Shares Magazine – Mr Markets
11 September 2009
The Recovery Years: In for a good time, but not a long time?
Stock markets turn and anticipate recovery when monetary authorities panic and take extreme measures. The recovery phase is always led by smaller quoted companies. They tend to be more heavily weighted to economically sensitive businesses. Market psychology changes dramatically to favour the most risky companies as the mood changes from pessimism to optimism. A dramatic cut in base rates sparks this turning point and is indeed a true leading indicator. The pattern in 2009 follows almost exactly that of 1992/3 when the unceremonious departure of Sterling from the European Monetary System enabled the then Chancellor of the Exchequer Norman Lamont to halve base rates quickly. Smaller Companies doubled over the next 18 months. Likewise, the Long Term Capital Management crisis of mid-1998 sparked sharp rate cuts pushing smaller companies to a near 70% rise over the next 18 months. This time around smaller companies bottomed on the 21st November 2008, well before the main market. Using the 18 month recovery analogy, this Bull Run in smaller companies could continue into July 2010. Given the scale of the monetary easing and the scale of the preceding bear market, it’s surely not unreasonable to think that this time the smaller company bull run could top 100%, giving us another 30% upside from here over the next 10 months or so. None of this type of analysis requires a Ph D in Economics but the correlation is clear.
Balance sheet destruction and repair
The financial crisis as well as destroying balance sheets in the banking sector caught many companies generally in the more cyclical sectors with their trousers down financially. The balance sheet repair process in the UK has been impressively swift, with £54 billion of new equity being raised in 2009 to the end of August. There have been 28 Rights Issues and 21 other issues of over £100m. More money has been raised in 2009 than any of the previous 10 years. Retailers, real estate companies, house-builders, plant hire companies, engineers, leisure and media have all arrived cap in hand asking to be bailed out often by existing shareholders in distressed equity fund-raisings. For existing shareholders who have been unable to take up their rights their stakes will be largely wiped out by the deeply discounted nature of many of these share issues. In the past such value destruction was normally accompanied by chief executives falling on their swords. However, subscribing for these new shares has been a sure fire way of making spectacular returns in the last few months. It could well continue to be a winning strategy right through until the end of this recovery phase.
A good year for the bankers
Investment bankers have thus had a bumper year as they collect fees as a proportion of the new money raised. And it gets even better for the bankers. Mergers and acquisitions will come along as trade buyers become more certain of the recovery and buy their competitors before the price goes up. Kraft’s attack on Cadbury’s may be the first of many. The icing on the cake for the bankers will be the arrival of the “new issues” bandwagon just after the start of 2010. This in turn will bring relief to private equity firms who can then unload debt laden companies from their ravaged portfolios on to a stock market eager for cyclical nuggets.
Quality left sitting on the fence
While all this has been happening the real smaller company gems have been left on the shelf. What I mean by that is the “larger companies of tomorrow”, the mould breaking, high quality growth companies. They are quietly being de-rated as investors rush for trash. It includes companies that have harnessed new ways of doing business, giving themselves a competitive advantage over their competition. Their growth is self financing, their balance sheets are robust, their profit margins are prodigious, their profits are predictable and their dividends are mouth watering. It would include such gems as Abcam online antibody distribution, Asos in on-line clothing, Paddy Power on line sports betting, Hargreaves Lansdown in financial planning services, Victrex in high performance polymers, Chemring in countermeasures and Fidessa in dealing room software. These companies are good for the long term.
What is more, in the recovery sectors surely it is right to back those operators that have managed to steer their firms through the crisis without resorting to the highly dilutive distressed share issue which should be very much the last resort. Take real estate for instance, my favoured picks would be seasoned operators like Shaftesbury Derwent London, Big Yellow and Hansteen, all of whom anticipated the downturn correctly and didn’t bet the farm with debt.
The short term may well be more exciting with the distressed operators but you do have to remember when its time to get off that donkey and back on the quality growth train for the longer term. The expression “investing for a good time, not a long time” springs to mind.
Harry Nimmo, Manager of Standard Life Investments’ UK Smaller Companies Fund, Standard Life Investments
This article was first published in Shares Magazine on 17th September 2009.
