Blog 21st July '10 - It isn't Nearly As Bad As You Think
Synopsis The China Syndrome plays out The Credit Crunch revisited – three years on Some ‘crunchy’ opportunities Wise Investment launches a new index The ‘odd years‘ phenomenon explained
This stuff is dry, but important. The market is distorted by the violent movements in the price of BP, up till recently its largest component. It is also the summer holiday season, when trading is thin, and market movements tend to be larger and more erratic than normal. All the same, the pattern is quite regular. The July 13th high was nearly as high as June 21st one, but not quite, suggesting a continuation of the downtrend pattern, which would be further confirmed if there is a new low below 4823. Our guess is that we won’t see a lower low, and that the downtrend we’re in is nearly over. At the moment, around 8.0% of TB Wise Investment and 5.5% of TB Wise Income is in cash. We want to invest the money back into the markets as soon as possible, and though our hunch is that we are near the low point, we prefer to wait till the chart confirms that the downtrend is over. We were a bit surprised that the uptrend which came to an end at the end of March didn’t take the index back above 6,000, and were then a little surprised at the extent of the fall, and subsequently rather nonplussed by the speed of the six-day rally, which our funds lagged behind. Still, though one is often wrong, it is important to have a sense of where things are heading, and adjust it as events unfold. The markets’ main worry just now, even more than the sovereign debt problems in Euroland, is the potential for a ‘double-dip’ recession in the US. Leading indicators – things like housing sales and housing starts, consumer and business confidence surveys and unemployment figures – are pointing towards further weakness in the economy later this year. However, we get a sense that the downward pressure in the stock market is easing now, so though we expect another downward spike or two, possibly not taking the market below its July 5th low point at 4823, we think that by the end of the summer the market will have built a good base from which to make further gains through the autumn and into 2011. Please note that the downtrend is a fact, while our view of it being near its end is an opinion. Our opinion is based on several factors. One is the strength of the fixed interest markets. Both government stock and corporate bonds have continued to be strong, and the stock market is now a lot better value relative to fixed interest than it was at the beginning of April. Also, the five-day losing streak which is just ending looks far less convincing than the rally which preceded it. In six days, the FTSE-100 rose 9.3%. Then in five days, it fell 2.5%. Today (July 21st) it has started rising again. Finally, the financial sector is holding up much better than it did. For most of the last three years, financial companies have done worse than the market on bad days. Recently, the opposite is often the case. This seems to us to be a sign of growing confidence, and it may indicate that the worst of this sell-off is behind us. There appears to have been a market inflection point at the beginning of April. Since then investors have become less fixated on mining shares, and more prepared to look for value in other sectors. This tendency has helped all our funds. From April 1st to date (July 20th), the FTSE-100 has lost 9.5% on a total return basis. TB Wise Investment is down 4.0%, TB Wise Income and Evenlode are down just 0.9% and 0.3% respectively during this period. FUNDS TB WISE INVESTMENT TB Wise Investment aims to beat the stock market, and cash. So far this year it has done both, up 2.4% where the FTSE-100 is down 2.8%, and is 31st in the Active Managed sector out of 131 funds for the year to date. I continue to hold all of my pension fund and nearly all our ISAs (the rest being in Evenlode) in this fund. Wise Investment holds funds which we now know very well, in interesting sectors, managed by intelligent and experienced people we know we can trust. Often these funds are priced in the market at a lot Iess than the value of their underlying assets. I do this because I don’t know a better way to invest money. Going back a decade to the start of 2000, this method has beaten the stockmarket overall by around 40%, and over all periods apart from a period of a little over 18 months, which began in mid-2007, and ended early last year.
