Mid-cap Grafton a good bet despite short-term risks

Investor  An insider's guide to the market: As we move into the second half of 2005, there are straws in the wind to suggest that the global economic outlook is improving. Economic conditions during the first half of the year were in fact reasonably benign.

It is true that the soaring oil price grabbed most of the headlines, but in the face of $60 per barrel oil the global economy has been remarkably resilient.

The US and Chinese economies have continued to grow strongly while the familiar story of euro zone underperformance lingered during the first half of 2005. During the second quarter some statements emanating from the ECB seemed to open the door to a possible cut in euro-zone interest rates.

However, over the past month there has been a perceptible improvement in a number of business confidence and activity indicators. The euro zone purchasing managers indices turned up unexpectedly in June and if this is followed with an improvement in other indicators, any further talk of a cut in euro interest rates will quickly dissipate.

Japan's Tankan survey and the US Institute of Supply Management survey of purchasing managers also turned up in June. These and other indicators feed into the OECD's composite leading indicator. This indicator has been declining so far in 2005 but June's batch of data has arrested this decline.

It will take a few more months data to confirm an upward trend, but with global inflation and interest rates low the global economic outlook for the remainder of the year is good.

This is clearly positive news for equity investors and should underpin share prices over the remainder of 2005. The first half of the year has been a mixed bag with European markets performing quite well and markets in the US standing still.

The ISEQ Overall index has underperformed European indices year-to-date but all of this underperformance is due to the collapse the Elan share price. In fact many mid-capitalisation stocks have performed very well so far in 2005 including Kingspan, C&C, Fyffes, Jurys Doyle and Paddy Power.

One mid-cap high flyer that has underperformed recently is Grafton Group. Over the past six months the shares have fallen by 8 per cent although they are still up by 10 per cent year-to-date.

Grafton's shareholders have enjoyed a stellar performance from the company in recent years.

Grafton's leading position in the Irish builders' merchant market was copper-fastened through the acquisition of its smaller rival Heiton. This ensures that the group can continue to capitalise on the strong growth of the Irish economy over the medium term.

However, a policy of acquisition in the UK over the past 10 years means that Grafton's UK activities now account for approximately 70 per cent of profits. Grafton has successfully executed its aggressive expansion into the UK and it now has a 9 per cent share of UK merchanting, making it the fourth-largest player.

The recent pullback in its share price is due to the slowdown in consumer sentiment in the UK market. If consumer demand continues to deteriorate in the UK then there could well be further weakness in the Grafton share price.

Grafton's prospective 2005 price/earnings ratio is now 12.5 which is roughly in line with the average for the UK builders' merchant sector.

Investor believes that this is an attractive rating in view of the company's strong medium-term growth prospects and its proven ability to execute its acquisition strategy.

There is a risk of further short-term share price weakness if sentiment in the UK sector remains negative. However, Investor takes the view that a cut in UK interest rates is on the cards in coming months, which would stimulate demand in Grafton's market segments.

If the UK market does improve in the second half of the year, and with the Irish building and construction sectors continuing to boom, the recent weakness in Grafton's share price would be arrested.

Therefore, Investor takes the view that investing in Grafton at current levels, despite the short-term risks should prove to be a rewarding long-term investment.