Aviva Investors: Long term outlook UK equities positive

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David Lis, CIO, Equities and Multi-Assets argues that Aviva Investors is upbeat on the long-term outlook for UK equities despite the recent sell-off.

• Strong UK economic output and M&A activity supports small-cap outperformance
• Underweight: miners; banks; food retailers; oil and gas
• Overweight: insurance; other financials; media; general retailers; industrials

Despite being more cautious in the short-term outlook for UK equities, which have fallen approximately six per cent since the beginning of September, Aviva Investors is optimistic on the long-term outlook.

While UK equities may struggle to advance in the short term, we are optimistic on the long-term outlook, which is supported by healthy domestic growth, the encouraging pace of global growth and low interest rates. Small caps, in particular, have been aided by exposure to a thriving domestic economy and strong M&A activity, outperforming the wider market this year, and we expect this trend to continue.

Within UK equities, there are three themes driving our portfolio positioning. First, high-quality franchises that grow revenue and cashflow regardless of economic conditions will be well placed to deliver. Second, ‘self-help’ opportunities, where management is taking action to improve the business, will perform well. And finally, we expect M&A in the coming months to remain strong after encouraging levels of activity so far this year.

Industrials to outperform mining on improving global growth

We believe that industrials look better placed than miners to benefit from a stronger world economy. Holdings in engineering turnaround specialist Melrose and aviation services provider BBA Aviation continue to perform well.

“The mining sector has underperformed in 2014 with falling metals prices prompting increased focus on capital discipline. Our preferred miners, Rio Tinto and BHP Billiton, have continued to cut production costs, and both look to have weathered the squeeze on miners’ margins from falling iron ore and other metal prices this year better than most.

Overweight financials ex-banks

The scale of political and regulatory interference facing banks remains a worry many underestimate. We therefore prefer to focus on growth opportunities offered by wealth managers such as Brewin Dolphin and the insurance sector. Prudential, for example, has a strong Asian franchise and distribution network with globally diversified earnings, helping differentiate it from peers.

Media have healthier cash flows than the market perceives

Reed Elsevier and ITV enjoy strong market positions and exposure to more predictable advertising expenditure than many. ITV generates strong cashflow and continues to deliver efficiency savings as a five-year restructuring programme draws to an end. The acquisition by US cable group Liberty Media, which owns Virgin Media, of a 6.4 per cent stake in ITV during July highlights the value attached to the broadcaster’s content.

Food retailers continue to struggle but general retailers see opportunity

We are extremely pessimistic on the outlook for food retailers, as large supermarket groups like Tesco, Morrisons and Sainsbury’s continue to lose share to discount-retailers Lidl and Aldi. Further, any supermarket ‘price wars’ in attempts to regain share are likely to erode their profits further.

Electricals retailers Carphone Warehouse and Dixons merged to form Dixons Carphone. We believe the merger creates exciting opportunities to boost earnings from the combined business, such as from the convergence of mobile, fixed-line telephony, broadband and media offerings.

Oil & Gas companies face challenging future

We believe the major oil companies face a challenging future, given recent falls in the price of oil, with productive assets in decline and the increasing difficulty they are having accessing new resources.

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