At this month’s Roundtable, our experts warn of more trouble ahead – and pick ten stocks that should survive the turmoil.
Our panel this week: Thomas Becket, director of investment strategy at Psigma Investment Management; Mike Hollings, chief investment officer at Matrix Investment Management; Barry Norris, partner, Argonaut Capital; Steve Russell, investment director, Ruffer.
John Stepek: So, is this a bear-market rally or the real thing?
Barry Norris: If you were building a case for it being a genuine market recovery, there are three elements you’d point to. One is that shares have fallen a lot and based on the last 20 years they appear to offer some value. You would also argue that leading indicators have troughed and will start to recover, albeit from levels still indicating severe economic contraction. And you would say that governments and central banks now get the scale of the problem and have embarked on quantitative easing, which will ultimately cause inflation and panic people out of risk-free assets into very risky ones. But I think all three points are flawed. If this was a normal economic cycle, this might be a multi-year buying opportunity in equities. But it isn’t normal – it’s the day of reckoning for a decade or more of cheap money and debt-financed growth. Many, many sectors are still over-earning relative to their history. I don’t expect a V-shaped recovery – earnings bubbles and leverage bubbles take a long time to unwind.
“The earnings season is looming on the horizon like a Horseman of the Apocalypse.”
Thomas Becket: I agree. The earnings season is looming on the horizon like a Horseman of the Apocalypse – frankly, I don’t think we’ll get much confidence from that. Until the problems in the credit market have been resolved, a strong equity-market rally is unlikely.
Steve Russell: The honest answer is I don’t know. The rate of decline in the global economy has been so bad recently that it simply can’t continue, or there’ll be nothing left! So I would expect quite a lot of relatively good news over the next few months, and it’s possible that people will think that there really is a recovery. Unfortunately, and this is where I agree with everyone here, it won’t be a recovery – things just won’t be as bad as we thought. Deleveraging is a process, not an event – it will probably go on for several years yet. But any rally could still be really powerful.
Mike Hollings: In my experience credit markets tend to get it more right than equity markets over the long run, as they take more of a big-picture view. The credit markets haven’t really gone along with this equity rally, so they are telling you it’s a bear rally. It’s worrying that we are all in agreement here, but…
Barry: I suspect in a month’s time, when the rally has continued, we’ll all be sitting here saying, “Well, it might be the real thing…” That’s what bear-market rallies do – they suck people into risky assets too early and set up the next leg down. But if it is a new bull market, the wrong things are leading it up. What’s leading the market is everything that led the last bull market – it’s like people buying Nokia in 2001 and again in 2002. Once a bull market is broken the next one is nearly always led by something else.
John: You mentioned inflation earlier?
Barry: In any severe economic depression prices go down – yet a lot of people are very, very worried about inflation. That confusion is down to quantitative easing – because nobody really understands how it is supposed to work. I have to say that, as it has been tried so far, it won’t work; namely, the Bank of England purchases gilts from banks or other financial institutions, and the banks then immediately put the money on deposit back at the Bank, and the people who sell the gilts buy more gilts. The only way it will work is if the Bank buys riskier assets, or if you have a solvent banking system ready to extend credit, and I don’t think we have either.
Thomas: It could use the money better by firing it into the corporate-bond market to reduce the yields.
Barry: But then the Bank exposes itself to credit risk, which it doesn’t have when it buys gilts.
Mike: It’s a tough call, but I would err on the side of deflation. In the US, people are talking about how the Federal Reserve is printing money and how its balance sheet has ballooned to $3trn. But on the other side of the balance sheet, $13trn has vanished (in terms of wealth, not real money). So yes, they are printing money, but it’s not going into the system because the banks are hoarding it and it’s not even close to replacing the wealth that’s been destroyed.
Steve: I think this slightly misses the point. What we’ve got is ‘x’ trillions of bad debts around the world. But the US government has the means of making more money than has been lost. And it will just keep pumping out money until the problem goes away. There’s no great surge in demand, but that doesn’t matter – because what you are getting is debasement of the currency, and because of the loss of faith in the purchasing power of money, we believe inflation could return very quickly. When Northern Rock went down, everyone thought, “Stupid Northern Rock, bad bank, bad management.” Then Bradford & Bingley went down: “A bit like Northern Rock, bad management.” But a couple more went down and suddenly the thought has changed: “A pox on all your banks, I don’t want anything to do with them.” And that might be how currencies work. It’s a difficult thing to argue because people say a currency must go down against something else. But, if you just imagine all of them going down against oil, food, gold…
Barry: And the more aggressive you get with quantitative easing, the more you trash the currency, so within the same economy you can have house prices going down and food prices and imports going up.
