John Stepek chairs our panel of experts and ask where they would – and would not – put their money in today’s markets.
John Stepek: How do you think the disaster in Japan will affect markets?
Michael Pate: It might hit quarterly global GDP figures. But it is an exceptional event rather than a course-changing one. The drivers of global growth remain intact as long as we don’t see further escalation in the Middle East.
Peter Walls: Certainly the Bank of Japan (BoJ) has reacted much more positively than after the Kobe earthquake in 1995. You’ve got an element of a Keynesian stimulus to the economy after such dreadful events, which will lead to greater demand for commodities. So after the pull-back we’ve seen, I would be more buyer than seller.
Killian Connolly: I think the liquidity from the BoJ is another positive for gold. I agree they need the liquidity – it’s what central banks do. But it’s exactly what they did in 2008 and 2000. The end result is just more money sloshing around, higher prices and, I’d argue, a misallocation of capital again.
Angelos Damaskos: I agree on gold and would be equally bullish for oil, because in the medium term who knows how regulators will react in relation to the design and approval of nuclear power stations. Short term, I am concerned about the impact on the global economy. There are three unquantifiable factors. The first is the hit to the global insurance industry. The second is, how will the Japanese government fund the reconstruction programme? Will it sell US Treasuries, or even gold? Third, how will the destruction of industry in Japan impact on global growth? It is the main supplier not only of cars, but of parts of all sorts – not just to China but to the rest of the world. It is not easy to switch suppliers from one day to the next.
Rahul Sharma: Yes, the reaction on day one was that if Toyota has problems, then potentially Ford will do well. But then you realise Ford has quite a lot of suppliers in Japan as well. You can have 97% of your parts in place, but if you don’t have that 3%, you can’t deliver that car to your customers, so there will be disruption.
But overall, I am more sanguine. From a consumption point of view, Japan is relatively self-contained. The impact has been muted for most companies. What encourages me most is that, in the US, employment is returning. And the headwinds that have buffeted consumers in terms of oil and food prices are being offset by companies starting to invest some of their cash hoards. That could be what sees us through.
Our Roundtable panel
Portfolio manager, PFP Wealth Management
Angelos Damaskos
CEO, Sector Investment ManagersMichael Pate
Partner, Killik & CoRahul Sharma
Independent retail analystPeter Walls
Fund manager, Unicorn Asset Management
John: Angelos, you mentioned the oil price – where’s that heading?
Angelos: In the medium term, I have no doubt that the oil price has to rise. The unrest in the Middle East is spreading closer to Saudi Arabia. It is evident that there is a new generation of Arabs who have been educated by the internet and cannot understand why they should be excluded from the decision-making process. We will have to see how it ends up. But consider what happened in Venezuela after the revolution there. Venezuela used to produce 2.5 million barrels of oil per day. Now, even all these years after the revolution, it is still at 1.8 million barrels – it never caught up with previous production levels. The same could happen again.
John: How do investors protect themselves from these sorts of events?
Killian: Diversify. Split the pie into the asset classes you deem appropriate – for us it’s debt, equity, absolute-return funds and precious metals. That’s how we’ve managed it from 2007 and it just seems prudent. Tunisia came out of nowhere. Japanese equities were doing great for the last five to six months and they’ve just lost more than 100% of whatever they’ve gained over that time. So all asset classes are risky, but you can’t leave cash in the banks because a) they are probably insolvent and b) we are in an inflationary environment. So spread it across the best value investments within each asset class.
Peter: I think this will just be a blip on the charts in five years’ time, just as every other situation has proved to be in the fullness of time. I agree we’ve got to spread our risks as much as we can, but I think over the next ten years, if you stick to your guns and look to buy on weakness and buy value, then you’ve got to see a fairly good outlook in the long term.
John: Closer to home, UK inflation figures have been terrible. What does it mean for interest rates?
Michael: We think inflation is here to stay, so bonds look less attractive than equities. But there are more fundamental problems in the UK economy – such as the housing market – that will stop the Bank of England raising rates aggressively.
Peter: I agree with Angelos that the oil price looks like a one-way bet in the long term. And how house prices are holding up, particularly in central London, mystifies me. I think the Bank is very concerned about sparking a fall in the residential housing market. So I think it will hike later rather than sooner.
