Some stocks currently look cheap – but in hard times, only large, sturdy, well-capitalised ones will go the distance, says John Stepek.
Barack Obama’s plans to spend an as yet unknown, but reportedly huge, amount of money rebuilding America’s infrastructure has given stockmarkets a boost this week. It may even mark the start of the Christmas rally that investors have been waiting for.
That’s not to say that stocks have seen the bottom yet. The outlook for the global economy continues to worsen. The World Bank has just warned that the global economy could well shrink in 2009 for the first time since World War II. Morgan Stanley reckons that corporate earnings will fall by around 43% from their peak in 2007, which would be the “worst earnings recession” in at least 40 years. In its most bearish case, the group sees the FTSE 100 falling as low as 2,500. This scenario assumes that banks need further recapitalisation, or even nationalisation, and that government efforts to put a floor under the economy fail – events that seem more than possible from where we’re standing. But even so, it’s hard to deny that some stocks look cheap. Share prices have fallen heavily, and are pricing in a great deal of bad news. This is already the third-worst bear market in European history and the second worst in America.
In part, stocks have been hammered so hard and so fast because of deleveraging – hedge funds and other investors selling off high-quality, liquid assets to raise cash to pay back borrowed money, fund redemptions, or make up for losses on poorer-quality assets elsewhere. As James Montier at Société Générale put it recently, “when I see the presence of a forced seller I get excited. After all, this kind of seller is selling regardless of value, and hence creates an opportunity for those with a longer time horizon.” So while there may be worse to come, buying the right stocks now should pay off in the longer run.
Large caps are the best bet
With hard times ahead, you want sturdy stocks that can survive the downturn. That means size matters. As Graham Secker and Charlotte Swing at Morgan Stanley put it, you’re looking for “large-cap companies with strong balance sheets and/or reliable growth prospects and/or a high and secure dividend yield”. Investors are already acting on this: “Having underperformed the FTSE 250 by 55% between 1998 and 2007, the FTSE 100 has outperformed by 14% this year.”
In a potentially deflationary environment, dividend yields are particularly important. With the Bank of England’s base rate at 2% and falling, the current FTSE 100 average dividend yield of 6.0% looks very inviting. But you have to make sure the firm can afford to pay what it’s promising. As conditions get worse, firms are no longer under as much pressure to maintain their dividends as investors start to prioritise strong balance sheets over regular payouts.
The other point is that, like investors with ready cash, big, well-capitalised stocks are best placed to take advantage of the slump. These companies will have their pick of the spoils when weaker rivals go to the wall, or come up against funding problems. In mergers and acquisitions deals, the main beneficiary is usually the target. But now, “the benefits of any transaction may accrue more to the acquirer than the target, given the latter’s bargaining position is likely to be weak”, says Secker.
Better yet, FTSE 100 stocks have less exposure in general to sterling and Britain. That’s important, because as Commerzbank analysts put it earlier this week, recent weak economic data (see page 6) have made a “strong case for the UK ultimately suffering the worst recession in the developed world”. In fact, the weak pound can be a positive benefit for investors in many UK-listed multinationals. In 2007, around 40% of FTSE earnings and dividends came from companies that report in American dollars.
What to avoid
We wouldn’t be keen to get back into any consumer-facing stocks at the moment. There’s too much scope for nasty surprises. That rules out high-street retailers, leisure and travel stocks. The likes of Whitbread may be doing well as business travellers downgrade to using its budget hotel chain, Premier Inns, but as the jobless figures rise further, trading down will be replaced by avoiding travel altogether. We’d also avoid the property sector, from commercial property to housebuilders. High levels of borrowing combined with exposure to an asset class that is still plummeting in value spells trouble. It’s not worth the risk.
And we wouldn’t go near the banks. As well as the very real possibility of further fund-raisings, the sector is far too deeply entrenched with the Government. When a share price is as dependent on what Alistair Darling and Gordon Brown decide to do when they get up in the morning as it is on that quarter’s profits, then investors are simply gambling. As if you needed any further reason to avoid them, Secker also points out that the banking sector has never outperformed when the savings ratio is rising – in other words, when households are saving rather than borrowing money.
