Oil exploration and production company Cove Energy has put itself up for sale.  Its Africa based assets include the 8.5% stake in the Rovuma Area 1 offshore Mozambique. The partners have discovered 15-30+ trillion cubic feet (“TCF”) of gas already with plenty more prospects to drill in what is shaping up to be a very significant liquid natural gas project.

This move is likely to see interest from both oil majors looking to add new resources and Asian utility companies seeking security of supply of gas.

Cove Energy is held in both the F&C UK Equity Income and F&C UK Alpha Funds, so both have done well from their holdings and are set to benefit from any further rise in the Cove share price now that the announcement has been made.

This is just the result we look for from companies in the E&P sector and is in line with Cove’s stated strategy since the Funds bought into the stock some time ago.  We have worked closely with the company and helped fund their exploration activities through a series of equity fund raisings.  This was on the clear understanding that there would come a point when they would look to realise the value of the assets they had discovered, leaving it to the larger players with deeper pockets to fund the final development and production phase of their assets.

Why is a manager of UK equities off on a fact finding trip to China I hear you say.  But as you know, the UK equity market is much more a play on the global economy than the fortunes of the UK, so it’s eminently sensible.

There area number of issues I will be focusing on in my meetings.

1. To find out what it’s really like on the ground rather than just believe what commentators tell us.
2. What are the supply chains like and how could they impact on economic activity elsewhere.  Remembering the impact of the de-stocking back in 2008/09.
3. How is the funding of industry and infrastructure segregated from that of the property sector?  Can the impact of any property bubble bursting be ring-fenced?
4. I am also attending a meeting involving the big mining companies and China’s state planners responsible for infrastructure investment. I will be looking to find out if the mining bosses are right in that the scale of the internal investment is still such that any moderation in global growth will not really be an issue for them.

So watch this space as I will be reporting back in a conference call on 20 October at 11.00 am.

The summer traditionally brings lower volumes and higher volatility. This year though this is likely to be exaggerated by the on-going European sovereign debt crisis and the ‘risk-on’ ‘risk-off’ trading patterns.  But with volatility comes opportunity.

The other big plus for the market at the moment is valuation. At the current stage in the recovery cycle the market’s price earnings ratio should be around 14x but it is actually only at some 10.5x.  This means there is the potential from earnings multiple expansion in addition to economic growth, once we have a bit more clarity on the macro environment.

Companies and their investment bank advisers need to have a serious rethink about the way they bring companies to the market otherwise the supply of funds and willing investors will dry up.

Glencore has just joined an ignominious list of companies coming to the market and then seeing their share prices take a tumble and this is not good news for the reputation of the UK market as a whole.

If you look at the chart below it shows the performance achieved from investing in IPOs (white line) against that of the overall UK market (yellow line). What we can see is that there has been a major disconnect since the market bottomed early in 2009.

Companies and their advisers are simply being too greedy.  The situation is also not helped by too many parties being involved in most IPOs which is making meaningful discussion with managements and, in turn, our own valuation assessments increasingly difficult.  So unless valuations become more appropriate I’m not interested, which is a shame because we do want new opportunities and new blood coming in to the market as they are one of the things that make us get up in the morning.

Focusing in quality
Against the current economic back-drop I’m focusing on quality.  Last week I added contract caterer Compass to the portfolio after a good meeting with the company, which has given me increased confidence in its outlook as their model is now being successfully rolled out in Brazil as well as the UK & US.

Don’t ignore the retailers
It’s true that the UK retail sector is having a difficult time. But that doesn’t mean it should be ignored, especially when your focus is on cashflow. The market can often take too pessimistic a view on companies. A recent good example was Kingfisher, where it ignored strong actual cashflow focusing too much on market sentiment and the bigger picture.  This provided a good trading opportunity, which we exited at a profit last week.

Stock selection remains key
Elsewhere in the portfolio I remain neutral on resources overall but continue to focus on Rio Tinto, Xstrata and Zanaga Iron Ore. As regards the banks, the recent comments from the Chancellor do not make them any more attractive in the short term - but never say never and I remain overweight Standard Chartered a long time favoured position.

The UK equity market has proved remarkably resilient in light of the headwinds during Q1; the results season has been fairly robust and the valuation of the market remains compelling versus other asset classes.  The main question now is how the companies can utilise these strong balance sheets in the most efficient fashion.

I genuinely believe good companies will be able to use their cash in a robust way which will allow operational gearing to come to the fore and enable these companies to trade on superior multiples to their peers.  We are beginning to see strong signs of growth capital being deployed but also there is ongoing M&A activity which is also underpinning the market currently.

That said, the IPO market continues to struggle in the UK compared to the strong performance we are seeing in the US and indeed Europe and I believe there are a couple of main reasons for this

1. There are a lot of asset allocators who have switched out of UK equities into global equities and thus there isn’t a “normal” pool of capital available
2. The IPOs have come relatively late in the investment cycle.  We are just over two years into the recovery and as such ‘the risk trade’ is less compelling; investors are therefore perhaps more inclined to support the companies they really believe in and truly understand rather than simply investing in the latest new stock.

