Seven small caps to get your hands on now

At our monthly MoneyWeek Roundtable, three investment experts shared their views on the 'frightening' state of the UK economy, bond market turmoil and more - plus the best stocks to buy in these troubled times.

Merryn Somerset Webb: What kind of economy has Gordon Brown left behind him?

Patrick Evershed: An extremely frightening one. We are living in a fools paradise with a bubble economy driven forward by excessively low interest rates and a vast amount of borrowing. We've got record personal indebtedness, a record number of people going insolvent, a record low savings ratio, record balance of trade deficit and government borrowing out of control. This is just unsustainable.

MSW: So, what can be done about it?

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PE: It's very difficult. The fact that money supply is out of control has led to an asset explosion. To be fair to Brown this isn't just a UK problem, it's just as bad in America. But I think we've got to nudge interest rates up to check the growth of money supply and then as asset values begin to fall I think we've got to bring interest rates down quite quickly. Given the record levels of borrowing, pushing up interest rates is going to be very painful but the only way of resolving the problem is to cause a bit of pain it's going to be pretty unpleasant. Wise people should be building up their cash.

MSW: What does this mean for markets?

PE: I think the stock markets have probably peaked out and are on the way down. The Chinese market is one of the more dangerous ones given how fast it has gone up but I also think the UK market and the American markets are likely to come down quite some way.

Marina Bond: I agree that in the UK we have got an inflation problem and I think the MPC have ignored money supply at their peril. It is now growing at nearly 14%. The last time it was so high was I think 1991 when interest rates were 14%. I know circumstances aren't quite the same but I do think that interest rates are going to have to rise. And of course that is going to have an impact on the consumer particularly as so many people have fixed mortgages coming up for renewal they are going to see huge hikes in their payments.

MSW: They are - they took those fixes out at around 4% and now the cheapest they can possibly get is about 5% and even those come with arrangement fees of £1,000 or £1,500.

MB: Still, I'm not as bearish as some. There are still too many bears around for there to be a real market collapse. Things will be fine until the last bear gives up.

PE: I don't think I've been more frightened of what might happen to the markets at any time over the last forty years as I am now.

MSW: Really! What makes this so much worse?

PE: These record amounts of debt which mortgage companies are making interest only loans that last for 25 years, with no capital repayment and even some for 50 years. And of course students are soon going to be coming out of university with £30,000 worth of debt and will never make it on to the housing ladder. As a nation we are already living way beyond our means. We also used to have the best private sector pension schemes of any country in the world our pension schemes were the envy of the world. The abolition of advanced corporation tax has destroyed it: companies are putting far less into pension schemes and individuals are putting virtually nothing into pension schemes. The next generation will soon realise they are in a pretty bad position and then they are going to have to start saving like mad.

MSW: Does your Doomsday scenario come with a housing crash?

PE: I think it would be a mistake to talk about a housing crash because there is clearly a severe shortage of housing; having half a million immigrants every year means we have a real physical shortage of houses. In London that shortage is bineg compounded by the huge bonuses so many in the City are getting. That said I don't think bonuses will carry on at this sort of level. Every seven or eight years there is a major shake out in the City. Job security isn't good. That might put a cap on London prices.

Nick Lewington: But it isn't just City buying. It's overseas buyers people from Russia and Hong Kong. Also London is now the financial centre. In the bond world my side of the fence - a lot of New York houses have shut down their international desks and moved them to London. That boosts employment here and demand for housing. I'm not bearish on houses and I'm not as bearish as everyone else on markets either.

MSW: So what do you think is wrong with the bearish case?

NL: Globally I don't see growth really slipping in the next few quarters. Yes in the UK and the US but not in China or in India which is booming away. Interet rates are low in China and they do need ot go up over time but they won't any time soon. This general switching of the global growth engine from the US to Asia should keep things stable. The bottom line is that over time, over the medium to long term, there is a lot of scope for that area of the world to continue to grow fast. In the UK I do think the point on money supply is interesting but the bottom line is that the MPC targets not that but CPI and that is forcast to be 2.6% over the next two years. Yes, the minutes of the last meeting shocked people but the concerns were more about fears of rising food prices and oil.

