Are interest rates going to rise not fall? Is the property market sliding? And what's the story with salmon? This month, we asked five investment experts for their views on interest rates, the property market, commodities, European markets and salmon...
Merryn Somerset Webb: Let's start with this week's hot topic: interest rates.
James Ferguson: There seems to be a general idea that we are at the start of a series of interest-rate cuts, thanks to the fact that the economy is running out of steam. Economists such as Roger Bootle are saying that, for example, there'll be a total of three cuts before the end of the year. I wouldn't be so sure.
I'm not arguing with the fact that the economy is weak. Of course it is. I just don't think rates are going to fall very far. Every time we get to this point in a cycle we get a consensus that rates must be cut, but usually we only get a couple of cuts before inflation starts to move out of control. This is the time in the cycle when people start asking for pay rises and in the UK they already are and that feeds through into inflation. Then there is the fact that a weak economy means a weak currency. That means imported inflation. These two effects make cutting rates to stimulate the economy pretty dangerous.
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In fact, in every single hiking session since 1970, except one, they have cut in the middle and then thought "Oh no, we can't" and gone back to hiking again. So thinking that a big round of rate cuts is going to bail out the housing market and the consumer is very over-optimistic.
Tim Price: Does this really matter for our equity market any more, though? A hefty proportion of the companies in the FTSE 100 are internationally based, so they are going to be driven by US and European interest rates at least as much as whatever happens in the UK.
JF: Don't get me wrong, I'm not talking about stocks here. Just short-term interest rates. In fact, I think stocks are driven by long-bond yields, so short-term rates aren't really of much relevance to them. At the moment, in the Anglo-Saxon world, you've got short-term rates going up but long rates going down, so I'd say that's positive for stocks. I might think the UK economy is an absolute mess, but I'm bullish on stocks.
Barry Norris: What we really want to be doing in this environment is investing in the FTSE 100 multinationals whose earnings are going to be helped by the pound falling a little, and selling the smaller companies that are much more dependent on the housing market andthe retail environment.
JF: Interestingly, that looks like a strategy that would work everywhere at the moment. Not just in the UK and the US, but in Japan and Europe too, big stocks are trading at a big discount to little ones.
Pelham Smithers: In the UK, you can see that clearly in the pharma sector. Both AstraZeneca and GSK have great drug pipelines with far more drugs in Phase 2 and Phase 3 trials than at this time last year. They've also got a string of drugs that are selling very well, and suddenly a currency advantage too as the pound weakens against the dollar. It all makes them worth looking at right now.
JF: I would add to that the fact that they are also very cheap compared to where they have been historically. You could make a very good case to say that even without any of the drivers to their earnings you've mentioned, share prices in the big European and UK pharma companies are way below where they should be if you look at them in a historical context.
BN: It strikes me that what is driving the market up is not that people are expecting profits to grow massively from here, but just that the cost of capital for most companies is low and that the yields on other investments are very low as well. In Europe, for example, government bonds now yield the same as the average equity, and that's always been a sign to buy equities and sell bonds. You get 2% putting your cash in the bank, 3% investing in a ten-year government bond and about 4% investing in a triple-B corporate bond. Yet you can find a number of blue chip European companies, such as France Telecom, Deutsche Telecom, BNP Paribas, ING big household names yielding 5% with well-covered dividends and the possibility of capital growth. Look at it like that and it doesn't matter what's going on in the economy. Which famous investor said "I think about economics for about five minutes a year and that's five minutes wasted"? I agree with him.
TP: It is certainly true that equities internationally look like the only game in town these days. Bond yields are low in both absolute and in relative terms, and a lot of alternative investments aren't looking any less expensive either. Equities offer a better risk-adjusted prospective return than any other asset class right now, relative to bonds, relative to so-called alternative investments, relative to private equity, relative to property.
BN: Certainly relative to property. All property, and particularly buy-to-let property, is a sell. Everyone should sell all of their buy-to-let properties if they can and buy equities. The yields on properties for buy-to-let, once youhave paid somebody to manage the property for you, once you've financed the vacant periods, are well below what you can get on the equity market and well below the cost of your mortgage. I can't understand why anyone is still doing it.
MSW: Does any one have anything encouraging to say about the property market?
BN: Not in the UK, but possibly in continental Europe. In Germany, the only major property market not to have seen any rise in prices in the last decade, there are some signs that prices are beginning to move in the right direction.
JF: I'm beginning to see articles about Polish people going across to Germany to buy up property there because it's so cheap. That's got to tell you something.
MSW: The other thing a lot of you are bullish on at the moment is commodities. What are everyone's favourites?
BN: Uranium and salmon.
PS: Water is another good one. There's an ongoing shortage of water.
