This month, MoneyWeek’s roundtable considers the fallout from the credit crunch. Is there anything left worth buying?
Merryn Somerset Webb: It doesn’t look like 2008 is going to be much of a year for markets does it?
James Ferguson (Economist and stockbroker with Pali International): No. The behaviour of the credit markets in the run up to the end of last year told us very clearly that things are much worse than most people expected in the summer and that they are getting worse all the time.
For me this suggests that in 2008 there will be a core tension in the equity markets. On one hand equities are really very cheap – I’m thinking particularly of blue chips – but on the other there is going to be lots more bad news and the threat of a recession.
I suspect that for some time this will mean sharp sell-offs on bad news followed by rallies in areas that clearly offer value. If I was being optimistic I think I would say that towards the end of the year equities might finally break out largely because by then interest rates and bond yields will be so much lower than they are now – the Fed and the Bank of England are going to have to keep cutting rates.
MSW: Even with inflation not really under control?
JF: People worry that inflation will make it tough for policy makers to raise rates. But I don’t think inflation is a risk. The prices that are rising are related to food and energy, they’re not internally generated. Right now one of the worrying numbers is PPI (the Producer Price Index) in the US which is just over 7%. But the last time we had PPI in the States at 7% was November 1990. That was the cusp of the last consumer and housing recession in the US. One year later PPI was negative. Look at it like that and clearly the fact that the number is high today tells us nothing about the future. So that’s my view in a nutshell. Oh, and UK housing – it’s absolute toast!
Patrick Evershed (New Star Select Opportunities Fund): I agree with most of that. Obviously the credit markets are in a mess and this is putting strain on the banks and on the consumer. But the situation is particularly acute because consumers are so overstretched already. We’ve got a record level of personal debt – people living far beyond their means – and a record number of people going insolvent.
So what we should see now – as a result of all this turbulence in the credit markets – is consumers in the US and the UK coming to their senses and spending a lot less. This will squeeze retailers and that will spread out to the rest of the economy. At the moment profit margins are at record levels in the US and UK, but a slowdown in the economy or a recession is going to end that. Perhaps shares aren’t as cheap as they look.
MSW: And inflation?
PE: Usually after periods of rapid monetary growth you get high inflation, but while we’ve had the former we haven’t yet had the latter. This is because the emerging world has been exporting goods to the developed world at lower and lower prices. But that is coming to an end. We are seeing inflation in China and in India, and I expect to see that exported to us. I don’t think it will be that severe, but I do think it’s going to creep up from current rates and that is going to make it more difficult for central banks to bring down rates of interest quite as rapidly as we might like.
MSW: So that would make you pretty bearish on everything?
PE: Yes. I’m cautious.
JF: I totally agree with you, but…
PE: You can’t totally agree with me because I disagreed with you.
JF: Just a political entrée. I disagree with you on the inflation bit. Because profit margins are very high right now, companies have the option of cutting prices if sales slow and that is probably what they will do. So we could see CPI falling quite fast.
PE: That still suggests though that margins are going to come under quite a bit of pressure over the next 12 months and that makes it hard to be optimistic about equity prices.
Jim Mellon (Chairman, Regent Pacific): I am more bearish than both of you. I think the house price downturn is going to huge. I expect prices to fall between 30% and 50% here and maybe 25% in the US. To me this says that the seizure in the credit market has only just begun – prices in the US have only fallen 4%-5% so far – and look at the trouble that’s caused. $400 billion worth of debt is practically in default. No one is lending. If you want to do a private equity deal right now you just can’t. It doesn’t matter how good a deal it is.
It is going to be really hard to sort this out especially since the reputation for competence that Greenspan had and the Bank of England had appears to have been lost. So in a nutshell, I think the Anglo-Saxon economies – the US, the UK, Canada, Australia, New Zealand and Ireland, coupled with the Mediterranean countries – are in very bad shape. The consensus view is that the UK will grow by 2% this year. I would be very surprised if it grew at all.
MSW: 30% is a nasty fall in house prices.
JM: Well, let’s look at it this way – who are the buyers? No one. And in an absence of any banks willing to lend money and cheap mortgages, there will be no new buyers out there.
Marina Bond (Rathbone Smaller Companies Fund): It is difficult not to be bearish at the moment and I am bearish on most markets as a whole. But I don’t think global growth is going to completely collapse. Emerging markets are going to be affected by a US slowdown, but there definitely is domestic strength there.
JF: It seems to me that history will see this not as a ‘subprime crisis’ but a banking crisis. Subprime has had such an effect because the banks – all of them – are seriously undercapitalised. Only this can explain their behaviour. The Catch-22 for banks is that if they bring their structured investment vehicles (see definition below) back onto their balance sheets to prevent them having to be sold in a firesale – this would push down market prices to very low levels, which would help no one – then the level of loans they have against their core capital goes up and they risk being visibly undercapitalised. Which is why the two banks that have moved big SIV assets onto their balance sheets have announced that they are being recapitalised by sovereign wealth funds.
