IG Index plc is a subsidiary company of IG Group Holdings plc. IG Index has paid Edison to prepare and provide this material, but exercises no influence on Edison's comments or opinions or the particular shares it decides to feature. Theoretical portfolio Prepared by Edison Investment Research on behalf of IG Group. 7 September 2009 qÜÉ éçêíÑçäáç áå íÜáë êÉéçêí Ü~ë ÄÉÉå éêÉé~êÉÇ íç êÉéêÉëÉåí ~ éçëëáÄäÉ áåîÉëíãÉåí ëíê~íÉÖó Ñçê ~ íÜÉçêÉíáÅ~ä áåîÉëíçê ïÜç ~ÅíáîÉäó íê~ÇÉë ïáíÜáå ~ íê~ÇáåÖ íáãÉJÑê~ãÉ çÑ çåÉ íç íïç èì~êíÉêëK
Transcript
IG Index plc is a subsidiary company of IG Group Holdings plc. IG Index has paid Edison to prepare and provide this material, but exercises no influence on Edison's comments or opinions or the particular shares it decides to feature. =
Theoretical portfolio Prepared by Edison Investment Research on behalf of IG Group.
IGG UK Theoretical Portfolio Performance: In the period from 6 August 2009 to 3 September 2009 the FTSE350 index rose by 3.8% (Price Index, excluding dividends), while our model portfolio performance was -0.1%. In the past month, the best performers in the portfolio were pawnbroker H&T, own brand personal and household products company McBride, medical technology company Smith & Nephew and insurer Beazley, and the worst performers were solar power semi-conductor maker PVC Solar, HSBC bank, and processed meat producer Cranswick. Despite the dismal performance in the recent rally, we feel that in light of our expectation of a near-term UK equity market correction in September/October, it is best to maintain the defensive stance of the portfolio, which is overweight on consumer non-cyclicals with relatively stable earnings and strong balance sheets, and to non-life insurers, which is a deep value sector enjoying premium increases. Exhibit 1: Additions to theoretical portfolio Ticker Company Name Motivation
TSCO LN Tesco Plc In a weak economic recovery food retailers should outperform general retailers. About a quarter of Tesco’s revenue is foreign, which suits our negative outlook for sterling. The stock has underperformed in the rally of the past six months, but as we expect a market correction we are happy with its beta of 0.9 and stable earnings growth record. Sales growth is strong, driven by Tesco’s Value lines. Tesco is moving into financial services with an untarnished reputation and is in a good position to grab market share. P/E of 12.3 with 10% near-term earnings growth and upward recent revision. Well covered dividend.
DPH LN Dechra Pharma Plc Excellent full year results (to June 2009) reported on 1 September: Revenue up 15%, adjusted operating profit up 30%, adjusted pre-tax profit up 39%. Strong cash generation, financial strength gave management the confidence to raise the final dividend by 11%. It is launching new products internationally to meet growing demand. P/E is 16.6 times; expected near-term growth about 16%. Good results and outlook led to strong upward revision for current and next year’s earnings.
AMLN LN Amlin Plc Amlin reported a 54% increase in first-half net income boosted by increased gross written premiums and a doubling of investment returns. Pre-tax profit rose 29% to £177m (consensus estimate was £133.5m). The CEO says the pricing environment is continuing to improve gradually, and he anticipates strong premium rises for aviation insurance. He says they are not seeking acquisitions. He has a conservative investment stance, and is not going to increase equities exposure. P/E of 8, near-term earnings growth forecast of 16%, yield of 5%. Recent four-week upward revision of FY2 EPS of 3%.
STJ LN St James Place Plc Wealth management businesses are struggling, but will gradually rebuild their assets under management, helped by the recent market rally. First half operating profits fell by 11%, but over the coming year they will add absolute return and bond products to attract a new group of customers whose objective is capital preservation. New inflows grew by 25%, countering weak markets, so that AUM fell only slightly to £16.9bn from £17.2bn last year. Value has been outperforming Growth recently in UK equities and STJ is very cheap relative to peers: P/E of 8.2, growth of 10.8, probably understated. Schroders is on P/E of 23, Henderson Group on P/E of 18, both with higher expected growth than STJ, but probably over-optimistic. STJ is 60% owned by Lloyds TSB, which is selling its larger asset management subsidiary Insight. Probably would not sell off STJ near-term, an indication that it is undervalued.