BN: Let's start with uranium. The uranium spot price is about $20 a pound up from a low in 2001 of $7. Yet over the last 60 years it has averaged $32. Adjust that for inflation and the average price has been $100. And demand is rising. Today 20% of electricity in the world is produced by nuclear reaction and electricity demand is set at least double over the next 20 years. A lot of that new supply has to come from nuclear energy, which is very attractive in terms of efficiency. But there is a limited supply of uranium. There are 170 million pounds of uranium used for power generation throughout the world every year, of which only 90 million 55% is actually newly produced. The rest comes from inventories or Russian stockpiles. But inventories are being run down and the Russians are quite keen to hang on to some uranium for their own reactors. So you've got big demand and lack of supply. I wouldn't be surprised if the price more than doubles over the next few years.
TP: Among other things, that would suggest that buying BHP Billiton wouldn't be a bad idea.
BN: My favourite is more of a pure play listed in Canada, Southern Cross Resources.
JF: You're recommending a Canadian mining company? Has anyone ever made money on a Canadian mining company?
BN: I'm not saying it's not speculative. Southern Cross Resources is currently being acquired by a South African company called Aflease. Aflease gets a listing in Canada, where most of the uranium analysts are based, and in the process combines two second-tier companies into one reasonably large uranium producer. Basically, you only have to assume a uranium price of $50 a pound over the next ten years ie that the price doubles and the new company that is will be trading on only two or three times 2007/2008 earnings.
JF: What if it doesn't double?
BN: That's why it is speculative. I'm not suggesting that you put your pension in it, James.
MSW: Now tell us about the salmon.
BN: Occasionally, you get opportunities whereby you can invest in an industry that everyone hates at the perfect time when it has consistently destroyed money for some time and when things have been so bad that no one will fund new ventures and capacity shrinks. That's the case in the salmon industry. So many farmers have gone under that the banks now won't lend money to anybody who wants to add capacity in salmon.
So supply is standing still or diminishing. And the demand side is obviously growing everybody knows that salmon provides you with a lot of good protein. This means prices are going to be pretty tight from here. In fact, they've risen substantially. Now the investment you want to be in here is a Dutch company called Nutreco. Its main business is animal feeds. A very boring business, but you can justify the current share price with it alone. So you get the group's salmon farming business thrown in for free. Yet if you were to value the salmon business on a reasonable multiple, there is no reason why Nutreco's share price shouldn't double. The risk/reward situation here looks good.
JF: Those are both nice stories, but I'm not sure I'm convinced that commodities are the right place to be at the moment. I have a nasty feeling that this particular leg has run out of steam. Most prices have come off enough to convince me that they've broken their up trends. Silver has done that, gold has done that. And many of the secondary commodities that have benefited from Chinese demand are beginning to suffer from a margin squeeze. The Chinese make plenty of their own steel now, for example, so their competition is pushing prices down.
PS: It is certainly clear that steels, shipping rates and things like that aren't at the highs that we saw last year, and that is relatively bad news for companies in those businesses. However, the revaluation of the yuan does give a relative advantage to those companies that have suffered very badly from Chinese competition, mostly in the consumer electronics, office automation and electronics goods areas. Many of these operate on minuscule margins, so a 2% move in the currency in their favour does make quite a bit of difference. It's certainly good news for Matsui and Samsung.
JF: There is one commodity I would buy, though: computer chips. Everything else is in danger of being quite near the top of its cycle but I think you can makes a good case for the chip cycle being quite near the bottom. It seems it hit a low about three months ago the Philadelphia SOX index has gone up 30% since then and now the foundry makers and the bulk chip manufacturers seem to be doing well again. That's the cycle I'd play at the moment.
PS: The semiconductor companies have destroyed amazing amounts of capital much more than the salmon industry.But the chip industry isn't quite like the salmon industry everyone in this one still has access to capital.
TP: And a lot of national champions are being artificially kept in business, whereas presumably that doesn't happen much in the salmon market.
JF: Which is why, when you buy these things, you have several rules of thumb. First rule of thumb is that you don't buy them until they are trading on one times their peak profits, which is now the case with some of them. UMC Japan, current share price 46,000, earnings per share at the last peak 46,000.
BN: Most of the ones that I see in my market (Europe) are still trading on 15 times peak earnings, so it is clearly different in different markets.
TP: Japan as a whole still looks interesting, doesn't it?
PS: Since the end of the war in Iraq, Japan has done very well. But most people still think that the move in the market is just a cyclical rebound rather than the beginning of a real bull market, as the economy just has too many structural problems to do well. And it is true that it is hard to tell a good economic story about Japan. You have a huge national debt of 180% of GDP, which is still running at 8% of GDP a year and needs to be reined in, something that can only limit growth. And you've got an ageing population, which needs to save for its retirement, given that its pension system has been wiped out in a not dissimilar way to the one that's been wiped out here.
