Jan 2006

(How Do We Profit From) What In The World Is Going On?

Martin Sorrell, CEO of WPP, is an engaging and thought-provoking speaker. I heard him again late last year at a Media sector conference, when he began his presentation like this – “I can condense my 45 minute slot into just three words – Internet and China”. He proceeded to explore that proposition as it relates to WPP, which as a global business itself, with a multiplicity of global customers, provides about as panoramic perspective on what’s going on as you can find. Sorrell’s message is, by now perhaps, not startlingly original, but he entertained as he expounded on various opportunities and threats. Is Google a competitor or an ally to an advertising agency? (Sorrell can’t make up his mind). Should aspiring global brands advertise globally or locally? (Both – the “correct” answer if you are an ad agency) Is the TV dying? (As we know it, slowly but surely) For me perhaps the most chilling point Sorrell made is that he knows of no instance where an “old” media company has lost “mind share” to a “new” medium or platform, then has ever been able to win it back. This resonates with comments made by Rupert Murdoch, last November. Decades ago, Murdoch described the revenue streams from newspaper classified advertising as “rivers of gold”. In 2005, he admitted – “I don’t know anyone under the age of 30 who has ever looked at a classified advertisement in a newspaper.” “Sometimes rivers dry up”, he lamented.

Of course, Sorrell’s model has implications for more than just the Media sector. The Internet and China are changing the world in a way that impacts virtually every UK-listed corporation. This is a truism that could spark pages of turgid discussion, which we foreswear here. Instead, we highlight the effects that we regard most relevant for our attempts to make money for our clients. Internet and China require funding. In particular, the Emerging Markets’ hunger for commodities and energy has stimulated a boom in the resource sectors. Much of the capital required to finance this boom will be raised in the public markets. It is clear that this makes for exceptionally attractive business conditions for capital markets and capital market proxies of all kinds – from the LSE itself, at the very heart of the boom, through asset gatherers, such as Schroders, Rathbone and HBOS (£1 out of every £8 of new investment into UK savings products in 2005 went into an HBOS vehicle), to companies which ensure the capital markets function effectively – Pearson, Reuters and, for us, Royalblue. Pearson remains interesting for a number of related reasons. Last month it added to its holding in NASDAQ-listed financial information provider, IDC, owner of FT Interactive Data and ComStock – a company whose revenues are up 70.0% since 2000. The purchase, from a retiring director, took Pearson’s stake to c62.0%, since when IDC’s shares have rallied nicely, up 7.5% and the bloc is now worth £765 million, or 13.0% of Pearson’s market capitalisation. We suspect investors ascribe little value to this holding when they think about investing in Pearson, but IDC is clearly an important asset. The Financial Times also gives Pearson leverage into the capital market cycle, of course, with the title moving into breakeven in the last financial year. But it is FT.com that presents an investor in Pearson with the real leverage to Sorrell’s global themes. The FT is “just” a newspaper, albeit a very special one, but FT.com is a rapidly growing piece of Internet real estate, which, at some stage, will attract a fancy rating. Analysts estimate FT.com’s revenues for 2005 to be £40 million, lifted by its 80,000 paying subscribers and the advertising that follows its 4 million monthly users. Last year, ITV paid 9.7x sales to acquire Friends Reunited, Daily Mail put up 10.2x sales for primelocation.com and EMAP 7.2x sales for the Worth Global Style Network. Such transactions suggest that FT.com might be worth c£400 million on its own, for a property with, we would judge, significantly more strategic value than these others. Putting this into context, that possible £400 million is rather greater than the value analysts were ascribing to the whole FT newspaper group as recently as Autumn 2005. Pearson’s education assets may surprise, too, as hundreds of millions of aspiring inhabitants in the Emerging Markets choose Pearson’s programs for learning the world’s language of business, English.

As to the resource stocks themselves, we have no problem with the proposition that their share prices will carry on climbing with those of the commodities they extract. We do note, though, that the average dividend yield of the six FTSE mining stocks is less than 1.5%, or c50.0% of the FT All-Share’s overall income return and that, given their cyclicality and capital intensity, there will be a point in the future, unfortunately we don’t know when, at which investors are likely to require resource stocks to offer a higher dividend yield than the market average.

The Internet is causing “the computer to crash into the TV”, as Brian Roberts, CEO of Comcast, the largest cable TV company in the US, quipped last year. Comcast’s stock fell 22.0% in 2005, as competition to its service intensified. We see Media, Telecommunications, Internet and the Software sectors in the All-Share Index as places of the greatest strategic interest, with big prizes at stake. We would follow the smart money and note the words and actions of Bill Miller, of Legg Mason US Value fame (he outperformed the S&P 500 in 2005, yet again, for the fifteenth consecutive year!). Miller sold his Comcast in 2004, switching into Yahoo. “Value is migrating to new media. We think content is getting more valuable and distribution is getting less valuable.” he explained. In particular, we expect BT, Vodafone, Sky, NTL, Telefonica (O2) and Cable & Wireless to lock into a price/functionality war that could be damaging to their market capitalisations. Meanwhile, relatively rare UK content owners are in a strategically improving position. Daily Mail, Pearson, especially Reed, Reuters and Sage can all harness the Internet to improve the utility of their services.

