John Stepek: We could waste the whole night discussing Greece. Let's turn to China first. Clearly, it's slowing down. Does this worry anyone?
Didier Saint-Georges: Our emerging-market team was there in February. The slowdown is real and it's significant. Exports are down. The investment rate has dropped. So there is a real drag on economic growth. The flip side is that this means China's need to rebalance its economy is even more urgent. It has to raise consumer spending and the standard of living. That's why the more concerned you are about a China slowdown, the more you should want to buy consumer stocks. It has to make sure the sector does its bit to drive growth.
But can China get the rebalancing going? Until the middle of last year, it didn't have much room for manoeuvre. Inflation was rising. It had to keep monetary policy tight. But inflation hit a top in October last year, and has fallen quickly. So it has room to step in if necessary. For now, it can live with 7%-8% growth. The Chinese recognise that they over-reacted in 2008 by pumping money like there was no tomorrow and creating inflationary pressure. They don't want to repeat that mistake. So they will loosen monetary policy very gradually this time. This is a well-orchestrated slowdown.
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Killian Connolly: I understand those arguments. But there are too many danger signs for me. Communism and centrally planned allocation of resources never ends well. Our financial crash was caused by a massive commercial banking boom and credit expansion. China has been through exactly the same thing. Are we supposed to think that their authorities can handle it better than ours did? Their banking system could be insolvent.
Jane Coffey: But it could also easily be taken over by the government and nobody would notice. They can support the banking system by socialising the loans more easily than we can, because they don't have massive government debt.
Killian: So we should invest in China because it's a planned economy?
Jane: More because it will still be growing. It may not grow at 10%, but 8% is still good. China has a lot more policy tools left than the rest of the world because it has excess savings. So invest in stocks that sell into China, rather than buying Chinese stocks.
Didier: Absolutely. I agree that you should be cynical about China. You need to check the data for yourself. But if you check with the car dealers, for instance, you realise that these guys are indeed selling more and more cars. You can see it for yourself, and when you are in traffic jams in Beijing you can feel it too.
I'm not saying that all the numbers are correct. I'm not telling you to buy a China exchange-traded fund. But very important things are happening. It might be slowing, but the economy still has a lot of growth left and that creates opportunities. If you find companies that can surf that growth, it's easier to make money than trying to find specific Chinese stocks.
John S: What would you buy?
Didier: We like strong brands that satisfy emerging-market demand. Yum! Brands (NYSE: YUM) is the parent company of Kentucky Fried Chicken (KFC) and Pizza Hut, among others. It has more restaurants than McDonald's and each year opens more of them outside America than McDonald's does. China already accounts for 40% of its earnings, so it is surfing on the change in emerging-market consumers' habits.
It has plenty of market share to gain, little competition, and all on the back of a cheap, readily available product so it gets both volume and pricing power. If you sell chicken wings to Chinese consumers, are you really that exposed to what Merkel and Hollande do next? I don't think so.
John McClure: What about the other Asian economies?
Didier: India is the bad student, which illustrates that things can go wrong.
Killian: Even in a democracy!
Didier: It's sad to say, but yes. India's prime minister was elected on a programme of reform. But two years on, reform is not taking place. The current-account deficit is widening, the trade balance is getting further into negative territory, and the Indian rupee is showing the way. So the Indian story is very disappointing.
Killian: Doesn't it all come down to valuations? I can be the bear and you the bull on China, but it doesn't really matter it's the price you pay that determines the return you get. So if you have the Russian index on four times and China on 12, which do you buy?
Didier: As long as the index and the economy are based on chemical and oil companies, which by definition trade on low multiples, Russia will always be a cheap market. India, by the same token, will always be expensive, because it's about technology and exports.
Killian: But four times is not expensive, even by Russian standards.
John S: Perhaps it's pricing in a big drop in the oil price.
Killian: But if you are asking clients to invest for ten years, which you should be, then should you look at a valuation of four times earnings and say that a lower oil price is a worry? I think you should be worrying about how high oil is going to go in the next ten years.
Didier: I don't have a problem with oil's investment story. I would just rather not do it in Russia. I think there are more attractive places.
Killian: There is massive risk in China.
Didier: But what do you think is the most important risk in China?
John S: How do you build a consumer boom on a bursting property bubble?
Jane: Doesn't China's property bubble involve a very small section of society? The consumer part is the mass at the bottom, not the people buying the £250,000 apartments.
Didier: Yes, the property bubble is at the high end Beijing and Shanghai. If you go to the middle of the country there is a huge need for housing. The number of kilometres of road built per inhabitant remains extremely small, so it's not as if they won't have to invest in infrastructure at all. There is a slowdown, but it is misleading to believe that China is so overbuilt that it will collapse.
John S: What about the impact on the commodity market?
Didier: China's move to a more consumer-led model will clearly affect commodities. Consumer-led economies don't have the same pattern of commodity usage. In the early stages you'll use less energy, whereas once you have a lot of cars per inhabitant you will be a bigger consumer of oil. Conversely, you will use a lot less cement than before. So as the pattern changes, you need to make sure you are in the right commodities. But to think that the commodities story is a thing of the past just because China is shifting focus is missing the key aspect, which is the supply side.