Rahul: The problem is, there is not much wage inflation to counter the rising cost of living. That’s partly why the Bank is trying to hold course. As for the property market, if you look outside central London it’s pretty tough, and you will see some nasty effects if you start to raise rates. London has its own little life. It’s not just the overseas buyer. The wealthy have almost never had it so good. On the other hand, you have a percentage of the population for whom inflation is not 4% or 5%, it’s closer to double-digit levels. So if you are a business trying to sell to that consumer, life is tough. But if you do anything related to the wealthy, you are quite happy.
Angelos: Inflation is going to accelerate. It’s not just oil. All the basic commodities have gone through the roof. There is always a long lag until these rises hit retail prices. On top of that we have huge debt problems. The US, the eurozone, Britain and other governments are prone to taking the easy way out of the problem and printing money, which is inflationary.
Killian: The base rate itself won’t move. But if I am selling a bond or any fixed-income instrument, I’m not going to get a good price on it now, because inflation expectations are picking up. The inflation that’s being caused now is not Mervyn King’s fault, it’s external. What is his fault is the growth in the money supply – that’s what they should be monitoring. I think it will, as Angelos said, do what all central banks do and take the easy option. It will stop bankruptcies, high unemployment, social unrest and generally do the work for the government. But it doesn’t end well. It will end in much higher rates, or with very little purchasing power left in sterling and fiat currencies.
John: Do you think we’ll see more US money-printing then – QE3?
Angelos: The Japanese catastrophe has raised the odds. We just have to wait and see the damage to global insurers.
Michael: It’s tricky. You’ve got the US on one side, but the European Central Bank (ECB) on the other, being fairly hawkish, and emerging markets now tightening.
Killian: Surely the ECB can’t raise rates. It should be hawkish, it should protect the value of the euro, but I just can’t see it happening. It will cause devastation in peripheral Europe.
Michael: But it sets the rates for economies like Germany, which is trading incredibly well at the moment.
Killian: But the Germans will do well out of a weak euro. So I wouldn’t say it is looking for rate hikes. Frankfurt may be, but I think Axel Weber’s leaving the top job is a signal that he doesn’t want to be around when the train crash happens.
Michael: That’s why we like German stocks – either the euro survives and gets stronger, or it goes and the deutschmark returns and goes through the roof anyway.
John: On that note, let’s talk about where you would all invest just now.
Our Roundtable tips
Investment Ticker Imagination Tech LSE:IMG Renold LSE:RNO BlackRock WM LSE:BRWM Herald IT LSE:HRI Strategic Equity LSE:SEC BlueCrest Allblue LSE:BABS Focus Minerals ASX:FML Fortuna Silver TSX:FVI SOCO Int. LSE:SIA Ford NYSE:F Estee Lauder NYSE:EL
Michael: Imagination Technologies (LSE: IMG). It has a £1bn market cap. It’s the world leader in low-power graphics chips for mobile communications – they are in around 70% of the world’s smartphones and tablets such as the iPad. Intel and Apple own 14% and 8.5% of the business respectively. At first glance the stock looks expensive, but for the year to April 2012, we are expecting earnings per share (EPS) of around 16.5p. So on 440p the shares trade on a forecast price/earnings (p/e) ratio of 26.6 times, with earnings growing at around 50% a year. We think that’s sustainable for a number of years.
First, the market is growing very quickly and there are lots of new applications for graphics chips. Second, margins are expanding as the company gets into different products, and as the industry assesses the superior performance of its Series-6 graphics chips. Due to the royalty business model, the company is highly operationally geared (defined on page 52) and therefore, if it is able to maintain its market share in this high-growth sector, it’s possible that it could breach a billion units shipped and will have earnings approaching 100p.
John: Any others?
Michael: We’ve been buying Renold (LSE: RNO), the world’s second-largest producer of industrial steel chain and also a major force in power transmission devices. The firm’s margins continue to rebuild, whilst trading in North America, 35% of sales, also appears to be very strong. The shares trade on a P/E ratio of around 10 times March 2012 earnings. For a market leader selling into diverse, growing end markets, that’s too cheap.
