PRINTER FRIENDLY VERSION

Mr Market Changes Mood

After a slight fall in April, stock markets have taken a more significant turn for the worse in May. As I write, the UK market is now down -6.2% since the start of the month. Evenlode has fared better, but has still lost money, -2.0% since the start of the month.

The two most pressing concerns on the mind of Mr Market – the Eurozone financial crisis and the Chinese slowdown – are not new ones. They have both been part of the economic landscape for some time now, but were brushed aside in the rally of the last six months as a combination of massive money printing from the ECB and a recovering US economy trumped these underlying concerns. Below I discuss each in turn, but conclude this month’s view by making some more optimistic observations.

The Europeans Say No To Austerity

The latest leg of the Eurozone crisis has been triggered by the recent elections in both Greece and France.  In particular, fears have focused on Greece’s potential exit from the euro. Stuck between a rock (austerity) and a hard place (a euro exit and massive depreciation of the drachma), it became apparent over last week’s elections that the Greek populace is now more seriously contemplating the ‘hard place’ option.

I do not venture a prediction on the exact path this currency and debt crisis will take. However, I do believe we are only at the very beginning of European money printing on a massive scale. Why choose austerity when you can print money to finance your deficits? It is the ‘easy’ (but by no means risk-free) route for policymakers and politicians to take. Ultimately, while a combination of austerity, debt default and economic growth will play their part, it is a persistent inflation combined with low base rates (‘financial repression’) that is likely to play the most significant role in reducing the real value of government debts over coming years. This is the historical precedent, at any rate*.

Evenlode holds no banking stocks and no European-listed stocks (both of which are right in the epicentre of this crisis). However, most of the businesses in the fund are globally diversified and I estimate that c25% of the revenue from underlying holdings arises from Continental Europe. Two thoughts reassure me, however. Firstly, Europeans are not going anywhere. Whatever happens to their currency regime over the next few years, history and human nature suggest that Parisians, Berliners and Romans will carry on consuming a steady volume of toothpaste, shampoo, painkillers, contact lenses, fizzy drinks, ice cream, dog food, nappies and other such essentials and little luxuries. These are the products that form the bedrock of the Evenlode portfolio. Secondly, portfolio holdings are in very good financial health and are already coping admirably with European adversity. The following four companies in the portfolio have reported results in the last two weeks – Diploma, Sage, Experian and Euromoney. All do a decent portion of their business in Europe. However, they are also asset-light businesses with low investment requirements and as a result are ‘drowning in cash’. This, combined with global diversification and resilient products mean they’re in good shape. Dividend increases accompanying these results announcements were as follows:

Diploma +20%
Sage +30%
Experian +14%
Euromoney +12%

China Syndrome

The second major concern for investors at present involves the ongoing slowdown in Chinese economic growth. I have mentioned our caution toward what we perceive to be an unsustainable credit boom in China several times over the last two and a half years (see Rusting Away In The Yard (June 2010), In Dr Bernanke We Trust (November 2010), The Paradox Of Debt (March 2011) and Some Thoughts On China (June 2011)). My view remains unchanged, and our current exposure to companies that have benefited from China’s construction and infrastructure boom (directly or indirectly) is of no significance.

Engineering stocks such as Rotork, Spirax-Sarco and Weir Group are of particular relevance for us in the context of China, and we are keeping a close eye on them. These stocks are on our watch list but are not in the current portfolio. They are great British businesses with first class reputations and difficult-to-replicate intellectual property (the kind George Osborne wants more of – they actually make things that the rest of the world wants). However, they have benefited in direct or indirect ways from the rise of China’s property and infrastructure boom and their profit margins and returns on capital are, as a result, much higher at present than their long-term averages. I look forward to owning meaningful positions in these stocks in years to come, but I’m happy to wait until they present themselves at more run-of-the-mill valuations. We’re not there yet.

A More Upbeat Take On The Current Gloom

Something very positive is going on right now, but it isn’t making the headlines of the mainstream press. Due to the economic concerns discussed above the oil price has fallen more than 15% over the last month and other commodity prices have fallen even further. This is good news for many of our consumer branded goods companies (whose business models involve ‘buying commodities and selling brands’). But more importantly, it will act as a huge stimulus for the global consumer, just as it did when commodity prices fell in late 2008, mid-2010 and mid-2011.

