Monthly Archives: September 2015

Stocks in Focus: Temple Bar

This week I am looking at investment trusts, which are listed companies enabling investors to gain exposure to a wide range of financial assets within a single investment.  More specifically, I am looking at how their ability to “gear up” can impact investors’ returns.

Usually expressed as a percentage, an investment trust’s gearing measures its debt in proportion to its equity capital. There are two main types of debt: bank borrowings and debentures (i.e. long-term fixed rate agreements, secured against the company’s assets). The reason that investment trust managers use gearing is to enhance investment returns from their portfolio during periods when they are confident returns will exceed the cost of borrowing. For instance, gearing may finance acquisitions without the manager having to sell existing investments (potentially at unattractive prices) in order to raise the required funds. However, companies with excessive gearing are more vulnerable to economic shocks as they still have to service their debts from potentially lower cash flows in downturns.

One example of how high borrowing costs can impact returns is Temple Bar, a £700m investment trust that has underperformed in the short term versus its peers. Gearing of 16% is via two relatively expensive debentures issued in the 1990s, before contrarian investor Alastair Mundy took the reins in 2000. Having retained high levels of cash largely to neutralise the increased market exposure that gearing can imply, it is interesting to note that Temple Bar’s first and most expensive debenture matures in 2017, allowing the opportunity to pay it off or refinance at cheaper rates. In the meantime Mr Mundy has taken advantage of the recent market weakness to add to investments selectively and thus reduce cash levels across several of his funds.


Points of View: US interest rates

Last week the US Federal Reserve voted to hold the federal funds target at 0 to 0.25%, keeping them at the same level they have been at since December 2008.  This was noteworthy as a rate rise had been considered a near certainty before the recent weakness in global stock markets.  Indeed, the US economy appears to be recovering well having posted annualised GDP growth of 3.7% in the second quarter of 2015.  Furthermore, US unemployment (named a determining factor ahead of the decision) is at the lowest level it has been since March 08.  However, the recent developments in China appear to have swayed the Fed’s thinking.  Having previously made only glancing references to overseas factors, Thursday’s statement that accompanied its decision made explicit reference to “recent global economic and financial developments” that will likely put downward pressure on US growth and inflation.

Looking forward, the Fed has introduced some uncertainty in its strategy by attaching greater importance to international events.  Having focussed primarily on US employment rates as a guide to the timing of rate tightening, investors will now need to take China into consideration.  If signs of a slowdown intensify, rates will likely stay lower for longer.  However, if markets do stabilise and inflation also starts to pick up, a rate rise before the end of the year could still happen.

Given it is hard to see a clear and immediate resolution to the issues in China, the chances must now be against a US rate rise in 2015.

30 years of the Financial Services Act – time to admit it has failed.

In this article Marcus Johnson calls for a radical simplification of the regulatory regime for financial services and draconian changes to Banking Regulation.

In 1981 the Trade Secretary, John Biffen, commissioned Professor Jim Gower to produce a report on how the Financial Services Industry might be regulated. He did this because there had been a spate of newspaper articles detailing how cricketer Colin Cowdrey and the pop group Pink Floyd had been fooled into parting with part of their (large) earnings by unscrupulous financial advisers.

The structure of Regulation introduced by the Financial Services Act in 1986 has failed the test of time in line with a rather prescient paper given to Margaret Thatcher by John Redwood recently released under the 30 year rule. He said, and I quote “there is a possible danger that the wide powers given to vary or revoke the self-regulatory framework could be used later by less sensible politicians to usher in a much more heavy handed approach without new law”. He was right and every five years or so since 1986 the number of regulators has doubled, the number of regulations has doubled and the cost of running the system has doubled. At the same time it has become steadily more remote from reality, the relationship with the regulated has become steadily more restrictive and the overall availability of advice has reduced substantially.

What Norman Tebbit and Margaret Thatcher missed was that by establishing a profession of regulators and an industry of regulation they would inevitably create a machine to lobby for more regulation and more regulators to enforce it. Clearly Financial Services will always need a legal framework in which it should operate and when expressed as ‘effective regulation’ everyone can agree the prescription. Recent history suggests over-regulation is worse than light regulation, and in particular the banking crisis of 2007/8 can be put down to excessive and detailed over-regulation. The FSA was not effective and there is little sign that the FCA will be any more effective. The biggest single problem is that the regulator tries to apply the same detailed rules (and there are thousands of pages of them) to everyone from an insurance company to a mortgage adviser as they apply to Barclays Bank. They try to have a prescription for every activity and to say exactly how every firm should relate to every client. This is not only foolish and costly, it is impossible.