Another sector we’d (perhaps surprisingly) be wary of is utilities. They are the classic defensive stocks. Recession or not, everyone needs water and power, after all. But we’re not sure we’d be buying them right now. For one thing, they are relatively expensive. In fact, utilities are trading at an all-time high compared to the market, says Secker. Moreover, as Nick Lindsell at Lindsell Train points out, utilities carry high debt levels. These are “apparently secured by monopoly cash flows”, so investors don’t tend to worry about them. But given the economic downturn, and especially the current outcry against energy firms, the Government may well take a harder line at the next regulatory reviews. “A populist adverse regulatory cycle would leave these levered entities horribly exposed.”
So what do we like?
One of our favoured sectors that currently looks good value is oil. We recommended in August that you sell oil via the Short Oil ETF (LSE:SOIL). Since then the price has fallen even further than we’d expected – anyone who bought the ETF will have more than doubled their money. But while shorting oil has been a good trade (we’d suggest, if you haven’t already done so, taking profits if it goes back above $50 a barrel), in the long-term the oil price is set to head higher.
That’s because the collapse in the price has been caused by a slump in demand, and the withdrawal of floods of speculative money from the commodities sector. Oil prices aren’t falling because we’ve suddenly found a great pool of easy-to-tap, high-grade oil somewhere. Nor have we found an alternative energy source to rival oil. And the steep fall will simply discourage the search for these alternatives. For example, Royal Dutch Shell has delayed expansion of its Canadian tar sands projects because the project isn’t viable at these prices. So falling oil prices now are merely sowing the seeds for another surge when the global economy eventually recovers. As the International Energy Association recently stated in its World Energy Outlook 2008 report, “even if oil demand was to remain flat to 2030, 45 million barrels per day of gross capacity – roughly four times the current capacity of Saudi Arabia – would need to be built by 2030 just to offset the effect of oil-field decline”. And in the meantime, oil majors’ balance sheets are “substantially stronger than during the last significant oil price correction” in 1998, says Secker. He likes BP (LSE:BP), on a forward p/e of 5.2 and a dividend yield of 5.7%. We’d also throw in Royal Dutch Shell (LSE:RDSB), trading on a forward p/e of 5.3 and yielding 4.9%.
Pharmaceuticals manufacturing is another attractive sector. Most people are well aware of the long-term arguments for buying drug makers – we’re all getting older, we’re living longer, and in the long run, as living standards in emerging markets rise too, there’ll be a whole new, growing market for healthcare products to tap. However, in the short run, big pharmaceutical companies are also getting some great opportunities to boost their product pipelines on the cheap. Big pharma generates plenty of cash – which is one thing that biotech minnows are being starved of at the moment. At the end of last week, for example, biotech entrepreneur Sir Chris Evans headed up an industry group asking the Government for £500m “to stop the sector from imploding”, reports Catherine Boyle in The Times. Britain’s biotech industry may once have been second only to America’s, but Evans said it could slip to fourth or fifth without help.
But even if governments don’t come to the aid of distressed biotech firms, big pharma is eyeing up the potential prizes. At the end of October, Jesper Brandgaard, chief financial officer of Denmark-based Novo Nordisk, told Bloomberg that the company is “earmarking as much as $2bn for takeovers” in the coming year “as the financial crisis forces biotechnology companies to seek buyers”.
Sadly for owners of these smaller stocks, the terms might not be great. In a bull market, companies tend to overpay for acquisitions. But in a bear market like this one, the option for many targets is “take it – or leave it and go bust”. In the FTSE 100, GlaxoSmithKline (LSE:GSK) trades on a forward p/e of 12, and yields 4.6%. Fellow pharma stock AstraZeneca (LSE:AZN) is on a forward p/e of 8.2 and yields 3.7%.
Media is hardly a defensive sector, but one stock stands out as promising – Pearson (LSE:PSON). The publisher expects 2008 profits to come in at the top of forecasts. The group has a “relatively defensive business mix”, says Morgan Stanley – its involvementin educational publishing is good during a recession, as more people go back to college to retrain, for example. Like the other stocks mentioned here, Pearson also benefits from weak sterling versus the dollar. It has a net dividend yield of just under 5% and trades on a forward p/e of 12.
