Are commodities still hot?

Jun 14, 2006

Are commodities still hot?  Is the housing crash finally here?  Here's what our experts say...

For our most recent MoneyWeek Roundtable, we invited four of the best strategists we know to join us for dinner and tell us what they think looks interesting in global markets. Here they reveal what they would - and would not - invest in today.

Merryn Somerset Webb: We’ve seen some dreadful numbers out in the housing market. According to the Land Registry, in the last quarter of 2004 prices fell 2.7% and transactions all but collapsed. Does this mean that the crash someof you have long been predicting has finally come?

Rupert Lee-Browne: I don’t think so.What the housing bears are missing is that the fall in transactions was a technical thing. Thanks to changes in the regulations at the end of last year, some big organisations - Abbey, for instance - couldn’t actually write any mortgages for a few months. And that meant that less transactions were completed. For anyone who’d been paying a tiny bit of attention to how the market works, the fall shouldn’t have been a surprise at all. And the fact that this month is difficult has no real information content in it either. January and February are always difficult months for the housing market.

MSW: James, I bet you think that the regulatory issues are a red herring.

James Ferguson: I do. This still looks like the start of a crash to me - they always take much longer to get under way than you would ever think. In the first stage, which can take a year, prices still look like they are rising, but actually volumes are tailing off. Then the remaining buyers start to haggle, and one by one the sellers capitulate and take lower prices. But this is a huge, illiquid market and it takes ages to see the turn. For the housing market to go full circle takes ten years.

Bob Catto: But the turn is here and I think it’s now rolling out of London too. I heard this week of someone offered a discount on a house down in Kent if he completed fast. Why? Because the owner has found somewhere she wants - so they are all in a chain. Chains like this are a sign of a bear market.

Tim Price: I think we have a consensus around the table that property prices are going south. But this isn’t necessarily bad news for stocks related to the housing market. I would argue that construction and housebuilding stocks are as good as anything else in the market right now. They are pricing in an apocalypse, which may well not come, and that makes them look cheap.

JF: But they should be cheap right now. Very cheap. These are geared,one-product companies that rely on their customers being geared too. Buying into them is a massive gamble. That’s why the market pays a low multiple. And don’t forget that just before the last housing crash, the market was paying even lower multiples - p/e ratios of 2.5 to three times - and even then most of these figures didn’t simply halve, but went down 90%. The fact is that, in sufficiently volatile, cyclical businesses, your earnings can disappear in a matter of months.

BC: But this time round, the housebuilders have much stronger balance sheets than they did then. They are far less geared than they have ever been before and there are fewer of them - the market is less competitive than it was. So the risks may not be quite so high. Also, we are building less houses than at any other time, despite the fact that demand has been rising - partially due to immigration.

JF: New house supply has not been falling. That’s a media myth. Look at the data and you’ll see that it just isn’t true. In fact, housing supply has remained remarkably consistent, with much the same number of houses being built every year for the last 25 years or so. And I’m not convinced about the demand argument either. People say that, with the divorce rate rising, more houses are needed - but is that really so? Both estranged spouses don’t need a house. They need a flat - and you can turn a house into two flats without too much trouble. And as for the immigrants the housing bulls go on about, they’re mostly economic migrants. They can barely afford the bus fare to the UK, let alone a house. And if they do make money here, they tend to repatriate it and, of course, they often end up repatriating themselves after they’ve made some money.

RLB: You seem utterly convinced about a crash, but as far as I can see the economy is on a much surer footing than it has been for a long time, and certainly than it was in 1989 - that’s got to help prevent a fall in house prices turning into a crash?

BC: I’m not sure where you get the idea that the economy is on a sound footing. Since 1989, we’ve lost more and more of our manufacturing base. We are importing more, our trade gap is widening - ie, we are exporting jobs abroad. All that is keeping us going is consumer spending, and that has been, to a large degree, driven by the rise and rise of house prices. When that stops, so will everything else.

