Small caps lose steam in the slowdown
Small caps have been out of favour since the economy took a turn for the worse last November. If we’re headed for a recession, small caps will do badly, runs the thinking, and not surprisingly there was indiscriminate selling of smaller companies in January.
“At the end of 2007 buyers disappeared for AIM and the share prices hit an air pocket and then just went down,” says James Henderson, manager of the Henderson Opportunities Trust. Henderson has increased his weighting to small caps this year, after a poor 2007 – as of February, 42 pct of his portfolio is in AIM companies, 12 pct in fledgling stocks and 26 pct in other small caps. “I am hoping that small companies will have some control over their own destiny when the market corrects,” he says.
Glimmers of opportunity
Last year was disappointing for small caps, with the Hoare Govett Smaller Companies Index returning -5.9 pct, but there have been glimmers of opportunity since January. Chris Bamberry, investment director, UK equities at SWIP, says that the small and mid-caps indices benefit from having no banking exposure, unlike the FTSE 100, whilst other large caps such as pharmaceuticals and telecoms have also struggled.
“By their nature, the small and mid-caps are more UK-biased, and there is also more manufacturing exposure,” he explains. “These areas got sold off heavily in the last quarter of 2007 but they bounced back quite strongly in February’s reporting season as the bad news has not come through. It’s a bit of a relief bounce.”
But domestic consumer exposure is also quite a large part of small and mid-cap indices, and Bamberry points out that high street fashion retailers are economically sensitive. “It is very difficult to differentiate between these and there is over-capacity. People’s incomes aren’t increasing at the moment, fuel and food bills are going up, and these shops have got rents that increase at inflation or above. So you have to run quite hard just to retain your profits.”
In the last few years fashion retailers have made cost savings by sourcing goods from China, but a lot of this benefit has been due to dollar weakness, and may be marginal going forwards. Car retailers are also expected to suffer as people defer their purchase of a new car for at least another six months. “Most people buy such large purchases with credit, and that is now more expensive to get,” Bamberry points out.
Richard Rae, head of UK smaller companies at ABN Amro, believes that economic uncertainty will continue to overshadow the more cyclical sectors, in which the Hoare Govett Smaller Companies Index is overweight. But he adds that the indiscriminate sell off will present some selective buying opportunities. The price/earnings multiple for the HGSC has fallen in one year from 18x to 12x, which is now lower than the overall market.
Niche players
Michael McLaughlin, senior investment manager for the Pictet small caps team, agrees, arguing that small caps have a decent chance of holding up in a slowdown because they tend to be niche players, and exposed to local rather than global conditions. “But it is hard for a large cap to hide and not be affected by a big global downturn. There is this perception that small caps are something you only buy when the economy is growing and risk appetite is high – that they are something to buy in fair weather. But there have been instances when small caps have done well in a tough year, so there isn’t a definitive argument that they’re only for the good times.”
Henderson’s co-manager Colin Hughes singles out three niche players in the portfolio – Asset Co, which supports the fire and emergency services, Concateno, which provides kits for drug and alcohol testing, and Faroe Petroleum, an oil drilling company.
“Asset Co owns, maintains and guarantees equipment availability for fire and rescue, but most UK services have yet to outsource,” Hughes says. “It has a contract with London Fire Brigade until 2021 and Lincolnshire Fire and Rescue until 2026, so it can point to those track records.”
Concateno is thought likely to be unaffected by external economic factors as it operates in a legislation-driven market, and is expected to grow consistently. “It should be able to grow its revenue by 15 pct per annum,” says Hughes. Finally, Faroe Petroleum, which has been in the portfolio for a couple of years, is seen as having huge potential, of over 1.2 bln barrels of oil, but it needs help to extract it. Dana Petroleum currently owns a 24 pct stake and Hughes feels the share price now has the potential to double in value: “It is well funded and has the cash to cover its programme over the next two years.”
Liquidity headache
However, the widespread fear and uncertainty in markets has added another headache for small caps managers as liquidity has dried up. “At the top end of the Hoare Govett this is not an issue but as you get to the small end it is more difficult,” says Bamberry. “And because investment banks have lost so much money in the credit markets they aren’t willing to take on more risk, so whilst in the past they would have made a market, now that has just disappeared.” This means liquidity is harder to find, and prices are more volatile. “So by trying to buy stock you can make the share price move against you quite quickly.”
