Monthly Archives: December 2015

Points of View: US interest rate hike

Last Wednesday the Federal Reserve decided to raise US interest rates by 0.25% and guided towards a “gradual” pace of future increases.

Investors have thus far welcomed the decision, choosing to focus on it being a sign of US economic strength rather than mourning the beginning of the end of the era of near-zero borrowing costs that have prevailed since the global financial crisis. This is perhaps not surprising given that it is possibly the most talked about and well-flagged rate rise in history.

Looking forward, a standalone 0.25% rate rise is unlikely to have a significant effect on the US economy. What is now of greater concern to investors is the pace of future rate rises. Interestingly, the market is pricing in interest rates of 1.25% in the US by the end of 2017, whereas Federal Reserve projections imply the central bank will raise them at twice this speed, with up to four 0.25% hikes next year. In contrast, economists expect no move in the UK rate until late 2016.

Whilst the broad macro-economic landscape is interesting, it is very difficult to have economic insights that can consistently be translated into outperforming investment strategies. By the time economic patterns have been recognised they have typically already changed or dispersed. Long-term investors are therefore best served spending their time finding strong companies that look capable of generating attractive returns through the cycle, have strong management (a good management team can navigate through a difficult economic background, while a poor one can get it wrong in a strong economy), and are not over-valued.


Stocks in Focus: Centrica

This week I am looking at Centrica, the parent company of British Gas and the biggest energy supplier in the UK. In a recent trading update, the company stated that it had made good progress since July and that its full year earnings are likely to be in line with expectations. More broadly, though, the business has been struggling under a challenging environment of weak commodity prices, political pressure to reduce household bills and low margins on power generation. Indeed, weak oil prices have been particularly problematic as Centrica operates an integrated business model whereby it owns significant oil and gas assets in the North Sea that guarantee its downstream gas supply.  Whilst this is a stable long term strategy it has been painful in the short term as falling oil prices have necessitated significant write-downs in respect of the value of these upstream assets.

In response to these challenges, management published a strategic review in July this year that proposed some changes to various parts of the business. The review focuses on achieving capital and operating efficiency via measures such as headcount reduction and lower spending on both power generation and upstream exploration and production.

Looking forward, market conditions look set to remain challenging in the short term. Set against this, expectations are modest and management are confident that the planned savings from the strategic review will help the business generate more than enough cash to cover the attractive 5.7% dividend yield. The full year 2015 results are expected in February 2016.

Stocks in Focus: Greene King

In its first reporting period since acquiring rival pub company,  Spirit, Greene King has announced that its revenue and profits increased by nearly 50% for the six months to 18 October.  The results, which were announced on 2 December, comfortably beat analyst’s forecasts and led to the share price rising approximately 17% over last week.

Greene King completed the acquisition of Spirit on 23 June 2015 to become the UK’s largest managed pub company.  The strategy is to create a larger company (with obvious synergies) that can compete with restaurants.  Indeed growth of the business is being driven by increasing food sales amid falling alcohol consumption.

Two recent changes in legislation will affect the business going forward.  First the introduction of a “living wage” is estimated to cost Greene King £6m a year as approximately 35% of their staff will see their wage increased.  This starts coming into force from April 2016.  Second the end of the “beer-tie” where pub companies could previously force tenants to buy drinks from them at a premium, in exchange for a reduced rent.  Over recent years, the company has reduced the number of tenanted pubs in anticipation of the end of the beer-tie, increasing the percentage of pubs that are managed directly.

Greene King is committed to improving their food offering, investing between £40m and £50m per year in their various restaurant brands.  It also owns a large percentage of its pubs.  This compares to Wetherspoons which owns none and Marstons which owns fewer in percentage terms.  Owning its pubs gives Greene King exposure to the property market and gives it opportunities to raise cash by selling non-core assets.  Furthermore, its base in the relatively affluent South East of the UK is helpful. The question for investors is whether these qualities justify the premium that the shares currently trade at over the sector.

Points of View: Bank stress tests

This week the Bank of England announced the results of its annual stress tests, which it carried out on the seven largest lending banks in the UK. The stress tests are designed to check that the banks have enough capital to withstand a crisis scenario put together by central bank officials. This time the scenario involved slowing growth in China, a further slump on commodity prices, further regulatory penalties and a deflationary recession in the UK and Eurozone.

The purpose of these tests is to provide reassurance to both consumers and investors that the banking sector, which makes up a significant proportion of the FTSE 100, is resilient enough to cope with adverse economic conditions. One of the main parameters by which this is measured is by calculating the amount of primary reserves a bank has compared to the risks it has undertaken, for instance through loans; this is often referred to as the Core Equity Tier 1 ratio.

All seven banks passed this year’s test, which was based on accounts at the end of 2014.  Having said this, both Standard Chartered and RBS were highlighted as falling below the minimum capital requirements. However, neither is required to submit a revised capital plan because the Bank of England took into account actions taken by the two in 2015 to address their capital shortfalls. Standard Chartered have announced a radical restructuring plan and a rights issue while RBS has sold its US subsidiary business and taken further precautionary measures.