Shares to pick with markets at the crossroads

Pundits are sharply divided as to the future direction of equities. Neil Thapar sees virtue in both points of view

Stock market gurus are divided as to where equities are headed. Leading experts, including Warren Buffett, the billionaire investor, are sitting on cash - (in Mr Buffett's case a $3.6bn (£19.7bn) hoard - as they fear share prices are too high. Long- time bears such as Andrew Smithers, the City-based financial economist, argue that equities could fall by up to 40 per cent before they reflect fair value.

Stock market gurus are divided as to where equities are headed. Leading experts, including Warren Buffett, the billionaire investor, are sitting on cash - (in Mr Buffett's case a $3.6bn (£19.7bn) hoard - as they fear share prices are too high. Long- time bears such as Andrew Smithers, the City-based financial economist, argue that equities could fall by up to 40 per cent before they reflect fair value.

Others are more optimistic about equities as global economic growth gains momentum. The bull camp is led by Kenneth Fisher, a US fund manager and commentator who correctly forecast the last bear market. He predicts equity markets will rise by about 20 per cent this year, despite leading indices currently showing a marginal decline for 2004.

Both have strong arguments in their favour. Pessimists believe equities have already surged since Saddam Hussein was toppled from power in April 2003. But the Baghdad bounce has petered out this year as investors fret that much of the economic recovery is already priced into share values. On top of that, consumer debt is at record levels just as interest rates are beginning to climb. Oil prices are trading close to multi-year highs, while investor sentiment has been further undermined by terrorism and signs that the Chinese economy is cooling.

Yet the bulls point to buoyant consumer demand, a recovery in business investment and company profits and cash flows exceeding analysts' expectations. The US market is priced at about 18 times expected earnings for 2004 while Europe as a whole is better value with a multiple in the low teens. While not at bargain levels, the bulls say these ratings are reasonable and are supported by dividend yields that are not out of step relative to bonds. A booming economy also bodes well for cyclical sectors highly geared to expansion. Despite worries that rising interest rates could hold back gains, bulls argue string earnings growth will push the market higher.

However, the conflicting views have led to huge volatility in stock markets, making the task of investors doubly hard. With no clear signs yet as to which camp is gaining the upper hand, The Independent has prepared two portfolios, a defensive one for bears who fear we are in for a rocky ride, and an aggressive one for bulls who think shares are set to head into the stratosphere.

Make sure you weather the weather, whatever the weather

BEAR PORTFOLIO

A defensive portfolio is designed to be resilient to stock market squalls, although there is no guarantee against loss. Typically, the more cautious strategy concentrates on companies with predictable earnings streams that are less exposed to the vagaries of the economy. Such companies are to be found in healthcare, food-retailing, consumer staples, brewers, utilities and tobacco.

Alliance Unichem: The pan-European distributor of prescription drugs is expanding into own-label generic drugs, which should strengthen profit margins. The retail division accounts for 20 per cent of group profits and has carved out a niche by providing specialist patient-monitoring services to the NHS. The shares are valued at 13 times expected earnings for this year and offer a 3 per cent dividend yield.

BP: With the bulk of BP's oilfields located outside the Middle East, the group is less vulnerable than some competitors to political turmoil in that region. Soaring oil prices mean BP is generating massive surplus cash flow, enabling it to buy back its shares. They are valued at about 14 times earnings and yield 3.3 per cent.

Cadbury Schweppes: The confectionery and drinks giant now boasts Warren Buffett as a shareholder. The group is expected to deliver a sharp improvement in profits, reflecting rising drinks volumes in the crucial US market and the turnaround of the Adam chewing gum business, bought for £2.5bn last year. For a global consumer brands company, the shares are modestly rated at about 13 times earnings and yield 2.6 per cent.

GlaxoSmithKline: The world's second-largest drugs group has one of strongest pipelines of potential new drugs. Demand for prescription drugs continues to grow at about 12 per cent a year in the US, where the group has a strong presence. The share price has weakened in the past week following a US lawsuit over sales of antidepressants to children. That provides a good buying opportunity, with the shares valued at about 14 times earnings and paying a 3.5 per cent yield.

Greggs: The bakery chain boasts a solid long-term growth record. Profits are likely to grow at a double-digit rate over the next few years as the group opens new shops in the UK and continental Europe. Trading in the first four months has been buoyant and three directors have recently bought large slices of the shares. Price-earnings ratio 14.5, yield 2.4 per cent.

