Is China in for a hard landing? And where are the profits to be found in today's markets? John Stepek talks to our panel of experts to find out where they'd put their money now.
John Stepek: Will China have a hard landing?
Bradley Mitchell: It's hard for any European or American to really understand what's going on. We can all pull out pictures of empty shopping malls, but what do we really know? Probably not as much as we like to think we do. It's not keeping me awake at night.
Subscribe to MoneyWeek
Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE
Kieron Launder: China has very experienced technocrats who are a lot closer to the issues. No doubt there has been significant misallocation of capital, but it would be rare for a country to go through that transformation look back at Russia and not see that happen. Do they have the will and the firepower to address it? I think so.
Mike Jennings: People have worried for months, if not years, about China's story ending, yet there's not a huge amount of evidence that it is. Fourth quarter GDP came in at 8.9% annualised. The Chinese authorities have done a very good job of managing their growth so far. I'm assuming they will cunningly manage it a bit lower, but not a lot lower.
John McClure: They have more than enough cash to see their way through it's as simple as that.
John S: That's interesting. Until now, I'd have said that being bearish on China was hardly a contrarian view any more.
Bradley: I think most investors are bearish just now all that changes is what they are most bearish on. We had a period when it was China, then everybody was worried about a double dip in America, then it was Europe again. General sentiment is pretty negative.
John S: Investors seem to be getting Europe fatigue now though they didn't react much to the Standard & Poor's (S&P) downgrades.
Bradley: Well, do you really want to open the FT every day and read article after article about Europe and how it's all going to end horribly? We've had that for about a year. Four or five months ago the market would have tanked on the S&P news. Now it's: "Well, tell us something we don't know."
John S: Anyone think Europe is cheap?
Mike: I'd look for stocks that have little exposure to their own domicile: what drives Pernod, for example? It's not sales of Pastis to the Parisians, it's sales of cognac to the Chinese. However, it does depend on what happens. If you have an Armageddon scenario then all bets are off. That's a bit excessive, sure. But growth in continental Europe is likely to be negative next year is that priced in?
John M: You've really got to divide Europe into the north and the south.
Bradley: Yes, DS Smith just made a big acquisition in Europe. People were asking: "Are they mad?" But when they heard it was in Germany and Scandinavia, they relaxed. Those are the acceptable bits of Europe from an investor's point of view. Then there are the unacceptable bits, the ones we know about. The big issue is: which camp do you put France in?
John S: How bad would a Greek default be?
Mike: For Europe, or for Greece?
Bradley: If the Greeks left the euro, it would be disastrous for them. Defaulting in the euro is preferable to defaulting and exiting the euro. Greece just isn't a viable economy. It lacks any credible advantage in any industry other than tourism, and has a non-functioning taxation system. As for the rest of Europe, that comes down to the banking system how vulnerable are French banks if the worst happens?
Kieron: Yes, but look at the haircut that bondholders are already taking on Greek debt. It's at least 50% notional and probably 70%-80% on a net present value basis if they can take that already, surely they can stomach the rest?
John M: There is a much more fundamental question here, though, that Germany is effectively demanding of the rest of Europe: is your economy functional?
Bradley: But not everybody in Europe can turn German. If nothing else, Europe has shown that economies are simply not that flexible. If you end the Italian reliance on competitive devaluation, which is what they used from 1945 until they joined the euro, it doesn't lead to the Italians becoming German. You just store up a huge problem.
John S: Given that we'll probably see a European recession anyway, what does that mean for Britain?
John M: Britain's problem is that we've got one very eloquent politician Alex Salmond and a bunch of others, including David Cameron and Ed Miliband, who are way below average. Forget the economics of independence politics-wise, Salmond is streets ahead.
Bradley: You can guarantee that Salmond will outmanoeuvre London on this. He is just too good at what he does. Remember, he single-handedly destroyed the Labour Party in Scotland and replaced it with the SNP. No one would have bet on that ten years ago. Whether you agree with his views or not, I have nothing but admiration for his political skills.
