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Fund managers seek bargains but wary of traps in 2014
FUND managers are bargain hunting but trying to avoid value traps next year as modest recoveries begin to shape up in developed markets.
"Right now we're in a stock picker's environment," said Ted Pulling, chief investment officer for JP Morgan Asset Management's Asian equity specialist unit. "Stock correlations are low . . . it's not an asset allocation market so much, it's not factor investing. It really is stock picking, and we would expect that to continue next year."
Some broad themes are gaining close to consensus status as 2014 approaches: The US and Japanese economies are picking up steam, but recoveries in those markets are still fragile. Europe is also getting glimpses of life, though deflation continues to threaten some of the peripheral economies.
"The eurozone overall continues to struggle," Schroders economist Azad Zangana said recently at the firm's international media conference in London.
In Asia, concerns about a China slowdown are balanced by confidence in restructuring efforts and by the fact that even a slower China is still growing at a robust clip.
South-east Asia, however, is facing a threat of capital outflows as developed markets improve, while the overperformance from previous years dulls the region's attractiveness on a relative basis.
Those broad themes form starting points, but asset managers stressed that the outlook remains highly sensitive to a large number of factors - when US tapering occurs, for example, and at what pace is anyone's guess - and there will be winners and losers. Figuring out how to tell them apart is therefore the challenge for next year.
One popular filter at the moment is income, with fund managers expressing a preference for dividend-paying stocks.
But the income play is shifting from traditional yield instruments, such as bonds and real estate investment trusts (Reits), towards more growth, such as dividend-paying cyclical equities.
"In a rising interest rate environment, we still recommend income products to our clients, but we are changing the complexion of the underlying investments," Mr Pulling said. "We can find stocks in sectors that have high yields, but also have better growth prospects. So maybe the yield is not as secure as the yield in, say, a Reit, but the growth of the dividend might be stronger."
Mr Pulling said that stocks in cyclicals, financials and materials, in particular, are where value can still be found. And he prefers North Asia to South-east Asia, partly because valuations in Singapore and its neighbouring countries remain elevated compared to markets such as China and Korea.
In the United States, Schroders portfolio manager of US large-cap equities, Joanna Shatney, said that healthcare and industrials looked interesting because of valuations, demographics and expectations of increased capital expenditures.
Ms Shatney believed that the year-long US equity rally still had legs. Slow economic growth should keep the Federal Reserve dovish for longer, while margin multipliers could amplify US corporate earnings improvements.
"I'm not a believer that margins have peaked . . . There are still, if you look by sector, opportunities for margins to go up, and to be honest I don't have an official margin forecast for next year, but we think that 4 per cent topline growth can be leveraged into 200 to 300 basis points for operating income growth," Ms Shatney said.
The stock-picking strategy also applies to Europe, where Schroders European equities fund manager Martin Skanberg is taking a bottoms-up approach.
An accommodative central bank and drastically improved availability of credit are all supportive of economic growth, and many eurozone countries have become more competitive in the wake of the region's financial crisis, Mr Skanberg said.
Valuations are also extremely cheap, with price-earnings multiples far below historical averages.
"This has been historically the best predictive tool towards future returns and it looks mildly supportive for next year," Mr Skanberg said.
Businesses leveraged to the domestic economy of Europe, such as telecommunications, offer some of the best value at the moment, and non-periphery banks have become investible as well.
The challenge in bargain hunting is avoiding value traps, where cheap multiples accurately reflect a business' limitations rather than over-pessimism.
An investment assessment must therefore combine valuation with a view on whether there is a catalyst that will unlock the mispriced value.
"Why do we need to own this stock now? What is the inflection point?" Mr Skanberg said.
"Because the risk is that you find all these cheap stocks, and they're value traps, or they're like the telco sector that's been underperforming for six years. You need to ask yourself why now . . . We're looking for a new management team, we're looking for a cost restructuring programme, we're looking for an acquisition, we're looking for a disposal. Changing dividend policies, or evidence that the underlying economy and their products are improving."