The Bears Bite Back
With the summer reporting season now upon us, those looking for some relief amidst the bearish gloom are likely to be disappointed. Whilst pharmaceutical stocks like AstraZeneca staged a recovery last week, other traditional defensives like BT have been punished after reporting a lower than expected rise in first quarter earnings. Expect trading to be extra light once the Olympics start.
Several asset managers who have traded through previous bear markets have pointed out that the race to the bottom has been much quicker this time around, possibly due to the sizeable participation of hedge funds. “The market fell out of bed at the start of June and over a six-week period we had a precipitous fall in share prices,” says Alan McIntosh, CIO of Cheviot Asset Management. “In past bear markets it has tended to take several months for share prices to fall so far, but the market reacted very quickly and has already priced in a deep economic downturn.” Because of this, McIntosh believes the current bear market may be one of the shorter-lived ones. “Bear markets tend to run for about 12 to 15 months, so it may run another three to six months.”
Adam Steiner, head of research for public equities at SVG Capital, believes that active trading by hedge funds is partly behind the accelerated share price fall. He points out that global hedge fund assets under management have increased from under US$200 billon in 1995 to over $1.8 trillion in 2008. As a result, over the last decade the average holding period of FTSE 350 stocks has collapsed. “In the mid-1990s it was about two years whereas now it is down to five or six months,” he says. “In mainland Europe the fall isn’t as pronounced due to large bank and family stake-holdings, but it is still down from about 18 months to 10 months.”
Know your rights
The rise of hedge funds has also created a conflict between financial markets and the real economy. “Until this bear market we never had a significant number of people who make money if a company goes bust,” he says. This has been reflected in the recent rights issues by the banks, where HBOS only managed to attract an 8% take-up because its share price was driven below the rights issue offer price.
Regulators have responded with a temporary ban on naked short selling in the US, and the disclosure of trading in rights issues in the UK market. “But the reason why the banks are trading below their rights issue price is more to do with the fact that they are in trouble, and people think that there will be further fund-raising,” says Steiner.
He points out that once, no one would have benefited from a rights issue failing so there was pressure for them to go ahead. Investment banks can make a lot of money from rights issues and they allow struggling companies to continue trading. But now hedge funds can express a view that a rights issue is priced incorrectly, and they will make money if that view is borne out. “Hedge funds remove muddled thinking from the market – they take prices very quickly to what people think they should be,” says Steiner. “That removes the ability of markets to muddle through, and muddling through can be quite useful at times.”
Steiner believes the pending UK recession could be as bad as that of the 1990s, and possibly that of the 1970s, but for totally different reasons. “The basic problem is that central banks have spent the last 15 years trying to iron out the economic cycle, and their focus has shifted from controlling inflation to steady growth,” he says. “In the US, whenever there was the slightest hint of a normal slowdown, Greenspan tended to throw money out of helicopters as fast as he could.”
This approach has led to a 15-year accumulation of poison in the system, which needs to be sweated out. “Unfortunately the banks are realising they have a problem at the same time as companies are at peak profit margins. So we would expect corporate earnings to come down even if nothing else was happening.”
Across the market, equities are now trading at comparable levels to the trough of the 1990-1992 recession. “The FTSE is trading at P/Es of 10.5x, against a trough of 10.4x in 1991, whilst bank stocks are at 5.4x, compared with a long-term sector average of 12x,” says Richard Moore, manager of the Santander UK Growth Fund.
A short squeeze
Ironically, financials have become so over-sold that they staged a rally in July, and are up a modest 1.73 percent over the past month. Peter Lucas, global strategist at Ashburton, attributes this bounce to a period of short covering rather than any change in the fundamentals, and Steiner remains wary: “The UK banks still haven’t taken any write-offs relating to the domestic economy [although the likes of HBOS have increased their provisions to cover bad debt], and our view is that there is no point investing in contentious sectors as the rest of the market is so cheap.”
McIntosh is also cautious about the bank bounce: “It is probably a bit risky to load up with those yet because we haven’t heard all the write-offs, and if a recession occurs then all the bad debts will start to come through.” But he adds that some banks haven’t been caught out by sub-prime and will be able to take market share from the weaklings.