This is a point worth holding onto, particularly when so many bits of negative news bunch up into a short period as they have this month (and as they did last August). A big risk in the current investment market is to be sucked in by short-term economic trends and attempt to extrapolate this pattern into an investment strategy. There are too many cross currents in the global economy to do this with any certainty (it would be hard enough at the best of times). And here’s some positive news – US leading economic indicators remain incredibly upbeat (in part due to the recent fall in inflationary pressures). A reminder, if one is needed, that the negative news of the last three or four weeks won’t necessarily continue in such unrelenting fashion.

Portfolio Quality Very High

I remain of the view that a patient, long-term, objective approach not only helps us cope with current economic and stock market volatility, but also means we can actively take advantage of it.

The strong market rally that began last Autumn and ended in April led us to increase our holdings in certain high return, stable, multinational businesses that underperformed the rising market. These included Procter & Gamble, Johnson & Johnson, Glaxosmithkline, Reckitt Benckiser, Pearson and Sage. I have increased the portfolio’s exposure to these six holdings alone by 18% over the last two months. Generally, this reallocation has been at the expense of economically sensitive companies that performed well as investors became more enthusiastic about recovery prospects (including the recent exit of both UBM and Intercontinental Hotels Group). However, the market has been more complex than that. Other stocks that one might have expected to fall into the former category, such as Diageo and Coca-Cola, have strongly outperformed the rising market too. I have reduced these positions accordingly.

In the round, I think the quality of the current portfolio (in terms of both returns on equity and the long-term durability of the underlying business models) is as high as it’s ever been. Despite this, valuations remain very compelling and Evenlode is fully invested (the portfolio’s current forward cash return is 12%, which compares very well to history). While the portfolio will of course exhibit price volatility, the underlying companies have limited balance sheet risk and I think could, on aggregate, continue to grow cash-flows and dividends even in a very adverse economic environment (the underlying holdings did this, for instance, in 2008-09).

Relative performance in the last few weeks has been helped by Evenlode’s current bias towards these stable, large-cap multinationals. However, we’re not operating a stopped-clock investment process. Where high-quality opportunities begin to present themselves elsewhere, we will steadily steer the portfolio towards them to take advantage.

Hugh Yarrow
May 2012

Please note, these views represent the personal opinions of Hugh Yarrow as at 16 May 2012 and do not constitute investment advice.

*I discussed this point in more detail in my November 2011 Investment View – Inflation: The Path of Least Resistance. Carmen Reinhart’s paper The Liquidation of Government Debt is a good resource on the subject of financial repression. (http://www.imf.org/external/np/seminars/eng/2011/res2/pdf/crbs.pdf)

‘A Concatenation of Circumstances’ – Short Blog

This was a favourite phrase of my ‘A’ level history teacher, who was very fond of long words. It meant ‘more than one thing going wrong at the same time’. Today, the world is facing a concatenation of circumstances.

There are a lot of small things going wrong, and two larger ones. The two large ones have been around for several years, but things have begun to move faster recently. It is hard to see how Greece can stay in the euro, and the authorities are coming to accept this fact, and are planning for it more openly. Also, it is becoming ever clearer that China’s twin residential property and infrastructure booms have ended, leading to a sharp fall in the prices of industrial commodities and mining shares.

We have been expecting this latter event for some time, and have positioned our fund portfolios accordingly. However, there is a strong consensus view that one should invest, not in the ‘developed’ world, where there is high debt and slow economic growth or none, but in the ‘emerging’ economies, where there is rapid growth and low levels of debt. There is a view that we have been in a ‘commodity super-cycle’ for the last decade or so, which is expected to last for another fifteen years at least. Today’s events are challenging that view.

The result of all the above is that investors have become even more risk-averse than ever. Today again, we are seeing the stock market fall sharply, bringing its losses since March 19th to around eight-and-a-half percent.

Being risk-averse is getting more risky

Nervous investors have increasingly been looking for safe havens. Last year’s favourites included gold, gold shares and UK government stock (a.k.a. ‘gilts’). The price of gold peaked in September, and has fallen by around twenty percent since then, while the gold miners’ shares are down by around 35% on average. Gilt prices are still going up. Ten-year gilts (ones that mature in ten years’ time) yield 1.88% at the moment. This is the lowest level of yields (= the highest prices) since records began in the early eighteenth century. Gilts are now more expensive than when we were about to be invaded by the French in the early nineteenth century or by the Germans in 1940. To buy an asset at the highest price it has been in the last three-hundred years requires a level of courage which we don’t have.

