Peering Through The Gloom

The Investment Thoughts of the Hamilton Financial Panel

Introduction

We have been extremely fortunate in assembling a group of "Wise Men" with substantial investment experience and impressive records. We have just held the first meeting of the Hamilton Financial Investment Panel and here follows some of the deliberations and conclusions.

On the inaugural occasion, Friday 6th November 2009, the Sages consisted of:

• Alex Hammond-Chambers (Chairman) - Former Chairman of Ivory and Sime, director of a number of investment companies.
• Angus Tulloch  Joint Managing Partner, Asia Pacific/GEM Equities, First State Investments
• Max Ward - Former partner of Baillie Gifford and current manager of The Independent Investment Trust plc
• Michael Pearson - Private investor, previously an Investment Director with the Bank of Scotland
• Robert Hunter - Investment Manager at Gillespie MacAndrew

 
The membership of this Panel may vary slightly between the six monthly brain-storming sessions and we aim to embrace this senior collective wisdom on your behalf. We are immensely grateful to our Wise Men for sharing their expertise with us.

The Debate

AH-C:    As an introduction, may I lay out a format for the meeting which involves considering, in the first place, the question – “has the financial world changed, and if so how?” and secondly how we would choose to invest money on behalf of two clients – one with a desire for capital gains and the other with a need for income?  The situation in which we find ourselves today is in the aftermath of yet another financial crisis, born of living beyond our means and paying for it by incurring ever greater amounts of debt.  In previous crises, the solution had been to inject liquidity and promote spending, giving rise to an ever rising mountain of debt.  The same has been applied this time, but can it create yet another economic and stock market boom?

So the first question to consider is – “What have we learned from history that can help us in these troubled times?"

 MP:    The main lesson of history is that, however long it takes, we do eventually come out of the crises that we undergo.  So keep being positive!  It is not so much a question of “if” as “when” and it could take some time.  However we are past the worst, as some recent company results (which have actually been quite good) have shown.

AT:    The creation of debt has been on a huge scale and will take some time to rectify.  As regards debt and the taking on of risk, attitudes will certainly change.   We also over-estimate the extent to which governments can fight against the tide once it has turned.

MW:    I agree; we are in uncharted waters and the mountains of debt will have a significant effect on the economy. We have never been here before; all the investment boys are watching each other. Many have been dragged into the bounce in this market without any conviction that shares are cheap. However, the stock market will not deteriorate significantly until investors start to fear the end of the government’s stimulus package.

 RH:    We are indeed in uncharted waters; it is a horrendous scene in the UK given the level of debt etc. This is the hardest market yet to try to fathom. But remember events have been worse.

AH-C:    I think we are all agreed that we are in uncharted waters. The economics of debt reduction are key to understanding what will happen.  AT, how do you see the effect of reducing debt on the economy and the stock market?

AT:    The government will try to keep growth going but will eventually have to finance this with higher taxes, which will, of course, reduce consumption. We also now have a very overextended unstable public sector.

MW:    I agree that the government will have to raise taxes and borrow more money, so I suspect there may be a collapse of confidence in the government bond market.  The consumer still wants to maintain his spending and, thanks in part to low interest rates, he can afford debt - which explains some very good retail results in recent times.

RH:    Given the huge issue of gilts that lies ahead, will they be able to sell them? Isn't there a risk that at some point no one will buy them? Thus gilts might end up yielding 8%, 9%, 10% with no one believing in them anymore!
MP:    Although the domestic outlook may be of concern, we may well benefit from economic growth in Far East spending.
AH-C: So the government is going to have a tough time financing its economic growth policies.  With all the money around and new debt being created to keep the system going, surely there must be a danger of inflation?

MW:    The risk of inflation in consumer prices is limited until the economy recovers, but there may be inflation of asset prices, including share prices.  But perhaps governments will tolerate inflation.  During the 1970's there was a period of double digit inflation. If inflation occurs, then equities will ultimately provide some protection - but it will be a bumpy ride!

RH:    Given the softness in the economy and the spare productive capacity, I would expect some deflation in the short term to be followed by inflation in the longer term; it is the only way out for the government.  The issue is duration, when deflation becomes inflation.
 
MP:    Inflation will return.

AT:  Most people not in the financial sector seem unaware that low interest rates will go up.  They are also unaware of the risk of inflation.  It will come as a nasty shock.
 
AH-C: There seems to be a consensus that inflation will come back to haunt us in time.  If so, what will the effect be on the value of the Pound?  Indeed there is a paradox in that inflation should lead to a lower Pound but the consequential rise in interest rates needed to combat inflation would lead to a stronger Pound.  What then are the prospects for currencies generally and the pound particularly?
 
AT: The US Dollar is the target/benchmark currency for all others but both the Dollar and the Pound, have very similar financial problems and need to fall against Far Eastern currencies.  The problem is that the Far Eastern countries tend to fix their exchange rates against the US Dollar. I am holding cash in Singapore Dollars.
 