Other sectors being given a wide berth by managers include companies that are vulnerable to higher input costs, such as food manufacturers, and consumer businesses that are operationally leveraged. “The impact of slower sales will be magnified by competitive pricing and rising input costs,” says Colin McLean, manager of the SVM UK Active Fund. “A feature of a number of consumer companies is higher balance sheet debt.”
He points out that buy-backs and stock tenders in recent years, combined with high levels of dividend distribution, have meant that many consumer businesses will enter the slowdown with a weaker balance sheet. This will trigger dividend cuts and force some companies to renegotiate banking covenants – something that appears likely to occur with some UK house-builders. McLean expects weak trading to combine with margin pressures and balance sheet problems to trigger further share price falls in many UK consumer businesses.
In such an environment, Steiner says SVG is looking for companies that aren’t reliant on the cycle to generate profits, and are on an attractive valuation, with no major structural problems. As a result, he likes pharmaceuticals, telecoms and non-cyclical industrials, but is frustrated by the sell-side analysis of telecoms, which he believes has made a wrong call on every major development since the dotcom blow up. “It seems like they got so burned by the TMT bubble that now they always assume the most negative outcome of any story affecting the sector. So telecoms, which should be a defensive, hasn’t been from a share price perspective, even though the quality of the management in UK telecoms is the best by a mile.”
Good hunting grounds
Steiner also believes that small caps have been unfairly written off because of the widespread perception that they do poorly in bear markets as liquidity dries up. “But between 1970 and 1979, small caps outperformed the FTSE All-Share by about 200 percent. Our view is therefore to buy small caps because they have fallen the most.” This means looking for individual stories because small caps are vulnerable to banks pulling their funding or changing the terms of their financing.
Another good hunting ground during a downturn is where private equity deals have failed to come to fruition, as companies wise up to their real value. “We are seeing more talks that don’t go anywhere, where one side is looking for a bargain and the other is looking for fair value,” he says. If the private equity house walks away because it found something in due diligence that it didn’t like, Steiner says SVG will steer clear. “But if the private equity firm walked away because the company’s managers are holding out for a good price, then it could be worth looking at.”
As traders and asset managers head for warmer climes and market volumes thin, a major sell off in miners and energy cannot be far away. July’s fall in the oil place has ensured that commodity-related shares have already taken something of a beating – and given that the resources sector has been the FTSE’s life support for the last six months, this is likely to prove fatal.
“The problem is that there is very poor breadth in the market with a concentration in resources and mining stocks – only a few shares have participated in the upside and we need to see that broaden out,” says Lucas. “But over the last few months, even though the oil price has been going up, oil-related shares haven’t followed it. I think the reason for that is people did not believe that the oil price was sustainable at those levels.”
If you want to read more about how asset managers are positioning their portfolios in the bear market, please visit:
http://www.thomsonimnews.com/story.asp?sectioncode=7&storycode=45093
Forever Blowing Bubbles
This time it’s different – the plangent refrain of the investor suffocating in a bubble. Ah, what bliss it is to recall the golden days of the dotcom era, when we thought the mini-scooter-driven party would never end. We would all be commuting to work via the internet and downloading our memories into cyberspace in a kind of Neuromancer-meets-Facebook “mash up”.
Now we look back and scoff at the delusions of our younger selves. What on earth were we thinking? Boy, we were really stupid 10 years ago! We forgot to ask important questions like: What does this company do? And: How will it make money? Thank goodness the commodities super-cycle is nothing like that.
And just why is it so different? Because China and India are industrialising like crazy, of course! Who could pass up that opportunity? Hmm, well let’s just run a slide rule over that shall we?
Tony Dalwood, head of public equities at SVG Investment Managers, believes that mining stocks and other natural resources plays, which have run up on the back of the commodities boom, are heading for a fall. “Value investing has underperformed because commodity stocks like the miners have got ahead,” he says. “The market is focusing on cyclical peak earnings, but miners are heading for a problem when returns normalise.”
Panic and crisis
Adam Steiner, head of research, public equities, at SVG adds: “The investment time horizon of hedge funds and traders is microscopic compared to pension funds, and the markets are now very momentum driven. In moments of panic and crisis no one is using valuation to pick stocks – they just churn their portfolios to try and keep up to date. They don’t want to be underperforming the market at the end of the quarter.”