However, it is much, much easier to come up with an investment story for Japan. The stockmarket is still trading at the same levels it was at in the early 1980s, so any one company from the dartboard of Japanese stocks is clearly at risk for takeover. To overcome that, what do you do? You raise the dividends to get the share price up. And that's what they are doing. Relative to cash and to bond yields in Japan, Japanese equities offer a good return and that makes them interesting.
BN: A UK fund management group has just launched a Japanese income fund.
Sven Lorenz: Like Barry, I rarely look at economies, just at stocks, so this is the kind of story that really makes sense to me. I'm always looking for cheap shares with a catalyst to push them to a new level. There's a lot of that about in Japan, but there is a good deal closer to home too. My mandate is to seek out opportunities all over the globe, but I don't need to go very far these days: in Europe there are simply scores of firms that look boring at first glance, but they actually have a pretty limited downside along with an upside of 20%, 30%, 40%, 50%.
MSW: Is there a European market that you particularly like?
SL: Yes. Germany looks like a disaster area economically, but I am a pure bull on its stockmarket. One thing to look at is the cross holdings situation. Few people realise that after the autumn election in Germany, there's likely to be a legislative change that imposes capital-gains tax on a firm's sale of a stake in another firm. That means large companies in Germany with cross holdings are now desperate to sell before the election. For example, Munich Re is selling off its holdings in Allianz. It used to hold 13%, but has sold its stake down to under 5%. That's pushed the price down. Allianz is a great-quality company and now it's on sale.
MSW: Any others?
SL: On the smaller cap side I'd be tempted to look at Dr. Scheller. It is a high-quality producer of cosmetics under the brand name Manhattan. You've probably never heard of it, but it is the second-biggest brand in Germany, selling in 11,000 outlets. Right now it is just a domestic player, which is why it has been seeing zero growth demographics have been working against it. But here's the interesting thing. Just before the retail slump kicked in in Germany in 2000, the firm built a huge sparkling new production facility in southern Germany, which they've only been able to run at about one-third capacity since.
Then a couple of months ago, a listed Russian company Kalina, the largest distributor of cosmetics in Russia turned up saying they had a shortage of product to sell and needed someone to produce for them. The result? Kalina has bought just bought into Dr Scheller at e4.3 a share (it is now trading at e4.8) and is going to be selling Dr Scheller cosmetics in another 23,000 outlets. This is pretty amazing news: Dr Scheller was already profitable working at one third capacity, so imagine how well they'll do working at two thirds capacity.
JF: Is Kalina likely to try and buy out the rest of the company?
SL: Under German takeover law, Kalina cannot buy more shares until April next year. But it would be barking mad not to try and buy the remaining shares then. Right now you can buy the shares at only a 10% premium to the price Kalina paid, but given how much value they're adding, the price will be much higher next year.
BN: How big's the company?
SL: It has revenues of e80m at the moment, so it is only a micro cap.
JF: One of the big caps I really like in Germany is (chemical company) Henkel. The shares have been more or less flat for six years, yet over that time its operating environment has improved. There are a lot of European stocks out there that have a lot of catching up to do. They're really cheap and they're very low risk, but not on investors' radar. Once they get on it, however, they're off.
TP: I suggest that another factor that should keep European markets going is that a lot of European investors have now come to terms with the scars of the bust years that started in 2000 and are regaining an appetite for risk. So they're getting back into their own markets.
MSW: Any other top tips before we finish?
TP: I'd just like to point to the fact that, year to date and over the last five years, there has been a remarkable consistency to the top ten performing sectors in the FTSE 350. There's tobacco, mining, electricity and oil and gas. I'm a believer in the existence of longer-term trends, and my contention would be that what's worked recently and what's worked over the last four or five years has every chance of working for the foreseeable future. So I say these sectors are going to keep outperforming not least because they are still trading at value prices.
Also, if we hit an air pocket in markets, which is possible, these areas will hold up better than so-called growth stocks, thanks to their defensive characteristics. Over the longer-term, the best returns you get as an equity investor come from buying value stocks that accrue good yield and some capital growth consistently over years and years and years. It outperforms growth over any longer-term period. If I had to single out one sector to be in it would probably be tobacco.
MSW: Thanks everyone.
Our panel
Barry Norris, manager of the Britannic Argonaut European Alpha Fund.
James Ferguson, economist and stockbroker at Pali International.
Pelham Smithers, managing director at Kensington Research.
Sven Lorenz, investment analyst and editor of Profit Hunter newsletter.
Tim Price, Senior investment strategist at Ansbacher Bank, www.ansbacher.com.
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