Where to find value in a tricky market

published 14 June 2006

It's a tricky market - but if you want value, look at oil, shipping and French property, say our panel.

For our monthly Roundtable, we invited seven experts to join us for dinner and give us their views. Here, they reveal what they would, and would not, invest in today.

Merryn Somerset Webb: What do you all think of the stockmarket? What's the outlook?

Ken Fisher: Good. It's a beautiful world. There's a lot of pessimists out there, but what's so bad? Take the dollar. For ages there's been an expectation that the twin deficits in the US will make the dollar implode. But that never happens.

Barry Norris: That doesn't mean it won't. The dollar has done well since the beginning of the year because back then a good number of people thought that the Fed would leave rates at 1% for the whole year - or at least until after the Presidential elections, or when the US economy started making jobs again. Instead, interest rates have gone up twice - so it's no wonder that the dollar has strengthened against most major currencies.

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Pelham Smithers: One interesting thing in the short term is the flow into dollars from Saudi Arabia. With the oil price high, they have major cash flow in dollars and they have made it clear yet again that they are not going to diversify their currency exposure.

Bill Bonner: Yes, oil is priced and paid in dollars. As the price goes up, people need more dollars, so the dollar goes up. But I think there's more to it than that. Most of the world's debt is also in dollars. And debt acts as if it were a short position. You know, debtors are betting the dollar goes down so they can pay off debts with cheaper money. That's been a good bet for nearly 100 years. The only time it wasn't a good bet was just before the Great Depression, when people had so much debt. Debt expansion is typically followed by debt contraction. That's the way the cycle works. And when debt contracts (typically, you get deflation) the currency becomes more valuable. I think we're heading into another major cycle of debt contraction.

MSW: Let's hold that for a moment and stick with oil. Where's the price going?

BN: At the last Roundtable, I was pretty bullish on oil. I still am. Over the last 20 years there has always been spare capacity on the supply side. Now there is very limited spare capacity - only about 1.2 million barrels a day shared between Saudi Arabia and Iraq. That's only just over 2% of global daily demand. And it's a lot less than it used to be. Twenty years ago, Opec had 18 millions barrels per day of spare capacity.

Tim Price: Good point. It seems to me that's the major difference between good sectors and bad ones - inventories. Intel got hit hard after it came out and told the world its inventories were rising. And that's the case in the whole tech sector - IBM, Texas Instruments, Cisco - they all have too much inventory. But in the metal and oil sectors, inventories are dwindling. Stockpiles of aluminium, copper, lead, tin and zinc are all going down. Aluminium supplies have been cut in half since January. Copper inventories are supposed to be down by almost 90% over the past year. They're working on opening new mines, but that's still a long way off. That's why we like diversified miners, such as Anglo American.

KF: What people don't understand is that rising oil prices are deflationary.

MSW: Well, it's a paradox. Generally, deflation means falling prices.

Dan Denning: Yes. But an increase in energy prices is like a tax hike. It slows down the rest of the economy. You have to ask at what point does oil become so expensive it stifles growth'? For example, in India - I was there in May - business got hit with rising interest rates and rising energy prices at the same time. That put a brake on economic growth. Then in Shanghai they've had to ration electricity. So higher energy prices are slowing growth there, too. At what oil price will the whole globe go into shock, or recession?

BN: What has happened over the last 15 years is that the price has been low and so there has been a problem of lack of investment. At the same time, the oil majors have been so focused on pleasing shareholders with huge returns on capital that they have had unrealistically low hurdle assumptions in terms of at what price a project becomes worth doing. Also, for many years Opec hasn't needed to invest because it had such a glut of oil that it could easily bring to the market.

MSW: Yes that's how we got where we are. We are at what appears to be a cyclical bottom. But what about the Peak Oil' hypothesis? Don't you think the world's supply of easily accessible oil has already been drawn down? Won't oil go up - no matter what - because there is less and it is more difficult to get at?

DD: All the big Opec oil producers have been overstating their reserves. They did that just to get higher sales allotments - which were based on how much oil they had in the ground.

TP: Poor old Shell has been clobbered for this, but it isn't just a problem for Shell.

BN: This all makes buying oil firms, even now, a pretty good move, given that most analysts are still assuming prices in the mid $20s when they look at where share prices should be.

MSW: Are you still a buyer of Shell, Tim?

TP: Yes, Shell and BP.

MSW: Ken, you're a bull on the equity market as a whole, aren't you?

KF: To me, this year looks like a back-end loaded year - it's like '99, '98 or '97, when shares boomed in the last quarter of the year. Right now, cash balances - across money managers and corporations - are at record levels relative to assets. Also, valuations are very low by historical standards - at least when compared to Treasury yields. Look at it like this. Historically, earnings yields around the world have been slightly less than the relevant Government bond yield. Today, the earnings yield is higher than the bond yield in almost every instance. Look over ten years, and even with a low growth assumption, valuations are low in comparison to interest rates.

Then there's investor sentiment, which I think is important. The Merrill Lynch index shows more people forecasting negative returns than positive. That's extraordinary, given professionals have a greater tendency to be over-optimistic than over-pessimistic. To me, it seems a bullish sign - they can't feel much worse. It's hard to see what's so bad right now. Most of my life, a lot of bad things have been going on. But there's nothing really bad happening right now. There's always the possibility of terrorism, but I'd rather have that than the constant threat of the Soviet Union. One of the mistakes people are making is to forget how volatile markets are. For the last year, things have been unbelievably stable. So the world has come to the view that things are going to be boring. But historically, markets are volatile - 70% of annual returns in the US have been either negative or higher than 20%. Next year will be either down or up big time. I think it'll be up, but either way it's exciting.

