Anyone who has endured the rollercoaster ride since the start of this bull market will know all too well that at some point a catalyst would emerge to dampen the overexuberance of market participants. Moreover, with Wall Street's gauge of fear, the Vix index, trending around 11 to 12, its lowest level since the 2003-07 bull market and a quarter of the high hit last summer, risk aversion had become overly low. It was no surprise, either, that concerns over a tapering of the latest money printing programme, QE3, set off the market correction since the best of the gains in equities in the past four years have coincided with periods when the US Federal Reserve has been running its quantitative easing (QE) programmes
That's because the Federal Reserve's (and Bank of England's) QE programmes are designed to drive down long-term bond yields and alter how investors value equities relative to fixed income. In turn, this increases the value of bonds held in many investors' portfolios, thereby encouraging them to rebalance their assets more towards equities (and other risk assets) in order to maintain current allocations. In effect, the UK and US central banks have been attempting to force fund flows into the equity market to boost household wealth and make consumers who hold shares feel better off. It has clearly worked, with the S&P 500 in the US hitting an all-time high last month, a rise of 153 per cent from the bear market in March 2009. And given the strong correlation between the US and UK stock markets, the FTSE 250 is in blue sky territory, too, posting a 160 per cent gain in the same 50-month period.
The Fed's view is that its own QE programmes operate through portfolio choices. When the Fed buys Treasuries, it lowers yields relative to other risk assets - forcing portfolios to shift up the risk curve. That shift incorporates strong capital flows overseas - which can be seen in rising foreign exchange reserves. In turn, emerging market central banks will print domestic currency to buy US dollars, to prevent excessive currency appreciation. This then raises deposits at banks, inducing a lending boom, with knock-on effects on commodity currencies and speculative flows.
Understanding impact of QE tapering on markets
It is therefore well worth noting what happens when QE3 ends, or when investors start to think it will end, because this has major implications for a number of asset classes and markets. This is where we are at right now after Fed chairman Ben Bernanke hinted at the possibility of tapering the US central bank's open-ended asset purchases of US Treasuries and mortgage-backed securities in a speech on 22 May. These programmes are currently running at $85bn (£56bn) a month and the Fed has more than quadrupled its balance sheet from $800bn in late 2008 to over $3.2bn through its QE1, QE2 and QE3 programmes.
However, when these QE programmes are reversed, it is only reasonable to expect Treasury yields to rise relative to other asset classes - the US government 10-year bond yield has risen by 60 basis points to 2.23 per cent since the start of May - making US bonds more attractive and forcing portfolios to shift back down the risk curve. This, in turn, is likely to trigger a reversal of speculative flows into emerging markets and can also lead to credit stress among companies with weaker credit ratings. It's also negative for commodity currencies: the Australian dollar has fallen by around 10 per cent since mid-April, although there are other factors at work here especially if the World Bank proves correct in its prediction that the resource supercycle is over.
So with hot money retrenching in the belief that the flood of liquidity resulting from the QE programmes could start to be reversed, it's no surprise that the worst performing markets in the past four weeks have been in emerging markets. In a 'risk off' environment, equity, bond and currency investors have understandably been reducing their exposure to these regions, especially as there is clear evidence of a slowdown in the once rampant Chinese economy. This has implications across the emerging market complex. Investors have taken note and emerging market equity funds had outflows of $5.8bn in the week to Wednesday 12 June, following net withdrawals of $5bn in the previous week, according to analysts at investment bank Citi.
To put the scale of the emerging markets sell-off into some perspective, since hitting a bull-market and record high four weeks ago, the S&P 500 has sold off a modest 3 per cent, both the FTSE 100 and FTSE 250 have fallen by around 7 per cent, but the Brics (Brazil, Russia, India and China) have racked up significant losses. The Brazilian Bovespa and Indian BSE Sensex indices are down well over 11 per cent, and the Hang Seng China (HSCEI) index of mainland companies listed in Hong Kong has plunged 15 per cent, during which it recorded its worst losing streak since 1995. As a result, the MSCI's developing nation index has lost 9.6 per cent this year, compared with a 9.7 per cent rise in the MSCI World index of developed country stocks.
The fallout from the move in US bond market yields has not only caused the most damage at the periphery by causing widespread damage in emerging bond and equity markets, and prompted a strong rally in the US dollar against these currencies as funds were repatriated and speculative trades reversed, but it has implications at the epicentre, too.