What happens next?

The charts of Far East markets, and of mining shares, suggest to me that these markets could fall significantly further before beginning to recover. Our exposure in these areas is minimal. However, we are now at a stage when selling can become more general and indiscriminate. In a thin market, a small sale can trigger a big price drop. Experience teaches us not to try to be clever or finesse markets at times such as these. We also know that the best opportunities come at times of greatest stress, and that the best market conditions often follow hard on the heels of the worst. Also, it’s clear that the stock markets have had to absorb a huge amount of bad news over the last year, and offer some real value now, whereas it is hard to see any value at all in safe havens such as absolute return funds or gilts.

Funds

TB Wise Investment

The changes I have made over the last few weeks have been to raise cash to around 7.5% of the fund, and to concentrate the portfolio into areas of greater conviction and defensiveness – for example, the holding in the Worldwide Pharmaceuticals Trust has been doubled. After a strong few months, holdings in UK smaller companies have been reduced.

TB Wise Investment has made a strong start to the year, making a return of 6.5% to the close of business on Friday May 11th, and is 3rd in the Flexible sector for the year to date out of 133 funds. This has been a difficult period during which growth-orientated funds such as M&G Managed Growth, and defensive funds such as Troy Capital, have lost value.

TB Wise Income

TB Wise Income holds around 7% cash, 19% property and 9% fixed interest. The property and fixed interest holdings have held their value very well so far. The other 65% of the fund is in shares, which are a mixture of defensive and quality holdings, together with some undervalued financial companies, and some ‘cyclicals’, such as the construction company Balfour Beatty. The cash has been raised mainly by reducing the financial and cyclical holdings in anticipation of these more difficult conditions. Holding cash temporarily will not have any effect on the income produced by TB Wise Income, as the holdings we sold had all recently gone ‘ex-dividend’, and will not pay further dividends for several months. The current quarter’s dividend, collected by the fund in the March-May quarter, and due to be paid at the end of July (August if you hold it through Pershing) is likely to be the largest we have paid so far. At present the quarter’s dividend pool is equivalent to roughly 1.7% of the entire fund.

I anticipate that following the current bout of turbulence, share prices could be very cheap, and yields correspondingly high. Should that turn out to be the case, and if our property and fixed interest funds continue to perform well, I may consider reducing them, and re-investing in shares.

In the year to date, TB Wise Income has made a total return of 6.06%, and is ranked 7th out of 133 funds in the Flexible sector over that period.

Summary

I read an interesting piece last week by the successful hedge fund manager Hugh Hendry. He summarises the crisis as starting in the US, moving to Europe, and ending in Asia. China is the ‘last shoe to drop’, and that’s what’s happening now. We are positioned for this outcome, in our funds and in our investment portfolios.

Greece leaving the Euro isn’t the end of the world. They should never have been in it in the first place. The end of China’s property bubble isn’t the end of the world either. There is no big advantage in building tens of thousands of tower blocks which then stand empty, and the resulting high commodity prices are a barrier to world growth – lower ones help most people.

I expect the next few weeks to be difficult, but we are now seeing extreme levels of risk aversion and levels of mis-pricing which are often the prelude to major changes in market sentiment.

Tony Yarrow

Please note – these comments are the personal opinion of Tony Yarrow as at May 14th, 2012, and are subject to change. They do not constitute investment advice, and are not intended as such.

Blog - April 27th 2012

Personal update

I had a hip replacement operation on March 1st, and have spent most of the time since then working from home. I was hoping to use the time to write a book. At the end of my sabbatical time, I am more confident than before that there is a book that needs to be written, and have a lot more ideas than before, and a better idea of the structure. On the other hand, not a lot has actually been written. This was partly because there was a great deal to read, mainly company reports and the kind of research I never quite get round to in the office.

I am now back in the office full time.

‘The Macro’

The news and the financial markets are still dominated by macro-economic issues. Anything that affects investor sentiment is likely to affect the prices of the assets we hold in our funds, and needs to be considered carefully. Sentiment today appears even more skittish than usual. The year began with a confident rally, prompted by evidence of strong growth in the US, and by the European Central Bank’s (ECB’s) initiative to help European banks by lending them unlimited amounts of money at 1.0% for three years. However, the rally has faded and over the last few weeks, investors have become nervous again. What’s going on? Let’s have a look at the world, by economic region.

U.S.A.