I’d like to mention two of Wise Investment’s larger holdings, both of which have held performance back recently-HG Capital (7.8%) and Ecofin Power & Water Opportunities Trust (5.1%). Both have done well for us over the longer term. HG Capital’s underperformance began on April 20th last year. Since then, FTSE-100 is up 35%, while HG is down 2.1%. There are a number of factors. Investors are skeptical about private equity in the absence of freely available bank lending. HG held a lot of cash on its balance sheet last year, saying that the right sort of deals at the right sort of price weren’t forthcoming. This made the fund unattractive to a market on the look-out for exciting recovery stories. Early this year, HG had a rights issue, raising even more cash, and proceeded to buy into six companies (an Austrian high-tech lock manufacturer, a German recruitment consultancy company, Sweden’s leading provider of care for the disabled, and the Isle of Man Telephone company, among others) as well as putting more money into its alternative energy fund. It is still too soon to see how these new companies are doing. Meanwhile, HG, generally acknowledged to be the best quoted private equity fund in the UK, has for several years traded at a premium to its peers, which have all been at very large discounts to their net asset values. It may be that investors are worrying whether HG still deserves its premium rating. HG is currently at a 13% discount to its net asset value – a wide discount by its standards, but low compared to Electra at 25%, and others. I am prepared to be patient. HG has read the cycle perfectly so far, and has bought what appear to be excellent companies at what looks like the bottom of the cycle. Longer term performance is good, too. Since the beginning of 1999, HG has compounded returns at 15.3% per annum, compared to a market return of 2.1% per annum. Ecofin’s underperformance began on June 15th last year, since then the fund has fallen 6.6% compared to a market return of 23.1%. There have been two problems, a general aversion to ‘boring’ utilities, and weakness at Hansen Transmissions, a large holding in the fund, which makes gearboxes for wind turbines. Hansen’s share price has halved in the last year. I met Ecofin’s Chairman, John Murray last week. Ecofin are concerned about Hansen, but have stuck with it. Hansen expanded rapidly a few years ago, just before the credit crunch led to the cancellation of a lot of wind-power projects. Currently, there is uncertainty on both sides of the Atlantic over what government policy towards wind power actually is, so there is very little activity. Meanwhile, Hansen has replaced its salesy Chief Executive with the former Finance Director, and Ecofin have appointed a member of their team to the Board, who are concentrating on cost-cutting and improving the cash-flow. I also asked John about a report in the FT, which mentioned among Hansen’s problems an industry move towards gearbox-less windmills. John tells me that only smaller windmills can operate without gearboxes. The industry is moving towards larger, offshore turbines, which need gearboxes. The gearbox-less ones are unlikely to form more than 10% of the market, John thinks. We will be doing further research into this area.
We continue to hold this fund because of the expert knowledge of its management team, and the long-term case for investment in power, for which demand is likely to rise over time.
However, it hasn’t all been problems. This is being a good year for smaller companies. Standard Life UK Smaller Companies (3.2% of the fund) and Herald Trust (4.5% - tech-related smaller companies, mainly UK) are up 15.0% and 9.3% for the year to date. Herald is still very cheap on a discount of 21.7%. TB WISE INCOME Our clients like to remind us what a bad fund Wise Income is. Agreed, the fund was badly positioned going into the credit crunch, with exposure to geared property funds particularly costly. However, it’s a little-known fact that since the start of 2008 (I like to say ‘during the last quarter-of-a-decade’, which makes it sound like a longer time) TB Wise Income has performed better than the great Neil Woodford’s Invesco Perpetual Income, and with lower volatility. The average holding in Wise Income yields over 6%. Now, for something to yield over 6% in an environment where the base rate is 0.5% and likely to stay there for a long time, there is either something badly wrong with the asset that produces that income, or it is undervalued. Only time will tell, but we have got to know the assets we hold in Wise Income very well over the traumatic last couple of years, and our strongly-held view is that they are undervalued. Wise Income had an excellent second quarter, which has continued into July. Since the start of April, while the FTSE-100 index has fallen 9.5%, the fund is down just 0.9%, placing it second in the Active Managed sector out of 131 funds over this period. Wise Income has held around 10% cash over the last few weeks. This morning (July 21st) we reduced the cash to around 5.5%. THE CHINA SYNDROME PLAYS OUT We have been concerned for some time about the sustainability of Chinese economic growth in the short term. The following sentence appeared in the Global Overview section of the FT on Saturday:- ‘A further worry for some in the markets came from signs that Chinese growth – long seen as the saviour of the global economy – was slowing. While year-on-year GDP growth eased relatively modestly in the second quarter from the first, avery weak report on June industrial production hinted at a more serious slowdown to come’ (my emphasis) We all know what happened to the US economy when their house-price bubble burst after June ’06. Now that the Chinese housing bubble is also coming to an end, it seems likely that the economy will be weaker in