Dec 2005

WILL ALL ASSET CLASSES CONTINUE TO RISE IN 2006?

Looking back over the past year perhaps the biggest surprises to the consensus views of investors at the beginning of 2005 were the general rise in the value of the US dollar and the strength of long-dated US Treasury bond prices. For Lindsell Train the combination of the two resulted in a welcome year to date appreciation of the US Treasury bond we own in our Funds (a 24 year issue) of 22%. This exceeds the year to date returns from both the US and UK markets and represents a competitive return from a relatively low risk security.

The performance of long-dated bonds was even more surprising considering the rise in price of commodities, especially gold and oil, which traditionally have been harbingers of inflation. Indeed an unusual characteristic of 2005 was that almost all asset classes, equities, fixed-interest and commodities went up. Maybe this was a lagged symptom of the massive boost to liquidity brought about by 1% short term rates (negative real rates) in the USA in 2002-2004. What is certain is that these benign conditions must end sometime, because rising asset prices are stretching valuations and the cost of money has risen in the US and Europe and may rise further. All this suggests to us, that at the least, not everything will go up together, as it did in 2005 making it likely that 2006 will exhibit far more divergent performance.

We think the reason for the competitive performance from long-dated bonds, which incidentally was even better in local currency terms in the UK - our holding of the undated 2.5% consolidated loan stock rose in value by 15% year to date, versus the local currency return from the US bond of 9% - was, once again, low inflation. The persistence of low inflation has been a central belief at Lindsell Train since we began writing these pieces five years ago. While 2005 offered up more challenges to this central assertion, in the shape of significant rises in commodity prices, the fact remains that general inflationary pressures remain remarkably quiescent. CPI in the USA is currently increasing at 3.5% and in the UK RPI by 2.4%. Wage rises remain low despite relatively full employment in both countries, UK average earnings (inc. bonuses) are currently increasing at 3.0% and US average hourly earnings at 3.2%. As a result long-term bond yields remain low in both countries, with investors presuming that today's level of inflation is just a temporary phenomenon. Market based measures of inflation support these conclusions. Implied inflation measured by subtracting real interest rates on index linked bonds from conventional ones in the US and the UK over maturities ranging from 3 to 50 years imply expected inflation on average of 2.8% in a range from 2.5% to 3.2%. Many smart investors have a contrary view and regard today's situation as similar to that prevailing in the late 1960's, when commodity prices had begun to rise but reported inflation was yet to accelerate. These investors argue that current tightness in labour markets will result in inflationary wage rises in the future, that real inflation is higher than reported numbers (a contention that may cut some ice when one considers that inflation indices include arbitrary adjustments for quality improvements- hedonic adjustments- tending to lower reported inflation) and expect any further economic growth to accelerate price rises in commodities that are already in short supply. On the other side of the debate and more persuasive to us is the recognition that there have been two major influences on low inflation for many years that continued to exert downward pressure on prices in 2005, namely the competitive influence of the Chinese economy as a source of cheap manufactured goods and the continued advances in technology led by the increasing use of the internet. These influences will persist in 2006 and may even exert more downward pressure on prices than in previous years. As a result we think inflation next year will remain contained and long-term inflationary expectations will continue to provide support to long-term bond prices.