He argues that resources companies are “grotesquely overvalued” – mining is a cyclical industry and is generating the highest returns it ever has, but as costs go up and more capacity comes on stream this won’t continue. “Whenever you have a bubble there is always an argument that this time it is different,” he says. “People are pointing to the impact of China, but the increase in the oil price is not completely accounted for by that. To pretend the demand for resources is in no way influenced by the global economic cycle is crazy. If oil goes to $200 a barrel then the average US driver has to spend 10 to 20 percent of their income on petrol. So you have to ask – if everyone in China owns a car, how will they afford to drive it around? High commodity prices in themselves slow global growth.”
He adds that the population of China is only three and a half times that of the US, and the majority are peasants in the north and west. So the Chinese economy will only become two or three times bigger than that of the US and it will take a long time to get there. “You also have to keep in mind that a lot of China’s growth has been financed by US debt.” That is, consumers withdrawing equity against their homes to keep spending – something they are unlikely to be doing much of in the foreseeable future.
The commodity gurus argue that prices are supported by years of under-investment, which has created a pinch point – miners can’t get the stuff out of the ground fast enough, so prices keep increasing. But when new capacities come on stream, shouldn’t prices correct to more realistic levels, especially if the US is in the doldrums? So investors have to ask themselves: How far do we want to ride this boom? You can bet the chartists are hunkered down over their models right now trying to call the peak.
Buy-to-let blow up
Steiner is also worried about the horrors that may lie ahead for the UK, especially if the buy-to-let boom turns out to be the UK’s very own sub-prime meltdown. “The banks have only written down their lending impacted by the US so far, not their UK lending losses,” he argues. “That will come if we have a nasty house price plunge. For the last few years there has been a very strong tailwind that has helped retailers, banks and property, but that has now gone into reverse, and it is likely to be a headwind for another three to five years. The issue will become – how are banks going to make money now? The ratings will recover but the earnings won’t.”
SVG takes a contrarian approach and is focused on companies not at the peak of the cycle – particularly, telecoms, pharmaceuticals, software and media companies. Steiner says that pharma stocks are interesting as they are “off the scale cheap” – some 40 percent below their 20 year average. “All the arguments for pharma – such as the ageing demographics – remain intact, but they have been hit by the FDA tightening up its approvals process and the market is fretting over near-term fears.”
He adds that media is “mind-blowingly cheap” because of fears that if the economy does turn down, media will do badly. SVG is focusing on business-to-business companies such as DMGT and the WPP agency, which is more diversified, and therefore less cyclical than people seem to think. “This is the exact inverse of 1998 to 2001,” he argues.
It’s an interesting idea – that TMT will ride again after a speculative bubble in commodities goes pop. M&A activity in the small and mid-cap telecoms and software sectors has been brisk in the last couple of years, with strong private equity interest. “A lot of small and mid-cap deals are happening and they have raised a decent amount of money,” says Steiner. Telecoms has now re-rated a little, but SVG believes there is further to go. Perhaps it’s time to dust off that mini-scooter and drive back into the TMT market again.
If you want to read more about developments in the TMT sector, please visit:
http://www.thomsonimnews.com/story.asp?sectioncode=7&storycode=42257
When Private Goes Public
The credit crunch has had a surprisingly positive impact on the UK-based managers ploughing the specialist furrow of applying private equity techniques to quoted equities. As well as the fall in equity valuations, which has led to reduced entry prices, the decline in the availability of credit for corporate borrowers means that investors like SVG Investment Managers, Acuity Capital and 3i QPE receive a positive reception from quoted companies in need of expansion capital.
“We have seen more cyclical opportunities coming on to our radar screen over the last six months,” confirms Bruce Carnegie-Brown, managing partner of 3i Investments, the adviser to 3i Quoted Private Equity Ltd. “There are some obvious sectors where rates are depressed at this point in the cycle, such as financial services, software, real estate and credit businesses.”
When the 3i QPE fund was conceived 15 months ago, the market was a lot stronger than it is today, he adds. “We are trying to find 10 investment opportunities that for one reason or another have been neglected, or are undervalued by the market. And we believed those opportunities existed 15 months ago. The credit crunch has created more volatility, and a number of companies have seen a reduction in their market value, for a variety of sentiment reasons not necessarily supported by underlying trading. And of course many of the things that might previously have got funded in the debt markets are now coming to the equity markets.”
