Six stocks to buy now

Markets are volatile, the economy is stressed and the threat of inflation hangs in the air. So what should you do with your money? MoneyWeek's panel of investment experts recommends six sturdy stocks to buy now.

John Stepek chairs our panel of experts and asks where they would and would not put their money in today's markets.

John Stepek: How big a problem is inflation? What will happen to UK interest rates this year?

Michael Stanes: You have to have some sympathy with Mervyn King energy and food prices are beyond his control. It remains to be seen whether core inflation will come back below 2%, as he hopes. But we're not seeing the sort of wage settlements yet that would make us embed inflation in our thinking. The fact is, we have a very stressed economy. The authorities have no real incentive to go early on interest rates.

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Julian Pendock: People also confuse high prices with rising prices. Yes, global food prices have gone through the last peak. But the real question for inflation is whether you think they will go up again next year. Most of the economies where food inflation is a serious problem are cash dependent. If you raise interest rates and the population has no debt, it won't reduce the price of rice, for example, because demand will stay the same. Increasing production which farmers are doing as they respond to higher prices will do, though. In Britain, raising rates would just mean a lot of problems for people on floating rate mortgages.

Kathleen Brooks: In the longer term we'll have to get used to higher prices: we are not importing deflation anymore, and energy prices will remain very high. But it doesn't mean inflation will keep rising at the current rate. With consumers feeling squeezed, it's going to be very difficult for retailers to push through price increases.

Simon King: The only long-term way out for the economy is to get unit labour costs down. One way is through inflation, and that's what they'll do. So unless there is a change in the political landscape, or in the numbers, I don't think you'll see anything until the fourth quarter at the very earliest.

John: But what impact is £1.30 a litre of petrol going to have on the British economy?

Simon: The market responds in various ways people buy cars that consume less petrol, for example. Or look at cotton, which has gone through the roof. As a result, demand for polyester has shot up we'll all be buying a lot more polyester clothes in the next two years.


Julian: Also, there are fully one in seven Americans on food stamps who must be thinking: "Thank you Mr Bernanke, that's really helpful not." If enough opposition builds to the Fed's reflationary policies and I think the Republicans will go nuts if they try and do QE3 [quantitative easing money printing] then that liquidity will start to come out of the market. If you accept that some of the high price of commodities is down to liquidity, then surely you might see quite a rapid fall off, similar to 2000 and 2008. I'm not suggesting a crash, but you will get disinflation again.

John: Well, China is already tightening in a half-hearted way and the Fed is meant to stop QE2 in June. What happens when the money flood ends?

Julian: I'd start with banks. Depending on who you listen to, in Europe they have a funding gap of anywhere between €1trn and €1.7trn. If they stop borrowing from the European Central Bank at 50 pips or 1%, or whatever, and have to issue bonds in the market, they'll be paying 6%-7%. Their cost of funding would be higher than the return they are getting on many of their assets. That's why I still find it difficult to get excited about banks.

Simon: We maintained from the outset that this recovery would be a five, six, seven-year process. Certain sections of the market forget that all we've done is defer the pain. But I presume liquidity will be withdrawn fairly gradually politically, I just don't see any will to withdraw it until the government is certain we won't go into reverse.

Julian: But during the Asian crisis, the International Monetary Fund's medicine was: 'stop what you are doing, behave, clean up your balance sheets'. The Singaporean banks bought the Indonesian banks; strong banks bought other banks; there was a difficult, dangerous cleansing process. I don't think that's happened here.

Michael: What you do is you keep the yield curve incredibly steep, which allows banks to rebuild their balance sheets over time. The core banking business is incredibly profitable; you rebuild capital to whatever the appropriate level is that way. You've just got to keep the game going while this healing process takes place. Clearly, we are in a world of great imbalances and none of those imbalances are being corrected. Nor are they likely to be. But there are signs of slow progress towards a more 'normal' environment. Western consumers are deleveraging. Corporations have deleveraged to an extent. Banks are slowly rebuilding equity.

