The future is utterly unpredictable. Every year the world's financial experts have a go at forecasting it and almost every year they are mostly wrong. However, we have more faith in the predictive skills of the MoneyWeek experts than we have in most. Last year, they told us fine wines, Canada, soft commodities, "virtual land" bought on websites such as Second Life, a selection of Japanese tech stocks and water stocks would be the best places for our money in 2006. This turned out to be pretty good advice: even the worst of the suggestions the tech stock selection was up nearly 10% on the year.
So what do our crystal-ball gazers say now? Sven suggests buying into the Russian consumer boom; Dan's placing his bets on the energy sector hooking up with private equity to make fortunes all round; and Peter Warburton tips the German market as being one of 2007's best buys. Closer to home James, Tim and Paul all expect market corrections, but offer different strategies for dealing with them.
Bet on the rise of Russia's consumer
Love them or hate them, the Russians are on the way up, says Sven Lorenz. Growth may be stalling in Europe and the US, and struggling to come through in Japan, but in Russia the sheer scope and speed of developments leaves visitors in awe. The Russian economy is growing for a ninth consecutive year, with annual growth for 2006 standing at above 7%. The country's foreign currency reserves of around $250bn now comfortably exceed those of the entire EU (only nine years after Russia's bankruptcy in 1998).
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So far, oil, gas and other commodities have been the main themes for investors considering placing a bet on the former (and potentially, future) superpower. However, valuations in this part of the market have already risen to a level where future potential is fairly limited, so to make money we will need to look elsewhere in 2007. Where? Perhaps to retailing. Most Westerners still think of Russia's consumer economy in the context of Soviet shortages. But an analysis by Euromonitor reveals something different: with 145 million people and GDP of $5,289 per capita in 2005, Russia is already the world's seventh-largest retail market. Wages have grown by a compound 34% during the 2000-2005 period (from $70 per month to $305), which is why the country's retail turnover is now well above $250bn. Both in absolute terms and in regard to growth rates, Russia has become a market that no retailer can afford to ignore.
Long-term predictions are always difficult to make, but given the average real GDP growth of 6% in Russia together with its ongoing real currency appreciation (driven by the positive impact of the country's virtually unlimited commodity wealth) and its low taxes, it seems entirely feasible that the Russian retail trade will grow at a 19% compound annual growth rate between now and 2010. That's just slightly slower than the 22% compound annual growth rate achieved between 1999 and 2005. There are obvious candidates to invest in to take advantage of this.
Any Moscow tourist will know GUM, the historic Red Square department store that had been among the first listed Russian securities. ADRs (defined on page 44) for it are listed in Berlin and Frankfurt. GUM has a rather secretive major shareholder, but it's no secret that, when compared to the value of its property holdings, the shares are vastly undervalued. There are currently no signs of an impending listing in London, though, were there to be one, GUM shares would almost certainly soar. Just what can happen to an undervalued department store share can be seen by checking on TSUM (Frankfurt/Berlin), one of GUM's major rivals. After its stellar six-fold rise, TSUM could still be a buy, given that it's going to expand its Moscow retail space through a considerable building extension, due to be finished in spring next year. Also, there is ample potential for turning TSUM into a Russian-wide department store chain.
Food is the largest submarket in retail by turnover, and also the least consolidated. Even the biggest food retailer has a market share of just 3%. The market is highly fragmented and further consolidation is virtually certain. One firm likely to benefit is X5 Retail Group NV, a Netherlands-based holding that owns the Pyaterochka and Perekrestok supermarket chains. Created through a merger earlier this year, this is the one firm that deserves to be called the future Wal-Mart of Russia. Its shares are traded in London (ticker symbol "FIVE").
However, some of the most interesting retail-related Russian investments could be yet to emerge on the stockmarket. Russia is a country with ample space for new brands. Anyone who missed out on investing in BodyShop, Starbuck's or Jimmy Choo when they were still small will be given another opportunity in Russia. Consumers there are eager for new, homegrown brands and they have the purchasing power to turn a fledgling new brand into a major business.
London's Aim market, as well as the rejuvenated PlusMarket, will be the most likely platforms for the initial launch of such ventures. I can claim to be both an insider in the matter, and a shameless self-promoter, given that I am myself invested in a Russian retail venture that is bound to float in London next year. You might simply interpret this as a sign that I am putting my money where my mouth is.
