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Managers look forward to recovery at last Back  
The global downturn combined with one of the worst profit recessions in the past 50 years meant that 2001 was a tough year for pension funds with the average pension managed fund falling by 5.4 per cent. However, despite the recent poor performances of several leading Irish stocks,a recovery is predicted for 2002. In this Finance pensions review, Ireland’s leading pension fund managers look back on the year that was and outline their investment strategies for 2002.
Looking back on 2001
The main factors influencing markets in 2001 were the aggressive cuts in US and global interest rates, the uncertain economic and corporate earnings outlook and equity valuations. As the economic outlook improved (we stood back in the immediate aftermath of the terrorist attacks in September), we reduced our exposure to the more defensive stocks, which had performed well, and took opportunities to re-invest in the more growth-oriented and cyclical areas, with a focus on quality stocks whose valuations could be justified by their long-term earnings prospects. When we became more confident that economies would recover from the terrorist attacks we increased our aggregate exposure to equities, mainly in the US and Asian markets (but reduced our exposure to Japan). In this regard, we benefited from taking profits in a number of the defensive stocks after they had performed strongly and cutting completely our exposure to the Japanese banks, whose financial position had deteriorated considerably. Overall, market conditions in which low growth stocks fared well did not suit our investment style, which is to favour those companies, which grow earnings faster over time.
Outlook for 2002
A strengthening in consumer and business confidence, and in leading indicators generally, and resilient consumer spending point to a reasonable recovery in the US economy during the first half of the year, led by a turnaround in the inventory cycle, which should in turn lead to a recovery in industrial output. In this renewed growth environment, equity markets should return moderate positive returns. Which sectors will outperform? Our choices are sectors which are geared to the economic recovery (e.g. materials, industrials, media and certain parts of the technology sector). In contrast, we expect the more defensive sectors to be more restrained this year. We are also cautious on pharmaceuticals, which are still a good long-term story but whose short-term prospects are clouded by patent expiry issues and / or limited new drug pipelines.

Much will depend this year on how earnings recover in response to the recovery in economies. We are looking to individual companies becoming more upbeat about their own earnings prospects in coming months and will focus on those growth companies where the earnings outlook looks more secure. In the short term, however, concerns about accounting standards are likely to continue to weigh on equity markets generally. The weakness in the Irish equity market may also lead to a revisiting of the issue of the weighting of Irish equities in balanced portfolios, although any further moves to reduce the weighting will have to take account of the relative value of Irish stocks compared to their international peers.

We expect the Irish economy to pick up in the course of the year, helped by tax reductions, low interest rates and a moderate recovery in the US and global economies. A pick-up in direct inward investment will have to await a recovery in the US investment cycle, which may not be until well into the year. On average, we expect the economy to grow by about 3% compared to about 4.5% in 2001.

Martin Nolan, chief investment officer, Hibernian Investment Managers

Looking back on 2001
During 2001, equity markets were undermined by significant cuts in company profit forecasts across the world as the economic slowdown took hold and past excesses were unwound. This was one of the worst profit recessions we have seen in 50 years. In the US, earnings per share (EPS) forecasts were cut by 33 per cent during 2001, which culminated in the S&P 500 index falling by 12 per cent. Similarly, declines in EPS forecasts in the eurozone (-26 per cent), UK (-13 per cent) and Japan (-64 per cent) resulted in the stock market falling by -19 per cent, -14 per cent and -20 per cent respectively in 2001. The downward movement across all regions was remorseless through the year with the Sept 11th terrorist attack prompting further downgrades.
Hibernian Investment Managers (HIM) had a disrupted start to the year due to a dwindling bias for growth sectors. By mid-February the portfolio focus had turned defensive and managed funds had moved to an underweight position in equities relative to peers. With the exception of a brief rally during April and May, global equity markets plummeted downward reaching a bottom on 21st September following a capitulation phase after September 11th attacks. HIM remained defensive and underweight equities for the majority of this period. Following the trough in September, HIM focused on controlled participation in the rally in equities to the end of the year. The underweight position in equities was closed out to a neutral position by year-end. The focus within portfolios has become skewed towards a recovery with cyclical, general industrials and telecoms to the fore.