the next year than most forecasters expect. It’s generally assumed that the authorities in China can fix any problem that arises – and maybe they will here, too, with a few judicious interest-rate cuts. All the same, we expect a slowdown. We don’t know how it will play out. It’s possible that there will be a stock market correction in mainland China, Hong Kong, and Taiwan, with overseas investors repatriating their savings, to the benefit of our investment strategy. But other outcomes need to be considered. Who could have predicted that a world banking crisis in late 2008 would have led to a savage recession in manufacturing in early 2009? There may be unexpected consequences and the situation will need to be carefully watched. THE CREDIT CRUNCH REVISITED Three years have passed since the start of the credit crunch (July 1st, 2007). Then, the FTSE-100 stood at 6,750, and didn’t look bad value to us, being still a few percentage points lower than its December 1999 peak. We thought that the over-valued asset was property, and moved a lot of money out of it. It’s clear now, looking back, that the crisis wasn’t about the valuation of shares, but about how much people had borrowed. Shares and funds got hit in exact proportion to the amount of borrowing they had, more or less regardless of the underlying quality of the company, or asset. The new ‘credit crunch’ valuation methodology persists, and has led to what we feel are significant opportunities. SOME CRUNCHY OPPORTUNITIES Let’s imagine that you are a property fund manager, and you have £ 100 million to invest. Plan A – you go out and buy £100m worth of property. Along comes the credit crunch. The properties halve in value. You now have £50m worth of properties, but you still have most of your tenants, and some rental income – in other words, you’re still alive. Plan B – you go out and borrow £100m from your friendly bank. You buy £200m worth of properties. Along comes the credit crunch. You now have £100m of property, and £100m of debt. Your by now very unfriendly bank manager is constantly reminding you that you are in breach of your covenant, and must sell property. You are now a forced seller in a buyer’s market. Result – your fund probably won’t survive. This was exactly what happened in the REIT (Real Estate Investment Trust) sector a couple of years ago. One or two of the funds which had borrowed nothing or very little (UK Commercial Property, F&C Commercial Property) got through pretty well. Some of the more indebted funds either disappeared (Teesland Advantage) or survived in a very reduced form (Invista, Invesco). The most interesting ones to us are the ones in between, where borrowings were around 30% (Standard Life, ISIS, IRP). There was a point around eighteen months ago where neither the fund managers nor the market could be sure that they’d survive. In the end, the funds have come out stronger than before, but the market still doesn’t trust them, which is why they are still yielding around 8%. They have good portfolios that are near to fully-let, they have good, experienced managers, and they will never look at gearing in the same way again. Another example is life insurance companies, and the better wealth management firms. Investors didn’t expect them to pull through the recession, and they were priced for oblivion. The prices have recovered, but an enormous amount of bad news is still priced in. The life insurance companies are, as an analyst put it in the FT a couple of weeks ago, ‘remarkable value’, and a fund manager we know recently wrote to the chief executive of one of the quoted life assurers, telling him that his company’s share price should be at least double where it is, and asking what he and other board members were going to do about it. It’s becoming clear which of the fund management houses should do well over the next few years – the ones that top fund managers have recently been migrating to. They are all priced for unending recession, and many of them pay nice, fat dividends. IT ISN’T NEARLY AS BAD AS YOU THINK I was reflecting the other day on the fact that we are now into the fourth year of the Crisis. The funny thing is that the media are always telling us how the bad bit is just about to start. Thinking back, the time to have been most worried was before the whole thing kicked off – around 2006, say, when most people, including all journalists, weren’t worried at all. Doesn’t the fact that we’ve had three very difficult years mean that we’re nearer the end of the crisis than we were when it began? Suppose that this crisis was the Second World War, a major event in most people’s book. Three years in, and we have reached the middle of September 1942. What’s happening? Well, it’s bad and can only get worse. The Germans have occupied the whole of Western Europe – France, the Low Countries, and most of Skandinavia. They are in the process of annexing Russia, and are at the gates of Stalingrad as we speak. The Germans also control the whole of North Africa, and their allies the Japanese have come in to the war, destroyed the US fleet at Pearl Harbor, and are blazing a trail of destruction through South-East Asia. Up to this point, almost nothing has gone right. A year from now, things are going to look a whole lot better. The German army will have been encircled outside Stalingrad, two million of them will have surrendered, and the whole front will be inexorably unravelling, as the Russians move steadily westwards. North Africa will be in the hands of the Allies. It will be less than a year till D-Day. I’m sure you get the point. We are further through this thing than anyone bothers to tell you. It isn’t nearly as bad as they think. WISE INVESTMENT LAUNCHES A NEW INDEX Several of my clients have been telling me recently how well their investments in fine wine have been doing.
