John Stepek chairs our panel of experts and asks where they would – and would not – place their money in today’s markets.
John Stepek: What’s next for Europe?
Steve Russell: My guess is it will find some way to muddle through. The EU clearly doesn’t want a technical default, but Greece is bust. It’s not a question of solvency or liquidity. It’s just bust. Greece can’t get out of this trap without writing off the debt, so it will have to come up with some solution. Will this crisis break up the euro? Probably not. It’s in Germany’s interest to keep a cheap currency area for it to export from, so it will have to pay up to keep the eurozone going. But the whole thing looks a mess at the moment.
Alexander Gunz: If it’s a choice between the collapse of the eurozone project or more imposing losses on various institutions, I think many politicians would prefer the losses. But you can’t bring a country back to health by simply piling on more debt. If you look back at previous sovereign debt crises, there is not a single example where a country has managed to restructure simply via austerity and privatisation policies. Instead, it has usually had to admit openly that it is in need of a default and a devaluation to become competitive again.
Gervais Williams: That’s the problem with the euro – member countries can’t devalue.
Alexander: Also, the European Central Bank (ECB) has something like €11bn of assets and about e600bn of liabilities. So somewhere down the line the ECB needs to be recapitalised. That is likely to mean extra costs for governments and potentially the private sector as well.
John: Even before Europe kicked off again, though, the global economy was slowing. Any thoughts on why?
Gervais: We’ve been in a credit boom for the last 25 years. We will now have a debt hangover, which means growth is going to be very slow. World growth is currently running at 4%, which is cracking, but in a year or three we probably won’t be anywhere near 4%. We might be very happy with 0.4%. So we’ve got to get used to a new world. More importantly, as fund managers we’ve got to find a way of delivering for our clients in the absence of economic growth. That’s a big ask. For many of us, this credit boom has spanned our entire careers as managers, so we’re not used to more ‘normal’ times.
John: So how are you going to do it?
Gervais: By doing all the things that we’ve got used to not doing. Ask any institution anywhere in the world and one thing we can all agree on is that we should not invest in illiquid, tiny companies. They are too fiddly and are never going to go anywhere. But it could be that, even in the absence of world growth, some of those companies will continue growing. So I think we all have to get a bit braver – putting a percentage of our portfolios in assets that aren’t that liquid, and where we, as fund managers, actually have to take a view and have to hold that view – not trade it – for a number of years.
Steve: I would agree with that.
Our Roundtable panel
Investment manager, Rathbones
Alexander Gunz
Fund manager, Heptagon CapitalSteve Russell
Investment director, Ruffer LLPManaging director, MAM Funds plc
John: When you say be braver, are you talking about managers no longer trying simply to hug their benchmarks? Is that really going to change?
Gervais: Well, from 1999 to today, if you’ve hugged the index, your clients have made nothing on capital gain. Clients will get fed up quite quickly if they’re getting lots and lots of volatility but no return. So in future, to make returns we are going to have to go back to being much more driven by conviction.
Steve: I think the 25-year period of benchmark investing will be viewed as an aberration. It was driven entirely by the self-interest of the fund-management houses, where they could pass investment risk away from themselves back to the client. It’s morally wrong in my opinion. Back in the old days – the 1950s or 1960s – people invested to make money, not to beat an index. So it’s going to take decades to get rid of this attitude, but it is already starting to erode at the edges.
John: So what does all this mean for our investments?
Marina Bond: Stock picking will become key. I don’t think the recovery is over – I think this is just a mid-point slowdown. But we really need to pick companies that are highly niche and can protect their margins, because it’s becoming more and more difficult to make money in this environment.
Steve: As far as the current slowdown goes, we are fairly sanguine about it. We think growth in the US will probably surprise on the upside come the second half. China we see purely as a risk, not an opportunity, as it tries to slow down inflation and tackle its property bubble. Global markets will slow when that growth engine is taken away, and it is a risk for commodities, which have been a fashionable play for some time.
