Tony Yarrow's Investment View - March 2009

Written by Admin, 09 March 2009

All The Signs Of A Major Turning Point

When you’re going through hell, keep going’-Winston Churchill

As usual, this blog will summarise today’s economic and market conditions, and give a summary of how we see things going forward. Amid the gloom, there are a number of positive signs, which are discussed below.


It is heretical these days to say anything positive about anything financial, and I feel I should apologise in advance for doing so. But the fact is, good things are happening, they just don’t get reported. I came across a good example in this morning’s Financial Times, which said that the gloomy mood has been underlined by a comment from Warren Buffett, ‘still easily the world’s most respected investor, that “ the economy had fallen off a cliff”’. Buffett is of course correct in saying so, but he went on to say (not quoted in the FT) ‘America’s best days are ahead…everything will be all right.. we do have the greatest economic machine that man has ever invented’

It is certain that this crisis is incubating the next recovery. We at Wise want to own the durable assets that will lead that recovery, and we want as many as possible of our clients to share in the benefits of the recovery when it comes.

If you miss the recovery, through having given up in despair, the media won’t apologise to you for the state of mind they helped to create. They will be too busy telling you how they predicted recovery all along.


The world economy stalled in late September. The whole western banking system was on the brink of seizing up, it became clear that the authorities weren’t in control, and we all stopped spending money. The result has been a collapse in economic activity, especially in ‘big ticket’ items such as cars, houses, and investment expenditure. Governments and central banks have been desperate to halt the downward spiral, but with no noticeable effect so far. Surprisingly, there has been no ‘Obama effect’. Obama’s first big project was to pass a comprehensive programme through Congress, including tax cuts, measures to support the banks, and ‘shovel-ready’ plans for improving roads and bridges, at a cost of $850bn. No one appears to believe that these measures will succeed, given the vast scale of the problems, and the world’s stock markets have continued to fall, accelerating if anything over the last couple of weeks.


Today’s problems have been caused by too much borrowing and not enough saving. Cash is king, and woe betide anyone who is short of it. Banks need cash, as do property companies, car manufacturers, an increasing number of national governments, and millions of their cash-strapped citizens. But if you have cash, it’s hard to know what to do with it. If you keep it on deposit, the rate you receive is minimal, and you can’t be sure how safe the bank is. Government stock pays next to nothing, corporate bonds carry a risk of default, while shares and property appear to be in an endless downward spiral. Gold pays no income and its price is moved by the whims of speculators.


As a company which spends a lot of time recommending shares as investments, Wise Investment has an interest in the stock market going up. From this point of view the last decade, in which the stock market has fallen by around two-thirds, adjusted for inflation, has been a big disappointment. So is the market cheap now? Yes, but it isn’t quite that simple. No one makes money out of investing in bad companies, or in good ones when they’re too expensive, and we always try to avoid these areas. A bad company is one that isn’t being run for the benefit of its customers, staff and shareholders, and a good recent example is Royal Bank of Scotland, whose former Chief Executive, Sir Fred Goodwin, has been in the news recently. Sir Fred’s aim appears to have been to expand the company at all costs, regardless of the quality of the business that was being taken on, a risky strategy at any time, but disastrous in 2005-7. If a company is being taken in the wrong direction, then shareholders suffer. Warren Buffett puts this bluntly ‘You can’t do good business with bad people’. We believe that people are more important than numbers, and we still believe that over the long term it is possible to make superior returns by investing in shares, so long as the companies are well-managed, and held through funds that are well-managed. The qualities that make a good fund-manager are the same as those that make a good business manager, and include dedication, sanity, patience, and a commitment always to act in share-holders’ best interests. Good fund managers tend to stay in their posts for a long time, usually decades. We believe that our competitive advantage over time comes from finding fund managers with such long-term attributes, , rather than flashier qualities such as good presentational skills and short-term performance based on following the fashion.

Not all companies are bad. An example of a good one is the housebuilder Berkeley Homes. Berkeley saw the top of the cycle in July 2007, and sold most of its land bank then. Times are hard, and trading is slow, but the company is sitting on a pile of cash which will buy land at knock-down prices in the next twelve months. The market has recognised this, and from a low point in July last year, the share has risen by around 45%

At times of crisis like this, it is important to know what we own very well, because our patience is tested to the utmost, and we need to know that our holdings are strong enough to survive and prosper. At Wise we have recognised the need to strengthen our capacity in this area, and have appointed Ben Peters, who with his DPhil in biochemistry has brought us scientific analysis and advanced computer skills, together with a deep interest in the workings of markets. We will be strengthening our research team further with a new appointment in the near future.


