Colin McLean founded the fund management house SVM Asset Management, based in Edinburgh, 20 years ago and was one of the professional investors featured in my book Money Makers. An experienced stockpicker, in this Q and A he describes his current thoughts on the markets and how he is positioning his portfolios.
How generally do you see the equity markets at the moment?
The global economy will slow next year, but still deliver robust growth. Many companies have yet to get back to peak margins, but are cutting costs sufficiently to do so. Quantitative easing will drive the US Dollar lower, and continue to boost most asset classes; emerging markets in particular. Equities are not over-valued, and more M&A activity is possible given the low returns on cash held in corporate balance sheets.
I see an analogy with the period post the initial recovery in 2003, when it was followed by a good further three years for equity markets and a lot of UK M&A in 2004 and 2005. I am not sure if the rally will last three years, but I do think we are still in the recovery stage for many businesses.
What is the best approach to adopt in this kind of market?
I think focusing on equities is still the best approach, particularly given the risk that inflation could pick up. There is little to be gained in sacrificing liquidity for small cap, and many of the themes can be played with major businesses, particularly in resources and industrials. Our emphasis is on companies that have a strong element of self-help in the form of management’s ability to improve margins even if the global economy slows.
Typically, these businesses have strong brands or intellectual capital, or entrenched positions in niches. However, we have also balanced portfolio risks by controlling exposure to less liquid names, low exposure to financials, an emphasis on the potential for further positive earnings surprise and pay-outs, and inclusion of some defensive growth businesses.
What opportunities do you see? Are there any striking valuation anomalies?
We have an emphasis on some junior oils that have strong drilling programmes, but where share prices are well supported by current production and existing discoveries. We also like UK industrials, many of which remain at a discount to US or European peers, but which are global businesses with strong franchises. A number of companies have declined bid approaches earlier this year, but these deals could return, as happened with International Power.
Why the market has been so cautious with these companies (eg Tullett Prebon, Shanks Group and Gulfsands Petroleum), we cannot see. Also, there are a number of British trophy assets in industries that are consolidating that merit premium ratings (eg Arm in technology and Croda in speciality chemicals). The relatively high yields on some businesses with inherent growth and relatively stable earnings appears anomalous, eg Centrica.
Please give some examples of stocks you have been buying and why?
Croda is a speciality chemicals business that would be an attractive bid candidate for European majors. It has potential for further margin improvement and has generated cash as it has disposed of commodity businesses, giving it a healthy balance sheet. In personal care, it should grow as customers like L’Oreal penetrate China.
IMI is a UK industrial group in fluid control and retail dispensing. It has potential for further margin improvement not recognised in the valuation. It operates in segments such as environmental controls that compete with major US groups, and would be an attractive bid candidate. IMI’s quality of management and earnings is not recognised, and we believe it has the potential to re-rate significantly.
Nautical Petroleum is a junior oil & gas business, drilling in the North Sea. Shares have already risen on discovery in the Catcher field, and a disposal which provides the group with cash for further drilling. Even partial success could justify a much higher valuation.
What are you avoiding (or going short of) and why?
We are currently avoiding investment banks and are short of Barclays. We believe the UK will set higher requirements for core tier 1 capital, following Switzerland, and this will dilute Barclays’ earnings.
We are short of Nokia which is rapidly shedding market share, but has still got much more to lose. It is fast losing its scale advantage, as Apple and Samsung catch up. Rivals are more profitable and have better product offerings – it will take time to get the product offering right.
We are also still avoiding Euro-zone banks, and particularly some of those in the peripheral nations. The sovereign debt problem is not yet dealt with, and ECB intervention is compromising its own credibility. I still expect a debt default/restructuring by Greece.
What are your thoughts on gold, bonds and property?
We have weightings in portfolios of approximately 10% in gold and precious metals miners. We believe gold, silver and platinum will rise further, but temper our optimism with the recognition that many miners are not delivering on production targets. Bonds hold risks at present given the potential for recovery and inflation, and we do not have strong views on property; it is not held in our portfolios.
Do you have any strong views on currencies?
We do not have strong views on currencies – the US Dollar is likely to remain weak and I do not expect the Chinese to re-value. This will continue to be a source of tension and risk.
If you had just one moneymaking tip for this environment, what would it be?
Focus on strong franchises rather than cyclical recovery. As the global economy slows, companies will need good balance sheets and to be able to defend their margins.
What is the biggest mistake investors could make in today’s market conditions?
The easy credit and equity refinancing environment of 2009 is unlikely to be repeated in this cycle, and it would be a mistake to think that businesses with weak business models (as many have in the consumer and media sectors) will get refinanced again without dramatic dilution. The global economy and markets are recovering, but credit may stay tight.
Jonathan Davis 