The US economy began growing last September, and began creating jobs at the rate of 200,000 a month. However, the latest month’s figures showed employment growth of just 100,000, suggesting that the rate of economic growth has already started to slow. Recent figures for manufacturing purchase orders confirm the slower trend.

During my time at home, I read Warren Buffett’s annual report to the shareholders of his company, Berkshire Hathaway. It was as usual highly readable, witty, and full of insights. Buffett knows about the US economy. Berkshire owns businesses across the USA. Some are owned outright, others are large stakes in listed companies such as Coca-Cola. Among many others, Berkshire owns Sees Candy, who make sweets, the Washington Post, the Burlington Santa Fe Railroad, and four companies in the construction sector, including Clayton Homes, the US’ largest producer of prefabricated wooden houses. Berkshire companies employ 270,000 people altogether. According to Buffett, the economy has turned decisively upwards in all sectors except housing, which has been in a depression (his word) for the last five years. However, there is a time in cyclical sectors when things stop getting worse before starting to get better, and that point has been reached in the US housing sector, with large regional variations, as you would expect. Construction and related sectors provide much employment, so even a small improvement should keep US unemployment on a downward trend, but with variations from one month to the next, to give the pessimists and the optimists plenty to argue about.

The US budget deficit remains at a record high of around $ 14 trillion, and the political deadlock over how to reduce it will remain unbroken till after the presidential election in November. The only possible courses of action are lower government spending, higher taxes or a combination of the two, and whatever is decided on will tend to slow the economy.

Meanwhile, US production of oil and gas through the technique of hydraulic fracturing, or ‘fracking’ is transforming the economy. But it’s a mixed blessing. Wells that produce oil are very profitable, as the price of oil has remained high. However, more shale gas has been produced than anyone knows what to do with, and as a result the price of natural gas has collapsed to $2 per million British Thermal Units (BTU), half what it cost in November and lower than the price of ten years ago. Some indebted producers are already in trouble with their banks. Longer term, this new energy revolution is likely to be transformational for the US economy, which is capable of producing more oil than either Russia or Saudi Arabia, but the beneficiaries may be consumers rather than the producers.

CHINA

The world’s second largest economy continues to give cause for concern. The three pillars of the Chinese economy are manufacturing for export, the construction of houses and infrastructure, and domestic consumption.

The export economy faces challenges. The result of China’s thirty-year-old one-child policy is that the population is ageing rapidly (1). We think of China as a young country, with an endless supply of cheap labour, and with a steady flood of migrants from the countryside to the cities in search of better-paid work. In fact, next year the size of the Chinese workforce will peak, and recently, the flood of migrants has become a trickle, so demand for labour has begun to exceed supply. Chinese workers have been demanding big pay rises, and bosses have been granting them. Chinese manufactured goods are no longer quite as spectacularly cheap as they were, so manufacture has begun to migrate to cheaper alternatives such as Vietnam. Also, we have begun to see a tendency for companies in the West to bring outsourced manufacturing back home, partly so that they can receive orders quicker, partly because of quality concerns and partly because Chinese companies have become known for devious and fraudulent practices.

The construction boom is coming to an end. Property prices in some cities have fallen by over 20% in the last year. I have read a report that orders for heavy earth-moving equipment have fallen by 70%. China is over-developed, and we have been expecting a slowdown in this sector for the last couple of years. As China consumes roughly half of the world’s industrial commodities (copper, zinc, steel, aluminium and others) it’s likely that the prices of these raw materials will continue to fall, perhaps substantially. Overall, our avoidance of the mining sector has been helpful to our funds’ performance over the last couple of years, and we continue to avoid it. We know from experience that when a boom ends, there are some obvious losers and some less obvious ones. At these times, less noticeable connections become apparent, and I am on the look-out for such hidden correlations, which will show up as unexplained weakness in prices.

Chinese domestic consumption has been the success story in recent months, growing strongly on the back of the big pay rises.

The slowing economy places strain on the unspoken bargain which was struck between the Chinese government and its people following the Tiananmen Square massacre in 1989 – we will make you richer, but you must stay out of politics. Chinese people hate the corrupt party and its officials, but are prepared to tolerate them while enjoying the benefits of rising prosperity. Now, the anaesthetic of rising prosperity may be starting to wear off. At the same time, ecological problems are becoming more demanding. China has a huge scheme to move water from the middle of the country to the dry but densely populated north, by means of three canals taking water from the Yangtse to the Yellow River. Now, the water table is falling across much of the south of the country, too. The party has built a reputation for efficient management of the economy. It will need it now more than ever.