Sven Lorenz is a fund manager and investor. His blog is at
Beware the slump, but be ready to buy
We shouldn't just look at what will probably happen in 2007; we should focus on how that differs from market forecasts, says James Ferguson. Shock events have more impact on asset prices than ones which are expected. My surprise'' for 2007 is a slowdown or even recession in the US. That's not bad news in itself: it will sap inflation fears still left over from last summer. Slowing growth is also good for bonds, which is in turn good for equities. Lower interest rates are almost always associated with higher p/e valuations.
The trouble is, equities are happy to use low bond yields as a platform, and to let them rise when the economy is weak (look at 1991, or 1995-96); but they don't like the initial move from high growth to low growth or recession. The problem is not just deteriorating sentiment, but the shift in earnings momentum from positive to negative. Consensus forecasts are for double-digit earnings growth in the US next year. But if the economy flirts with recession, earnings growth is more likely to be negative. That transformation in outlook and strategy, from growth to value, usually knocks the market for six, albeit briefly. In 1990, when housing last tipped the US into a downturn, the S&P fell 20% in three months. But then a ten-year bull market began, based on falling bond yields and eventual earnings recovery. I expect something similar in 2007's first half.
As a result of the slowdown, commodity bull markets will lose support as demand growth eases. Later in 2007, oil and some base metals could even see something of a crash. Rampant commodity inflation has only led to very subdued inflation across the globe, and recent US GDP revisions have sharply cut the rate of unit labour cost growth. So what will inflation look like without commodity inflation? I say it'll drop sharply and deflation will become the new fear next year. This will be great for government bonds, but very bad for anyone who is overly leveraged.
The Fed will cut rates hard, but this is unlikely to help much at first. US mortgage delinquencies, especially at the sub-prime level, are already near double last year's rate. Soon banks will tighten lending criteria. Any rise in unemployment will make things worse, but as the projects now underway in the housing sector are completed we should expect lay-offs. (Who'd start a new project now?)
Rising US unemployment and a sharp $500bn annualised drop in net mortgage equity withdrawal (MEW) to September (equivalent to 3.7% of GDP) will batter US consumption. In the worst-case scenario, the US consumer starts to save again, consumption freezes and a credit crunch (lenders going on strike) ensues. A credit crunch and deflation would be terrible for speculative assets, especially those bought with debt (such as private equity, mortgage-backed securities, small stocks, etc).
But don't let all this doom and gloom put you off. Major market equities are still very cheap compared to bond yields and the latter are falling, which makes equities look even cheaper assuming you can rely on the earnings. Markets will focus on where they believe earnings are reliable and a classic growth to value switch is the most likely scenario. There will be great relative performance in government bonds and blue-chip stocks especially defensive, high yield, low p/e ones. So play it very safe in 2007 until you see headlines about market mayhem. That'll be your signal to buy.
Click here to find out more about James Ferguson's Model Investor Letter
Germany's virtue brings its own rewards
In March 2005, economic storm clouds had gathered over Germany, says Dr Peter Warburton. Output growth was insipid, the government had breached the Maastricht borrowing limit and unemployment was above five million. The European Central Bank hiked eurozone interest rates in October. In November's elections, Angela Merkel was denied an electoral mandate for radical reform and, in May 2006, the new chancellor had to concede tax rises which seemed liable to drain what little GDP growth there was.
But the clouds have passed without a downpour, despite a series of rate hikes. The eurozone mortgage lending boom boosted regional demand, while the accelerating Asian economy lifted German exporters. Unemployment is down and the public finances look much healthier than expected. Sceptics still worry about January's VAT increase, from 16% to 19%, but I believe Germany will beat the consensus by a wide margin in 2007. There is a solid case for German stocks exposed to the consumer and real estate sectors, resting on five premises. First, Angela Merkel must foster rapid growth, and keep east German unemployment falling, before 2009's elections. Second, the country has plenty of room to relax controls on household borrowing since December 2003's lows, annual growth in German bank lending has risen to about 4%, against recent peaks of around 10% in France and Italy, 27% in Spain and 31% in Ireland. The savings ratio edged lower in 2006, but remains above 10%, much higher than its neighbours. Many ingredients for a consumer spending revival are already in place. Vehicle sales jumped in November. Fear of unemployment has fallen, although the national rate remains above 10% and, in the eastern Lander, above 15%. Consumer confidence is up and retailers are at their most upbeat in six years.
