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Evenlode Investment View – December 2009

Surviving The Black Death

Being a UK company has been an uphill struggle over the last year - six successive quarters of negative economic growth is a long, hard march. Company managements, embroiled in redundancies and balance sheet repair, have assumed a sort of Victorian frugality. “Make do and mend” and “sides to the middle” have been suitable phrases for 2009.

Interestingly though, companies are now releasing results produced entirely during this recession and many of them are not bad at all. While a few companies have ceased to exist (and some only saved by government intervention or rights issues) many have just carried on grinding out cash-flow and dividends in spite of it all. For a business to trade successfully on its own internally generated cash-flow through such an extraordinary period has to be a strong sign of health.

The Black Death provides a good analogy - when the plague hit Medieval Europe populations of many towns and villages were cut in half. But for the surviving peasants an era of strong real wage growth was ushered in as labour became scarce but plentiful resources kept inflation at bay. This is happening at a company level as we move to recovery mode. Businesses left standing and in good shape are taking market share - we are seeing it in several sectors. Capacity has shrunk and customers only want to deal with market-leading firms with sound finances. The strongest are growing stronger.

On this note we appreciated the comments of Keith Clarke, CEO of WS Atkins, on his conference call last week:

“If GDP rises by 10%, everyone will look like a hero. Everyone can talk about compound growth rates and it’s all terribly easy. You just have to choose the right sectors, and everyone’s happy. But it’s not going to happen. Now you have to choose the right companies.”

Other Matters

Elsewhere in the market, the short-term trading community seems pre-occupied by marking the mining sector up and down by 3%+ a day at present. If the FTSE 100 is a sign of the times, we are living in a time of metal and coal. As a result, august operators such as Eurasian Natural Resources and Kazakhmys make it onto the list of the UK’s 100 most highly valued companies. We have nothing against these companies, but we’re not confident of their staying power in this particular index. The basic materials sector in the UK trades on the highest 10 year trailing PE of any sector in the market. For a collection of cyclical businesses with little or no pricing power we think this is a stretch. There is of course a great argument to buy them – hard assets act as an inflation hedge and emerging markets are roaring back to their consumptive best – but there usually is for sectors on lofty valuations.

In fact, The FTSE 100 is a slightly unsettling index when you take a step back and look at it with an objective gaze – with around 50% made up of financial and resource stocks. This composition offers several risks we’re not keen to expose half a portfolio to at present valuations (not least high financial and operational leverage, often both together). Mark Twain once said that if all you have is a hammer, all your problems start to look like nails. If you are a UK investor, there is a danger that all your investment ideas start to look like financial and resources stocks. We don’t plan to fall into this trap.

Hugh Yarrow
December 2009

Please note, this investment view contains the personal opinions of Hugh Yarrow as at 1st December 2009 and does not constitute investment advice.
WS Atkins is not currently held in the Evenlode Income Fund.

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