Peter: On the fund side, much as I believe in the long-term GDP growth story for emerging markets, I don’t hold any pure emerging-markets funds. I prefer the commodities-based funds.
John: Why’s that?
Peter: GDP growth and share prices don’t always go hand in hand. But whatever happens, that GDP growth will result in further demand for commodities. So I would go for something with a diversified portfolio and an experienced management team, such as BlackRock World Mining (LSE: BRWM), which you can buy on a 12% or 13% discount to net asset value. I’m also quite heavily weighted to technology – every small British business seems to have some exposure to the iPad. So I have been buying Katie Potts’ Herald Investment Trust (LSE: HRI). It’s come in from about a 25% discount to 15%, but still has good fundamental value and a fairly strong earnings-growth-driven story.
John: We like investment trusts. We like the idea you can get stuff on the cheap.
Peter: That’s why I like them too, but to be honest there is not a lot of discount value out there at the moment. At the end of 2008, when they were giving some investment trusts away, I bought Strategic Equity Capital (LSE: SEC). Although it has done well – I paid about 18p a share and I think they are 81p now – it’s still sitting on a 15% or 16% discount. That could narrow – if they don’t hit certain hurdles in terms of performance or managing the discount, they’ll have to return cash to shareholders. If you believe in small caps outperforming as we come out of tough times, it could continue to
do quite well.
Killian: We were just talking about spreading risk. Well, we’re looking at the most expensive exchange-traded fund (ETF) around. It’s 3.25% a year all in.
John: It had better be good.
Killian: Since inception in 2006 it has averaged – after fees – 30% a year. In 2008 it returned 145%. It’s called Qbasis Invest – it’s a trend-following fund. The ETF tracks their flagship hedge fund. The two strategies are breakout-trend following and swing-reversal countertrend. In effect, it’s a black box.
Angelos: The question is, when will the box break?
Killian: Well, I’m not saying you should just have one in your portfolio, but if you can find a fund of trend-following funds, it’s worth doing. These strategies have a negative 0.03% correlation with the equity market, so it’s a great diversifier. The Qbasis ETF has a minimum investment of around £10,000, but we’re an Isa plan provider so people can invest via us at smaller levels. BlueCrest Allblue (LSE: BABS), a fund of internal BlueCrest hedge funds, is another option. It has annualised about 11.3% in the last five years and through 2008 only lost 1%. Again, it’s a great way for retail investors to get what we would define as a better risk/reward profile on their portfolio and to get them away from the traditional asset classes of bonds and equities which we think – certainly bonds – will be a disaster in the next five years.
John: How about you, Angelos?
Angelos: I would put forward three of our current biggest holdings. The first is Focus Minerals (ASX: FML) – it’s the biggest holding in our Junior Gold Fund and has some very high-grade deposits in Coolgardie in Australia. It produces about 75,000 ounces per annum, and aims to grow that to about 120,000 ounces by 2012. That will mean two things. First, it would fill the plant to capacity, so operating expenses would drop significantly. So as well as hopefully reaping the benefits of a rising gold price, they could also expand profitability through increased efficiency. Secondly, there is also significant exploration potential in one of its properties. The market cap is around A$250m and it will generate about A$40m of cash flow this year. So, on a cash-flow multiple it trades at a very attractive level.
The second is a silver producer, Fortuna Silver Mines (TSX: FVI). It has two projects – the most important, a silver, zinc, lead, copper and gold mine – is in Peru. It operates with about 1,200 tonnes per day capacity from an underground mine, but that could grow to in excess of 1,500 tonnes per day in the near future. It has resources of about four million tonnes at 156 grams per tonne of silver, which is very high grade indeed. Secondly it is developing a gold and silver mine in Mexico, which is fully financed and expected to come into production towards the fourth quarter of this year.
In the oil space we like SOCO International (LSE: SIA). It had some disappointing results in its exploration and development programme last year, but has invested something like $200m in developing its acreage. We think this year the exploration programme will yield some very attractive results. It has about $1.5bn market cap and about $258m cash. Again, it is fully financed. The management team is a serial deal maker – it buys assets early, develops them and sells them once they reach maturity to other operators. And it has publicly stated that it is looking for deals for its existing assets or for the company as a whole. So it is a possible takeover target.
