John Stepek: The banks have been in the press a lot, but would any of you buy them?
Chris White: The ‘buy’ case for banks goes something like this: banks are trading at a big discount to net book value. In three years’ time they will be making 15% returns on equity, compared to a 10% cost of equity, say. So they should trade on 1.5 times book – on a three-year view, you might make a decent return. The trouble is, I think this prospect has been pushed further into the future by a whole host of factors, from GDP slowing to Greek debt write-offs. If you look at Lloyds, for example, the core business is making money. But it has a bad bank, which is big enough to write off hundreds of millions of pounds on. So it’s very hard to make confident predictions.
Marcus Ashworth: Lloyds is surely a straightforward punt on the housing market. It owns so much of it that if house prices were to drop 10%, 15%, 20% from here, it would be in trouble.
Jane Coffey: No other sector in the market is trading on hypothetical earnings three years hence. Lots of other stocks have great balance sheets, lovely cash flow, and high dividend yields. If the banks are set to do well in three years’ time because the economy is good, these other things are going to be doing much better.
Guy Stephens: Yes, give me an exporting metal basher anytime. You can understand the balance sheet and the valuation.
Jane: And nobody is going to say: “Oh, we are just changing the rules”.
Marcus: You’re not worried about global GDP growth? For metal bashers it’s all about China.
Our Roundtable panel
Head of fixed income, Espirito Santo Investment Bank, incorporating Execution Nobel
Jane Coffey
Head of equities, Royal London Asset ManagementFraser Mackersie
Fund manager, Unicorn Asset ManagementGuy Stephens
Chief investment officer, Rowan DartingtonChris White
Senior investment manager, Premier Asset Management
Fraser Mackersie: We haven’t seen any evidence of a slowdown in the stocks we hold that are exposed to China.
Chris: On China, I would rather buy a miner than an industrial. I’m underweight both, but they look more interesting now because some are 30%-40% cheaper than they were at the start of the year. I’d favour miners because China has been the marginal buyer of all these metals, and I think they’ll get inflation under control and keep investing in infrastructure. The industrials, on the other hand, will probably remain volatile because global GDP is under pressure. You’re starting to see some real selling of cyclicals by investment houses that have downgraded their view on the global economy.
Jane: Yes, there has been a huge disconnect between commodity prices, which have held up well, and mining stocks, which have fallen dramatically.
John: So are miners going to catch up, or will commodities fall on their backsides?
Marcus: I don’t think China will have the soft landing people are hoping for. China has a very serious debt problem in its local government financing vehicles. The authorities are trying to tackle it, but there’s a chance of a substantial mid-cycle slow down, at least. That would come at just the wrong time for a lot of commodity-driven stocks and for Australia’s economy in particular. Korea and Taiwan are the most sensitive to it, but other economies and other big trades will suffer too. I don’t think the market has got its head round this risk yet.
Jane: But China is engineering the slowdown. It wants to get back to 8% growth from 10%. China has had high inflation and has been tightening policy to deal with that.
John: Can it really fine-tune the economy that easily?
Jane: Well, 2008 showed that if the entire globe stops trading, then China has a big problem. But because it is a command economy, it can tell banks to lend, and it can start projects if things start slowing too quickly.
Marcus: I don’t think it’s quite as easy as that. I don’t think China has got inflation under control. The base effects from last year when food prices went ballistic are helping, but inflation is still rising noticeably. China is as subject as the rest of the world to the American consumer. As far as being an engine of growth goes, I don’t think China is quite what it was, or what it will be in the next few years. It could have a stumble. I don’t think its growth will fall below 7%, but that’s a big drop from 10%. The point is, everyone is looking to China to keep things ticking over – but China can’t do it.
Guy: I agree with what you’re saying, but I think there are plenty of other places to be worried about, such as Europe. The Eurocrats are trying to kick the can down the road yet again, but we’ve got to get to the end of this – otherwise none of us are going anywhere.
Jane: People keep saying, ‘European politicians have to do something’. But what do we want them to do?
Guy: Allow Greece to default. Just do it.
Jane: But they’ve already, in effect, said that Greece is going to default. People are going to lose 21% of the value of their debt. Do you want euro bonds and total fiscal union, with Greece in the union?
Guy: No, I don’t think Greece should be in the European Union – that’s painfully obvious.
Marcus: It will send them back to the dark ages if they’re kicked out of the euro.
Jane: And how do you stop the same happening with Portugal and Ireland?
Guy: That’s the thing. I just hope that the European Central Bank and Angela Merkel and Nicolas Sarkozy recognise this isn’t just about Greece, this is about a solution for the rest of the countries too. You’re absolutely right: if Greece goes, it will move onto the rest.