Mike: We are going to teach the Europeans how to dissolve a country.
John S: I wasn't really thinking of Scottish independence when I brought this up but given that most of our politicians are uninspiring, where does that leave British investors?
Bradley: It's very tough out there and it's going to be for a while. We've had tinkering on public spending, but the government shied away from any real radical action, while at the same time scaring the life out of the consumer with all its chest-beating about how tough it was going to be.
John S: But high inflation can't have helped. There is a genuine squeeze on real wages.
Bradley: That's true the recession was in 2009, but from a consumer-spending perspective, every year since has been a lot worse. Back then, provided you didn't lose your job, you got an immediate benefit as mortgage rates fell. Now all of that is just being clawed back. There are always winners and losers, but the macro backdrop for consumer spending in Britain is very poor.
John S: Just on British consumers did anyone think Tesco's profit warning was a great buying opportunity? Or is it all downhill from here?
Bradley: There's an old adage that a profit warning is the last sign of a company in trouble. I've been concerned about the food retail industry and Tesco in particular for two or three years now. It did well for a long time, and people naturally assumed that was because it was very good at what it was doing. It was, but it was also because Tesco's competitors were making a complete mess of things, which isn't the case anymore. Tesco is going to have to be more aggressive on price than people perhaps realise, which is bad news for Sainsbury's and Morrisons too. Also, when you get to be as big as Tesco is, you become the market so if the consumer is really hurting it is hard to avoid that.
John M: It's a mature market too. The internet is changing everything.
Bradley: The internet is really bad news for food retailers. When you shop online, you stop impulse buying. You are no longer walking down the aisles thinking: "That's cheap" or "they look nice". You just buy the same thing every time. So customers spend less and you also have to bear the cost of sending the stuff to them rather than having them coming to you.
Mike: It's a valuable lesson though. A lot of people are hiding in stocks they think are defensive, because they are nervous about the bigger picture. But if that sort of stock then stumbles, the market will really cane it.
John S: So where are you all investing just now?
Our Roundtable tips
Bradley: I have a British focus, but I'm looking at companies exposed to America. We've had six months of good economic data, and companies are telling us that America is getting better. That's probably good news for global cyclicals too. Most UK-quoted defensive companies feel overbought and overvalued.
Kieron: Historically, America has always come through it's a very dynamic economy. There is the concern that it may have been benefiting from the weak dollar, and that's changed over the last six to 12 months. But America is probably reasonably safe.
Mike: I'm pretty bullish on emerging markets. In China, inflation seems to have rolled over, and monetary policy is now being eased. On the US versus Europe: the easy call is to buy the US. But given the dreadful sentiment on Europe and the low valuations, at some point I suspect this year Europe will have a strong catch up.
But I agree, we should be wary on defensive names. If global economic growth ends up being reasonable, then staples probably aren't the place to be. Instead, I like what I call "chicken cyclicals". These are firms that operate in economically sensitive industries, but which are in fact themselves quite defensive, because they have a very high market share, strong pricing power, high recurring revenues, or a combination of the three. They've been marked down because they're seen as cyclical, yet, unless you have economic Armageddon, they will sail through happily.
John M: We are very bullish on America. It's clearly in recovery mode. One way to play it is through Lupus Capital (LN: LUP). It makes windows, and has massive exposure to the American housing market.
Kieron: Does the firm manufacture in America?
John M: Yes. We are recovery specialists to an extent, and the company had got itself massively overgeared. But it has been dealing with that. If the numbers are anywhere near correct, then the company is there, or thereabouts, in terms of being tidied up. And housing in America is not expensive the market is going to recover.
Bradley: We had some American guys come to see us a while back who wanted to raise money to buy distressed half-developed sites in the US. It was very depressing listening to them quote what they saw as a crazily overvalued price for a very nice house in a very nice part of Florida, and we'd just be looking at it thinking: "that's an absolute bargain". Unfortunately, it's rather a long commute.