Central Banks have not been immune to the threat of inflation as is evidenced by the tightening in monetary policy worldwide, with the notable exception of Japan. In the past such a move might have caused bond prices to fall but in today's disinflationary environment this has not occurred. Instead short-term interest rates have risen to equal or exceed the level of long-term interest rates. We think it likely that the negatively sloped yield curves (long term interest rates (10 year) lower than short term interest rates (1 year)), currently evident in Anglo Saxon countries such as New Zealand, Australia, and the UK will persist, widen further and in due course will be joined by the USA as short rates continue to rise. This has broadly negative implications for the financial sectors of these countries as easy profits from arbitraging the yield curve disappear. Higher short-term rates have restrained housing activity outside the USA and will do so within the US even though most mortgages are financed at long-term fixed rates. Over recent years, adjustable rate and exotic mortgages have accounted for more than 30% of new mortgage activity in the USA, increasing consumers' vulnerability to higher short term rates. We expect house price increases to moderate if not halt in the USA, which could curtail demand for equity release schemes to finance current expenditure. At the same time, from a high level, general loan asset quality could worsen which in turn will force a tightening of lending standards. Just as retail sales growth came to halt in Australia and the UK once housing prices stopped rising so the same is likely to happen in the USA, which could have wide-ranging implications for those countries and companies that depend on US consumption growth for their growth. Negatively sloped yield curves, falling mortgage demand, worsening bad debts and less buoyant property markets suggest, at best, a patchy outlook for financial sector profitability and, at worst, some downturn. As approximately 30% of total market profitability is accounted for by financial shares in the USA and UK the implication of stagnant profits could be profound, especially if these changes foreshadow a general downturn in corporate profitability in the market as a whole. Falling or stagnant profits would raise risk in corporate bond markets where bond spreads have sunk to multi-year lows. Although the extent and pace of US interest rate rises may moderate, like the UK, interest rates will likely stay relatively high for most of the year preserving the wide interest rate differential between the US dollar and other currencies, notably the Yen and the Euro, helping to underpin its strong rise in value this year. A rising US dollar has a number of important influences. It puts additional pressure on US corporate profits as multinational business account for 30% of the market, it encourages capital inflow into US dollars helping to finance the current account deficit, that may even start falling as consumption moderates and it reduces the attraction of Gold, an investment with a negative yield (when one considers the cost of storage and insurance).

A booming Chinese economy had a material influence on the rest of the world in 2001-2005 as the country became the production base for a wide variety of manufactured goods and at the same time absorbed a significant proportion of the world's resources in building up its fixed investment. In other words, China has deflated finished goods prices worldwide but inflated commodity prices. China's influence in the future will not diminish but may change. In 2006 the Chinese economy is likely to have to contend with two negative influences, lower demand for exports from the USA and falling or slower fixed investment, the effect of which will increase the deflationary influence China has on the world. A measure of Chinese export prices (using as a proxy the HK government series for the prices of HK's re-exports of Chinese exports) have begun to fall, a trend that would be reinforced should US consumer and housing demand moderate. Within China domestic inflation has fallen from 5% in 2004 to just 1% today and reflecting this long-term bond yields are now only 3%. The margin squeeze brought about by rising input costs and static to falling output prices has hurt profits (aggregate profits of Shanghai A share listed companies were falling by 16% year-on year in the 3rd quarter of 2005. Smaller and medium sized companies should be hurt even more) and will crimp corporate cash flow and in due course restrain investment. This is already evident in import statistics for industrial machinery where growth in the first 10 months this year was 0% as compared to 27% over the same period last year and evident from falling asset turnover in most industries due to weakening utilisation rates and rising inventories. In the past faced with a cash flow squeeze Chinese companies resorted to increasing borrowing from banks to maintain production, but today with the private economy much bigger than before and the banks more cognisant of risks, credit is likely to be less readily available forcing restraint on businesses. Not only is it likely that fixed investment will fall but also import demand could moderate, reducing demand for inputs especially commodities, leading, we expect, to some reversal in prices especially as China is widely recognised to have been the marginal source of demand for many such products over recent years. The strength of demand in China since 2003 has been a boon for trade in Asia and for the export orientated economies of the region. As demand in China moderates so those countries dependent on it will suffer commensurately. This is already evident in the country most closely bound to China's fortunes, Taiwan, where nominal GNP growth is now rising at just 1%. Japan is not immune either. From 2001-2004 50% of the growth in Japanese exports was accounted for by China, a figure even higher than Taiwan's. As exports have been by far biggest contributor to Japanese economic growth from 2001 (nominal exports have grown 21% but nominal GDP has contracted 1%) any abatement in demand from China would have a material effect on Japan and the revenues and profits of its corporate sector.