This implies that the banks that haven’t done it yet haven’t because they can’t find someone to recapitalise them at the same time. The other thing they could do, is they could let the SIVs go. But they can’t. If the SIVs get to a certain default proportion, it’s written in their contracts that they have to liquidate themselves – again in a firesale. The problem with this is that much of the banks’ capital is made up of similar assets, so after a firesale they too have to be revalued down and that too ends up shrinking core capital. The banks are really caught between a rock and a hard place.
MSW: And they aren’t coming clean very fast, are they?
JF: The thing with the banking world is that it is forever finding ways to not tell you the whole story. UBS said after its third-quarter announcement of losses that the chances of another loss of the same magnitude in the fourth quarter were very small. In one way that was true – it actually announced a loss three times bigger. I don’t think the banks have even begun to show us the size of the damage: note that the only banks who have ’fessed up so far are the ones that can also announce a capital injection, which tells us nothing good.
Sandy Weill, when he was talking about Citigroup results, said it had done really well to find some funding given that there are 19 other large financial institutions in the States out there that also need capital. That’s him, as an insider, telling us that the big banks are undercapitalised.
JM: I think a lot of the UK’s big banks are going to have to raise more capital too.
PE: The most worrying thing is that the banks don’t trust each other. They won’t lend money to each other and they won’t deposit money with each other, but they haven’t declared any meaningful amounts of losses yet. Most of them have come clean about small amounts, but obviously each bank has a better idea of what the other banks are doing than we do. And they won’t lend to each other, so there must be something seriously wrong which hasn’t yet come out in the open.
JF: In Japan, once the banks were close to bankruptcy in the 1990s, they just lied. I’m sure it will be the same here. You learn fast that you can’t go by what they say. You have to look at their actions. In the end, the banks in Japan distrusted each other so much that they all ended up borrowing from and lending to only the government – they just bought bonds. Any consumers who wanted a loan had to pay 30% to a doorstop lender.
MSW: So what is the safest bank in the UK, James?
JF: Probably Lloyds.
MSW: Patrick, there must be something in the market you would buy?
PE: I have got a record amount of liquidity in my own fund, but one of the things I am buying – for the fund and for myself – is Alpha Pyrenees (ALPH). It is a UK-listed property company investing in mainly French property around Paris, where there are yields of over 7% (in France rents go up in line with building costs every year, so the rents should keep going up). The shares are currently off a good bit and yield 9%, so I’m taking advantage of all these credit crunches to lock into a high-yielding security with a rising income.
MSW: Are you still keen on German property, Jim?
JM: The German property company I’m involved with, Speymill Deutsch, is up 5.5 times since we launched it two years ago, so that’s not bad. I do think you will see a gradual rise in property prices in the next few years. I was in Berlin in December and there does seem to be some positive momentum. The German banks don’t have huge subprime-related problems, and they are both lending and taking market-share back from the foreign banks. The yields are very attractive and I’m buying as much as I can afford in German property companies.
One I like is Estavis (E7S.DE) – listed in Germany. The stock has fallen a lot recently and the firm has now got almost as much cash on its balance sheet – with no debt – as its market capitalisation. The market cap is about e90 million and the firm will make e22 million profit this year with a dividend yield of well over 11%. Basically, the firm buys property and sells it on. It buys buildings and sub-divides them and sells them on to individuals. And it assembles portfolios to sell to foreign buyers – and thereis still a lot of foreign buying in Germany and a lot of competition. We are trying to invest a billion eurosin the German residential market, and it’s very hard to do.
MSW: Any other tips?
JM: A UK online money-transfer company called Neteller (NLR), which has fallen from a peak of about 900p to about 55p. Its founders fell foul of the law and ended up prison. But the new management has developed the business in Asia and the UK and the firm now has about 100,000 active clients. Its market cap is about £65 million and it’s got £50 million of cash. I think transaction numbers are growing by about 15% to 20% a year, depending on the area.
And in the online gaming area, which is still growing despite the US strong line on it, the firm has got a very strong position – it is the dominant provider. I also think the US will open up to internet gambling again in the next two or three years. And if that happens, then companies such as Neteller will do really well.
MSW: James, any specific tips?
JF: It’s going to be a tough year, but I do still think there is a reasonable floor under equities that have strong balance sheets, high dividend yields, good franchises, and so on. So where would my money go now? Japanese REITs (real-estate investment trusts). This is a similar story to Germany in that property prices are far from bubble levels and yields are high. The REITs are mainly trading around their net asset values and yields for the sector are about 4% (although you can get 7%, even 8% yields).
In a country where government bond yields are 1.5% and the REITs’ own short-term funding costs them less than 1% and long term funding something in the 1.5% to 2% range, that’s pretty good. My personal favourite for quality of portfolio is a trust called Nippon Commercial, (3229). Its yield is about 5%, which is not as good as some of the residential REITs, but it has a central Tokyo location. Some of the land prices in its area are going up 20%, 30%, even 40%.