Kathleen: But what about debt levels? Will America end up like Japan? They can't afford a higher interest rate.

Michael: I haven't seen anything to suggest that there is a number beyond which you can't have more debt. There are some very big debt-to-GDP numbers out there. Look at Japan. It tends to self-fund, but we're talking 300% or 400% of GDP, once you add all the debts in the private sector, the corporate sector and the government sector together.

Julian: But because of the demographics, Japan starts not being able to self-fund beyond about 2014. If they have to go to external funding and instead of giving 1% and change, they have to pay 6%...

Michael: In that case they will change the law so you have to put more money in the Post Office. That's what they've done in the past.

Kathleen: But we haven't had the demographic issue in the past even America is facing that now. You have this tidal wave of baby boomers, a bankrupt social security system, and in America you have the Medicaid issue as well. How do you deal with that?

Michael: On the secular issue, you are absolutely right. The entitlement state whether in Europe, the US or Japan is just not funded; the numbers don't work and nobody has the political will to address this. But the cyclical forces are incredibly powerful. After the tech bubble in 2000, every individual US state was thought to be bust and one or two places, like Orange County, did go bust. But after just two or three years of a recovering economy, the deficits had closed incredibly quickly.

Julian: But one problem is that the deficit as a percentage of GDP is rising for 2011 it is going to be 10.9% of GDP, which is higher than in 2009. And one reason is that Federal receipts as a share of GDP are the lowest they've been since 1943. That's a long road to make up. Especially if there is a municipal bonds crisis in some of these places.

Kathleen: And that would weigh on unemployment even more, as they'll have to cut public-sector workers.

Michael: Look, we are in year three of the political cycle in the US nothing ever happens in year three. The president has laid some pretty modest budget cuts on the table. The Republicans won't go for it. They'll argue, we'll get to December, there will probably be a threatened shut down in the US government, as has happened in the past, and something will get cobbled together. So do I think things will get sorted in the States? Not at all. But the big question is: when do markets force fiscal responsibility on the US government? And I don't know the answer to that.

John: So where should we be putting our money right now?

Julian: I'm a nervous optimist. The European Financial Stability Facility expires in 2013 so that's going to be interesting. And there are a lot of national elections the politicians might have the will, but austerity fatigue is a big political issue. But it doesn't matter what you think the politicians can and can't do I am always bearish on politicians, wherever they are from. However, I'm very bullish on a lot of European companies. I will just mention one a smaller company with a global brand that is expanding globally Piaggio (Milan: PIA). It deals in Vespas for the first time it's selling in the States, and you also see the scooters here. It gets 25% of its volumes in India; it's just opened its second factory in Hanoi.

John: What about emerging markets? They've had a tough few months and there's talk of money shifting back from East to West as governments over there tighten policy.

Kathleen: I don't think emerging markets will continue to underperform. First, they don't have the fiscal issues plaguing the West. Second, corporate governance standards are improving, albeit slowly. Third, you probably won't see as many tax increases. No one in America likes to pay tax, but the reality is they will have to, including corporations. Fourthly, I just like the growth dynamic. I have spent quite a lot of time in India and it is unbelievable how fast it is moving. Demand for Western luxuries is off the scale. They think nothing of blowing money on luxury handbags or whatever.

Julian: But then don't you buy European firms to benefit from that? There is zero correlation between GDP growth and equity market growth. When I spent a couple of weeks in Beijing with a fund manager friend of mine, we just sat there going: "This is like Potemkin." Of China's GDP growth, 95% is driven by fixed-asset investment, most of it funded with ten-year bullet repayment loans (see page 56 for more). So you aren't going to see that there is a problem until there is a big problem. And emerging markets have historically always been geared plays on global liquidity. The first stuff that gets sold down is Philippine and Vietnamese small caps, and then the bigger companies.

Michael: You can't be very bullish about the developed world and be that bearish about the emerging world there seems to be a bit of an inconsistency there.

