2014: the year of not living dangerously

Investors could be forgiven for looking ahead to 2014 with some confidence. The economy is on the up and the FTSE has enjoyed another year where returns have outstripped inflation. But will this continue in 2014? Leading fund managers say it can, but returns may be harder to come by. Picking cheap companies with an ability to grow earnings will become all the more important.

Dan Hanbury, a fund manager at River & Mercantile, says the hunt for undervalued stocks has become even harder but opportunities remain. "We are buying quality and income stocks, as well as being focused on undervalued structural growth companies or those that still have depressed margins and recovery potential," he says. "This is against a backdrop of very high and possibly unsustainable profit margins across global stock markets."

He cites FTSE 250 packaging company DS Smith as a stock that stands to benefit from recovery in the UK and Europe, with the majority of its sales coming from both.

Simon Brazier, head of UK equities at Threadneedle Investments, says the recovery still faces numerous obstacles: "There are still risks out there, so I want to back companies that can grow in a low growth environment."

Mr Brazier adds that a number of large companies offer the potential for defensive earnings, are attractively priced and often pay healthy dividends. He cites BP, offering investors a dividend yield of over 5 per cent, as one large cap to back for 2014. The unloved pharmaceutical sector also has the potential to positively surprise next year, he says.

But Carl Stick, manager of the Rathbone Income fund, has been buying more cyclical businesses. He names bookmaker William Hill as one to watch for 2014. Although the stock has been hit by concerns about betting tax and online competition, he has been buying on weakness and expects the share price can continue to recover. Leigh Himsworth, the fund manager at City Financial, says Scottish TV could do well during the run-up to the vote on Scottish independence. He also highlights Ubisense, which provides technology that helps to locate staff and tools in factories.

Peter Lowman, of Investment Quorum, highlights equities and commercial property as investment areas for next year. He says: "In Europe, we feel that further opportunities will arise. While we do have investment exposure to the larger caps, the Barings Europe Select fund, managed by Nick Williams, offers investors an alternative proposition."

Bill McQuaker, of Henderson Global Investors, suggests Japanese equities. With the driving force of Prime Minister Shinzo Abe's stimulus programme, dubbed Abenomics, he suggests the Morant Wright Japan fund as one to watch.

But investors in Japan could be in for a volatile ride if 2013 is anything to go by. The market fell 20 per cent in late May after US Federal Reserve chairman Ben Bernanke announced plans to end the quantitative easing programme, but has since recovered.

Gavin Haynes, managing director of Whitechurch Securities, suggests the safety of being paid a dividend while you wait for share-price rises could prove a good call over the coming year. Coupled with his bias towards fund managers who target companies with recovery potential, he suggests the Schroder Income fund. Mr Haynes says commercial property offers investors the option of capital appreciation and a steady income – not something to be sneered at when interest rates remain low. He highlights the Henderson UK Property fund, saying: "The fund invests directly in a portfolio of over 50 properties with an emphasis on quality to ensure they maintain a high level of tenancy and will also hold a weighting in cash for liquidity purposes. This fund provides a yield of 4.1 per cent, which is attractive."

For those seeking bond funds, Henderson's Mr McQuaker recommends buying fund managers that have the flexibility to invest across the market as opportunities arise. His top pick is the Old Mutual Strategic Bond fund, run by Stewart Cowley. Although performance has lagged over the past year, he expects Mr Cowley's long-term track record will come good in 2014.

As recovery seemingly gathers pace and we approach the new year, investors must tread carefully. Mr McQuaker's advice for 2014 is not to overestimate the returns that equities can offer, and forecasts a range of 5 per cent to 10 per cent next year.

But, like Mr Brazier, he warns that substantial question marks loom: "When you look at the world, there are still major issues to be dealt with. I worry, while there is a hope we might be back in a normal world, in China there is a big rebalancing story and Japan is trying to generate inflation for the first time in 20 years. Meanwhile, the European banking system is profoundly challenged and in the US wages have not grown for a generation."

Danielle Levy is news editor at Citywire.co.uk.