John Stepek: Chinese internet giant Alibaba has gone public, worth more than eBay and Amazon combined. Is this the top?
Robert Jukes: I suspect not – but valuations are certainly pretty full. We had a whiff of that earlier this year with the IPO (initial public offering) of the Candy Crush game company, King.
James Maltin: Parts of the tech sector are clearly frothy. If we do see a general correction – which, five years into the bull market, is highly likely – I suspect tech will be one of the hardest-hit sectors.
Killian Connolly: I think there’s more trouble in the fixed income (bond) markets than in equity markets – there are still pockets of value in Japanese and Chinese stocks for example. Alibaba is the eBay of what’s going to be the world’s largest economy in a few years’ time. So yes, it’s expensive – but there are other companies you’d be more worried about.
Marcus Ashworth: Alibaba has made a lot of people very, very rich. You can now expect many more companies to come to the US market from China. You could argue that this is really the start of Asian companies accessing US capital markets in a big way – expect some ‘sons of Alibaba’ to come along, and a lot more tech companies too.
Yes, these sectors are frothy – but clearly the demand is there, and lots of people have made a lot of money. So there’s a bit further to go.
James: The only caveat is that, if there’s a political dispute between the US and China, access could vanish overnight. But I don’t think that’s in anyone’s interests.
John: Speaking of politics – last time we discussed Russia, some of you were pretty bullish. What are you thinking now that the latest oligarch has been arrested?
Killian: The bullish argument was never based on corporate governance – it was based on valuation. Russia’s MICEX index is the world’s cheapest market – I think it just jumped ahead of Myanmar – so that argument still stands.
And this is not a country the West can refuse to negotiate with. Ukraine will rumble on in the manner of the Middle East, but I don’t think it’ll affect the cash flow statements of a lot of Russian companies.
Marcus: Russia is always cheap, so you have to look at it on a different scale – buy when it’s extremely cheap and sell when it’s merely very cheap. But I would happily invest 5% of my free ‘punting money’ in Russia now. I’m very bullish on Japan but Russia is potentially an even bigger trade.
That said, the Russians have a capacity for putting themselves through pain like no others. And on Ukraine, Putin has a much stronger hand as we get into winter, with the Gazprom pipeline.
Robert: What concerns me is that the US is slowly retreating from the world stage. You’re seeing the results in Russia; in China, Japan and the South Sea Islands; in the rise of Isis or Isil or whatever; even with Israel and Gaza – several trouble spots seem to be pushing the envelope as the US withdraws, and I think it’s no coincidence that we’re seeing lower levels of global trade alongside this.
I wonder if, one day, we’ll look back at the 20 years just gone and see it as a remarkable period of calm. I worry the next five to ten years may resemble it only slightly.
Marcus: Actually, I think the trend for stepping back – which worked brilliantly for the first four years of Barack Obama’s administration – has, in the last two years, worked very badly for the US. I think this coalition Obama is building against Isil may see a change on the geopolitical front.
On trade you’ve got the Trans-Pacific Partnership, which is essentially a move against China by the US, Japan, and the rest of Asia. If that does come off – admittedly it isn’t looking great right now – it would be positive for global trade.
Robert: But even if the next president is more willing to engage on the world stage, how much support will there be from the Senate? I think we’ve already seen the high water mark for US action abroad. The same is true for the UK. As a result of austerity, the population is becoming far more insular and less interested in world affairs.
Marcus: Well, you look at Scotland potentially leaving, and the UK coming out of the European Union – that would all fit into your theory.
James: I have a lot of sympathy with that view. Equity investors tend to see the future as being fairly rosy. But we also underestimate the potential for catastrophic events.
Russia is one of the most significant risks to stability today, and although the market is incredibly cheap and so offers opportunity, the hostility is increasing rather than decreasing – we’ve seen additional fairly serious sanctions against Russian companies this week for example. So I’d be cautious – not just on Russia but on its potential impact on global trade.
Marcus: We are making it worse. The more pressure we put on Putin, the more he’s forced to become the big bear dictator. And there is no value for the West in Ukraine – it’s a basket case.
James: What about Ukraine’s farmland?