Bond market watch
Chris Godding, head of global equities at Signia Wealth, explains: "Our conclusion from the QE tapering discussion is that whether intentional or not, the "trial balloon" from the Fed has yielded some vital market intelligence on the impact of an exit strategy to central banks around the world."
Mr Goddings adds: "We can expect to see more of the same over time, but believe that in the short term the negative feedback loop on the US economy, through the violent reaction in the mortgage-backed security market (yields have spiked as investors factor in a reduction in the Fed's open-market buying activities) will lead to equilibrium in bond markets at lower yields than we are seeing today. The US economy, and the recovery in real estate is not robust enough to absorb a brutal move up in borrowing costs and yields will moderate from current levels as investors find an appropriate equilibrium."
He has a point, as a direct consequence of QE3 has been to markedly reduce long-term US mortgage rates, which trade at a yield premium relative to risk-free Treasury bonds. Moreover, with house prices stabilising - and rising in some states following substantial falls between 2006 and 2012 - the availability of low-cost mortgages has improved affordability and clearly buoyed the country's housing market. Given that consumers account for over two-thirds of US GDP, the sharp rise in US mortgage bond yields in the past month highlights the tightrope Mr Bernanke is walking as it comes at a time when a sustainable recovery has yet to prove itself in the economy, the housing and employment markets. Rest assured, Fed chairman Ben Bernanke will be all too aware of the dire implications of tightening monetary policy too quickly.
Watch the Fed
Interestingly, Mr Godding believes that "the bond bull market is over… and equities will only be able to progress in the face of QE [tapering] fears if earnings revisions gain some positive momentum from stronger global growth." That may indeed be the case, but in my view it is just as likely that equity investors, who became far too complacent in the spring, are now overreacting to the possibility of the start of QE tapering in the autumn.
Indeed, any comments from Fed chairman Ben Bernanke in the coming months to dampen expectations of the timing of QE tapering would in my view set markets off to the races once again. That's not a forlorn hope as economic data from the US is mixed to say the least. As Michael Pond, interest rate strategist at Barclays, has commented: "The bond market seems to be missing the point that the Fed's policy of tapering depends on the tone of economic data. The market has moved from pricing in less bond buying to a full-on tightening cycle and we believe that is a different story than what the Fed is trying to communicate." Mr Bernanke's hand may be hovering above the QE tap, but let's not forget the tap is still running at full flow.
Moreover, it's also worth noting that the key driver of the performance of the US equity markets, and by consequence UK equities, has been inflation expectations. In fact, the investment banking team at Credit Suisse found that in the five years between 2008 and early 2013 "the prospective earnings multiple for the S&P 500 has been closely correlated with inflation expectations. Indeed, the single most important driver of valuations has been inflation expectations."
Clearly, the level of real bond yields and the inflation rate itself also have implications for the pricing of equities and the earnings multiple investors are willing to pay and the dividend yield they are happy to receive. On that score, 12-month forward earnings multiples of less than 12 times in the UK, and around 14 times in the US, are not extreme by historic standards. There are also some indications that earnings revisions are on the cusp of recording net upgrades in the US, according to analysts at Citi. This analysis has since been corroborated by analysts at Morgan Stanley in their own research. It would make a lot of sense for the Fed to allow these positive earnings trends to emerge rather than risk extinguishing them by turning off the liquidity tap prematurely.
I will of course be keeping a close eye on the rhetoric emerging from the US central bank's Federal Open Market Committee (FOMC) and from Mr Bernanke himself in the coming months. It would be foolish not to, given the increased levels of market volatility witnessed when investors think, rightly or wrongly, that the QE tap is going to be turned off (if only slightly). I would be very wary of the emerging market complex for the time being for all the reasons mentioned above.
However, without appearing complacent, my own strategy for the next few months, and one which I set out in my article at the end of April ('Seasonal stockpicking strategies', 29 April 2013), is to continue to seek out special situations that have clear potential to produce financial gains irrespective of general market moves. It has served us well so far as the recommendations I have made in the past six weeks have held up remarkably well in the general market sell-off. In my view, this is in no small part down to the fact that, for the current time at least, this is a stockpickers' market.
So with that in mind, I have noted some potentially profitable investment opportunities in a number of the special situations on my watchlist of companies.
