The Investment Column; Cyclicals and small caps swing back into favour

AS THE mid-point of the year draws near, it is clear that it has been a topsy-turvy six months for UK investors. While 1998 was the year of the growth stock with sectors like telecoms, pharmaceuticals and computer services all recording huge gains, their progress has been more pedestrian this year.

By contrast, cyclical stocks, the great unloved of 1998, have returned to favour. Some of the worst performers of last year such as mining, chemicals and construction have recorded some of the healthiest gains.

The mining sector, for example, underperformed the rest of the market by 22 per cent last year but has outperformed by 39 per cent in the first six months, helped by swings in commodity prices and a return of investor support. But can these trends continue?

A recent piece of research by the equities strategy team at Salomon Smith Barney compares the fortunes of what it describes as "momentum" and "contrarian" investors. At the start of every year a contrarian investor buys the worst performing 10 stocks of the previous year and sells the best 10. The momentum investor does the opposite. The theory is that the stocks they sell have as big an impact on their portfolio as those they buy.

Salomon's figures show that contrarian investment returns have only beaten the momentum brigade in five of the past 14 years. Last year would have been the worst performance for contrarian investors since 1984.

By contrast, the momentum investors would have enjoyed a storming 1998 with a combined outperformance of around 50 per cent buoyed by huge rises in stocks such as Orange, BT and Vodafone.

But there has been a shift this year with the worst performers of 1998 such as British Steel and BTR (now Invensys) recording big gains. The reason, Salomon says, is because of the change in the economic outlook, with fears of a hard landing last autumn proving unfounded. A rebound in expectations of an economic improvement in the US has also been a major factor.

The shift has had a dramatic effect on sector rotation and performance. Of the 10 best performing sectors last year only telecoms and electronics have continued to outperform over the last six months and even those at a lower rate.

But should we all be piling into Pilkington and ICI? Not necessarily. Salomon says that while there has been a shift in sentiment there is little scope for the earnings upgrades that will drive the share prices higher still. A further leg of outperformance therefore looks limited.

It is a view supported by Bob Semple, chief equity strategist at BT Alex.Brown. His view is that the bulk of the re-rating for cyclical-industrials, such as oils, took place in the first few months of the year and that further progress is limited until later in the year. Consumer cyclicals such as general retailers have not yet enjoyed such a recovery and require further evidence of a pick-up in Europe and Asia.

The equity team at Merrill Lynch is more bullish. It says the economic backdrop makes cyclicals and smaller caps more attractive than growth stocks and larger companies. It is most positive on banks, construction, engineers, brewers and gas while recommending underweight positions in pharmaceuticals, telecoms and media.