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No one's talking much about whether we face inflation or deflation any more. Investors seem to have decided they don't really care. Whatever happens will be good – or so the rally says.
Yet getting this call right will be very important for your portfolio over the next few years. Everyone else might be hoping for the best, but alert investors need to stay on top of this.
The only trouble is, it's also probably the hardest investment call to make right now. And so we need to think about how we can minimise the downside if we get it wrong …
Inflation or deflation – we can't be sure
It's still a tough call as to whether we get inflation or deflation in coming years. I'll look at it in more detail in a future email – but the point is that it's impossible to be sure. So smart investors should be thinking about how to minimise the downside if they're wrong.
Let's take the example of equities – in particular, let's look the two types of leverage a company can have. These are financial leverage (its debt burden and debt service costs); and operating leverage (how its costs adjust in response to a change in sales).
A company with low financial and operating leverage will cope best under deflation. Its revenues may fall, but it has little debt to service and its production costs should also fall. So the impact on its profits shouldn't be too severe. For example, a 5% fall in sales might mean a 10% fall in profits. A highly leveraged company is in a much worse situation. With so many fixed outgoings, a 5% fall in sales might be enough to plunge it into a loss.
Under inflation, on the other hand, we have the opposite outcome. Because so many of the leveraged company's costs are fixed, rising prices for goods it sells translate straight into profits. A 5% sales rise might be enough to boost profits by 50%, for example. Meanwhile, more of the low-leverage company's costs will rise in line, so that a 5% sales rise will only mean a 10% profit increase.
This suggests that if you expect deflation, your portfolio should be biased towards low leverage companies. Meanwhile, if you expect inflation, you should lean towards higher leverage ones. (Note that I'm talking about moderate inflation here, not a seventies-style wage-price spiral – in this, most companies will survive but their shares will do badly.)
But there's a snag. What if you're wrong? If you bias your portfolio for deflation and you get inflation, your stocks should still do well – just perhaps not as well as some more geared ones. However, if you bias it for inflation and you get deflation, you could be in serious trouble. The very survival of highly leveraged firms will be in doubt in tough deflationary conditions. So even though I expect moderate inflation, I don't want to be over exposed to leveraged firms, in case I'm wrong.
Now, obviously this isn't the only consideration when selecting stocks. I'm happy to own more leveraged companies when I can buy them cheaply enough so that the risk/reward trade-off is good. But it's an important factor to take into account when looking at the overall shape of a portfolio. If your portfolio is too geared to inflation, think about adding some lower leverage stocks
An out-of-favour stock that ticks the boxes
One candidate I like is video games giant Nintendo (TYO:7974). The firm has no debt and a cash pile of ¥749bn (US$8.25bn). And other than in 2005 – when it was ramping up for major product launches – operating leverage (measured here by percentage change in operating to profit to percentage change is sales) has been low.
Nintendo's operating leverage
Right now, the stock is deeply out of favour. It had an excessive run-up in the last few years as investors got carried away by strong sales of its Wii console; now as sales tail off, everyone is bailing out. Nintendo is one of the few stocks that hasn't participated at all in the global rally, as you can see below.
Nintendo's share price
Both hardware and software sales were off sharply in the first quarter of this year. That was partly down to the global recession, but a bigger problem is that a significant number of the potential customers for both the Wii and the handheld DS console have now bought one. Meanwhile, software releases so far this year have generally been less exciting than last year. The analysts' consensus that profits will still rise this year looks hard to justify, and the market clearly expects them to be proved wrong.
Nintendo's results and consensus analysts' forecasts
| 2005 | 2006 | 2007 | 2008 | 2009 | 2010E |
|---|
| Revenues (¥bn) |
515 |
509 |
967 |
1,672 |
1,839 |
141,740 |
|
|
-1% |
90% |
73% |
10% |
-5% |
| Net income (¥bn) |
87 |
98 |
174 |
257 |
279 |
299 |
|
|
13% |
77% |
48% |
8% |
7% |
| EPS (¥) |
663 |
762 |
1,363 |
2,012 |
2,182 |
2,346 |
|
|
15% |
79% |
48% |
8% |
7% |
| Source: company reports, Bloomberg |
On top of weak sales, there's been a steady flow of negative news. The strong yen is a drag on profits, since the bulk of its sales are in dollars and euros, whereas many costs are in yen. There's a great deal of speculation about whether a new add-on device for Microsoft's Xbox 360 console will eat into the Wii's market share by copying its innovative motion-sensing interface. And Nintendo has annoyed many investors by snubbing calls to cut the retail price of the Wii to boost sales in the short-term.
Three reasons to be positive
But I think the market is missing Nintendo's healthy longer-term prospects. Firstly, Nintendo now has a substantial installed base of Wii and DS users who will continue to buy software for their machines. The recent fall in software sales only reflects an uninspired set of new launches this quarter. Once Nintendo produces another attention-grabbing title, sales will be back up.