Jane: Yes, 8% growth in an economy that was 10% larger the year before and 10% larger the year before that that still means a huge demand for materials.
John S: What about gold? And while we're on the topic, why have the gold miners performed so badly compared to the gold price?
Jane: Not many ever manage to produce the amount of gold that they say they will.
Didier: The key issue has been cost control or the lack of it. We've been very disappointed in the gold miners. They told us they were controlling costs, whereas they have been going up by 20% a year for the past two years. Unless you get a similar rise in the gold price your margin takes a hit. But the miners who do control their costs have fallen along with those who don't. So at this level, if you are careful, you can find really good value. You have to go back to the 1970s to find the same level of value in the miners when compared to the gold price.
Killian: Investment that once would have gone into the miners now goes into exchange-traded funds (ETFs).
Didier: Some miners started raising their dividends last year, which would give them an advantage over the ETFs. If they get their costs under control and start paying dividends, that would make a compelling investment case, particularly once you've throw in the huge discount to the underlying metal price. On gold itself, I saw a chart the other day that plotted the price against the US debt ceiling.
It's almost exactly the same line. So if you believe the debt ceiling will be pushed up further, then there are probably more gains ahead for gold. Since 2009 central banks have been buyers of gold, which was not the case before.
Killian: Of course, they only hold it what was it Ben Bernanke said? because of tradition!
Didier: The Chinese are buying gold simply because they have a huge exchange risk on their currency reserves.
Jane: Well, everybody else is printing money, aren't they?
Didier: Exactly. If you believe the fiat currencies are in danger and you are a central banker in China, India or Brazil, you have a hell of a lot of currency risk and you want to hedge that by increasing the proportion of gold you own. So gold itself has potential, not just the miners.
John S: What miner would you buy?
Killian: The miners have got even cheaper in the last year, so there is the question of whether you are prepared to try to catch a falling knife. We see miners as a bit like holding bullion. Rather than have your gold in a vault in Switzerland, you have it in the ground.
Analyst Don Coxe recently looked at how much gold you could buy with $1,000. If you bought bullion, you would get 60% of an ounce. With Canadian mining group Eldorado, you are getting more than five, and for West Africa-focused Perseus you are getting more than seven. So the mining sector is a levered play on the gold price, without actually borrowing any money.
Our favourite is Fresnillo (LSE: FRES), which trades at a relatively high 17 times price/earnings (p/e). We feel that's justified by its assets. The silver price has to drop to $15-$16 an ounce for it to shut down production, whereas its peers start losing money when silver drops to $20-$25. It also offers employees shares as part of their compensation, which helps its valuation it has an impeccable history of mines not shutting down due to strikes.
John S: Seeing as Killian brought it up earlier, what do you all think will happen with oil? Inventories are very high.
Jane: They are but if something goes wrong in the Middle East
John S: Something could always go wrong in the Middle East.
Jane: But that's why nobody has any strong ideas. You can't put this into a model and say, here's the demand for the next ten years, this is the supply' the gap is getting smaller, so oil will fall. It is much more about the politics. And not just the Middle East. Yes, Iran could be disruptive. But growth could also be a lot lower than people think if Europe goes belly up. You've also got substitution in the US from shale gas, which will have a huge impact on life in general. If America becomes energy self-sufficient, it won't care what's going on in Europe anymore.
John M: That's one thing I think everybody needs to get their heads round.America could become self-sufficient and say "stuff the lot of you".
Jane: I don't think they will become more protectionist. They will become ultra competitive, particularly for anything that requires energy in the manufacturing process. They will be able to net export stuff they couldn't previously export, so they will be less worried about the oil price or what's going on in Europe or the Middle East. So they can disengage from protecting those kinds of interests, which could be huge politically.
John S: We should probably talk about Greece very briefly.
Killian: Greece is likely to be better off outside the euro. It's consumed by debt; it needs to get rid of it one way or another. There hasn't even been austerity in Greece, by the way. It has been running budget deficits. It hasn't stopped, it's just been financed by the public rather than the private sector.
Jane: The trouble is, it doesn't actually have an economy. It doesn't export; it doesn't manufacture anything. It will be an attractive place to go on holiday if the price is right. But there will be a downwards lurch in standards of living before you get any growth.
Killian: Oh, there will certainly be a contraction in GDP.
Jane: Although not necessarily much worse than if Greece stayed in.
John S: How do you think the end game will play out?
Jane: I don't think it will be a quick process. I think the Greeks and Portugese might go first and then they'll get the firewalls out for Spain and Italy. I reckon the Germans are prepared to protect Spain and Italy for quite a long time. Otherwise it is game over.
Killian: Why would an electorate unhappy with Greece say OK to bailing out Spain and Italy?
Jane: You can argue that they've made an effort. The Greeks aren't collecting any taxes.
Killian: Yes, but remember that Germany also has over 80% debt to GDP. That's just sovereign debt, not the national liabilities. Do you think it can bail out the whole of Europe?
