Merryn Somerset Webb talks to Bruce Stout, manager of the Murray International investment trust, about the dangers facing developed markets, and the opportunities for investors in emerging markets.
• If you missed any of Merryn’s past interviews, you can see them all here.
Merryn: I’m here today with Bruce Stout, who’s the manager of the Murray International Trust. This is a trust that I know a lot of readers hold, so I think we have an awful lot to talk about.
The first thing I want to ask about is something we talked about in the last interview I did with Bruce which I know a lot of you will have read, and that’s deflation. We talked a lot last time about the deflationary environment. I just wonder, Bruce, is that playing out the way you expected?
Bruce: We’re not outright deflation yet. Outright deflation is when consumers start deferring purchases because they think they’ll get goods and services cheaper in two weeks or a month’s time.
We’re certainly at a period where prices are falling in lots of different areas. We know in commodities and oil and iron, ore and copper and the primary metals, but also in retail and services, a lot of pressure on pricing, because a lot of customers have got debt, both the private sector and the public sector, and there’s still far too much capacity chasing too little demand in the world today.
The issue about deflation is not whether it happens or not, it’s what does it do to corporate profitability when you’re forcing prices downwards, and that’s the biggest issue that we have.
Merryn: Is it partially – we talked about debt – but is it partially a demographic issue as well, aging societies have less demand? It’s a problem that is going to go on for decades.
Bruce: It’ll certainly go on in the developed world for a long time because we do have an aging demographic, there’s no doubt about that. It’s not so much about the age structure. It’s more about real incomes and the fact that the jobs that have been created in the last five or six years are not high paid jobs, not in the developed world. We’ve seen a lot of zero hour contracts. We’ve seen a lot of lower-paid jobs and these jobs, we know they’re low paid because they’re not contributing to tax revenues so they don’t really sustain consumption, and for consumption based economies that’s a real problem.
Merryn: We are beginning to see some pressure on wages aren’t we, we are seeing real wages beginning to tick up slightly, we’re seeing demands for higher minimum wages etc. There is some pressure here on wages.
Bruce: There maybe demand for higher minimum wages, but whether they get them or not remains to be seen. I mean the main issue is if there’s areas of scarcity in certain skill sets then you will get some wage pressures, there’s no doubt about that.
Just in general, real wages continue to fall in most of the developed world. That’s what the numbers tell us and that’s what the purchasing pattern tells us as well, that people continue to cut back on volumes that they buy, they continue to trade down from branded goods into more generic goods and also just buy less.
“I haven’t seen any evidence of any sustainable recovery”
Merryn: I’m guessing that you’re not really a believer in the Great British recovery?
Bruce: I haven’t seen any evidence of any sustainable recovery that would match the type of stimulus that’s been applied, because in the last six years have really thrown the kitchen sink at the global economy. For many governments they’ve increased the size of the balance sheets by a factor of three or four times in printing money and the best they can generate is 2 or 2.5% growth. That’s very, very low relative to previous cycles.
It remains to be seen once quantitative easing stops in the States, and no doubt somewhere else, maybe in the UK, will they be able to stand on their own two feet? Well we’ll have to wait and see.
Merryn: I’m guessing you think you know the answer. It sounds like you know.
Bruce: It’s very difficult to predict and growth itself doesn’t translate into profit. The most important thing for us as investors is the kind of companies that we invest in, make money, can they make sufficient free cash flow to reinvest in the business and grow the business. Also return cash as dividend to us shareholders, that’s the most important thing. Therefore any analysis in the backdrop of the environment is with an aim towards trying to make that assessment, whether they can grow their profitability.
Merryn: Would you say that markets across the developed world, not just in the US, but across the developed world are valued at the moment? I think there’s a general consensus among most people that the US is remarkably expensive, but elsewhere that concern just doesn’t exist.
Bruce: I think on any historical measure markets are very, very expensive and we know that quantitative easing in liquidity has pushed prices up. We also know that central banks have neglected their main job, if you like, which is looking after growth and inflation in economies to focus on controlling asset prices and that’s not healthy. We also know, and we know returns from cash or negative yields on bonds that people feel compelled to buy equities, but you have to be very careful because if you pay the wrong price you’ll lose your money.