This year seven of the nine members of the ruling elite, the Standing Committee of the Politburo, will step down and be replaced. One of the seven expected to be promoted was Bo Xilai, the left-wing strongman who has recently been purged in the midst of scandal (Bo’s wife, Gu Kailai, stands accused of murdering the English businessman Neil Heywood). Questions are being asked (and where better to ask questions than in a country whose top leaders are called Hu and Wen?). It appears that another top official, an ally of Mr. Bo, will be purged too.

2012 could be a year of change in China. I continue to believe that the prudent course of action is to watch events from the sidelines. I wonder how things will play out. Cheaper commodities including oil would benefit consumers everywhere. If the world’s largest economy is producing more oil, and the world’s second largest economy is on the point of consuming less, then despite the problems of Iran and elsewhere, cheaper oil could be a possible outcome. Separately, the price of wheat has fallen by a third in the last year. One side-effect of lower commodity prices might be an increase in consumer spending in the West.

The majority of stock markets in the Far East have been weak so far this year. The charts suggest that these markets have got further to fall.

Some experts believe that the Chinese economy has already started to pick up following a period of slightly less rapid growth, and expect construction activity to re-accelerate. This is important – the Chinese economy will either continue to slow down, or it will recover, and much will depend on whose prediction is right.

One way to follow this story is by keeping an eye on the price of iron ore. China accounts for around 60% of the world’s consumption of iron ore, and the current price is around $ 145 per ton. A rising price equals a recovering Chinese economy, and vice versa.

EUROPE

You could have been forgiven for thinking, as I did, that the EBC’s grand bank-saving exercise, the LTRO (Long-Term Refinancing Operation) would take pressure off the single currency for perhaps a year, or even longer. In fact, it has taken around three months for the concerns to resurface. And yet, perhaps it isn’t surprising that they have come back so fast.

All the structural problems remain. Germany has a world-competitive economy, while that of Greece is a lame duck, with others (Portugal, Spain, Italy, France) all seriously challenged in one way or another. To contain these disparate elements in one entity would require strong, committed central government, which the current patchwork quilt of European institutions is struggling to provide. There is nothing like the Euro crisis to bring panic to the minds of investors, and with good reason. This crisis is unlike anything we have seen before. All we know is that it is very big, very ugly, and that none of us knows how it will play out, or when. As with China, there are obvious ‘avoids’ such as European banks and any investment south of the Alps, but once again there will probably be the less obvious connections, which will become apparent in due course. Much anxiety is priced into European stock markets already, and many non-financial companies in Northern Europe now look very attractive in all but the most pessimistic scenarios. However, the Euro continues to be the unwanted wild card.

UK – Austerity debate intensifies

Wednesday’s figures showed that the UK’s economy shrank marginally during the first three months of the year. The government continues to believe that it is correct to bring the budget deficit under control, while the opposition says that it would be better to increase spending in the short term, to create employment which would increase economic activity and the tax base, and make cutting the deficit easier in a few years’ time. They argue that austerity is being taken too far, to the point of being counter-productive. It may be worth remembering that the result of two years’ worth of austerity measures, plus a rather feeble economic recovery, has been to reduce the annual deficit from around £ 180 billion to around £ 120 billion. In other words, in the last year, which was one of austerity and spending cuts, our government still borrowed a new billion pounds roughly every three days. This year’s deficit will be only slightly lower. Unfortunately, in addition to all the ‘official’ borrowing, we also have massive unfunded liabilities under the Private Finance Initiative (PFI), and for public sector pensions.

The government worries that should it abandon the path of deficit reduction, the financial markets might begin to avoid its debt (gilts), leading to falling gilt prices, rising yields, and more expensive borrowing in future. In view of the fact that the nation’s finances are weak and continuing to weaken, you might wonder why the financial markets have continued to support gilts. I think there are three reasons. First, the Coalition government is making a genuine attempt to bring the books back into balance. Second, we are not in the Euro, which makes us more attractive to international investors. Finally, the aim of quantitative easing (QE) is to support gilt prices. The Bank of England creates money and uses it to buy gilts. The total money thus created totals £325 billion so far, in a period of just over three years – equivalent to roughly two-and-a-half years’ worth of deficit at its current rate.

With the US, UK, European and Japanese central banks creating money through QE, it’s remarkable that inflation is still fairly low. The reason usually given is that the QE money has stayed in the banking system. Only when it leaks out into the economy as a whole will we see higher inflation.

