What next for Japan and America? Which stocks should investors bag in 2013? John Stepek talks to our Roundtable panel of experts to find out what they’re buying now.
John Stepek: Does Japan’s new government finally mark the turning point for the country?
Jim Mellon: Yes. The government is determined to inflate, and dividend yields are 2.6 times the level of ten-year government bonds. Every time that’s happened, the market has had a big run. We could see 50% upside on the stockmarket. Meanwhile, the yen will depreciate to maybe 90 against the US dollar. The Japanese yen is way overvalued on any measure.
Steve Russell: We had a false dawn at the start of 2012 when the Bank of Japan (BoJ) accepted a 1% inflation target. It was by far the best-performing major market for the first quarter, but gave it all away in the second. So I am not jumping up and down yet. But with the target rising to 2%, and a changing of the guard at the BoJ in April, the landslide victory of Japan’s new prime minister, Shinzo Abe, could give real power to any bull run. Even at 0% real [inflation-adjusted] GDP growth and 2% inflation, you get 2% nominal GDP growth. That gives huge operational gearing to Japanese firms. So it’s the place to be.
Max King: I am positive, but growth through money printing and devaluation is always dangerous. Without structural reform, will you really make great long-term returns in Japan? A lot of companies still don’t generate the returns on capital you would expect. Japan doesn’t tend to have management incentives; companies are not particularly well run; and Japan, even more than Britain, is dominated by dinosaurs – companies that were once great, but have been in decline for a long time. So you need to pick the right stocks.
James Ferguson: There is another area, beyond the yen, that offers a lot of potential – the banks. During the financial crisis something very interesting happened. Bank lending fell, but for the very first time, losses in the Japanese banking system didn’t rise. So it would appear that, maybe 20 years on, Japan’s banks have finally dealt with all their hidden losses. If that’s the case, lending could pick up. That in turn could see land prices – which are back to 1971 levels – recover. And that would lift all boats.
Our Roundtable panel
Chairman, Burnbrae Limited
Portfolio manager, Investec Asset Management
Investment director, Ruffer LLP
Director of investment, PFP Wealth Management
Steve: The big banks also began paying corporation tax this year for the first time since – well, since James was there. So not only are they making some profits, but they’ve also used up their many billions of deferred losses [to reduce past corporation tax bills]. That could have a big impact. Japan’s government-debt-to-GDP problem is largely a tale of low tax revenue, rather than overspending. So if nominal GDP growth returns, tax revenues could surprise quite dramatically on the upside.
James: Yes, Japan still has a very low retirement age, given how long everyone lives, and very low sales tax. So it could drum up a decent amount of tax if you could get some growth. But if you buy Japan, don’t hedge the currency. That’s what protects you. If the bull case doesn’t work out, the yen will strengthen, so even if you don’t make your money in stocks, you’ll make some back via the currency.
Jim: On another point, everyone argues that Japan’s demographics are a negative. But in a world of rapidly increasing automation, Japan might be better placed than many emerging markets, where large swathes of the population are under 25, but have nothing to do but cause unrest. In an age of driverless cars, additive manufacturing and other new technologies, an older population may be a good thing.
John: If technology means fewer jobs, what does that mean for investors?
James: Machines can replace humans doing dull, repetitive tasks, but they can’t necessarily do so when it comes to writing the manual on a new, complicated product, or sorting out legal issues around patent ownership. The real problem is that there will be fewer low-paid jobs. The solution Britain pursued was to educate people more – but we didn’t actually do that, we just gave them all a degree.
Max: There are fewer full-time, long-term jobs around. But technology is also making it much easier to be self-employed, or to have multiple jobs. I see a tremendous outbreak, particularly in Britain, of entrepreneurialism and self-employment among the next generation.
Jim: Yes, but maybe 50%-plus of the global population, particularly in emerging markets, won’t have jobs. That’s going to be a big social and geopolitical problem. And it’s all very well to say that people are getting multiple jobs, but workers in McDonald’s have to be on call – they don’t have a specific shift, they are called in to meet peak demand.
Max: Extracting tax will certainly become harder. It is much easier to get tax from people with full-time, permanent jobs than from those who are casually employed.