Marcus: I don’t think the Russians want the farmland – they’ve got their own. But they do want to stop the Chinese – who were all over it at one point – from having it, and they certainly want to stop Europe from creating different routes for pipelines which would make the Gazprom investment story far less valid.
James: But Russia’s invaded another country.
Marcus: A decent-sized majority of people in that part of the world speak only Russian. I really can’t emphasise enough how every Russian or Russian-related person I speak to sees Ukraine as part of Russia.
Robert: So you’re saying – in a fixed income context – that Ukraine and Russia are fungible.
Marcus: Look, the West is being led to believe that there’s some form of moral outrage being committed here. But the Russians are now very much of the opinion that they are under attack in all but name from the West – and they will react accordingly.
James: So you’d say let them have it?
Marcus: I can’t understand why we got involved in the first place. It’s going to cost us tens and tens of billions for no benefit whatsoever.
John: Just tangentially on Russia – the oil price has been sliding too. Any thoughts?
Marcus: It’s mainly supply. Various bottlenecks have been cleared – Libya’s back on stream, the Nigerian situation is better – and on the demand side, Chinese buying has slowed, Japan’s about to turn its nuclear reactors back on, Americans aren’t driving as much – a couple of toll road companies have run into trouble – and while the US is not exporting shale oil yet, we know they’re going to.
Killian: Is there a deflationary angle too?
James: Yes, perhaps it’s the canary in the coal mine and we’re heading for a global recession.
Robert: I wouldn’t dismiss it.
James: Italy’s in recession again, Germany is weakening, France is flat.
Robert: Looking wider, China will struggle to deliver on its 7.5% growth target. The US probably has the most well-balanced recovery of the developed nations but it’s still sub-trend. The UK has done remarkably well but it’s incredibly sick – it’s not well balanced at all. Europe is stagnating. There was a paper out this April by Professor Laurence Ball.
He reckons that potential growth for developed economies as a whole has fallen as a result of the last recession – what’s known as ‘hysteresis’. Tell-tale signs that he’s right include the fact that labour-market participation is falling – in other words, some people have dropped out of the jobs market – and that companies are not investing.
The thing is, if growth potential is lower than assumed, equity markets should be lower too – maybe by 10%-15%. So why is the market ignoring it? At least part of the discrepancy is due to share buybacks. If you look at the most recent earnings season in the US, earnings growth was around 10%, but top-line sales growth was just over 4%. That’s been the pattern for a while.
This rise in earnings per share is being boosted considerably by buybacks – and in this environment it makes sense for companies to buy back their own shares rather than do anything else, because in a low-growth world, there are no better investment opportunities out there – hence the lack of corporate investment.
Marcus: That’s been a trend since Lehman. But we are getting evidence of very strong growth in the US – and the right type of growth, unlike in the UK. That means we’ll get higher interest rates. Surely we’re at the point where buybacks should end and we’ll see more merger and acquisition (M&A) activity?
John: Do you believe rates are going to go up next year, here or in the US?
James: If they do, it’s going to be a very small amount and once they put them up they might put them back down again.
Marcus: It doesn’t matter if they put them up by 25 basis points (0.25%) or by 300 (3%), the fact that they’ve put them up at all will change the whole dynamic.
Marcus: It will massively boost the stockmarket, refinancing and M&A. All of a sudden everyone will think – “hang on, we’ve got a forward rate forecast which is saying: get in and get in now!”
John: A case of “better lock in my cheap money now”?
Marcus: Yup. Recession is over.
Killian: But are companies who aren’t borrowing right now really going to pile in if they see rates go up by just 0.25%?
Marcus: Yes. The point is, you go with the momentum – once you have a following wind, everything goes with it.
Killian: So we should be bullish? That kind of goes against everything that history has shown about higher interest rates. Didn’t Warren Buffett say higher rates are gravity for asset markets?
Marcus: I disagree – it’s the part of the cycle where the animal spirits kick in. Ironically it’s normally very good for the property market as well. The US corporate sector has never been leaner or fitter.
