Few professional investors can claim to have had a better training in investment essentials than Sandy Nairn, CEO of Edinburgh Partners.

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Few professional investors can claim to have had a better training in investment essentials than Sandy Nairn, the youthful looking CEO of Scottish investment management firm Edinburgh Partners.  For ten years he was one of Sir John Templeton’s most trusted acolytes, latterly as Head of Global Equity Research for the multinational investment business that still bears the Templeton name. Although Sir John himself gave up day to day investment management more than ten years ago, in order to devote his time to a range of philanthropic foundations, the contrarian investment principles he established over is 60-year career as a professional investor have continued to prove their worth. Sitting in his office in Edinburgh’s Charlotte Square, Dr Nairn offered me his thoughts on the current crisis in banking, and what they mean for the investment markets.

You said six months ago that it was time for investors to “hunker down”? Why did you say that?

Towards the middle of last year it became readily apparent to me that we were not simply facing a traditional economic slowdown, but one in which the severe after effects of asset inflation were going to have to be resolved simultaneously across a range of different fronts.  In my view the valuations of stock markets have been based on an absurdly benign economic picture. The probability of events unfolding in a way that is consistent with that rosy-eyed perspective was – and remains - negligible.

After a prolonged period in which financial institutions were willing to lend on almost anything to almost anybody, it was clear that not only were we going to see the quality of their loans being called into question, but also that the lending bowl would eventually be taken away, such that only those who did not need to borrow would be lent anything!  In a world of capital scarcity, lending standards would inevitably be tightened massively.
 
Have things got better or worse since then?

The position is unchanged, except that some of this has begun to unfold. Most of the focus so far has been on the problems faced by the financial sector and the need for the majority of companies to replenish their capital. Many banks have raised capital either from their existing shareholders, or sought finance from the capital-rich areas of the world (largely the owners of energy resources). Share prices of banks and other financial companies have been punished accordingly. Obviously, since many banks have raised new finance, it means that their position has improved.

They may now at least be able to do some of what they are meant to be in the business of doing, which is making loans. Without the fund raising, we clearly could have seen a savage downwards deflationary cycle. The credit crunch is now working its way through the initial stages where capital is raised, but the period of restricted lending has only just begun and will have years to run. In the years ahead we will all have to be nice to bank managers again.

Why hasn’t the stock market recognized this yet?

The paradox is that equity markets, whilst penalizing the banks, have largely limited the damage to a few sectors and breathed a sigh of relief that all is now better.  In my view that is a dangerously complacent view. What I expect to see is a growing awareness that recessions cause profits to fall and that valuations also typically decline in such a situation. Adding capital scarcity to slowing growth does not create rising profits.  From a position 12 months ago of record company profits, there is only one direction profits can go, which is down. This has already begun.

The benign view will sooner or later therefore be shattered.  At the epicentre are the banks and housing companies.  Moving outwards the consumer stocks have been sporadically seen sharp downward falls in share prices.  Beyond them are industrial companies which will soon begin to see their order books dry up. As consumers and industrials draw in their horns, this will then in turn feed out to the emerging markets and commodity companies, which so far have been bucking the general trend.

Have the central banks handled the crisis well to date?

Some have, some haven’t. In my view the Federal Reserve understood the issues very quickly and acted accordingly, but the Bank of England and European Central Bank have been slower to realize the dangers. The criticism that the Federal Reserve has been creating ‘moral hazard’ by bailing out the banks is misplaced.  The owners of those companies which have been bailed out have seen their capital pretty much wiped out. It is hard to believe they feel they have been encouraged to do the same all over again.

It is true that the reputation of Alan Greenspan [the former Chairman of the Federal Reserve) is being pulled apart by those who think that excess liquidity is the root cause of how we got to the painful and dangerous position the world now finds itself in. The critics are correct that a prolonged period of inappropriately low interest rates was the root cause of today’s issues.  If you look back in history, it is always the same old story. When policymakers try to escape from the economic cycle, it always ends in financial excess and collapse.  

Should they then be raising or cutting interest rates now?

The remedy for the previous problem, which was inflation in asset prices, as manifested in property, private equity, hedge funds, bonds and parts of the equity market, was higher interest rates. However, because of the low cost exports that have been flooding in from emerging markets, there has been little wage inflation in the developed markets.  So, while we may be entering a period of “stagflation” again, this time round it is not being driven by higher wage claims, as it was in the 1970s.   The remedy of higher real interest rates is not required when inflation comes from such a source.

Instead we are faced with the very different problems caused by falling asset prices. The big issue I see is not inflation, therefore, but one of falling real disposable incomes. In the developed world, relatively stagnant wages and the higher cost of debt, food and energy are putting a squeeze on discretionary spending. If you accept that this is the case, then lower interest rates - not higher ones – are the appropriate course of action. In that sense the Federal Reserve has been correct but the European Central Bank and the Bank of England have been playing the wrong instrument.

