Sixteen investments that will prosper in 2012
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MoneyWeek Editor
John Stepek Dec 23, 2011
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Unfortunately, there's little chance of leaving the financial turmoil of 2011 behind in 2012. So, where should you put your money? John Stepek talks to our panel of experts to find out.
John Stepek: Will we have seen the eurozone end-game by this time next year?
Tim Price: I doubt it, but here's hoping. It would be in most people's interest if Europe got its act together. But it requires political will, and we haven't had evidence of that for as long as I can remember.
Jim Mellon: A much weaker euro would be a partial solution – it would greatly help the southern European states. But I think the most likely outcome is that Germany leaves Europe, along with some of the so-called 'hard' countries, such as Holland and Finland. The alternative is that Greece and Portugal leave soon and the European Central Bank (ECB) offers unlimited guarantees, but the political will for that doesn't seem to be there.
Marcus Ashworth: This is not going to be solved within a year. Europe is either already in recession or is about to be. There is no way it can grow its way out of this. So either it inflates its way out, which the Germans are preventing, or it walks away from the debt, which would cause a mighty bang. The trouble with the European banking system is that everyone is lying. That's why Greece can't be allowed to default, because if it does, the banks will finally have to mark their assets down to their true market value and admit their losses.
Our Roundtable panel
James Ferguson
Head of strategy, Arbuthnot Securities
Jim Mellon
Chairman, BurnBrae
Steve Russell
Investment director, Ruffer LLP
Tim Price
Director of investment, PFP Wealth Management
Marcus Ashworth
Head of fixed income, Espirito Santo Investment Bank, incorporating Execution Noble
Steve Russell: I'm not as gloomy on this. I think people underestimate the Germans' willingness to do a deal. They clearly want some form of binding fiscal rules. The ECB will not monetise unless it sees the politicians making very tough decisions. But I think there is a good chance that the ECB and the Germans will back the weaker nations in return for changes.
The real problem is that you will have ongoing bank deleveraging across Europe next year. On top of that, fiscal austerity will be forced on people. From the German point of view, that's fine. In real life, it might come back more to this table's view that bits will start to crumble and Europe won't be able to deliver.
John: So the euro will hang over us for a while yet. When do you think America will make a convincing comeback?
Jim: The general view is that this is China's century. It isn't. My view is that it is still the century of the United States. America is the depository of just about every good innovation in the world. It also has many natural advantages: its demographic structure is a lot better than anywhere else in the West, Japan or, indeed, China. Somehow it will find a way of resolving its difficulties over the next five or ten years. We don't know exactly how – but I feel much more confident about America managing this than anywhere else.
The problem now is that it is being weighed down by everywhere else. US exports should be soaring because of the weak dollar. Instead, they are only rising by about 15% a year when they need to be rising by 30%-40%. So growth isn't going to be very strong. As for the market, there is nothing compellingly cheap, except in the biotech and pharmaceutical area, and one or two of the technology firms. I do think US Treasuries have probably run most of their bull-market course: maybe not all of it, but most of it.
John: James backed government bonds at the start of 2011, which was a good call.
Marcus: But you can't still like bonds at this price, surely?
James Ferguson: It's not about whether I like them or not. It's about whether the people who are forced to buy them are still being forced to buy them. Since the crisis began, the Western world's banking system has been forced to take less risk. That means they shed loans to the private sector (you and me) and replaced them with short-dated loans to the public sector – the government. When the Europeans ordered the banks to raise their capital ratios sooner than expected and by more than previously indicated, they told them they should also realise some of their losses more rapidly. They also ordered them to recapitalise. These are the same instructions the US and British bank authorities gave to the banks around September 2008. The rest of the world says, Lehman Brothers caused all that trouble. But what caused it was the authorities telling the banks to recapitalise and hike capital ratios right when those capital buffers should have been run down as we began to absorb losses.
The fact is that the Europeans are only now starting to deal with their banking system. There are two problems here: the European banking system is about twice as highly leveraged as the American system is; and it's at least twice the size.
John: Do you think we will see the lows in stocks that we saw in the 2008 crisis?
