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The scattergram approach

Created:
19 August 2008
Written by:
Mr Bearbull

There is a rising chorus of 'buy for recovery', or words to that effect. True, members of this chorus are self-serving. By and large, they comprise the so-called sell-side analysts whose role is to generate commission income from share transactions, and it is always easier to persuade clients to buy than to sell.

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This, however, does not mean that the chorus is wrong. Indeed, in a tentative way, I have added my voice to it. The logic goes like this: intuitively, we know that share prices will recover one day, so why not buy now in order to be in there nice and early for when the recovery does emerge? Thus one buys, say, shares in newspaper publisher Trinity Mirror or housebuilder Taylor Wimpey, because these firms won't go bust and, even on reduced expectations, there may be a fat dividend yield to be going on with - 9.4 per cent in Trinity Mirror's case, perhaps something similar for Taylor Wimpey.

The problem is that buying for recovery at this stage of the business cycle involves much faith and patience, which may not be rewarded even in the long run. Sure, it is easy to imagine a day when Taylor Wimpey's shares once more trade at £5 (current price - 51p), and that's a tempting proposition. But it's driven by our imagination, not by rational analysis. It's equally easy to imagine a turkey the size of a tennis court, but we wouldn't pop into Tesco expecting to buy one.

For now, therefore, it is better to focus on those equity opportunities where the odds favour decent returns in preference to those where the glory may be greater but the chances of achieving it lower. In other words, back the favourites not the long shots.

To help this selection process, I plot the London's stock market's sectors on a scattergram. Imagine such a chart, where the horizontal 'x' axis plots companies' vulnerability to the business cycle and the vertical 'y' axis plots the spectrum of how companies' customers spend - from small-ticket consumer spending to big-ticket capital goods items. Put another way, those sectors most sensitive to cyclical spending patterns go at the opposite end of the x axis to those sectors least sensitive to it. Simultaneously, those sectors most sensitive to a mix of small ticket/regular/personal spending go at the opposite end of the y axis to those exposed to big-ticket corporate spending on capital account. Clearly, placing the sectors is subjective and some don't fit easily into this arrangement. Even so, the exercise tells us something.

Essentially, three clusters of sectors emerge, which we can label: first, hold for safety; second, buy for recovery, but not just yet; third, sell short.

The first cluster - hold for safety - comprises non-cyclical sectors where customers have to buy a company's products whether they like it or not. It is biased towards small-ticket items sold to the personal sector and comprises pharmaceuticals, healthcare, food processors, food retailers and tobacco. It also includes utilities, whose business is split between serving the personal and commercial sectors, and the defence components of aerospace and defence. A typical portfolio from this cluster might comprise: Tesco, GlaxoSmithKline, Associated British Foods, National Grid and British Aerospace.

The second cluster - buy for recovery, but later - lies at the opposite end of the x axis to the first cluster. It features sectors in consumer-orientated industries exposed to shifts in discretionary spending - general retailers, beverages, travel and leisure, media and household goods - where share prices have been savaged. For obvious reasons, we might tag on the banks sector. A representative mini portfolio might be: Marks and Spencer, SABMiller, TUI Travel, Trinity Mirror, Taylor Wimpey and Royal Bank of Scotland.

Third, there is a cluster of sectors, whose activities are also highly cyclical but are exposed to the long-term capital spending plans of commercial customers, and are - to use the jargon - late stage. This embraces chemicals, oil services, technology hardware and software, transport, engineering and electricals, and it is where brave investors take a deep breath and go short. A representative cross-section might be: Johnson Matthey, Wellstream, Aveva, Spirent, Forth Ports, Weir and Chloride. These are firms where, mostly, current trading is good and their bosses are confident, so it will take courage to sell short. Yet the reassuring thought is that they will struggle to overcome the pull of the business cycle, as the downturn shifts to big-ticket commercial spending every bit as vainly as companies exposed to the early-cycle effects struggled.

My challenge is whether - and how - to adjust the Bearbull portfolios to be consistent with this thinking. Meanwhile, I have made a couple of moves in the Bearbull Hedge Fund. I have bought back the fund's short positions in business software supplier Misys, and property website operator Rightmove. Misys may not be in glowing health, but it looks brighter than the business whose shares I sold at 207p almost three years ago. So I have bought back the shares at 172p each, for a 20 per cent gain on my stake of 7,000. A bounce in Rightmove's shares, following rumours that the government would tinker with stamp duty on home purchases, pushed their price through my buy-back level. So I have exited this short sale at 342p, realising a 21 per cent gain in three months. My guess is that Rightmove faces years rather than months of miserable housing markets, so, if its shares approach 400p, I may go short again.

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