John Stepek: Political risk has reared its head again. Is anyone worried about Ukraine?
Garry White: No. This will fizzle out in a few months unless Putin goes for Moldova or starts playing a grand game of risk. But it’s not in his interest to escalate the conflict. The one thing that will hit the Russian economy is a fall in the oil price and I don’t see that happening. Of course, there’s always a risk in investing in Russia, and it trades at a discount to reflect that.
John: It’s so cheap – can it get any worse?
Killian Connolly: Swathes of strategists are saying buy Russia, but last June the broad Russian market was actually lower than it is now. I agree that it’s a buy, on a five times price/earnings (p/e) ratio.
But it’s not as low as when there was no war and no political upheaval on Russia’s doorstep – yet no one was picking up on it then.
James Davidson: Exactly – where are the equity vigilantes?
Killian: To people who say ‘I wouldn’t invest in Russia’, I ask – ‘at what price would you?’. We can have these polemics about the state of Russia or China, but you’ve always got to ask – what price is cheap enough for you to discount these risks?
For me, five times in Russia looks good. It could be a value trap, but why couldn’t banks grow earnings from here?
James: Population shrinking? People queuing up to leave, getting poorer?
Robert Jukes: What’s really interesting with emerging markets, not just Russia and China, is that we saw the equity risk premium shrinking (ie, people were willing to pay more for stocks) and quantitative easing (QE) driving money into these markets on this great yield hunt.
But it stopped a couple of years ago, along with the commodity bull market. The equity risk premium had simply contracted too far.
There’s always political risk out there – we just got too complacent. Now the nature of global growth has changed. Developed market growth is weak and unlikely to recover to anything close to the pre-credit crunch trend. So emerging-market growth has to change too.
It was dependent on demand from developed markets and now there’s overcapacity in many of those industries. This is only now starting to be recognised in prices and earnings multiples. As for Russia, I think it could be a big mistake to go in now when who knows what’s going to happen? I mean, Putin’s mad.
James: What drove emerging markets was that 400 million Chinese people left the farm and went to the city and everybody else got dragged along for the ride.
Russia supplied the oil, Brazil the iron ore and everybody else had a credit boom. Then China ran out of people and decided to keep more of the winnings for itself, the growth rate went from 12% a year to 7% or 6% or whatever, and everybody else had a hard landing.
During the boom, you had a rush of money into these markets, which perhaps led local policymakers to believe they were doing something right. In fact, it was just printed money finding a new home. That resulted in a lot of over-investment, which we’re now living with.
What I’d like to see is activist investors in emerging markets – you won’t get a break-up or a change of management or a takeover in emerging markets, as you will in the US, the UK and Europe. That’s my concern – governance.
Killian: So if five times earnings isn’t a good enough discount to compensate you for that, what is?
James: I remember doing my economics A-Level. The first thing you were taught was that a stock market is a market for corporate control. So unless somebody can come in at an AGM, kick out the management, take over the company and get the cash out, it’s a problem.
Dividends on Russian stocks are hard to forecast too, which is a problem for income investors. Equity investing is all about getting cash out or owning the company. And I don’t think you get that in Russia.
Killian: You got all that from your A-Level? That’s amazing.
Robert: I didn’t go to the right school.
John: How do you see this playing out for emerging markets then?
Robert: I don’t think it’s a quick fix. The US is recovering – it’s probably the best of a bad bunch – and the UK’s been getting good press. But no developed economy is going to shoot the lights out. We’re all going to limp along at trend or just below.
That has an impact on these demand-driven export-led emerging economies. They need to embrace domestic demand in a way they haven’t before. Japan never really made that transition. There’s an assumption that China will, but I’m not convinced.
I think lower growth is a big problem. Investments that were viable at 10% growth are probably no longer viable at 7% or lower. Meanwhile, the Chinese state is trying to shrink the shadow banking system. But the correlation between the Chinese stock market and shadow banking sector growth is one for one – it’s extraordinary.
