David Harbage Blog

The old stock market adage, advocating “Sell in May, and stay away, until St Ledger day”, appears to strike a chord with current investor sentiment.

While we are still three months away from the famous Doncaster race, due on 15 September this year, markets appear to have become increasingly range-bound – struggling to decide if the regular key updates from Europe and China represent good news or bad. Monday was a typical instance: did the prospect of a ‘larger than expected’ Euro100 billion bail-out of Spain’s banks lend weight to the positive view that the authorities would take strong measures to address the crisis? Or was the magnitude of the rescue package indicative of a bigger problem than had previously been perceived. The former view appeared to be the ‘knee-jerk’ reaction, as equity markets in Asia welcomed the announcement with a 2% rise and the FTSE100 index made similar early progress. However this optimism prove short-lived, doubts began to hold sway and led, as is often the case, by government bond markets, the UK equity market retreated back to overnight pre-announcement levels.

The truth of the matter probably resides in the uncomfortable place that the brightest financial minds – of central bankers or politicians – are struggling to understand the current parlous state of finances within a number of southern European countries, and therefore construct a suitable response. While Euro500 billion has been ‘found’ by member states and allocated to a newly established European Stability Mechanism, this sum would not begin to be sufficient to shore up countries of the size of Spain or Italy. (Remember it cost Euro130bn to rescue Greece in May 2010, having shelled out Euro85bn on Ireland in November 2010 and Euro78bn on Portugal in May last year). Against a backdrop of ongoing political manoeuvring, and in the absence of a solution which could retain any aspiration of popularity, coalitions and compromise would seem the order of the day. Plans to introduce a unified banking structure (supported by member banks) across the Euro bloc to introduce standard practice to the institutions may help to address the longer term issue, but do not begin to offer a ‘sticking plaster’ remedy to the immediate wounds. And self interest is likely to mean that even core unionists, like Germany (to say nothing of the UK which sits, as a partial participant, somewhat precariously), will have an eventual limit on their appetite to support weaker economies.

On a different plane, in terms of the pace of economic activity, and certainly against a very different political backdrop, China has also given equity markets further ‘food for thought’ this week. Widely appreciated as the world’s manufacturing base, Chinese industrial production fell short of expectations and retail sales posted their slowest pace of growth in six years in the year to 31 May 2012. That the respective numbers were +9.6% and +13.8% introduces some perspective (relative to Europe, most obviously), but the downward trend in activity is undeniable and has continued in June. Economists expect the current quarter to represent a low point – after seeing GDP growth of 8.1% in Q1 2012 – and predict an upturn in the second half of 2012, citing recent evidence of firmer demand from the United States.

Over the past week, as we move towards the end of the calendar half year, there has been little company news to excite the wider market. BP’s plan to find a buyer for the one-half share in its Russian joint venture, BP-TNK, represents a significant move for the accident prone oil major. The US$7bn investment in 2003 could be worth four times as much today, but finding a suitable purchaser may prove difficult - as three oligarchs own the other 50%. Unable to progress its arctic exploration plans, because of its BP-TNK arrangement, a good price would restore some potency to BP’s management. Aided by closure on the final cost of the Macondo spill, consideration of a special payout to shareholders post BP-TNK, or an alternate compelling strategic plan could lead to investor sentiment taking a turn for the better. While not alone as a major unloved multinational (BP shares are priced on 6 times the current year’s earnings, which appear set to represent three-fold cover on the likely 5% dividend yield), equity bulls might cite this company as illustrating an apparent and common disregard of stock valuation.

Share buybacks and special dividends caught the writer’s eye this week, featuring Dragon Oil’s launch of a US$200m spend and near daily repurchases by BSkyB which have exceeded £50m in May and June to date. Johnson Matthey, the chemical & precious metals group best known for automotive catalytic converters, is paying share holders an exceptional dividend of £1 in addition to a 20% rise in the regular distribution. Dragon had built up a near £1bn cash pile from its Turkmenistan base and, while it has plans to expand (notably its geographic base), the company chooses to make an early return of shareholders’ funds as it awaits the right opportunities. BSkyB captured headlines this week for retaining the prime rights to Premier League football, for a further 3 seasons until May 2016 - at an annual cost of £760m, which represents a hefty 43% hike on the previous 3 year deal. But the broadcaster boasts healthy cash generation and, with limited expansion opportunities and new customers more expensive to acquire, it is using this to facilitate share buybacks as well as enhance a progressive dividend policy. There are, of course, a number of large businesses (typically FTSE350 constituents) that have similar ongoing programmes in place to repurchase their own shares, as a means of re-engineering their balance sheets. From A (AstraZeneca) to V (Vodafone), if not quite Z, finance directors are enhancing the efficiency of their company’s balance sheets – against a backdrop of low costs of debt, relative to the cost of servicing their equity capital – and enhancing the rate of earnings return produced on the remaining shares in issue.