Chris: The problem is that this is both an economic and a political crisis. In the US there’s a political impasse between the Republicans and Democrats. In Europe you’ve got government by consensus and over here, while the coalition seems to be working, will that be the case in a year’s time? Political risk is hard to price in – it’s taking a long time for any decisions to happen. That means uncertainty, which markets hate.
Marcus: To my mind, this isn’t an economic problem – it’s a purely political one. The US debt problem could be resolved overnight. Look at what we pay for petrol in this country. They could raise a lot of money by upping petrol taxes in America. It’s anathema to them, but they could sort it out if they wanted to.
Chris: Yes, I’m more optimistic that America can get through this on a five- or ten-year view. The tax take is around 14.5% of GDP, the lowest it’s been for 60 years. It just has to change its mindset.
Marcus: Exactly. How much has it spent on Iran and Afghanistan? It could simply stop being the world’s policeman. In Europe, the problem is that it’s being run by committee.
Guy: In some ways the American election next year is quite good timing because we might get some clarity.
Jane: In any case, as a long-term investor rather than a punter, you should be ignoring the noise and taking opportunities when you can.
Chris: Yes, and where else do you go for income? A bank account or ten-year gilts will pay you 2.5%. You can stick it in property and maybe get a 5% or 6% yield, or you can pick up stocks on price/earnings (p/e) ratios of ten, with dividend yields at 5%-plus and free cash yields at 10%. Assuming those earnings are solid and may be growing, those stocks will probably deliver you a total return of 10%, perhaps a bit more.
John: It’s interesting how we’ve all got used to this argument about stocks yielding more than bank accounts. Sure, they’re blue chips, but it’s nothing like a bank account – your capital is still at risk.
Chris: You can split the British market into three groups. The oils and the miners rely on global growth and China – so put a question mark there. You’ve got the defensive stocks: utilities, telecoms, tobacco and pharmaceuticals. They have reasonably reliable earnings, big dividend yields and low valuations. So I like that area. Then you have the rest: media, financials, industrials – where again you are reliant on global growth, so there’s a question mark there too. To me, that bit in the middle deserves to trade on a much higher rating than it does now.
Marcus: There is one thing you must remember: don’t touch bonds. When it all blows up, the big trade will be 1) to buy the dollar and 2) to sell the bond markets, because they are the most nonsensically priced things on the planet. But here’s a question: who thinks we are going into recession?
Jane: I don’t. I think we’re having a global slowdown. That will feel nasty for the man on the street. However, for companies it’s not the disaster that’s been priced into markets. My caveat is that the euro doesn’t implode before that.
Guy: Companies are the key. Earnings are in rude health, there’s lots of cash on balance sheets – if you put all the macro factors to one side, you’d think, “this is great”.
Jane: I’ve met several industrials that say that if they had a 10% fall in their top line, their profit margin wouldn’t fall, because they’ve cut fixed costs compared to flexible costs. When things picked up all they did was increase overtime and outsourcing – they can get rid of that easily enough.
Marcus: So we’re saying that the 2007/2008 slump has been a household balance-sheet problem. Firms were not the problem to start with, and have become even more efficient because of it. So we all agree, I think, that companies that make things, have cash flow, have decent dividends and strong balance sheets, are the place to put your money long term.
Chris: We’re also starting from a lower base than in 2007/2008. Capital spending is pretty tight and share prices are lower, so there are a number of reasons why things won’t go as badly wrong as they did a few years ago.
Guy: QE would be re-enacted too: ‘Oh, things are slowing down. Let’s just print a bit more money’. It’s a put option.
John: What do you think, Marcus?
Marcus: I think there will be a recession – a pretty ugly one. QE will be triggered here, and Europe will reverse the two ridiculous rate hikes it made earlier this year. But none of this will have an impact. You’ve already seen that in America. Until they get the US housing market off the ground, none of this will be resolved.
John: So what would you buy now?
Our Roundtable tips
Investment Ticker Iomart LSE: IOM NCC LSE: NCC ASOS LSE: ASC Vodafone LSE: VOD GlaxoSmithKline LSE: GSK Brit Am Tobacco LSE: BATS G4S LSE: GFS Imperial Tobacco LSE: IMT Smiths Group LSE: SMIN Firstgroup LSE: FGP Pennon LSE: PNN IG Group LSE: IGG Petrofac LSE: PFC WPP LSE: WPP Lancashire LSE: LRE Tata Motors NYSE: TTM
Fraser: Even in a time of low growth, I think there are good opportunities out there. One is Iomart (LSE: IOM), which provides managed hosting services. It’s a really interesting business in a growth market. It’s got good sites and owns its properties freehold. It’s operationally geared, has cash on the balance sheet and pays a dividend. The second is NCC (LSE: NCC). There are two main parts to the business. One is software escrow – it stores software codes for large businesses, so that if the original software firms cease to exist, they still have the source code. There’s quite high recurring revenue in that part of the business. The second is based around cybercrime and network security testing, which is an interesting growth area. The company has a 2% yield. The third is online retailer ASOS (LSE: ASC). It is highly rated on over 40 times forecast earnings, but it’s good at what it does and I think the overseas potential for the company is quite impressive.