James: The interesting thing is that this is all very bad for the economy. But that means that they will almost certainly have to do quantitative easing (QE), which we know is good for stocks.
Tim: In the short run.
James: Well, over the time when the QE is being enacted. Although the US talks about QE as a tool for pushing down yields, it never seems to have done that. The moment QE2 finished, US Treasury yields slid, because QE was no longer threatening to weaken the currency and create inflation. Investors instead returned to focusing on the fact that the big picture is actually very deflationary, and so attractive for bonds. Having said that, the good thing is that the Americans really have done a lot now, especially with the big listed banks. Citigroup is a buy – it's almost impossible to kill now.
Steve: It's far too early to talk about buying banks. The political atmosphere and economic backdrop will be biased against them for years to come. We do like the US dollar, we like US firms and we see a recovery coming through, but it's just the best of a bad bunch. The best thing about the dollar is that at times when you can't hope for a return on your capital, or even the return of your capital, you can at least get liquidity. You can get your money out – you don't know what it's worth but you can get it out. That doesn't work with the euro or most of the other currencies now.
Jim: I bought a couple of apartments in San Francisco at the start of the year and I'm thinking about buying in Miami. The Brazilian real is so overvalued that Brazilians are going to Miami, which is much nicer than Rio or Sao Paulo, and are literally queuing up outside the real-estate agents. You can buy a fantastic apartment in Miami for one-tenth of the price it would cost you here in London, or one-fifth of the price of Rio. So why wouldn't you? It's a great place, with access to all the fun things America has to offer. So I think American property is a buy.
Tim: The problem I have with all this is that you can talk about nominal returns on indices or assets, but in any rational analysis the system ought to have broken apart by now. You've got the central banks desperately spinning plates, but the reality is that the purchasing power of everyone's money is being destroyed.
Steve: There is one asset you should put your money into: index-linked bonds. Central banks will have to monetise. That leads to inflation. There's no way round it.
Marcus: We are going to get deflation first. That's what Mervyn King says.
Steve: You need deflation to have the inflation – that's what QE is there for, to offset the shrinkage in the money supply. But it doesn't mean the value of money starts rising, which is what you would expect in a deflation. We have a deflationary world at the moment and the value of money is already falling.
Marcus: We have a deflationary world, but the practical reality in Britain is that we've got rampant inflation. Do we think that King is right, and that prices will actually come down over the next year?
Steve: No chance. But it's a clever trick to play on investors and the general public and good luck to him. If he can get away with it for as long as possible, then year by year Britain's debt will be reduced. We've got an average duration of 13 years, so we could get there in the end.
John: Tim, you are probably the most bullish person here on gold. What would make you sell up?
Tim: A return to sound fiscal policy – anywhere. I see no evidence of that. Every day you get news that, logically, would be supportive of gold, in terms of money printing and QE. It isn't necessarily having that effect for now, but it's a long game.
Marcus: That's telling you one thing – it's a 'risk on' asset and far too many people are betting on it.
Tim: For sure, it's a very crowded trade. Every time you get 'risk off' moments, the hot money leaves. That's to be expected. But there are two types of players in gold. There is the portfolio insurance group – people who simply want a genuine store of value. That's gold – it has always arisen as money, without state coercion, for 5,000 years. It has outlasted every paper currency and will continue to do so. The second are the momentum investors: at the first sign of trouble, they're out.
Marcus: So why hasn't the gold-mining shares story worked out?
Tim: The rise of exchange-traded funds that track the gold price means that investors who once would have bought gold miners to play gold can now get access to the physical asset without having to take equity risk. Also, look at 2008 – gold came off then and mining stocks went too.
Jim: Also the cost of production is rising rapidly in almost every gold mining jurisdiction. That hurts profit margins. Cost of production for some Australian producers is up to around $800 an ounce.
John: But what marks 1980 for this gold bull run? What would stop it dead?
Tim: You need another Paul Volcker. Someone who would act to defend the value of the world's paper currencies.
But I wonder whether we've gone past the point of no return. If there is too much debt that can't be repaid then ultimately someone is going to have to lose a large sum of money. As long as it's not our clients, I am happy with that.