Beyond that, we think the endgame is inflationary. We think it’s inevitable because there is no other way to get rid of the debt. As for what that means for stocks, that’s a tough question. The myth is that stocks offer inflation protection, but that’s simply untrue – at least when inflation goes from a low to a high level, rather than staying flat. So our focus now is largely on guarding against the loss of wealth and spending power that inflation will bring about.
Alexander: I worry more about deflation than inflation, but that’s only because I think the debt will be repaid. Repaying debt is deflationary.
John: If the US surprises on the upside, what will that mean for the dollar? Will we get a third round of quantitative easing (QE3) or not?
Steve: Our view is that we won’t need QE3, but it is there if it is required. There is tremendous political pressure not to do it. But the reason we aren’t too worried about deflation is that if it were to rear its head, there would be more QE. So we’d expect the dollar to strengthen through the rest of this year. Overall, though, our position is still ‘a pox on all the currencies’. Governments are still trying desperately to devalue against each other.
John: What does that mean for gold?
Steve: It’s got to levels where there is risk both ways. So we’ve cut back our exposure a bit. It’s still worth having as a hedge: if what we think is likely to happen comes about, then there is every chance gold will go to $2,000-plus. But it could go crashing back as well.
Alexander: There is a very obvious correlation between gold and real short-term interest rates. Gold will outperform when risk-free rates are negative. So taking a view on gold is effectively taking a view on interest rates. If we see increasing pressure, particularly in the US, to raise rates over the medium term, that’s when gold may start underperforming.
John: Where would you invest just now?
Alexander: We see equities as the ‘least bad’ place to be. In terms of countries, we are more upbeat on the US, at least in the near term. Capital expenditure by US firms this year can be depreciated, so we may see a mini-boom before the end of the year.
Marina: I like investing in companies I can see, meet and understand, so I would still invest in Britain. I do end up favouring the smaller healthcare sector just because I’ve found some companies that have their own niche and which have tremendous growth and good margins.
Steve: I’ve just come back from a rather encouraging week in Japan. The political mess may not be resolved in the short term. The right thing to do is for the Bank of Japan to buy government bonds the way the Bank of England and the US Federal Reserve have. What Japan needs above all else is inflation or positive nominal growth via inflation, which will make the government’s debt problem disappear. However, although there is a constituency that supports this, we are not holding our breath. What was encouraging was the quality of the Japanese firms. If you want to do stock picking, Japan is the place to go now. I was a small-companies fund manager in the 1990s when Britain was full of beautiful businesses that were on great valuations and just needed to adjust their business models. In Japan companies have been changing their business models since the Lehman Brothers shock.
One lovely little business we came across, which has a market cap of about £1bn, makes ice-making machines and drinks dispensers. It’s got a price-to-book ratio of one, a price-to-earnings (p/e) ratio of about 12 and 70% of its market cap is in cash, which it intends to spend. It will probably spend it badly, but not as badly as holding it in cash in Japan with a return of zero. So we remain positive on Japan.
Alexander: We’d need to see a little bit more political visibility and good- will, and firms improving their disclosure to markets before we felt fully happy with Japan.
Steve: True, there are still some old Japanese companies that are not communicative. I had my worst-ever meeting with a company last week. That said, more and more of them are becoming open and sensitive to shareholders.
John: A final question before we get to tips: does anyone think UK rates will rise a lot higher by, say, the end of next year?
Steve: I’ve got no idea, obviously, but I fancy that, with this phony war with Greece and all the rest of it, we’ll just keep hanging on and nothing will happen on base rates.
John: So you don’t see inflation getting to 8%, for example?
Steve: Yes. I can absolutely see that. But I still don’t see any movement in rates.
John: You think the base rate will stay at 0.5%, even if consumer price inflation (CPI) is at 8%?
Steve: It might go up a tick or two, but that still means you are losing more than 5% of your spending power a year in cash. That’s how it has to be to get rid of the debt.
Alexander: Absolutely, we all have to become poorer.
John: But how does CPI get to 8% if the economy isn’t recovering?