John: Does anyone worry that broke governments will target companies for more tax?
Max: Long-term tax rates will go up. But governments will still have problems plugging leaks in the system. While they will get more tax out of some people, they will lose it elsewhere. They are unlikely to raise more tax overall.
Steve: You’ll also see moves that are effectively tax hikes – like utilities being told they can’t raise prices. So some areas will be hit much harder than others: what seems to be a sound business can suddenly have the rug pulled from under its feet.
Max: It’s something to be aware of when you look at stocks – how vulnerable is this company to an effective tax increase, or licence fees, or anything else? It’s another reason to be wary of dinosaur stocks – the likes of BP, Shell, Aviva, Vodafone, GlaxoSmithKline and AstraZeneca. They look cheap, they’ve got great dividends, but they are dying. You have to find the new, growing companies.
Tim Price: That makes life difficult for income-hungry small investors – at least those businesses are providing dividends.
Max: Dividend growth is the key. A British stock with a 2.5% or 3% dividend yield, growing at 10% a year, is much more attractive than a high-yield stock on 6% that is going nowhere.
John: The other big issue is the bond bubble – when will it burst?
Max: The best argument I’ve seen against bonds is not that the bubble is going to burst – it’s that there’s no upside. With yields in Britain at 1.5%, is there any scenario under which you would get a double-digit return out of government bonds? No.
Tim: Outright deflation in the West.
Max: Well, OK, if prices fell in the West, yes, it’s possible.
Tim: That’s not necessarily my medium-term outlook. But we keep coming back to Japan. Shorting Japanese government bonds (JGBs) has been the ‘widow-maker’ trade for the duration of my career. My deepest concern is that Western economies are turning into Japan. Central banks are going into uncharted territory to massage government bond yields lower. So perhaps next year’s surprise is that the bond bubble ought to explode, but in fact it does not.
Jim: But Japan essentially has a domestic bond market. Almost all the others are highly internationalised. So you can’t just say that deflation equals much lower bond yields, because you will have all sorts of cross currents associated with central-bank activity. Overall, I agree that there is no upside in bonds – so why bother?
James: Bear in mind also that bonds in America now show proper downside risk. Quantitative easing (QE) was an unconventional monetary policy, designed artificially to prop up the broad money supply at a time when American banks were destroying money [by cutting lending]. But US banks are no longer destroying money.
So while previous bouts of QE merely neutralised the threat of deflation, this incarnation of QE could actually be inflationary. The fact is, the American economy is on its way back. It’s vulnerable and weakened, but it’s also heading back to a ‘normal’ structure again. You can’t say that about Britain or Europe. That’s why I think that from here the dollar looks like an unstoppable force.
John: Won’t the Fed try to weaken it, through even more QE?
James: The trouble is that if the Fed does that, it could generate a lot of domestic inflationary pressure, so it may not have the leeway it thinks it has. I believe the Fed will think: “Hey, a little bit of inflation after four or five years of deflation won’t do anyone any harm.” But a year later it will go: “Oh, actually it is doing us quite a lot of harm.”
John: How long will it take to show up?
James: The trouble is, by the time inflation appears, it’s too late to reverse it unless you are willing to accept at least a year of pain. My suspicion is that the Americans will realise that they have been overcooking it at some stage in 2013, but by then the bond market will be way ahead of them.
Steve: I’m not so optimistic on America – it still has a lot to do to get rid of the debt. But I do think that positive growth surprises in the US could start to have the perverse effect of being bad news, because everyone is worried about exactly this –the bond market backing up.
Max: I agree with James. I think that US monetary policy is too weak, fiscal policy is too loose and there is a risk that, as the economy gathers pace, we will head into the next boom-and-bust cycle. But I think it will go on printing money until it’s too late. The dollar bulls might have to be patient for another year.
James: I’m giving the authorities more credit than you are – and I’m sure on that basis alone you are right. But I’m also thinking about factors such as shale oil and shale gas, and ‘reshoring’ [moving manufacturing production back to the US from overseas]. Put that in the mix, and it really could spell an upsurge for the dollar.
Tim: But the dollar compared to what? Global leviathan currencies, such as sterling and the euro?
