This month, we invited the best experts we know to discuss whether or not the market has reached the bottom and which investments they would put their money into now.
Our panel: James Ferguson, Economist and stockbroker at Pali International; Jonathan Compton, Managing director of Bedlam Asset Management; Michael Jennings, Manager of the Premier Global DSR Fund; Tim Price, Director of investment at PFP Wealth Management.
John Stepek: Easy one to start with: have we reached the bottom yet?
Tim Price: We’ve come an awful long way down very, very quickly. I don’t have any strong conviction on whether we are at the lowest point yet, and there is plenty of deleveraging to come – but I am starting to see, at a stock-specific level, the sort of valuations I never expected to see in my life.
Mike Jennings: There are fundamentals and there are technicals. Fundamentally, I think the market is fantastically cheap. I reckon that in two years those who sit on cash will kick themselves and say, “Why wasn’t I brave enough to buy in Christmas 2008?” If the UK market ends this year as it is, it will be the second-worst year in 312 years. So I think fundamentally the market is very attractive. Unfortunately, technically it’s dire, because volumes have dried up. As Warren Buffett says, it’s cheap – but it might get cheaper.
Jonathan Compton: I agree, there are cheap stocks, of course – but the bottom? Definitely not. It’s almost impossible to have a bottom when you’ve still got bank lending contracting.
John: Will the bail-outs help?
Jonathan: I think the Government has made the right decision, in that it is saving the core banks by nationalising them. This is really important because you have saved the system in terms of the small saver and therefore you are building a base from which lending can eventually recommence.
John: But how much further has this process got to go?
James Ferguson: At the Roundtable in March, (The banking crisis: is it all doom and gloom?) I said that investors should assume that they would get 80% diluted in their bank shareholdings. Obviously, I was wrong – it was 90%! There has now been about $700bn in terms of both losses and capital injections. But we haven’t had all the losses in from the securities holdings of the banks yet, or any from the loan book side of the business. And what banks tend to do after systemic banking crises is get rid of their risky assets.
This results in asset prices falling as banks foreclose on loans and then try to sell the collateral at auctions to buyers who can’t get access to credit. That in turn pushes down the value of the collateral, which means a load of other borrowers breach their covenants, and so on. This cycle means banks tend to make four or five years of losses, at least at the net level. So only the wildest optimists on the planet believe that we have finished with capital injections from governments. I am afraid bank rallies are there to be sold.
John: Suddenly everyone’s more worried about deflation than inflation and piling into gilts. Is this sensible?
James: I think gilts are a fantastic buy and will remain so throughout this whole four- or five-year process. The objection to this is that you are going to get a huge increase in gilts issuance, which will increase the supply of gilts, and you are also going to get foreigners selling theirs.
But there is going to be huge demand for gilts too. First from normal investor demand. US Treasuries make up about 10% of total portfolios. At the back end of the 1991-1992 recession it was more than 20%. So ordinary investors are natural buyers of gilts in a recessionary deflationary period. Second, de-risking means that banks will take assets that are risky (loans to you and me and people who might not pay them back) and switch them for those that aren’t risky (loans to the Government, who are guaranteed to pay them back). That can lead to a huge increase in demand for government debt from banks – usually 20%-25% of total bank assets.
John: Aren’t gilt yields already low?
James: There is no yield that can’t halve.
Jonathan: I’m not sure you’re right. Japan stuffed the Post Office and that took up half the supply. They had that big reserve pool of suckers’ money. I think your point is valid – but I still think the supply argument is crucial.
James: Well, from past bank crises we can see how much, on average, banks’ holdings of government bonds go up. We are looking at about a 20% rise in government bonds as a percentage of total assets. This year, following the Pre-Budget Report, gilt issuance is forecast to be £148bn. The previous record was £62.5bn and last year was £58bn. So we’re looking at about £90bn of excess gilt issuance because of bailing out the banks and so on.
Say it averages out at about £80bn a year over the next five years. That’s about £400bn of excess gilt issuance. That’s equivalent to 20% of Royal Bank of Scotland’s (RBS) assets. In other words, if RBS raised its gilt demand to 20% of assets, that bank alone would absorb all the record excess gilt issuance we can expect in Britain over the next five years. So it hopefully dwarfs the supply argument.
Tim: But there’s a happy medium here. You don’t have to share James’s conviction on gilts. You can shelter at the front end of the market anyway. Central banks across the world are causing the yield curve to steepen. So either way, the least-worst bit of the gilt curve to be in is short-term gilts.
James: I agree with that entirely.
Jonathan: The problem with the previous bank-crash analogies, though, is that previous crashes hadn’t synchronised. When Japan and Scandinavia got into trouble, there were external buyers willing to take a punt. This time, every country is trying to have the equivalent gilt issuance and that’s a real problem. We haven’t had competitive government issuance up to this level before.