The household sector has plenty of appetite for credit, as we can see on the consumer credit numbers. So in terms of the credit cycle, we are already on the way – and the point where it really lifts off is coming soon.
Killian: What about the impact of higher rates on government bonds and their ability to finance themselves?
Marcus: The growing tax take will more than offset the massive losses on the Federal Reserve’s vast bond holdings.
Robert: You’re getting to the nub of something quite interesting. I suspect future historians will agree that quantitative easing (QE) was wonderful for putting a floor on the market and boosting asset prices but really it hasn’t delivered growth.
That’s the quandary Europe’s in at the moment. There’s very little that European Central Bank boss Mario Draghi can do to promote growth – that’s got to be about structural reform and infrastructure spending. Whereas in the US they need to reform corporation tax, to encourage US-based multinationals to repatriate cash.
Marcus: There are three big things that could boost the US economy overnight: reform of the tax inversion deals situation; a huge infrastructure fund – one would pay for the other; and the third, which we all know about, is shale gas and oil.
But Europe is completely different. QE is going to come in Europe, but it probably won’t have any impact, because there is no demand in the system. That’s exactly your point Rob – that monetary policy has run out of room. They’ve had the QE effect in Europe already – the yield curve is flat and as low as it’s ever going to get.
We need to get demand into the system and for that we need structural reform of legal systems, for example, and real change. That’s very different to the US. On Europe, I could not be more bearish. I don’t see how it avoids going down a Japan-style deflationary path. I cannot see any possible upside other than hope.
James: That’s where the opportunity lies.
Marcus: Growth may just come about if Europe manages to catch a bit of a following wind from strong US growth. But it’s not going to be home generated.
James: But the US market is at an all-time high, whereas Europe is – not dirt cheap – but a lot cheaper.
Marcus: There’s a very good reason why.
Robert: But global growth has disappointed even the most impartial onlookers – the International Monetary Fund were the latest ones to nudge down their forecasts. It’s just been going one way: disappointment. It’s not a normal recovery. I applaud your enthusiasm for the US achieving escape velocity but I worry that it won’t.
John: Speaking of lousy growth and cheap markets, what about Japan?
Robert: Japan had great first-quarter growth and a very poor second quarter. Before the sales tax went up, consumption was pulled forward, but post-tax it was very weak. So net-net, you’ve got year-to-date growth of around zero. Not great.
We’ve seen plenty of QE, but very little structural reform. The World Economic Forum says Japan is becoming less competitive, not more. Politicians often talk about competitiveness and reform, but do very little to deliver – and I’m sure it’ll be the same in Japan. The story will just fall flat.
James: But the Japanese market is at a seven-year high. So arguably Japanese QE is working.
Robert: It’s driving up asset prices and driving down the currency – but it’s not delivering growth. That’s a fundamental problem with QE.
James: But you have to look at this in the context of where they are. Historically the market is still…
Killian: Dirt cheap.
Marcus: Japan is now going for QE – pro rata – of more than two or three times what the Fed did. They will not give up. Abe can only go one way. They are going to raise the sales tax in October 2015 to 10%, which means one thing – the Bank of Japan is going to have to do QE on a scale which is incomprehensible to the rest of the world. They have no other way out.
They are going to restart the nuclear reactors and pray there is not another earthquake, because they have no other way out – this is Japan, one of the most resource-poor countries in the world.
They are locked into a situation whereby the yen is going to get weaker – it’s going to be 120, then 140. And the Nikkei is going to go to 17,500-18,000 by year-end, then 20,000, 25,000, whatever – it’s going to have to happen.
Robert: But Japan already tried QE and had ten years with no growth whatsoever.
Marcus: You need proper wage growth, which feeds through to household income, which in theory feeds through to consumer spending. Close to 40% of the Japanese workforce is temporary now, but demand is very tight.
We are starting to see the Toyotas and the Mitsubishis pushing up pay. These are small deals, but it’s a start. And it’s all about politics. Abe has a mandate to carry on. If the yen keeps weakening, the rest of Japan Inc. will stop offshoring and start re-shoring.
Killian: But China isn’t going to put up with losing that competitiveness.