Bonds are less risky than shares. Bond payments are legal obligations for companies, whereas dividend payments are not. Investors in bonds, so long as things don’t go wrong, get a fixed return on their money. Shareholders stand behind bond-holders in the queue for rewards, but can potentially do much better. If things go well, shareholders are rewarded with rising dividends and rising share prices. That is far from what’s happening at the moment, so the market law which says that you get paid to take extra risk appears to have broken down. The extra risk you take when investing in shares has not been rewarded at all for a long time, and over the last decade the best investment would have been the safest one, government stock. Corporate bond investors point out that the actions that companies are taking now are favouring the bondholders at the shareholders’ expense. An example is Land Securities, who have just announced a rights issue to raise cash, and at the same time cut their dividend. The rights issue will strengthen Land Securities’ cash position, making the payments to bond-holders more secure. Meanwhile shareholders have to pay for extra shares, or see their holdings diluted, while receiving a lower dividend in return.

The last ten years have been a nightmare for anyone who invests in shares, but we think a major turning point could be at hand. We also like corporate bonds, so long as the issuing companies are sound.


Some of us thought that the collapse in prices in October/November would be the end of the bear market, encouraged by the extremely low valuations and the fact that revered investors such as Warren Buffett and Anthony Bolton thought so too. This has turned out not to be the case, but the sell-off has been different this time round. Stock market falls in 2009 have been concentrated in the areas of greatest concern-anything to do with debt, financial commitment, borrowing against assets, and property. There seems to be no floor for the shares of banks, life insurance, property and private equity companies. But the rest of the market hasn’t been affected much, including such formerly hated sectors as retailing (Marks & Spencer shares are up 18% since the beginning of October, for example, while the UK stock market has fallen 27%) What this appears to mean is that in most sectors, investors feel that the woes are already priced in. The financials, though, are in the eye of the storm, and are very hard to value. On the other hand, financial shares can’t fall  too much further ( you can buy Land Securities’ shares today, for example, costing 32% less than what you would have paid for them on July 16th 1987) and as they fall, they represent less and less of the overall market.


I have never seen anything like this crisis, and can’t pretend to know how it might play out. But, apart from Cuba and North Korea, we are in a capitalist world now, for better or worse, and the solution to the current problems is likely to be a capitalist one. People like to point to the similarities between the world today and Japan at the beginning of its ‘lost decade’ in the early 90s, but the main difference is the vigour with which the authorities have responded to this present crisis, having once realised its full magnitude. Of course some of the measures being taken now will not work, and there are unintended consequences, not least the effect of punishing savers when it’s clear that we need more saving rather than less. However, it is hard to believe that monetary easing on the current scale will not have some effect, even though that is what many investors appear to think. Monetary stimulation typically takes around a year to work, and until the effects are felt it is easy to believe that it won’t work this time round. In the aftermath of the tech-bust, Alan Greenspan cut US interest rates to 1% at the start of this decade. For a long time nothing happened, so rates were kept low. What followed was a recovery that turned into the bubble that is now unwinding around us.

The announcement of the details of the Quantitative Easing programme (known as QE or ‘printing money’) had an immediate effect last week. The Bank of England is going to buy government stock (‘gilts’). On Thursday and Friday gilt prices, which had been drifting downwards, shot up, exactly as the authors of the policy intended. Long gilts now pay  0.67 of the UK stock market yield, the lowest this ratio has dropped for over 50 years. This is despite the stock market yield being reduced by substantial dividend cuts, mainly the banks, which are likely to be re-instated in due course. The stock market is blindingly cheap just now, but it will probably stay this cheap till investors begin to see an end to the downwards spiral.

Will the spiral end, and if so, how? The world economy stalled because bank lending dried up, and because of the extent of the problems in the financial system. These problems won’t go away quickly, though in due course the stimulation will help. In the last six months, we have all had to adapt quickly to an unfamiliar and harsh economic environment.  Businesses and households alike have had to cut spending deeply and quickly. That has already happened. What happens next will either be a further ratcheting-down of the spiral, or a gradual bottoming out, now we have learned to cope with the adverse conditions of the slump.

The Asian economies could be the leaders out of recession. They were growing too fast, their stock markets were over-valued, and they needed to slow down. China needed to address the environmental and social problems created by two decades of rapid growth. However, Asian economies don’t have the huge debt problems and bankrupt banks that we have in the West, and Asian governments are better funded and better able to apply economic stimuli. China announced last week that its economy has stopped contracting. We may not believe the numbers, but the commodity markets appear to support them. The prices of major commodities such as oil, copper and aluminium have stopped falling, indicating that supply and demand are more or less in balance, and indeed copper, oil and the Baltic Dry index ( an index of the cost of shipping dry bulk goods) have been rising for the past few weeks.