M&A activity
Adam Steiner, head of research, public equities, at SVG Investment Managers, says the mega buy-out market is still closed as banks are unable to syndicate loans, but smaller deals below $1 billion are continuing, as banks can do these on a solo basis. He is upbeat about the prospects for M&A activity in the small and mid-cap arena and sees private equity playing a significant role. “The high funding levels of private equity firms and the reduced availability of debt means that equity will represent a greater proportion of these deals,” he points out. In addition, as prices have come down, private equity groups can afford to put in more equity.
But Acuity’s Judith Mackenzie, who will manage the upcoming Real Active Management Fund, stresses the importance of doing your homework on stocks that have de-rated badly: “Sometimes that’s completely warranted because they have messed up badly and the fundamentals have been wrong in the first place, but more often it’s because of a relatively naive management team who haven’t been well-versed by the broker as to what the market wants. Yet the fundamentals of the company tend to be quite strong.”
Steiner says that SVG looks for a small number of companies that create a lot of value. “It’s a seven month process to research companies, and we analyse the company’s customers, suppliers and competitors, as well as using industry experts to undertake ad hoc research.” A strategic advisory board will also look at a prospective investment and give its view.
In terms valuations, Steiner says that traditional asset managers will look at P/E ratios and compare those with a company’s peers. “We don’t really do that. Instead we look at buy-out models and try to work out how much money we would make if we took the company private. We also look at transactions done in the sector and what P/E multiple they were done at.” Cash flow yield is also important as this attracts buyers for companies in the mid-market buy-out space.
Unlocking value
Once the company is in the portfolio, Mackenzie says that the assistance provided by Acuity might include identifying acquisitions or partial disposals, but she expects to have about 10 to 15 stocks where not too much needs to be done: “The company may just be unrecognised by the market, so it might need a few tweaks like a new investor alongside ourselves, or a new broker. It’s about looking for unlocked value and finding out where the trigger points are going to be over the next 12 to 18 months.”
Steiner adds that SVG will speak to the company management regularly, and help them improve the value of the company. “For example, if they need to make an acquisition and do a fund-raising, we will put some of the money in to help them place that fund-raising. We will also help them find better non-executives, and will urge them to introduce private equity style incentive schemes for management if they create value for investors.”
3i’s Carnegie-Brown says that this more intensive investment approach can offer companies an appealing alternative to delisting after a disappointing or bruising experience on the AIM. “Delisting is quite hard to do. If you’ve brought your company to the market and then delist it within two or three years, then institutional investors get pretty ticked off,” he warns.
“Also, if you delist and go private, you are essentially putting yourself up for auction and there is a risk that the winner will have a different business plan than the one you envisaged. But if you’ve got someone who is interested in minority positions and committed to keeping the company quoted, it’s a much more benign and supportive model. We can help the management team drive the business the way they want to go.”
He cites the example of Jelf Group, a UK insurance broking and wealth advisory business aiming to be a leader in the consolidating regional commercial insurance sector. It has made 15 acquisitions over the last two years and QPE has helped finance five of the most recent of these. Also supportive is the fact that with its previous investments in asset management and insurance brokers, 3i has already accumulated a range of skills and expertise in this area.
Exit strategies
When the time comes to exit an investment, Carnegie-Brown says there may be several options such as selling to a private equity firm or trade buyers, or back into the market. “But the idea is to keep the company in the portfolio for a meaningful period of time. It’s a constraint on private equity funds because they need to return cash to shareholders to show the value they’ve created, but with this you can see the value at any time.”
The average investment period is expected to be about five years, and 3i QPE is looking at a number of other investments in the UK, France, and Germany. “The Nordics are also interesting because they have an international perspective and it’s a strong region for 3i,” says Carnegie-Brown. “But there are more opportunities coming out of the UK because the concepts are generally better understood.”
If you want to read more about how this approach differs from traditional asset management, and where managers are finding opportunities in this space, please visit:
http://www.thomsonimnews.com/story.asp?sectioncode=7&storycode=42257
Time to pay
Market commentators are fond of historical parallels. As the UK consumer is finally waking up to the fact that one day the bill really does fall due, economists and asset managers are torn between likening this downturn to that of the early 1990s – when house prices tumbled – and the 1970s – when inflation ran amok. I’ll let you know when we get a consensus.