It can only be a matter of time before we see this higher inflation. Our government has had an inflation target for the last two decades. In the last three years, the inflation target has been exceeded nearly every month, but no action has been taken. Higher inflation would help the government with its debt problem. At 7% inflation, the real value of a debt halves every ten years. At 10%, it halves every seven years. Such conditions would be challenging for all savers and investors. Probably, as happened in the 1970s, real assets such as shares, property and commodities would hold their value better than cash or gilts.

In Praise of Henry Boot

In the midst of all these macro-economic events, we look for investments which show resilience. We like companies which don’t need to borrow money, which supply goods and services that are in everyday demand, and are good enough at doing it to keep competitors at bay. We like companies who leave decent margins of error, so that when things go wrong they don’t end in disaster. These are companies which can deliver returns even if things don’t get better, and which will probably know how to adapt if things get worse. Such companies don’t tend to boast of their achievements. They tend to under-promise and over-deliver. They tend not to make stupid acquisitions, or to dilute us shareholders by rewarding themselves with over-generous share option schemes.

Henry Boot, a new investment in Wise Income, has many of these characteristics, in my view. It is a small family company based in Sheffield. It is listed in the Construction sector, but it does a lot more than construction. One division finds land, applies for planning permission, then sells the plots on to third parties, typically house-builders. This process requires a long-term approach, as it often takes 5-20 years to obtain planning consent. House-builders went into the downturn with large land banks, and have been developing at a much slower rate over the last few years from their existing stocks. Now they are beginning to need more land with planning permission, and Henry Boot has a plentiful supply.

The company also develops property, but will only do so when the buildings are pre-let. They also run a profitable and growing tool-hire company, and own maintenance contracts, such as a thirty-year contract to maintain the A69 trunk road, which stretches 55 miles from Newcastle to Carlisle. Finally, the company owns a portfolio of let properties, the value of which is slightly higher than the market value of the company. In other words, when you buy shares in Henry Boot, you get the property portfolio at a slight discount to its current value, and the rest of the company thrown in. The company has no debt.

The Chairman concluded his introduction to the Company’s annual report as follows:

‘It is clear that there are still risks to the slowly emerging recovery in the property market….and though it is likely that the recovery will be patchy and protracted, the strategy outlined above will allow us to make further strides in the business’.

This is a cautious, risk-aware company that can thrive in today’s harsh conditions, and pay an attractive income. One that I believe we can invest in, while China does this, and the Euro does that.

Pension deficit

One unintended consequence of the QE has been to increase the deficit in Henry Boot’s final salary pension scheme, and the same is true for other companies whose annual reports I’ve read in the last few weeks. Boot’s scheme is closed to new members, but continues to exist for older employees and retired members.

The effect of the QE is as follows. The administrators of a final salary pension scheme have a fund, which has accumulated from contributions and investment growth. They have obligations to pay lump sums and pensions to the scheme members over many years into the future. To determine whether a pension fund is sufficient to cover its future liabilities, a formula called the discount rate is used, which assumes a future long-term rate of growth in the assets. This rate is calculated by the scheme’s actuaries, and changes from time to time. However, the discount rate depends on the yield on gilts. When gilt prices are very high, as now, their yield is very low, so the discount rate is low, which results in a larger pension fund being needed to cover the same liabilities. Fully funded schemes become underfunded, and underfunded schemes become more underfunded. Companies such as Henry Boot have to make substantially increased contributions to their pension schemes, which appear as an expense in the accounts, and reduce the year’s profit.

Thus a policy which is intended to boost the prices of assets, and thus stimulate the economy, increases the costs of companies such as Henry Boot, and depresses their profits.

Should inflation rise, as we expect, the position would change. Gilt yields and the discount rate would rise, underfunded pensions would become fully funded again, and companies could reduce their pension payments, or even take pension holidays, which would feed straight through into profits.

By now, all listed public companies have closed their final salary pension schemes, and run money purchase schemes, where the investment risk is borne by the individual members. Over time, the funding of final salary pensions will cease to be a major factor in company accounts.

Our funds

Since the start of 2012, our benchmark FTSE-100 index has risen by 2.43%. During the same period TB Wise Investment B shares have risen by 8.85%, and Wise Income B shares by 7.71% with net income reinvested. Over this period Wise Investment is 11th, and Wise Income 15th, in the IMA Flexible sector which contains around 140 funds. This improved performance to some extent offsets the funds’ underperformance of the index during the second half of 2011.

