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November 2012 Monthly Investment Bulletin
Bedlam Asset Management
November 28, 2012

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The new rule book
Equities have rarely been so attractive yet any investor acting on the perceived wisdom of the last 50 years would scoff and keep selling: the bad news will worsen for economic activity, growth in credit, wages, consumption, employment and in several countries, political stability. Few indices are glaringly cheap as measured by Cyclically Adjusted Price to Earnings multiples (CAPE: chart p.4) with many expensive, especially in many emerging markets. Historically, buying indices when CAPE is over 16x has resulted in losses for several years. Earnings revisions on the World Index have been negative for the twenty-ninth week running, with the most downgrades in the EU and Japan. In America, 76% of guidance on third quarter results was negative. Real household and business debt in developed economies has been tumbling; real consumer and capital expenditure the weakest for any post-recession period since the end of WWII. The EU is expected to fall back into recession in 2013, Japan already commenced its third this century (and is about to have its sixth prime minister in seven years). Separatism stalks Europe, with Spain’s Catalonia region (20% of GDP) showing signs of spinning out of control. Newspaper headlines have announced “the death of the cult of equity”.

The inversion of risk
Few dispute these trends. Historically by now, equity markets would be on their knees; so why are many close to all-time peaks? The answer is the inversion of risk. Governments are hooked on debt, their central banks hell-bent on financial manipulation, allegedly to promote growth. This is not working. Richard Fisher - a key member of the Federal Reserve Bank - recently stated that “nobody really knows what will get the economy back on course”, echoing similar central bank comments overseas. Yet the primary purpose of this manipulation is to ensure that the real value of government bonds (and cash) tumbles so that when government debt falls due for repayment, it is worth a fraction of its current value. In this, central banks will succeed.

America’s new administration is dominated by chatter about the “fiscal cliff” (or “sensible budgeting”?), but the decision is already made. Legislation will be enacted to prevent cuts in Federal expenditure and tax rebates equivalent to a c.3% reduction in GDP thus ensuring that rising government debt and budget deficits remain structurally entrenched. All major developed nations are strenuously evading financial discipline, knowing that prudent economic stewardship is an electoral disaster. Perhaps the surprising feature of America’s election was not President Obama’s victory, but how close Mr. Romney seemed to success; for the former was offering more debt-funded money to the 80% of the population which has seen minimal growth in real incomes for the last three decades (chart p.4).

The bell is ringing out the message that the lowest risk lies in real assets such as equities or gold with many stocks being rightly perceived as safer than the debt obligations of their governments. Turkey’s largest brewer Anadolu Efes issued 10 year bonds with a sub-4% yield; less than that of either Turkish Government bonds or of Russia, its second largest market. The Efes example is becoming common. There is often a better probability of being repaid by cash-generative businesses than by national governments.

Equities are also heavily supported by less selling pressure; major owners have already adjusted their portfolios. By the end of September, UK pension funds held more bonds than equities for the first time since 1957. (The same applies in many other countries). The weighting of the 6,316 defined benefit schemes is currently 43.2% gilts, whose real value is certain to deteriorate, and 38.5% in equities where the median yield is 35% greater than for gilts before taking into account long-term dividend growth.

There is also an unusual trend in many equity markets: they are shrinking. Normally the amount of equity in issue steadily increases through public offerings and placements. These have stalled and often the few public offerings such as Facebook have been an investor disaster. For the MSCI All World Index, the amount of equity in issue appears to have contracted by 0.7% p.a. over the last three years, 0.9% over the last 12 months. National data is particularly interesting. The S&P 500, Germany’s DAX and the UK's All Share indices shrank by 3.1%, 5%, and 1.8% respectively in the 12 months to September. Emerging markets in contrast continue to pump out new shares; Shanghai and Brazil increasing by 20% each, Hong Kong and India by 17% and 10% over the last two years. The developed market contraction is being driven by corporate buybacks, take-overs, bankruptcies and a lack of IPOs. This shrinking pile of real assets is meeting a wall of money printing by governments. This is supporting prices.