The key with these stocks is that they should be able to maintain their solid dividend yields during the hard times ahead. Given that interest rates are tanking across the world, and deflation is uppermost in investors’ minds for the time being, being able to bring in 5% a year or so in income while holding on for capital gains in the longer term is a pretty good position to be in. We have some other interesting – if a little more risky – bargain plays below.
What other bargains are out there?
Adventurous investors might want to look at some of the tips by James Montier at Société Générale, who chose stocks based on the work of value investor Ben Graham. Montier looks for a trailing earnings yield (the trailing p/e inverted) that’s twice the AAA-bond yield; a dividend yield at least equal to two-thirds of the AAA-bond yield; and total debt at less than two-thirds of tangible book value. These criteria “ensure that stocks are cheap, returning cash to shareholders and not laden with debt”. As well as several oil stocks (including BP and Shell), the screen throws up several housebuilders and mining stocks. We’d be avoiding builders for obvious reasons and for now, with commodity prices still falling, mining stocks are facing too much uncertainty. But if you’re happy to take on a bit more risk, then his screen also throws up industrial groups Tomkins (LSE:TOMK), yielding 12.4% and on a forward p/e of seven, and Charter International (LSE:CHTR), yielding 6.1% and on a forward p/e of 3.4. Toy and model manufacturer Hornby (LSE:HRN) also turns up, yielding 8.06%, and on a forward p/e of 7.5. All three stocks have recently warned on profits, but the point of the screen is to find stocks that look cheap and also have sufficient breathing room to survive tougher times. That doesn’t mean they won’t get cheaper in the meantime – anyone interested in buying them should probably pick up a few to spread the risk in case the bet goes wrong. As Montier puts it, “Will I be early? Almost certainly yes, but if I can find assets with attractive returns and I have a long time horizon, I would be mad to turn them down.”
As for the wider markets, as noted above, we’re not convinced that stockmarkets have bottomed out yet. That’s why we’re not suggesting you put your money into a FTSE 100 tracker. However, bear-market rallies can last a long time and can result in some large gains; in Japan between 1990 and 2003, there were four rallies of 50% or more, which each lasted for more than a year. If you do want to bet on a bounce in the stockmarkets, we’d suggest that the best way is to invest in Japan.
Why? Because of all the major economies, Japan is the one least-afflicted by the problems facing the West. Its consumers and companies have cash, something the West does not. And with global stockmarkets currently moving in tandem in any case, if you’re going to buy one market, it may as well be the one with the best chance of coming out of a global recession earlier and in better shape than the others. A simple way to buy into the Japanese market is via the iShares MSCI Japan Fund (LSE:IJPN).
Another asset to consider is corporate bonds, which are currently pricing in a depression, as many commentators have pointed out. As Tim Price of PFP Wealth Management points out in his Price Report email, “investment-grade bonds are now trading at their cheapest levels relative to government bonds since the 1930s”. And as Morgan Stanley points out, many of the moves being taken by companies – with government backing, in the case of the banks – are positive for “credit and not for equity holders,” such as recapitalisations via rights issues, and dividend cuts. We’d be reluctant to buy individual corporate bonds right now – 2009 will be grim, and we wouldn’t rule out some headline-grabbing bankruptcies that could push corporate bonds to even cheaper levels. But for investors who’d like to get broad exposure to the market, the iShares £ Corporate Bond ETF (LSE:SLXX) has an annual management fee of just 0.2%. It has an average maturity of around 12 years, and a yield to maturity of more than 8%.
Finally, Montier suggests that inflation-adjusted government bonds, which have been driven lower by fears of deflation, look attractive. Given the Federal Reserve’s ongoing efforts to print the US economy out of trouble (and moves by the Bank of England on that front in Britain too), there’s every chance that inflation could make a comeback sooner than anyone thinks. One way to get exposure is through the Barclays iShares Index-Linked Gilt fund (LSE:INXG).