Steve: It’s a tricky one. But when asked the same thing a year ago I would have said it would be tricky to see how we could get to 5.5%. Yet we are already there. Sterling weakness is always part of that. Chinese moves to counter inflation in China can be inflationary in the rest of the world because as China stops exporting, others set prices. We are seeing that in some food and chemical products at the moment. But what really gets inflation going is once the penny drops that savings are shrinking by 5% a year and that that’s not going to change. Gradually people realise that they might as well spend rather than save. As they do so, the velocity of money picks up. That’s probably how you get to what seems an unlikely level of inflation.
John: But what happens if CPI is at 8% and wage growth is at 2% or 3%? That’s a recipe for riots surely?
Steve: We’re seeing it in Greece already.
John: I’m thinking about here.
Steve: Here, no. Fortunately, the British public are much more stoic. The economic sitution is a difficult one for the government, but what we’re getting is an awful lot better than the alternative, which would see mortgage rates at 7% or 8%, and a guaranteed boot out of office because everyone’s home is being repossessed.
Gervais: It comes back to this idea of the least bad outcome really. The government’s austerity measures are by far the best way out of a really nasty hole.
John: And the lesson for the future is what? Don’t save any money because the government will always bail you out?
Steve: Yes, well, unfortunately there is moral hazard.
John: Let’s talk about specific stock tips. Alexander?
Our Roundtable tips
Investment Ticker Aggreko LSE: AGK ASOS LSE: ASC Harry Winston US: ASC Renew LSE: RNWH Adv Med Sol LSE: AMS Surgical Innov LSE: SUN Abbey Protection LSE: ABB Playtech LSE: PTEC Vodafone LSE VOD Invensys LSE: ISYS Hoshizaki JP: 6465 Sony JP: 6758
Alex: First I’d tip temporary power supplier Aggreko (LSE: AGK). It’s been a phenomenal performer, but we are still buying. There is a structural imbalance between energy demand and supply. Aggreko dominates its market, and management has a very good track record. It has been very good at managing expectations and we think that the story has further to run.
Staying on the growth tack, we also like online fashion retailer ASOS (LSE: ASC). Less than 10% of all clothing is purchased online, so there is still massive upside there. It also has the potential to take the business model it’s successfully established in Britain and export it. The other thing it’s doing at the moment is a free returns policy. We think that’s a brilliant marketing initiative that will help bring customers to its site and increase customer loyalty.
A more esoteric pick is a little US business called Harry Winston Diamonds (US: HWD). It owns the largest diamond mine in Canada; it’s responsible for about 6% of global diamond production. It owns 40%, Rio Tinto owns the other 60%. But the real jewel here is its retail business, which analysts have failed to appreciate. To run this division, the firm recently hired a new chief executive, who used to run Cartier’s North American operations. It currently has 19 stores globally. We think there is real potential to grow its retail presence, both in terms of increasing the visibility of that business and seeing that flow through to the share price.
Marina: I like Renew (LSE: RNWH). It’s involved in mainly regulated, non-discretionary sectors, such as energy, rail and environmental sectors, and it survived the recession in reasonably good shape despite being exposed to the construction industry. The reason I am interested is that, a few months ago, Renew bought Amco, a specialist engineering company. It’s a big step towards its final goal of becoming a specialist engineer itself, and the acquisition has improved the company’s margins. CEO Brian May has a very good track record. He came from construction giant Tarmac and he sorted out Land Construction and Mowlem, so we are backing him in this. Renew is on seven times earnings to September this year, falling to about 5.8 times.
My second pick is a medical stock. Advance Medical Solutions (LSE: AMS) develops wound-care products. It sells in Britain, Europe and America. Its most exciting product at the moment is a wound glue called LiquiBand. In Britain, AMS has a 70% market share and competes against Johnson & Johnson (J&J). Now AMS is selling its product in America, where the biggest competitor is also J&J, which has a 70% market share over there. Currently, AMS has about 3%-4% of the US market share. Its goal is to get 20%: if it gets anywhere near, the numbers will defy expectations. The company is very conservatively run, with a strong focus on cash. The management really knows what it’s doing. It’s on a rating of 17 times this year and 14 times next year’s earnings.