It is logically impossible for a regulator to know more about the industry he regulates than those engaged in it, because if they knew how to do the job better the people concerned would be more valuable doing it than regulating it. Therefore effective regulation has to work with the knowledge that the regulated will always be smarter, have better advisers and receive high rewards for arbitrage and evasion around the regulatory structure. The banking crisis was the result of off balance sheet structures created to get around regulations which turned into bad assets on the balance sheet. Although the off balance sheet structures were created to arbitrage regulatory systems a by-product was such complexity and opacity that the boards of the banks lost control. The depth of the 2008 recession was wholly the result of the application of stricter capital controls by regulators. It was a problem created by regulators and was turned into a crisis by regulators. The worst aspect was that regulators subsequently concluded that if only they had more regulation and more regulators they could stop such problems recurring. They were and are wrong. What is required is effective regulation and this means specialised sectoral regulators, it means structures and principles, it means monitoring and controlling who is allowed to practice but it does not mean laying down exactly who does what to whom and how they do it.

The secret of effective control of the financial services industry is structural, but today the FCA attempts to codify and control every aspect of behaviour. It cannot. The lesson learned in the early 1930’s after the Wall Street crash, was then successful for 60 years. The SEC in the USA and the Prevention of Fraud Act in the UK introduced a regulatory regime and industry structure which worked well for 60 years. It depended on authorising individuals and controlling structures but otherwise letting the private sector and voluntary associations do most of the work in controlling professional standards. In the UK the banks were effectively regulated by the Bank of England for most of the last 200 years, but the way in which it was done is partly responsible for today’s impasse. Every time there was a crisis the Bank would get a profitable bank to take over the problem firm so as time went by we had fewer and fewer banks. The answer is not to have more controls, it is to have more banks. If we can solve the problem of how to regulate the banking sector once and for all then it will become much easier to address the less significant problems of other financial services where misconduct does not pose a systemic threat.

What we require in the UK (and EU and USA as well) is a structure of banking which ensures we have no repetition of the 2008 crisis for the next 60 years at least. The reason for legal controls on industry structure are simply that because the banks have the power to create money and the state is the source and sole guarantor of the value of money it must control the action of private sector agents who create it. This is particularly so where it underwrites the solvency of retail banks by guaranteeing deposits.

It is essential to have a division between banks which accept retail deposits (say <£100,000) and wholesale banks. Retail banks should be prohibited from investment underwriting, broking or securities dealing and from owning a stake in excess of 10% in any company performing such activities or from having a controller who performs such activities. A retail bank with a market share (defined as the total deposits of all retail banks in the UK) up to 5% should have deposits with the Bank of England  of 1% and a liquidity ratio (bank and highly liquid securities) of 10%. If its total deposits (including any non-UK) exceed 5% then for each 1% above 5% it will have an extra 1% deposit with the Bank. There should be no other capital controls, but every retail bank should be required to have a rating of at least “A” to have its deposits guaranteed.

Wholesale Banks, Investment Banks and International Trade Banks with their head office in the UK should have similar liquidity and deposits requirements but no market share test and it will be made very explicit that they will never benefit from a government guarantee. There should be no state imposed rating requirement, although one might expect the market to impose an effective “BB” or better floor on any banks seeking financing.

All banks should be required to follow sound and prudent practice in their business. The Bank of England (or its successors) should be solely responsible for bank supervision. Each Chief Executive should be expected to meet with the Governor collectively once a week and to present a rolling comprehensive 5 year plan annually which will have been approved by the board and will be subject to public scrutiny within 6 months of presentation to the Bank. No other regulation will apply to a retail bank.

Once regulation of banks is removed from the equation a radical reform of how we deal with insurers, investment firms and other financial intermediaries becomes much easier. The ever more detailed prescriptive approach has not spectacularly failed here in the same way as it has with banks. It has spectacularly failed in a different way. In 1984 Professor Gower estimated the structure he was proposing might cost £8m a year to run. Today a reasonable estimate (based on industry spending £2 for every £1 the regulator spends) might be that the cost to investors is £20m per working day and it is almost certainly the case that fraud losses and opportunity costs mean the general population is paying through the nose for a system which has made sensible financial advice unavailable to huge numbers of people, has severely restricted availability of advice to middle income earners and made sophisticated financial advice the preserve of the wealthy and well connected.

