John Stepek chairs our panel of experts and asks where they would – and would not – place their own money in today’s markets.
John Stepek: What next for the UK? Will we have a double dip, roar back to health, or just muddle through?
Marina Bond: I don’t think we’ll see a double dip. GDP has come in well above forecasts and corporate earnings and balance sheets have rarely been stronger – excluding the banking sector, obviously.
John McClure: I think we’ll do more than just muddle through. I think we’ve turned a corner. And as long as it gets funded, British manufacturing will be more than all right. In a recent Mail on Sunday article, Vauxhall was complaining about local component suppliers not being funded by the banks. I think that’s the biggest constraint in Britain right now.
John S: So you think the manufacturing sector can ‘rebalance’ the economy away from banks and consumption?
John M: Without a shadow of a doubt.
Mattias Westman: There is no choice!
John S: What sectors are we talking about? Aerospace? Pharmaceuticals?
John M: It could be anything. It could be making parts for trucks. Car sales in Britain are lower than they were before Lehman Brothers. But car sales worldwide are higher, truck sales are higher. It’s easy to make the mistake of confusing our own economy with what’s going on in the rest of the world. There are a lot of medium-sized British exporters, who probably can’t get the finance they need to expand to service the order book they’ve got now. You’ve seen it in [truck maker] Scania’s latest statement. They can’t keep up with demand because their suppliers can’t make enough parts for the trucks.
John S: So how do these companies get around the financing problem?
Mattias: Well, the banks are still in more of a state of shock than any other part of the economy and they are very hesitant about becoming expansionary again. It may take a little while for them to get over it. But funding these types of companies is the sort of relatively low-risk activity that they should be focusing on.
John M: They’re slowly starting to fund firms. We made hay about a year ago. Ultra-small firms were being knocked back by the banks. So we created convertible bonds at extremely advantageous rates for our investors. However, that window seems to have closed now.
Marina: A lot of firms have reduced the size of their debt too, and some are approaching refinancings where the cost of their debt will actually be cut. It depends on the type and size of company.
Mattias: I guess it’s natural for many companies to be cautious with their funding now that they know that it can be withdrawn at a moment’s notice. Many of these firms have been well run for decades. For their banks to tell them all of a sudden that no, they can’t have any money, must be a very shocking experience and something that they don’t want to expose themselves to again.
Our Roundtable panel
Fund manager, Rathbones
John McClure
Investment manager, Unicorn Asset ManagementMike Savage
Partner, Killik & CoMattias Westman
Founding partner, Prosperity Capital
John S: What specific stocks do you like?
Marina: Optos (LSE: OPTS) is a small-cap stock that supplies machines which take digital images of the eye. It identifies eye conditions, but there is also evidence that it can help identify conditions such as diabetes and certain cancers. The machines are very fast and accurate – optometrists in the US like them because they can differentiate themselves by using these machines. The renewal rate is about 80%, and the company plans to introduce a smaller version of these machines to try to infiltrate emerging markets. It’s got a strong balance sheet and is on a price-to-earnings (p/e) ratio of about 11 to September 2011.
Clarkson (LSE: CKN) is a shipbroker. It represents shipowners and charterers in the transportation of cargo, but also does futures broking, fund management and advising on shipping-related transactions. It was created as the market leader in agency shipbroking and also has the largest commercially backed research team. If you believe that global trade is on the rise, then ship brokers should do rather well. The balance sheet is strong, it’s got a 4%-5% yield and it’s on about ten-times earnings.
Mike Savage: We like Titan Europe (LSE: TSW), which makes undercarriages and wheels for the likes of John Deere and Caterpillar. The shares have trebled from the lows of earlier this year, when it was priced to go bust. Sales are roughly split between agriculture, construction and mining. It has some debt, mainly in Italy. The visibility on that debt isn’t as great as it could be, in terms of covenants. So it’s for the investor with a higher-risk appetite. But there aren’t many stocks in the market that are on six times 2011 earnings, yet trading strongly, judging by its customers’ comments. And there remains the chance of an outright bid or at least an approach for one of the two divisions, which would cut most of its debt.
I normally don’t like biotech – I prefer diagnostics businesses. But I make an exception for Renovo (LSE: RNVO), which is in the scar tissue market. It makes a product, Justiva, which produces a material improvement to the appearance of scar tissue. It has to be injected twice – once at the time of operation and once within 24 hours. The pricing structure is designed to be one of $200 a pop. So for $400 a time, the surgeon can charge $500, or whatever he wants, to the customer. Renovo is just waiting for Phase III results to come through in the first half of next year, covering Europe. It’s in bed with Shire on the product in America.