James: Countries that have done QE have seen their currencies drop in value because they’ve been diluted. But their stockmarkets have risen. So the US stockmarket is now pretty much where it was before the crisis hit. Europe is somewhere in the middle. Britain is a bit higher than pre-crisis. Japan is right back at the bottom.
But if you measure them all in US dollars, they almost all turn up. In other words, your policy response determines how people will make money in your particular economic scenario. So when the US dollar starts to rise, we can expect the S&P 500 to fall.
In Japan, if the currency weakens, as we all expect, you’ll get your money via the rising stockmarket. In Europe, the banks are going to start reining in lending, so I think the authorities will have to do QE. While that would be very negative for the euro, it is quite positive for euro-based stocks.
Jim: The obvious short against the US dollar is the Australian dollar. The mining boom has peaked and miners have taken on lots of debt. The yen is an obvious short too, and the euro is at the top of its range: in the last year you’d have made good money selling the euro near $1.30, then reversing the trade at $1.20. But on the US booming, I think it’s unlikely. The government is still shrinking. Manufacturing and export sectors aren’t really growing. The only bright spot is housing, which is a relatively small part of the economy and it’s hardly booming – and there is still a big inventory hangover.
James: The US boom will be relative not absolute. America supports a trade deficit in only two areas: China (manufactured goods) and energy (oil). So if the oil deficit falls as more shale oil is produced domestically, and the deficit with China falls as more goods are manufactured in the US, then the overall trade deficit could start to look better.
Meanwhile, housing is picking up – yes, it’s a small part of the economy, but it has lots of knock-on effects. Banking may not be a great growth story, but it’s no longer a drag. So I think the US economy will be interesting. But for the reasons I said earlier, that doesn’t mean the S&P 500 will rise.
John: Let’s move on to share tips. Most of you did very well last year. What have you got this year?
Our Roundtable tips
Investment Ticker Synergy US: SGYP Pacira US: PCRX Webis Aim: WEB Secure Trst LSE: STB Travis Prks LSE: TPK Cranswick LSE: CWK Sumitomo JP: 8316 Citigroup NYSE: C Bnk of Am. NYSE: BAC Reed Elsev. LSE: REL Schroders LSE: SDR Prudential LSE: PRU IAG LSE: IAG BG Japan LSE: BGFD Russian Prosperity Fund Newscape Strategic Bond Fund Blue Trend LSE: BBTS Vodafone LSE: VOD Apple US: AAPL Centrica LSE: CNA
Jim: I recommended three pharma companies last year – Pfizer, Astellas and Roche – and I favoured biotech as a sector. Dividend stocks have probably had the best of their run partly because of US taxes on dividends going up, and also because, if bond yields start rising, they will become relatively less attractive.
But I still think biopharma is the most interesting sector in the world. US healthcare spending, at 18% of GDP, is out of control. Almost all of that goes on hospitalisation: half of many people’s total lifetime spending on healthcare is during the last three months of their life. You go to a US hospital and it’ll cost you $4,000 a night – it’s the most expensive hotel you will ever stay in.
Drugs keep people out of hospital, so while America has high drug costs, which will undoubtedly come under pressure, firms can still maintain relatively good pricing because that’s what drives research and development. America is very keen on that, as it’s the world’s dominant producer of drugs.
Then there are emerging markets. Per head, these are tiny consumers of branded drugs for now, but they tend to favour branded drugs because the local equivalent is often counterfeit or not as good.
So two of my recommendations this year are drug related (I have holdings in all of them). One is Synergy (Nasdaq: SGYP). Synergy has plecanatide, a drug for chronic constipation and irritable bowel syndrome, in late Phase III clinical trials. The results are out early next year.
A direct analogue drug has been approved from a firm called Ironwood, but plecanatide has fewer side effects. It’s a binary event – it may or may not be approved – but Synergy’s share price should treble if it is successful.
The second is Pacira (Nasdaq: PCRX). Its revenues are growing fast. It has a non-opioid anaesthetic on the market, with a duration of over 72 hours. Opioids are a big problem when people are hospitalised in the US because post-surgery everyone has one of these drips that administers some form of morphine-based drug. That adds to your stay in hospital, at vast expense.