Despite some broad indices offering only middling value, many sectors andcompanies still enjoy record balance sheet strength, access to uniquely low-cost credit and earnings growth. One example is the great bull market in farming because of poor harvests. The UN FAO estimates a maximum wheat supply for 2012/13 of 661m tonnes and minimum consumption of 688m, forcing the stocks-to-use ratio (reserves) to 24%, the lowest level in 30 years. Another is the looming dramatic shift in energy because of new discoveries of conventional and shale gas. Results will include a revolutionary switch in electricity generation from nuclear, coal and oil, together with a gas-related infrastructure boom. Energy and other input costs for many businesses will fall. Elsewhere, the pharmaceutical sector has passed its patent expiry trough, resulting in these cash-generative businesses restructuring and focussing on margins and better capital allocation. These are just three examples of how many sectors will defy the old rules even as risk has become inverted. Corporate profits in many sectors will be surprisingly robust.

During October the fund fell more than the index, giving up part of the significant gains from the previous quarter. The prime reason was weakness in Japan’s Softbank after its bid for 75% of Sprint in the US. As a dilutive deal with zero synergy and less geographic logic, it affected the prices of both Softbank and its local associate Yahoo! Japan. Each was sold after their share prices had fallen then subsequently bounced. Two of the other telecommunication holdings, Far Eastone and Hutchison Telecom, were also weak for less logical reasons, as both had reported good numbers in the previous month. The probable cause was extreme weakness in the share price of Apple Inc. (not held). Its production and technological glitches will have a minimal impact on the business of either company, which will enjoy the normal seasonal uplift over Christmas and into the Chinese New Year.

Once again the three precious metal holdings performed well, despite a small decline in gold and silver prices, which sharply reversed after President Obama’s re-election on the correct perception that America’s easy money policies will continue. It is noticeable that since the beginning of the year precious metal share prices have started to outperform changes in those of the physical metals, reversing the trend of 2010-2011. The 8% of the portfolio in agriculture-related holdings also performed well, the sole surprise being that the gains were not even greater given poor global grain harvests and worse food stockpile data. Investors seem to be unwisely sanguine about the risks of food price inflation squeezing consumers (especially in emerging countries) and the impact on profits for manufacturers and retailers in the food chain between the grower and consumer. Save for the two Japanese companies already mentioned, the principal transactions were to increase the holding in the Swiss pharmaceutical group Lonza, and to top-slice the holdings in the silver miner Fresnillo and the medical products specialist Celgene. These reductions were for risk management purposes because gains in their share prices had made their weightings excessive. There were two new holdings - Pentair and ADT Corp. These are the businesses spun out from the existing holding, Tyco.

The important portfolio characteristics remain largely unchanged with low gearing as measured by debt to equity at c. 20% versus c. 60% for the market. This lack of financial gearing should not be at the cost of growth in profits given earnings per share are expected to rise on average by 19% over the next twelve months. Financials and property account for a mere 4% of the portfolio, given that both sectors require a robust credit cycle to increase profits, an event as likely as governments applying fiscal prudence.


Bedlam Asset Management plc is authorised and regulated by the Financial Services Authority (212757). Bedlam Funds plc is regulated by the Central Bank of Ireland pursuant to the European Communities (Undertakings for Collective Investment in Transferable Securities) Regulations, 2003 as amended by the European Communities (Undertakings for Collective Investment in Transferable Securities) (Amendment) Regulations, 2003 (the "UCITs Regulations") and is a recognised collective investment scheme for the purposes of section 264 of the United Kingdom Financial Services and Markets Act, 2000. Shares in Bedlam Funds plc may only be sold on the terms of, and pursuant to, its most recent prospectus. This document is not investment advice or a recommendation to purchase, hold or sell a security. Past performance is not a reliable indicator of future results.


(c) Bedlam Asset Management


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