The subsequent sell-off of shares globally, was relatively mild, though sharp, and acted as a reminder to market participants that linear extrapolation has its dangers. As there has been thorough coverage of the subjectl, suffice it to say, that securitisation funding does not remove the credit risk but simply reallocates it, often to people who have little control of the underlying assets. Part of the subsequent market volatility presumably reflected the general call by financial institutions to tighten portfolio specifications and credit controls. Concerns about credit losses and the detrimental effect of adjustable rate mortgage (ARM) resets, and foreclosures on lower-end properties have perhaps some way, to unfurl. However, the chatter from the street is at present focused on the bigger picture of the day, namely globalisation and the recycling of ‘surplus’ savings.
Adherents to this new paradigm believe that the world has achieved that highly desirable state where the developing world’s surpluses neatly accommodate the developed world’s insatiable consumers. At the same time, new producers supply an abundance of tradeable goods (facilitated by the free movement of capital and know-how, plus seamless logistics) to remove the traditional inflationary bottleneck of labour, that so stunted economic growth in the 1970s and later. The changing composition of developed economies also seems to have flattened the economic cycle. For the moment, these observations are evident though highly dependent on the willingness of those nations with savings to place them where needed. A less plausible notion of the new paradigm is that Central banks have developed such a cunning understanding of all the moving parts of a modern economy as to be able to guide them with intricate precision!
At present, the disregard for risk and the belief that easy funding will persist has virtually eliminated the distinction in valuations between quality and junk. This careless view will not persist forever and hence offers us the opportunity to accumulate great companies that are on valuations almost in line with the market in general2. Here we define quality, as those businesses with an achievement record that sets them apart, often enjoying dominance of their industries globally and with the prospect to grow in any but the worst circumstances. Their balance sheets are invariably free of debt (on account of their superior profitability) and incremental growth can be achieved and still cast off free cash flow. The paradox is that one can acquire these companies on such relatively attractive terms3 even though they are in some cases below peak profitability, and may benefit from home currency weakness. One explanation is that they tend to be too large to be “privatised” and secondly, some of these companies are perhaps being disgorged as American-based funds choose to increase their foreign holdings. Interestingly these shares are in most cases on free cash now yields for 2007 that exceed those of US long treasuries; so does their progressive derating portend a deflationary future, or alternatively, is our analysis plain wrong?!
The first four companies that fit this mould are Cisco, Microsoft, Ericsson and Samsung. Each has clear dominance of its place in today’s electronic highway, and market place (the mobile Internet) and while one can take issue with aspects of each of their businesses, in general they are hard to fault. One exercise we do is to project the likely free cash flow for the next three years and net this off (together with current net cash holdings) against the current capitalisation to arrive at the entity’s 2009 price earnings ratio (PE). On this basis, three of them are on forward PEs of less than 10 times.
Apart from the information technology sector where we have deployed about 15% of the Fund, we have similar exposure to industrials and materials. In the case of industrials it is companies like Siemens, Bombardier, Mitsubishi Heavy Industries, Yokogawa Electric and JGC each of which is trading at well-below peak profitability, and yet serves markets that face a growing backlog of under investment, be it public sector transport or neglected services such as power generation or new endeavours such as alternative energy. Exposure to materials reflects our two themes of tightening agricultural commodity supplies, and the growing capacity constraints in pulp (and paper). Mosaic is the world’s second largest potash producer and a major supplier of general fertilisers. Apart from the near-term pressures exerted by the bio fuel subsidies, we see longer-term pressures which will also benefit Ajinomoto, the world’s leading producer of lycine, an amino acid feed supplement. Our strongly held view that the market is underestimating the impact of China and India on the demand for pulp is gradually gaining acceptance with spot pulp prices having risen by 30% in US dollars in the last year. The other component in materials is the 3% in major gold producers. These have been hibernating as the mines have failed to meet production forecasts and costs are running much higher than anticipated. Perversely, this strengthens our resolve!
As the table reveals, the areas where we are clearly, under represented against the world’s top 5,000 companies are financials, energy and utilities. It should be emphasised here that our ‘weightings’ are a consequence of individual stockpicking combined with themes, rather than a macro overview. It so happens that we are not able to find many financials that interest us relative to other opportunities. Those that do are mostly, in Japan which is on the cusp of a reflationary, pulse with the increase of land and property prices now migrating to the provinces and into residential accommodation. It is remarkable that after 14 years of deflation, that some find it so difficult to envisage observable trends in a positive light!
In energy, our exposure is to Royal Dutch Shell, and Areva, the world’s leading integrated nuclear producer (from mining yellowcake through to plant building and fuel recycling). Shell is a gift we believe on a PE of less than 9 times, a 4.5% dividend yield and is showing all the signs of contrition for its fleeting dalliance with corporate pretence.
You may query the relatively high commitment to those areas which can peter out in the latter stages of an economic boom. We would share the same reservations but point to the individual holdings and the fact that this cycle has been characterised by surprisingly weak investment in basic infrastructure, particularly in the West. In addition, we are very comfortable with the growth prospects and valuations of our more defensive holdings.
The de-risking episode that was recently witnessed, following the mortgage problems in the States will have left a scar on perceptions of derivatives and of the reliability of some funding sources, with adverse consequences for housing and leverage buy-out (LBO) financing. Global growth remains solid with Asia continuing to grow the fastest and with the gilt coming off some Western economies. Most forecasts expect company earnings to slow into single digits in the developed markets, but the systematic de-rating of the larger companies suggests this is well anticipated.
The portfolio is positioned in companies that are generally operating well below their peak earnings capacity and yet face an environment that should favour sales growth and are on valuations that are sound. We believe this and the shorts we are running on highly-valued small stock indices, REITs and emerging markets will protect investors in what we believe to be the later stages of the economic cycle.
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