But this drug is non-opioid, which means you can give it before the operation and it will still be having an effect by the time the post-op pain is dissipating. So it’s an economically sound proposition, yet it’s priced at about five times 2015’s earnings.
My last tip – my father is on the board of this one – is Webis (Aim: WEB), a sports betting firm. It has a turnover of about £150m a year, yet its enterprise value is only £3.7m. It never took any US bets online in the past, which means it’s still able to operate there, unlike many other British firms. It has just bought a racetrack in California, which is what it has to do to apply for an online gaming licence over there. I believe California will be the first state to go for online gambling, and the market for it in America is going to be big.
John: Steve, among others you went for homebuilder Barratt, which has more than doubled, and small bank Secure Trust was another good one.
Steve: I’m still happy with all of them. Secure Trust (LSE: STB) is in a great position – big banks are pulling out of lending and leaving great opportunities for small banks. The share isn’t as cheap anymore, but it’s got a strong long-term future. Barratt has doubled, so you might want to take some profits and roll them into a firm that would profit more from rising building volumes rather than rising prices – such as builders’ merchant Travis Perkins (LSE: TPK).
As for new tips, sausage maker Cranswick (LSE: CWK) has started to appeal. We like the way it’s run, it’s pretty cheap and it’s got an extra kicker; they have been able to negotiate selling the bits of the pig that the Western market doesn’t eat to the Chinese.
Lastly, there’s Japan – if that market is going to move, then the banks will benefit. I’d go for Sumitomo Mitsui Financial Group (JP: 8316). It’s the best of the Japanese banks and it’s yielding 3.6%, even though it pays out hardly any of its earnings as dividends. It could be a fairly volatile ride, but it could be worth it.
John: James, you mentioned Europe earlier – do you think the eurozone will break up?
James: I have no idea. The people who run the euro have paid no attention to anything that anyone else has said at any stage in the entire process, which means it’s very hard to know what they’ll do.
Tim: But the FT made Mario Draghi the man of the year, James!
James: To be fair, given the circumstances, he’s done an outstanding job. In Draghi and Angela Merkel, Europe has the best officers it could have. Two good officers can’t necessarily hold the army together, but they can hold it together longer than most people would have expected. I think that’s what will happen in Europe.
I don’t really think the issue is Greece. The real problem is that Europe is going through its very own banking crisis. European banks are only now ready to start recognising their losses, which means they’ll start destroying money supply by reining in their loans. As a result, Europe will need QE.
Max: I take it you won’t be tipping European or British banks then?
James: I wouldn’t mind owning Standard Chartered, but it’s not cheap enough. But in America? I love them.
John: You did tip Citigroup last time, and it is now up 50%.
James: I stand by Citigroup (NYSE: C) – it could be a multi-bagger. I’m not saying it has no more losses to take, but I am saying that those losses can no longer destroy the bank. Its capital is now bigger than the losses it is likely to take, even before allowing for the fact that it will actually make money over the year to top its capital position up.
John: Any other US banks you like?
James: Bank of America (NYSE: BAC) is also at a decent discount to where it should be. Wells Fargo (NYSE: WFC) and JP Morgan (NYSE: JPM) are OK for the conservative investor, but I don’t think they are cheap enough. I still think Citi is probably the best of the bunch.
Max: The story for stocks is basically the same as a year ago. Avoid the dinosaurs. Cheap and cheerful is out – go for reassuringly expensive. Buy quality stocks with sustainable growth. Look for the ones that meet the criteria, but have been left behind just a little bit.
Publisher Reed Elsevier (LSE: REL) is one. It’s faced challenges translating its business model online, but it’s a good long-term growth story. It’s not cheap, but it’s done quite well and I think it’ll continue to do so. If you think equities will do well, as we do, then buy quality franchise fund managers like Schroders (LSE: SDR) or Prudential (LSE: PRU). If you want a recovery story, I would consider International Consolidated Airlines (LSE: IAG).
If airlines are going to grow, they need to spend money, and they can’t do that unless they make money. So either they make good profits, which means they can finance growth, or they don’t, so they can’t finance growth, and they cut costs instead. Either way it could be an interesting one. Other than that, my contrarian bet is to back Japan via the Baillie Gifford Japan Trust (LSE: BGFD).