Exhibit 2: Removed from theoretical portfolio Ticker Company Name Motivation
PVCS LN PVC Solar Plc Sales were down 3.7%, much better than the -10% guidance in May, but this was just management engineering a positive surprise. Pre-tax profits were €22.2m vs €52.8m a year ago. Losing support from brokers, GS cut most names in the solar sector to sell, and cut PVCS from buy to neutral. RBS cut PVCS to sell. The share price is bouncing on better than expected sales results, and we are using this as an exit opportunity. Unrelenting downward earnings revision. The capacity overhang and sharp pricing pressure in the solar sector will persist into 2010. Negligible yield to compensate.
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T=pÉéíÉãÄÉê=OMMV 3
=Exhibit 3: Theoretical portfolio valuation, growth and risk metrics (priced as at4 September 2009) Ticker Company Sector Industry Price
Exhibit 7: Global macroeconomic summary September 2009 US UK Europe ex UK Asia
GDP growth
Q2 GDP fell 3.9% y-o-y but only fell 1% annualised q-o-q (-1.5% forecast; Q -5.5%) helped by government spending, consumption supports: cash for clunkers, homebuyer incentives. July consumption growth slowed and consumer sentiment fell. Q2 house prices rose 2.9% and July home sales rose 7.2% (existing) and 9.2% (new homes). Q3 growth of 2.9% expected; ISM shows manufacturing expanding, on restocking production. Strong July factory orders.
House prices are up 2.6% over the past three months; mortgage approvals are at 14-month high, though only at 10% of pre-crunch levels. The economy contracted 0.7% in Q2, while other economies grew. Q2 business investment fell by 4.5%. Consumers are repaying debt at a record pace, limiting discretionary spending despite low interest rates, falling petrol and utility bills. July manufacturing unexpectedly contracted, ISM 49.2.
The eurozone recovery is gaining momentum; it grew 4.7% in Q2 y-o-y. French and German recessions ended in Q2 on strong export demand and recovering service sector, boosting eurozone business confidence. Industrial goods new orders rose 3.1% in July. Germany is replenishing low inventories. Consumption remains weak. Exports to China were +40% in H1. Optimism has not yet spread to Russia, where the economy is contracting after 7% average growth 2003-07.
Japan: Stimulus package and exports have pulled Japan out of recession. GDP +3.7% (+3.9% expected) annualised in Q1 to June after falling 11% in Q4. Growth slowing in Q2 on falling business investment. July production grew at slowest pace in four months as restocking dissipates. China: High H1 loan volume supported strong August manufacturing output, export orders. August PMI 54 is expansionary, but lending curbs should challenge 8% 2009 GDP growth target.
Employment and wages
The pace of firings is slowing as housing and manufacturing stabilise. The effect of auto plant shutdowns is out of the data. Fed, Treasury expect jobless rate to peak in H210 at 10%. No upward pressure on wages. Payrolls down more than production: productivity gained 6.5% in Q2, better than expected.
The unemployment rate is 7.8% overall, but 20% for the under 25s. Youth unemployed for 12 months will qualify for government-sponsored work placements to avoid potential disadvantage later. Further job losses in manufacturing and services could pull the jobless rate above 10%. Fear of losing jobs is inhibiting consumer spending.
Eurozone unemployment is expected to rise from current 9.4% to 11.5% next year, which will cause retail consumption to lag the manufacturing recovery. The German government is subsidising the wages of 1.4m short-time workers (equivalent to 400,000 workers) supporting consumption. The end of the car scrapping scheme will see further redundancies.
Japan: The jobless rate rose to 5.4% in July. Wages fell by 7.1% y-o-y including a fall of 14% in bonuses. No wonder the new government prioritises shoring up consumption. China: The lending curbs will bring more unemployment and downward pressure on wages.