So I’m really not sure that China will have a soft landing. If you’re not growing at trend, you’re not creating jobs. If China stops producing jobs, who knows what will happen?
John: But if you’re not investing directly in China, do you need to worry?
Robert: A recent Manufacturing Advisory Service survey found that a quarter of British manufacturers are on-shoring – bringing production back from China to the UK. Roughly 20% were doing so for cost reasons, while another 20% are doing it for quality control or supply time reasons. So I don’t think it’ll matter as much as people might think.
The global economy never became that synchronous. If China were to slow down while we’re recovering – fine. It’s going to be a hard recovery anyway.
James: And remember that while these overeducated Western intellectuals were queuing up to pour money into emerging markets, people living in emerging markets were queuing up to come here and wait tables. If the story was so great, you’d stay put and live the dream.
Killian: But in the last three years emerging markets have vastly underperformed developed ones. Is that not played out now? China trades at ten times earnings. As a value investor, that means you buy. If you have a problem with credit creation and banking pressures, you probably shouldn’t get involved, but if that’s the case, you also wouldn’t have got involved during the late 1970s US equity market.
But while you waited for a crash, the market corrected by 30%, then took off in the 1980s. So you always need to look at valuations.
There’s a reason Britain became the top economy in the 18th century. Yes, it had one of the planet’s biggest internal economies and the British Empire to source goods from. But it became pre-eminent, because it had one of the biggest populations.
Similarly, there are a billion people in China and its policies aren’t that different to ours. Its elections are more contrived, but not hugely. When did a common person last become leader of the UK?
John: Are you buying China then?
Killian: Not yet, but we are looking – at ten times, it jumps on to your screens.
John: So no ‘Minsky moment’ for China?
Killian: If there’s going to be a Lehman Brothers-style event, it’s the most forecasted financial disaster in history. When the Creditanstalt bank in Vienna blew up in 1929, it wasn’t mainstream, it wasn’t being debated by investors. But everyone’s looking at China today.
James: Are any of these companies on five or ten times earnings buying their own shares back though? If it’s such a good idea, shouldn’t they take the lead?
Killian: But US firms don’t buy their shares when they’re cheap and sell when they’re overvalued either. Ultimately Chinese entrepreneurs are similar to ours – they’re trying to grow earnings. There are bad firms in the US and China. But if you could find a manager who can tell the difference, it might be a good investment.
John: So what about developed markets? The US looks quite frothy.
James: We’ve all seen the chart that shows that for all the talk of stock-picking, the market moves with the level of the Fed’s balance sheet. That stops being added to in a few months’ time.
Robert: Yes, the end of quantitative easing has got to be a big headwind. But QE has been rubbish. Absolute rubbish. It hasn’t addressed the economy’s demand problems. All it’s done is trigger asset price inflation – whoopee – but for the wrong people.
I am not a socialist, but the money has gone to consumers with a low propensity to consume – in other words, wealthy ones with big houses. It did succeed in putting a floor under really volatile markets, but it’s had its day and now we need to move on. Now we need to build infrastructure. We need the Keynesian spending boom.
Killian: But the US already runs huge deficits. How much more do you want?
Robert: The deficit doesn’t matter. Bonds have had their best and worst periods through the twin deficit. Equities have had their best and their worst periods through the twin deficit period. Why worry about it? Let’s just carry on.
James: We have a lovely time spending and emerging markets do the work.
John: Where are you investing just now?
James: I think on the deficit arguments that it’s all been about bailing out voters and consumers. I don’t think the banks were bailed out, so much as individuals. You saw US retail sales quickly rise above their previous peaks, and the same here too. I’m wondering if the same will happen in Europe – so I’m looking for stocks with exposure to consumer discretionary spending.
Broadcaster BSkyB (LSE: BSY) has always grown its dividend by 15%-20% a year. It yields about 3.5% and there is a potential merger scenario at the end of the road. Sales grew last year by 7% year-on-year.
