Every month, we invite some of the best investors we know to a Roundtable discussion. Here, they tell us what they think of the prospects for stocks in the wake of the collapse of the market for subprime mortgages in the US – and reveal three of the hottest investments around.
Merryn Somerset Webb: Let’s talk about the volatility in the market. Is this the start of a bear market?
Bob Catto: On 27 February the S&P had the worst day since 1926 in terms of breadth: 498 shares fell and two rose. Everyone rushed to say it was a buying opportunity, but I can’t see how that works. There’s too much uncertainty.
We don’t know how much leverage there is in the system. You’ve got the yen carry trade, derivatives market and all the games the hedge funds are up to. We also still don’t know how much the subprime market in the US is going to affect credit there and what the knock-on effects of that will be on the consumer, and hence on China and India, and so on. It’s all difficult to call, but I think this setback is serious.
Peter Warburton: I’d agree. It looks like a dress rehearsal for something more problematic later this year. Over the last six to nine months, we’ve seen a lot happening in the credit markets, especially the US mortgage market. The critical thing to watch is the progress of the spring home-buying season. A lot of people took their properties off the market last September. But they’ll now come back to the market in the hope that the new season will flush out new buyers and better prices. If that fails to happen, I think it will set us up for a new cascade of market falls. Right now, there may be distressed-debt buyers who could put a floor under the market and re-establish prices, but a weak spring in the physical buying market will make that a less tempting prospect.
Makis Kaketkis: I disagree. What we have right now is a disconnect between the markets and the underlying economy. There may be turmoil in the market and that may be worth worrying about, but what we haven’t seen is the real economy suffer. This is very similar to what happened last May. We had the first drop, then things stabilised before we tested the lows again. But after that things just went up again. The truth is that the structure of our markets is very different to ten or 20 years ago. It used to be that the market was actively run by fund-management investors who bought and sold based on fundamentals.
But today it is dominated by investors who are less moved by fundamentals and more by technical issues. If a stock goes up, they’ll buy more; if it goes up again, they’ll buy a bit more. If it falls, they’ll halve the position; if it falls more, they will short, and so on. And that, I think, builds in a kind of self-perpetuating mechanism. We first saw the effect of computers in the crash in 1987 when the falls were much bigger than they would have been otherwise. But since then they’ve become an even bigger part of the market – maybe 30%. The point is that this kind of volatility doesn’t tell us anything about fundamentals. It just tells us that computers buy and sell for lots of reasons. As long as it doesn’t spill over into the economy, then at some point investors will see that stocks are cheap on a long-term basis and start buying.
MSW: But is the market cheap?
MK: Yes. Look back to 2000 and stocks were trading between 18 and 22 times. When earnings started to go down, the stage was set for a hard bear market. But now we are trading on an earnings yield of 7.5%, which, by historical averages, is pretty much spot on. Equities are also as cheap as they’ve ever been relative to debt. That tells me that so long as earnings stay up (rising at 5%-10%), stocks are very cheap. There’s no reason not to buy.
MSW: Right now?
MK: Well, you may want to wait for the dust to settle and then take a look at which valuations are best. There are FTSE 100 stocks yielding more than 5% and raising their dividends. That’s telling you that they are confident earnings will keep rising. I’d look at Shire (SHP), which I think can grow substantially, particularly given its recent acquisition of New River in the US. Or perhaps Resolution (RSL).
MSW: Does all that make sense to you, Matthew?
Matthew Ridley: A lot of it does. We are more concerned about the credit market than the equity markets. Equities are currently reflecting most of the fear in the market, but the area people should be scared about is credit, which is very tightly priced. There’s room for discussion on whether equities are cheap or not. That’s not the case with debt – the market is so expensive it has only one way to go from here. We’re worried about the subprime market in the US.
Traditionally, the subprime borrower in the US hasn’t been allowed to borrow. But over the last few years, they’ve had good access to credit only to find that the affordable structure of their adjustable-rate mortgages relied on rising house prices. Now prices aren’t rising, they are unable to refinance and are suddenly faced with very high payments and are defaulting. That said, the majority of US consumers aren’t in quite the same trap – they mainly have fixed-rate mortgages. Subprime is also a small part of the market, so while it is likely to be wiped out over the next year, the crisis may not spill over into the rest of the market. It’s a very new market so there hasn’t been that much time for it to grow.
PW: The subprime market is 12.75% of the mortgage market – ie, $1.3trn. Of those loans, 80% have been written since 2003. So it may be a new market, but it’s a big one.
MSW: So there will be a big shake-out?
PW: In theory, yes, but I’ve been surprised time and again by the way the system has proved to be elastic and tolerant of risk. What we need to know is what might change to alter that tolerance. One thing that has changed recently is that the secondary buyer of subprime debt has disappeared and the subprime businesses are facing the possibility that their bank funding will be withdrawn. The other thing that must be considered is the amount of subprime debt that has been bought by non-residents of the US. A lot of this very domestic debt has become an international asset and we don’t know how that will play out. The one thing I wouldn’t do, however, is underestimate the capacity of this system to find solutions to problems.
MSW: Shall we move on to talking about commodities? Bob, are you still convinced we’re in a commodity super-cycle?
BC: Yes. It’s possible to envisage a scenario where the American consumer stops buying and that has a knock-on effect on global growth around the world. But I think the big drive for commodities comes from the infrastructure being built in China, India, Russia and so on. New airports are being built all over the place. And the supply side just can’t meet this demand. So while I think we will see volatility in prices, there will be a long-term secular shift upwards in prices. What should you buy? The stocks that are fundamentally cheap. If you buy BHP, Rio Tinto and BP on nine times earnings, I don’t think you will go far wrong.
