JOHCM UK Equity Income fund’s James Lowen explains why low valuations and leaner companies mean now is a good time to increase equity holdings.

Investors can be forgiven for thinking that the roof is falling in at the moment.

Each day seems to bring with it news of another sovereign debt downgrade in Europe as the continent’s politicians vacillate further, while the outlook for growth in the global economy is looking increasingly gloomy, with the IMF’s downgrades of GDP estimates for the major economies adding to the despondency.

Not 2008 redux

We have been more optimistic than many on the UK and global economy in the past couple of years, but we recognise that the macroeconomic picture has undoubtedly deteriorated over the summer.

Nevertheless, as tough a proposition as it is, the time to buy equities is often when risk abounds – this is when the longer-term rewards can be at their highest.

The flight to safety towards government debt and corporate bonds – the latter now priced for perfection, the former remarkable given the debt burden of the US and UK – amid a collapse in investor risk appetite has brought UK stock market valuations down to post-Lehman levels that more than discount major earnings downgrades.

Many commentators have likened the current market turmoil to the events of autumn 2008.

But while recent weeks have shared to a degree that same slow-motion car crash sensation, the big difference is that companies are in much better shape this time round: firms are much leaner and, crucially, they are carrying far less debt on their balance sheets.

Equities v corporate bonds

The indiscriminate market sell-off has provided a plethora of opportunities for the disciplined investor who can stay calm and focus on individual corporate fundamentals rather than the screaming economic headlines.

The market volatility will be with us for some time to come yet and patience will be required to see the fruits of these investments.

The extent of the market weakness means we can now buy into high quality UK companies with leading business franchises, safe balance sheets and juicy dividend yields at rock-bottom valuations.

These dividend yields often easily eclipse those available in the corporate bond market.

Take two stock market giants as examples: Vodafone and GlaxoSmithKline. Vodafone’s equity yields 8.4%, comfortably outstripping the 3.2% yield on its seven-year corporate bond, while its dividend is expected to grow by 7% during 2011.

Meanwhile, GlaxoSmithKline, which is generating rising free cashflow, has little debt, will grow revenue by 5% over the next 12 months and where dividend growth of 8% is expected this year, is currently yielding 5.7% while its seven-year corporate bond yields 2.5%. Given these disparities, surely it makes more sense to own the equities of these rock solid franchises rather than their corporate bonds?