Tim: We reckon the cheapest market out there is Russia. We’d play it via the Russian Prosperity Fund (www.prosperitycapital.com), which since its inception in 1996 has returned 2,160%. The average 2013 price/earnings ratio (p/e) for its top ten holdings is just five times. I have not seen that in any other market.
Jim: What about gas price risk?
James: Or corporate governance risk?
Tim: I accept there’s a legion of risks. But a five times p/e is a reasonable buffer. It’s for the long term – I’m not suggesting it’ll be an easy ride. Then on the bond side I’d throw in my cap with everybody who is wary of this market. We’ve started investing into the Newscape Strategic Bond Fund (tel. 020-7024 4810).
It’s a recent launch, but the returns have been decent over the last year and we like the manager. It can go long and short – it’s currently short Japanese bonds – and take currency bets too. The last would be a trend-following fund.
Trend followers have had a disappointing time over the last two years – partly because normal price signals are not being allowed to arise in these rigged markets. BlueCrest Blue Trend (LSE: BBTS) is our preferred option.
It hasn’t had a losing year since launch in 2005, although 2012 may prove the exception (as of mid-December it was down 1.5%). But since this is the toughest market I’ve ever encountered, we’re quite happy to have something that is basically a non-discretionary approach.
John: What about gold?
James: I’m concerned. Gold is the ultimate hedge against fiat currencies being heavily diluted. If the dollar stops being diluted by the Federal Reserve in 2013 it will become the number one, liquid, conservative asset of choice over gold. So while I am neutral on gold just now, if the dollar becomes more attractive, that could be the end of the gold run.
Jim: But gold is still the ultimate insurance. I think we all have to own some. Even if the dollar stops being debased for a while, they will get back to it quickly. That’s the way of governments.
Tim: And it’s only tradition that values gold in dollars. In euros you’ll find it is close to an all-time high.
James: Gold’s bull run has lasted for ten years. I don’t know anyone who might be tempted to buy gold who hasn’t bought it. I think it’s a very crowded trade.
Tim: But some of the 99% of institutional funds that don’t currently own gold could be buyers.
James: I think almost all of them would never buy gold because their mandates wouldn’t allow it.
Tim: Well, then they are stupid.
James: Mandates and stupidity go hand in hand. I’m just saying that gold will work extremely well if there isn’t a viable alternative. My concern, on behalf of gold holders, is that I think the dollar will become a viable alternative in 2013. If it was sterling, it wouldn’t matter – but the dollar is the other big guy in town.
Tim: The Fed was set up in 1913. Since then, the dollar has so far lost 98% of its purchasing power. If that performance is to continue, then gold is a must-have investment as part of a balanced portfolio.
Max: Gold or gold mining?
Tim: A bit of both.
James: The secret is to find a gold miner who has a lot of gold currently coming out of the ground and get them to sell that gold forward.
Max: To lock in their profits you mean?
Jim: The problem, James, is that the gold mining executives are terrified that the price of gold will go to $5,000 an ounce. If they hedge the whole lot at $1,700, they will lose their jobs.
Max: The real problem with gold miners is that the main costs associated with gold are energy-related, so if energy costs go up, so do gold-mining costs. It’s not that easy to control costs. We are sticking with gold, but it is certainly not an easy call.
Steve: Our worry is that, even if bits of the economy, such as America, are starting to pick up, all the debt is still there. If it’s not hidden in banks then it’s sitting with the government. So I find it difficult to get too nervous about gold because we still haven’t started the process of getting rid of government debt.
Max: Shall we have a dog stock of the year too? My short would be Vodafone (LSE: VOD). It’ll go the way of Nokia.
Jim: What about Apple (Nasdaq: AAPL)? Its margins are 45%, yet others in the sector make the same stuff on nearer 2%-3%. It’s ludicrously expensive.
Tim: I would sell short any French bank.
Steve: I thought my short would be a utility – there’s the risk the government will just stop them from raising prices. And they’re extra vulnerable if they’ve been bid up on the basis that they are high-yield defensives. I’d go for Centrica (LSE: CNA). As far as I can see it’s a good company, but it gets it in the neck every time it passes on any price rise.
John: Thanks everyone.