Inflation/interest rates/currency
With recovery beginning, debate over ending stimulus measures begins. The Fed voted not to increase its $1.75tn asset purchase programme ($300bn Treasury bonds and $1.45tn mortgage debt), but pushed the completion back to October will decide then whether to expand asset purchases. The dollar has stabilised recently as investors shun expensive risky assets such as Chinese equities.
On August 6 the BOE surprised the market by adding £50bn of bond purchases to the QE programme, now £175bn, in order to expand money supply and shorten recession. Lending to companies fell 1.7% in June. First rate hike expected in Q210, later than in the US and eurozone. Sterling weakened in August and we expect further weakness on negative real interest rate and dire public finances. The Treasury may want the BOE to delay rate rises, to inflate away the real value of debt.
Eurozone: August CPI estimated at -0.2% vs July -0.7%. PPI down 8.5% y-o-y. The ECB believes inflation will turn positive by year end. IMF says that the ECB should not set 1% as a floor. The euro should find support in its relatively good real interest rate, and better public finances than the US, UK and Japan. Eastern Europe: The Rouble is weak as Russia may lower interest rates by 25bps to 10.5% in September to fight economic contraction despite 12% inflation. Hungary cut its rate from 8.5% to 8.0%.
Japan: Despite export recovery, persistent weak consumer demand has seen Japanese deflation fall to record 1.8%. Yen/US$ has strengthened to a seven-week high on exit from recession and on first change in ruling party in 50 years, but now policy uncertainty could prompt weakening. China: Deflation is unlikely to persist as growth picks up and excess capacity is stemmed by lending curbs. New loans in July fell 75% from June.
Source: The Economist, Financial Times, Bloomberg
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8 7 September 2009
Commodities
With no pressure on wages owing to high unemployment, the main possible source of possible cost-push
inflation is commodity prices. Industrial metals and oil are aligned to Chinese industrial production in particular.
Industrial metals prices have risen lately on Chinese restocking, but now that this has run its course the
momentum could wane. The last day of August saw a drop in global equities and also in copper, zinc and oil.
The curbs on lending in China, the second largest energy consuming country, have caused crude price to dip
below $70. Despite the Chinese growth slowdown, oil price will probably not drop. Oil producers are reining-in
production to reduce excessive inventories. Russia has said it will cut production to support OPEC’s
reductions.
Marubeni, a Japanese rubber trading firm expects that after near-term weakness, the price of rubber should
rise by 19% by the end of 2010 on strong Chinese auto sales, which rose 71% y-o-y in July on tax cuts and
government subsidies. Besides accelerating Chinese demand, new car-buying incentive programmes in US,
Japan and Germany are adding to demand for rubber.
Soft commodities are less affected by the global economy and more by supply and weather. Technicians are
positive on wheat, which is turning up from low prices. Sugar prices have surged in the past month.
Sterling’s recovery from its crash in the later part of last year has been interrupted over the past four weeks. It
lost around 3% against both the dollar and the euro in August. The recovery of sterling after its steep
correction last year faltered in August, as the UK’s economic recovery lagged behind the US, Germany,
France and even Japan, which all posted positive GDP growth last quarter while the UK economy contracted
0.7%. Reflecting concern over the depth of the UK recession, the BoE added £50bn to its QE programme and
three Monetary Policy Committee (MPC) members, including Chairman Mervyn King, voted for £75bn. It
seems the intention is to weaken sterling to support exports and to inflate away the real value of the public
debt in the way Japan has tried to do. The immediate response to the BoE’s QE expansion has been
successful – inflation has stopped falling and the pound has lost a few per cent against other currencies.
UK Chancellor Alistair Darling attempted to shore up flagging confidence, saying he was confident of a return
to growth and sustainable recovery around year end. He stated that the government was prepared to spend
whatever it could to end the recession and reduce unemployment, and aims to halve the deficit within four
years. Darling also pledged a further £7bn on top of a £9.2bn pledge in April to the IMF to support the
emerging markets that were worst affected by the financial crisis. In fact, the IMF has expressed concern over
UK public finances and the impact of the UK house-market crash on the UK economy.