David Shea, portfolio manager of the Putnam Global Small Cap Growth Equity Fund, says that Putnam does screen on liquidity before it invests in a stock, and if there are likely to be constraints it limits the position. “So the very liquid stocks balance out those that are less liquid. But we don’t have heavy positions on the less liquid stocks, and the price volatility can be dramatic even with single transactions.”
McLaughlin adds that Pictet monitors the daily trading volume of the stocks in its portfolio, and the proportion of the portfolio that can be sold over one day, 10 days, two weeks and so on. “At the moment we can sell the vast majority of our portfolios in under 10 days doing less than one third of the daily volume, so it’s pretty cautious.”
If you want to read more about how small cap managers are piloting their portfolios through the slowdown, please visit:
Waiting for the next domino to fall
Bond managers have suffered horribly since the credit crisis started to bite. With liquidity hard to come by and treasuries yielding little, it has been difficult to know where to turn. Such was the unhappy picture until euro zone spreads obligingly began to widen out from German bonds, providing a splendid spread trade opportunity.
Bond traders have also tried to identify suitable macro trades, in order to ride the yield curve down. But generally bond markets look expensive, as government bond yields have fallen so far on the safe haven bid. For example, short term government bonds are giving only a 1 pct yield because they are being used as a place to hide. “The hedge funds who started to pull their collateral from Bear Stearns went into Treasuries because they didn’t want to see that collateral disappear into a bank bankruptcy,” said James Gledhill, head of fixed income at New Star Asset Management.
He doesn’t see this changing in a great hurry. “Government bonds will remain at a premium, but as the banking system stabilises and inflation remains stubbornly high, they will start to look poor value. Inflation is bad for government bonds – some of those commodity price increases are bubble induced, but some of it is permanent.”
Bond managers like Scott Thiel, global co-head of fixed income at BlackRock, and Thomas Kressin, senior vice president, global bonds at Pimco, are particularly frustrated by the continuing lack of liquidity in the fixed income markets, which has made it harder to execute strategies. This liquidity drought relates to continuing market fears over counterparty failures and the downfall of Bear Stearns last week has merely accentuated this. “These days you can’t trust anyone as you don’t know if there will be another bank failure – you don’t know which will be the next domino to fall,” says Kressin.
Thiel adds that bid/offer spreads, and the amounts that are tradeable at particular prices, have all deteriorated much more than he would have anticipated, even in June or July of last year. “That all comes back to balance sheet usage by dealers, and the dearness of government bonds. We are all a bit surprised by how illiquid bond markets have become. If you look at the currency markets, they have remained liquid and I would argue that the stock markets have been. So it’s an interesting development for a market that was once the bastion of liquidity.”
In this environment, Thiel says managers are forced to take a longer term view: “We’re investors, not traders so we have time to put a position on and have it come good. But these conditions make market making very difficult, and for traders relying on short-term price movements, the amount of transaction costs or slippage can sometimes become too onerous. It forces us to look at relationships and transactions and think about them in a more strategic and longer-term way simply because the transaction costs will be higher and the return has to be higher per unit of risk.”
He says that BlackRock is pretty neutral duration in terms of overall exposure right now, but it has some important country allocation trades. For example, Australian government bonds look attractive as the Reserve Bank of Australia has been in tightening mode whilst other central banks have been easing, so rates are high. If global economic growth slows the RBA may have to cut, so these bonds offer value versus US government bonds.
Thiel adds that European government bonds are one of the cheapest markets available as the ECB has been quite hawkish, but it should ease monetary policy as it begins to feel the effects of the US slowdown.
For the US, Sebastian Mackay, senior economist at SWIP, sees a bottoming out towards the end of the year as residential investment eventually finds a floor, but adds: “We think yields are going to be a fair bit higher in 12 months’ time. They’ve been supported by the financial crisis and the bid for safer assets and some of that will unwind over the next year. So we see 10-year yields back up at 450 on a year’s horizon.”
If you want to read more about the opportunities in the European government bond markets, please visit:
Coming unbalanced
GTAA funds promise better than equity returns with bond-like volatility – but last year a switch from low volatility conditions put some managers in the soup.
According to Mercer, which has surveyed GTAA managers’ results in 2007, there was a much greater dispersal of returns last year, as some managers found that their risk models didn’t stand up in the new conditions.
Although the median return for Mercer’s GTAA universe was 3 pct in 2007, and for the upper quartile 10 pct, the lower quartile returned -8 pct. Diane Miller, a principal at Mercer, says that GTAA managers generally got through February and March okay, but in the summer things began to unravel: “Quite a few managers had positions calibrated for low volatility, so when volatility increased they had to adjust their portfolios. But at the same time, other managers were trying to do the same thing.”
