Market view

March was the month when the great bull rally of 2003 was meant to come to an end. An al-Qaeda outrage in Madrid raised the threat of terrorism. And there were worries on both sides of the Atlantic that the recovery was either too hot or not hot enough. Despite that – and oil prices spiking sharply higher – the FTSE 100 lost just 1.54 per cent to close 1 April at 4,410.71.

Those high crude prices and a promise of multi-billion-dollar share buybacks from BP meant that Oil & Gas stocks were the mainstays among the blue-chips.

The Barker report into Britain’s need for a massive increase in its housing stock gave the housebuilders – many of which are in the FTSE 250 Index – a mammoth boost, as did data showing that UK house prices continue to defy the doomsters and to steam ahead. The FTSE 250 Index closed 1 April at 6,294.25, a gain on the month of 0.17 per cent.

Small caps – the stars of 2003 – suffered disproportionately during the mid-month lull. It was not a question of bad newsflow – if anything, the reverse was true. But there was clearly some end-of-tax-year position clearing and, in the face of a mini-buyers’ strike as investors digested the implications of Madrid, it was inevitable that the illiquid stocks would be the hardest hit.

The FTSE Small Cap Index ended 1 April down 2.07 per cent on the month at 2,634.88, while the FTSE AIM Index finished at 909.68, a loss of 2.4 per cent on the month.

Terrorist impact

Did the outrage in Madrid change the world? It might have changed a government but there cannot have been anyone who thought that al-Qaeda had gone away. Even serial fantasists such as Tony Blair no longer claim that the war on terrorism has been even half won. So while the carnage might have caused a temporary collective loss of nerves on the world’s equity markets, it was temporary. No one really thinks that the terrorist threat is any higher or lower now than it was in February, so there is no real alteration in the risk premium demanded for holding equities.

As ever, the real issue is the economy – well, to be precise, the divergent path of the US and European economies. In the US there was a (noticeable) mid-month blip caused by data suggesting that the economic revival was a jobless (and thus in some ways unsustainable) one. But a succession of indicators at the end of the month – notably cracking Non Farm Payroll numbers – flatly contradicted this hypothesis. That put some backbone into the dollar – which will be welcome news for British exporters – but also into Wall Street, which can now really buy into quite aggressive forecasts for corporate earnings growth for 2004 and, possibly, also for 2005 as well. Economies rarely falter in Presidential election years, and 2004 looks like being no exception.

Continental concerns

In euroland there is no such recovery, and whilst in the UK and US base rates are heading higher (or will do shortly in the case of the US), in the restrictive and inefficient economies of the Old World the talk is of base rate cuts. That is not helping British exporters to Europe, nor is the fact that the UK’s obsession with housing and house prices is forcing the Bank of England to hike base rates, which is pushing sterling to an uncomfortably high level. March manufacturing data in the UK actually showed some contraction in the sector. With record levels of personal debt and an ongoing tightening of fiscal policy by the government, if any economic recovery is built on somewhat shaky foundations it is that in the UK.

So what does that say for equities? Day after day the balance of trading statements issued by quoted companies on both sides of the Atlantic is positive – that is to say, the guidance is for analysts to increase their forecasts. However, with the FTSE 100, trading at just under 4,500 (i.e. on an historic price/earnings ratio of 18 and a forward rating of around 16), it is hard to argue that the market is not already factoring in a significant increase in corporate earnings. Certainly there is no fundamental reason for arguing that shares as a whole are essentially cheap.

And in terms of investor sentiment it is hard to see why it should improve given that base rates in the UK will almost certainly increase by at least 50 basis points – if not by 75 points – by Christmas. Rising interest rates are rarely good for sentiment, and on this occasion they pose the particular double threat to the real economy of squeezing manufacturers by strengthening the pound and squeezing over-borrowed consumers. Certainly there are good reasons not to have too many consumer-related or interest-rate-sensitive / foreign currency earners within your portfolio.

And there are other reasons for caution. There appear to be a number of bubbles developing within the economy, which could at any time burst, leaving either consumers or investors dangerously exposed. Many of us have been predicting a housing market crash for so long that the record seems to be jammed, but instinctively one must recognise that price/earnings valuations are become over-stretched by historic standards and eventually this band will stop playing. That would affect not such consumers but also the banks whose bad debt provisions have – to date – remained surprisingly low, allowing them to report record profits.

