The smart investors will be staying home this year

When stock markets continue rising for an extended period, investors' feelings tend to be mixed: they may be delighted with the gains, but they also get nervous that setbacks are imminent. So it is with the UK stock market, which has been hitting new highs since the turn of the year.

This week, the FTSE 100 Index of shares in leading UK companies hit its highest level since December 2000. At above 6400, the market is now trading at less than 10 per cent below its all-time high, achieved at the height of the dot.com boom of 1999.

British investors are understandably nervous - the UK stock market represents the bedrock of most portfolios, because it is more accessible than overseas alternatives and because people like the comfort of knowing their money is invested closer to home.

In fact, the UK is no less risky than most other developed stock markets, though at least British investors don't have to worry about the risk of currency movements.

Can the good times continue? It's certainly true that investing in the UK has proved lucrative since the end of the bear market in March 2003. The FTSE 100 index has almost doubled over that period, the FTSE 250 mid-cap index is up almost 150 per cent, and the FTSE Small Cap index has more than trebled.

The good news is despite these gains, valuations do not look particularly stretched, particularly in certain areas. Richard Buxton, head of UK equities at fund manager Schroders, says that while the FTSE 100 index as a whole is trading at a reasonable valuation of 14 times this year's profits, the so-called "mega-caps" - the 10 to 15 largest companies in the index - are trading at an average of just 11 times.

Given their relatively modest performance compared with small and mid-cap stocks, the consensus is that 2007 will be the year where the largest stocks finally come back into their own.

"The mega-caps have performed woefully in comparison with the rest of the FTSE 100 and mid-cap stocks over the past few years," Buxton says. "In value terms, these stocks were trading at a 30 per cent premium to mid-caps at the end of the bear market four years ago. They're now trading at a 30 per cent discount. We've got more exposure to them than we have done in a number of years."

Buxton believes the market has overreacted to some of the problems within the largest stocks. Shares in HSBC, for example, plummeted 3 per cent last week after it conceded that it had seen a worse than expected level of bad debts in its US business. But Buxton believes that, given HSBC's size, the latest US hiccup has been blown out of all proportion.

He remains indiscriminative when it comes to which of the UK's largest stocks he likes most, pointing out that it is only a matter of time until sentiment improves towards all these companies.

Although investors are currently chasing growth stocks, he points out that sentiment towards the largest companies always picks up when economic conditions get tougher. In the meantime, he says that given the generous dividends that many of these stocks pay, investors are being "paid to wait".

However, Jeremy Smith, manager of Neptune Investment Management's UK Growth fund, disagrees with Buxton, claiming that stock selection remains important, even among the largest companies.

As an example, he cites the two largest oil companies - BP and Shell - claiming that although their valuations look cheap, they do not reflect the changing nature of the oil market. Smith believes that with a growing proportion of oil demand coming from the eastern hemisphere, the likes of BP and Shell, which have most of their assets in the West, are poorly equipped to meet demand from the East. Furthermore, with growing cost bases, he says that these companies need to grow at a substantial rate to even stand still each year.

Smith is also bearish about mining stocks, and holds none in his portfolio. "People are assuming that China will continue to grow exponentially and will hence continue to demand more base metals," he says. "Although we agree that China will continue to grow, China is now a net exporter of some of these metals - such as zinc and aluminium - so their demand will not be sustained in these markets."

He is most bullish about prospects for the pharmaceutical sector - in particular GlaxoSmithKline, which has an encouraging pipeline of new drugs in advanced stages of trials. He also likes media and telecoms stocks, but remains pessimistic about banks, which have become popular among many of his rival managers.

Stephen Whittaker, for example, the manager of New Star's UK Growth fund, believes the UK banks are particularly cheap as their "share prices are discounting a recession, which I believe is not going to occur". As a result, the top four holdings in his fund are Royal Bank of Scotland, HSBC, HBOS and Barclays.

While opinions remain polarised on exactly which sectors and stocks will perform well in 2007, most managers remain relatively confident that the UK will see another year of positive returns.

Buxton warns that there remains a strong chance the market will see another correction in the near future, as it did last spring, but adds that this is likely to be a short-term blip and should not be a concern for long-term UK investors. The biggest risk is the possibility that the current global slowdown is worse than expected. The economic fortunes of the UK remain linked to those of the US, Europe and, increasingly, China. While recent data from the US has suggested it is seeing a soft landing to its economic slowdown, it's too early to predict with certainty that conditions may not deteriorate further.

Simon Murphy, manager of the M&G UK Growth Fund, says that given the uncertain economic backdrop, he aims to focus on companies that will do well irrespective of the external environment. He cites Tesco as one of his favourites, pointing out that its earnings growth has been steady rather than cyclical over the past few years. He believes its recent international programme of expansion should continue to deliver earnings growth, while in the UK its non-food business expansion is continuing to produce strong results.

Unless you're a relatively experienced investor, the best way to get exposure to the UK market is by investing in an investment fund, where a fund manager will make the individual stock selection for you.

However, Paul Ilott, of Bates Investments, the Leeds-based financial adviser, warns investors to be careful to understand exactly what they're investing in: "Within the UK All Companies sector, there's a tremendous array of different strategies adopted - so investors need to be fairly selective over their fund choice, to be sure it meets their risk tolerance."

Ilott recommends investors plump for one fund that looks for growth stocks, one that focuses on undervalued companies, and a third that has a blend. Of the growth funds, he suggests Axa Framlington's UK Select Opportunities, managed by Nigel Thomas, whose strategy is to identify "growth at a reasonable price".

The best place to look for value funds is in the UK equity income sector. Here, Ilott picks out Invesco Perpetual's UK equity income fund, managed by Neil Woodford, or Jupiter's Income fund managed by Tony Nutt. For investors looking for a more blended approach, he recommends Schroder's UK Alpha Plus fund, managed by Buxton.