Innovation in the technology industry and, most particularly, the disruptive effect of new technology on long standing business models is an important, if not directly measurable, influence over inflation over time. The internet is all about transparency of pricing and cutting out the middle man. As soon as the process of selling products and services can be adapted to the internet, more often than not the internet becomes a redoubtable competitor to other more traditional channels. Most often internet distribution expands market potential, cuts costs (both capital and variable) and provides a more transparent route to market than other distribution channels. In short as an alternative or as an adjunct to existing distribution it wins hands down. Up to now, a limiting factor had been the diffusion of internet access and/or broadband. Now penetration is rising fast and at the same time is becoming more affordable improving the utility of the medium. As a result successful internet businesses, such as Google and eBay, have an aura of infallibility much in the same way as others did in the late 1990's. This breeds competition and encourages innovation and probably, in time, more fallibility. Warren Buffett may have purposely avoided investing in internet companies whose business models hadn't passed the test of time but he had no doubt that the effect of the internet could revolutionise existing businesses models. Understanding how was the most important issue for him. Listening to Rupert Murdoch's in his speech to the American Society of Newspaper Editors earlier this year warn the industry that it was 'remarkably complacent' about the effect of growing internet usage and then to cite research which showed that 'consumers between the ages of 18-34 are increasingly using the web as their medium of choice for news consumption' showed how prescient Buffett's comments were. This is still just the beginning. Many more will be under threat in the future and the overall effect will be disinflationary.

Pulling all these thoughts together we conclude that by the end of 2006 disinflation or deflation is likely to be more of a concern to investors than inflation which should provide a benign environment for long term bond prices, even if there is an inflationary scare early in the year. The US dollar should experience a second consecutive year of strength. Renewed disinflation is not consistent with rising commodity prices. Gold, Copper, Nickel etc should fall in price as demand from China moderates at the same time as investment in new capacity raises production. Processed metal prices such as steel and aluminium and plastics and other materials prices will all subside reducing corporate margins in these industries. Expect overall corporate profits growth to moderate or even fall by the year end. Financials, resources and consumer facing businesses will all be under more profits pressure next year. In the circumstances we think that owning steadily growing global franchises may be more than usually rewarding in 2006. Not only do such businesses offer the prospect of more predictable growth but also a low capital intensity that is consistent with rising shareholder rewards both from dividends and share buybacks. Furthermore investors might chose to value these attributes more highly than of late not only because assured profits growth may be rarer but also because the competition in terms of yield from other financial assets such as bonds has become much reduced over time.

Some examples, most of which you will be familiar with already, but in our view continue to trade at prices far below intrinsic value:

Cadbury

A record of 8% annualised growth in operating profits since 1991 with only one down year. Current free cash flow yield is 6.2%, a 2% premium to the long term bond yield (undated gilt). Return on equity averages 15%. Should the company trade on a discount to the long bond yield given the record of profits growth? If it did the shares would be £8.00, 50% higher.

Reed Elsevier

This is a company that adopted the internet early to distribute its legal and scientific publications reducing distribution costs and increasing utility to its customers. It is one of the few 'old economy' businesses that embraced the internet for its long term benefit. 75% of earnings are generated in US dollars. Current free cash flow yield is 5.3%. ROE 15%. Worth at least £7.50 in our view.

Nintendo

The company earns 22% average operating margins selling game hardware and software, has minimal capital expenditure costs and yet trades on 1.7x EV/sales and a 2.2% dividend yield (2.4x the market's). What is missing is growth. We think the new platform releases, 'Nintendo DS', the hand held, and 'Revolution', the new console, have to potential to provide this vital ingredient.

Diageo

Another business delivering average operating margins of 22%, generating a free cash flow yield of 5.3%. The dividend yield is 3.6% but total returns to shareholders (inc. buybacks) are higher and double this year's yield. Following divestments the business has the best collection of alcohol brands with some economic interest in 9 of the top 20 sellers in the world. Revenue growth is expected to be slow (less than 5%) but nonetheless requires little capital commitment and the compounding effect at ROE's above 25% is alluring.

Heineken

Currently trading at 1.4x EV/Sales, generating a 7.8% free cash flow yield with a 22% ROE for what we judge to be the best global beer franchise. The low valuation is arguably attributable to dilutive acquisitions to buy lesser brands to access distribution, an expensive and questionable management strategy. Nevertheless this cannot take away from the exceptional position that premium Heineken enjoys both within and outside the home market of Western Europe, especially in North American where operating profits contribute to 30% of the total on just 17% share of the global sales.


Michael Lindsell
Jan 2006

6 Jan 2006 LTL 000-032-1