Markets discount the doom scenario

Global fears sparked by the credit crisis have swamped steady reports of healthy balance sheets. The markets are signalling that they do not expect widespread fallout from the present turbulence.

The traditionally quiet summer months were anything but in 2007. Generally healthy corporate news has been swamped by the macroeconomic fears surrounding credit markets and the possible knock-on effects to the global economy.

Over the first six months of 2007 European markets generated strong returns for investors, with the FTSE Europe ex UK index returning 12.1% (total return) in local currency and 11.4% in sterling terms. As subprime credit news flow started to deteriorate rapidly in America – particularly visible in the problems at Bear Stearns, which culminated in management change – shares fell steadily through July and by August 10 were down 7% from mid-year levels.

The Federal Reserve responded with a cut in the discount interest rate and a $28 billion (£13.6 billion) injection of liquidity to the banking system in one day. This was backed up with a surprisingly aggressive half-point cut in the key Fed funds rate in September. Such decisive action by the central bank, coupled with consistent positive earnings releases by European companies through August and September, helped drive European shares back towards previous all-time highs.

By mid-October the market had rallied 10% from its August lows. This recovery was short-lived, though, as rating agencies started to downgrade tranches of subprime-related asset pools and financial companies such as UBS and Merrill Lynch reported big write-offs related to credit, thus signalling further problems to come in the fourth quarter. Since the end of October, European markets have fallen 8% to November 20 and year-to-date returns have fallen to 2.5% in local currency (still 8% in sterling terms owing to euro strength).

This huge volatility always presents a challenge to investors, the general options being whether to ride out the storm by doing nothing, adding to positions on weakness, or to sell on the rumour in the hope of buying shares back cheaper later. It is clear that on any measure of valuation most European companies trade on low multiples.

At times of stress in the past (for example, 2002), multiples have sometimes sent a false signal of value when many balance sheets were stretched owing to high levels of gearing. That is not the case this time – corporate balance sheets are strong versus history. Indeed, this is something many investors have criticised companies for over the past 24 months, arguing that management should “releverage” in the interest of shareholder value. Many chief executives are probably relieved to have resisted some of the more extreme pressure in this direction. So, with balance sheets healthy, the markets are sending an explicit signal that they do not believe the earnings number within P/E-type valuations and by extension are discounting widespread economic fallout from the turbulence we see today.

If economies broadly muddle through, there are some attractive opportunities to buy many companies cheaply in these markets. Emerging economies such as China and India are booming and even the most pessimistic of commentators would not predict this to change. Many European companies are strongly exposed to these growth markets and continue to see healthy order trends.

It is the job of the active investor to take advantage of volatility by identifying where expectations have become overly pessimistic. Experience of managing money through previous periods of “crisis” can help investors avoid the temptation to sell good-quality companies with solid fundamentals at bargain valuations. Panic never contributes to sensible investment decisions. Heightened levels of volatility are likely to stay, though, so we need to be ever more vigilant for company-specific disappointments or downgrades. Regular company contact is a must in this respect.

The biggest risks – but hence the biggest opportunities – lie in the financial sector. The Fed has suggested subprimerelated write-offs could total $200 billion; other commentators point to figures as high as $400 billion. Accounting rules will allow many financial companies to smooth the pain over long periods but there is going to be a steady stream of bad news in this area, with some prominent casualties. Industriekredietbank and Northern Rock are early examples.

That said, the removal of some of the more aggressive operators from the financial services industry is good news for those left standing and those with strong balance sheets will also be able to buy assets from distressed sellers at attractive prices. GE’s purchase of part of Bradford & Bingley’s loan book is a recent example.

The equity market has not discriminated efficiently between financials with solid growth prospects and strong balance sheets/cashflows and those that are financially constrained and operate in mature markets. Consolidation is likely to accelerate if current valuations persist.

If the muddle-through scenario is wrong, strong balance sheets should provide reasonable support despite more widespread earnings downgrades. Companies such as Total have talked for five years about waiting for a slowdown to acquire more distressed competitors, and there are many management teams who share that sentiment.

Only time will tell who is right, but in valuation terms the equity market is positioning itself much more cautiously going into a possible downturn than at any equivalent period in the past 20 years.

For longer-term investors this is clearly important. There is always a tendency for commentators who are not fund managers to endorse asset classes after they have just gone up, whereas history suggests “buying low and selling high” is a far more successful strategy.

In this context, clients can rightly expect their investment managers to put newspaper headlines in context while proactively seeking out the investment opportunities that will generate the strongest returns over the coming 12 to 24 months.