She suggests that those managers who experienced difficulties were perhaps trying to reduce or reverse positions at the same time as a lot of other managers and under-estimated the crowd effect. However, Miller is keen to stress that not everyone suffered. “Some managers had processes that were able to anticipate fairly well what was going on and got out in time,” she says.
Others had stop loss limits which cut their positions as they lost money and some deleveraged when they saw markets behaving in an unpredictable manner. “If they got out quickly enough then they were able to control their losses. And some managers were well positioned against this and profited when others were scrambling to get out,” she says.
After August, managers no longer assumed that volatility would remain low and ran lower levels of leverage, so in November the damage wasn’t as great. “The key to last year was for managers not to lose their earlier gains when the markets went against them,” Miller says. “That differentiated between those who had risk controls that worked when they were tested and those whose risk controls proved inadequate.”
She believes that this may have prompted a rethink. “They’ve realised that they’ve got to try and hang on to the gains, and not lose them when their models get signals wrong. The aim is to have all your positions full on when the market is quiet and then get out before the steamroller comes along.”
Talib Sheikh, co-fund manager of the JPM Cautious Total Return Fund, says that he uses a mix of quantitative and qualitative strategies, with the emphasis on the latter: “A lot of people running these funds concentrate on one asset class but we are really agnostic about where we see returns coming from.” He says there is a lot of uncertainty at present but he is reasonably optimistic over the medium and long term. “One of the things that consoles us is that equity valuations are reasonable. Provided there isn’t a serious global profits recession there is value in equities on that basis. However, we are cautious short term because the extent of the credit crisis write downs are still unknown.”
Guy Monson, founding manager of the Sarasin GlobalSar Balanced Fund, has witnessed 20 years of financial crises over the life of the fund, which finished 2007 up 9.4 pct. But he says the current crisis is one of the more frightening he has seen because of the uncertainty over the actual worth of a large part of the collateral in the banking system.
He is also concerned about climate change, and the implications for excessive resource demand: “There are no quick and easy solutions and we are likely to require huge amounts of capital to solve these problems, and that probably means slower growth in the years ahead. So in the short term I would say that I’ve experienced much worse, but in the medium term the challenges are quite substantial.”
Monson says the risks now are as much about Ben Bernanke rescuing the banking system as they are about him failing to do so and the economy plunging into a 1930s-style correction. “In other words, the possibility that in his evangelical drive to resist deflation, it could be that he sets off a medium-term inflation issue, from which it takes many years to correct.”
As a result, Monson sees the role of the balanced fund manager today as being more about inflation protection than it is about volatility management. “I think we may have seen the worst on the volatility front, but we’re just beginning on the inflationary front,” he argues. “That probably means that some material proportion of the modern multi-asset fund should be allocated to commodities for a longer period than has been normal in most other commodity cycles.”
To read more about GTAA and balanced fund management in volatile markets, please visit:
http://www.thomsonimnews.com/story.asp?sectioncode=7&storycode=37164
Steady as she goes
Mainland Europe has been largely overlooked in the apocalyptic scenarios cooked up for the US and the UK. It is generally accepted that it isn’t facing the same kind of meltdown, but the region’s steady-as-she-goes, invest for the long term philosophy has been overshadowed by the white heat of industrialising China and India.
Perhaps slow, steady growth is just not worth getting worked up about. But ABN Amro recently released research in association with the London Business School* which found that it was low growth countries that did best over the long term, whilst emerging markets only outperform in the short and medium term. Yes, it sounds like heresy, but 108 years is a long time in economic history. Meanwhile, we have more pressing problems.
Trying to manage through the current volatility is proving a headache for managers. “These are very volatile markets and have been for some time. From one day to the next, any company can get taken apart by the markets,” says Tim Stevenson, portfolio manager of the Henderson EuroTrust. “Valuations are attractive but investors need to be patient. I am anticipating a period of below trend growth. But although I am nervous for the next two to three months I see that as an opportunity to get involved.”
Robert Quinn, European equity strategist at S&P, says that European equities appear to be in the throes of an ongoing whipsaw market, in which investors seemingly convinced by events on the spur of the moment find themselves less so after more mature reflection.