Marcus: The Japanese will print money faster than anyone on the planet. The US has nearly stopped QE and the Europeans aren’t getting their act together. The Japanese will beat everyone.
John: So if I want to bet on Japan, what fund or funds should I buy?
Marcus: The GLG Japan CoreAlpha fund, run by Stephen Harker, is a good option. Or a top performer is Legg Mason’s Japan Equity fund, run by Hideo Shiozumi. But if you have more to invest (£100,000 minimum), speak to your private banker about Coupland Cardiff’s CC Japan Alpha fund – they really do their research and hunt down the very best 30-35 stocks they believe in.
John: And what else would you buy now?
Marcus: I’ll go for Quadrise Fuels International (LSE: QFI). In layman’s terms, it takes the useless, toxic stuff off the top of the gas silo, and recycles it as a synthetic fuel – now Maersk, the big shipping line, is buying it for its ships. So that’s my hot little stock tip.
I’m also looking at Standard Chartered (LSE: STAN). The Asian bank is unloved and has fallen, along with the other banks. But it’s seen all the trouble it possibly could as far as fines go, and it took its pain very quickly. It is a major emerging-market bet – it’s not going to give you instant returns, but you could do very nicely over one to two years. And it’s still covetable by some foreign bank.
John: Are emerging markets a buy today?
Marcus: I must confess, against my point, I think they’re utterly screwed.
Killian: Is this because of the dollar?
Marcus: Yeah. High dollar, low commodities isn’t great for emerging markets. But Standard Chartered isn’t as correlated with that as many emerging-market stocks – it has an excellent business and is pretty well run. But that’s one reason it’s priced cheaply, certainly. The other stock is ARM (LSE: ARM).
My tech analyst is convinced that ARM is the gift that’s going to keep on giving. It’s nowhere near its best levels and it is the best thing we have in the UK as far as tech is concerned. The ‘internet of things’ is a trend which won’t go away and ARM is in pretty much every mobile phone.
John: Thanks. Killian?
Killian: I’ll go for oil giant BP (LSE: BP). It has put aside $3.5bn to pay the clean water fine arising from the Gulf of Mexico spill in 2010. That averages at around $1,400 per barrel of oil spilt. The range could be anything from $1,100 to $4,300, so you can see why sentiment is poor – the fine could be a lot bigger. But BP probably has as good a set of lawyers as anyone else.
And it’s cheap – it trades on 1.07 times book value, and for the last three years it’s grown its cash flow, and its return on equity (ROE) has been above 17% a year. So despite the compensation, it’s making a lot of cash.
Fairfax Financial (TSX: FFH) is a bit like Buffett’s Berkshire Hathaway in the 1970s. It owns four insurance underwriters. The holding company invests the dividend payouts from these subsidiaries. Around 15% of the group is this investment portfolio run by the holding company, while 85% is the insurance gig.
Quality-wise, ROE has been around 20% since 1985. So these guys know what they’re doing – they bought Bank of Ireland at eight cents and sold at 30. So it’s a way of getting a good investment manager on the cheap.
John: Any tips on Russia?
Killian: Lukoil (LSE: LKOD) is the largest privately owned oil and gas company in the world by proven oil reserves. Unlike Gazprom, it’s 100% privately owned, so there is less risk of the Russian government imposing its will on the corporate strategy.
It currently trades at a price-to-book ratio of 0.47 times. This reflects the impact of Ukraine and also the recent legal proceedings taken by the Russian courts against the oil firm, Bashneft.
But we believe the extreme valuation neglects the quality of the company’s financials. The average annual ROE over the last decade has been about 19%. The operations are very cash-flow generative, so the dividend yield of 6.7% is nicely covered.
John: What’s happening with gold?
Killian: I have no idea what’s happening right now. But every time I wonder what I’ll do with my money, I come back to precious metals because this isn’t going to end well. I think we’ve come a long way, in the wrong sense, from understanding money and how it’s created and how it’s destroyed – even though 2,000 years of history is replete with periods of non-convertibility of currencies.
You have to look back and see what happens when governments deficit spend. It’s not pretty, and it doesn’t lead to growth, because there’s no investment. And gold is not expensive on a ratio basis – compared to the Dow Jones, for example. But looking at the gold price chart, it is going to get worse before it gets better. That said, it’s still being bought by the central banks.
