Seven investments that will shine in the gloom

By MoneyWeek

published 4 January 2008

in Features

This month, MoneyWeek's roundtable considers the fallout from the credit crunch. Is there anything left worth buying?

Merryn Somerset Webb: It doesn't look like 2008 is going to be much of a year for markets does it?

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I suspect that for some time this will mean sharp sell-offs on bad news followed by rallies in areas that clearly offer value. If I was being optimistic I think I would say that towards the end of the year equities might finally break out largely because by then interest rates and bond yields will be so much lower than they are now the Fed and the Bank of England are going to have to keep cutting rates.

JF: People worry that inflation will make it tough for policy makers to raise rates. But I don't think inflation is a risk. The prices that are rising are related to food and energy, they're not internally generated. Right now one of the worrying numbers is PPI (the Producer Price Index) in the US which is just over 7%. But the last time we had PPI in the States at 7% was November 1990. That was the cusp of the last consumer and housing recession in the US. One year later PPI was negative. Look at it like that and clearly the fact that the number is high today tells us nothing about the future. So that's my view in a nutshell. Oh, and UK housing it's absolute toast!

So what we should see now as a result of all this turbulence in the credit markets is consumers in the US and the UK coming to their senses and spending a lot less. This will squeeze retailers and that will spread out to the rest of the economy. At the moment profit margins are at record levels in the US and UK, but a slowdown in the economy or a recession is going to end that. Perhaps shares aren't as cheap as they look.

PE: Usually after periods of rapid monetary growth you get high inflation, but while we've had the former we haven't yet had the latter. This is because the emerging world has been exporting goods to the developed world at lower and lower prices. But that is coming to an end. We are seeing inflation in China and in India, and I expect to see that exported to us. I don't think it will be that severe, but I do think it's going to creep up from current rates and that is going to make it more difficult for central banks to bring down rates of interest quite as rapidly as we might like.

Jim Mellon (Chairman, Regent Pacific): I am more bearish than both of you. I think the house price downturn is going to huge. I expect prices to fall between 30% and 50% here and maybe 25% in the US. To me this says that the seizure in the credit market has only just begun prices in the US have only fallen 4%-5% so far and look at the trouble that's caused. $400 billion worth of debt is practically in default. No one is lending. If you want to do a private equity deal right now you just can't. It doesn't matter how good a deal it is.

It is going to be really hard to sort this out especially since the reputation for competence that Greenspan had and the Bank of England had appears to have been lost. So in a nutshell, I think the Anglo-Saxon economies the US, the UK, Canada, Australia, New Zealand and Ireland, coupled with the Mediterranean countries are in very bad shape. The consensus view is that the UK will grow by 2% this year. I would be very surprised if it grew at all.

JF: It seems to me that history will see this not as a subprime crisis' but a banking crisis. Subprime has had such an effect because the banks all of them are seriously undercapitalised. Only this can explain their behaviour. The Catch-22 for banks is that if they bring their structured investment vehicles (see definition below) back onto their balance sheets to prevent them having to be sold in a firesale this would push down market prices to very low levels, which would help no one then the level of loans they have against their core capital goes up and they risk being visibly undercapitalised. Which is why the two banks that have moved big SIV assets onto their balance sheets have announced that they are being recapitalised by sovereign wealth funds.

This implies that the banks that haven't done it yet haven't because they can't find someone to recapitalise them at the same time. The other thing they could do, is they could let the SIVs go. But they can't. If the SIVs get to a certain default proportion, it's written in their contracts that they have to liquidate themselves again in a firesale. The problem with this is that much of the banks' capital is made up of similar assets, so after a firesale they too have to be revalued down and that too ends up shrinking core capital. The banks are really caught between a rock and a hard place.

JF: The thing with the banking world is that it is forever finding ways to not tell you the whole story. UBS said after its third-quarter announcement of losses that the chances of another loss of the same magnitude in the fourth quarter were very small. In one way that was true it actually announced a loss three times bigger. I don't think the banks have even begun to show us the size of the damage: note that the only banks who have 'fessed up so far are the ones that can also announce a capital injection, which tells us nothing good.

PE: The most worrying thing is that the banks don't trust each other. They won't lend money to each other and they won't deposit money with each other, but they haven't declared any meaningful amounts of losses yet. Most of them have come clean about small amounts, but obviously each bank has a better idea of what the other banks are doing than we do. And they won't lend to each other, so there must be something seriously wrong which hasn't yet come out in the open.

JF: In Japan, once the banks were close to bankruptcy in the 1990s, they just lied. I'm sure it will be the same here. You learn fast that you can't go by what they say. You have to look at their actions. In the end, the banks in Japan distrusted each other so much that they all ended up borrowing from and lending to only the government they just bought bonds. Any consumers who wanted a loan had to pay 30% to a doorstop lender.

