UK manufacturers give new hope to old economy

There's still value to be found in Britain's proudest industries, says James Daley

Remember the sick man of Europe? For more than 30 years, one truth about Britain's economy has been held to be self-evident - in time of boom or bust, the country's manufacturing sector has continued to decline.

The struggle to compete with the cheap labour markets of Asia and eastern Europe has practically killed off industries such as textiles and cars, once the mainstay of the country's economy.

Against that backdrop, investors would be crazy to buy shares in the few British manufacturers remaining, right? Well, possibly not - in recent months, certain sectors have been staging a recovery. And government figures published last week showed that British manufacturing grew at its fastest pace in a decade during the first quarter of the year.

Put another way, maybe it's time to forget about high-risk sectors such as technology and health. Are the real growth stars to be found in the old economy?

John McNeil, an investment manager at Resolution Asset Management, says the recent change in the sector's fortunes has been driven by a global manufacturing boom, though he warns it may be short-lived.

"The growth in global manufacturing has been staggering, so given that pull, it's not surprising that even a manufacturing sector as poor as the UK's has been lifted on this tide," he says. "I'm still quite sceptical about the durability of this pick up."

McNeil is not alone. Few fund managers believe that anything will stem the longer-term decline amongst Britain's manufacturers. But that is not to say that as the sector evolves, there won't be any decent investment opportunities for the canny stock picker.

"Manufacturing has been steadily declining in the UK for the past 50 years, if not longer," says Richard Hughes, who runs the M&G Dividend fund. "But it's still quite sizeable and it probably hasn't shrunk quite as much as people think. I'm still optimistic that we have a number of companies in the UK that are adding value - which is the key from an investment perspective."

Hughes cites Rolls-Royce amongst his favourites, on the grounds that the company will continue to do well from the boom in civil aviation. Rolls-Royce also has a big presence overseas, so while it gives investors exposure to the UK manufacturing scene, fortunes do not rely on it exclusively.

Luke Newman, who runs F&C's Special Situations fund, takes a similar view. He points out that while the statistics paint a rosy picture, many manufacturers have, in fact, had a particularly hard time in recent months, as raw material and energy prices have risen. And there is the continued threat of competition in the labour markets from emerging markets. But he believes there are a handful of sub-sectors which have the ability to tough it out through these conditions.

"The areas we've been looking to invest in are those where companies have a degree of pricing power; those who have the ability to pass on the cost increases to their customers," he says.

Like Hughes, he picks out the aerospace and defence sector. "These sectors have been more attractive than most others," he says. "They benefit from an element of price protection due to the sensitivity of what they produce. There is always some work which the Government will not want to outsource beyond the UK."

In addition to the companies who work on government-sensitive projects, McNeil believes those manufacturers which will be most successful in the future are the ones that have a greater intellectual property input into their product - businesses making advanced technological parts for use within computers or televisions, for example.

While he concedes that the battle against the Asian labour markets for high volume business is, in effect, already lost, quality is still at a premium for more specialist manufacturers.

Hughes agrees. "Most things will probably end up being made in a cheaper country, but in the meantime, you may be able to develop and refine your product," he says. "By the time China can do it cheaper, you may be able to do something better - quality is critical."

James Ridgewell, the manager of New Star's Special Situations fund, says investors should not get too bogged down in the long-term trends of the sector. He says people have been talking about the decline of manufacturing for decades, yet there are still some good investment opportunities

"They're real issues but they're not new," he adds. "Asia's been increasing its manufacturing for a long-time but in spite of that, you're still seeing companies over here that can continue to do well."

Ridgewell adds that there will always be industries that need to make their products in the UK - certain heavy industries, such as steel, for example, for whom transporting weighty products across the globe would prove too costly.

"Who knows what's going to happen in five years' time in Asia?" he says. "There are some long-term trends which will continue. But from an investment perspective, you need to look at the fundamentals of a company today."

Although sceptical that there is any stamina in the manufacturing sector's recovery, Ridgewell is keen to focus on individual companies that appear mispriced. He cites the likes of Invensys and Cookson as two examples. While they may continue to face the competitive pressures of globalisation in the long-run, Ridgewell says they are currently underpriced and present a perfect investment opportunity for the medium-run.

The trick with these stocks is knowing not only when to buy but when to make your exit. If you're not a well-seasoned investor, it makes sense to invest in the funds of those such as Ridgewell and Newman, who can pick and choose the best opportunities for you.

There are no funds that specialise exclusively in the manufacturing sector - and even the M&G Blue Chip fund is now merging with the M&G UK Growth fund. But most general UK growth funds will provide you with some exposure to the sector.

Six companies for manufacturing loyalists

* James Ridgewell, manager of New Star's Special Situations fund, says his manufacturing favourites include Cookson, the engineer. "Cookson looks very interesting at the moment," he says. "It has been through a major restructuring during the past couple of years, and its results have been either meeting or outperforming our expectations recently. I think the rating is far too cheap. It's on a price earnings multiple of 11.5 times this year's forecasts, and it's growing at 20 per cent.

* Ridgewell adds: "Invensys is also interesting. This is a company that nearly went bankrupt a couple of years ago. It has made a number of disposals and it's restructured its debt - which has been one of the biggest worries during the past few years. Before, earnings growth was masked by high interest charges, but now that's on the way out."

* Luke Newman, who runs F&C's Special Situations fund, says the only manufacturing stocks that interest him are in the aerospace and defence sectors. "Rolls-Royce is something we hold," he says. "It's been benefiting from the dynamic in the civil aviation market."

* From the same sector, Newman adds: "We also like Auto-electronics, which makes defence electronics for the ministry of defence. Because its contracts are of a sensitive nature, it has a certain protection."

* Richard Hughes, the manager of M&G's Dividend fund, looks for companies with a good yield. For example, he holds bread and cake-maker Rank Hovis McDougall in his portfolio. "There will always be some things that are too expensive, or impractical, to move to China," Hughes argues. "If our bread was made there, it would have gone off by the time it had been transported to the UK."

* Hughes also admires its rival AB Foods. "Food manufacturing is a good example of an industry that will almost certainly always be around in the UK," he says.