Once our cash is invested, Wise Income’s yield will be comfortably over 6.0%p.a., net of basic rate tax.

Most of the sub-funds we hold are run by excellent managers, who we have got to know well over the years, and have every confidence in for the future.

However, in the short term, I am not convinced that the markets have overcome their current bout of the jitters. I don’t believe that investors fully appreciate the scale of the challenges facing China, and a new bout of Euro-panic could break out at any moment if a bond auction goes badly, or an election result isn’t to the markets’ liking, or someone unexpectedly resigns. So, I have raised cash in both funds, and at present Wise Income is around 8% cash, and Wise Investment around 11% cash.

Some price moves are hard to explain. In Wise Investment, our two biggest private equity holdings are the excellent Graphite Enterprise trust, and HG Capital, which has been voted the best trust in its’ sector in each of the last five years. Both trusts fell in value during the autumn. Since then, Graphite has recovered and is slightly above its July 2011 peak. HG Capital hasn’t, and is still 18% below its July 2011 peak. From all I hear and read, HG’s investee companies are performing strongly, and some companies will be profitably sold (or ‘realised’ in the jargon) this year, which normally enhance the trust’s net asset value, together with the price. But for now, investors aren’t interested.

Another interesting one is RIT (Rothschild Investment Trust) Capital Partners, a strong, defensive international trust whose Chairman is Lord Rothschild, who is also the largest shareholder. RIT is a fund which investors normally turn to in difficult markets, and it often trades at a premium. Wise Investment has held this trust and made good money in it in the past, but we haven’t owned it for a couple of years on value grounds. Recently, the price has slumped, and yesterday RIT was down again by over 1%, while the market was up. We are grateful for such opportunities, and intend to take advantage of them.

Summary

US economy – recovering

China – export and construction may struggle

Europe – difficult

Higher inflation – a real possibility

But - we have plenty of good investment ideas.

Tony Yarrow

April 26th 2012

Please note – this blog contains the personal views of Tony Yarrow as at April 26th, and does not contain financial or investment advice.

The ‘New Normal’ Is A Lot Like The ‘Old Normal’

As noted in previous monthlies, the post-crisis world of the last three years has been characterised by lower trend economic growth, shorter business cycles and more frequent recessions. 2010 and 2011 were both highly unusual years for developed economies (relative to the thirty years before them) in the sense that both saw two inflection points in the business cycle (a peak earlier in the year followed by a trough later on). In this context, it’s not surprising that investors are reacting even more nervously than usual to every economic data point. Stock market falls over Easter following the release of US unemployment data are a case in point – no-one wants to miss the next turn in the cycle.

Bond investor Bill Gross has dubbed the current economic era as ‘the new normal’, and the phrase has entered the investment vernacular. From a very long-term perspective, however, current levels of trend growth and economic volatility are by no means unheard of – only when directly compared with recent history do they look abnormal. As the Economic Cycle Research Institute recently pointed out:

“Starting in the early 1980s, we got three relatively long expansions (8 years, 10 years and over 6 years) back-to-back so many people think that’s the norm. But we now have extraordinarily low trend growth, and the Great Moderation of the business cycle is history. More frequent recessions should not be a surprise, nor is it unusual. For example, from 1969-82 the U.S. had four recessions in less than 13 years. Going back a bit further, from 1799-1929 almost 90% of expansions lasted three years or less.”*

Perhaps it’s more appropriate to describe the current era as the ‘old normal’ – back to muddling through, coping with uncertainty, and facing down more frequent recessions. For a time-travelling investor from most of the last two centuries, it would all feel quite familiar, and not too terrible.

Creating Shareholder Value In A Slow-Growth World

In this harsher climate, Evenlode businesses have generally experienced slower demand growth than in the pre-crisis years. However, this revenue slowdown is by no means disastrous. For most of the businesses we focus on, the impact has been fairly small (thanks to economic resilience but also thanks to sizable exposures to higher growth rates in emerging markets). As Procter & Gamble recently pointed out, global fast moving consumer goods markets were growing at 4-5% per annum pre-crisis. Since 2007, the trend growth rate has dropped, but is still running at a quite healthy 3-4%.