MSW: But there is every chance that food and oil prices will keep rising. Surely that will keep hitting the CPI?

NL: That's why the market is pricing in a 40% chance that rates will hit 6 and a certainity that they will hit 6%. Yet most economists expect rates to peak at 5. I expect 6% and that's why I think that the UK bond market is currently oversold. I would be buying short-dated gilt positions right now.

MSW: Patrick, what's your take on the idea that Chinese and Indian growth can cover for everyone else?

PE: There is no doubt that India and China are now dominating economic growth but this has been brought about in the first place by the developed world increasing their imports massively. As a result of what's going on in the US and the UK they have absolutely massive trade deficits and this again can't go on forever. When the squeeze on the consumer begins to bite in the US and in the UK, as I'm sure it will, that's going to put quite a dampener on the economies in India and in China.

MSW: They're not generating enough domestic growth to cope?

PE: In China there is a massive savings ratio, so the consumer in China could certainly take up any slack that's created by a fall off in demand in the US and in the UK. But that doesn't mean they will. At the moment a very significant proportion of their income is saved and has been for some time. Certainly, they could start spending but the fact that they could doesn't mean they will.

MSW: Isn't there anywhere at all that you would be tempted to invest?

PE: I would invest in non-cyclical stocks. Over the last couple of years I have had a bad time, in relative terms, because cyclical stocks have been rising very sharply and I'm more invested in long term growth areas healthcare and biotech companies which should continue to grow whatever happens for example.

MSW: Are you in similar sort of stocks Marina?

MB: I do like the healthcare sector - there is a real structural growth story there. I also like the technology, which is slightly more cyclical, particularly in the small cap area. There you can find really find decent cash generative earnings growth. Multiples are also low and consolidation in the sector is really taking off. So those are two sectors I like at the moment.

PE: There isn't much good in looking for high yielding property investments in the UK because yields have been driven to very low levels, but I'm invested in a company called Alpha Pyrenees (ALPH) which invests in high yielding commercial properties in France where they get 7 or 8%. In Europe rents tend to be tied to either the cost of living or building costs so rents are adjusted upwards every year according to an index. So yields should keep rising.

MSW: What about the German property market?

MB: I am still positive on the German property market. There is still a significant yield gap to exploit and while there have been a few hiccups the German economy is doing very well. And there is still a lot of potential for restructuring in terms of increasing labour flexibility, reducing taxes and cutting red tape. I still feel there is a lot to go for in Germany and eventually it will be reflected in property prices.

PE: I'm invested in a company in the Balkans called Equest Balkan Properties (EBP) which like Alpha Pyrenees, invests in high yielding properties but they also look for properties with capital growth potential. They may buy a warehouse with a large amount of land attached so that they are getting a high yield initially from the property they've got but they've also got great expansion possibilties. They might buy up an old hotel that's already giving good yield but they can pull it down and turn it into an office block or something. The problem with this kind of thing of course is that if there is a slow down in the world economy it will hit emerging economies harder than others. But the only problem is that with some of these emerging economies if there is a slow down in the world economy it might hit them harder than others. However basically the idea of looking for high yielding properties in economies which are growing rapidly is a good one.

MSW: What about all the Chinese AIM-listed companies? If you are a believer in Chinese growth are they safe way to invest?

PE: I am invested in one Chinese AIM-listed company called China Shoto. It makes which makes stand by batteries for mobile phones and electric bicycles one of China's great growth sectors. The company is growing at an enormous rate and is on a very low p/e ratio.

MSW: Where do you see the oil price going from here?