Outlook for 2002
Hibernian Investment Managers (HIM) expects a global economic recovery in 2002, driven by the predicted recovery in the US; though maybe not as soon or to the extent as generally anticipated. HIM anticipate a sub-consensus 0.5 per cent GDP growth rate in the US for 2002, and consequently expect US interest rates to rise by 0.7 per cent in the second half of this year. The Irish economy is forecast to experience a decline in GDP growth from 6.5 per cent in 2001 to 4 per cent this year. Ireland faces the problems of rising unemployment and inflation, which is expected to be 3 per cent higher than the EU-12 average in 2002. For the eurozone, HIM sees a best-case scenario of 1 per cent GDP growth in 2002, lagging behind the US until late 2002 or early 2003. A major reason for our lack of optimism is the relative inactivity of the European Central Bank compared to the US Federal Reserve in cutting interest rates to stimulate growth.
HIM are positive about the outlook for equities and bonds but property may have to take a back seat. We envisage that the gains made in equity markets since the 21st September low will continue into the first half, supported by ample liquidity, the lowest interest rates for thirty years, fiscal stimulus and lower oil prices. However, uncertainties remain regarding US corporate profitability, corporate cash flow and consumer demand. These uncertainties are likely to affect the ability of the equity markets to sustain a rally into the second half of the year. We are looking for moderate returns of about 8-10 per cent in 2002. For Irish equities the outlook is uncertain with earnings forecasts below the eurozone average for 2002. Given the defensive sector composition of the Irish market the ISEQ is likely to under perform if global markets continue their rally.

Eugene Kiernan, head of asset allocation, Irish Life

Looking back on 2001
While 2001 was a poor year in terms of absolute returns for pension funds, we were delighted that our approach and strategy again added value for our client portfolios in what were difficult investment conditions.
Our key win in 2001 was once again our value approach to stock selection, which is at the core of our investment process. We invest only in those companies, which have solid balance sheets, solid prospects and are, in our view, undervalued by the market. This approach yielded fantastic relative returns for us in 2001. In the US, for example, we produced healthy positive returns in what was a downmarket.
Another key decision for us was to fully maintain our equity exposure at the time of the September 11th tragedy in the US. We felt markets had gotten to distress levels of valuation and that the surge in liquidity and the drive to lower interest rates would support an oversold market. Subsequent rallies vindicated this.
In retrospect we could have made huge gains by going overweight markets such as Taiwan and Korea at that time (we were in fact neutrally positioned in both) as these markets enjoyed a 50 per cent bounce from their lows. However we believe we can achieve very respectable returns by being positioned strategically correctly without taking undue tactical risks.

Outlook for 2002
Looking forward into 2002, our overriding belief is that value will once again be the cornerstone of a successful investment strategy. Investors, facing into volatile market conditions and what will be a mild economic recovery, will zone in on those companies who are built for survival and have the balance sheet strength and solid cash flows to prosper.
We do believe that the world economy will pick up in 2002 but it will be a gentle recovery. However we are encouraged by many of the moves we have seen at the company level where significant progress has been made on clearing excess inventories and getting costs into line with this new level of demand. This will support profit growth.
We will maintain our exposure to equities, while making some tactical adjustments between the major blocks of US and eurozone.
At home we believe that while the Irish economy will slow down in 2002, it will still post a reasonable level of growth. Underlying this view is our conviction that the global economy, and principally the US, will see a pick up in the second half of the year. We believe that the Irish economy can deliver a growth rate of around 4 per cent for calendar 2002, which will be vastly superior to an OECD average. However, the key point for the domestic economy is less the point forecast for 2002 but the fact that the medium term outlook is still solid and the economy can deliver superior growth for a number of years.

Noel O’Halloran, chief investment officer, KBC Asset Management Ltd

Looking back on 2001
Reflecting on 2001, it was the most difficult year for investment markets since the 1970s. In hindsight, we were too optimistic on the timing of the recovery in the US economy, which impacted asset allocation in that we were overly optimistic on the prospects for equity markets. Across economic sectors we underestimated the extent of the inventory overhang in the IT sector, not just in the USA but globally. Many leading companies such as Cisco had built up inventories in anticipation of strong demand for their products. That demand didn’t materialise due to the extent of the corporate and economic downturn. Whilst the funds were underweight TMT stocks, they would have been better served to own none at all.
On the positive side, at the macro level KBCAM made a very strong and early call that global central banks had the scope and ability to aggressively cut interest levels and would do whatever it took to regenerate final demand. Allied to this call was an absolute belief that inflation was yesterday’s war and that if anything Central Banks should be more concerned about deflation rather than inflation....witness Japan. KBCAM also maintained a contrarian view all year that the euro would not strengthen versus the US dollar. In the final quarter, after the devastating events of September 11, and after much research and consideration, the team made a decision to invest further in equity markets. That move was well timed as equity markets returned more than 20 per cent since the decision, as strong evidence emerged that the US economy has bottomed and has begun to recover.