Merryn: So what will prompt these equity markets to fall back?
Bruce: I have no idea. I mean ultimately the only thing that holds an equity price up is earnings and dividends, not hope and expectation, not hot air and not liquidity. So if a company starts to see its earnings go down then at some point in time either the multiple compresses or the capital value goes down. So profits and dividends are absolutely key in this type of low growth, low interest rate environment, and where you’re unsure of them being delivered then you have to be very wary.
Merryn: Where can we conceivably be sure of them being delivered?
Bruce: Obviously the market makes judgement about that and looks at traditional areas of profit dependency and things like consumer staples and things like pharmaceuticals. These multiples on those stocks are already very, very high. Some of them are high double digit or even in the 20s, yet the realistic level of growth is in the low single digits. Just because an industry is perceived to be safe doesn’t necessarily mean it is, if it’s still very expensive to own the particular company.
Merryn: So if you pay too much for it it’s still dangerous?
“look for the tailwind of rising real incomes, of rising volumes, and rising purchasing power: ie emerging markets in Asia, Latin America and parts of Africa”
Bruce: Absolutely, we have to look around areas where perhaps expectations are lower where there might be a bit more cyclicality, but where there is the definite tailwind of rising real incomes, of rising volumes, rising purchasing power and that’s into the emerging markets, in Asia and Latin America and parts of Africa. Where, although they’re coming off a low base, they don’t have the debt overhanging, they do still have rising real incomes and demand for goods and services.
These sorts of areas are completely out of favour at the moment. In fact there’s almost widespread revulsion towards anything commodities, anything oil, anything emerging markets or emerging debt, which is very interesting because we’ve not really seen such conviction from the consensus that there’s only one trade in time and that’s the strong dollar in the strong US. Really since 98/99 period when the US dominated returns and then we all knew what happened after that when the technology bubble burst.
If you’re looking to be a bit contrarian and not just follow the herd then you have to look elsewhere that’s out of favour but where good profits and dividends are realistic.
Merryn: You mentioned investing a little in Africa, what areas are interesting there?
Bruce: It’s very difficult to get direct investment into Africa for the big trusts because the markets are very small. So you have to look at perhaps companies in the developed world that are selling into Africa or individual positions. I mean MTN is the South Africa mobile communications company, they have businesses in Nigeria and South Africa and the Middle East, so that’s quite interesting. There’s one or two others that have certainly got good growth ahead of them.
Merryn: Elsewhere in Asia?
Bruce: Asia’s always very difficult as well because it’s dominated by China and the outlook for China. The other thing that’s quite interesting about it is if you look at the development that Asia’s made in the last ten years in terms of contribution to global GDP which is huge, the growth, the market gap doesn’t really grow in line with that and because there’s still a great reluctance from families to go public with their companies. There’s no need, why would you float your company into the public market to have the scrutiny of analysts every quarter when you don’t need to, because you have access to capital and there are now developed bond markets and emerging markets in local currency out to 30, 40 years. You can borrow a local currency and match your liability.
There isn’t the desire to go public and there isn’t the stock of equity, and some of the best situations are still in private companies so you need specific vehicle to take advantage of it.
Merryn: And China? My guess is that you’re relatively pessimistic on the economic situation in China?
Bruce: Not really, I think you have to be totally pragmatic towards China. So it’s an $11trn economy, it can’t grow at 7%. You mean the US was $11trn economy in 1999, if it had grown at 7% what would interest rates have been? At that rate of growth you’re going to get bottlenecks, you’re going to get wage inflation and things. At some point in time it has to slow down to a more manageable 3% to 4% growth rate.
Merryn: A lot of people say it already has.
Bruce: You don’t know what the actual growth rate is, you just know it’s slowing down from what it was before. Ultimately if they want sustainable non-inflationary growth it has to be in the 3% to 4% range. Whatever they need to do they will do it.