Obviously, there is some applicability in the general surgery market (there are 80 million operations per year in Europe and the US). But the major markets are set to be paediatrics and cosmetic surgery. Of the market cap, 75% is covered by cash; it is burning through £15 to £20m a year, and it costs around £50m to get through Phase III trials. We feel there’s virtually nothing in the price for this product’s potential success.
There are simply too many fund-raisings from commodity plays just now, and we are moving more towards interesting industrials with an exotic flavour. We like Specialist Energy Group (LSE: SEGR), which makes boiler circulation pumps. It sells heavily into China and India, so it’s a play on the growth of thermo-coal power stations in those countries, and also on nuclear power in America. It’s on about six-times next year’s earnings, a big discount to a company such as the much-admired Weir. For extra potential spice, an Indian civil engineering giant has just taken an 11% stake in the company, so there is a corporate angle as well.
John S: John?
John M: My first pick is ACAL (LSE: ACL), which is an electronics component distributor. It’s a recovery stock; the chairman kicked out most of the management two or three years ago. The order book is up 43%, according to the last interim statement, and the results are due shortly. Electrocomponents, one of its competitors, recently released good results ahead of expectations. So it should be fine.
The other is Castings (LSE: CGS), which is a well-run, old British company that is totally countercyclical. It’s going gangbusters. It makes truck parts, as I was discussing earlier. The biggest two customers are Volvo and Scania, whose orders are absolutely through the roof. Castings has been taking on staff at a rate of 20 a week, give or take, and retraining them. It’s got more staff than it’s ever had. And it’s got a strong balance sheet and a decent yield.
John S: Where’s the demand coming from?
John M: For Volvo and Scania it’s partly from outside Europe, but you’ve also got Land Rover. I think people missed the whole automotive sector in the UK – it’s had a massive upturn. And it’s not simply recovering, these firms are actually having problems finding people who can do the jobs for them. There aren’t enough people that do what they need them to do.
John S: That’s interesting. So judging by what you’re saying – this whole thing that the Bank of England always says about the existence of the ‘output gap’ – is nonsense.
John M: You just need to look at two companies we know. At Renishaw, all the staff agreed to a 20% pay cut when the crunch came. They have now had all their pay reinstated and backdated and they are recruiting more people. And Casting is now having to recruit people who have not been involved in that industry and retrain them. So that gives you quite an interesting feel for what’s going on.
Mattias: That’s the thing about the output gap – if you change the structure of the economy then you don’t have the same output gap as you would if you were trying to grow into the same surplus that you had before.
John S: Given that fact, and given that we’re not seeing deflation from emerging markets anymore, how much of a problem is inflation likely to be in Britain?
John M: I don’t think it’s a major problem. Britain has become much more efficient. I think there will be a small window of above-target inflation, driven by commodities and basic foodstuffs. I don’t think you are looking at the 1970s.
Mattias: Well, it’s not that small. Inflation has already spent at least a year above target, with no sign of decline.
John M: Yes, but you’re not seeing huge wage rises, or anything remotely like that. What you’ve got is a period where rises in certain commodity prices are going to have to be swallowed.
Marina: I think the Monetary Policy Committee has virtually suspended its inflation target, in favour of keeping the recovery going.
Mattias: You see why they are doing it, but they can only do it for so long before people lose faith in it.
John M: Yes, but if the pound doesn’t weaken you can do it for a very long time. Anytime Britain has got into serious problems, the currency has always been very weak. It’s not weak right now.
Mattias: That’s only because most other currencies look ugly too. You can’t hide in the dollar, you can’t hide in the yen – it’s even ridiculous to try hiding in the Swiss franc, given how far it’s risen. What happens then is that people try to shift into real assets as an inflation hedge. There’s a limit to that too, but you can see commodity prices rising further, which will then mean more inflationary pressure.
Marina: I think further down the line, if inflation gets a mind of its own and real wages start following prices, you’ve got a problem. But I don’t think we’re there yet.
John S: You were talking about buying real assets, Mattias. What about gold?
Mattias: I’m a little bit afraid of gold. It might go up a lot further, but it’s not cheap at this level and it feels a little bit speculative. In some other commodities there is much more well-rounded demand. I can see why people are afraid and want to have gold. But if they become a bit less afraid, they might not want to have as much gold.
John S: And what about UK property?
Marina: I don’t think prices are really going anywhere. Certainly not up. It’s a buyers’ market.
John M: I think prices are about to collapse.
John S: Why?
John M: I think they are hugely overvalued. Look at where interest rates are. Look at the rate you currently pay on your mortgage, compared to what that rate has been historically and what it could do in the future. If interest rates went up it would cripple the housing market.
Mattias: Which is why rates won’t go up, I guess. I agree with you on house prices. But surely it’s difficult to be constructive on the economy as a whole if you think house prices are going to collapse?