The Internet and China have a profoundly disinflationary impact on the developed world. This is obvious from the quiescence of inflation in the West, despite both a commodity price and a consumer boom. The gradual acceptance of this low inflation is having radical effects on the valuation of various asset classes, most obviously bonds and gilts. We do not believe long dated gilts are in an unsustainable buying frenzy, as some claim, but reacting fairly rationally to falling inflation expectations. As Cazenove’s economics team noted last month, the current implied real return on conventional gilts of 2.0%, is marginally above the average annual real return from that market over the last 50 years, of 1.9% - in other words, “real” gilt yields are not actually as low as the nominal returns suggest. Caz go on to put a provocative question. Gilts, they argue, are simply the 10-year expectation of overnight interest rates. So they are only overvalued if it is clear that base rates will average more than gilt yields over the next ten years. In the current cycle, rates have apparently already peaked, at 4.75% last year, having troughed at 3.5% and averaged just over 4.0%. The question is will base rates average more than 4.0% for the next 10 years? We would say that the odds are good that inflation and hence interest rates stay surprisingly low. To our minds this means that gilts will likely deliver further real returns and that quality preference shares, with gross yields still over 6.0%, are actually cheaper than ever.

The decline in gilt yields intensifies many investors’ need for high, safe income and, in part, this explains the strength in the UK property market, where it is notable that returns have been driven more by decline in yield than acceleration in rental growth. One beneficiary has been the UK buy-to-let market, which saw an improvement in activity in the second half of 2005. We believe buy-to-let has become a reputable investment class for the yield-hungry and that the quality of its loan books has every chance of remaining more profitable and less impacted by bad debts than mainstream mortgage lending. Buy-to-let mortgage arrears are running at 0.87%, of book, compared to the 2.1% attrition rate for conventional lending, on average since 1974, according to Citigroup. This is definitely one explanation for the strength of Bradford & Bingley’s share price in Q4 2005, a stock we find interesting. What really holds the attention about B&B, of course, is a net dividend yield 20.0% higher than that of a gilt. Of course, it is not alone in this and we continue to think that the risk/reward in Lloyds Bank is acceptable for investors who value a high starting dividend yield. The pick of the sector, though, must be HBOS. We were so impressed by a recent press release from the bank, outlining its current market position. HBOS now claims 22 million UK customers. Two out of every five households in the UK have some sort of relationship with the bank. HBOS remains the largest mortgage provider, with a share of one in four of all mortgages outstanding and a book of over £200 billion. It is the largest savings institution in the country, with a share of 16.0% and deposit assets of £113 billion. Its share of current accounts has risen to 21.0%, challenging Lloyds and more are switching to HBOS than any other. Finally, its asset gathering prowess, referred to several paragraphs above should mean that its current investment assets of £91.0 billion are heading up. No other UK bank, whether domestic or international, enjoys these sorts of market shares. You can buy HBOS, too, on a net yield greater than a 50 year gilt and some 20.0% higher than the equity market average.

There is another implication from the fall in gilt yields – certain equities have got a whole lot cheaper. For the most predictable and consistently cash-generative businesses, a decline in gilt yields lowers the discount rate at which it is appropriate to value the future streams of cash flow. For instance, we do not think it far-fetched to take the consensus earnings estimate for Diageo in 2006, of 53.0p and discount it at the current yield on the 2.5% Consolidated Loan Stock, of 3.9%, to arrive at a warranted, intrinsic valuation of Diageo of £13.58, against the market price of £8.43. Arguably, that £13.58 would still undervalue Diageo equity, because the company seems certain to us to generate real growth in its future free cash flows, whereas the one thing we know for sure about the gilt is that its nominal income will never vary. Why should we be so confident in the growth of Diageo’s future free cash flows? The answer is the Emerging Markets, which each year create hundreds of millions of new potential customers for Diageo’s products. The company acts as though it agrees its stock is cheap. Already in 2006, Diageo has bought back over 17 million shares in itself, for treasury, at a cost in excess of £140 million, or 0.57% of its market capitalisation. Conclusion

Perhaps the most significant implication of “Internet and China”, we save until last. It seems clear to us that “globalisation” means that most companies are not big enough. They are not big enough to exploit the opportunities that globalisation presents, nor, in many cases, big enough to deal with the disruptive effects of the Internet or China competition. This lack of scale means more consolidation, in virtually every industry. It is why BOC, Centrica, Lloyds, LSE, P&O and others not yet dreamt of are in play. It is why the London equity market remains a prime location for participating in “Internet and China”, because it is a market place where transactions can take place. Would the Germans permit a bid for Deutsche Borse? Not likely. Could the LSE be bid for? You bet.


Nick Train
Feb 2006