“in the emerging world, expectations are now so low that there’s a chance that growth will exceed expectations”
Merryn: So there’s no great China crash coming?
Bruce: They’re very aware of the shadow banking system and the issues that they have in terms of falling property prices and the misallocation of capital through some of the fiscal policies they’ve had. I suppose the thing they have to watch is that if they do start to devalue the currency significantly then that will be another wave of deflation on the export around the world. So we need to keep an eye on that.
We work it out based on where the company earns its money. Therefore when you look at the direct holdings in emerging markets in Asia and then you look at companies such as Casino in France or BAT and businesses like that that have large overseas exposure then that’s still the main theme within the Trust. On a longer term basis that’s still where we see better relative growth, and the tailwind of falling interest rates at some point in time – and surprises on the upsides in earnings then. If the danger for developed market companies is not delivering earnings in a difficult environment, then the opposite hopefully will be the case in the emerging one in two or three years’ time where expectations are now so low that there’s a chance that growth will exceed expectations.
Merryn: What would make you feel more positive about the developed world? Is there anything that would make you go, the UK isn’t so bad, there’s good reason to invest here.
Bruce: There isn’t any reason to become positive just as there isn’t any reason per se to be negative. I mean what we try to do just be realistic about what’s in front of us. Using that information can we make sensible judgements about the future?
The main issue we have just now is for you and for me and for everybody involved is that many of the relationships that persist we’ve never seen them before. We’ve never seen negative nominal bond yields on €3trn worth of bonds in Europe. We’ve never seen being charged to put your money in a bank in Switzerland or Germany or Sweden and Norway. We’ve never seen deflation, we’ve never seen prices fall and the pressure that puts on raising revenues.
When you try to use your experience to predict the future you look for evidence of things that you’ve seen in the past. If you’re facing a situation where many of those relationships you’ve never seen them before then you have to be very cautious. You don’t necessarily have to be negative or positive but you have to try and work out what you’re dealing with and to a large extent in some areas it’s the unknown.
“a whole generation that’s used to holding bonds is now watching their savings being eaten away by inflation”
Merryn: So with that in mind how does a reader allocate their portfolio? Obviously they hold a little Murray International, maybe a lot of Murray International, but what else do they hold that hedges themselves against this environment?
Bruce: This is the whole centre part of the difficulty that we’re experiencing at the moment is that with no return on cash and bond yields negative, then a whole generation that’s used to holding bonds is now watching their savings being eaten away by inflation.
So what do they do with their cash? They’re going to have to ask an investment advisor because they can’t ask people like ourselves.
Merryn: Should they not hold cash?
Bruce: If you have a certain process and a certain style you can’t do that in all market situations.
So of course when markets go down people want to preserve their capital, but in the last 12 years we’ve had two down-markets, that’s all. For a lot of people the memories are distant of 2000 and 2001 and 2002 when we had three straight down years. So they get caught up with making more money perhaps rather than preserving capital. If we do get a shakeout then I’m sure that’ll be come the number one priority.
Merryn: I think it might be already. Bruce, if you had ruled of the world, which you could…
Bruce: There’s certainly no chance of that ever happening…
Merryn: How would you sort out this weird over-debted deflationary environment in the UK, the US?
Bruce: We wouldn’t know where to start would we, because it’s so completely alien to the financial structures that we’ve been taught at university or read about in the newspapers or learned from our parents or whatever. This environment in which we live is totally alien.
Merryn: You can’t see a way out?
Bruce: It’s very, very difficult because it depends what kind of pain we’re prepared to take to have…
Merryn: Let’s say we were prepared to take pain, let’s pretend that we live in a world where everyone’s rational and is prepared to take short to medium term pain for a better world….
Bruce: The real issues are always the same, it’s always the young people and the elderly people who suffer the most and take the most pain.