There have been a number of IPOs where the underlying businesses have been good, but the vendor and their advisers have been asking just too high a price and this has caused real issues between investors and sellers of the business. 

Indeed, I would go as far as to say that there are far too many advisers attached to each individual IPO, meaning that a robust discussion can not happen. This is definitely to the detriment of the company concerned.  Some new companies would be nice though!

Much has been made of China’s desire to put the brakes on its economic growth.  But it’s important to look behind the headlines, with one of my regular contacts on the region still very bullish on the outlook.

Earlier this year the Chinese government announced the construction of 10 million social houses and recently announced that a further 10 million affordable homes are to be constructed.  But this could still only be the tip of the iceberg as 85 million people have been given permission by the state to move and another 65 million are allegedly on the waiting list. 

He also added that one of the issues facing construction of these houses is a lack of infrastructure so its no surprise that China’s largest concrete producer has its largest ever order book. On top of this has been the recent announcement of a pause in the China’s nuclear power programme, in light of the events in Japan.

What this means for an investment perspective is further strong demand for the miners in terms of both infrastructure construction and coal for power generation. As such I’ve been adding further to both Xstrata and Rio Tinto in the F&C UK Equity Fund.

I have recently added GKN to the portfolio of the F&C UK Equity Fund to increase its exposure to ‘late cycle’ potential.

GKN is very interesting for a number of reasons. Its Driveline business is the world’s leading supplier of such equipment to the automotive industry.  Automotive output across the board has increased strongly as the global recovery continues.  In turn, demand for GKN’s driveline products has increased sharply and capacity constraints are now an increasing issue, which puts GKN in a very nice place.  Some twenty years ago 11 or 12 companies would have been competing with GKN in this space but now it’s down to a couple of smaller players.  As a result, the auto industry heavyweights are now working increasingly closely with GKN to add new driveline capacity to enable them to increase their output.

This means much greater earnings visibility for GKN in the years to come.  In addition, the company also looks to have control over its pension fund deficit, which came down sharply in 2010 and is generating its own cash.

The latest results from advertising group WPP, also bode well for late cycle recovery, with earnings growth greatest in the US and UK markets.  We also hold this in the Fund.

The latest set of figures from BG Group were good and ahead of expectations, but what really interested me was the commitment to its growth strategy, with increased production targets from its key Brazilian and US assets.  This should, in turn, feed through to increased dividend payments. This again emphasises why I prefer the growth offered by the likes of BG as opposed to the more modest potential offered by ‘big oil’.

Elsewhere too there seems to be a clear trend of rewarding equity investors with increased payouts. For example, we have seen increased dividends from a number of Lloyds Brokerages syndicates and Xstrata have just announced an increased payout, which will now start to put pressure on the other UK listed miners such as BHP Billiton, Rio Tinto and Anglo-American. Imperial Tobacco also recently announced that 50% of profits will be distributed to shareholders, with the intention of increasing this ratio in the coming years.

Are we seeing an increased appetite for equities?
The recent oversubscribed placing of Harbinger’s 14% holding in Inmarsat (it took under an hour) along with placings from a number of resource stocks including Indus Gas, seem to indicate that investors are now starting to look at the potential of equities compared to the risks associated with bonds in an environment where inflation is on the rise.  The emphasis though continues to be on quality rather than quantity.

We have been saying for quite some time that the UK equity market, with its significant weighting to miners, is potentially one of the best ways to access the growth in the emerging economies. And the proof of the pudding… is in the chart below, which looks at the Fund against a number of indices over the last twelve months (as at 20 Dec 2010).

Source: DataStream

But its not just the miners, a couple of weeks ago I discussed why Tesco has a role to play in a high alpha fund due to its expanding presence in Asia, something underpinned by its recent results. And let’s not forget Standard Chartered, GlaxoSmithKline and the Prudential all of whom have significant emerging market exposure and are held by the F&C UK Equity Fund.

About a year ago the F&C UK Equity Fund took part in a fund raising for Zanaga, to finance the first stage in the development of rich iron ore resources in the Congo. We know the management of this company well and our decision to take part was further boosted by the fact that Xstrata were also providing significant financing for the first stage in proving the deposit’s potential.

Our position was taken on the basis that Zanaga had firm plans in place to float on the Aim market and they have duly announced that this is to take place in late November.  We currently expect that the company will come to the market with a valuation in excess of $500m, which should act as a significant catalyst to the current more cautious book valuation.

In 2011 Xstrata will also decide if they wish to continue to be part of the development of this extensive iron ore deposit.  If so they are likely to take a 50% stake in the mine, which should then provide a further positive catalyst to the share price.

This shows is the value in us developing and maintaining close links with private companies that have ambitious growth plans.

The current size of the F&C UK Equity Fund means that we can have a weighting to a small number of this type of asset, offering good long-term potential for those able to wait.