I like TUI (LSE: TT) as well. That’s obviously about European consumers taking more holidays, and you’ve also got the funny corporate set-up with TUI and TUI AG, which at some point, although it was denied yesterday, will lead to one joined up, happy family.
My third pick is a stock I don’t actually own – hotel manager Accor (Paris: AC). The argument here is that US hotel room rates are currently 15% above peak, and in Europe they’re 15% below. That’s it.
John: Do you think Europe’s recovering?
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Killian: Speaking as an Irishman – it used to be that you’d get into trouble and you’d default. Then the IMF would give you plenty of money and you’d tidy yourself up: like going through a car wash – you’re all spanking new and everyone wants to get into your car.
Now everyone says: “Ireland’s obviously out of it”. Well, it’s not. Debt is still near 150% of income. It could export its way out, but the global growth’s not going to be there for that.
James: You’ve still got the low corporate tax rate.
Killian: I’d worry about what the politicians promised Europe to keep that.
Robert: So why haven’t we had the debt write-offs in Ireland yet?
Killian: The hope is that, as politicians are behind the policy, we just eventually grow our way out. But I’m not sure.
John: Obviously stocks have bounced back a lot in Europe.
Robert: It’s phenomenal – Spain especially. Particularly when you think about what it’s got to go through this year – there’s going to be a proper banking stress test. And if you look at the peak-to-trough fall in property prices in Spain, and compare that to the US, then the number of mortgage write-offs compared to the US is fractional.
So there’s some value discovery to be done on the Spanish banking system. Some banks you’ve never heard of and some you have will go pop. We’ve still got to go through that this year.
John: Might we return to a point where everyone fears the collapse of the euro, or are we past that now?
Robert: It’s gone through some pretty tough shocks, so I think the idea they’d capitulate now would be disappointing.
Killian: But the European elections will engender some kind of realisation that the Greeks are not happy.
John: What about the UK’s political situation? We’ve got Ukip and the European elections, and then there’s Scottish independence.
Garry: It’s not going to happen. It’s just about getting it off the agenda for the next 15 years.
Killian: But is this what debt does to nation states? Venice wants out, Catalonia wants out, Scotland…
Garry: It’s not relevant and you shouldn’t base any investment decisions on it.
Robert: If you were to split out Scottish stocks from the FTSE – let’s call it the SCOTSE – and compare them against what’s left of the FTSE, from the start of this year, their performance is the same. That’s even though the debate has been really heating up recently.
There are certainly some large political and economic risks – and yet the market’s reaction is saying that the chances of those risks actually materialising are small. Ultimately, there are returns to scale when it comes to the UK and it’d be a crying shame to break that up.
John: What about the recent Budget? Any thoughts on the changes to pensions and Individual Savings Accounts (Isas)?
Garry: The Budget usually isn’t that interesting to the City – but this year it was. Some of the share price reactions seemed to assume the annuity business will disappear altogether. But that’s not going to happen – if you’re retiring and you think you’ll live until 100 and your granny lived until 108, then an annuity is a pretty good idea.
Of course, if, like me, you’re an unfit smoker, then maybe buying a Lamborghini and putting it all in buy-to-let isn’t a bad idea. But I don’t think their business is going to vanish.
John: Is it purely cynicism ahead of the election? Because the chancellor didn’t exactly fix the public finances, did he?
Killian: No, but you’re wasting your time waiting for either Labour or the Conservatives to tackle the debt problem. I mean how can you solve a debt problem of this magnitude, except by inflation?
John: Shall we go back to tips? Robert, what have you got?
Robert: I like your point about the consumer, James, but for different reasons. I think the way out of austerity for the consumer is wage increases.
Killian: I tried to get a wage increase recently. It’s not that easy.
Garry: We have to inflate our way out of the debt, it’s the only way to get out of it – wages have got to keep up.
Robert: Exactly – consumers need wage inflation to fix their balance sheets. Until now, wages have been kept below inflation, but they’re going to start rising above it as a matter of policy. We’ve already seen several references to raising the minimum wage in the UK and the US. But this gives firms an earnings problem.