Lonmin: Demand for platinum is growing steadily, contributing to a surge in prices for the metal making Lonmin, the world's third-biggest producer, a prime takeover target. The shares have come off sharply on jitters about the slowing Chinese economy, but the fears may have been overdone. The shares yield 4.5 per cent and are on an artificially high p/e ratio of 35.

Scottish & Newcastle: The European brewing group has built a significant presence in Russia and India, where beer consumption is growing rapidly, and some industry experts believe that it is likely to be taken over in the next round of industry consolidation. The shares do not reflect the group's strategic value, nor its defensive qualities at about 13 times expected earnings and a near-5 per cent yield.

Severn Trent: Water prices are likely to go up by above the rate of inflation following a five-year price review being undertaken by the industry regulator. That should underpin long-term prospects at the group, which owns Yorkshire Water. The group has a strong balance sheet, which means it has the financial strength to boost dividends above the inflation rate over the next few years. The shares, which yield almost 6 per cent, have also made a break to the upside on the charts. P/e ratio 14.5.

Tesco: Although facing competition from Asda and Wm Morrison, Britain's leading food retailer is thriving as it uses economies of scale to deliver low prices. The group is also exporting the supermarket format to the emerging economies of eastern Europe and Asia, where sales are growing at over 25 per cent a year. Tesco is a growth stock with defensive qualities and a share rating in the mid teens. Its yield of 2.7 per cent makes it good value.

Now is the time to be brave

BULL PORTFOLIO

An aggressive porfolio is designed to maximise growth, but also tends to maximise risk and will include pro-cyclical shares.

Close Brothers: A rising stock market willbring in huge fees from takeover activity and share flotations, enabling its corporate finance unit to rake in vast fees. In addition,, and boost trading volumes at its market making arm, Winterfloods. Close provides asset-backed finance to manufacturers, which invest more when the economy is strong. The shares are valued at 14 times earnings and yield 3.4 per cent.

Hilton Group: the hotel industry is coming out of a three-year slump with hardening room occupancy and prices. The group's betting arm, Ladbroke, is also growing strongly. Pre-tax profits are expected to surge by about a third to £365m this year, valuing the shares at 16 times earnings and paying a 3.5 per cent yield.

Pilkington: The glass-maker has delivered robust results over the past year, cutting costs while lowering dependence on the building industry by winning new business from automotive manufacturers. Taxable profits were down marginally to £136m on unchanged annual turnover of £2.75bn last year, but the result hides strong cash generation. Pilkington is now ready to reap rewards from any upturn in Europe, which accounts for a third of profits. The shares are trading at 12 times earnings and offer a sustainable 5.5 per cent yield.

Prudential: The mighty Pru has ably steered its way through the downturn despite a tough UK market. It is in talks to sell its controlling stake in the Egg internet bank for an estimated £1.4bn which will provide it with capital to fund overseas expansion. The shares yield 3.7 per cent and sell on 29 times earnings.

Reuters: The financial information giant's fortunes are closely tied to the health of financial markets, so any big surge by equities is bound to rub off. The chief executive, Tom Glocer, has stemmed the decline in revenues by introducing new products. Analysts expect the group to return to growth next year, putting shares on 18 times expected earnings for 2005 and a yield of about 2.9 per cent.

Regus: After a recent refinancing the serviced office provider has few debts to worry about. The group should be an early beneficiary of an economic upturn as businesses take on additional space. It is also winning business from multi-national companies that may want small offices in secondary locations but do not want to commit to long-term leases. Profits are expected to surge over the next two years, valuing the shares at about 14 times earnings for 2005.

Systems Union: A significant international supplier of accounting and analytical programmes. Thanks to acquisitions and rising demand, profits are expected to surge by about two-thirds this year. Shares are valued at about 12 times earnings, a substantial discount to the sector.

Vodafone: A strong operational performance from the group leading to bumper cash flow. Vodafone is getting ready to roll out 3G telephone technology, which should help to boost revenues from content delivery long-term. With the group capable of double-digit earnings growth, the shares look cheap at 13 times expected earnings.

Wolfson Microelectronics: This Scottish chip designer and supplier has benefited from soaring demand for new consumer electronics devices. The company is heading for an 80 per cent-plus surge in profits this year. Order books also look strong for next year, which makes the shares good value at 18 times prospective earnings for 2005.