19th May 2013

The panel discussion danced around many and varied subjects, and as always, these notes are just a flavour of what was raised at the meeting.

Japan

So closely fought has been the recent race between global currencies to devalue that none have appeared to be very successful. That was until Japan entered the fray in the second half of 2012. It now seems that there is to be a clear winner, with the Japanese yen off 25% since September. The long term impact on Japan’s economy is uncertain as QE ought to provide a fillip in the short term, but longer term the economy will only benefit if it proves successful at generating domestic demand. In the shorter term, there are a few direct implications that have not received sufficient coverage in the panel’s view. The first is that it is very bad for markets that have to compete with Japan, especially emerging ones. Korea is the worst hit, but even the likes of Germany are also likely to find exports suffering. Another point is that it is deflationary for the rest of the world who can take advantage of the cheaper goods priced in yen. For those expecting global QE to create inflation in the longer term, that wait may be getting longer as inflation is actually decreasing (down from over 3% to nearer 1.5% in the US), and there is no evidence (as yet) of a significant increase in lending to offset the short term deflationary pressures.

Various Opportunities

The whole panel were agreed on one point: that there are not very many attractive investments for those seeking value. With that as a proviso, we discussed several opportunities specifically.

Perhaps the recent move in the gold price can best be explained by three points: inflation has been decreasing (the price of gold is positively correlated to inflation); US real interest rates are increasing (also as a result of inflation decreasing); and the dollar has strengthened (which impacts the price of gold in USD). Gold mining stocks have struggled, and given the discrepancy in performance of that sector with that of the gold price in the last 10 years, it has become a much more interesting. The panel all favour miners that have assets in “safe” jurisdictions (essentially either in North America or in Australia), but even then, whilst some of the miners are trading at a discount to NPV using the current gold price, they might not be if there is any significant weakness from here. Perhaps the margin of safety is not as large as it at first seems.

The oil industry (oil majors in particular) is also an interesting area. It has underperformed the wider market significantly in the last 4 years, but it is interesting to note that at the bottom of all major bear markets of the 20th century, oil was the largest market sector. In other words, it has a history of holding up well in bear markets. Those worried that the recent bull market may not last forever should take note.

Finally, house prices were also touched upon, alongside the fact that REITS have had a phenomenal run since 2009. For several reasons, the panel see this as one of the most dangerous investment classes available. First, rental yields look cheap versus bonds. However, when bond yields are artificially low, REITS look artificially attractive. Secondly, they are highly vulnerable to an economic slowdown – this does not seem to be priced in. Thirdly they are trading at peak prices, despite rental yields being near all-time lows – a sign that the market is not entirely rational.

In short, the search for companies yielding double digit returns (in operating or cash flow terms, not necessarily in dividend or capital gains terms) is not easy at present. For the time being, opportunities are rare and very specific.

Peter Hollis, Russell Napier, Angus Tulloch and the Kennox investment team.

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