Steve: If there is too much debt that can't be repaid, then it will be spread around as many people as can be found
to spread it around – that's inflation. Gold is fine, but if you put all your money in gold you run the risk of confiscation and taxation.
Tim: But don't you run the same sort of risk with index-linked gilts? Who is to stop the British government arbitrarily changing the terms of its debt?
Steve: Government can tweak away but it's still your safest bet for now. I don't mind if they change terms so that they track the Consumer Price Index instead of the Retail Price Index. It doesn't matter.
John: What about stopping future crises? How do we reform the financial industry?
Marcus: How many more rules do we need to have? Many of the ones we had in the last five or ten years actually created more problems.
James: From Basel I through Basel II to Basel III now, the regulator has fiddled with the definition of capital and of assets. The latest idea, under Basle III, is to return the definition of capital almost back to square one, tangible common equity. They don't call it that because it would be embarrassing for them to admit that they should never have changed it in the first place. The fact is that they are tacitly admitting that the entire Basle exercise was not only wrong, but also caused the entire crisis.
Steve: Don't you think it's unacceptable to blame the regulator? The crisis was caused by individual and collective greed and the least greedy people are probably the regulators. The fact that the regulators didn't stop people doing bad things doesn't mean they caused the crisis. It's the people who did the bad things.
Tim: The reason everybody is spitting blood here is because every other industry in Britain operates on the basis that if it loses money enough times, it will fail. The one industry not run on that basis is banking, where if you lose enough money you get bailed out by taxpayers. As Nassim Taleb says, you can resolve this at a stroke: no banker gets paid more than a civil servant. Why should they?
Jim: Basically there is no distinction being drawn between genuine entrepreneurship and managers who get to be in charge of these £100bn businesss by happenstance, almost like civil servants rising to the top. These managers are getting paid as though they were entrepreneurs, and that's wrong.
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John: So what is everyone buying now?
Our Roundtable tips
Jim: I am interested in biotech, which is one reason why I like a Japanese company called Astellas (JP: 4503). It is partnered with Medivation, one of my favourite drug companies. I also think that the Japanese market is going to do better than almost any other market, so it's got that going for it too. And it yields 4.2%. Microsoft (Nasdaq: MSFT) is another good option – a quarter of its market cap is in cash, it's trading on nine times earnings, and pays a 3% dividend yield. On the biotech side again, of the big companies, Roche (SIX: ROG) stands out. Because of the Swiss franc being re-pegged it should have strongly rising earnings.
It's got very little debt and owns Genentech; it's trading on 15 times earnings and pays a 4.4% dividend yield, which in Swiss francs is amazing. Of the big US companies, Pfizer (NYSE: PFE) is getting its act together and, despite the patent cliff that everyone talks about, I think it can still grow its earnings. It pays a 4% yield, and has $12bn in cash.
John: If you invest in Japan, should you hedge your yen exposure?
James: No, you mustn't. In Japan, what happens to the stockmarket depends so much on what happens to the currency. If you hedge the currency, you are totally exposed to the volatility of the stockmarket. However, if you don't
hedge it you will find that the two offset each other.
Jim: More than offset, in fact. Indeed, the sensitivity of earnings to the depreciation of the yen is enormous in Japan. If the yen hit 90 to the dollar, Japanese stocks, instead of being on 15 times earnings, would be on five times earnings.
James: The one problem is that we lack a catalyst. But Japanese banks have now stopped shedding assets and realising losses. That may or may not mean that there aren't many losses left to deal with, but given that cumulatively they have seen almost record-breaking losses, you would hope so. When Northern Rock went bankrupt it had loans that were three times its deposits. The Japanese banking system has deposits that are 50% higher than loans. We are looking at the most amazing springboard if you can just turn that supertanker round.
Jim: The Bank of Japan will intervene to weaken the yen. It put $94bn into one intervention about a month ago – I am certain that it is going to do it again.