Outlook for 2002
Looking into 2002, the major focus will be the extent to which the global economy rebounds and the strength of the corporate profits rebound. KBCAM believes that the recovery will be globally synchronised, with Asian and European economies and profits lagging the US turnaround by no more than three months. Japan will most likely continue to perform poorly, with its domestic economy continuing to contract in the absence of any major initiatives from the authorities and Japanese corporates. Closer to home KBCAM is neither in the ‘boom and bloom’ nor the ‘doom and gloom’ camp, forecasting the economy will grow close to 4 per cent this year.
In forecasting the magnitude of equity returns we might reasonably expect, the sectors to watch are financials, technology and energy as they are the heavyweight sectors in most indices. For example, in Ireland, financials compose over 35 per cent of the index, in the US financials and technology combined make up 45 per cent of the index, whilst in the UK, financials, energy and technology (including telecoms) combined make up close to 60 per cent of the FTSE index.
Following two years of negative market returns, KBCAM is more optimistic for 2002, believing it will be a positive year. The consensus view on the markets for the coming year is one of cautious optimism and perhaps the optimists will have it this year!

Brian Gray, director of investments, Montgomery Oppenheim.

Looking Back on 2001
Economic recession became a reality in 2001, an outcome that the stockmarket had already begun to discount in the second half of the year 2000. During the year, the dramatic late 1990’s capital expenditure surge within the technology sector also ground to a halt, as over production and falling end market demand squeezed inventories dramatically higher in the early part of the year.
The US Federal Reserve and other leading Central Banks have fought the economic and investment slowdown tooth and nail, with 11 successive interest rate cuts over a 12 month period, to bring US rates down to 1.75 percent, the lowest level since the 1950’s. Yet, the most entrenched bear market squeeze since the 1970’s dominated, saved only by a liquidity driven fourth quarter rally in equities, supported by a stabilisation in technology inventories and the expectation of economic and corporate earnings recovery in 2002.
In the pensions arena, long term performance is what makes the difference to a scheme’s liability funding requirements. But of course in reality the long term is nothing more than the compounding effect of a series of short term performances. Therefore 2001 was predominantly a year built on consolidating the strong performance that has been cumulated over the past 10 years.
During the year, our pension fund held a lower than normal weighting in equities and a higher than normal in fixed income securities. This proved to be the correct strategy for the first nine months of the year as equities performed poorly, although we forfeited a portion of our strong comparative performance in the fourth quarter as excess liquidity spurred equities higher. Within equities, we tilted our portfolio towards the more defensive sectors of the economy for much of the year including, healthcare, consumer staples and utility stocks. We were marginally underweight to technology and more significantly so to telecommunications equipment and service providers. We focussed on identifying best of breed technological leaders, capable of growing market share despite the slowdown. This proved to be a particularly successful strategy as technology leaders like Microsoft, IBM, Intel and Dell Computer all performed very strongly in 2001. Less successful in 2001 was our fully weighted position in utilities, a sector which prematurely reversed its strong performance of the previous year, particularly in the US, where woes within the energy sector crept into utility stocks.

In bonds a key feature was yield curve steepening (whereby short dated bond yields fell significantly more than long dated bond yields) a development that suited our relatively short duration bond portfolio.
All in all, a year in which favourable asset allocation and strong relative stock selection drove the relative performance.