James: But this is why I fall back on the bank aspect. Within each country, banks are far less likely to take the extra risk of international exposure and so are likely to play within their own markets. So I’m looking very much at just UK banks dealing with just the UK issuance.
John: Is there any way the West can avoid what happened in Japan?
Tim: It would be healthy if, just for once, we could let some bombed-out, meaningless businesses fail – such as the car manufacturers in Detroit. Inflation may not be on the immediate agenda, but for me there’s a comparable risk, which is that money everywhere starts to look increasingly meaningless. The nature and the extent of the bail outs is becoming so huge that it calls into question the guarantees behind them. What is wrong with a little bit of creative destruction?
James: Japan’s problem was that it refused to take creative destruction. You do run a risk that if you mitigate the downturn too much, you not only drag it out, but you also do lasting damage to the psychology of the market. If, in two or three years’ time, we halved residential property prices in this country, frustrated first-time buyers would be queuing up to buy. But if you take ten years to do this, at the end they’re all going to go, “No, if I know one thing now, it’s that you don’t go near property because you’ll only lose money.”
John: We, of course, have been fans of Japan for a long time – what’s the outlook for now?
Tim: Whenever international investors start to get a love for risk again, Japan is logically a place they should look at, because I can’t find anywhere cheaper. Of course, to use James’s point, any cheap stock can still halve.
James: Especially if it’s been a very long time getting there.
Jonathan: I think Japan is interesting. In a real crisis, everyone takes their money home. You don’t trust the foreign bank to pay you out – you trust your local nationalised bank. And when Japanese money overseas goes home, it could be very significant indeed.
James: A big crisis that could be on the cards is the Japanese trying to deal with the fact that their currency is too strong. The traditional Japanese safe equities are exporters. They will find it very, very tough with a strong currency and a global drop in demand. So repatriated Japanese funds could easily go off into the normal places, which is highly geared, small, domestic plays. On a long-term basis, Japanese property is super-cheap – or at least, having fallen for 16 years, should be pretty unexposed to speculative premiums. We also know that Japanese bank lending is only 75% or so of deposits, so there is huge potential to grow lending. The problem is that there is no reason why they should do it anytime soon. But it certainly looks like the yen story will run and run.
John: Talking of currencies, what about gold?
Tim: In a world where you are concerned about competitive currency devaluation across the board, then you go to the oldest store of value. So as classic insurance, I think gold – and silver – are as relevant as they’ve ever been.
James: Aren’t you worried about the fact that gold is now higher compared with a basket of other commodities, such as the CRB Index, than it’s ever been?
Tim: Not really. Currencies are only worth as much as the faith and credit, and the politicians’ promises, that are implicit in them. And I’m not convinced we are in a bull market for belief in politicians.
James: Well, there is a very high correlation between real interest rates and gold. If we are going into deflation, then I think that’s going to be tough for gold. I can see a case for gold in a disaster scenario where we actually get a loss of faith in the entire world financial system. Having said that, I don’t believe that this recession, however bad, means it’s the end of the world.
Mike: I struggle with gold. Where is the demand? It’s investment demand and it’s jewellery. That’s not terribly attractive in a declining economy. Where’s the supply? It’s stuck in central banks, you don’t know where it’s coming from. And I think the reasons that people give for gold rising and falling change according to what suits at the time.
John: What about commodities in general?
Mike: I don’t like metals, but I’m ambivalent on oil. In its recent report, the International Energy Agency said that decline rates could be as much as 8% or 9% from 4.5% previously. So there’s an argument to say that if capital expenditure is cut back sharply, as logically the oil majors would want to do, then you get a supply squeeze and a couple of years down the line we’re back at $70 or $80. I can buy that argument more than I can assess what Chinese demand for iron ore is going to be. So I think the outlook for commodities is patchy – but I would worry particularly about metals and less so about oil.
Jonathan: In the last four months, irrespective of the supply/demand fundamentals, all commodities have fallen a lot. But this correlation is largely credit-cycle related and I think it’s largely unwound now. I believe you’ll start to see a differentiation. The oil market is saying that people are driving less – and they are. The iron-ore market says that China is buying less – well, OK. But the coffee market tells you that the Chinese, who account for 0.4% of consumption, will not drink coffee anymore – you think, “um, that’s a bit odd”.
So I expect that this time next year we’ll find that those few commodities in genuine short supply will have gone up, and others in real oversupply will have gone down. Grains intrigue me. Last year’s harvest was a record. Yet even after the most fantastic harvest the world has ever had, in absolute number terms, we are at our third-lowest level in stock piles since World War II.
James: I agree. I didn’t buy into the agricultural commodity story at its peak of craziness last year. Now we’ve had the sell-off, but we haven’t gone to new lows. We’re looking more at a structural movement. I would say now that soft commodities look like a very interesting investment.
John: So what are your tips for now?
Tim: To go back to equities, I was doing a search over the weekend on Bloomberg using traditional metrics, such as price-to-book ratio (PTB), forward price-to-book ratio and Altman’s Z score…
James: Which is the most important single criteria for the next five years for investing in equities.