While the US, China, Japan and the eurozone are all in deflation, UK CPI inflation remains positive and has
stopped declining, possibly owing to the weaker sterling y-o-y. From an interest rate parity viewpoint, sterling’s
negative real interest rates make it unattractive relative to other economies, such as US and Japan, whose
deflation renders even their lower nominal interest rates positive in real terms. The eurozone and Canada also
have better real rates than sterling. News that Germany and France have emerged from recession has helped
the euro to break out against both the dollar and sterling in the past few weeks. The Canadian dollar has the
attraction of Canada’s very small budget deficit, a legacy of the commodities boom.
Given the BOE’s negative outlook, interest rate rises are likely to occur later in the UK than in the US, where
fears of reflation are beginning to brew, and the eurozone, where the ECB’s vigilance could return, but only
once Germany and France’s recoveries from recession spread to more eurozone countries and appear to be
durable. Even the ECB’s tough inflation fighter President Trichet is unwilling to declare victory over the
recession just yet. The G20 meeting this weekend might discuss exit strategies, but it is premature for any
action in the way of higher interest rates and public spending cuts.
The yen has climbed to a seven-week high on the recent election to power of the Democratic Party of Japan
(DPJ) ending over 50 years of almost unbroken LDP, ie Conservative rule. Cash exiting the Chinese stock
market has flowed into the yen in recent weeks, although a wider exit from global equities in coming weeks is
more likely to favour the euro as a safe haven. Moreover, the yen could weaken near term on doubts as to
whether the new DPJ’s policies of supporting the consumer while cutting waste in government spending will
achieve a reduction in the Japanese budget deficit.
The August correction in Chinese equities coinciding with stabilisation and appreciation of the dollar are the
first signs of a waning of risk appetite and a preference for safe haven assets.
In the face of criticism of inviting hyperinflation, the Fed declined to expand its programme on 12 August,
although it allowed for a decision to be taken in October. Alan Greenspan expects inflation rise to above 10%
if the Fed maintains its current debt level and does not raise interest rates soon.
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10 7 September 2009
Exhibit 9: Currencies
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Source: Thomson Reuters
Fixed income
In the medium term, the UK Treasury prefers that the BoE will follow an easy policy, allowing inflation to
reduce the real value of the enormous deficit. However, in the near term the QE expansion has made us
bullish on bonds, especially as the preference last month for £75bn rather than £50bn expansion by Mervyn
King and other MPC members suggests an imminent further expansion to the QE programme if UK economic
recovery falters. The IMF estimates that QE is responsible for keeping long-term gilt yields 40 to 100bps lower
than they would have been otherwise, so we believe gilts have further to run over the near term. Our view is
compatible with a negative near-term stance on equities, in that bonds may once again serve as a safe haven.
Exhibit 10: Steep UK and US yield curves
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Equities
Stock markets tend to recover by an average of 20% before the end of recessions. This recession, typical of
recessions brought about by financial crises, has been longer and more severe than average, even assuming
it is V rather than W shaped. The global recession from which we are emerging is certainly the most severe
since the end of World War II. We have had an enormous relief rally since 9 March of on average twice the
normal 20% pre-recovery rally and more for some major markets. From market valuations priced for disaster,
markets were propelled by positive earnings surprises which, in turn, motivated upward earnings revision.
Economic data indicating that the combination of bank rescues, QE and government spending programmes
have succeeded in averting a 1930s style depression.
With this eventuality dismissed, the recent six-month market rally was led by weak companies that had been
priced for failure (the dash for trash). Steep yield curves supported bank profits and the likelihood that no
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7 September 2009 11
further Lehman failures would be allowed to occur propelled bank shares to lead the recovery. The turnaround
from losses last year to profits in the first two quarters in the banking sector bolstered overall market H1 profit
growth. In addition to interest margins, investment banking fee income is also reviving. Barclays and HSBC
both doubled their earnings in their investment banking units in the first half, off low bases last year.
According to Nomura, global GDP growth is expected to recover from -1.2% in 2009, to 3.4% in 2010, and
4.2% in 2011, including the high growth of China and India. Growth in the first year out of recession is
historically stronger than this, even though in the past the weight of high-growth emerging economies has
been much smaller.