Julian: But a slowdown in China might be beneficial. I've read other people saying that China's growth isn't good for the world; they pump up commodity prices; and most of the cars they drive there are built there. So it's not necessarily bad news if China slows.

Simon: But it's difficult to think of a scenario where it implodes on any short-to-medium-term view. I am not for a minute suggesting they get everything right. Growth could slow materially and obviously that will have a massive global effect. But it's still growth.

Michael: But like any investment it's about what you are being asked to pay for it. We have some emerging-market investments, but we don't have anything in China directly, nor India, because while they're great growth economies they're very expensive. We think you can buy their growth in British or European firms that have exposure to them.

John: What about the idea that manufacturing can revive Britain? Are we winning business back from China?

Michael: There is wage inflation in China and that will slowly help to rebalance the Chinese economy. But if the question is, 'do you think the UK can rebalance its economy?' the answer is clearly 'no'. We are not about to become a manufacturing economy again just because sterling has moved a bit. The infrastructure is not there, nor the skills.

Simon: You're not getting company creation on a large enough scale either. Britain tends to do well not with big multinationals, but with small entrepreneurial firms, and I'm afraid there we get back into banking issues with lending to small companies. There are still some very good engineering firms, but most of their employees are overseas. I suppose in the long term you've got to invest in education and turn out better quality graduates whether charging £9,000 a year is going to help with that is another matter.

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Our Roundtable tips

Swipe to scroll horizontally
PiaggioMilan: PIA
CompassLSE: CPG
MelroseLSE: MRO
RepsolSpain: REP
InBevBelg: ABI

John: Let's talk about some specific stocks.

Simon: My first is a company called Cape (LSE: CIU). I like stocks that are misunderstood and Cape fits that bill. Most fund managers think it's a scaffolding firm. In fact, it's an industrial services company that does all the dirty work other people don't want to do in power stations, petrochemical plants, mines, and so on. Profit margins are exceptionally high 15% to 16%, and 90% of the business is outside of Britain, in pretty horrible areas in Australia, Kazakhstan, and the like.

Cape had a dreadful 2008 it had overpaid for a couple of acquisitions in Australia. That put pressure on the balance sheet and the market became convinced it would need a rights issue. But the market missed the point that, with 16% margins, you're always generating quite a lot of cash. The recession didn't have as much impact as expected, so Cape got through it without resorting to an equity issue or rescheduling its debt, and profits recovered in 2009. The share price in 2008 touched 20p it's now above 400p, but still only on a p/e of about ten.

It's one of the biggest companies on Aim at the moment, but is going to be relisted next month on the full listing. So that's a nice way of playing mining and oil capital expenditure, which will continue to be a big theme in the next two or three years.

Right at the other end of the scale is Compass (LSE: CPG). It's been a favourite of mine ever since the new management team went in about four or five years ago. It provides food to every canteen that you can possibly imagine. One of the few advantages of the recession has been that all the nonsense we heard over the last ten years about what great business models companies had, and what great cash flow profiles they have, was finally put to the test. Compass came through with flying colours.

The market had worried that with high unemployment, there would be fewer people eating in the canteens. There may have been a few less mouths to feed, but the firm engineered the cost out of that pretty well. Also, in more austere times, companies and public authorities look to outsource more, so Compass's pipeline is currently as strong as it has been in that five-year period.

John: So outsourcing is working for Compass then? Some smaller companies have been hit badly by outsourcing disappointments.

Simon: There are winners and losers. If you take Britain, for example, local authorities are getting together in groups of four or five and banging all their contracts together. That means they are just too big for some providers. Compass may not win all of these contracts, but it'll be on every bid list and it will win its fair share. And it's not really a British story it's more about America, continental Europe and, increasingly, the Far East.