Steve: We are not saying “let’s bet everything on inflation”, because it could be a nasty, slow process. But as the inventory cycle and destocking comes to an end, and also as we’ve seen such a credit-crunch shock within the working capital of the world, there’s a real risk that in a few months nobody will have any stuff left to sell.
John: This is the theory that supply is falling faster than demand?
“Deflationary assets – long government bonds, for example – are a disaster waiting to happen.”
Steve: The factories haven’t been dismantled, but they’ve got no inventory because they couldn’t afford to hold it, so there’s a gap. That could refill very quickly, except I don’t think anyone has the money to expand their working capital again. So what could happen is you end up paying a big premium for the fact that somebody actually stocks something and will sell it to you today, rather than having to pay up front then wait six weeks for it to come along.
That’s why we think deflationary assets – long government bonds, for example – are a disaster waiting to happen. Gold is more interesting. It’s a play on currency debasement, so would do very well under the scenario I just described. But it’s far too volatile. So we only have 5%-10% in our portfolios. It’s a great friend when it works, but it will kick you when it doesn’t.
John: So – tough question – where should we be investing now?
Barry: There are four characteristics I would look for in stocks. First is dull and worthy – things that never had a very good bull market. Within those stocks there are no earnings or leverage bubbles. Indeed, they could lead the next bull market. After all, in 1999 and 2000 mining companies were thought of as very low beta (low volatility) stocks. Second is companies in cyclical industries, which will take market share because they are the low-cost producer. Ryanair in airlines, and in retail Inditex or H&M, or even, dare I say, Next. Third is things that are still doing very well but are out of fashion. For example, I think internet stocks are a fantastic place to be. Ten years ago you would have had to pay ten times sales to buy them, now you can buy them for one-and-a-half-times sales – but they are still growing fast. Fourth is that if you buy cyclicals, you have to buy something that is under-earning and has been in a bear market for three or four years. A lot of cyclicals have only been in a bear market since July 2008 and are still forecast to earn profit margins way in excess of the long-term average. The clue’s in the name – if you buy a recovery stock it’s got to be recovering from something. Most cyclical parts of the market aren’t.
Steve: I agree on recovery plays. A stock we like is Ericsson (US:ERIC). It was rubbish well before anybody else managed to be rubbish – but it has found itself an industry where its customers will have to replace and spend on capital expenditure, partly because the governments are going to push them into it on the telecoms side. All its competitors are going bust, so Ericsson will have huge market share when it comes out the other side. And there are certainly plays out there – corporate bonds and great quality supermarkets, food firms and so on – high-yielding businesses that you can buy now. But that doesn’t guarantee they won’t go down by 30% or 40% at any point in the next year or so.
Barry: And they might not go up in the rally either.
Steve: We also think index-linked gilts are good value. In September last year you got the inflation indexation for free. They’re no longer that cheap, but we think that is a great place to be.
Thomas: US Treasury Inflation Protected Securities (TIPS) are still great value for long-term inflation protection. But given the uncertainty over deflation, one could still argue for a small weight in conventional bonds, particularly if you hold UK gilts within the timeframe the Bank of England is looking to buy. So I would still hold ten-year gilts up until the yield hits around 2.8%, then I’d get out and stay out for quite a long time.
Corporate bonds look attractive, but I can’t see any way you’ll make more than the coupon this year – I don’t think there’s much in the way of capital gains to be had until 2010. We put quite a lot of money into certain commodities, thinking they were too cheap on a five-year view. Unfortunately, they’ve achieved our five-year aim in the recent rally! So we’re backing out of those too.
John: Which commodities?
Thomas: The oil price was undervalued where it was in the short term. I’m not saying it can’t go back to those levels, but it seemed too cheap. Agricultural commodities in the long term are pretty exciting. There’s desertification, global warming – we’ve also got more mouths to feed, especially China, where they are eating more high-quality foods.
I think the base metals are being driven up by restocking from China. But when that stops, base metals could have quite a lot of downside, even from current levels, given the demand situation in parts of the developed world. Agricultural commodities are a better bet, but you have to get exposure to a big basket of them as individually they’re just too volatile.
Barry: On index-linked bonds, what exactly should readers go out and buy?
Steve: We own around the ten to 15-year UK, so 2017 to 2020 UK Government Index-Linked. US TIPS are great because some have par protection. So if there is deflation they will pay you back par, and if the bond was issued recently it’s close to par. But the problem is we’ve just seen sterling fall by 30%-40% against most major currencies. As a British investor, there’s a real risk of making money on US TIPS but losing much more if the currency rebounds. So I’d recommend sticking with UK index-linked.
Barry: If you believe headline inflation is going to be negative over the next 18 months, presumably you don’t buy.
Steve: You’d wait!
Thomas: You’d wait for the next deflationary scare, such as we saw back in October and November.
John: With all this government borrowing, can anyone see us going to the International Monetary Fund again?