John S: How do you invest for all this?
Killian: First of all, in a world full of bankrupt and near-bankrupt governments, where can you find yield? We like the Wealthy Nations Bond Fund (contact: 020-7766 0888). Normally in the bond markets the big players end up buying the worst credits the countries that have issued the most debt because of the way the indexes are built. But you can play the bond market in a more nuanced way and also get a real yield (ie, after inflation), which beats anything on offer in the American Treasury or gilt markets.
Stratton Street Capital, which manages the fund, looks at the net foreign asset (NFA) score of nations. This incorporates corporate, government and household debt. They rank the nations according to their NFA score and invest in the most credit-worthy the ones with a lot of hard assets behind their debt. It's like looking for firms with a strong balance sheet, or which are generating a good income.
So Stratton Street is investing in the most creditworthy nations the likes of Qatar, Singapore, the United Arab Emirates rather than the biggest bond issuer.
The yield is just over 6.5% and there's not much real duration risk. The average maturity on the portfolio is five years, so if inflation increases, that limits the impact of higher interest rates.
John S: Jane?
Jane: I'm looking for UK equities backed by a story that's not dependent on any macro-economic scenario. BSkyB (LSE: BSY) has been in the press, and it's on a big discount because of what's been going on with Rupert Murdoch. However, I think that if he either sold his stake or stood back from the company, its valuation would rise.
I also think it's worth more than he previously bid for it because it's just about to come out of an investment cycle and start throwing off cash. It's already sent out all the new High Definition (HD) and Sky+ boxes. That was a lot of cost upfront, but it should now generate higher average revenues per user (ARPUs). In the last results, much higher ARPUs were coming through, because not only was BSkyB able to sell the TV packages and HD, but it is getting a good share of the broadband market, which is making customers more sticky'.
John S: What about fears that Apple or another big player comes into the market to bid in the latest round of football rights renewals?
Jane: That's one reason why the price has been depressed Al Jazeera said it will bid. So analysts had priced in a 20% rise in the cost compared to last time. However, now we know how the bid packages will be structured, analysts are more optimistic that Sky will get what it wants for about the same price as last time.
Competitors will probably get some of the small packages, but that's fine Sky just needs the majority. It actually wants a bit of competition, or else the competition authorities will be all over it. So you've got a historically defensive stock with a good income stream; and which should be able to pay out increasing dividend yields in the future.
We also like student accommodation firm Unite (LSE: UTG). It is on a 40% discount to net asset value. Commercial property is a tough area, but this is a very specialised niche. There is a shortage of good-quality accommodation for students.
John S: Will there be enough demand?
Jane: Yes. Higher fee rates won't stop the students who live in Unite accommodation from going to university. It's pretty expensive it's generally taken by foreign students and relatively well-off parents who want their children in well-built accommodation. The demand is also highly visible: 72% of next September's year is already rented out. That's around the same as at this point last year, and actual occupancy ended up being 98%.
Unite will get a boost from the Olympics: when the students are out of London, it will charge premium rates for their accommodation. But that's a one-off. The main thing is, you've got strong, visible earnings; it's building more beds and although it's a leveraged firm, it's just done its refinancing. As there is reasonable demand for student accommodation, it's able to sell its non-core portfolios to focus on the top ten universities.
John S: Didier?
Didier: I like specialty chemical company Croda (LSE: CRDA). It supplies crucial ingredients to the cosmetics and health industries. The value of what it provides accounts for a very small part of the product cost, but in terms of the product's efficacy, it is vital. So the firm has a lot of pricing power. And it is doing very well. I read that around 80% of the biggest names in cosmetics use Croda ingredients. This tells me that the company has a lot of leverage over its clients. The multiples are not huge, given it's growing at about 13% a year. It's very defensive health and cosmetics is a good place to be right now.
John S: John?
John M: I'll start with a pure arbitrage play: Arbuthnot Banking Group (LSE: ARBB). It's worth about £71m today, but has a 70% stake in Secure Trust, worth £150m. I'm sure you can work those economics out. Plus it's got another business, Arbuthnot Banking Group itself, which you're getting for free. My other pick is VP Group (LSE: VP), a plant hire business I've always liked. It had a tender offer that it made a bit of a mess of, but it's a good stock.
This one will throw you completely. For the first time in ten years, I'm going to tip a consumer group car dealership Lookers (LSE: LOOK). Many British consumers have had enough of depression. They are never going to buy a house again, but they will buy cars.
In fact, they already are month by month the numbers are going up, quite significantly. If you were going for an all-out recovery stock, you'd go for Pendragon (LSE: PDG), but it's got a lot of debt and that frightens the life out of me. I feel Lookers is safer. But I still think there's a lot of stuff at the bottom end of the market that could really fly.
This article was originally published in MoneyWeek magazine issue number 590 on 25 May 2012, and was available exclusively to magazine subscribers. To read all our subscriber-only articles right away, subscribe to MoneyWeek magazine.
John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.
He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.
His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.
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