Some economists think this means there is scope for upward revision for 2010 GDP growth. However, further
out, probably over the next decade at least, they believe secular trend GDP growth will be curtailed by:
• high long-term financing costs as government borrowing crowds out the private sector;
• higher taxes, eg in the UK the recent 2p rise in fuel duty and a return to17.5% VAT in the New
Year are just the beginning;
• reduced public sector spending and jobs starting in 2011, once the current stimulus packages
have achieved a rescue;
• the end of incentive schemes such as cash for clunkers currently supporting consumption; and
• demographic factors: the end of peak consumption years for the baby boomer cohorts.
As in the aftermath of most recessions, cost cutting during recessions, combined with return of demand and
improved operational leverage, can boost earnings dramatically. Additionally, eliminating some competitors
can give improved pricing power to the survivors in concentrated industries. However, after this initial fillip,
over the next few business cycles we expect EPS growth to reduce below the growth of the last couple of
cycles in line with our scenario of reduced nominal GDP growth. In recent business cycles EPS growth has
been supported by anti-dilutive effect of share buybacks, whereas recently growth has been subject to the
dilutive effect of rights issues. With credit markets likely to be tight for a long time, companies will want to
preserve cash and are unlikely to restart share buyback programmes any time soon. Companies might also
continue to cut dividends.
Significant further appreciation will require upside earnings surprises in Q3 and upward revision of full-year
2009 and 2010 earnings. We feel that current equity market valuations do not fully discount our expectation of
muted long-term earnings growth. The consensus growth for FY2 and FY3 are influenced more by previous
cycles and incorporate too low a probability of a W-shaped recovery. The current consensus counts too much
on a V-shaped recovery and relies too heavily on Bernanke’s recent statement that the “economy is levelling
out” whereas previously he said it was “contracting more slowly”. These large positive earnings growth figures
for FY2 and FY3 are vulnerable to downward revision.
After the rally, P/E ratios on current-year forecast earnings, even after being revised upward, are not cheap at
15.9 for the US, 15.6 for the UK, and so on (see Exhibit 11). Price/book values of global equities including
financials are below, and exclude financials at the low end of the range of the past 20 years, according to
Nomura’s analysis. Whether they are actually cheap or only appear so depends on the extent of further write-
downs to come. Royal Bank of Scotland Group and Lloyds Banking Group, the UK’s biggest taxpayer-funded
banks, may post a combined £17.7bn ($30bn) of write-downs on commercial and residential property this
year, according to Bloomberg News.
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12 7 September 2009
Exhibit 11: Equity fundamentals Note: * LTG = Median five-year annualised prospective % EPS growth. ** Coefficient of variation is the standard deviation /mean of FY1 EPS. The higher the number the more disagreement among the forecasts.
Fair valuation of a market is a function not only on the expectation of earnings growth, but also on risk.
Financials are a high-beta sector, having led the market down and then up in recent market cycles. As such,
their perceived risk is crucial to major developed markets. Despite partial nationalisation, banks remain a risky
sector. Although banks are likely to be bailed out if they look set to fail, so far there have not been enough
safeguards in regulatory reform proposals to avert future volatility in bank earnings. The UK’s Financial
Services Authority (FSA) has proposed higher reserve requirements for large banks, but its recent white paper
did not included credible sanctions to undue risk taking by individual bankers. The asymmetrical bonus system
continues – bankers and fund managers cash-in on outperformance without sharing the losses on
underperformance. Increased regulation is an added cost to the economy; ineffective regulation is far more
expensive. In recent months we said that less allowed leverage should reduce both the return and risk of the
banking sector. However, with ineffective regulation allowing the probable return of securitisation and new
forms of opaque financial innovation, the risk has not been eliminated. With the riskiness still inherent in this
sector, one could argue that the fair market valuation over a cycle may be higher than a year ago, but it is
lower than in pre-bonus culture/pre-globalisation era.
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7 September 2009 13
Equity market preferences
We find it difficult to justify overweighting the UK over the US at this point.