For other businesses the impact has been more severe but, in aggregate, the current stocks in the Evenlode portfolio have demonstrated they are well equipped to withstand the new economic era. In particular, they have benefited from two positives that go a long way to offset lower volumes. First, weaker competition has in some cases dropped by the wayside. Second, cut-backs and an increased focus on capital discipline have resulted in a decline in new capacity for many industries. There is less volume to chase, but there is also less capital chasing it. This has been particularly evident in more cyclical markets where, for instance, businesses such as WS Atkins and Severfield Rowen have been able to make big market share gains as competitors have steadily withdrawn.

Weighted average earnings growth for the current portfolio over the last five years has been as follows**:

2007: +10.7%
2008: +22.1%
2009: +6.2%
2010: +10.5%
2011: +7.9%

Crucially for shareholders, this growth has been self-financing – the companies in the portfolio generally spin cash off rather than suck it in thanks to their intrinsic intangible qualities (brands, reputations, intellectual property etc.). Very respectable growth in shareholder value is the result. It’s a boring grind at times, but we are confident that progress will continue to be made by this collection of businesses.

Some Thoughts On Managing Through The Business Cycle

As I have already alluded to it seems that the current economic environment is, more than ever, giving weight to the idea that a successful investment strategy must make a regular and accurate stab at predicting the next twist or turn of the business cycle. But I’m not sure that’s a very helpful way to look at things.

I recently read the book There’s Always Something To Do, based on the diaries of the great Canadian investor Peter Cundill. It spans a period from the late 1960s to the 2000s, and is worth a read. In general it’s a reminder that consistently applying an objective, patient, risk-averse investment approach is a sensible way to navigate all sorts of varying economic conditions. As a first person piece, it also
highlights how difficult it ever is to see the economic wood for the trees – even during ‘The Great Moderation’. Cundill, for instance, wrote the following in his diary in July 1991:

“I find myself thinking about buying things but world events, plus the economic uncertainties, could in reality spell ‘crash’. I am alert to both danger and opportunity and I can’t decide which it is. Everyone else is depressed.”

Even in the foothills of one of the greatest ever bull-markets for equities it was not exactly easy to see what lay in store. It is even harder today.

In my view, our best bet with Evenlode is to stick to our guns. We are trying to invest ‘one stock at a time’ in businesses with excellent long-term economics. The changes we make to the portfolio are in the main incremental, and are attempts to manage valuation risk, rather than attempts at market timing.

Charlie Munger, Warren Buffett’s business partner, was the main inspiration for our investment process, and I’ll leave the last word to him:

“A standard technique that applies to a lot of investors is called ‘sector rotation’. You try to figure out when oils are going to outperform retailers etc. etc. etc. Then you just kind of flit around, being in the hot sector of the market making better choices than other people. And presumably, over a long period of time, you get ahead. However, I know of no really rich sector rotator. Maybe some people can do it. I’m not saying they can’t. All I know is that all the people I know who got rich did not do it that way. They made their money owning high-quality businesses”***

Hugh Yarrow
April 2012

Please note, these views represent the personal opinions of Hugh Yarrow as at 16 April 2012 and do not constitute investment advice.

*Full presentation available here - http://ecri-prod.s3.amazonaws.com/downloads/ECRI-Frankfurt-Yo-Yo-Years.pdf
**Source: Wise Investment, Collins Stewart (EPS growth)
***From Poor Charlie’s Almanack, Third Edition, Donning Publishers, 2008 (my edit)

18 Bulletin – April 2012

TB Wise Investment Factsheet – April 2012

TB Wise Strategic Factsheet – April 2012

TB Wise Income Factsheet – April 2012

Evenlode Income Factsheet – April 2012

During my daily round-up of the red-top front pages in the local supermarket yesterday, I was interested to see one of our investments making the headlines. The chief executive of Greggs, Ken McMeikan, has been lobbying the government to reverse the introduction of VAT on takeaway food that is served at “above ambient temperature”. The tax could affect up to a third of Greggs’ product lines, although Ken expects the impact to be much lower in reality.

There could be a knock-on impact on Greggs’ revenues and profitability due to the tax increase, and the stock has been marked down by the market since the budget. What’s more interesting to me though is the place that Greggs now occupies in the national psyche. The chain has become synonymous with good value, tasty food on the go, a position being cemented by the current pasty-gate debate.

We like it when a brand becomes a byword. Name-checking during Treasury Select Committee hearings bodes well for the future of Greggs.

Please note, the above contains the personal opinions of Ben Peters and does not constitute investment advice