BN: As a professional equity investor, I'd be delighted if you are correct. But I think the worry is that 2004 is looking like the peak year of this economic cycle. At the moment all the leading indicators are declining - the US economy isn't creating much in the way of jobs, for example.

BB: Did you see the US revised the latest figures? They found 100,000 more jobs. Investors were pleased. But the US economy needs at least 150,000 new jobs every month, just to stay even. I recently took a long trip across the entire country. I saw thousands of new houses and shopping malls being constructed - but not a single new factory. Or, to put it another way, I saw lots of new ways for Americans to spend money, but no new ways to earn it. Where are the new jobs going to come from? They can't just sell things to each other.

BN: The fact is, this may be the best year in the cycle for earnings - we've had all the big market stimulus - tax cuts and low rates. From now on, economic growth decelerates.

BB: And the American consumer is running out of buying power.

KF: Yes, but they've been saying that for four years.

BB: That makes it more true, not less. With the low level of job creation and income growth, the consumer can't keep spending forever.

PS: The US is still a pretty fast-growing economy. But with rates rising, the consumer can't re-mortgage any more in order to finance his spending. So where is the spending to come from?

DD: There's also the worry that after the election - whoever wins - something is going to have to be done about the budget deficit in the US. At $400bn, it's the largest ever. So I'd say that there's a chance that we'll see post-election tax rises. The winner will want to do it fast so as not to pollute the rest of his term. That's not going to help spending.

BN: Tax hikes, interest rates on the up and slow job creation - it's pretty hard to see where the US economy could surprise on the upside. Everything on the horizon seems to be negative.

KF: Folks have been forecasting rising rates for a long time and it's not happening. They're not gonna happen.

BN: Not if the economy is weak.

KF: The economy has not been weak. The upside will come from the fact that everyone expects rates to rise, but they aren't. There's also no reason to think that we are at the peak of a cycle here. Alan Greenspan wants to keep thiscycle going until the end of his term. He has very little reason to do something extreme - like raise rates too far. He's at the end of his tenure as, arguably, the greatest Fed Chair in the history of the Federal Reserve. And as for taxes, it doesn't matter what Kerry says, the fact is that were he elected, with a Republican House, he just can't raise taxes.

DD: It would not surprise me if even the Republican house voted for a tax increase in the first part of the Kerry term. There are some Republicans, believe it or not, who are still fiscally conservative.

MSW: Let's talk about specific stocks.

PS: I'm still in Shell. It's still undervalued.

BN: I'm still holding Frontline, the shipping stock that I recommended to MoneyWeek back in September. Anyone who bought them would have made total returns of about 240%.

MSW: Wow, we should increase the subscription price.

BN: I've actually come across another stock that I'm very excited about, as excited as I was about Frontline in September. It's also related to the energy sector, which I think represents a good bet, in that the supply side is very limited, so prices are going to stay high unless you get a hard landing from the global economy. And even if we do move into a global economic recession, there will be worse places to be than in the energy sector. However, the place to invest within the energy sector is not necessarily with the majors. Their costs go up too - because they'll have to invest more in order to stay in production. So you either want to invest in a small exploration and production company that's got lots of reserves, like Cairn Energy used to be, or, if you want to invest in oil services companies, my fund has a high exposure to these.

The firm I'm very excited about is Maurel Et Prom, a French E&P [exploration and production] company. They have been looking for oil in the French Congo, not to be confused with the Belgian Congo, which has been a civil war area. They've found 280 billion barrels of oil there. The value of the company is about US$1.2bn. So you're basically paying just over $4 a barrel for the oil already discovered. And the chances of finding more oil are quite high. In addition, the tax rate that they pay in the Congo is low in terms of international comparisons. Yet the company trades on about eight times 2005 earnings.

Rupert Lee Brown: My favourite investment is still property. But not UK property. French property. There's high demand and the Brits are still piling in.In fact, the bigger the house, the cheaper it is. Buy chateaux.

MSW: Wow again. That's a daring, contrarian recommendation.

RLB: Well, it's not for everyone. And it is odd. But then, these are odd times.

TP: At the first Roundtable I attended, my favourite stock was Anglo American, and that remains the case today. It's almost a bullet-proof investment, over the longer term. If you believe there are risks of global inflation, that China is a growth story, commodities really make sense. And Anglo American is into everything from platinum to coal.

DD: I'd go for New York-based firm Bunge. It does soy beans, fertiliser and some other foods. My reasoning is simple. As the world gets richer, the demand for high-quality food, notably proteins, rises. And that's the business Bunge - an agri-business with major operations in South America - is in. Did you know that Argentina has 11 feet of topsoil? Bunge exports to China, where demand for better food is soaring. And it's still cheap. The stock trades at only about 11 times earnings.

KF: In the US, I'm keen on Scholastic, a leading purveyor of children's books. They've beaten themselves up with bad management in the bad past, but that has changed. There is now a nice turnaround in place. The other one I'd recommend is a restaurant chain, Crackerbarrel, which is doing great picking up market share in suburbia as America flees city centres. They have great locations and also sell merchandise - collectable kind of things - with their food, so they're half a retailer too.

BB: I'm still a buyer of gold - it's the only asset class that holds its value over the very long term.

MSW: Didn't you recommend that six months ago?

BB: Yes.

MSW: Gold hasn't gone anywhere.

BB: No.

MSW: Aren't you afraid of being called a stopped clock?

BB: Hey a stopped clock is right two times a day. That seems good enough. Gold was the wrong investment for the last 20 years. Its hour must be coming around soon. Besides, the last bull market in gold took it up more than 2,000%. I don't mind waiting.