Swim with the inflationary tide

published 21 April 2008

Every week, a professional investor tells MoneyWeek where he'd put his money now. This week: Graham Neale, head of equities, Killik & Co.

With soaring energy costs and a rising weekly food bill, the UK consumer is feeling the inflationary heat (given housing market weakness and slowing confidence, UK inflation is largely a result of growth in the cost of inputs, such as foodstuffs and energy).

While the Bank of England's (BoE) monetary policy committee has cut rates to 5.0% this month, its ability to make further cuts is constrained by a consumer price inflation figure that has been above the 2.0% target rate for five months.

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Our investment approach is to swim with the inflationary tide. Although valuations of a number of input cost threatened businesses will appeal to some, we believe cost pressures will continue to weigh on earnings for firms such as food producers. We're generally avoiding UK consumer-facing businesses, for which household cost inflation will add to credit-induced woes. Tesco, for example, will find it hard to pass on price rises to the top-line in the way it has in the past.

We are, however, taking advantage of inflation by investing in stocks that are beneficiaries, such as Syngenta (NYSE:SYT). This company was formed through the 2000 merger of the agribusinesses of Novartis and AstraZeneca. Population growth in the emerging world, a limited global agricultural land stock and biofuels demand is increasing the need to maximise crop yields.

Syngenta sells crop-protection products (80% of revenues), such as herbicides, fungicides and insecticides. It also operates a seeds business (20% of revenues) that covers both field crops and vegetables and flowers. Demand momentum is strong and, we expect, durable. In its first quarter update in April, Syngenta raised its 2008 earnings growth guidance to above 20% after experiencing strong growth in sales of crop-protection products.

Despite the BoE's three cuts to the base rate since December, borrowing costs remain elevated and credit supply tight. Some banks, most publicly HSBC with its mortgage grab last week, have tried to exploit this vacuum. But in the financial sector we see better value in the likes of Erste Bank an Austria-based operator with no UK or US exposure and Close Brothers Group (CBG), which has several divisions, including a defensively-positioned banking operation.

Close Brothers was the subject of bid interest in early 2008 from Cenkos among others which fizzled out, contributing to a fall in the share price of about 30% this year. We believe the outlook for its asset management and corporate finance businesses are weak, but its banking business and market-maker Winterflood, combined with excess capital of about 130p a share, should demand a higher rating than is currently implied at 686.5p a share.

The firm has taken a cautious approach to loan book growth and management over the last few years, which now seems to be paying dividends. It has a £2bn loan book, 121% covered by deposits. It has historically lent short and borrowed long, insulating it from the wholesale funding crunch that has afflicted some of the weaker clearing banks. Close states it has committed borrowing terms for up to four years on its £1.24bn bank facilities, while 50% of its loan book is due for repayment within 12 months. Bad debt levels for the banking unit remained at 1.0% in the first half of 2008, unchanged year-on-year. In fact, we believe its banking division will have benefited in some areas from an improved competitive position due to the credit crunch.