John Beck, co-director of international bonds at Franklin Templeton Fixed Income Group, says that August 2007’s credit crunch is only now hitting the wider economy, and despite the measures that are being put in place to help UK banks over the hump, further pain is likely.
Last week’s breakfast meeting at Downing Street quashed hopes of a quick fix, with the Bank of England offering its collateral swap facility only at a significant haircut, whilst the capital risk will remain with the banks rather than being shouldered by the groaning taxpayer.
No such thing as a free breakfast
Under the terms of the special liquidity scheme, banks can swap high quality mortgage-backed and other securities for UK gilts and then use these bonds as collateral for loans from other banks. But the banks need to provide the Bank of England with assets of much greater value than the Treasury Bills they receive. And if the value of the assets falls, or are downgraded, the banks will need to stump up the difference, replace them with better assets, or return some of the Treasury Bills. “This is the most expensive breakfast those bankers have ever had,” says Beck.
But as Howard Archer, an economist at Global Insight warns, for the scheme to have the maximum beneficial impact, several other developments need to happen in tandem. These include greater transparency from banks on their losses and exposures to the sub-prime crisis; steps by the banks to improve their balance sheets, such as the rights issues by RBS; and a commitment by banks to quickly reflect any fall in market interest rates in their products and loan rates to customers.
Beck believes the RBS rights issue will be the first of several capital-raising exercises. “With the banks we are potentially at a turning point similar to what we saw with the telcos in 2003, when their debt was downgraded. There was vast excess capacity in the telecoms industry and the bond markets had been paying for it. Now I think we are getting to the point where the bond markets and the regulators have got fed up with the banks, and will only let them raise capital at penal rates.”
Although he sees the move towards raising equity capital as good news for debt-holders, he doesn’t expect an improvement in the economy for some time. “Debt spreads are still very wide for banks and stock prices haven’t recovered. Now we are seeing the consumer impact. The first round was the write-offs from securitisation. Now the write-offs on loans to consumers are coming.”
You are now entering a recession – please take care
Not surprisingly, UK equity managers are gloomy. “The economic data has been much worse than expected and the credit crunch has been deeper and more long lasting than we expected six months ago,” says F&C’s Ted Scott, manager of the UK Growth & Income Fund. “My view now is that the UK will have a recession, whereas six months ago there was a chance that we might avert a recession or it would be a pretty shallow one.”
But with the financial system still frozen and banks reluctant to lend, the housing market is beginning to implode under the pressure of unsustainable price rises and higher interest rates. “In the US, house prices have fallen 30% or so and it’s quite conceivable that in the UK we will see a fall of over 20% peak to trough,” Scott argues.
With home-owners struggling to meet their mortgage payments, other spending is expected to dry up. “They will be cutting back quite severely, and that’s going to have a big effect on the economy.” And Scott believes the recession could be more severe if unemployment rises from its current relatively low level of one million.
“Back in the last recession it got up to about three million, so if we start to get a lot of redundancies that would make it worse,” he says. “At the moment the problems are confined to the financial sector but if it’s a wider economic problem we could find that lay offs increase sharply.” With the credit crunch still ongoing, he draws a comparison with the 1970s and the UK’s secondary banking crisis, which took place against a backdrop of rising inflation and oil prices, pay freezes, and the three-day week.
Mark Lovett, co-CIO of European equities at RCM, is also pessimistic, but adds that RCM has been quite negative on the UK consumer since the beginning of 2007. “We’ve been concerned about the ongoing pressures on disposable income and the fact that the savings rate is so low, and how that will affect consumer spending.”
He sees the UK growing at below trend for two or three years, with a sharp V-shaped recovery in 2009 or 2010. “We don’t think this is something that will be resolved quickly, and below trend growth will probably be quite healthy in terms of unwinding some of the consumer debt and the low savings rates that have been so prevalent.”
Bear-market rallies
Ironically the market has roared ahead in the last month and is up nearly 10%, but Mark Lyttleton, manager of Merrill Lynch/BlackRock’s UK Dynamic Fund, remains wary. “People are saying that the worst has happened and that this is reflected in the valuations already. And now they see some solutions to the credit crunch. But it’s not just about getting the banks to lend to each other, it’s about all the losses they have made, and actually announcing them,” he says.
