Better Value for the Money

Expatriate finance guru, Bruce McWilliams, identifies significant advantages enjoyed by investors willing to straddle the line between the US and European markets.

As a US investor, you have had to endure quite a battering in recent months. With Enron and WorldCom going under in the way they did, you could be forgiven for taking the view that the stock market is just too risky. If companies the size of Enron can deliberately deceive investors, what is the point?

Who can you trust…if you can’t trust them?

Of course, this is a valid view and one I won’t try to sweet talk you out of. But what I can do is offer you an alternative to the US market you may not have considered… the UK! The fact is, the UK stock market offers many advantages over the US market. Once you are aware of the differences, you are in a position to exploit them… as I shall explain.

But first, let’s take a look at the global market and ask a simple question: when will we see a bull market again?

The answer, in my view, is simple. The next bull will happen…when we least expect it. Demanding investors always say: "But can you put a date on that please? I want to know." What I am at pains to point out is that the exact date of the turn – by definition – is unknowable in advance. If anyone knew when that date was, they would pile in the day before. But if you knew that someone was about to pile in, you would pile in two days before and on and on.

The truth is, all those toiling away in Wall Street and City boardrooms wish they could affect the market, but it is you and me, dear reader, with our investments, who drive the market higher. Study after study has shown that big market advances take place unpredictably. It would be good if we could nip in and duck out right before advances and falls were to take place…but how can one foretell the future?

The secret is to never take your eye off the ball. The big market turn of the 1970s took place on Friday, December 13, just as everyone was getting ready for the Christmas holiday. What an auspicious time that must have been. What I find so surprising about that date is that during that week (or even that whole month) most people were probably not paying attention to the markets. The economic world, like the weather, was dark, cold, and foggy. Just the kind of pessimistic atmosphere that would keep shares prices down. Yet they started rising, like steam out of a manhole cover.

Peter Lynch, one of America’s most successful and famous fund managers, has said, "I’d love to be able to predict markets and anticipate recessions, but since that’s impossible, I’m satisfied to search out profitable companies. When even the analysts are bored, it’s time to start buying. Whatever method you use to pick stocks, your ultimate success or failure will depend on your ability to ignore the worries of the world long enough to allow your investments to succeed."

But what about the whole issue of "dodgy" accounting? It’s seems pretty simple to me: A coalition of US bankers, US accountants, and US company officials have contrived to steal money from investors. The only party to not be implicated so far are officials from the US Government. If you think about it, you’ve got to believe that they had something to do with the situation as well.

I hope these guys go to jail. I know this has been around the news a bit, but the whole thing just gets me so angry. They were in a position to take advantage of the situation, which they did, and then they bribed everyone along the way to go along with them.

Let me assure you of something – the chances of a fiasco like Enron or WorldCom happening in the UK is miniscule. Accounting procedures in the UK are significantly more stringent than in the US.

In America, companies are voluntarily concluding that "option award" expenses should be deducted from a company’s reported profits. This has been discussed for a generation, but it finally looks like it will now be put into place. If companies correctly subtract the expense of options from their income statements, in some cases, it changes a profit into a loss.

And what some companies have been doing is buying back shares to keep the share price up. They do this for two reasons: one, so that the price will remain in the exercise zone for the options, and two, the exercise of options floods the market with shares, thereby causing the price to fall even more. So the company must buy back shares just to stay even.

So, in some extreme instances, you had companies whose sole business appeared to be the issuance of options and extinguishment of shares, all to the detriment of existing shareholders and hapless bondholders, who were financing this charade.

During the bubble, many telecom companies got carried away by the massive jump in their share prices as investors jumped on the TMT bandwagon both in the UK and US. But in the states this fuelled the acquisition mania that has proved the undoing of WorldCom, Tyco and the rest. A similar trend of acquiring rivals happened in the UK in the 1980s. UK rules were tightened at the time, to prevent exactly the sort of fallout that is happening in the US from happening in England. We have not seen this sort of activity in the UK since then, so I don’t think we’ll see any home-grown scandals as a result of acquisitions accounts unravelling.

The bottom line is that it’s much harder to cook the books in this way in the UK. Since the Robert Maxwell scandal where the notorious newspaper proprietor made off with millions of pounds from his company’s pension fund, UK company accounts try to show the true position of the company. In America, home to over 500,000 lawyers, it tends to be the other way round.