The result of the debt crisis, the result of quantitative easing and the huge debt loads have been placed on means that the debt that young people now have limits their opportunities significantly. So the average age of a first time buyer has risen in the UK from 26, six years ago to 33, 34. So I hope you like your children, because they’re going to be living with you for a very long time. By the time you put on student debt on top of that, and then looking for 10% or 15% down on your first house, it basically makes the housing market completely inaccessible to younger people.
Then on the other end of the scale the elderly with their pensions are watching their savings being eaten away by financially repression and the suppression of bond yields to levels that won’t meet the liabilities.
It’s these two groups that always suffer the most.
“I hope you like your children, because they’re going to be living with you for a very long time”
Merryn: But we do know that in the UK pensioner incomes have been fine. If you look at the statistics pensioners have not been the ones who’ve done the worst, it’s been the young. But when I write about that the pensioners wrote in to tell me, quite rightly, that the young are far too profligate, and if they spent less money on cocktails and coffee things wouldn’t be so bad. So I feel little conflict starting here.
Bruce: I suppose if they spent less on cocktails and coffee then the consumer side of the economy really is going to go downhill. Given that all developed market economies are consumer-based economies, then that’s what central banks have been trying to get people to do for the last six years is spend some money. Of course that’s the great difficulty when the credit cycle doesn’t work and you push on a string because there’s no price for money. You can lower rates to zero but you can’t make money borrow more.
Merryn: Make people spend.
Bruce: You can take the horse to water but you really can’t make it drink. It’s a very difficult situation and it’s the cost side I suppose for people like pensioners. Do we really see energy bills falling through the floor as energy costs have fallen by 50% in the last year? My gas bill is certainly not down 50% neither is my electricity bill. It’s not because we’re using more. I suspect as always these prices are rigid on the way down and very quick to go up. So that’s what eats into pension and disposable incomes.
Merryn: How about we try and end on a positive note. A positive note. What’s your favourite stock in your portfolio at the moment?
Bruce: You don’t have favourites. Do you have a favourite child?
Merryn: Of course not.
Bruce: Well you can’t have favourite stock.
Merryn: On the other hand I don’t have more of one child than I do of the other child and you and your portfolio will have more of some stocks than you will of other stocks. So you’ve already expressed favouritism.
Bruce: If you’re being simplistic to say that by holding twice the amount of one you prefer it twice as much as the other…
Merryn: I am simplistic Bruce, you know that…
Bruce: That’s the sort of logic that doesn’t take valuation into consideration, because obviously you want to have twice of something that’s half the price of something that’s more expensive.
“You have to be very bold to spend money and invest for the future when the near term outlook is very opaque”
Merryn: let me rephrase, what’s your favourite stock taking valuation into consideration?
Bruce: We don’t have favourites. You don’t have favourites. We have 46 stocks in Murray International and like any group every single company we own has problems. They have issues. They’re trying to do business in this difficult world that we’ve outlined. They’re trying to grow their revenues, they’re trying to compete with people who are cutting prices to provide similar services.
We often forget in investment management that the hardest job is running a business. If you were actually running a business and you have a headwind like that, then that’s very very tough and it puts pressure on expansion and investment. You have to be very bold to spend money and invest for the future when the near term outlook is very opaque.
So I’ve got a lot of respect for all the businesses that we own and the people that run them, because I know it’s such a difficult environment. Some will have more success than others in the environment which they find themselves, to be able to do it, and I’d say come in and try and run a business for shareholders and for the staff at a time like this it’s very, very difficult. So we have to be supportive.
Merryn: and you won’t tell me what your favourite stock is.
Bruce: I don’t have a favourite stock, I told you.
Merryn: What’s the most recent stock you’ve added to the portfolio?
Bruce: There was only one new stock that was added last year and that was SQM, which is a potash producer, it also produces lithium for batteries and iodine and it’s based in Chile. It’s had a particularly difficult time in markets; one, because it’s located in an emerging market; and two, because the potash market has not been easy in the last few years. There’s a lot of bad news discounted in that company share price and that’s why we initiated that position last year and we’ll look to build it up on weakness.
Merryn: Brilliant, thank you very much.
Bruce: Thank you. You’re welcome.