MW:  The big undervalued currency is the Chinese "Renminbi". The US Dollar will not plunge from sight because the world is so dependent on it - but the Pound is vulnerable!  The Japanese Yen is fascinating - the huge budget deficit/government debt problems in Japan, plus its ageing population could easily bring about a collapse in the Yen. Don’t be long of the Yen!
 
RH:    There are good reasons for not holding any of the major currencies, including the Euro (which is a political currency).  Under these circumstances, gold is a haven from the devaluation of the purchasing power of currencies.
 
MW: Because gold has no intrinsic value (in contrast to, say, oil) the investor who buys it does so in the simple belief that there will be a greater fool to whom he will be able to sell it at a higher price! (there followed a general discussion on gold as a store of value with different views on whether gold holds its purchasing power over the long-term).

AHC:  Given that much of the troubles that we face have been – in part at least – bought about by unsound government policies and incompetent administration, the question “Can a Conservative government make a difference?” arises.  Do we think that it can?
   
MW:    Not much! The problems are so huge that any government is going to have to make tough decisions which are unlikely to improve economic growth rates.  It will all come down to confidence in the bond markets.

(There followed another general discussion on the Conservative party generally and on David Cameron particularly, there being some doubt about his integrity and his commitment to principles)
 
AT:    Is David Cameron tough enough?  What does he really stand for?
 
RH:    It would serve Gordon Brown right if he were re-elected! 
 
MP:    The Tories should make a difference.     
 
AH-C:  The policy that a Conservative government needs to pursue is that of diverting more of the economy into the hands of the private sector.  That would ensure the speediest recovery.  This is similar to what the Swedish did to sort out their banking crisis in the early 1990s.

So now that we have had a chance to consider some of the important issues affecting the economy, and therefore ultimately the stock market, where would we invest our money at this point in time?  We will first address the investor looking for capital growth rather than income.
                  
MP:    Primarily focus investment on economies with reasonable economic growth prospects (notably the Far East) and the sectors and shares of companies with large overseas sales and profits.  An example would be international oil companies.  Try to keep your exposure to economies outside the UK.
 
AT:    In the short term, shares in the Far East now look toppy.  However, in the longer term it is still a very good part of the world to be exposed to.  Interestingly, it is a good idea to try to identify companies involved with activities at which the Chinese are not skilled.    Invest in the equities of companies with "pricing power" and with exposure to overseas economies.  Avoid gilts because people have over-invested in them and there is plenty of extra supply coming on stream.  10% of my investments are in gold!!

MW:    Invest – directly or indirectly - in the Far East and perhaps Brazil.  Essential for any long-term portfolio is a commitment to the oil sector, in part because there simply is not enough oil to replace the depleting reserves (particularly at current oil prices).  Be vigilant for investment opportunities in companies with strong balance sheets and cash flow (a classic example of which is the tobacco industry; it has an unusual franchise with its own pricing power).

RH:    I am a long-term thematic investor – 5 to 10 years in duration. An example of this would be companies invested in the water business.  I also believe we will face energy and agricultural shortages.  Short-term trends are more difficult to identify and inherently more risky.
 
AH-C:    We all seem to agree - invest outside the UK and in the Far East by preference.
 
AT:    Yes – and there are more share price anomalies in the Far East – and, therefore, more opportunities to make capital gains.
 
AH-C:  And so finally where do we invest on behalf of those needing income to spend to live?
 
MP:    High yielding equities - albeit for the long term.  It is the one area you can get a reasonable yield and one with the potential to grow.
 
AT:    Investors should not invest in stocks and shares just for income but rather for both income and capital gains – i.e. total return!  They should then sell enough each year needed to live on the proceeds.  (There was disagreement with this approach but it is one that is advocated by some).  Investors should avoid investment in bonds and stick to sound equities.
   
MW:    By all means invest in bonds but not in government bonds.  Invest in good corporate bonds of companies with sound balance sheets and good cash flow.  There may also be opportunities in property investment.  By this, I do not mean open-ended collective property funds which cannot honour redemption commitments in difficult times.  Certain equities, including tobacco companies, are also a possibility – although the issue of timing is a tricky one.
           
RH:    I would consider investment in index-linked bonds.  
 
AHC:  Well we could go on forever but I think we have a good feel for the economic and stock market environment and where to invest money. We seem to be in agreement about a number of things but we have also had one or two healthy disagreements on some smaller issues.  To summarise; the environment will remain tough but investment in the shares of companies with sound finances, good business franchises, a reasonable dividend yield and exposure to overseas economies (most particularly those of the Far East) will provide a safe haven for the long-term investor.  Thank you very much everybody for your participation and your views.

Postscript

What I find most striking about these exchanges is the unanimous fear of debt and inflation. I would add one more piece of advice flowing from something Angus Tulloch alluded to – if you are a net borrower and presently enjoying the breathing space afforded by record low interest rates, do have a strategy in place for repaying debt before interest rates start to rise – which as sure as night follows day, they will.

The Hamilton Financial panel of wise men meet again in the Spring of 2010 when another bulletin will follow.

With very best wishes,

Yours sincerely,

Andrew Hamilton FCA CTA Cert PFS