Outlook for 2002
The prospect of economic recovery looks reasonably good for 2002, driven primarily by the availability of cheap capital and the near completion of the inventory imbalance that plagued the technology industry in 2001. However real demand within the economy, including in the consumer sector will likely remain below normal levels in the year ahead. We would worry particularly about the consumer who remains heavily debt burdened and who generally tends to lag in terms of effect during an economic slowdown. Corporate earnings should improve into the second half of 2002.
However, whether this converts in a meaningful way into stockmarket performance is less certain. Equities are not screaming cheap (a position they often are in at cyclical bottoms) and it is difficult to envisage a general re-rating within markets over the next number of months. Therefore stock and sector selection will be crucial and managers who can and have demonstrated a skill in this should potentially outperform the passive or index manager.
Within the Montgomery Oppenheim Pension Funds we continue to tilt portfolios towards early cyclical sectors such as basic materials, energy and selected technologies such as semi-conductors. Following a punishing 18 months, telecom stocks are also revisiting levels at which value and returns on invested capital based investments may be considered. Specifically of the above paper, oil services, telecommunications equipment (Lucent) as well as the already mentioned early cyclical semi-conductor stocks are our preferred plays this quarter.
Interestingly, pharmaceutical stocks, although generally defensive in nature also score very highly on relative valuation measures coming into 2002.
With longer dated government bond yields expected to begin to rise this year (accounting for the extra funding costs and the significantly increased defence budget) we are beginning to move more underweight in financial stocks this year.
Overall, we see this as a year of constructive consolidation within equity markets world-wide. Headline returns over the coming years may not match those required from pension plans, making active management an essential strategy for the years ahead.
As regards Irish economy, growth forecasts for the year ahead are as much dependent on international economic events as on domestic expansion. We estimate growth will be in the order of 4% and that the stockmarket as always will behave as a market of individual stocks. We still favour globally competitive players such as CRH and Kerry Group.

John Nolan, deputy chief investment officer - retail, Bank of Ireland Asset Management

Looking back on 2001
Certainly 2001 was a year to remember. Sadly for many, the strongest memories are the shocking events of September 11, and the subsequent war in Afghanistan. But even prior to this global markets were in decline, and for the first time since the middle of the 1960s, the economies of the US, Germany, and Japan all shrank in the third quarter of 2001.
Against this backdrop, our objective has been to minimise the negative impact of the global downturn on client’s portfolios. We are very pleased that we had considerable success in achieving this goal and that right across the board, our funds enjoyed strong relative performance.
Looking back at 2001, perhaps the most significant trend to emerge was the return to more ‘normal’ markets.
What I mean by this is that in 1999 and 2000 many investors concentrated too heavily on just one sector - TMT, (technology, media, and telecommunications). They lost sight of one of the basics of investing - namely that you need to diversify if you want to achieve good, risk-adjusted returns. Increasingly in 2001, investors returned to this fundamental, investment approach. Throughout 2001 the TMT bubble continued to deflate, while at the same time, good solid non-TMT businesses were revalued upwards, in line with their true worth.
Economic woes were not confined to the TMT area, however, as slowing economic growth throughout the world hit most sectors, the notable exception being the ‘defensive’ areas of the market, namely food and beverage, tobacco and pharmaceutical stocks. We have been overweight in these areas for the past few years, as this was where the real value lay in our view.
We are fundamental, bottom-up stockpickers and place a huge emphasis on value.
For our part, there has always been, and continues to be, a consistency in our investment approach. This has been tried and tested over time. A good example of this is the TMT bubble, which acted as a’stress test’ for our investment process. At the time, remaining underweight in TMT stocks was seen as an opportunilty lost. However, as events have unfolded and the bubble burst, our adherence to a disciplined and rigorous investment approach protected our clients and enabled us to achieve strong relative performance.

Outlook for 2002
We expect equity markets to continue their healing process.
• The global economy will likely spend much of 2002 digging itself out of late 2001’s recession, with growth set to recover somewhat in the second half of the year. However, the strength of this recovery may not be as powerful as anticipated by the rapid rebound in equity markets and increasing bond yields.
• While corporate profits are likely to remain on the weak side, we expect to see some pick-up as the year progresses. The wave of interest rate cuts over the last twelve months should lead to some improvement in the economic climate, however, absolute levels of returns are unlikely to reach the levels of the late 1990’s.
• As September 11’s attacks illustrated, the uncertainties created by so-called external shocks to the economy and markets have risen.
• While there is unlikely to be a meaningful direct economic impact, the debt default by Argentina’s government and the Enron bankruptcy - the largest in US corporate history - are further reflections of the increased risks.
• Markets have corrected a good deal of the obvious anomalies within sectors, over the last two years. So, we believe that 2002 will be a year for concentrating on stock picking rather than focusing on whole sectors.
In our view, the ‘winners’ over the next few years will be companies that achieve top-line revenue growth. Despite the uncertainties about the macroeconomic outlook, there are a number of companies likely to produce good earnings growth and margin expansion, independent of the economic cycle. These are the types of stocks we will look to add to our portfolios.

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