John M: Not really. If we agree that the economy could export its way out of trouble, then it’s not nearly as bad as you think. You have to remember that the vast bulk of the population didn’t buy their house last week. They bought at a range of times. But the reality is that everybody knows they are massively overvalued – the affordability factor is dead simple.
Mike S: But there will be huge regional divergence, won’t there? The South East will be protected because we are relatively light on public-sector exposure.
John M: Only Central London, because there are a lot of overseas buyers.
Mattias: But that’s very concentrated.
John M: It’s concentrated, yes, but it radiates out, because people spend an awful lot when they buy a house. These people will come in and buy £25m houses in Belgravia, and spend another £25m getting them sorted out. But once you get further out into the southeast, the impact diminishes, depending on how far you go.
Mike S: I’ll settle for 0%-5% down.
John M: I think you will actually find they will all just crunch.
Mattias: They do look a little bit expensive to me, as a foreigner.
John M: They crunched on the way up – and they will crunch on the way down.
How to play Russia without getting burnt
John S: Mattias, you’re an expert on Russia. It’s a fascinating market, but it fell the heaviest of all the emerging markets during the crunch. How do you play Russia without getting burnt?
Mattias: If you look at what’s actually happened over a longer period, the annualised return has been something like 25% over the past 15 years, which includes two major crises.
Clearly, Russia is more sensitive to what happens, and it has less long-term domestic capital, but the profit growth and improvements in its companies are stronger than almost anywhere in the world, and that’s the underlying trend you need to find. If you look at it, hardly any Russian companies went bankrupt, even in this crisis. So they are pretty resilient.
Of course, you shouldn’t invest money in Russia that you may need next week. But if you have long-term capital and you believe in this secular story, then Russia should be one of the best places to invest in.
John S: What’s the best way for British retail investors to get in?
Mattias: Well, without saying via our funds, there are some very solid companies. If you’re looking for a London-listed stock, then I guess it’s Gazprom (London Int’l: OGZP). It’s not the best-run company in the country, but it is on a p/e of less than five and I think this year it will probably make more profit than any other company in the world, which is interesting in itself.
We have also made some very interesting investments in agriculture in Russia and the Ukraine. There are big differences between companies in the sector. There are some very poorly run, land-bank-type companies, and some that are really well run by proper farmers. The difference is like night and day. Some have twice the productivity of others and that makes quite a big difference, as they have similar costs. That’s the easy part, in some ways, about investing in Russia – there is such a big difference in quality of management between the companies, that anybody who is prepared to do the work tell the good operators from the bad ones relatively easily.
John M: The differences are probably not as big here, but I think you are absolutely right. The advantage of having one of your people go and see a company is huge.
Mattias: These truths are the same everywhere – it just makes a little bit more of a difference in a place like Russia, where things are changing so quickly. This is something that people perhaps misunderstand about Russia –they think it’s so different and that the performance is only about what the oil price does.
In reality, your investment returns are much more dependent on what these owners and management teams do with their companies. They came into something that was a Soviet production unit. What matters for your returns is: how good are they at turning this into a modern corporation? That’s why we have outperformed all other funds, because this is the kind of metric we’re focusing on. We are not focusing on the cheapest way to buy a barrel of reserves in the ground, or the cheapest hectare of land, or the cheapest megawatt of electric capacity, or something like that. We’re focusing on who is capable of turning their business into a proper company.
John S: So do you think the political risk is exaggerated?
Mattias: I think so. There are issues with corporate governance, which is not exactly the same. Any failing of the political system is more that they don’t enforce all the laws that they have. But you see that the people who are good managers, and who can run their businesses, have a lot fewer problems. Sure, you find many firms run by people who have more political than entrepreneurial skills. But while that might help you in terms of acquiring assets generally, it doesn’t help you to run a company. And generally it’s not that difficult to tell the entrepreneurs from the politicians.
John M: But do successful entrepreneurs keep their capital in Russia?
Mattias: There have always been some people taking part of their winnings out, understandably considering it’s not the most mature country in terms of its legal system. But foreign direct investment is coming in. Russia’s not perfect, but nor are any of the other emerging markets; they all have problems.
John S: Have you got an agriculture tip for us?
Mattias: Yes, there’s one listed in London – MHP (London Int’l: MHPC) – which is very good. However, there’s also a firm listed in Frankfurt, called Mriya (Frankfurt: MAYA), which may be even better.
John S: What does it do?
Mattias: It’s just playing the agriculture story, but it has grown from having something like 100,000 hectares three years ago, to 300,000 hectares now. I think that growth is almost certain to continue at that sort of rate going forward. If the average Russian or Ukrainian farm has two tonnes, or 2.5 tonnes, of wheat per hectare, they have five. That makes quite a big difference to your profits. And it’s that huge difference in quality, not only there, but in many other industries, that you must try to identify.