My final pick is more risky. Surgical Innovations (LSE: SUN) designs and makes devices for use in the minimally invasive surgery market as well as in the industrial market. It has identified a gap in the market for devices that are partly disposable and partly reusable: it’s branded these ‘resposable’ – for example, a tool can have a handle that is reusable with a blade that is disposable. There is a big cost advantage to using these devices. It’s growing quite fast and margins have been improving, but revenue is very lumpy. So forecasts are reasonably conservative for this year, but further out I think you will see significant growth.
John: Gervais?
Gervais: I’ve set up a new diverse income fund – so good and growing income is what I’m looking for. My first tip is a tiny company called Abbey Protection (LSE: ABB). It has a £60m market cap and profits of about £10m. It’s growing nicely in a number of different areas. It supports small businesses by offering services they can’t always organise themselves, such as human resources and legal support. It’s run by Colin Davidson. It’s not going to knock the socks off the growth rates of some of the other companies we’ve talked about, but it’s a great little business. It’s probably over-capitalised, probably got excess cash on the balance sheet, and the yield is around 5.3%.
More controversial is a much bigger company, Playtech (LSE: PTEC). Playtech is involved in making software for gaming companies. It’s a strong business with a very strong market position – unambiguously cash generative, strong balance sheet, and so on. But it’s been out of fashion for all sorts of reasons. It wanted to change its finance director and there were questions about who that might be, then it took a non-executive and made him finance director, so some people aren’t entirely happy about that.
Playtech has also bought back a business that was demerged at the time of the float, and some of the directors have financial interests in that, and that’s been upsetting to people. And, of course, there have been uncertainties about all the changes in the gaming sector. It has no exposure to regulatory risk, of course, because it only supplies the shovels to the gold miners, but it’s been a real problem. The share price has been falling almost continuously for 15 months. But it’s got a good yield – over 5% – and I’d say it’s now at a great entry price.
John: Steve?
Steve: The government has been kind enough to open up National Savings index-linked certificates again, so I would suggest anyone who has a small amount of money to put away, jump in quick. As for stocks, I like Vodafone (LSE: VOD). It’s good value, yields around 5.5%, and there’s a lot of interesting stuff going on with its stake in Verizon and the growth in mobile data. If the inflation scenario we fear comes about in the near term, it will go down – but not much, and it will still be there and doing fine at the end of it.
John: What will happen with Verizon?
Steve: Probably not much beyond paying a dividend, but as that could increase Vodafone’s own dividend by about 40%, that would be quite a juicy return. The other stock we like relates to something Alex said earlier. The only growth potential we can really see is going to be fuelled by corporate cash flows, so investing in beneficiaries of corporate capital spending seems sensible. We particularly like control systems group Invensys (LSE: ISYS). The old chief executive did a brilliant job of rescuing it from being a basket case. He has gone now because the company wanted somebody else to take it on now that it’s recovered. But we think it’s really quite an attractive stock.
As for Japan, the stock I love is Hoshizaki Electric (JP: 6465), which makes ice-making machines and drinks dispensers. But that is probably for experts only. So I’d also suggest Sony (JP: 6758; US: SNE), where there is a real restructuring story.
It’ll be a bumpy ride – Sony has got problems with hacking – but it may end up being the only real competition to Apple in the entire global consumer electronics world. Sony has all the customer-facing products; it has the brand name and it has the reach. Not only would Sony be worth a lot more if it just organised its business properly and got rid of the loss-making bits, but it does have a television in most people’s houses and television is where Google wants to get to. It’s got an alliance with Google to try and fight against Apple. It might be pie-in-the sky this ‘Apple’ scenario, but Sony is likely to restructure successfully and it is at a particular low point right now, so I think, as a big liquid name, it could become the poster child for Japanese recovery.
• This article was originally published in MoneyWeek magazine issue number 544 on 1 July 2011, and was available exclusively to magazine subscribers. To read all our subscriber-only articles right away, subscribe to MoneyWeek magazine.