In his view, the indiscriminate nature of the sell off in January, where utilities suffered the steepest declines, suggests a rotation out of asset classes. Quinn identifies potentially oversold positions in industrial, capital goods stocks – a sector also tipped by the managers interviewed for my recent focus on European equities. This sector fell by 30 pct from peak to trough, despite robust order intakes and order books, equal to a backlog of several years in many cases, says Quinn.
“Many capital goods stocks have been hit disproportionately versus historical standards, with companies in the sector in a better position today than in recent downturns to weather more moderate conditions,” he points out. Order books are strong as investment activity is continuing in many customer segments, with emerging market demand providing further support. “Cost reduction efforts will remain the key factor in maintaining margins, although it is questionable how much of this has already been discounted by the market,” Quinn says.
Stevenson also tips outsourcing companies such as Adecco, which supplies temporary workers. “There is a shortage of skilled workers around. It might suffer if there is a heavy recession, but this is already reflected in the valuations,” he says. Other attractive stocks include Sodexho, a catering company that is highly cash generative, and Maersk, the shipping company.
Despite the spectre of inflation, Stevenson remains fairly sanguine about the European economy this year, arguing, tongue in cheek, that growth will be boringly weak as opposed to boringly strong. “The key is to prevent wage inflation. It’s possible to create an Armageddon scenario where the US goes into a serious decline and the dollar becomes a problem for European exporters. But I think we will see lower growth rather than a recession.”
Quinn takes a gloomier view on market direction. “The perverse situation we find ourselves in now is that the market has traded the recession card so aggressively, with a consensus hardening around no immediate data, that it is vulnerable in the near-term to positive news flow. Our advice is that any such uptick is likely to prove a false dawn,” he says.
In particular, before the market’s ratings and earnings recover, he believes we need to see some negative news flow regarding the increase in default rates across the credit spectrum (such as auto loans or credit cards), as well as the release of “several challenging quarters of macroeconomic data”. This is not expected to happen before autumn at the earliest, suggesting that managers will have to suffer through several more months of wild swings and knee-jerk sell offs.
You can read more about European equity managers’ stock tips at:
http://www.thomsonimnews.com/story.asp?sectioncode=7&storycode=36755
* ABN Amro Global Investment Returns Yearbook by Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School and Rolf Elgeti, consultant.
Oscar’s guide to capitalism
Markets in freefall? Not sure what’s in that CDO surprise? Can’t remember who’s supposed to be bailing out the monolines this week? Just remember this: you could have bigger problems.
With oil flick There Will be Blood and legal thriller Michael Clayton both up for best film this year at the Oscars, the corporate world has been given an insight into how film-makers view capitalism. And the results aren’t pretty. Because surely there’s no better way to unwind after a hard day at the office than to go out and off a few of your irritating evangelical neighbours or conscience-stricken colleagues.
What, one wonders, is Hollywood’s problem? Both films might have lost out in the end to the remorseless No Country for Old Men, but not since the heady days of Oliver Stone has capitalism had to undergo such excruciating examination. Is this relentless movie bleakness another key data indicator that we are already in a recession? And why does killing all your barber shop clients make for a good business model? Does it only lead to good earnings growth if you’re running a pie shop on the side?
After ruminating on these perplexing issues for rather longer than is necessary, it seems Hollywood may be trying to tell us something, so here is a handy checklist for all of us down at the screen face powering on through the endless recession-led negativity. Just in case you’re ever faced with a tricky corporate dilemma.
Don’t lose it in the middle of an important class action law suit you are defending and run naked through a car park in a snow storm.
Don’t burble incoherently in the street whilst clutching 20 baguettes – it will be tricky to persuade anyone of your moral argument.
Don’t steal any money from drugs deals gone wrong.
If you’re offered a deal TAKE IT, no matter how unpalatable it might seem at the time.
Don’t send someone else to terminate the original contractor you hired for the job – this is unlikely to go over well.
Don’t accept the offer of a shave from two dishevelled Goths you just “happen” to meet in the street.
Don’t browbeat demented oil barons into professions of faith just because they want to run a pipeline across your land.
Don’t go bowling with demented oil barons, even if you need the money.
And most of all: don’t forget about drainage.
Recess is over
March 25, 2008 at 10:46 am (Macroeconomic commentary) (Inflation, Market turmoil, Federal Reserve interventions, 1930s style depression, Bear Stearns, HBOS, house-building)
The Easter break may have given the market time to reflect, but it would be unwise to expect a sudden improvement in fortunes. Bob Doll, CIO for global equities at BlackRock, has pointed out that a series of explosive daily moves is the norm for a bear phase to end, whilst high profile financial failures, such as that of Bear Stearns, are often coincident with market bottoms – think of Savings & Loans associations in 1989, LTCM in 1998 and Enron in 2002.