Guy: I don’t think you need steer too far from blue chips – you can pick up Vodafone (LSE: VOD) on a 6% yield. It’s not exciting, but it’s dependable. I could equally add GlaxoSmithKline (LSE: GSK) or British American Tobacco (LSE: BATS). Hot off the press is G4S (LSE: GFS), which is now a ‘core buy’ for us. Permanent outsourcing is a big thing for prisons, police services, facilities management and the courts. G4S has also won a £120m Olympics contract, which has already risen to £140m, and it could sell security to other Olympic teams visiting Britain. It’s very well diversified.
Chris: I like defensive blue chips: Imperial Tobacco (LSE: IMT) is my largest holding. It’s had a few issues in Spain because of a price war with Philip Morris but that looks like it’s in the past. I think the company is capable of growing its earnings and dividend at near-10% a year; you are starting off on a prospective p/e of ten; and it yields 5%: a really solid holding. I also like Smiths Group (LSE: SMIN). It’s been sold off as an industrial, yet half of its business is in medical equipment, for which it got a bid from Apax about six months ago. It’s on a prospective p/e of ten, yields 4.5% and I think that Philip Bowman, the chief executive, who I regard very highly, will realise the value in the group somehow, so I imagine you will see disposals and maybe some acquisitions as well.
Then there’s bus and rail stock Firstgroup (LSE: FGP). It has five divisions. All are performing well, except for its US school bus business, so the management there has been changed; the company has taken a write off and I think it will get the margins back. In 12 months’ time it should be firing on all cylinders. It’s very cash generative – the stock yields 6.5% and the plan is to grow the dividend at 7% a year for the next two years.
Jane: I like Pennon (LSE: PNN): it’s a water stock with a growth kicker. The dividend yield is 4%, which is set to grow by retail price inflation (RPI) plus 4% a year. But it also has Viridor, a waste management arm. Local authorities are under pressure to do something with waste other than put it in landfill. Over the next few years, Pennon plans to produce lots of incineration plants, where you burn waste and sell the resulting electricity, so it’s a win-win. The unit is growing at 20% a year – so that’s your growth kicker.
Then there’s spread-betting firm IG Group (LSE: IGG), whose recent earnings thrashed expectations. IG benefits from volatility in the market, as it encourages clients to trade more. But even during the lull, when people weren’t trading as much, IG’s customer base was still expanding. Now you’ve got volatility, plus a growing customer base, so you’ve got a 20% rise in active clients. That’s resulted in an 8% increase in the revenue that each client generates. It may not maintain that rate of growth, but it’s a market leader in its field, it’s got a lot of cash, it’s paying a 5% dividend and it’s on ten-times earnings. And it’s still got structural growth to come from expanding into other markets.
My final pick is oil services business Petrofac (LSE: PFC). You might say this is more cyclical, but if you take a long-term view, demand for oil is only going to rise over time. It has an incredible order book: 28 months’ worth of orders. Mainly it’s engineering and construction projects, but the group is also investing in projects where it owns an equity stake in the oil field. This is good for the oil companies who don’t want to give away potential upside to the likes of Shell or BP. So Petrofac expects to double its earnings by 2015, almost regardless of the oil price.
Marcus: I like WPP (LSE: WPP) on 8.5 times 2012 earnings. I think people are going to start spending more money on clever advertising again, rather than on the promotional gimmicks that have been played out now, and big agencies tend to do better in a tough economic climate like this. There is great growth in emerging markets and potentially in the US too. WPP is extremely well run. I also like Lloyd’s of London insurers, where Lancashire (LSE: LRE) is my top pick. It’s partly a seasonal play. We are through the hurricane season pretty much (famous last words) and it looks like insurers have kept their cash intact, so they are in a very good position. Lancashire has the best underwriting record I know of.
My other tip is India’s Tata Motors (NYSE: TTM). It owns Jaguar Land Rover over here – that’s actually the worst part of its business, although I think they are getting their act together. In India, Tata is unparalleled. Of all the emerging markets, India is the most domestically driven and Tata has a 63% market share of commercial vehicles and 17% in cars. It’s also growing market share all over Asia.
John: Are India’s recent corruption scandals a good buying opportunity?
Marcus: India suffers a lot from corruption, but it’s no worse than in China and many other places. Anna Hazare’s hunger strike is really resonating, so hopefully India will realise the benefits of beating corruption. I also think it’s over the hump of its inflation problem – it has tackled inflation in a much more realistic way than China has.
• This article was originally published in MoneyWeek magazine issue number 554 on 9 September 2011, and was available exclusively to magazine subscribers. To read all our subscriber-only articles right away, sign up for a three-week free trial now.