“If you’re prepared to take a two-to-three year view, there is probably some value in some of the bombed-out UK discretionary names. The problem is the news flow is going to get a lot worse before it gets better. So you have to decide how much of that is in the price and whether you can afford to wait. There will be some speculative rallies when some of these sectors will bounce back up, but I’m playing it quite cautiously.”
And although the markets have recovered in the last fortnight, and the VIX has been less choppy, Lovett does not believe that this reflects a change in confidence levels. “The average market participant is still very nervous because of the lack of visibility about the economic environment, and I expect volatility to remain high through the rest of 2008,” he says.
If you want to read more about how UK equity managers are positioning their portfolios to weather the slowdown in consumer spending, please visit:
http://www.thomsonimnews.com/story.asp?sectioncode=7&storycode=39125
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:
Is it volatile enough for you yet?
At the back end of last year there was one thing that everyone agreed on, even if they couldn’t agree that the US was headed into a recession – 2008 was going to be a lot more volatile. Last week that volatility arrived with a sad inevitability, as markets began their breathless rollercoaster ride through the Fed’s rate cut, SocGen’s discovery of an “extraordinary fraud” and finally, arriving at the gallop, like a desperate envoy, the news of the US’s fiscal stimulus package.
The markets gyrated like a demented dancer, as negative and positive news flow threatened to overwhelm traders. Neil Dwane, CIO, Europe RCM, says that in Europe the markets saw massive futures trading, hedged through the cash markets: “The sharp falls in share prices are therefore trading and hedge fund related rather than traditional investor selling.”
Max King, strategist at Investec Asset Management, attributes the volatility to the fact that investment professionals try to learn from their mistakes. Unfortunately they do this by being ultra-sensitive to the issues that tripped them up last time and reacting as if the problems will recur. “A classic example of this is investors’ paranoia about earnings forecasts,” he says.
King says that investors are making the same mistake as in the 2002-3 bear, where analysts remained optimistic for too long, only cutting forecasts after share prices had fallen and companies were admitting problems. “So while the consensus of analysts’ forecasts shows global earnings growth of 13 pct in 2008, the consensus of everyone else is that these numbers are worthless.”
King points out that this ignores the possibility that both companies and analysts also learned lessons from the bear market. “The impact of the current downturn on corporate earnings should be much less than in 2002-3, but investors don’t believe it.”
In times like these it is tempting to cleave to the arguments of the behavioural financial analysts who say the best thing to do is simply to ignore the madness. Contradictory news flow getting you down? Don’t know which way to turn? Then just retreat to a cloister for two months until everything settles down again.
“The classic advice to investors in periods of considerable volatility is to not make big ‘knee jerk’ changes to portfolios,” says Andrew Milligan, head of global strategy at Standard Life Investments. “If there is spare cash, look out for any ultra-cheap assets, whether individual stocks or markets, which have experienced panic selling.”
He adds that there is usually a short-term rally after such a sell-off, but a genuine, sustained uptrend normally takes months to develop. “Investors need to see much more evidence not only that all the news has been fully priced into markets but also that negative trends on earnings and business activity are turning positive again. The worst might be over but, just as importantly, investors should prepare for more pain to be felt in 2008.”
It’s little comfort to know that such volatility is typical of this stage of the cycle. But with the bear out of the cage, contrarians are looking for bargains. RCM’s Dwane points out that there is a world outside the US, and investor capitulation, whilst painful, will soon provide a great entry point into the markets. Tony Stenning, managing director of UK retail at BlackRock is also sanguine: “Now is the time to look behind the charred exterior and spot the value shining through….Even if there are further undulations ahead, investors are likely to do well on 3-5 year view.”
Danger of getting too bearish on equities warns RLAM
Royal London Asset Management’s Jane Coffey says financials will be toughest sector to call – but picks out HSBC and Lloyds TSB as best of a bad bunch.
Investors face a real danger of getting too bearish on equities, according to Jane Coffey, head of equities at Royal London Asset Management, but timing the upturn, and especially the right time to go back into financials, will be tricky amid a series of false dawns.