James: To put this into perspective, if you go back as far as you can realistically go with government data – to around about 1961 – then the Topix index is as undervalued now compared to Japanese government-registered corporate profits as it was overvalued at the very peak of the bubble. No one notices because the bad times have gone on for so long. In Japan there are bank managers with 20 years' experience who have never made a loan. Most of the population has never borrowed any money. So people don't realise things could be any other way. The way to make really big money is when you spot where the fundamentals have changed, but the mentality is yet to follow.
Jim: Do you think that's the case now?
James: I can show it. The market is in a completely different place. It is about to double bottom with where it was, what, two or three years ago? But back then, earnings were about 60% lower than now.
Steve: Even though you can't call the timing, you're being paid to wait. You can buy an Astellas, or a Japanese real estate investment trust, yielding 6%-odds. So you can't necessarily say Japan will fix itself and do well next year or the year after, but if you're going to be paid a decent amount to wait then it makes sense to start moving across there.
Marcus: I disagree. I see your arguments. Maybe they're right. Japan might have another August 2005 moment when it raced up, what was it, 40% or something to the end of year and everyone made out like bandits. But it then fell yet again. The point is you can have the flip side, which is that Japan goes horribly wrong. The demographics are getting worse. The debt is getting worse. There is a point where Japan just goes over the edge. That could be the yen/dollar rate getting pushed below 75, and they don't have the guts to do anything about it.
The Swiss probably spent nothing pegging the franc to the euro – the market just believed them when they said they would defend the CHF1.20 mark. The Japanese have spent billions of dollars and will have to spend that again and again. At some point, the people who are short Japanese government bonds (JGBs) will be right. Japan has been cheap before. Then it got cheaper, and now it's even cheaper again.
James: That is not actually the case. You've only once before been able to say Japan was cheap, and that was around about the first quarter of 2003 – but it wasn't as cheap as it is now.
Marcus: How cheap is zero for you? It's going to go to zero.
James: OK. Let's say you actually run out of domestic savings and Japan's whopping great debt pile is no longer internally funded. A sensible central bank would say, I could buy it all via QE. Now the moment that happens, two things happen. One, the currency falls, so we get our intervention. Two, we create inflation as the currency weakens. So ironically, I suspect that the moment Japan really takes off is the moment that the disaster scenarioists think it blows up – ie, when domestic savings run out.
Marcus: So we need Armageddon in Japan to get Nirvana?
John: So what would you buy, James?
James: I've been bad-mouthing the banks for a long time. But as I mentioned before, I think Citigroup (NYSE: C) is now a buy.
Marcus: I sold it recently, so by definition you must be right.
James: I look at the banks as being in a balance-sheet recession. So you don't look at the income statement, you look at the balance sheet. You have to look at how much of a loss a bank is going to have to take on its assets before it's finished writing them down. The historical average is 10% over loan assets: the Japanese banks were 20%. Citigroup has already realised loss rates of over 15% on its loan assets. If it was to go to 20%, that would be another $40bn of losses to come. When I last recommended it a couple of months ago, it was trading at a $100bn discount to assets. So even if the $40bn gets eaten up, you've another $60bn there before it looks overvalued.
Marcus: What about litigation costs over the US mortgage mess?
James: I'm factoring in litigation. You have to guess a bit, of course. Bank of America is probably facing $50bn of US litigation costs. But it will take the biggest hit. I don't think they'll bankrupt Bank of America. Instead, they'll say, you owe us $50bn, but you can't pay right now so spread it out over ten years.
Jim: As Steve says, this is why you avoid banks: bankers are such a hated class that, when they start making what are seen as excess profits, it'll be windfall taxes, special taxes, and all the rest of it.
James: Yes, but the really big risk in banks is going to be in Europe. People here are not paying attention to this US mortgages story, and yet some banks over here were equally exposed. The other stock I like is Renault (FP: RNO). It's on a historic price/earnings (p/e) multiple of two. Whatever happens with the eurozone, France is probably going to be on the right side of the fence. When the Europeans are finally forced to print money, it'll be 'risk back on' time. When that happens, the stuff that will move is the stuff everyone had written off. That'll be good for stocks like Renault.
