Asset Allocator's Soapbox: Distinction's Patrick Armstrong

Patrick Armstrong, joint managing partner and head of portfolio strategy and construction at Distinction Asset Management, assesses the impact of recent turmoil in Japan and the Middle East on global markets.

Investors’ attention in recent weeks has been on Japan and the Middle East and how events there will impact the global economy and markets.

We expect industrial output in Japan will decline severely for the next two months as Japan deals with power shortages, damaged manufacturing facilities, and puts its emphasis on dealing with the human tragedy of the situation.

We also expect that the ongoing situation in the Middle East will keep investors’ aversion to risk relatively high.

With this as a backdrop and now that the bull market in equity markets has reached its second birthday we are not surprised to see the market sell-off. However, we do see sectors which are not impacted by the Middle East or the Japanese disaster which now represent very attractive value.

We expect a rotation from the early cyclical sectors into the late-economic-cycle sectors. With bonds yielding less than inflation we also expect investors will be attracted to equities in defensive sectors with much higher yields.

The MSCI World index bottomed on 6 March 2009 in GBP terms and has risen by over 70% in the past two years. We believe large-cap defensive stocks which have lagged cyclical growth now represent good value while some cyclical sectors are now expensive.

Sectors such as healthcare, utilities, telecoms and global water offer high dividend yields which have become increasingly attractive relative to their corporate debt. Also, given the low cost of debt financing for these companies, they have the ability to carry out capital structure arbitrage, whereby they can issue debt in order to return cash to shareholders in the form of share buybacks.

Many companies in these sectors can issue bonds which yield 4-5%, and buy back their shares which yield 6-9%. This approach is actually cash flow positive for the company as interest on bonds is tax deductable and the company does not pay dividends on the shares it repurchased.

In early March we began adding to European healthcare stocks in our multi-asset funds. European pharmaceutical companies have not participated in the equity market rally over the past year.

They trade at a 25% discount to the broader index based on forecast 2011 earnings and they are also trading at depressed levels on book value and cash flow. Their lowly rating reflects concerns about future revenues after the so-called ‘patent cliff’, which sees many companies lose exclusivity on their blockbuster drugs, as well as US healthcare reforms and European austerity measures.

Nevertheless, these companies are highly cash generative, are set to benefit from positive demographic trends (ageing populations) and, despite committing billions of dollars to research and development over the coming years, we believe the markets has drug pipelines priced at zero in terms of economic success.

We have also been adding to Western Telecoms (European, US, Canada) over the past few months based on very strong dividend yields and the prospect for growth in dividends above rates of inflation.

We believe telecoms are underpriced as investors believe they can identify better earnings momentum elsewhere but this is more than offset by very strong dividend yields. Telefonica for example is trading 17 euros a share, has an historic yield of 8% and announced it will be increasing its dividend to 1.75/share.

The one area of the market with cyclical characteristics that we do like is the luxury brands sector.

Demand for high-end European brand names is exceptionally strong in Asia and these stocks have sold off significantly based on exposure to the Japanese consumer.

We expect the Asian consumer and Emerging Market consumer will continue to be fuelled by the very loose monetary policy in the West and companies involved in high-end branded luxury goods will continue to exhibit tremendous growth despite a potential slow down in Japan.