Mike: I can.
Steve: I think it’s largely unlikely. Britain is benefiting from the fact that it isn’t in the euro, which has allowed us to trash our currency to soften the blow of the recession.
” If you really believe the economy is going to recover, you want to be long of cyclical currencies, even long the Norwegian krone.”
Mike: We didn’t trash it – other people trashed it for us. It’s the same result, but it wasn’t the Bank of England getting in there selling pounds – the market just did what it had to do. If you are going to be bullish at all, I would be bullish on America, because it’s way more dynamic and entrepreneurial. It’s a bit more socialist these days, but still ahead of the UK and way ahead of Europe – which is why we are not mega-negative on the dollar, although we’re not mega-bullish either. If you’re worried about currency positioning, it may be a bit early, but we’d begin to look at the Canadian and Aussie dollars. If you really believe the economy is going to recover, you want to be long of cyclical currencies, even long the Norwegian krone.
Thomas: Steve, you guys did fantastically in the yen. Are you still playing that?
Steve: Unfortunately, the yen and currencies broadly seem to have been last year’s battleground, and from a sterling investor’s point of view you are a bit snookered because you are on the floor. Even if things get worse, we’re unlikely to see much change there. The Canadian dollar and the krone might be interesting, but overall we have a fairly neutral position.
Thomas: How would you play them?
Steve: In Norway you can buy short-dated conventional bonds yielding 4% or so. Because Norway has great pension funds, they don’t seem to be facing the same need for quantitative easing. But to be honest, the Norwegian krone is a proxy for the oil price – it works nicely as that but it’s not much more.
Barry: The krone looks attractive until you think that maybe the oil price, like everything else, will revert to where it was in 2002 – $20 a barrel,say. When you look at the industries Norway relies on – shipping and oil and oil services – then look at the banking sector in Norway, which lends money to oil services and shipping – it’s not so rosy.
Steve: One market we think is interesting is Japan. You’ve got a stockmarket and cyclical economic conditions that have been as bad, if not worse, than everywhere else – but they don’t have a credit crunch at all. Of course, they are suffering, a bit like Germany, in that they forgot their customers might have a credit crunch. But it’s an economy that’s been on its back for a long time and has now been kicked again – so we would favour it as a recovery play. But Japan does have a habit of confounding people. And there’s the currency risk to be aware of.
Thomas: If you can hedge out the currency, I think it’s a great investment, but you do have that Catch-22 situation where the market goes up because the yen is going down and vice versa. But you can buy some funds – there is an investment trust called Morant Wright Japan Income Trust (LSE:MWJ), which, because of the currency swap they’ve got, benefits when the yen goes down. So that’s one to look at. It didn’t have a particularly successful year last year when Japanese stocks went down and the yen was incredibly strong, of course.
Mike: So now’s the time to grab it.
John: What other tips do we have?
Mike: I quite like United Utilities (LSE:UU). I know a lot of people don’t, but there is just so much bad news priced in there. Even if you take a slightly more bearish view on the consensus earnings, it’s on about a 6% yield, trades at book value, and it’s not particularly geared. A boring stock, but in this environment, I’m happy with that.
Barry: I will give one dull and boring one and one that is only for people with high-risk appetites. The boring one is France Telecom (EPA:FTE) – it’s yielding 9%, and in an inflationary environment that’s fantastic. And there is a limit to how much value the management can destroy.
Steve: And you have the French government on your side, which is what you want in a bear market.
Barry: If I was to pick a more racy stock, I would go for Meetic (EPA:MEET). It’s a leading online dating company in Europe.
Thomas: What’s the growth like in internet dating at the moment?
Barry: It’s exploding because there are lots of people at home with time on their hands! You could argue that when people have less cash they want to do their research beforehand, instead of going out to a bar and spending lots of money on meeting somebody.
Steve: On the boring end, I would pick either BP (LSE:BP) or Shell (LSE:RDSA) – you are getting a 6% or 7% dividend yield and some inflation protection because oil prices would go up if inflation came back. I’d also go for tobacco group Philip Morris (US:PM), which is giving a 6%-7% yield again and is a beneficiary of a weaker dollar were that to happen, so offsets some of your currency risk.
At the risky end, take your pick. There’s Japanese real estate investment trusts and smaller companies that are outstanding value. Then there’s a whole bunch of firms in Britain and in Europe that have fine balance sheets, probably net cash, but are just a bit too small. Companies like Diploma (LSE:DPML) or Castings (LSE:CGS), who make fine products and are yielding 7%, 8% or 9%, with low p/es. You’ve got to be patient because there is no liquidity in the smaller cap market, they’ve all fallen 50% or so, and could easily fall again if people get bearish on the market. But if you hold for five years, then the yields alone will probably pay you back.