In the UK our weak currency will be helpful for our manufacturing businesses ( still almost 25% of GDP) and tourism.

One should not underestimate the tendency of adversity to bring out the best in people. Most of the business people I know are grimly determined to get through this, and are working longer hours for less money. Will that have an effect across the economy? It should do. The housebuilder McCarthy and Stone almost went bankrupt in the early 90’s recession. The company decided it would never again borrow money, and turned itself into the highly profitable retirement homes company that became a household name. In the process the share price rose from 20p in 1992 to £ 8.00 at the time of the takeover a couple of years ago.

Sentiment is an important indicator. Assets are cheapest when everyone hates them, as now. The Guardian on Saturday carried an article saying that shares are a ‘con’.  It featured someone who had been investing in a low-cost index-tracking fund through a regular savings plan for the last ten years. After ten years, despite the low charges of the tracker, and the benefits of pound-cost averaging, which works in favour of regular savings, the investment was worth around 7.5% less than he had paid in. What wasn’t mentioned was that the returns in the ten years up to 1999, when he started, were extremely attractive, which was the reason why he took the plan out.

A graph on the cupboard behind me shows that on the five previous occasions in the past two hundred years when the US stock market’s returns were as poor as they have been in the last decade, exceptional returns followed.

While investors have every reason to feel disillusioned, it is heartening to know that all the professionals we most respect believe that the market is very attractive now, always with the caveat of the need to be selective. These include Warren Buffett, Neil Woodford, Anthony Bolton, Barton Biggs, Crispin Odey, and Dr. Sandy Nairn of Edinburgh Partners, who recently wrote an article called ‘The Risk Today is Not Buying Cheap Equities’

Another indicator which has been consistently positive throughout the nightmare of the last six months has been the ratio of directors using their own money to buy shares in their companies to those selling. Last week directors in thirty-six companies were buyers of their shares, while the directors of four companies were sellers, a ratio of nine to one. This ratio has never been lower than six to one since last summer. Over time this ratio has been a consistently accurate predictor of value.


Though it would have been hard to have avoided all losses over the last two years, it has to be said that my errors and failures of judgement haven’t helped. These errors have lost you-and us- money. Above all, we must learn the lessons of our mistakes.

Going into the credit crunch, I believed that commercial and residential property were over-valued, but that the stock-market, apart from certain obviously expensive sectors (property, mining, emerging markets) was reasonably valued. Property, after all, had trebled in value in a decade, while the stock market was still below its 1999 peak level in June ’07. In the event, the stock market (down 47%) has fallen by even more than commercial (40%) or residential (20%) property. As a result, we have kept too much exposure to shares and called the bottom far too soon. Also, we weren’t able to know till far too late just how much trouble the banks and other financial institutions were in. The defining feature of this slump has been over-indebtedness, and we would have limited losses much better by avoiding anything that could be affected by the level of debt in the economy. It is clear now just how insidious debt is-it can affect you in so many different ways. As a company, you may be debt-free, but if your customers are over-indebted, and stop spending, you get pulled down anyway.

In the funds, we have been exposed to areas which have been decimated by the market because of worries about debt and valuations-private equity in Wise Investment, and property, banks (till we saw the light last spring) and insurance companies in Wise Income.

Recently, however, the story has begun to turn a little more positive, with both funds considerably out-performing the stock market over the past three months.


Wise Investment has a more concentrated portfolio now than in recent years, with the top 13 holdings representing 62% of the fund by value. Over the three months from December 8th to March 6th, while UK stock market has fallen 17.1%, six of our top holdings have risen, while the worst performer (Invesco Perpetual Income) is down 10.6%. Overall the fund is down by 3.9% during this period.

It is pleasing that the recent sell-off has virtually missed UK smaller and medium-sized companies, which have been among our best performers.

The worst performers have been private equity companies, especially 3i, Candover and Pantheon. These three holdings comprise around 3% of the fund. Our other, larger, private equity fund holdings, HG and Graphite, are cash-rich and have done much better. There will be some real bargains for these companies to pick up as the year progresses.

TB Wise Investment continues to hold little cash, preferring to invest in funds which hold cash themselves, and can deploy it as opportunities arise.

