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23 January 2006

Energy Sector outperforms all others

“Energy outperformed other sectors rising about 29%, and significant exposure was needed”

The S&P 500 rose a lacklustre 3% in 2005 and, despite better performance from the mid cap S&P 400 index and small cap S&P 600 index, the US lagged behind other markets. However, after adjusting for the 11% appreciation in the US dollar, sterling based investors have achieved better returns.

Energy outperformed other sectors but significant exposure was needed to generate above market performance. Health care equipment and services rose, in contrast to the pharmaceutical and biotechnology group, which fell 2%. Utilities were also strong, up 13% despite rising interest rates, as they were seen as an alternative play on higher commodity prices. The weakest industries included autos, media, telecommunication services, food & drug retailing and banks.

Looking forward, the macroeconomic environment remains solid with fourth quarter GDP growth up 3.7% and forecast growth for 2006 in the 3.5%. Corporate profits have grown at nearly 15% in 2005 and while this won’t be repeated in 2006, 5% - 10% growth is very achievable. Inflation is the bigger concern and will be a key factor for the Fed in determining how long they will continue with interest rate increases.

The start of 2006 has been strong as investors anticipate an end to interest rate increases in the first few months of the year. Investor sentiment measures suggest many participants are still relatively cautious, and certainly more negative than other developed countries. This is typically a positive indicator for the markets. Earnings expectations for 2006 have come down over the past few months and now look more achievable but may still fall further given that top-down forecasts are less aggressive. However, the dollar was surprisingly strong last year versus the pound and with interest rates starting to peak, the risk for sterling investors is that this trend reverses in 2006.

Market valuations are supportive with a trailing price earnings ratio of 16x - 17x. This is near 10 year lows but earnings growth is well above trend and margins are at 30 year highs, therefore any weakness in margins going forward will lead to an earnings shortfall. However corporate balance sheets remain healthy and provide additional support for the market at current levels.

Going into 2006 we still like certain industries within the health sector. We have been building positions in the pharmaceutical and biotechnology industry. We have sizeable positions in energy names although we are more cautious than before and have taken some profits. Select industrial and financial names also look interesting. We would highlight railroad stocks, as well as select investment banking and insurance companies. Utilities have been solid but we have been taking money out and will continue to do so as valuations look stretched. We remain cautious on consumer discretionary stocks given current spending trends. We also have no exposure to the telecommunication services industry.

From a style perspective we marginally prefer growth stocks over value stocks given relative valuation differentials and while large capitalisation stocks have underperformed for many years we still think many mid cap stocks provide attractive valuation profiles.

James Kinghorn
Investment Manager, US equities
The Scottish Investment Trust PLC

Published in Investment Week

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