Compass has doubled its margins in the last five years it's starting to generate proper returns, proper levels of cash, and that cash is going to be deployed either to small bolt-on acquisitions, and/or to increase dividends and buy-backs. It pretty much grows at 10% a year, year in, year out, and I think there is still scope for another 200 basis points on the margin. It's a nice, steady company.

My third pick is a slightly different beast Melrose (LSE: MRO). It's a £1.5bn mid-cap. It's run by the type of management team I don't tend to like, sort of corporate financiers. But they made an awful lot of money in a vehicle called Wassall in the mid-90s and they're very smart. They buy companies that they feel are underperforming, turn them around and sell them. They align their interests with shareholders they make a lot of money if they get it right, but they don't if they get it wrong.

They did this very successfully with a British company called McKechnie they sold half of it for what they paid for the whole thing about two years ago, so they have half of that left. Then, just at possibly the worst time at the end of 2008 they bought FKI, another well-known British industrial company.

They have done stupendously with that, even through a very difficult trading period. They haven't sold any of it yet, but they will do. Meanwhile, they have completely transformed the company. What the market has missed is that it has now again got 15% and 16% net margins from 9% or 10% and it's still only on a p/e of ten.

And it can do another large deal at some point. Rightly or wrongly, the market is tending to reward companies that do deals at the moment, mainly because they are being paid for in cash and they can be made to be hugely earnings accretive. I would put a note of caution in there a lot of these deals will turn out to be bad deals. But we don't need to worry about that for a couple of years, until these things go wrong.

Kathleen: We don't look at individual companies, so I will take a slightly broader outlook. There is a structural story for a weaker dollar versus the euro. There are too many long-term drivers of the euro that aren't being priced in. One is Asian central bank demand. They have a hell of a lot of reserves and they want to diversify so why not go into Europe? In terms of the currency, it's the only real alternative to the dollar.

Also, Europe is tackling its problems. Yes, there is probably going to be a default in the periphery. But I don't think Spain is actually that bad an economy. That's quite a controversial view in some quarters, but Spain does have a very strong export market. And while its regions are suffering, it's been able to bring down its deficits centrally in rapid time.

Other countries are dealing with their problems too, working to become more competitive and putting in labour reforms all the things that Germany had to do at reunification and when it joined the euro. It will take a very long time, but I think it is going to work. By contrast, I just see America getting into more and more debt over the next ten or 20 years.

John: So Europe has been forced to confront some of the political issues that the rest of us haven't had to?

Kathleen: Exactly. These weaker economies are having their 'Asian crisis moment'. The problems in peripheral Europe are immense; there will probably be a couple of defaults at least. However, if they can agree on a default mechanism, then even with defaults the euro could still be supported particularly if the Asian central banks are buying. They came in at $1.20 last year and propped it up, then again at $1.30-odd earlier this year. They are very good buyers on the dips.

Julian: I've already given you Piaggio. My second pick is Repsol (Spain: REP). I don't normally like oil companies you are just rolling the dice on geopolitical rights and the price of oil. But people aren't giving the company the benefit of the doubt for the value of its Brazilian assets, and I thought it would monetise them somehow. You've already seen that with the Chinese coming in and doing a 40% joint venture with the firm. That takes pressure off the balance sheet and capital expenditure overheads. Repsol is continuing to find a lot of oil off West Africa. And around Brazil it has rights to so much stuff it hasn't quite ascertained the level of retrievable reserves.

My last choice is InBev (Brussels: ABI) because it is the global Pacman of the beer industry. Every single deal it has made has been value accretive. It only gets 5% of its earnings from western Europe. InBev is very well hedged against input costs, so people should not panic. And just to give you an idea of quite how smart this company is, using its Ambev platform it has started to cross-market Budweiser, as an upmarket American beer in Brazil. InBev just goes from strength to strength and you don't bet against that.

This article was originally published in MoneyWeek magazine issue number 526 on 25 February 2011, and was available exclusively to magazine subscribers. To read all our subscriber-only articles right away, subscribe to MoneyWeek magazine.

John Stepek

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.