UK earnings growth is forecast as very negative and economic recovery prospects would be helped by
sustained housing market recovery. Delinquencies on UK residential mortgage-backed securities fell for the
first time in two years in the second quarter, a sign that interest-rate cuts are having some positive effect on
credit performance. The UK housing market is stabilising, but with mortgage lending still restricted and fixed
mortgage rates high, recent price increases which are concentrated in London might only be sustainable with
the help of foreign buyers attracted by a weak pound. The relative attractiveness of US equities has increased.
Forecast current-year earnings growth is positive for the US, including significant positive recent revision,
compared to -30% for the UK. There is also a much greater dispersion among the forecasters of UK earnings
estimates (coefficient of variation FY1). Next year’s US earnings growth is superior to that of the UK. Apart
from a superior dividend yield, we find few features that are more attractive in the UK equity market relative to
the US.
While other equity markets continued to rally in August, Chinese equities corrected by more than 20% and
tipped China into a bear market. The sell-off reflects fears that Chinese equities are overheating after having
surged over 100% from October 2008 to the end of July 2009. The rally has been mainly an expansion of
valuation multiples, which are way ahead of the expansion in earnings and book value. Restrictions in Chinese
bank lending to curb excess production capacity and property have made investors focus on fundamentals.
Their 21x earnings valuation might seem justified by their high earnings growth forecasts, but the challenge of
managing this economy is seen in 8% inflation turning to deflation within a year. Trying to reduce major
excess capacity and maintain the 8% growth target by lending curbs is fraught with risk. The Chinese equity
correction is unlikely to stop here.
Russian equities are on a modest valuation, but the value of the rouble and the recovery of earnings forecast
for next year after a dismal current year are entirely dependent on oil and metal prices. We are slightly bearish
on these, given reducing Chinese demand set to reduce before Western demand for construction takes off.
After the Chinese stimulus spending, big inventories of steel have built up. With the recently introduced
lending curbs, factory building will drop off and steel production will decline, reducing demand and prices of
iron ore, coking coal, manganese etc will fall, adversely affecting the Russian economy. Latin America has
fared relatively well in the recession but, there too, failure of the recovery in copper, demand for Chinese
construction, and a long wait before Western construction revives, will not be good for Brazil and other Latin
American equities.
September and October are, on average, negative months for equities. Following the strong rally of the past
six months caution is warranted. We would reduce any significant overweights in global equities, shifting into
UK bonds to benefit from QE purchases. Within equities we would overweight US and Indian equities and
underweight UK, Japanese and Chinese equities. While Japanese industrial production has risen 16% (58%
annualised) in the past four months, the equity market is very expensive. Within emerging markets, Indian
equities remain attractive on valuation relative to growth.
Eurozone equities are mixed. We would avoid Spanish and Italian equities, but French equities can be
overweighted, especially dollar earners such as luxury goods. The German market is expensive but has
exceptional growth forecasts for next year. Exporters such as chemicals and selective manufactured products
might be able to expand margins as well as gain market share if Chinese production is limited by lending
restrictions. However, with there still being a lot of excess production capacity, we cannot see the case for
machinery stocks outperforming unless valuation is very cheap.
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14 7 September 2009
Within UK equities, if sterling is set to fall further forex-exposed stocks, especially dollar earners, should
benefit. However, pharma and aerospace stocks are dollar earners, but US sales of these are subject to
respectively US healthcare defence policy.
With valuations generally high, we now expect value stocks to outperform growth as they have started to do
recently. Investors should also be searching for companies in concentrated industries that can increase their
market share as well as increase prices and margins following the exit of weak rivals.
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EDISON INVESTMENT RESEARCH LIMITED Edison is Europe’s leading independent investment research company. It has won industry recognition, with awards in both the UK and internationally. The team of 50 includes over 30 analysts supported by a department of supervisory analysts, editors and assistants. Edison writes on more than 250 companies across every sector and works directly with corporates, investment banks, brokers and fund managers. Edison’s research is read by every major institutional investor in the UK, as well as by the private client broker and international investor communities. Edison was founded in 2003 and is authorised and regulated by the Financial Services Authority.
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