RLB: We may have lost manufacturing jobs, but we’ve made up for it with new service-orientated jobs.

BC: We’ve certainly had growth in the number of civil servants - all UK growth these days comes from Government expenditure, on Government-created jobs. There were a quarter of a million public-sector jobs created last year.

JF: Anyway, Rupert, what you are implying is that last time the housing market crashed, the economy was wobbly in advance of the crash. But don’t forget that last time round, even after the housing crash had officially started, Britain was boasting decade-low levels of unemployment. The economy actually turned nasty after the housing crash - as a result of the housing crash. That could easily happen again today.

MSW: Let’s not depress ourselves too much at this Roundtable. We know there’s lots of money about - sitting on deposit. So what do you do with it?

TP: I think the UK equity market is reasonably valued. Not the whole market, but if you look from a bottom-up perspective, there are any number of decent stocks out there with interesting yields. That means that you can still make double-digit returns without taking too much risk. But you have to be very specific and invest not by sector, but in stocks on an individual basis.

RLB: You wouldn’t agree with that would you, James?

JF: Actually, I would. I think the economy is about to come to a stop - but that’s not the same as markets at all. In fact, the economy often moves in the opposite direction to the markets - or rather, markets move in the opposite direction to the economy. Warren Buffett made a point about this once. He noted that if you take a look at the last 100 years, you can roughly break up that period in the US into half a dozen periods where either you had strong economic growth, or you had virtually no economic growth at all. And the stockmarket moved almost entirely during the periods where you had no economic growth. Why is that? Because when you had no economic growth, you had falling interest rates. You had declining yields on investment in bonds, so you get declining earnings yields in equity markets. That, in turn, means that higher p/es are justified and the market rises. It is all about the value that we place on earnings. So I can be bearish on the economy, yet bullish on shares.

TP: People assume that strong economies and strong stockmarkets go hand in hand, but the reality is you can get these massive de-couplings where the market does extraordinarily well despite the fact that the economy’s poor, or vice versa.

MSW: You wouldn’t count yourself as bullish, would you, Bob?

BC: Not entirely. I think there is room for a shock coming from a severe consumer squeeze. There is already evidence of a consumer slowdown, but if that becomes more serious, then it could have some very nasty repercussions in terms of company profitability, and a lot of companies - Marks & Spencer, for example - are pretty expensive. I would want to avoid the retail sector as a whole, particularly as the housing market slows. Less people moving means less new carpets, less curtains, and so on.

MSW: So what would you invest in at the moment?

BC: Well, I approach stocks in a very, very conservative way at the moment. There’s too many risks around to think any other way. The UK does look cheaper than the US market, but still I don’t think one can invest here indiscriminately. I’m also nervous about sterling - I want to be getting out of sterling. In fact, I don’t much like any currencies and I still think that gold is the best long-term store of value around. It has always been the hard currency, and I think it will get that status back over the next five years. I think there will be a lot of money made in the gold sector.

The other area worth looking at is energy. More and more people are coming round to the view that nuclear energy is going to power the future. That means that there could be money in uranium stocks. You do want to be careful about buying too many of the more speculative Canada-listed stocks, but there are some very interesting opportunities out there. I would name Aflease in South Africa and Paladin Resources Ltd and Giralia, both in Australia.

I’m also still interested in the oil sector. I don’t think that oil is going back down to $25 or $20 a barrel: it’s staying over $30 from now on.

MSW: You’ve tipped Heritage at this Roundtable in the past. Do you still like it?

BC: Definitely. It is a huge, huge play in a brand new oil province.

 JF: I’m keen on oil too - I like a lot of the related stocks - but I’m not convinced about commodities as a whole this year. It was a great story last year, and although I don’t see any commodities falling back to their lows again in terms of pricing, enough has been made of the sector’s long-term attractions for now - everyone knows the story. And for the moment, the demand side is weakening a little.I don’t think commodities will be the big investment story of 2005.