NL: I can't really see what might move the oil price from where it is now. I can see it trading in maybe a $60-80 range but I can't see any rationale for why it would move out of that range. Clearly if it stays in the top of that range it will fuel inflation but given that real rates are rising, which should keep inflation in check I don't think it would be that negative a scenario for economies. I also think central banks have done a fantastic job keeping inflation expectations in check. In the UK expectations are for inflation to be a tad over 3% over the next 10 years that's in the face of sharply rising interest rates. I don't see oil or inflation being a long term problem.

MB: RPI is quite a lot higher than CPI and a lot of people watch that.

NL: It's important for wage settlements usually but this time round wage rises have undershot expectations. expectations. In the past RPI over 4% has got the unions upset and meant negotiations for higher wage settlements but it hasn't happened this time round. RPI is important for the man on the street and the trade union and the wage settlements but as time goes on, CPI will become the major focus as it has in pretty much every other country.

MSW: But people notice that prices are going up more than 2%, don't they?

NL: So why isn't inflation expected to go up over that period?

PE: The Bank of England and the Chancellor of the Exchequer have done absolutely nothing to keep inflation down. Money supply is out of control normally when money supply is growing rapidly you expect to have high rates of inflation. We haven't got it this time but that's nothing to do with the MPC, its to do with cheap goods coming in from China and India keeping prices down. and that's because we are getting cheaper and cheaper goods coming in from China. If you go into the shops you will find that imports are falling in price but as anything home based services and particular is rising in price fast.

MSW: But that's coming to an end as wages start at least levelling and perhaps rising in China and India. We might soon start importing inflation instead of deflation from China and India.

NL: It is true that cheap prices from over there are not going to last forever. I read in the FT recently that in India now, in order to get Chief Executives to come and manage booming companies, you have to pay in excess of what you would pay someone working in London. But that won't necessarily translate into inflation here given how the MPC is pushing interest rates up. If the markets were really fearful of inflation they'd be pushing bond yields much higher.

PE: I agree that we needn't worry too much about inflation compared with the past but I certainly think that the MPC and Gordon Brown deserve absolutely no credit. It's capitalism coming to life in India and China that's kept inflation down here.

NL: I think the greater issue in today's markets is what is happening to risk generally. In the last five to six years buying risky assets such as junk bonds has been a very successful thing to do but now suddenly there has been an enormous repricing of risk with credit spreads rising fast. In the UK the spread on AA bank debt has doubled relative to government bonds in a month.

MSW: And why has that happened?

NL: Because I think investors are starting to look at some of the actual investments on people's books the CDOs, CDO squares, CDO-cubes and the volatility of the market is increasing. Look at what's happening to US home equity company ABX. Its bond issue 07/01 was issued at 2.5% over LIBOR. Now it is trading 13% over. That is a disaster - and a lot of people are suffering. I would be interested to understand what effect this repricing of risk will have on global stocks.

PE: Given all the gearing in the economy it would seem to me that once assets start to fall there could be enormous financial problems. Private equity deals have been massively geared for example and but profit margins are already at record levels. What if they start to come down? And interest rates keep going up? There could be a crisis.

MB: Surely the key to the bond market correction is that real yields have been rising. So while yes there has been a repricing of risk and there is inflation in the system it also reflects the fact that there is real growth out there. So I feel that when it comes to equity investing we should shifting away to investing in yield assets and into growth stocks. I think it's time for the growth stocks to see some fun really.

MSW: So, back to healthcare.

PE: In the last six months there has been tremendous mobility in the markets and much of the focus has been on bid speculation. This has meant that people have been ignoring sound, solid, cheap growth companies which should go on growing whatever happens.

MSW: So, it's the very small companies that have been ignored.

PE: Yes, in the main. There are a lot of good growth companies which shouldn't be hit by a slow down in the economy which are still are low ratings.