Third, incomes are likely to pick up in the next two years. As in many other major industrial economies, the share of wages in national income is at a multi-year low (66%). But Germany's social bargaining system is designed to ensure that labour benefits from an improving outlook, and the tide looks set to turn. Fourth, impending corporate tax reform will help to stem the exodus of companies when new rules take effect at the start of 2008.
Fifth, the commercial property market will come to life as international investors seize on its low relative valuation. One consequence of Germany's financial conservatism has been flat property prices in recent years. But now that cross-border capital flows into commercial property are rising strongly, it presents an attractive destination. According to the information and analysis group IPD, German commercial property has shown a total return of less than 25% in the past five years (in sterling terms) against gains of 80% and more for UK, Spain and France. The advent of German REITs in 2007 should attract foreign investors and boost capital values, which will then stand collateral for faster borrowing growth.
While the US and UK credit systems are creaking under the strains of past excesses, the eurozone is relatively late to the party. It has only been in the past couple of years that private sector bond issuance has ignited. The ECB is likely to lift interest rates a little further, but is unlikely to seriously threaten eurozone credit expansion. German companies have benefited from the warming of its neighbours. Now is the time for salaries to reflect the country's unexpected success, and for household borrowing constraints to be eased, to allow conventional credit access to filter down to the poorer members of society.
Dr Peter Warburton is managing director of Halkin Services
Energy stocks will soar as takeovers continue
Interest rates have been the key to understanding equities for the last two years, says Dan Denning. Higher short-term rates in the US have led to a slowdown in the housing market. The knock-on effects are just now being felt in America's huge consumption-driven economy, including the retail and housing-related sectors of the stockmarket. It's possible that the US may even enter recession early in 2007 (see James Ferguson, page 25). But there is one thing of which we can be relatively certain: interest rates are unlikely to rise. Which brings me to the most compelling story of 2007 the convergence of the private equity boom with the energy bull market.
Private equity firms and their ultra-rich clients will find themselves competing with the world's national oil companies in a fierce bidding war for the energy assets of publicly listed stocks. I'll get to the stocks that could benefit shortly. But first a word about why 2007 will be even bigger for private equity than 2006.
It was a record year for merger and acquisition (M&A) activity across the world, with over $3.5 trillion in deals, according to Thomson Financial, up 30% on 2005. Private equity firms which use a lot of cash and even more borrowed money to buy a majority of shares in a public company and then take it private already have $146bn stocked up for a new round of acquisitions in 2007, PriceWaterhouseCoopers reports. And if interest rates fall, that number could rise.
Private equity firms are essentially clubs of high-net-worth investors who seek to take over public companies with the intention of "extracting value" by "optimising performance". Advocates of private equity say such deals unlock shareholder value. That may be the case. But it looks very much to me like "pirate equity": buying up a firm with the aid of leverage, chopping up the assets, and then re-floating them to a gullible public a few years later for a sizeable return. We'll see if that's how it turns out. But meanwhile, it's worth noting that four of the five largest M&A deals in 2006 were private equity deals.
No asset, no matter how sacred (Qantas, for example), is immune from such interventions. With enough borrowed money, it seems any board can be persuaded to sell to pirate equiteers. Which brings us to the energy story. Private equity analysts must do the same thing you and I try to do each day as investors: buy a dollar's worth of earnings for less than a dollar. But the private equity world has added a twist. Private equity buys a dollar's worth of assets for $1.20, but puts only about 40 cents down in real money. The rest is financed.
That kind of leverage makes any deal possible. But to finance the necessary borrowing, you don't want to enter into just any deal. The target must either have lots of cash per share (to finance the debt), sell at a deep discount to sales or book value (making the turnaround and resale easier), or be in a sector in which demand is growing but supply is scarce (in which case the pirates are counting on booming earnings in the near future.)