BC: I do. I think this is a commodities decade. And climate change is part of that - you see more and more pictures these days of dried-up reservoirs and river beds. The fact is that agriculture is just getting more and more difficult. And on top of all that, you’ve got this enormous movement into the cities and growth in the middle class in China, both of which point to rising protein consumption. You see what the story is… buy agricultural commodities. So buy into Argentina and New Zealand and Brazil. Those are the countries where the money’s going to be made. Brazil has a huge amount of fresh water - 19% of the world’s fresh water, and fantastic soil. 

MSW: It is in Argentina, of course, that Ted Turner has been buying up millions of acres of land with good water supply.

BC: Argentina has huge potential - it was the sixth-richest country in the world in 1910.

MSW: What about diamonds? I used to consider them less than worthless - back in the days when the De Beers stock pile was huge - but I understand things have changed in the market now.

BC: There’s a shortage - DeBeers don’t have a stock pile any more. Diamonds are hellishly difficult to find and they aren’t finding any new mines. BHP, Rio, DeBeers - they’re all out there looking for new sources of rough diamonds, but it isn’t going well. Yet there is plenty of demand - new demand coming from all over Asia.

JF: A bit of rough is harder and harder to find.

MSW: Hmm. But which diamond stock do we buy?

BC: There’s quite a few in London. I think Brazilian Diamonds is underrated - it’s got good management, ex-DeBeers and ex-CBRD people - and they’ve got an enormous database and their own lab. Firestone Diamonds is also worth a look, as is Petra Diamonds, although it is in Angola. They’re sitting on great properties, but the environment is difficult. [Petra Diamonds has since been suspended after the announcement of a merger with Crown Diamonds.


MSW: Tim, what would you buy?

TP: I’m with Bob on the commodities and metals stories, so I’m still into diversified mining - such as Anglo American. On the short side, it’s got to be technology. I have just installed a new browser on my PC at work and at home called Mozilla Firefox, and it’s fantastic. It’s fast, secure and much easier to use than Internet Explorer. Right now, it only has about 1% of the browser market, but it’s going to end up in the double digits. That has to be bad for Microsoft. I think that the whole tech sector has way further to fall.

I’d also be very nervous about owning US assets in general. If anything looks overboiled, they’re it. If you look at the UK market, you can see that retail investors aren’t particularly interested in the market, and we know that institutional investors aren’t particularly interested, so it’s difficult to know where the waves of buying will suddenly start coming from. Conversely, if you look at the US, there’s massive amounts of complacency in the market - retail investors are heavily invested - yet with rising interest rates that could all turn very nasty quite quickly.

MSW: Okay, any more tips?

RLB: Skiing chalets. Looking at the people who deal through us, I see a lot of the smart money heading for Chamonix and other resorts where property still looks reasonably priced.

MSW: James, what have you got for us?

JF: One I think we should be taking a look at is Legal & General. Since their peak in 1999, the group’s shares have slumped 40%, yet the underlying profit has continued on a steady rising trend and the outlook is up more than 50% since those 1999 levels. This has resulted in an unprecedented drop in L&G’s p/e ratio to just 11 times next fiscal year’s earnings - half its long-run average of about 22 times. That implies an earnings yield of 9%. This is especially pertinent at the moment: bond yields are currently at near-record lows of about 5%, which suggests that, if anything, the earnings yield should be lower than average.Put another way, the p/e should be higher than average. A return totrend is now a reasonable and, indeed, I’d say a conservative expectation. If the company can maintain the 20% growth in UK new business it reported in the final quarter of 2004 and head back towards trend multiples, potential stock-price upside could easily be 100% plus.

MSW: Anything else?

JF: I’m also still keen on the oil majors. Many people are acting as if the story is over with the results announcements out and the oil price having peaked back in the fourth quarter of last year. But neither Shell (for obvious reasons) nor BP has yet fully discounted the size of the oil price rise, nor the apparent need to revise up long-run oil-price projections. Since they started from an oversold position in 2002, I see both stocks going to new highs in 2005.

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