John M: British Polythene (LN: BPI) is my next tip. It makes silage bags and polythene bags. It's a Scottish company, like the dairy group Robert Wiseman, which was just sold to Mller. I think there are lots of people in that age group late 50s, early 60s who are now thinking about leaving their businesses, particularly if they are worried that politicians might impose a big capital-gains tax hike on them. In the case of British Polythene, you can see another German company coming along and saying, "thanks very much".
Kieron: And they are selling to like-minded investors, which makes it all the more attractive. What was interesting about the Wiseman sale was the focus on maintaining the company's roots and looking after its people one clause more or less said: "you can't make anyone redundant".
John M: The third is Silverdell (LN: SID), a really small (£20m market cap) asbestos removal firm. Asbestos is heavily regulated you find it in a shop and you have to remove it, or you get fined. It's on about 7.2 times earnings, with a small dividend yield of about 1.8%.
Bradley: That's a good business to be in you can't quite charge what you like, but the customer is very price insensitive because the cost of any delay is astronomical.
John S: What about you, Mike?
Mike: I'm going global. First, a very macro-orientated play: China Construction Bank (HK: 939), the second-largest commercial bank in China. The stock has derated massively as the market was very weak last year. But we've got monetary policy being eased in China, and the stock now trades at 5.9 times earnings and yields 4.4%.
John S: Are you worried about bad debt?
Mike: Yes, but it's very conservative. It has a 62% loan-to-deposit ratio, so it's not RBS or anything like that. It also has the highest return on equity (ROE) of all the major Chinese banks at 20%; a 40% payout ratio; and a core tier 1 ratio of 10.7%. So it's basically very solid. Yes, if China has a nasty hard landing or a big property crash, it's not the stock to own. But assuming that China muddles through, then it's due a substantial re-rating.
My second tip is a French firm, Zodiac Aerospace (FP: ZC). Global airline traffic has grown by about 45% in the last decade. With the oil price remaining high, there's a big drive for more fuel-efficient planes. Airbus, for example, has a backlog equivalent to seven years' worth of sales. Some of that will fall away due to a lack of finance, but it is mainly Middle and Far Eastern-driven and so pretty solid.
Zodiac kits out both Boeing and Airbus with aeroplane interiors: the seats, food areas, emergency slides, that sort of thing. Things are unusual just now, in that the cycle for both new planes and for refitting old ones is strong. The trend towards wide-bodied planes is also good for Zodiac it needs twice as much interior kit as a narrow-bodied plane. The balance sheet is sensible, with gearing at 35%. Cash flow is strong and there's very little competitive pressure. It's a good example of a "chicken cyclical" the airline industry is a horrible, cyclical industry from the operators' perspective; but it is a duopoly from the kitting out perspective.
John S: Who is its competitor?
Mike: A similar-sized American company called BE Aerospace. Zodiac should see 17% sales and earnings growth this year, and it trades on 12.5 times earnings. It is a beneficiary if the euro is weak against the dollar.
The third is Google (US: GOOG). In technology you have the big incumbents, like Microsoft, who dominate their field and look cheap, but are so big they can't do anything innovative and so end up being value traps. At the other end of the scale you've got the social media names that trade at ridiculous valuations. Google offers the best of both worlds: it dominates the search field, but it also has its foot in various other camps. So you can buy a cheap, solid incumbent with a strong balance sheet, but you've got a few call options in your back pocket, in the form of ventures with exciting potential.
Google owns YouTube, which will benefit substantially from online advertising growth. About 12% of political advertising in the US this year is expected to be online Google has a 45% share of that. It's also got Google Plus on the social media side. Almost certainly that will come to nothing it's not priced to come to anything but if it does, it's attractive. It owns Android, which has been outselling Apple for many months, and it is just beginning to monetise that. It is flush with cash, so there are no funding issues and it's got really strong growth.
Kieron: We look for quality management and visible earnings. One company we like is accountancy software group Sage (LN: SGE). It's been massively derated from 18 times earnings to 12; it's grown earnings through the cycle; it's cash generative; and it has sensible management that won't waste all that cash, which is always a question to consider with tech companies. In the US we like General Mills (US: GIS). Again, it's a sensible, solid firm, with visible earnings and popular brands.
