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The coming year looks challenging for investors, but all is not lost – indeed Russ Mould argues that there is something to be won, provided investors keep their eyes open and their wits about them

Anyone and everyone who invests in the stock market has a strategy. It may be a carefully calculated methodology, which focuses on just small caps, for example, or looks only at stocks that fit certain performance metrics, such as cashflow or profit margin. It could be more a matter of instinct, which comes out in a preference for some sectors and stocks and an innate distrust of others.

Whatever it is, we all have a system geared not only to outperforming the key benchmark indices but to pulling in cold, hard cash, in the form of either capital gains or dividend payments – or maybe both.

Current market volatility, which last week saw the FTSE 100 crash back below the psychologically important 6,000 level, means it is more important than ever to stick to the disciplines that have served us all so well in the past in order to recession-proof the portfolio.

GOLDEN RULES

The first thing any investor, no matter how experienced, should remember is to only invest money that he or she can comfortably afford to lose. The second is never, ever borrow to invest in the market.

Once these golden rules have been taken on board, an investor then needs to work out whether income or capital growth is the goal, and whether the investments are simply for some pleasure punting or a serious attempt to top up the pension fund pot. In times of great volatility, such as we have witnessed in the past two months, a policy of cash preservation could also be examined.

Once a goal has been defined, this will determine what strategy the investor should deploy when it comes to deciding which companies are potentially suitable investments, and which ones are to be avoided at all costs.

There are many possible approaches, but two key investment ‘themes’ consistently recur:

• Growth, or ‘momentum’ investing

Momentum investors prefer high-growth, high-risk investments, where shares can just as easily rise ten-fold as they can crash to zero when a firm fails and goes bust. The focus is on companies with the best short-term profits growth prospects – or sometimes even simply the best-looking share price charts – in an attempt to identify good prospects for large capital gains. Dividends are not a consideration, as most growth stocks have to reinvest their cashflow to maintain their rapid progress. Nor is valuation a particular issue for momentum players, who tend to jump quickly from one bandwagon to the next. Technology and biotech stocks have been momentum darlings in the past, while metals, resources and oil stocks were favourites in 2006 and for most of 2007

• Value, or ‘contrarian’ investing

Contrarian, or ‘value’, investors are the direct opposite of momentum investors. Capital growth is still the ultimate goal, although value hunters are quite partial to income in the form of a juicy dividend yield, if one happens to be available. Contrarians tend to shun the momentum crowds and snuffle around in the market’s darker recesses, seeking out firms that are totally out of fashion. Such companies are often in the red, have made strategic blunders such as a bad acquisition, and can be financially distressed. All of them will have seen their share price plunge. This strategy can yield huge returns, providing the investor is very patient and is totally sure the target company will not go broke, no matter what. A cash pile, or a stash of saleable assets is always a good sign, and the contrarian must be certain something is going to happen to turn the company around and help it better realise the potential of its business. A change in management or a major restructuring programme are often good pointers.

VALUE PREVAILED DURING 2003-07

Once the UK equity market bottomed in March 2003, value stocks began to wipe the floor with growth stocks, massively outperforming and maximising investors’ gains from a rampant bull market. Companies with earnings power and market valuations that had been dampened by the economic slowdown of 2001-02, which followed the bursting of technology, media and telecoms bubble (see chart 1), roared back.

Improved trading conditions helped firms in sectors with earnings that had been cyclically depressed, such as engineering, chemical and financial stocks, and enabled those companies to capitalise fully upon restructuring and productivity programmes introduced when times were tough.

As earnings blossomed, so did valuations and therefore share prices. After all, a share price is constituted of both a company’s earnings power (the ‘E’ in the benchmark Price Earnings, or PE, valuation calculation) and also the price or multiple (the ‘P’) that investors are prepared to pay for those earnings. The stronger the economy and the faster the earnings growth, the higher multiple that will be paid as market confidence in future earnings power rises.

When both the ‘P’ and the ‘E’ rise, as they did in 2004, 2005 and 2006, that is the recipe for the sort of bull market seen in the UK, where the FTSE 100 basically doubled between its March 2003 trough and June 2007 peak of 6,732.

...BUT ECONOMIC AND STOCK MARKET WEAKNESS...

But, as Shares (4 January) pointed out in its preview of this year for a variety of asset classes, global economic and corporate earnings momentum is beginning to sag under a welter of painful blows. Soaring oil and agricultural prices, rising raw material costs, slumping house-building activity in the US, weakening consumer spending in the UK and the decreasing availability of cheap debt following the sub-prime debt debacle, are all starting to chip away at growth – and confidence.

Last week’s ZEW survey revealed German business confidence has hit a 15-year low, while a shocking 0.4% drop in retail sales for December is the latest red flag to have appeared in the US.