Despite the appalling economic backdrop, it looks right to stay  more or less fully invested in shares, which continue to be by far the best value asset class, using market weakness to improve the portfolio quality as and when we can. The lesson of the last two years has been the need to be extremely discriminating, to take nothing on trust, and do as much research as possible.


Over the past three months, Wise Income has fallen 9.9% compared to a fall of 17.1% for the UK stock market.

Performance has been held back by negative sentiment towards several shares the fund holds, in particular Legal & General, Aviva, Land Securities and BT, all of which have fallen sharply over the past few weeks. These shares are all extremely cheap now, and unless they become insolvent have significant recovery potential.

Dividend income has held up reasonably well. For the four payments commencing with the ex-dividend date May 31st, we anticipate a payment of 5.09p per share, which is a reduction of 4% from the total of 5.3p paid in 2008.


Aviva is an area of great disagreement among investors. The company is either in deep trouble, or unbelievably cheap. The company announced full-year results last week, which were not well received, and held its dividend at the 2007 level. The current dividend yield is 20.9%


Aviva is the UK’s largest insurance company, comprising the old Norwich Union, Commercial Union, and General Accident. The company offers general insurance (cars, contents, etc) life insurance, pensions and investment. Two-thirds of the company’s business is now overseas.

In a bad year, the company managed to raise its operating profits by 4%. Life and pensions sales rose 11%. General insurance premiums rose 5%. 80% of the company’s profits come from existing life and pensions contracts, so it is not obliged to chase new business. General insurance profits were up 17% following a return to more normal weather after the floods in 2007, and are sufficient to cover the dividends. The company is now targeting profitability and cash flow rather than sales growth, and says it does not need a rights issue to raise cash. The company has a good credit rating, had dropped strong hints that the dividend would be held, and has done as it promised. It says it can maintain the dividend at its current level, while keeping the dividend cover (the number of times the dividend can be paid out of net profits) at a comfortable 1.5-2.0 times

The operating profits for 2008 turn into a loss due to extra provisions made against possible losses on the company’s portfolio of corporate bonds, and its £ 11.8bn commercial mortgage book. Large write-downs on the value of its investments turn a £ 885 loss after provisions into a loss of £9,883m. After paying the dividend, the company has £ 1.2bn in spare cash over and above what the regulators require.

The Chief Executive, Andrew Moss, said ‘There is a dislocation in the trading price of the shares, relative to the underlying value of the company’.


This rests on the quality of the investments Aviva holds, and the assumption that things may get a lot worse before they get better.

Across the mortgage portfolio, following the big falls in property value, the loan to value is 103%. On the other hand, only 0.2% of the mortgages are in arrears, and the company has made provisions of £670m against defaults. The company points out that 23% of the loan book is on properties which are let to government agencies, reducing the potential for defaults.

The company also has a large portfolio of corporate bonds. There is an unquantified potential for defaults here, too, and the current provisions, which have been increased by £300m in the current year, may not be enough.

Analysts feel that Aviva needs to preserve cash, and should have cut its dividend.

An analyst said, of the results ‘It is a re-run of the banks. We had exactly this, saying ‘It’s all all right, trust us’ and then we got this little bit here and then major problems.’


The analyst may be right. Aviva’s mortgage and bond portfolios are vulnerable to further deteriorations in the economy, their investment income is being hit further by more market falls, and the worst of it is that none of these numbers can be quantified. On the other hand, Aviva isn’t Royal Bank of Scotland. It hasn’t needed a bail-out. We are now almost two years into the financial crisis, Aviva are still trading profitably at the operating level and generating cash, and the share price has already fallen by 80%.

Wise Income holds Aviva. There seems no point in selling now, and there isn’t enough clarity to add to the holding, though if you believe they can hold the dividend, it is a cheap way to buy a lot of income. Our attitude to other sectors which the market dislikes is the same. We think that prices over-discount the risks, even though the risks are considerable. We won’t sell or add in these areas, but as and when things start to improve, the recovery potential in these areas is enormous.


With the possible exception of the second half of 1974, we have just lived through the worst six months in the stock market since the Great Depression. The recession is going to be with us for the rest of this year at the least, but there are a good many signs that the worst is over in the stock market. Commercial property, yielding a little above 7%, is becoming interesting, but values are likely to fall further yet. Residential property has a good way further to fall. Meanwhile, selected corporate bonds are good for income, paying in the 6.5-8.0% region.

Many thanks for reading this blog. If you have any comments, please contact me or your usual adviser. We are all in this together, and we will try to help in any way we can.

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This blog contains the personal views of Tony Yarrow as at 9th March, and does not constitute financial advice.

Tony manages TB Wise Investment and TB Wise Income.