A quick glimpse at recent private equity deals shows a remarkable diversity in the kinds of firms being taken private. But it was two recent deals that really got my attention. First is the proposed merger between Norwegian oil and gas firms, Norsk Hydro and Statoil. Second is the $15bn private equity offer for gas pipeline company Kinder Morgan. And here (finally) is where the energy bull market meets the private equity market.
At first blush, energy exploration and production companies do not look like typical private equity targets. Exploration involves a large capital cost which must be financed through cash flow, debt, or equity. When you're private, adding new debt is the easiest alternative, but it's unattractive, given the high debts private equity deals tend to saddle a firm with. But two factors make more private equity bids for energy assets likely. The first is that the supply of well-managed energy groups with good balance sheet value is limited. When you're borrowing to buy scarce, high-quality assets, money is no object. The second factor is the underlying scarcity that's driven energy stocks higher since 2004. Oil and gas are getting harder to find. Listed energy groups and state-run firms are having trouble replacing reserves, especially as demand keeps rising. Private equity sees the bullish fundamental picture for energy and would like to get in now, while credit is cheap, energy prices high but stagnant, and before other bidders start arriving.
And there will be other bidders. Private equity buyers will find themselves bidding against state-run oil companies, flush with cash but desperate for new production sources, as well as against countries such as China and India, also cash-laden from trade, but also in need of secure energy supplies. The question is: which companies will they be fighting over? Since private equity borrows money, assets across all sectors will go up somewhat indiscriminately in 2007 as the super-rich battle it out for control of the world's capital assets. But the most plum assets will be oil service companies and oil exploration and production companies.
On the back of the Kinder deal, there is speculation that service companies such as Diamond Offshore (DO: US), Global Santa Fe (GSF), and Noble Energy (NBL) could be next. There are worse ideas than going long those stocks for 2007. Or, if you're a speculator, buying in-the-money call options on the Oil Service Holders (OIH) is a way to be long private equities' most sought-after assets for a few hundred dollars per contract. The tactics must suit your tastes and budget. But of the strategy, there can be little doubt: 2007 will richly reward investors who can find out what private equity wants to buy, and buy it first. I see the convergence of the energy bull market, the strength of private equity, and the race for control of scarce energy assets all adding up to an epic bull market in energy stocks.
Dan Denning is editor of the Daily Reckoning Australia
Look for quality in the shadow of a US slowdown
Having sustained three successive years of good gains following the millennial low of Autumn 2002, it seemed to me that Western markets seemed poised to disappoint in 2006. But they didn't. Instead, in the face of overabundant liquidity and, perhaps more importantly, decent valuations, making money turned out to be surprisingly easy. Except for the bond buyers including, sadly, most of the UK's pension funds everyone, from the property and equity bulls to the commodity bulls, has had a great year.
However, despite clearly having been too cautious this year, I'm a bit worried again. What disturbs me is the near-unanimous view that a US slowdown will pass the baton of economic growth to Europe and Asia. It would be remarkable if investors escaped next year unscathed by volatility, which has been absent from markets for far too long. My natural scepticism about broad market returns from here on is based not on valuations, which are fair, but on mean-reversion. Stockmarkets have had four good or great years since their 2003 lows. They may well surprise most pundits and exhibit marked volatility next year with a downward bias.
So what will I be buying? Quality, whether in terms of cash flow and defensible earnings, or in fund management terms, quality of manager. While not as cheap as it was a few years back, I still see merit in global tobacco (Altria and British American), and I like the longer term outlook for luxury goods (and hence stocks such as LVMH and PPR) as a play on Asian growth.
In terms of funds, I've recently been buying two closed-end investment companies with excellent managers: British Empire Securities and General Trust, and Caledonia Investments. The former is a classic value fund, the latter more a financial sector play. While many see evidence of a bubble in commercial property, I still view the sector as an alternative to expensive bonds, not least because the upward-only rent reviews give it an element of real rather than nominal capital growth. Two funds I've recently bought in the sector include the Glanmore Property Accumulation Fund, a broadly conservative UK vehicle, and the racier TR Property Investment Trust, a pan-European fund.
I expect commodities prices to consolidate as global growth slows in 2007, but I will be a buyer on weakness as long-term fundamentals seem strongly supportive of secular growth and the commodities supercycle rolls on.