How do you see the stock market playing out from here?

My guess is that one of two things will happen. Either we face a period of persistent short-term volatility which disguises the fact that share prices are gradually falling, or at some point in the next 12 months we have a meaningful bear market. In the first case we will all turn round in two years time and discover that we are worth less then than we now. In the second we will feel that way much sooner. It is a case of pay now, or pay later.

My view is that those sectors where investors are currently the most complacent, such as emerging markets, will be the worst hit while those where the concerns are currently the greatest will weather it better.  My guess is that companies at the epicentre of the storm, including the banks, will generally preserve their value better than each successive layer running out from consumer stocks through to industrials, emerging markets and ultimately commodity stocks.  

How are you positioning your own funds to deal with this scenario?

Pretty much as you would expect from what I have said. We have 20% in financials, where the short-term sentiment is about as ugly as you can get. We have little idea how share prices will move over the next six months, but a lot more confidence that they will generate decent returns over say five years. The earnings of telecom companies are less susceptible to the economic cycle than most, which caps the upside on their returns but also helps to set a floor which is also supported by their strong dividend yields.  They are pretty boring but do a job for now.  The pharmaceutical sector is similar to the telecoms in its earnings outlook, that is to say dull but supported by cash rich balance sheets and reasonable dividends.  We have approximately 20% in each of these sectors in our global funds.  

Of the balance we are holding around 5-10% in cash ready to pick up bargains as they appear.  We believe that the next 12 months will be a fantastic time to invest in companies with strong growth prospects, with the crucial proviso that when the time comes you have to have preserved sufficient capital to do so.  If the market does fall as I think it will, there will be some very good companies whose valuations become hit too hard.  It is not a question of whether this will happen as much as whether or not you are able to take advantage when it does.

Is John Templeton’s philosophy still relevant to the current market?

In my opinion the Templeton philosophy is timeless, so the answer has to be yes.  The way I interpret his philosophy is that it says the principal market imperfection is the time horizon of investors.  Most investors are impatient and overly influenced by emotion. This has the effect of driving share prices either too high and too low.  The only certain way to cope with these extremes is to take a long-term view and look to ride out the various storms.

That means being a contrarian – or, to adopt Sir John’s own words, to buy at the time of maximum pessimism.  You can only do that though if you have a clear view of what the long-term value of a business really is.  One only knows when pessimism is at its maximum after the event. This is why whatever you do has to be anchored by fundamental valuation.

To give an example, there is certainly a huge amount of pessimism about the financial sector at the moment.  Investors are frightened to buy for fear of looking foolish in the short-run, but on any long-term valuation basis, the value is clearly there. The important thing to realize is that you are bound to be out of step with conventional opinion when the biggest bargains come round. Once you realize that, you don’t have to worry about it any more.

The fact that you cannot pick the top of the market to get out, or the bottom to get in, is not as important as most investors think. You should never be wholly in cash or wholly in high risk stocks. Managers or individuals who do this always look like heroes for a short period.  But they rarely stay on this pedestal.  The mundane truth is that the most certain investment returns are made slowly and cumulatively.  The market imperfection exists because of the human imperfection that refuses to accept that this is the way of the world.

What advice would you have for individual investors?

It is important to recognize that while lower interest rates the central banks are providing will help bank profitability, borrowers won’t see much of the benefit. Banks will be reluctant to pass on the benefit of lower interest rates to their customers, and in an environment of capital shortage there is no mechanism to force them to. However the best periods for investors are those in which you are going to be beset by negative comments about economies and markets.  If you can preserve your capital until that point comes round, you will do very well by investing in companies with good long-term prospects.  

If wage inflation is not an issue, then bonds do not look quite as overvalued as many commentators are suggesting.  However, government bond yields are not particularly exciting. Where there almost certainly is outstanding value is in some of the debt and collateralized instruments where liquidity has completely dried up.  Distressed sellers equal bargains, and there most be some specialist managers of specialist debt funds licking their lips at the moment.  

So far as gold is concerned if the argument for lower inflation holds then the one for holding gold does not. As for hedge funds, the next few years will definitely sort the wheat from the chaff.  There are a number of hedge funds staffed by individuals with incredibly specialized knowledge of their specific area.  With capital in short supply and liquidity drying up they will be able to make exceptional profits since their insight on underlying value is better than others.  

The vast majority of hedge funds though have made their profits mainly be leverage, by gearing up investor’s money.  Geared funds give geared profits (and geared bonuses) during the good years.  When liquidity is a scarce commodity and valuation becomes the key, the opposite holds. That means there will be a lot of blood to let in the hedge fund world.  



Jonathan Davis
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