Secondly, the lifespan of this installed base is likely to be longer than many expect. People are used to rapid evolution in consoles, with a new generation arriving every five years or so. For other machines like Sony's Playstation 3 and Microsoft's Xbox 360, this is likely to be true. However, these cater to hardcore gamers; Nintendo's recent machines have catered to more casual gamers.
Crucially, the technology in the Wii and DS is at a point where it can do everything a casual gamer wants. So while enthusiasts will expect a new generation of consoles in the next couple of years, Nintendo is likely to be able to continue selling the Wii and DS, with a few enhancements, tweaks and cosmetic changes, for quite a while. Its main focus is trying to lure non-gamers, not winning the next round of the console arms race.
Thirdly, there are still largely untapped markets for Nintendo to chase. Education use for the DS or a spin-off from it could be one, while wealthier consumers in Asia and other developing countries offer excellent growth prospects for home entertainment firms in decades to come.
So although hardware sales have peaked for this cycle, Nintendo should be able to maintain good sales of its current hardware over a longer period than many expect. The bigger that installed base gets, the more software it can shift – as long as it keeps coming up with innovative games.
There's a lot of negative sentiment around the stock which has held it back while the rest of the market rallies. I don't necessarily expect this to improve for quite a while. But for patient investors, Nintendo looks too cheap, on a price/earnings ratio is 11.5 times last year's earnings.
Unusually for a Japanese stock, it's also a decent dividend player with a yield of 5.1%. I wouldn't treat it as a steady income stock – it usually pays out a set percentage of earnings, so a cut is possible this year if profits come in lower than expected – but the payout is still attractive.
Nintendo's primary listing is in Japan (JP:7974), but at a share price of around ¥25,000 ($275) and a minimum dealing size of 100 shares, this is impractical for most private investors. Its US-listedAmerican Deposit Receipt (US: NTDOY) is an easier option; each ADR (currently priced around $34) represents a one-eight interest in a Nintendo share and the market for these is highly liquid.
In other news this week …
| Market | Close | 5-day change |
|---|
| China (CSI 300) |
3,328 |
+5.2% |
| Hong Kong (Hang Seng) |
21,161 |
+4.1% |
| India (Sensex) |
16,264 |
+3.7% |
| Indonesia (JCI) |
2,416 |
+4.0% |
| Japan (Topix) |
950 |
+1.6% |
| Malaysia (KLCI) |
1,208 |
+2.5% |
| Philippines (PSEi) |
2,871 |
+2.4% |
| Singapore (Straits Times) |
2,681 |
+2.2% |
| South Korea (KOSPI) |
1,652 |
+2.7% |
| Taiwan (Taiex) |
7,337 |
+2.6% |
| Thailand (SET) |
708 |
+5.9% |
| Vietnam (VN Index) |
548 |
+3.7% |
| MSCI Asia |
105 |
+4.1% |
| MSCI Asia ex-Japan |
448 |
+4.0% |
Former Taiwanese president Chen Shui-bian was sentenced to life in prison after being found guilty of corruption and money-laundering during his 2000-2008 term in office. Few Taiwanese seem to believe Chen is innocent; however, many suspect that there may have been political motives in his prosecution. Chen was the first Taiwanese leader not to come from the Kuomintang group (KMT) that formerly ruled Taiwan as a military dictatorship and is now back in power following last year's election.
In the same week, premier Liu Chao-shiuan and his cabinet resigned in response to criticism of the government's handling of rescue efforts during Typhoon Morakot, in which more than 700 people died. The change will not mean any significant shift in politics, since overall policy direction is set by the president under Taiwan's system.
In an unusual trade between two sovereign wealth funds, Abu Dhabi's Advanced Technology Investment is to buy chipmaker Chartered Semiconductor, currently 62% owned by Singapore's Temasek, for US$1.8bn. Chartered is currently the world's third-largest custom chipmaker, after two Taiwanese firms, Taiwan Semiconductor Manufacturing and United Microelectronics. Following the deal, Chartered will be merged with Abu Dhabi's much smaller Global Foundries. Elsewhere, creditors of Korean commodity chipmaker Hynix Semiconductor invited bids for their 28% stake in the loss-making firm.
Chinese lending was surprisingly strong in August. Net lending was RMB410bn ($60bn) up from RMB356bn the previous month; markets had expected it to slow further. If sustained for many more months, this will increase worries about bad loan growth and asset bubbles. However, for now the government believes that the economy needs more stimulus; premier Wen Jiabao told the World Economic Forum that the recovery was "not yet solid".
• This article is from MoneyWeek Asia, a FREE weekly email of investment ideas and news every Monday from MoneyWeek magazine, covering the world's fastest-developing and most exciting region. Sign up to MoneyWeek Asia here
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Cris Sholto Heaton
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