M&S vs FTSE – from Thomson Datastream
On the whole, Coffey is cautiously optimistic on equities, but she stressed this is related to valuations, which are not at too high a multiple. ‘Bond to equity yields are at 30 year lows in the UK, which suggests that equities are cheaper than they have ever been,’ Coffey said. ‘Equities versus other asset classes haven’t re-rated this cycle, but we’re at the peak of the earnings cycle now, so the question is how far will they fall over the next few years?’
She said that as interest rate cuts are expected, this should trigger a re-rating of equities based on trough earnings: ‘We’re seeing quite a lot of value in the market now.’ In this environment, Coffey said RLAM was positive on cash in the short term, as it wants to be ready to go back into the market when the earnings downgrades are discounted and the interest rate recovery is coming through. ‘But it will be very volatile with a lot of false dawns,’ she warned.
She thinks that the upturn might appear first in financials, where RLAM is currently underweight, but added: ‘We don’t want to get too weighed down by negativity and miss out on the opportunity to make money.’
In this troubled sector, she said she will look for banks making big write downs and becoming more realistic about impairment charges, which she believes are still too low. Last week Lehman Brothers recommended an overweight to financials, arguing that the sector appeared oversold, and that the dividends being paid are much higher than the current market price would indicate.
‘Banks are at unprecedented lows, but that doesn’t mean they are necessarily a good buy – it might be that they can’t pay the dividend yields they are projecting,’ countered Coffey. ‘Banks don’t like cutting their dividends, but it is starting to happen in the US, with Citigroup for example, and I expect the Royal Bank of Scotland to cut because it is looking overstretched.’
In this sector she said RLAM holds HSBC and Lloyd’s TSB, which seem the least bad of the bunch. ‘The balance sheet at HSBC is in reasonable shape – there is nothing bad enough there to suggest a dividend yield cut or a rights issue,’ she said. ‘They have some exposure to US sub-prime and will probably have to take some write downs but it is a drop in the ocean for them and they have good growth prospects in Asia.’
She added that Lloyd’s TSB (see chart) has only just increased its dividend yield after a long period with a flat dividend. This was related to its poorly timed acquisition of Scottish Widows, which made the bank capital constrained and hence conservative at a time when the other mortgage banks were extending large amounts of cheap credit: ‘This means they are not over-stretched and this should be one of the more guaranteed yields in the market.’
Lloyds TSB vs FTSE – from Thomson Datastream
However, Coffey added that RLAM remained very cautious on the UK economy, with a number of concerns about the over-indebtedness of the consumer and high house prices. She pointed out that building volumes have been a lot lower in the UK compared with the US, so there is no massive over-supply, but affordability ratios are overstretched: ‘So house prices will decline and the UK economy will face a tough time in 2008.’
Instead, Coffey says RLAM is looking to the BRICs, which it believes are now so big that they can rely on their own internal growth generators. In particular, RLAM is overweight on oil and the mining sector, as the main drivers for resources continue to be from the emerging markets.
For more please visit: www.thomsonimnews.com
Into The Woods
July 11, 2008 at 1:08 pm (Macroeconomic commentary, UK equity markets) (banks, Bear market, Commodities, energy, financials, Japan equities, mining, monolines, UK equities)
Careful there! Tread quietly! We are now in official bear territory. Who knows what dangers lurk in these woods?
Yes, the FTSE finally succumbed to the inevitable and crashed through the technical bear barrier this week, following the S&P 500’s ignominious tumble into the badlands earlier this month. On Tuesday the FTSE All-Share fell 20% off its October high of 3,467, whilst this morning the FTSE 100 ventured into bear territory by crashing to 5,333.9, well below the 5,385 bear threshold.
“The news that we have officially entered a bear market comes as no surprise to many investors whose shareholdings have halved in value,” said Angus Campbell, head of sales at Capital Spreads, on Tuesday. “The 20% rule simply confirms what we have long suspected since the beginning of the year – we are well and truly in the grip of a grizzly bear market.”
Manoj Ladwa, a senior trader from TradIndex, said that financial stocks, including RBS and HBOS, had fallen further in response to losses in New York, while house-builders had had another bad morning following a predictably weak trading update from Persimmon. “Mining stocks, which have been a mainstay of the index this year, started to weaken, as analysts lose faith in BHP Billiton’s takeover of Rio Tinto happening any time soon.”