Tim: … What was shocking was that literally dozens of firms in the FTSE 350 trade at fractions of book value. Sure, we are already in recession, and it’s difficult to know how bad it’s going to be. Yet some of these valuations are staggering. One example is materials technology firm Cookson Group (LSE:CKSN). It trades on a forward p/e of 1.3, it’s not highly geared, it has a net dividend yield of 18% and a PTB of 0.3 times. I just think, wow!
James: Bankrupt!
Tim: That, of course, is one possible interpretation. Another example is mining group Kazakhmys (LSE:KAZ). It trades on a forward p/e of 1.3, a 12-month net yield of 9%, has very, very low gearing, virtually no debt whatsoever, and is on a PTB of 0.26. I wouldn’t put all my eggs into one basket. But you could choose, say, half a dozen of these mid-caps, trading on fractions of book value, away from the financial arena, with little or no debt. One or two may not make it through this cycle, but for the survivors I would expect significant upside [see below for more of Tim’s suggestions]. For a safer option, there are lots of blue chips you can treat as bonds. An example would be BP (LSE:BP) – yielding 6%, p/e of 5. Own it for the dividend and if you get capital growth as well, fantastic.
James: I would be more cautious on Tim’s deals. I know that the most important thing to worry about is exposure to debt – but operational gearing is also potentially very troublesome. Great numbers can turn into very bad numbers quickly if you’ve got operational gearing going into a deflationary recession. But I think Tim’s other point is excellent. Equities that can masquerade as gilts – I’m talking about proxy bonds, like the oils, the pharmas, tobacco, utilities – will do very well.
John: On that point, how far would the oil price have to fall before BP’s and Shell’s dividends came under threat?
James: I think they are going to be pretty robust. I would have to do the sums, but I’m pretty sure they are safe down to $30 a barrel. They would probably make it down to $20 – certainly $25 – because they never really hiked dividends on the way up from those sorts of levels.
Mike: I like Microsoft (NASDAQ:MSFT) – obviously it’s a dominant business in its field of operating systems. It is the cheapest it’s ever been on any single metric you choose to use, but it’s still likely to have about 10% earnings growth. It’s trading on less than ten-times earnings and is awash with cash – 13.5% of its market cap is in cash. I also like German group Fresenius Medical Care (DAX:FME). It’s a world leader in kidney dialysis – if there was ever a defensive sector, unfortunately this is it. It has a great business model, great management, high margins and defendable positioning. My third example might be too early, but it’s got a good business model, good management and a fantastic balance sheet. It’s Esprit (HKG:330), a Hong-Kong-listed retailer. About 40% of its turnover comes from Germany – there’s a long and quirky reason why it’s listed in Hong Kong, which makes it cheaper than many of its global peers. It competes with the likes of H&M, but it’s on about half the multiples – it’s only on 7.5 times earnings – and again, it’s got net cash worth about 13% of its market value.
Jonathan: I want big-cap. Pharmaceuticals, even in deep recession, tend to go up fairly steadily. I’ll put in Bristol-Myers Squibb (NYSE:BMY) quite happily and GlaxoSmithKline (LSE:GSK). And things that people use, such as telephones. Not mobile, which looks bad – but things people use on their phones, such as broadband. If you buy telecoms firms you are buying pornography – it accounts for 40% of all broadband use – and that’s a great bear-market thing. So I’d buy France Tel (PAR:FTE). And again for recessions, I quite like security group Group 4 (LSE:GFS). No debt, lots of cash, its primary cost is labour – and that’s going to fall.
Tim: One more point I would add – it’s probably way too early to be talking about inflation risk – but when it starts to get back on people’s radars, there is probably a fair point at which a carefully selected basket of equities is as good an inflation hedge as anything.
James: Assuming inflation is something you need to hedge.
Tim Price’s risky tips
| Stock | Fwd p/e | Net yld | Price |
| Cookson (CKSN) | 1.3 | 18.2% | 81.5p |
| Kazakhmys (KAZ) | 1.3 | 9.9% | 222.75p |
| Ferrexpo (FXPO) | 0.7 | 10.3% | 29.5p |
| Melrose (MRO) | 4.1 | 10.8% | 63p |
| DS Smith (SMDS) | 3.7 | 17.4% | 50p |
| International Ferro Metals (IFL) | 1.5 | 8.5% | 11.5p |
Our Roundtable tips
| Stock | Ticker | Price |
| BP | BP | 520.5p |
| Microsoft | NASDAQ:MSFT | $20.69 |
| Fresenius Medical CAre | DAX:FMEX | €35.62 |
| Esprit | HKG:330 | HK$38.40 |
| Bristol-Myers Squibb | NYSE:BMY | $20.10 |
| GlaxoSmithKline | GSK | 1,120p |
| France Tel | Paris:FTE | €19.94 |
| Group 4 | GFS | 199.4p |