Rahul: I think we’re forgetting that many firms have used this crisis to become more efficient. So the scope for returns where demand is relatively healthy can be good, even for industries once seen as awful. I’m going to tip a dog of yesteryear, Ford (NYSE: F). What I like about the car industry is that you’ve had two high-profile bankruptcies in the US. These allowed the industry to restructure; deal with its biggest headache, the unions, and get its inventory back in line so that firms don’t have to discount every year like they used to. Peak US demand was about 17 million cars per year – at that level, Ford was losing money hand over fist. We’re now at about 11.5 million, yet last year, Ford’s margin was 9% – it was making more money than it’s ever made. And 11 million is not remotely near replacement demand – that’s nearer 15 or 16 million.
It brings other benefits too – because volumes are low, credit arms are not lending as much, and can return more capital to the parent company, which de-levers more quickly. As a result, Ford is in a net cash position today, having retired almost $20bn of debt in the space of two years. So there are two reasons to buy here. The leverage you can get if sales return to 13, 14, 15 million vehicles a year is tremendous. And because it is retiring debt at this rate, the equity ends up looking very cheap, so you get rewarded either in terms of dividends or a buy-back.
I will tell you one more thing that makes me very bullish. For the last seven or eight years, Ford has been cutting people every year in America. But last year, Ford started adding people in America. This tells me there are a lot of corporates sitting on a load of cash and you are starting to see that money come back into the market. Yes, the US government situation is dire and it is not facing up to it, but offsetting that, you are starting to see private investment pick up.
Angelos: I’m not convinced by the auto-makers. I think what happened is that they got bailed out, focused on the higher margin products and cut the mass-produced ranges. Again, it’s all this liquidity creating the two-tier economy. The haves are buying luxury cars, and the have-nots are buying the old bangers.
Rahul: I agree that the luxury consumer is in a fabulous place. But a manufacturer like Ford isn’t reliant on luxury cars. The whole industry is simply a lot more rational than it has ever been. It is discounting far less.
Angelos: What I am questioning is the sustainability of this growth.
Rahul: Well, when you are at 11 or 11.5 million sales a year, and your replacement level is 15 million, your cars have never been as old as they are now. You can postpone replacement for a while, but there comes a point. And I don’t need to assume 12, 13, 14 million to make the numbers work. Ford is at six times earnings today.
Killian: But remember, employment in the US is, if you look at U6, close to 20% unemployed or underemployed.
Rahul: We know all that, but that’s static. If you have had a job for the last two years, you are getting more confident, and you are starting to spend. Month after month, demand in the US is surprising on the upside. Wealthy consumers in particular are starting to feel a lot better because they’ve started to see their wealth increase – be it shares or property.
Killian: Nominally.
Rahul: Absolutely. But the other thing with luxury goods companies is that more than half of the business is wealthy Asians, for whom these brand purchases are incredibly aspirational. Think of an international brand, like Coca Cola. It sells for one-third of the price in China that it sells for here. But a Louis Vuitton handbag sells for 50% more in China than here. And we haven’t even talked about India, which is even more ‘show it in your face’ than any other market.
With that backdrop in mind, my second tip is Estée Lauder (NYSE: EL). It’s a family business, but two years ago it brought in a professional manager. Its biggest rival is Shiseido in Japan, which couldn’t be a worse-run company, yet it makes a 15% margin. Its best-in-class competitor is L’Oréal with Lancôme, which makes a 20% margin. Estée Lauder is on 11% and this manager aims at hitting 13% or 14%, which is still worse than the worst-run company in the sector, despite Estée Lauder having the best, most-recognised brands. And remember, cosmetics is hugely cash-generative. There is no capital expenditure.
Michael: What’s the valuation?
Rahul: About 20-odd times earnings. But if you believe the numbers are going to go up sharply, as I do, it’s not that expensive. And the second point is that you are paying the same valuation, give or take, two years out for Estée Lauder – even assuming less-fast growth numbers – as you are for something as dull as a Proctor & Gamble, which is effectively a ‘GDP plus growth’ company.
• This article was originally published in MoneyWeek magazine issue number 530 on 25 March 2011, and was available exclusively to magazine subscribers. To read all our subscriber-only articles right away, subscribe to MoneyWeek magazine.