Danger – loose bears
Campbell said that it is a clear danger signal when there is a 100 point rally in a market that is trending lower, followed by a large sell-off to test new lows. “That is exactly what we have seen [this week] with financial stocks yet again leading the way. The outlook for pretty much every stock though is truly dire at the moment and if it was not for the energy and mining sectors keeping us afloat, we would have been testing the 5,000 level months ago.”
He added that if investors now pull out of the energy and mining sectors, it is anyone’s guess where global indices will bottom out. The FTSE 100 currently contains 10 mining companies, and seven oil and gas companies. By market cap, there are four mining, and three oil and gas stocks in the top 10 alone, and these companies collectively account for 50% of the FTSE 100’s total market cap. This is creating some concern amongst the trackers, which are now heavily exposed to what tend to be very cyclical industries.
Meanwhile, the outlook for financials worsens day by day. As the economy grinds to a halt, credit defaults are finally starting to come through, threatening to turn what was a liquidity crisis into a solvency crisis – witness Bradford & Bingley’s increasingly desperate attempts to raise cash. All those blank cheques written by merry banks in the consumer spending boom are now falling due. The UK banks are staring into a black hole of buy-to-let mortgages and worthless credit card debt.
This is reflected starkly by the sector’s performance since the credit crunch began. According to Bert Veldman, senior investment manager, global equity, at ING Investment Management, share prices of financials have dropped by an average of 43 percent since the peak in April 2007. And in the second quarter, global financial equities fell by an average of 12 percent.
Eaten by bears
House-builders are also feeling the pinch, with Capital Economics now predicting a 15 percent fall in UK house prices this year, and a fall of 35 percent over three years. Not surprisingly, house-builders have received a thorough mauling by the bears and are desperately trying to raise capital.
Back at sub-prime’s ground zero, the investment banks are still announcing new write-downs following the long-anticipated monolines downgrades last month. After many warnings, Moody’s finally downgraded Ambac and MBIA – the former by three notches and the latter by five notches. S&P had already downgraded both, suggesting that we will see further fire sales by those investors and conduits who can only hold Triple A-rated securities. Investment banks must also increase their risk-weighted capital to offset these downgrades.
For example, Merrill Lynch holds some $18 billion in collateralised debt obligations and asset-backed securities, of which the majority is insured via monolines. Now that these insurers have been downgraded, the risk for Merrill Lynch has increased. The worry is that this will lead to fresh, substantial write-offs and that banks will be forced to liquidate positions, says Caspar van Grafhorst, head of investment grade credits at ING Investment Management. The market is expecting Merrill to write off about $5 billion for the second quarter.
But Guy de Blonay, manager of the New Star Global Financials Fund, says that the key issue for investment banks is not necessarily whether more write-downs will be revealed but whether they can write new business over the next few years. “There has been a fundamental shift in institutions’ desire to embrace risk. Some profitable business lines may, therefore, be closed for months and perhaps years,” he says.
The worsening economic outlook does not rule out the possibility of bear market rallies, however, and this morning the FTSE 100 obliged with a rebound. This followed reports that the US government was mulling a bail out of its hapless Fannie Mae and Freddie Mac mortgage agencies, which Lehman says will have to write off another $75 billion.
This rally was short-lived, however, as the market then charged headlong into bear territory, perhaps after realising that the fundamentals in the UK hadn’t changed. The question now is whether the combined strength of energy and miners will be able to prevent the FTSE falling further. State Street’s latest fund flows note reported that institutional investors are becoming increasingly sceptical about the commodities boom, with selling already underway in the materials sector.
Bear traps
Joost van Leenders of Fortis Investments points out that bear markets usually end with a final sharp fall as the last bulls capitulate. The average decline during bear markets after recessions is 28 percent, but this includes some very large drops, such as the 50 percent fall after 2001. “These large drops started with overvalued equity markets, which was not the case this time,” he adds. However, earnings have been high, and have only just fallen back to trend. He also believes that economic and profit forecasts for the second half of 2008 look unrealistically high.
Fortis is now adding to Japanese equities – still leading the field as the least loved market around – followed by US and emerging market equities. “We have not suddenly become Japan optimists but we think that a lot of the bad news is priced in,” Leenders says. Certainly the Japanese economy is looking in better shape than the UK’s for once. And those bulls have got to find somewhere else to chew grass, right?
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