James: Wood Group (LSE: WG) is an oil services business. It helps customers cut drilling costs, particularly in deep water. The shares have gone nowhere in the last year but it recently issued a strong update and hiked its dividend by 25%, a sign of management’s confidence.
John: Are you at all concerned about deepwater drilling with the oil price?
James: The marginal cost of production is $70-$100 per barrel depending on location, so Brent crude around $95 makes deepwater drilling feasible. Another plus point is that since Wood Group listed in 2002, it has compounded dividend growth at about 20% a year, which is pretty impressive.
My second idea is in the retail sector – Kingfisher (LSE: KGF). It’s the world’s third-largest DIY company, and the shares have been pretty weak. But in the first half, sales rose 6%, and profits 18%, which is welcome news. It’s expanding into Germany, Portugal and Romania. It also benefits from buoyant housing markets, which feeds into my third suggestion, housebuilder Bellway (LSE: BWY).
It just issued a very strong trading update. Its order book is the strongest it’s ever been, up 39% year-on-year, and mortgage availability is growing. If interest rates go up at all, I expect they will rise only a little. The government wants to maintain the strength of the housing market – so Bellway could be in for a good run.
John: You don’t see housebuilders as vulnerable?
James: There’s still a significant gap between availability and demand. That’s why house prices are up 10.2% in a year.
Marcus: What does Labour want to do? Build 200,000 new homes. So do the Tories. They’re pushing on an open door. We’re going to carpet the south of England in concrete, just like Japan.
John: Would that do anything to bring house prices down, given that the problem isn’t actually physical supply?
James: House prices have to keep going up, otherwise the economy is stuffed.
Marcus: The top end is doomed already. London’s already on the way down. The Russians are pulling out for sanction reasons, while the Italians and other Europeans aren’t there anymore. Sterling is the barometer for prime property prices. It correlates directly.
James: But if sterling keeps falling, that’ll surely make London property attractive to overseas buyers again.
Marcus: I don’t think this time there’ll be the same – “it’s cheap, I must come to London, things are all wonderful” feeling as we get closer to the election – especially following this whole Scotland referendum and now the ‘ums’ and ‘ahs’ about English votes for English laws etc.
James: But the reason the UK is attractive internationally is because we have relatively stable markets and good property laws.
Marcus: We have the highest property taxes if you look at it in a certain sense in Europe. And they are starting to really apply the taxes to the non-doms. That’s why lots of them are pulling out.
James: The Chinese are still trying to buy over here, by the coach load.
Killian: Ah, I remember when we had all these ideas in Ireland. It’s all the same. It’s a ratio – house prices to earnings – and it will revert right back to the mean.
John: Any tips, Rob?
Robert: If you place any credence on my argument that growth potential is lower than it once was, then you might want to buy high-yielding stocks that return cash to shareholders sooner rather than later – the likes of utility SSE, drug maker GlaxoSmithKline or tobacco group BAT.
In that mould, Cobham (LSE: COB) is quite interesting. It’s a stable dividend payer – it yields around 3.8% – with high operating margins. It’s outperformed the FTSE All Share by about 20% over the last ten years, which is always a good sign. It’s trying to move away from being a pure defence company to 50/50 civilian – it’s getting there with its recent acquisition of communications group Aeroflex.
It’s got some more room to go there, but it has a good track record of acquiring and maintaining operating margins and sales along the way.
Continuing the theme of lower growth globally – to me that’s a strong US dollar story and it’s not a strong commodity story, so I would continue to short the Canadian dollar. It’s been a good trade. I think the Canadian dollar could go to $1.30 to the US dollar.
The Canadian economy is a bit like Australia’s, but more so – it’s really suffering from Dutch disease. It’s over-exposed to real estate and to commodities. My third pick is a US stock, Take-Two (Nasdaq: TTWO).
It owns Rockstar – the maker of computer games including Grand Theft Auto, Civilization and the NBA 2K series. It has momentum, value and growth qualities – the main qualities we look for.