Worse, last week’s decision from American megabank Citigroup’s (C:NYSE) decision to write off $5.4 billion of credit card debts followed hard on the heels of similar warnings from American Express (AMEX:NYSE) and CapitalOne (COF:NYSE). If the financial services giants do pull in their horns after such heavy losses, and make borrowing harder, or at least more expensive, for consumers and corporates alike, some kind of economic slowdown on both sides of the Pond looks a serious risk.

After all, since cheap credit did so much to fuel the upturn of 2003-07, it seems logical to assume greater borrowing costs will put the clamps on at least some consumer spending, corporate investment and merger and acquisition activity going forward.

In fact, corporate earnings began to disappoint late in 2007, and not just in the stricken banking sector. This suggests the global economy may already be slowing down.

‘It seems self-evident that economic growth and corporate profitability have already diverged considerably during 2007,’ says Nick Stevenson, of equity strategy think tank Mirabaud Securities. ‘Indeed, last year’s “strong” global GDP growth of around 5% seems to have boiled down to virtually flat EPS in the US and barely 4% growth in Europe,’ he says, before continuing on his bearish tack: ‘What worries us is the willingness of analysts to subscribe all the apparent disconnect between strong growth and weak profitability to problems in the financial services sector, while apparently ignoring the acute margin pressures afflicting many manufacturing and non-financial services businesses’.

A flood of profit warnings and disappointing trading statements from retail, technology, leisure and even oil stocks in the US and UK – names ranging from Intel (INTC:NDQ) to Marks & Spencer (MKS), Punch Taverns (PUB) to BP (BP.) – which reportedly recently talked down analysts’ fourth-quarter estimates – have got 2008 off to a bad start, too.

As a result, while it is far too early to paint the picture too black, the ‘R’ word – recession – is becoming more commonplace, as bad news seeps out across a variety of sectors.

Should confidence sag further, the price – the ‘P’ – investors will pay for these declining earning forecasts could slide too, as confidence in future prospects ebb. This double whammy explains why the FTSE 100 is 12% off its June 2006 peak, why the US’s Dow Jones is trading at ten-month lows and why Japan’s Nikkei 225 has crashed below 14,000 for the first time in two years.

Further drops in confidence in future earnings forecasts could see further so-called ‘multiple compression’ (a drop in the ‘P’ investors are prepared to pay for the ‘E’) and falls in the broader market indices.

Mirabaud Securities’ Nick Stevenson highlights some of the key market valuation metrics when he says: ‘The broad European equity market is now trading on 15.6 times’ trend earnings (peaked at just over 18) and the US market valuation is 18.3 trend,’ adding: ‘Both are well above their long-term averages (15 in both cases), which still leaves plenty of room for correction on valuation grounds, with the European market usually troughing at about 12-times trend.’

Numbers crunched by Mirabaud reveal the UK equity market has traded at a long-run average PE of 15.9 since 1985, once the short-term effects of economic cycles on corporate earnings are accounted for.

But that number is bloated by the bubble-inspired years of 1999-2002 when the market soared to previously unseen multiples of 20-25. Going further back, the UK market since 1962 has an average PE of around 12, so it could be argued the market is still hardly a snip on its current trend PE multiple of 13.9, even after the recent pullback

... MEANS GROWTH IS MAKING A COMEBACK

All of this means that since last July, when initial revelations from US and European banks regarding their credit and debt market losses were made, investors have started to seek out safe havens. Subsequent stumbles, and finally the rout seen in late December and early January, have only served to intensify this pressure.

Traditionally, a dash for safety means investors tend to pile into sectors such as tobacco, utilities, food retail and healthcare. All are areas where demand is seen as relatively insensitive to the economic cycle, as smokers still can’t kick the habit, consumers still need to take a bath and buy their groceries and demographic trends show the population is on average still getting older and therefore still needs more treatment.

But to blindly head for traditionally ‘defensive’ names may not be the simple solution it first appears. After all, utilities and tobacco stocks in particular have already performed brilliantly during the bull run, partly due to a wave of merger and acquisition activity within both industries.

Meanwhile, food retail has seen Sainsbury’s (SBRY) share price collapse due to a failed Qatari-backed bid, and Tesco (TSCO) has come rattling back from 480p to barely £4 after its UK arm disappointed, with 3.1% like-for-like sales growth over the Christmas period. Healthcare stocks have been dogged with problems such as rising generic competition, patent expiries and product recalls and, as a result, pharmaceutical giants GlaxoSmithKline (GSK) and AstraZeneca (AZN) performed dismally in 2007.