In most developed markets, the share of company profits to GDP is at an all-time high. In layman’s terms, it doesn’t get better than this. So we’ve already got an earnings squeeze due to weak growth, and now firms will have to start paying higher wages too. So while I think consumer-facing stocks might be the best of a bad bunch, I’m also interested in alternative growth plays, such as infrastructure.
I tipped International Public Partnerships (LSE: INPP) and HICL (LSE: HICL) last time I was here, and I’m going to stick to my guns, because they’ve done phenomenally well and will carry on doing so. The government’s way out of austerity is public-private partnerships and infrastructure spending.
But back to the corporate profit share squeeze. If that transpires, more companies will look for consolidation opportunities to manage cost and drive earnings growth – and that’s likely to mean more mergers and acquisitions (M&A). We saw lots of M&A last year, and I think this year’s going to be the same. So mid to small cap is where you want to be, not large cap.
John: So buy a FTSE 250 tracker, such as iShares FTSE 250 (LSE: MIDD)?
Robert: Brilliant. As for emerging markets’ problems, and the resulting resource squeeze, you could play it via a currency trade – long the US dollar, short the Canadian dollar (which is a commodity currency).
Killian: That’s not the most racy. I was expecting the Philippine peso versus the Taiwanese dollar.
Robert: That’s fine for hedge funds and high-frequency investors with short attention spans, but longer-term investors need something that isn’t too volatile, and that has a strong fundamental story with longevity.
The Canadian dollar has already given up around 10% in the last six months, and that will carry on while we grapple with this resource oversupply, and global growth settles onto a slower sustainable path than we’re used to.
Killian: We’ve got an infrastructure play too, but it’s on infrastructure in the Gulf States – the GCP Sovereign infrastructure (LSE: GULF). It has a structure similar to a private finance initiative (PFI) in the UK.
Corporations get inflation-linked revenue from building a desalination plant or other infrastructure. This vehicle itself is offering you the highest of 7%, or Libor (a benchmark interest rate used by banks), plus 6.5%. It resets every three months.
You’ve got credit risk, but the project company is getting contractual payments from local authorities, be it Saudi Arabian water companies or whatever. These authorities carry the same credit risk as Saudi Arabia and Bahrain and UAE themselves, and by any objective measurement these nations are wealthy.
My next pick is Gazprom (LSE: OGZD), on a price-to-earnings ratio of around two to three, with a 5% yield. Russia joins Euroclear in July, which will make Russian equities more accessible, so we expect some inflow from that. Also, legislation in early 2013 said that state-owned enterprises in Russia have by law to pay 25% of net profit in dividends, so there have been incremental improvements in corporate governance.
My final suggestion is Fresnillo (LSE: FRES). It’s a silver and gold miner with a really robust balance sheet and a 4% dividend. Its production costs are among the cheapest around. And right now silver looks cheap compared to gold.
Garry: Going back to infrastructure funds, I’velong been a fan of HICL, and its latest acquisition is interesting. It’s bought a 6% stake in a desalination project in Victoria in Australia. Water security is a fascinating theme over the next ten years and there are few ways to buy into it in the UK market.
I also like Greenko (Aim: GKO), which is building wind farms and hydroelectric power in India. India is structurally short of power, and it’s very windy and wet in the monsoon season. Greenko has increased its capacity by 74% over the last year and a half and it’s going to grow it by another 20%-30% before the next monsoon season. It’s an Aim stock, so it’s risky, but it’s building infrastructure in an interesting place.
My third pick is based on a theme I’ve been harping on about for years – diamonds. There is a worldwide shortage of diamonds. No major mines have been found since the 1980s, while the market for diamonds is taking off in China and India.
Petra Diamonds (Aim: PDL) produced 2.7 million carats last year. It plans to do five million by 2019 – almost double. It has five mines in South Africa and one in Tanzania, and it’s going to expand using its own cash flows – rather than raising equity or borrowing more money – which I think is compelling.