Tim: Once again, I'll tout the merits of the New Capital Wealthy Nations Bond Fund (tel: 020-7766 0820), which invests on the revolutionary philosophy of only lending money to countries that can afford to pay it back. It invests in countries that have net foreign assets – huge surpluses – as opposed to countries that have huge liabilities, which is most of Europe. That you can get exposure to resource-rich countries in the Middle East and Asia at a yield north of 7%, in a hard currency like the Singapore dollar, I find compelling.
As for the second, I'll go for Fresnillo (LSE: FRES), the world's largest primary silver producer. It's got five mines in Mexico. It produced a record level of silver last year, and operating profit approached $1bn. It has gold interests too, one is a byproduct of the other, and the cash cost for both is great. The average cash cost for gold for Fresnillo was $309 an ounce in 2010. The average cash cost of silver (remembering that silver is trading at about $30 an ounce) was $3.30. This is genuinely compelling.
Steve: Obviously for me the building block of any portfolio is index-linked bonds, be they British or American. The next step is Tesco (LSE: TSCO). It has issued an index-linked bond, but I want the stock.
John: What do you make of retail bonds?
Steve: I prefer the government ones.
James: Surely they have less opportunity to wiggle out of their contracts?
Steve: They may or may not. I wouldn't touch utility issues: I think the pricing regime will change; you won't be allowed to put electricity prices up 20% and so the guarantee of paying indexation will disappear. Tesco has the best chance, but I'd rather have the shares with a 4% yield upfront, indexed by growth, rather than the bonds with a 1% yield upfront indexed by inflation.
Another theme is to try to benefit from banks' distress, and what the banks are selling. Oakley Capital (LSE: OCL) is a private-equity group that picks up these assets and it has got some lovely businesses. Secure Trust Bank (LSE: STB) is a proper old-fashioned bank whose moment has come.
Also, of course, we invest in Japan. The last time I was here I mentioned ice-maker Hoshizaki Electrical (JP: 6465), which has around 70% of its market cap in cash. It has gone up and continues to go up, and I still think it's great. But for anyone not keen to invest in Japanese stocks, UK house builders could be interesting. The same goes for America. If governments keep printing money, which they will, then where will they put it? In Britain, house prices haven't collapsed, but we have a problem with the number of houses being built, and we've already seen moves to address that in the chancellor's autumn statement. So while I'm not a UK property bull, new-build could be interesting. Barratt (LSE: BDEV) is trading at way less than book value.
John: Marcus?
Marcus: Philips (Amsterdam: PHIA) is a large consumer electronics firm with three main arms. There's consumer electronics, which it is pulling back on – in the last year or two it's got out of the TV business, which is good news. It also has an LED lighting business, which is a huge story, but also vastly competitive. Where it does have an edge is in the area of medical devices. This is its fastest-growing business, with around 37% coming from emerging markets. The group has left CT scanners and other large-scale stuff to Siemens, and instead concentrates on more consumer-driven medical treatments in the emerging markets, such as sleep apnoea in China, which is huge with the amount the population smokes.
As a kicker it has a €2bn share buyback scheme, which is about 27.5% done. I don't think the shares are going down and if the firm gets one of these things right, it can do extremely well. I'm not saying it's been a brilliantly well-run company, but now there's a new chief executive and a new chief financial officer, and the stars are aligning for it.
More interesting is SuperGroup (LSE: SGP) as in SuperDry, the fashion label. It has suffered huge systems errors and has made just about every mistake it could possibly make. So why buy now? Because by now it ought to have learned, and it actually gets paid to go into shopping centres – it adds that much brand value. So I think that this Christmas its numbers could surprise.
Another interesting stock is Aberdeen (LSE: ADN), an extremely well-run, undervalued fund management company. If the world does go to a beautiful place, then firms like Aberdeen are much higher beta than everything else and will benefit disproportionately. But even if not, you are still getting a very well-run company that offers a lot of different ways to make money.
• This article was originally published in MoneyWeek magazine issue number 569 on 23 December 2011, and was available exclusively to magazine subscribers. To read all our subscriber-only articles right away, sign up for a three-week free trial now.
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