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Equities: Strategy for 2012

With sovereign bond yields in the major developed markets hovering around 2%, investors are increasingly forced to take risk, assuming they want to beat inflation. Equity markets will doubtlessly attract a substantial part of the “risk budget” investors are willing to employ, even if seatbelts have to be fastened for new bumpy rides. After all, equities still offer value. But which sectors offer the best value?

Looking back to recent years, investors should have favoured defensive sectors (like food, pharma, etc.) in 2008 and cyclicals (like industrials and commodities) in 2009 and 2010. Last year, the defensives were in favour again, as economic growth was hampered by the debt crisis and a mild credit crunch. How should investors position themselves in 2012? Should they continue to play the winners of 2011 or hope for a rebound of the cyclicals?

We do not think the split between defensives and cyclicals will be as clear-cut in 2012 as it was in previous years. The reason for this assumption is twofold. Firstly, neither sector category appears particularly over- or undervalued in a historical context, with the possible exception of consumer staples, which look quite expensive. Secondly, we think that economic developments in 2012 will not surprise sufficiently in either direction to warrant a continuous preference of investors for safe havens or risky plays. US policymakers will probably keep supporting (modest) growth at least until the elections and eurozone policymakers are likely to prevent a deep recession, even if they remain re-active rather than pro-active. Inflation is likely to decline somewhat and emerging market growth will keep commodity prices well supported at present levels.

Given this scenario, we generally like stocks and sectors which have certain characteristics in common:

International diversification with a good presence in emerging markets

Sufficient size and standing to have good access to capital markets and limited dependency on bank credit

Attractive dividends, with a focus on the potential for dividend growth rather than the absolute level of dividend yield

Dependence on the commodity cycle, rather than on the capital investment cycle

These preferences lead us to still like healthcare and consumer staples in the defensive arena. Although these stocks are not cheap anymore, they generally do fit three out of the four criteria. In the cyclical arena we like the commodity stocks, both in the energy sector and recently also in the material sector. The latter sector was the worst performing sector in 2011 (even worse than the financials) but we see better prospects for 2012. Lastly, we still like the technology stocks, many of which combine a structural growth story with strong balance sheets and reasonable valuation.

Two defensive sectors which did relatively well in 2011 but are likely to prove more risky this year are utilities and telecoms. The dividends in these sectors are very high but are more likely to decline than to increase. These companies generally also lack diversification and have leveraged balance sheets. In the cyclical area, we remain cautious on industrials and most consumer stocks (except some car and luxury companies), as we have been throughout 2011.

One of the most difficult sectors to judge remains the financial sector. No other sector is as dependant on policymakers as this one, especially in Europe. We have recently adopted a “neutral” stance on this sector as the sovereign risks appear well balanced by low valuations and pro-active central banks. These are the stocks for which the “fasten seatbelt” sign still burns brightest of all.

To conclude, we think investors should adopt a balanced approach in 2012, consisting of “boring” healthcare and staples as well as more economically sensitive commodity and technology stocks.

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