I also think it is worth looking at the junior gold firms, perhaps Medusa (MML). It comes with some political risk as it is based in the Philippines, but with a market cap of £55m and cash flow of £25m by the end of 2007, it is so cheap it doesn’t matter. If the market doesn’t price it right, it will get taken over. I’ve liked the uranium story for a long time, but it has now been overdone – every Tom, Dick and Harry is long on uranium stocks, so I think it’s an area to be careful of. I like diamonds though. The fundamental story is very strong indeed. De Beers has an extraordinary marketing team, which did wonders for consumption in Japan. They are repeating the trick in China – and the numbers are a lot bigger. I’d look at Firestone (FDI), which has fantastic management, and Brazilian Diamonds (BDY), which is tiny but has potential.
MSW: Makis, how do you feel about the commodity sector?
MK: The two commodities I’m really interested in are gold and diamonds.
The rich are getting richer everywhere in the world and diamonds are a natural luxury product for them to invest in. The point about Japan is key – in 1966, I think about 1% or 2% of Japanese engagements involved a diamond and by 1982, when De Beers stopped their marketing campaign, 90% did. Imagine a diamond at every wedding across the rest of Asia. A favourite stock would be Gem Diamonds (GEMD). The management used to run the De Beers business – you can’t get much better than that. Then gold, which is now beginning to be seen again as an asset class in its own right, and that’s quite right. Gold isn’t only immune from default, but with the way global liquidity is debasing currencies you would naturally expect physical gold to go up in value.
MSW: Any favourite gold stocks?
MK: Peter Hambro (POG), which by 2009 will be one of the top-ten gold producers globally. Right now, it is valued at only 20% to 30% of its real value. That is partly because it is in Russia, so there is concern about the security of its assets, but I think that is overdone. The shares could easily more than double. Another is Canada-listed Kirkland Lake Gold (CN:KGI). It is cheap, it is safe and it has the capacity to more than double its resource base from here.
MSW: What about other small caps? Any good tips?
MK: Aim-listed Velti (VEL), which provides services to the mobile telecoms industry in southeast Europe. It’s on a p/e of ten and growing 30%-40%. That’s cheap.
MSW: Where would your money go at the moment, Matthew?
MR: I would highlight three areas where people have fallen out of love with equities; perhaps too much so. Where there is a lot of bad news in the price and people are patient, there should be good returns. One would be Canadian oil and gas juniors. They took a good hammering last year, but if one believes in growth in emerging markets, then the fact remains that they are selling a product at a price that will allow them to make good profits over the medium term. Next is Taiwan. The Taiwanese market, like the Thai market, hasn’t made any progress for 20 years and everyone is negative for political reasons. These negative thoughts may be well founded, but they are also in the price. Moreover, Taiwan has the benefit of a large technology weighting, which is good, given how out of favour the sector is. We think there should be a new wave of technology spending in the pipeline – particularly given the move from analogue to digital.
MSW: I think Bob will be with you on Canadian oil and gas.
BC: Yes. I also agree on Taiwan and Thailand. A well-managed Far East fund that includes both would be a thing to buy on weakness. In the UK, I like Egdon (EDR), which stores gas. It is dirt cheap because people are worried it won’t get the planning for its storage facility, but I think the risk is tiny. It will be on a brownfield site and the gas will be 2,000 metres below the surface in caverns. All the relevant local councils have agreed and the UK is desperately short of gas storage. Other than that, I like Centamin (CEY) in Egypt, a gold play. Its market cap is only about £270m and it has one of the biggest gold deposits anywhere in the world. It may well get taken out this year. And for the more adventurous, there is Pursuit Dynamics (PDX).
MSW: Have we tipped that here before?
BC: We have, and it has had its ups and downs. But it is looking likely to get orders from Tyco for fire fighting, from the US Defence Department for decontamination, and from the brewers, and it’s already got orders in the food-processing area. It is a fabulous technology. In a nutshell, when steam condenses it occupies 16/100ths of its former volume and so, if you inject the steam into a tube, it immediately condenses to create a vacuum. You can use this process to do all sorts of things:
it can heat tomato soup in seconds, for example, or fill a huge space with liquid to put out fires, for example.
MSW: Peter, what are your favourite places for money at the moment?
PW: Domestically, oil and gas services. Business investment in oil and gas exploration rose very sharply last year. A second theme would be high-yielding Swiss equities. It’s partly a currency play – I think the Swiss franc will rebound. You can get a yield of 3% or 4%. It isn’t huge, but with an expectation of capital and currency gains, it is fine. The third theme is Singapore. I don’t think people have grasped the extent to which Singapore has aligned itself with India rather than China. It’s also a big beneficiary of Middle East money – there is some switching in custodial activity between Switzerland and Singapore. And while it has had a deadbeat real-estate market since the Asian crisis, it’s now just coming to life. So basically, you’ve got a domestic property move, you’ve got oil monies and you’ve got spin-offs from India. I don’t see how that can go wrong for the next five years.
To read a longer version of this discussion, see our Special Reports page.
Our panel:
Bob Catto
Investment director, Williams de Broe
Makis Kaketkis
Manager, Foreign & Colonial UK Dynamic Fund
Matthew Ridley
Director and chief investment officer, Consulta
Dr. Peter Warburton
Managing director, Halkin Services