Points of View: Turning Japanese

Last week saw Amlin become the latest takeover target in a string of recent acquisitions by Japanese corporations of UK companies.  Mitsui Sumitomo Insurance, the world’s eighth largest non-life insurer, is hoping to acquire the British insurer at around 670p, representing a 35% premium to the pre-bid share price.

Other Japanese targets have included Domino Printing Sciences and the Financial Times.  Domino, a Cambridge-based maker of barcode printers, agreed a £1bn takeover by Japanese multinational Brother in March. More recently, the 127-year-old Financial Times has been sold to Nikkei, Japan’s largest media group, in a £844m deal that was agreed by its owners Pearson in July.

Japanese companies have traditionally squirreled away their cash mainly as a result of two decades of deflation.  However, they appear to be starting to adopt a less conservative approach due to a mix of various regulatory initiatives and the prospect of rising inflation, which makes the tiny returns on deposits look even more miserable.  Companies have been encouraged by Prime Minister Shinzo Abe’s push for them to create value, whether that is via mergers and acquisitions, raising dividends or share buybacks.  Even as the yen falls to its lowest levels since 2007, which makes overseas acquisitions more expensive, this has not stopped the rush for growth through deal making.

Overseas takeovers such as these are clearly a short-term positive for shareholders, who receive an immediate premium to the market value of their shares.  However, the departure of good quality businesses from the UK stock market is not so positive over the long term.

Stocks in Focus: Meggitt

This week I am looking at Meggitt, the British engineering business specialising in aerospace equipment. The company’s share price has been weak of late due to a dampening in takeover rumours as well as the broader market weakness.  Takeover rumours took hold when Meggitt, which has equipment on over 63,000 aircraft worldwide, appointed renowned dealmaker Sir Nigel Rudd as chairman last December.  However, the price an acquirer would have to pay along with competition concerns may hinder any bid, especially given a United Technologies-Meggitt combination would have a near monopoly in aerospace fire protection and control up to half the market for wheels and brakes.

Recent results were generally in line with consensus and within civil aerospace, where the company makes more than half its revenue, business jet revenue was up strongly.  The military market environment is becoming more benign.  Growth is expected to continue through 2015, but will be slightly lower than in the first half.  The energy division will continue to be impacted by the effect of low oil prices on the capital expenditure plans of their customers.

Looking forward, the civil aerospace division should continue to benefit from low oil prices and GDP growth. Furthermore, available seat kilometres, which are a key driver of large and regional jet aftermarkets, continue to grow at a rate above the long-term trend.  However, in terms of whether the shares offer a good investment opportunity, the question as always is whether this is a good quality company (ie one which can generate attractive returns through the cycle and has a strong balance sheet) trading at an attractive price.

Stocks in Focus: BHP Billiton

With average commodity prices currently trading at their lowest levels this century I thought it would be interesting to take a closer look at the recently announced full year results of BHP Billiton, the FTSE 100 mining, metals and petroleum company. Unsurprisingly, profits were down across all divisions. However, the business has thus far been able to cope with lower commodity prices admirably. Indeed, the company’s simple portfolio of high quality assets combined with its ability to cut costs whilst improving productivity are thus far enabling it to maintain attractive profit margins and strong cash flows despite the external pressures. Specifically, the likes of cost reductions, productivity gains, lower energy costs and more favourable exchange rates helped to offset around a third of the decline in earnings caused by falling commodity prices.

Looking forward, the extremely high dividend yield of nearly 8% suggests that the market is pre-empting a dividend cut. However, BHP’s dividend has withstood past pressures (it was the only major company in the sector not to cut its dividend during the financial crisis) and management has reiterated its firm commitment to the progressive dividend policy, highlighting that the strength of the balance sheet along with robust cash flows should support payment of the dividend as well as further investment.

Commodity markets remain volatile and it is not impossible that prices could yet trend lower – if they do, profits in the mining sector will continue to fall, putting further pressure on already depressed share prices. In these circumstances it makes sense for investors in the sector to stick with the businesses that have a solid balance sheet and operate at the bottom of the cost curve.