On the stock market there are increasing signs of bubble madness developing in the Mining/resources sector. Analysts are quitting the City to set up their own companies, and there have been some shockingly overpriced and thoroughly speculative IPOs hitting town over the past couple of months. A major investment disaster in this area would hit the speculators hard.

It is pointless to deny that the real economy is improving fast. But valuations remain generous and there are clear risks on the downside. Though many of you will have rushed to fill your ISAs with equities in a mad last-minute scramble, this market is far from being a one-way bet.

Tom Winnifrith runs the free-to- register share tip and market report service www.UK-Analyst.com.

UK STOCK PERFORMANCE






Small caps sector view

Smaller companies enjoyed a wonderful run in 2003, outperforming the sedate FTSE 100 by a mile as they soared by just over 50 per cent. So now any num-ber of un-scrupulous tipsheets will try to persuade you to part with your hard-earned cash by promising more of the same. Don’t bet on it.

Over the long term, small caps have – as a whole – outperformed blue chips. Instinctively that seems likely as smaller firms tend to be more dynamic and hence grow their earnings faster than larger outfits. As Jim Slater put it, “Elephants don’t gallop”. However, just as one larger order gained can transform the prospects of a smaller company the reverse is true as well. Moreover smaller companies tend to have more relaxed internal management and accounting procedures than blue chips and thus tend to be more likely to suffer fraud and, with weaker balance sheets, they are more vulnerable to any downturn in trading. As ever, high reward equals high risk. Oddly this is something the tipsheets neglect to mention outside the small print!

Over the medium term, one issue to watch for is base rates. Small caps tend to outperform when base rates are falling or, at least, stable. Historically, monetary tightening – and there is no doubt that this will be the macro-backdrop over the next 18 months – has tended to accompany underperformance. This is partly because the small caps are more vulnerable to credit squee-zes and partly because in-vestors tend to be drawn to small caps only when their appetite for risk is fairly well whetted.

Aside from company-specific risk, the other issue for small cap followers is illiquidity. The lack of a huge free float in many small cap stocks can mean that they suffer large share price movements on the back of relatively small volumes. Getting in can be a lot easier than getting out – especially when something has gone wrong. The illiquidity of small caps heightened the bull market of 2003 but the tipsheets have short memories. In 2001 and 2002 the illiquidity of small caps heightened the bear market. In short: small caps in 2004 are not a one-way bet.

Small caps share view

The ‘safe’ way to play small-cap shares is to back a specialist fund with a proven record – such as Eaglet, managed by Peter Webb. But funds are managed by humans and humans err, so whilst Eaglet and Webb have a great historic track record there are no guarantees for the future. Moreover, individual fund managers switch jobs and fall under buses and their successors may not be quite as talented. As a small-cap specialist myself it would be cowardly not to select two stocks for outperformance.

Domino’s Pizza shares are already up by more than 200 per cent since I first tipped them, but at 199p (and valued at just over £100 million) the stock is still cheap. The beauty of this pizza home-delivery company is that by using franchisees (16 of whom are already millionaires) the company needs no cash to fund an exciting roll-out programme. Meanwhile, the larger the company becomes, the more franchises it has to fund central overheads and TV advertising.

That should mean that Domino’s delivers like-for-like as well as rollout driven growth. It is a virtuous circle, which should see profits race ahead from £6.5 million in 2003 (when Domino’s ran 300 stores) to, perhaps, £40 million by 2012 when it should be running nearly 1,000 franchises across the UK and Eire. And with minimal capital needs this is a company that can boost its earnings significantly via share buybacks. On a five-year view this is my top small cap ‘safe pick’.

If you fancy something more speculative then, at 7.25p and capitalised at £16 million, oil-exploration company Northern Petroleum is a good place to start. The company has some small-cash-generative Spanish production assets with exploration upside and net cash of around £4 million. But the real excitement lies in its extensive acreage in Southern England. Its share of one well at Avington could well be worth up to £10 million (thereby justifying the current share price) but it also has extensive acreage in the blocks close to the Wytch Farm field in Dorset which could just contain up to 100 million barrels of oil net to Northern. Data so far is preliminary, and drilling won’t start until this summer but if (and it is an if) Northern gets lucky and one values a find at £1 per barrel, then these shares are going only one way.