Lack-lustre trading updates from Sainsbury (like-for-like sales, which excludes new space, rose 1.4% in the 12 weeks to 9 June) and Tesco (domestic turnover has fallen for the fourth quarter in succession) should surprise no-one. Discerning domestic food shoppers are being ever more thrifty in an environment of falling real incomes, (evidenced by discounters Aldi and Lidl, with 1,000 UK stores between them, enjoying record shares of the UK grocery market), and, according to Tesco’s new CEO Philip Clarke this week, these savvy shoppers increasingly await offers before spending. Cut-price alcohol continues to be a prime draw in this respect, and something of a British phenomenon according to a report published by Symphony IRI this week. That beer is generally regarded as a loss leader (the expression ‘sprat to catch a mackerel’ comes to mind), was reinforced by the suggestion that 70% of alcohol sold in the UK in 2011 was effected on special offer terms, with the Netherlands’ 30% on promotion being the 2nd closest within Europe. Perhaps ahead of any imposition of a minimum price per unit of alcohol, the supermarkets have reduced the magnitude of discounts on beer. Post a successful boost from the Jubilee, they will be hoping that consumers will stock up for the European football Championship, the Olympic Games and, most importantly, the prospect of some overdue sunshine.

While the overall mood amongst UK fund managers remains pessimistic, corporate buyers continue to see value in equity and have quietly been ‘buying while stocks last’. According to the monthly Bank of America Merrill Lynch survey, UK based fund managers are particularly risk-averse – at levels not seen since 2001 (the twin towers tragedy, when the US was in recession) – and, relative to normal positioning, currently hold large cash balances and are underweight in equity (particularly in Europe). This suggests that upon any improvement in the investing landscape, there could be a lot of cash chasing stocks. Meanwhile some are not waiting, with medium sized businesses appearing on the menu for larger cash-rich predators: Cairn Energy has paid a 50% premium to make an agreed takeover of North Sea operator Nautical Petroleum, following up on its April purchase of Agora Oil & Gas. American bidders also emerged this week as Upsher-Smith Laboratories is buying neuroscience biotechnology Proximagen Group and venture capitalist Symphony has made a late trumping bid for software business Kewill. The latter follows the £1.7bn bid from Canadian group CGI for the UK’s largest IT services provider Logica a fortnight before; with a low hurdle rate - cash earns next to nothing on both sides of the Atlantic - such corporate action is unsurprising.

UK government stocks, which represent the natural home for the domestic £-based risk averse, continue to enjoy support – primarily from the Bank of England’s QE programme of gilt purchases. There have recently been calls, notably from Christine Lagarde the Managing Director of the International Monetary Fund, for central banks (in the UK and on the continent) to reduce their prime interest rates to provide an additional stimulus to the flat economy. Last Thursday, the Bank of England’s Monetary Policy Committee decided to leave Bank rate unchanged at 0.5% and not to increase the sum of £325 billion that has been applied by QE to date. The ten year gilt currently offers a gross (before taxation) to redemption yield of 1.7% per annum which, of course, is a negative real return after consideration of local inflation. This also represents an exceptionally low rate, relative to the double-digit earnings yield of the UK equity market and the current dividend yield, and seemingly must reflect a belief that ‘things are going to get worse before they get better’. Whether that is three weeks, three months (per the St Ledger saying) or three years remains to be seen. Although such obvious valuation anomalies cannot last forever (some aspect has to change, for better or worse), it is wise to heed the words of the most famous British economist of the 20th century, John Maynard Keynes, who opined that “the market can remain irrational for longer than you can remain solvent”.

Finally, we’ll leave you with a 1 Good, 1 Bad and 1 Controversial from the week’s news in the form of an upward revision of production progress at Russian gold miner Petropavlovsk (ahead of an analysts’ visit next week), a debt-driven revamp at infrastructure & business services group Mouchel (which attracted a bid of 153p per share from Costain last year) that is set to leave its equity worthless, and further evidence of the so-called investor or ‘Shareholder Spring’ as almost 60% of the shareholders of WPP, one of the world’s biggest media businesses, voted against the company’s latest remuneration report (which featured a £6.8m payment to its CEO, Sir Martin Sorrell).

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.