JM: 5%? That’s the dividend yield you are talking about?
JF: That’s the dividend yield.
JM: Wow!
JF: I also think there is a good chance the yen will go up against the pound.
PE: Or sterling will go down. With a record trade deficit, the economy in serious trouble and interest rates likely to fall, it can’t not. You need to be holding other currencies.
MSW: Marina, small caps have been having a tough time. Anything you would still buy?
MB: Yes. Perhaps Immunodiagnostic (IDH), which produces bio-markers testing for things such as bone-density loss. It is well run and a good organic growth story. Also CVS (CVSG), a leading vet operator in the UK. A lot of the owner-operators in this market are reaching retirement age and finding that their children don’t want to take their businesses on. CVS is using this as an opportunity to consolidate the veterinary market. It can get in at attractive prices and the underlying market is strong. More people have pets – more people live alone than ever before, and pets offer company – and it is a market that is quite protected: you are not going to let your cat die just because the economy has turned down.
PE: One of my other favourite companies is Bioquell (BQE), which for several years has been developing a new method of cleaning out superbugs from hospitals. You clear out the patients, you clear out the bedding, but you leave everything else in. Then you puff dry hydrogen peroxide into the ward. Twelve hours later you take it out again, you clean it out and you put the patients and the bedding back. This is almost 100% effective. The problem in the past has been that it is not the cheapest method, so it hadn’t been a favourite with the hospital trusts.
However, now all the cheaper methods have been proven to be completely ineffective and MRSA has been spreading and getting worse, so the cost isn’t looking such a big deal now. About six weeks ago the NHS gave Bioquell’s method a Category One rating – meaning that it is a favoured method. I think it will grow very rapidly from now on. It’s also working on trials for treating leg ulcers. These are quite a killer and there is no known method of dealing with them at the moment.
MSW: This presumably doesn’t involve spraying hydrogen peroxide on them?
PE: It is a bit similar, but no not quite. It’s been highly successful in all the trials it’s been put through so far and now it’s going into double blind trials. If these are successful then the treatment could earn the company an absolute fortune. Bioquell has also been doing deals with the Department of Defence in America for putting filters into armoured vehicles to clean up air contaminated from bacteriological or nuclear warfare, and that could also be very profitable.
The firm also does testing for telephone systems and critical parts in aircraft. It’s got about five or six different parts to it and all of them are suddenly beginning to come right. So I think that’s a company that ought to do well over the next couple of years, regardless of the gloom elsewhere.
Roundtable tips 2008
Immunodiagnostic (IDH)
CVS (CVSG)
Bioquell (BQE)
Nippon Commercial (3229)
Estavis (E7S.DE)
Neteller (NLR)
Alpha Pyrenees (ALPH)
How our 2007 experts’ tips fared
This time last year we said that one of the better strategies for 2007 might simply be to buy all the Roundtable tips from that issue and be done with it. As it turns out, that wouldn’t have been a bad thing to do – as long as you had bought them all. Overall, the shares in the portfolio rose 7.57% while the FTSE 100 managed only 3.8%.
However, within that figure came notable successes and failures. David Fuller suggested Rio Tinto and Toshiba, which went on to rise 112% and 13.13% over the next 12 months, while Marina Bond did well with Renew (up 25.85%), as did Andrew Jackson with Dolphin Capital Investors (up 26.38%), Steve Russell with Unilever (33%) and Andrew Green with Carphone Warehouse (10.59%).
On the downside, Sebastian Lyon’s bet on German property prices with Puma Brandenburg did not work out (down 29%), nor did Jim Mellon’s hopes for Melco PBL Entertainment (down 43.31%).
On the face of it, Mellon’s other tip, Billing Services, didn’t do that well either (–30%). But that doesn’t take account of the fact that the shares were tipped at 26p and have paid out a special dividend of 20p since (as Jim predicted they would). They now trade at 18.12p, so rather than losing money investors have in fact made 46% (12.12p) on the shares. Add this in to the calculation and our 2007 Roundtable portfolio actually looks pretty good – up 14.5% on average.
I wish I knew what an SIV was, but I’m too embarrassed to ask
Structured investment vehicles (or SIVs) are usually created by investment banks to raise “off-balance-sheet finance” – raising capital without having to record an obligation to repay it.
Say a bank’s retail arm issues $100m of mortgages; the investment banking arm could then create and sell $100m of IOUs called “mortgage backed securities (MBS)” to an SIV for cash. The SIV in turn sells $100m of its own IOUs to other investors, often as short-term “commercial paper (CP)”.
The SIV aims to get more interest from the MBS than it pays out. An SIV’s ability to keep selling CP depends on lenders having confidence in the MBS held by the SIV. Otherwise funding may need to be sought from the original bank.
Our panel:
Patrick Evershed
Manager of New Star Select Opportunities Fund
Marina Bond
Fund manager of Rathbone Smaller Companies Fund
Jim Mellon
Chairman, Regent Pacific
James Ferguson
Economist and stockbroker with Pali International