A recent report by HSBC compares earnings growth forecasts for large UK companies (FTSE 100) to those of smaller UK companies. What the figures show is that if you strip out the tech companies, small UK companies are great values.

The estimated annual earnings per share growth for the FTSE from 2000 to 2004 is a positive 3.9%; for smaller companies, it is a paltry negative 15.3%. But if you strip out tech companies from the smaller company list, the annual earnings per share growth in the same period jumps to a positive 13.9%. Meanwhile, the overall price to earnings ratio on the FTSE is expected to be 14.7 – or about the historical average of the S&P 500 in the States. This number is only 11.1 for UK small caps, minus tech.

These numbers tell the whole story. The market is much cheaper than the US…and the figures for the smaller companies by themselves are horribly distorted. This is because the sector now includes the tech and telecom names, which were once big and now are small. But take them out of the equation, and you can see that the earnings growth for the UK smaller company market looks pretty rosy.

There are many opportunities for you to make money in UK shares. UK companies offer good value and an accounting system you can trust. My advice to you – look across the Atlantic!


Bruce McWilliams,
for The Daily Reckoning
October 1, 2002

Editor’s Note: If anybody understands what European markets have to offer for Americans, it’s Bruce McWilliams, an American ex-pat who has lived in Europe for the last 15 years. Before he left "home," he wrote the book on "Penny Stocks" for Doubleday, which honed in on successful oil, gas, mining, and high tech stocks. Bruce has also served as Vice-President at Citibank on Wall Street and in Switzerland.

If you’re interested in taking advantage of the significant opportunities in European markets, largely ignored by most "head-in-the-sand" Americans.

"We are at a loss for words," writes economist Paul Samuelson in MONEY. "If nothing else, this baffling economy has defeated the vocabulary of economics. We are supposed to be in a ‘recovery,’ but is doesn’t feel like one."

Samuelson needs to learn a few new words. "Bear Market" would be a good place to start. We also offer a definition: Bear markets correct the excesses of bull markets. And a helpful predictive tool: Generally, a bear market will be about as awful as the bull market preceding it was delightful.

Yesterday, the bear market on Wall Street continued. (Eric has more details below.)

It was the worst September since ’37. Stocks have gone down 6 months in a row. You’d have to go all the way back to the middle of WWII to find a longer period of consecutive monthly declines; stocks fell 9 months in a row in 1942.

So far this year, stocks are down about 25%…wiping $3.4 trillion from the nation’s stock market wealth.

Of course, anything could happen. Readers are warned that there is no guarantee stocks will continue falling. In fact, Mr. Bear might be getting ready to pull one of his tricks – allowing stocks to rally for a few weeks in order to keep the suckers in the game.

But bear markets (we repeat ourselves for Mr. Samuelson’s sake) do not end until people stop looking for them to end. They end when people stop asking "Is this the bottom?" and begin saying "I don’t care where the bottom is, I’ve had enough."

Also for Mr. Samuelson’s sake, we remind readers that an economy can only recover after whatever is ailing it has run its course. Cheerleading to improve consumer morale…and rate cuts to improve their cash flow…do little good. For what afflicts this economy is not a shortage of consumer and investor confidence but an excess of it. Believing they had nothing to fear, they feared nothing…and did things they shouldn’t have. Now, those mistakes need to be corrected.

In particular, Americans borrowed too much money… William V. Sullivan Jr. tells us that nonfinancial debt topped $20 trillion in the last quarter. "Debt is nearly two times larger than nominal gross domestic product," he writes, "or well above the ratios that prevailed just a few years ago."

This Everest of debt will one day wear down and wash out to the sea. But it will take time. And in the meantime, the high altitude makes noses bleed and consumers wheeze.

But let’s see what Eric has to say…


Eric Fry, on the other side of the Atlantic:

– Paris office: 1, New York office: 0…Congratulations to Bill and the rest of the gang in the City of Lights for predicting yesterday, "If there is a bubble in bonds, we wouldn’t be surprised to see it get even bigger than it is now." The Daily Reckoning’s cyber-ink had scarcely dried before the bond market launched a great big rally that pushed the yield on the 10-year Treasury down to 3.60%, from 3.66% on Friday. Nice call, Bill. Enjoy it while you can. The bond market still looks like a dangerous place.