John M: Is that Pillsbury Doughboy and Hagen-Dazs?
Kieron: Yes around 70% of its revenues is domestic but overseas sales and brands are growing. They do build out but in a very conservative fashion, which is good, because I think the economic environment is going to be tough for some time.
John S: Are investors focusing on return of capital more than return on capital?
Kieron: It goes back to what we were talking about earlier. People hate the macro outlook, but the markets are marching on in spite of it all. Central bank policy is working. If you penalise savers with ultra-low rates and inflation, then people ultimately think: "enough's enough". Now that you're being paid a yield premium over fixed income for taking the risk of investing in equities, you are returning towards more traditional equity investing, where people are happy to be paid to wait for something to happen. That's different from, say, a late-cycle property boom, where everything is incumbent upon capital growth.
John S: What about you, Bradley?
Bradley: My first pick is a miner. Everybody gets obsessed with demand when they look at miners, but supply is equally important. What you want is strong structural demand growth and a chronic supply situation. Kenmare Resources (LN: KMR) mines mineral sands, which ultimately end up in titanium dioxide. Titanium dioxide producers, such as DuPont, are seeing business grow strongly. But margin pressure is high, because input costs are going through the roof due to a chronic shortage of new mineral sand deposits. That's where Kenmare comes in.
The company is based in Mozambique, a good place to do business. It's going to double production this year that's fully funded. Beyond that, production may be raised again, but the cash flow will be rolling in because of what we're seeing on the supply side. DuPont and the other paint manufacturers need to secure supply. So although you might think another miner would bid for Kenmare, actually DuPont should take them out. So you've got strong reasons to own those shares.
As for the US property market I like construction equipment rental group Ashtead (LN: AHT), which makes 85% of its revenues in the US. It's had two huge profit upgrades in the last six months. If you look at its share price chart, you might think you've missed the best of it. I don't think you have. There are two strong structural reasons to buy the shares. Americans have tended to own construction equipment in the past. But because of the recession, they've been unable to replace old equipment becausethe banks aren't lending the money to buy it. So they've been forced to try renting, and they've found it works well. So rental penetration is rising. The other big structural benefit is that Ashtead's number-one and number-two rivals are merging. That will be great for pricing in the sector. Also, nobody is factoring in any kind of recovery in US construction, so if you get a pick up in actual physical activity, you will see more profit upgrades.
Lastly, there are the Falklands oil explorers. Rockhopper (LN: RKH) has gone up by 20% so far this year, but I think it could double. Before it found oil, we were its biggest shareholder. That came about because we did a lot of work on risk/reward and valuation. Ultimately, yes, you need to be lucky you need a firm to find oil. But the more work you do, the luckier you get.
Using the same analysis process, we think Falklands Oil and Gas (LN: FOGL) is a potentially outstanding opportunity. It's fully funded to drill two wells during the summer. Rockhopper drilled a prospect that geologists reckoned would be more than likely to hold 170 million barrels, assuming oil was found. In the end, it turned out to be much bigger. Falklands is going for, I think, Loligo, which is a 4.5 billion barrel field.
These are high-risk fields real frontier stuff. But if it comes in, the valuation will go through the roof this is an enormous, world-class field. Now, it is more than likely they will find nothing. You have to recognise that, if you buy the shares, you could lose all your money. But on a risk/reward analysis, and taking a view on what is priced in to the shares compared to those of similar explorers, this is an incredible opportunity. It's extremely high risk, but the potential rewards are high.
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.
Pension withdrawals on the rise, HMRC data reveals
Pension withdrawal data has led to some raising concerns over savers ‘raiding’ their pensions unsustainably.
By John Fitzsimons Published
ONS: UK economy recovered from pandemic faster than previously thought
Revisions from the ONS showed the UK economy has grown since the pandemic, while the latest data showed GDP grew in the second quarter of 2023.
By Nicole García Mérida Published