By contrast, former telecoms darling Vodafone (VOD), which had long been in the market’s doghouse, enjoyed a renaissance in 2007 under chief executive Arun Sarin. Select asset disposals in mature European markets raised cash, which has been recycled into acquisitions in faster-growing emerging markets such as India and Turkey. Rising data usage, as adoption of 3G technology became more widespread in the UK and Europe, also boosted revenues, giving Vodafone’s earnings a boost and giving the stock a ‘growth’ sheen it had not enjoyed since the turn of the century. As a result, the mobile telecommunications sector has been the sixth best performer of 2007 and has begun 2008 relatively brightly too.

Investors are therefore not blindly buying ‘defensives’ at the moment, they are buying specific stocks in specific sectors that can offer organic, secular growth, almost irrespective of the broader economic environment. Stocks capable of such growth will look like beacons in 2008 relative to the stocks and sectors that will suffer earnings downgrades due to any deterioration in the economic environment.

As a result, growth stocks began to outperform value stocks last November, and this looks to be the makings of a fresh trend, breaking value’s four-year winning streak. (see chart 3)

CAPITAL PRESERVATION

Certain classic defensives will still feature in any selective growth portfolio and, despite last year’s woes, pharmaceuticals stocks are a case in point.

GlaxoSmithKline performed abominably in 2007, sinking from £14.80 to £11.60 as it encountered problems with diabetes treatment Avandia and cervical cancer drug Cervarix. But such problems are now well known and discounted by the share price, which has started to motor again. This is partly in anticipation of the arrival in May of new chief executive officer Andrew Witty, but also partly because GlaxoSmithKline is still expected to generate 4% earnings growth in 2008. That might not sound a lot but, come December, it could look interstellar compared with more cyclical sectors, such as house builders or engineering, which will bear the brunt of any economic slowdown.

Putting your faith in what looks like a near certain 4% earnings growth looks like a better bet than sticking with cheap-looking value cyclicals. This could be because those cheap stocks may not really be as cheap as they look.

After all, a lowly valuation can quickly become a lofty one if earnings forecasts prove to be wildly wrong. The UK banking sector, for example, looks tempting to value punters right now. HBOS (HBOS), Barclays (BARC), Alliance & Leicester (AL.) and Lloyds TSB (LLOY) all trade on a prospective PE for 2008 of between six and eight. Yet consensus analyst forecasts still have earnings growing by between 1% and 9% for the quartet this year. If economic conditions deteriorate further, this will look hopelessly optimistic, as UK banking earnings halved during the last UK recession of 1991-93. Using that as a benchmark, UK banks could in fact be on double-digit PE ratios for 2008-09, which looks less beguiling altogether.

Going for solid growth prospects therefore looks a safer prospect than getting the prayer mat out and hoping interest rate cuts in the US, UK, Canada and beyond can stave off an economic slowdown.

This should at worst preserve capital and at best chip in some tasty capital gains and a few dividend payments, too.

TRACKING THE TRENDS

Of course, the market’s mood could swing just as quickly from bearish to bullish as it did the other way round last year. Tracking sector and stock performance trends, as Shares does in the data tables in the Headlines section, will develop a feel for the markets and help spot key inflection points.

Shares (26 Jul ‘07) used this technique when it pointed out large caps had broken a four-year spell of underperformance against small caps in April last year. Since then, large caps have continued to outperform handily: the FTSE 100 is down by just 3% since the end of July, against 18% for the FTSE SmallCap index and 16% for the Aim All Share.

Last autumn’s new trend of moving away from value to growth should therefore be worth following too. Having such a clear strategy is vital as markets continue to gyrate wildly, as it will help investors choose which of the 1,100 or so companies listed on the main market, and nearly 1,700 more on Aim, are the most suitable for their portfolios.

Five stocks to beat any downturn in 2008

GlaxoSmithKline (GSK) £12.07

Earnings growth of 4% in 2008 might not sound much but it could look good by year end. Plans to launch 25 new drugs over the next three years are afoot and the arrival of a new chief executive in May could also shake things up.

Pennon (PNN) 651p

A well-run water utility, which looks well prepared for 2009’s regulatory review. Earnings per share are forecast to rise by between 9% and 11% for each of the next three years, helped by strong performance in both water and waste treatment.

Reckitt Benckiser (RB.) £25.08

Lofty profit margins and good exposure to growth in emerging market economies should translate into double-digit earnings growth in each of the next three years and, in turn, great free cashflow and dividend increases.

Unilever (ULVR) £15.75

Raw material cost pressures are an issue but disposals, restructuring and management change should all convince doubters Unilever can achieve its 2010 profit margin target and generate 7% earnings growth this year and next.

Vodafone (VOD) 171p

Chief executive Arun Sarin’s 2006 five-point strategic plan is working its magic as the telco cuts costs and boosts exposure to faster-growing emerging markets. This should translate into 10% EPS growth this year and next.