MB: If you take out the loss makers out of the equation and look one year forward the average AIM p/e is around 14 times. Yet the growth rate is more like 20 times. Compare that to the FTSE 250 which has I think, a forward PE of 15 times and growth 9%. And the FTSE 100 a PE of 13 times but growth of 5.5%. AIM has had a bit of a bounce recently but I still think there is real value there. There are over 1,600 stocks on AIM some growing at 30% plus and trading on very low multiples.

MSW: Last time we spoke you were very bullish on Renew. What happened to that one?

MB: It's done well. I'm still holding it, it's not expensive and has seen very good results.

MSW: Patrick?

PE: We mentioned Chinese companies China Shoto (CHNS), which makes batteries. It's on a single figure PE and growing rapidly and obviously with the Olympics in Beijing next year, anything to do with mobile phones and standby stations should do well. There is also this tremendous growth in demand for electric powered pedal cycles and they do that.

MSW: Have you been to China recently?

PE: To China? Never.

MSW: Have you Marina?

MB: No, I haven't.

NL: No.

PE: Baltic Oil Terminals (BTC) I quite like at the moment too. They are building two oil terminals in the Baltic which should come on stream later this year. The shares have fallen out of favour for no particular reason and are now on a p/e of around 5 times and about half the value of their assets. They are also exploring for oil and there is nothing in the valuation to reflect that. value on oil. for them finding oil, they are standing about half asset value and on a PE of 5. Of course anything in Russia can be dodgy.

MB: In the UK I like Inland (INL). The company buys up land that it thinks it can get through the planning process. It specialises in getting difficult situations through and has got a really good track record of doing so. Once it has permissions it sells the land on to the house builders. They floated recently with an estimated NAV of 41p but since then they have made an acquisition and the shares are still only trading at around 49p. They look good value.

MSW: Even if house prices start falling?

MB: Its less about prices than the supply of land. That problem is not going to go away and the problem of the getting land through the planning process which we've had for ages, that's not going to go away either in the short term.

NL: We like the US refiners Valero Energy (VLO.US) and Tesoro Corporation (TSO.US). They are both independent trading refiners and are both looking a bit too cheap on forward p/es of around 9-10 times. We're also still very keen on the bit mining stocks such as Anglo American (AAL) which should be a long term hold for everyone.

PE: I worry a little about oil. Its liable to be volatile because of the potential political problems. The Middle East is very unstable and Putin could decide to cut off oil supplies or of course if anything happened in Iran, you could see the price of oil rise very sharply. But if these political problems die away and the higher price of oil lead to more conservation and more exploration I think we will see the price of oil come down. It is totally impossible to see what's actually going to happen but it's going to be either a sharp rise of a gradual fall over time. Either way I think one has to keep a reasonable stake in oil.

MSW: Have you been investing in the renewable energy companies?

PE: I am in a company called Renesola (SOLA) which makes solar cells in China that's done extremely well. I have been invited to invest in various wind farms and I haven't. I have invested in fuel cells and made money out of one or two of them. But discussing alternative energy must bring one back to food. Growing energy takes up land that could be used for food so with less land being used for food food prices are rising. Every time the green brigade get somebody else to build another power station based on bio-fuels they are actually forcing up food prices more and more. There are more and more bio fuel stations being built for generating electricity and producing fuel for the automotive industry and I think that will keep food prices going up.

MSW: So rather than investing in alternative energy we would be better off just buying soft commodities.

PE: Possibly yes.

MB: I was in Renesola but have sold now. There are lots of companies coming to market doing similar things but I just feel that they are coming on at ratings that are pretty high at this point. We also own Tanfield (TAN) which makes electric engines and you could argue is green. Its done really well.

PE: I'm also in Enova (ENV) which sells electric controls to Tanfield and also those hybrid vehicles. That might do extremely well it doesn't matter how green you are using energy more efficiently makes sense.

Our Roundtable Panel

Patrick Evershed New Star

Marina Bond Rapids

Nick Lewington UBP

Merryn Somerset-Webb