– The renewed enthusiasm for bonds yesterday was hardly a mystery…Stocks stunk up the place. All the major stocks indices dropped again, both in the States and overseas. Therefore, buying a bond, even one paying a mere 3.6% per year, seemed like a better idea than buying a stock.

– Shortly after the opening bell, the Dow careened 200 points lower, before recovering somewhat to finish the day with a loss of 110 points at 7,591. The Nasdaq Composite dropped more than 2% to 1,172. Yesterday’s losses put the finishing touches on one of Wall Street’s most forgettable quarters ever.

– The Dow and S&P 500 both declined about 18% in the third quarter, while the Nasdaq produced a 20% loss. "It’s the first time the market has had to endure consecutive negative double-digit quarterly declines since the 1930s," says CBSMarketWatch.

– At some point, we suppose, all the urgent selling of stocks ought to come to an end. Problem is…there is no urgent reason to buy.

– Now, back to the bond market…From my side of the pond yesterday, I lobbed in the thought that maybe – just maybe – the bond market was becoming "the latest of the serial bubbles floating through our economy."

– Bill did not embrace the notion. "Our guess here in the Paris office," he wrote, "is that [bonds] will go up for a while longer – as the U.S. economy continues to deflate. We wouldn’t be surprised to see yields drop to 3% on 10-year notes before the current trend runs its course."

– Could the 10-year note continue soaring in price until its yield dropped below 3%? Sure it could, just like the Nasdaq soared above 5,000 in March of 2000. But that doesn’t mean the bond market isn’t already a risky place for capital…just like the Nasdaq was when it first climbed through 4,500.

– "While we are impressed by the security of the Treasury note," Bill wrote, "we are unimpressed by the currency in which it is quoted. Maybe the T-note will rise in value, but among the things that could happen, a decrease in the value of the dollar seems at least as likely."

– Maybe the bond market can emerge unscathed from a collapse of the US dollar. But I wonder; Can what is bad for the US dollar "goose" be any less bad for the US bond market "gander?" Might not the very same investors who flee the dollar also be inclined to flee the US bond market? Certainly, America’s current account deficit poses as great a risk to the holder of US bonds as it does to the holder of US dollars.

– "AFTER more than two decades during which the United States bought and consumed far more than it produced, has payback time finally arrived?" wonders Edmund L. Andrews of the NY Times.

– "The American economy has seemed to defy gravity for years, running steadily bigger trade deficits almost every year for the past two decades. Yet because growth was so strong through most of the 1990’s, the economy has also acted as a vacuum cleaner, sucking in hundreds of billions of dollars in foreign investment every year. "The upshot has been an impossible balancing act – a huge need for foreign cash, yet an indefatigable domestic currency – that has caused hand-wringing from foreign central bankers who can’t believe the United States keeps getting away with it."

– We can’t believe it either.

– The US current account deficit is on track to hit nearly $500 billion this year. That’s a whopping 6% of the entire world’s savings. As long as the money keeps flowing in, we’ve got no worries. But if the money doesn’t continue flowing in as eagerly as it has in the past, the US dollar would certainly weaken…Would the bond market be any better off?

– "If foreigners lose confidence in the dollar en masse, interest rates will soar," writes John Myers. (Washington would be forced to pay more to attract and keep its creditors.) That would set off a chain reaction of a vicious cycle that dampens consumer spending, which causes corporate profits to fall, which knocks the legs out from under the stock market. In quick fashion fear would replace uncertainty. Bond and stock sellers would be certain to put a portion of their money into hard assets."


Back in Paris…

*** Fannie Mae dropped below $60 yesterday. A lot of people are going to lose a lot of money in this stock. FNM turned itself into a quasi-central bank, providing the whole nation with mortgages at government-subsidized rates. It was a great business for a long time. But nothing fails like success, we like to say. Fannie’s success at pushing mortgage debt onto marginal homeowners will inevitably be followed by Fannie’s failure to collect its mortgage payments from marginal borrowers.

*** Gold rose $4.10 yesterday. It was one of the worst quarters in stock market history. But gold rose 11%.

The Daily Reckoning