I appreciate that gold arouses almost religious levels of passion in the
market. But those of us with a lingering concern at the unchecked rise of fiat money, and not least the recent wobble in the US dollar, will be there at the altar, again, in 2007.
Tim Price is CIO for global strategies at Union Bancaire Prive, London
After a very strong end to 2006, I think we're due a correction. Mergers fever, massive liquidity, the recycling of petrodollars and the attraction of infrastructure assets to the leveraged-buy-out industry, along with hedge fund speculation, have bid up the shares of many defensive stocks. I cannot understand how mature low-growth large caps on such high p/e ratios can once the M&A frenzy dies down offer much upside from here. The likes of BAT, Boots, Tate & Lyle, AstraZeneca, Capita and Diageo look as much as 30% overvalued to me. I think at at some point in 2007 common sense will prevail and these expensive defensives' will come down to earth.
Get out of 'expensive defensives'
In the rush to buy the large caps, investors have been diverting cash from Aim. The FTSE 100 has risen by 30% in two years, but Aim has hardly moved. That suggests that Aim offers fertile hunting grounds. So which to go for? AT Communications, SmartFocus, Asian Citrus and Armor Group spring to mind. There are risks. If there was a global recession, all equities would suffer, and if the dollar suddenly dived, the resulting inflation would push up interest rates everywhere and send most economies into reverse. I don't think this is likely, however, but it does need watching.
Another theme I think will be big next year is quadruple play services video, telephony, mobile and internet all delivered over high-speed broadband. The infrastructure is largely in place, coupled with aggressive advertising by key protagonists (BT, Sky, CPW, NTL, etc). And 2007 could be the defining moment for the home digital revolution. Expect each house to have a new box' a superfast computer, accessing the internet via broadband, which will connect to the web, 3G mobile, cable, satellite, TV and radio networks. The digital content will be wirelessly transferred around the home on to screens, PCs, gaming machines, wireless speakers and phones. We will be able to watch and listen to much more, and to download just about any movie or song.
There will be winners and losers in this huge area. The winners will be consumers, and as-yet-undiscovered firms, slightly off the beaten track, who help consumers to configure network services easily and protect them from security or virus breaches. The losers will be any business that fails to go digital fast.
Click here to find out more about Paul Hill's Precision Guided Investments service
Will 2007 be the year that the tech sector reboots?
Technology has been an unloved sector since the tech bubble burst in 2000: Merrill Lynch reports that the average fund manager is still more than 20% underweight in the sector. But they may well be missing out. Ben Rogoff, manager of the Polar Capital Technology Trust, reckons "a stealth tech boom" is just beginning and this time the good times look sustainable.
Business models for tech firms in the Nineties were based on what were, at the time, wild projections on advertising, broadband coverage and e-commerce trends. But most of these are now reality: 70% of US homes are set to have broadband by the year end, while in the UK, it'll be 50%. One benefit of the wild over-optimism then was that companies made sizeable infrastructure investments. They may have bankrupted themselves building fibre-optic networks, but their successors and consumers now enjoy cheap bandwidth as a result. Starting up is cheaper; firms achieve break-even sooner.
So how should investors get exposure to the new tech boom? Stay away from mature stocks such as Dell and Intel, says Rogoff. New cycles in tech stocks tend to be led by newcomers unburdened by older products which may going obsolete. One example is Renesola (SOLA), a London-listed Chinese company which reconditions scrap silicon wafers from the semiconductor industry. The recycled wafers are then used in solar energy equipment. Renesola is already breaking even and made an operating profit of $5.2m (£2.8m) in the first half of this year, and growth prospects look good. 3G mobile technology is also making an impact. Rogoff claims 3G will have 10% penetration worldwide by the end of 2006, which he sees as an important tipping point. Firms involved in content provision such as Qualcomm (QUA) and ARM (ARM) are a good way to play this trend.
For broader exposure, you might consider a technology trust. There's Rogoff's fund, which has 40% of its portfolio in the US, and has managed a 48.3% return over three tough years, against a 57.2% return on the FTSE World Index. Or there's Herald Investment Trust (HRI), which invests mainly in small UK-listed firms and is weighted towards communications and media.
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