I have been reminded of 1989. After the stock market crash in 1987, a large number of investors gave up on shares and decided to concentrate on ‘real’ assets instead. The fashionable assets that year were fine art and classic cars. A number of records were set in the art world which haven’t been broken till recently. Classic cars reached prices far above anything seen since. Then came the recession of 1990, and down went the prices. Today, it’s fine art again, and fine wines. I decided to do some research. I found out that 2000 was a particularly good year for Chateau Lafite. Since the start of 2001, the price of a case of Chateau Lafite 2000 has risen by 21% compound per annum, or by 700% altogether. This dramatic rise has been caused by demand from the new millionaires and billionaires in China, and by investment demand over here. We tend to think that all asset prices are depressed because we are in a recession, but recession hasn’t stopped the price of art, gold, wine or government stock from rising ever higher. Shares are the only asset class which pays more income today than it did a decade ago.
So, we have launched a new index – the Wise Investment Glaxeau Lafite 2000 Index. This index calculates the number of Glaxo shares you need to sell at any given time in order to buy a case of Chateau Lafite 2000. At the beginning of 2001, your Glaxo share was £18.90, and the wine was £1,875 a case. Today, Glaxo is £11.84, and a case of Chateau Lafite 2000 is £15,000. So, in January 2001 you needed 99 Glaxo shares to buy a case of Lafite, and today you need 1,267. Interestingly, the annual income you’d have lost by selling 99 Glaxo shares in 2001 was £33. Today, you have to sell 1,267 shares and the income you lose is £780. We think that at a level of 1,267, the Wise Investment Glaxeau Lafite 2000 Index is at an exceptionally high level, with both the shares very undervalued and the wine very over-valued. Given a recession in China, you may see at least one of the elements in this equation change. ODD YEARS EXPLAINED In the late 80’s, I began to notice that the stock market tends to perform better in years ending in an odd number than in years ending with an even number. This tendency appears to be completely random, but it has persisted up to this day. In an article in the Financial Times last Saturday, Trevor Greetham of Fidelity explains this phenomenon by saying that it coincides with the global inventory cycle. Businesses stock up, and de-stock all at the same time, stocking up in the odd years and de-stocking in the even ones. Greetham dates the ‘odd-years’ phenomenon to 1998, though in fact it is a good deal older. He goes on to say that the company profits being announced at the moment are good, based on last year’s higher activity levels, but that now we are in the early stages of a de-stocking phase, which is being reflected in the weaker stock market. He expects activity – and stock markets – to pick up towards the back end of this year. For interest, the whole sequence is shown below, and gives the annual return on the FTSE-100 index (excluding dividends). The same pattern can also be observed in the Hoare-Govett UK Smaller Companies Index, and the Dow-Jones Industrials, which are the only other ones I’ve checked.
As usual, all share price and market statistics quoted in this blog have been taken from our Lipper database. If you have found this blog useful or interesting, and have a friend or colleague who you think might be interested, please ask them to contact becky@wiseinvestment.co.uk PLEASE NOTE – ANY OPINIONS EXPRESSED IN THIS BLOG ARE THE PERSONAL OPINIONS OF TONY YARROW AS AT JULY 21st 2010, AND DO NOT CONSTITUTE FINANCIAL ADVICE. TONY MANAGES TB WISE INVESTMENT AND TB WISE INCOME |
Tony Yarrow's Fund Management Blog
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