PE: I have got a record amount of liquidity in my own fund, but one of the things I am buying for the fund and for myself is Alpha Pyrenees (ALPH). It is a UK-listed property company investing in mainly French property around Paris, where there are yields of over 7% (in France rents go up in line with building costs every year, so the rents should keep going up). The shares are currently off a good bit and yield 9%, so I'm taking advantage of all these credit crunches to lock into a high-yielding security with a rising income.

JM: The German property company I'm involved with, Speymill Deutsch, is up 5.5 times since we launched it two years ago, so that's not bad. I do think you will see a gradual rise in property prices in the next few years. I was in Berlin in December and there does seem to be some positive momentum. The German banks don't have huge subprime-related problems, and they are both lending and taking market-share back from the foreign banks. The yields are very attractive and I'm buying as much as I can afford in German property companies.

One I like is Estavis (E7S.DE) listed in Germany. The stock has fallen a lot recently and the firm has now got almost as much cash on its balance sheet with no debt as its market capitalisation. The market cap is about e90 million and the firm will make e22 million profit this year with a dividend yield of well over 11%. Basically, the firm buys property and sells it on. It buys buildings and sub-divides them and sells them on to individuals. And it assembles portfolios to sell to foreign buyers and thereis still a lot of foreign buying in Germany and a lot of competition. We are trying to invest a billion eurosin the German residential market, and it's very hard to do.

JM: A UK online money-transfer company called Neteller (NLR), which has fallen from a peak of about 900p to about 55p. Its founders fell foul of the law and ended up prison. But the new management has developed the business in Asia and the UK and the firm now has about 100,000 active clients. Its market cap is about £65 million and it's got £50 million of cash. I think transaction numbers are growing by about 15% to 20% a year, depending on the area.

JF: It's going to be a tough year, but I do still think there is a reasonable floor under equities that have strong balance sheets, high dividend yields, good franchises, and so on. So where would my money go now? Japanese REITs (real-estate investment trusts). This is a similar story to Germany in that property prices are far from bubble levels and yields are high. The REITs are mainly trading around their net asset values and yields for the sector are about 4% (although you can get 7%, even 8% yields).

In a country where government bond yields are 1.5% and the REITs' own short-term funding costs them less than 1% and long term funding something in the 1.5% to 2% range, that's pretty good. My personal favourite for quality of portfolio is a trust called Nippon Commercial, (3229). Its yield is about 5%, which is not as good as some of the residential REITs, but it has a central Tokyo location. Some of the land prices in its area are going up 20%, 30%, even 40%.

MB: Yes. Perhaps Immunodiagnostic (IDH), which produces bio-markers testing for things such as bone-density loss. It is well run and a good organic growth story. Also CVS (CVSG), a leading vet operator in the UK. A lot of the owner-operators in this market are reaching retirement age and finding that their children don't want to take their businesses on. CVS is using this as an opportunity to consolidate the veterinary market. It can get in at attractive prices and the underlying market is strong. More people have pets more people live alone than ever before, and pets offer company and it is a market that is quite protected: you are not going to let your cat die just because the economy has turned down.

PE: One of my other favourite companies is Bioquell (BQE), which for several years has been developing a new method of cleaning out superbugs from hospitals. You clear out the patients, you clear out the bedding, but you leave everything else in. Then you puff dry hydrogen peroxide into the ward. Twelve hours later you take it out again, you clean it out and you put the patients and the bedding back. This is almost 100% effective. The problem in the past has been that it is not the cheapest method, so it hadn't been a favourite with the hospital trusts.

However, now all the cheaper methods have been proven to be completely ineffective and MRSA has been spreading and getting worse, so the cost isn't looking such a big deal now. About six weeks ago the NHS gave Bioquell's method a Category One rating meaning that it is a favoured method. I think it will grow very rapidly from now on. It's also working on trials for treating leg ulcers. These are quite a killer and there is no known method of dealing with them at the moment.

PE: It is a bit similar, but no not quite. It's been highly successful in all the trials it's been put through so far and now it's going into double blind trials. If these are successful then the treatment could earn the company an absolute fortune. Bioquell has also been doing deals with the Department of Defence in America for putting filters into armoured vehicles to clean up air contaminated from bacteriological or nuclear warfare, and that could also be very profitable.

On the face of it, Mellon's other tip, Billing Services, didn't do that well either (30%). But that doesn't take account of the fact that the shares were tipped at 26p and have paid out a special dividend of 20p since (as Jim predicted they would). They now trade at 18.12p, so rather than losing money investors have in fact made 46% (12.12p) on the shares. Add this in to the calculation and our 2007 Roundtable portfolio actually looks pretty good up 14.5% on average.

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