in the economic cycle. But markets move very quickly to anticipate any change on the economic horizon – as evidenced by its response to the Federal Reserve Bank’s promise to pump a further US$40 billion per month into the US economy (restraining yields and increasing money in circulation via the purchase of bonds).

Defensive Portfolio of 10 UK equities

Royal Dutch Shell – the FTSE100’s largest constituent by market capitalisation, this Anglo-Dutch fully integrated natural resources business has major interests in both upstream (exploration) and downstream (refining and marketing) in almost every country of the world. Some might view this as a cyclical company, as it will benefit from higher levels of economic activity (and, yes, a higher oil price), but its prime attribute - of being a huge oil & gas producer, which is an essential product to heat and provide fuel for transport, homes and commerce – deem it appropriate for this portfolio. Perceived as cautiously managed, the company boasts a strong balance sheet, features a well-covered dividend and a consensus of equity industry analysts’ (of whom16, of the 33 reviewed, rate the shares as a Buy, 15 say Hold and 2 say Sell) anticipate:

AstraZeneca – this major biopharmaceutical company owns prescription medicines for gastrointestinal, cardiovascular, neuroscience, respiratory, oncology and infectious diseases. Operating in over 100 countries, newly appointed top management will be focused on defending a business whose future growth appears less assured in the absence of new discoveries and as a number of drugs are due to lose patent protection. The business has a clear ‘run for cash’ approach (as robust finances facilitate stock repurchases, as well as particularly high dividends), which is a clear attribute – alongside the essential nature of medicines (whose need increases with an ageing population) - in this cautious portfolio. Beyond that, the equity’s worth may be enhanced by earnings-enhancing acquisitions. The consensus of health industry analysts’ (6, of the 38 reviewed, regards the stock as a Buy, 21 say Hold and 11 say Sell) forecast:

Vodafone – one of the world’s leading mobile telephone companies, its networks – in 30 countries, plus partnerships in another 20, over five continents - are used by more than 400 million customers. Data transmission has rapidly joined voice telephony as an essential service, with new handsets and technology a prime driver. The industry is mature in most developed nations, as regulators and competition prompt lower margins, to make telecommunications a quasi-utility in investors’ eyes, but opportunities for growth also exist. The United States is one such region, and the group’s 45% stake in Verizon Wireless is critical – in terms of profit, dividend and potential corporate event – in assessing the ‘sum of the parts’ worth of Vodafone. A consensus of equity industry analysts’ (with 19, of the 30 with published recommendations, viewing the stock as a Buy, 8 say Hold and 3 say Sell) currently anticipate:

Scottish Southern Energy – the third largest supplier of electricity and gas in the UK, via 3 million customers primarily in southern England, south Wales and Scotland, the business of this utility is regulated (as prices and other financial metrics are set) which restricts the growth potential and limits balance sheet engineering. However, the prospect of a stable, and potentially growing (in line with inflation) dividend makes this stock a prime candidate for this non-economically sensitive portfolio. Although such distributors can face cost pressures on their raw product, they can typically pass such higher prices onto their end customers. Looking at the expectations of the consensus of equity research industry analysts’ (of whom 19, of the 30 inspected, view the stock as a Buy, 8 say Hold and 3 say Sell), this reveals the following numbers and valuation ratios:

Imperial Tobacco Group – the fourth biggest tobacco company in the world, best known for its Embassy, Gauloises, Rizla, Davidoff, and John Player, with key markets being UK, France, Germany, Spain, US, Australia, Russia, Ukraine, Taiwan and Morocco. The addictive nature of tobacco qualifies the stock for this portfolio of defensive ‘essential’ products and services, although it is acknowledged that the number of smokers in developed countries is not growing. By contrast with smoking bans in public places, there is less regulation in emerging economic countries – where consumption of internationally recognised cigarettes (viewed as a luxury item) is rising, at the expense of local tobacco products. Higher taxes or stricter regulation remain a perennial concern: such as the advent of plain packaging could devalue the company’s brand worth. A consensus of industry analysts’ (of whom 6, of the 38 reviewed, rated the stock as a Buy, 21 say Hold and 11 say Sell) forecast:

BAE Systems – the UK’s leading defence contractor, whose interests extend from nuclear submarines to fighter jets (per the Hawk flown by the Red Arrows), military vehicles and security systems, has historically featured very long term contracts that provide insulation from local economy conditions. BAE has been in the recent news, following talks with EADS - the European owner of civil aircraft Airbus - a merger proposing 40% BAE, 60% EADS ownership. In the face of tough trading conditions, prompted by governments’ austerity cutbacks (especially the US and the UK defence spending), this combined entity (notwithstanding it being subject to high political hurdles) might provide the shares with some respite. A consensus of industry analysts’ (of whom 9, of the 20 reviewed, consider the stock to be a Buy, 9 suggest it is a Hold and 2 say Sell) forecast:

RSA Insurance Group – this Royal and Sun Alliance combine is a leading general insurance (and to a lesser extent, life assurance) group, which wrote £8 billion in premiums in 140 countries last year via prime operations in UK, Scandinavia, Canada, Ireland, Asia, the Middle East, Latin America and Central and Eastern Europe. A steady and dull, rather than spectacular, business profile is achieved via the diversity (which has the effect of de-risking the overall book) of its insured business lines. Beyond the company’s essential business activity, the shares’ boast strong supportive valuation attributes in asset valuation terms (as well as in earnings & dividend yield, demonstrated below), and are geared to any recovery in equity and corporate bond worth. The consensus of research analysts’ – with, of the 22 reviewed, 7 consider the stock to be a Buy, 12 suggest a Hold and 3 say Sell - forecast:

Tesco – the leading domestic supermarket chain has extended its offering into non-food (most recently into mortgages) and its reach into 13 countries overseas; employing 500,000+ people, the retailer’s revenue is second only to Wal Mart. Inevitably, growth has slowed as its UK market share reached 30%, and general merchandise (such as electrical goods) suffered from web-based competition and weak domestic consumption. The UK economy is likely to evidence sub-trend growth in the foreseeable future but its size suggests that Tesco will be a natural survivor and an ultimate winner, compared to smaller retailer. The new board are taking action (notably: putting the brakes on store expansion) but short term will have ‘to run hard to stand still’. The consensus of industry analysts’ (of the 24 reviewed, 8 consider the stock to be a Buy, 10 suggest it is a Hold and 6 say Sell) anticipate:

HSBC – one of the world’s largest banking and financial services organisation, with assets of US$2,652 billion in more than 80 countries. While it was not immune from the 2007-09 banking crisis, the company’s diverse geography – in particular featuring a significant emerging economy presence – and conservatively run operations and balance sheet helped to shield HSBC from worse. Banks represent a particularly large segment of the FTSE100 index and some might consider their core business activity (of lending money) a cyclical, rather than defensive business activity. However, rather like Royal Dutch Shell, the size and geographic diversity of its operations counterbalances and reduces the risk profile to merit portfolio inclusion. The consensus of financial analysts’ view the stock in favourable terms (of the 40 reviewed, 28 consider the equity to be a Buy, 9 have a Neutral recommendation and 3 say Sell), and forecast:

I shares S&P Commodity Producers Gold – the final selection, of an Exchange Traded Fund, might surprise. The writer would not have felt obliged to incorporate a mining company – despite the industry being one of the FTSE100 index’s biggest sectors – as these businesses are highly cyclical and their share prices (like the inherent commodity values) sensitive to economic performance. However, the prime defensive merits of gold could not be overlooked. Against a backdrop of continual increases in money in circulation (post further QE bond-purchasing) and low interest rates, owners of limited supply assets such as gold – which can have alternate currency appeal - anticipate appreciation. Individual gold miners incorporate inherent risk, but this basket of companies (currently 61 stocks, with a strong bias to Canada, including London-listed Randgold Resources) reduces that. Launched in September 2011 by Blackrock, the world’s biggest fund manager, this ETF has a total expense ratio of 0.55% per annum and its income is reinvested.

In the next article we will consider individual UK company shares which are more aggressive, in that they exhibit higher levels of growth and possess greater exposure to prevailing economic activity.

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.