But Doll has also warned investors that the lack of confidence in the banking system has developed its own inertia, and this is likely to persist until policy intervention becomes significant enough to arrest the trend.
Sadly, last week events seemed to be threatening to spiral even further out of control, as rumours circulated about various US investment banks, before the UK’s HBOS came under fire. “What is genuinely terrifying for financial markets is the power of market rumour,” said Neil Dwane, CIO Europe at RCM. “The most important thing here is the speed with which this all happened…You can get talked into going bust in these financial markets.”
Regulators may suspect mischief-making behind the rumour mill, but the underlying fear that haunts the markets is of a chain reaction of defaults setting in that would see the whole banking system go down, like in the 1930s. “There’s a sense that investors have become more risk averse, and there’s a spiralling effect with that so if one set of investors gets more risk averse the price of the asset falls and that contributes to the general sense of pessimism,” says Simon Ward, chief economist at New Star Asset Management.
The credit markets are not functioning particularly well – liquidity is pretty close to zero, and in the bank loan market there is a high mismatch of supply and demand due to deleveraging by hedge funds and the unwinding of SIVs and conduits. “That is putting out prices to levels that have nothing to do with the fundamentals as we are not seeing a lot of defaults,” says James Gledhill, head of fixed income at New Star Asset Management. For example, high yield debt is discounting a default peak of 10 pct, even though defaults are only at 1 pct at present.
And even though the Fed has been cutting significantly for some time, the market’s expectations of further rate cuts mean that this is already factored into T-bills: “They are way ahead of where the Fed is, so rate cuts are now just psychological.”
Inflationary impact
BlackRock’s Doll agrees that as equity markets won’t rally until the credit markets stabilise, this will require a sense that the Fed is finally getting ahead of the curve.
But the Fed’s rate cutting is making some economists, like Ward, nervous about the impact on inflation. “The rise in energy prices is one of the reasons why the US consumer is under so much pressure,” he says. “I think they should have eased policy more gradually. They should have waited for some weakness in commodity prices and inflationary pressures more generally, and at that point they could have cut more aggressively.”
Indeed, there has been an understandable reticence from the Bank of England to cut as aggressively as the Fed as it has to focus on its inflation targets, whereas the Federal Reserve also has a mandate to consider GDP growth. “Inflation is just about to spike up because of rising commodity prices, but once we are past the oil spike we may see more aggressive rate cuts from the Bank of England,” says Toby Thompson, manager of the New Star Higher Income Fund.
He suggests that equity markets seem to be expecting an early 1990s-style recession, but he doesn’t see this in the UK, arguing that different factors are at work this time round. “In the 1990s, we saw negative equity fuelled by heavy falls in house prices and significant write offs in bank lending. There were also significant commercial property write offs. It looks like the markets are expecting this again, and therefore see a big hit to banks’ earning capacity,” he says.
Debt blow up
However, he points to a big difference in the rate of debt expansion this time around as borrowings in real terms have increased by only 5 pct per annum, whereas in the run up to the 1990s recession they were up by 13 pct per annum. The biggest factor in predicting whether this will blow up in the banks’ faces is how much has been piled on at the top of the cycle, and for some analysts, the size of the buy-to-let market in the UK is a key concern.
But Thompson also argues that in the 1990s, the UK house-builder market was more fragmented, and house-builders had greater levels of debt. “So they had to sell as many houses as they could to generate cash and worried less about the prices.” Now the top 10 house-builders have control of half the market and are not as significantly indebted. They have also realised that their land holdings are of value, so they prefer to reduce the numbers of houses they build if the market is soft rather than waste that value. “In the 1990s there was a greater degree of speculative build, and house-builders continued to build when the market softened,” Thompson says.
However, RCM’s Dwane strikes a more sober note: “We have to remember that in parts of Europe, particularly the UK, the biggest growth in jobs has probably been in finance and housing related industries and we need to remember that many individuals may well lose their financial firepower over the next few years.”
If you want to read more economists’ responses to last week’s interventions by the Federal Reserve, please go to:
http://www.thomsonimnews.com/story.asp?sectioncode=7&storycode=37388
and:
http://www.thomsonimnews.com/story.asp?sectioncode=30&storycode=37485
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