A tasty investment
The market shake-out has produced a buying opportunity in the shares of chocolate manufacturer and retailer Thorntons (THT: 85.25p).
To recap, I first recommended buying the shares last month when the price was 82.5p ('A sweet investment', 13 May 2013). It proved popular because within a week they had hit a high of 102.25p, within a whisker of my 105p target price. In the circumstances, it was only rational for some investors to take the 20 per cent quick-fire profit and await a better buying opportunity. I feel that has now arrived.
Chairman Paul Wilkinson is certainly confident enough of the company's prospects as he purchased 200,000 shares at 78.5p to take his holding to 1.2m shares, or 1.76 per cent of the issued share capital, following the company's eye-catching third-quarter trading statement at the end of April. Analyst Bethany Hocking at brokerage Investec Securities is pretty bullish too, having upgraded her pre-tax profit estimate for the financial year to June 2013 by 50 per cent from £3m to £4.5m to produce EPS of 4.8p. These estimates represent a fivefold increase on the £0.85m of underlying profits Thorntons made in the prior financial year, and are based on sales of £223m for the 12-month period, up from the £221.6m previously forecast. Thorntons reported sales of £217m in the 12 months to June 2012, so it is clear that higher-margin incremental sales - all of which are being generated by commercial, private label and international sales - are strongly benefiting profits.
Analysts Philip Drogan and Jean Roche at broking house Panmure Gordon are more bullish still, having upgraded their profit estimates from £3m to £5.7m for the financial year to end June 2013. On that basis, expect EPS of 6.3p. Moreover, the analysts note that "there is scope for these numbers to move ahead further, although it should be remembered that the fourth quarter is a much less important trading period". For the financial year to June 2014, Panmure is expecting pre-tax profits to rise further to £7.4m to produce EPS of 8.3p.
Pullback is clear buying opportunity
Having pulled back on profit-taking, Thorntons' shares are now once again trading on 10 times Panmure's earnings estimates for the 2013-14 financial year. The broker has been advising clients that "June 2014 estimates still have upside... because we believe that Thorntons can drive sales through a number of channels and that profits will further benefit from a reduced cost base. Historic levels of profitability are within reach." In the 2007-08 financial year, Thorntons' pre-tax profits peaked at £8.5m on sales of £208m to produce EPS of 9p.
Interestingly, the retracement in the share price has taken it back to test the previous chart breakout point at 83.5p. I have seen this type of price action many times before where a prior resistance level (83.5p) then turns into support on the first pullback after the breakout and, having been tested, the price makes a move back towards the high (102.25p). I believe this process is now happening, especially as Thorntons' 14-day RSI (relative strength indicator) on its chart is entering oversold territory, so both the technical and chart set-up are favourable.
Moreover, we don't have long to wait for a catalyst to emerge to send the share price higher once again, as Thorntons is expected to release a pre-close trading update to the market in early July ahead of full-year results on 12 September. On a risk:reward basis, the shares rate a decent trading buy priced on a bid-offer spread of 84.25p to 85.25p. My target price remains 105p.
Time to capitalise on LMS Capital
LMS Capital (LMS: 74.5p), an investment business in the process of winding itself up, and a company I have followed for some time, has just announced it will be returning £35m of its cash to shareholders through a tender offer. A circular will be sent to shareholders in early July to approve the capital return. Following realisations, LMS was sitting on net cash of £42.2m at the end of March, or 25 per cent of the company's market value of £166m, so can certainly afford to.
It also makes sense to use the tender process to return cash as LMS shares are currently priced on an unwarranted 16 per cent discount to net asset value even though the book value increased by 4p to 89p a share in the first quarter this year. And it's not as if the company's investment portfolio is overvalued. In fact, the disposal of Apogee, one of the UK's leading suppliers of digital document solutions, for £16m in mid-March was at an 18.5 per cent premium to the carrying value in LMS' accounts. The sale price represented a 2.1 times return on the cash LMS had invested and equated to an internal rate of return of 30 per cent since Apogee's acquisition in 2010.
Smart way of returning cash
This is the second tender offer by LMS as the company repurchased 17.4 per cent of the issued share capital through a tender offer at 84p a share last autumn. Importantly, this method of capital return enabled shareholders to sell down further chunks of their holdings at book value without impacting the share price. Assuming the board prices the new tender offer at book value of 89p a share, which means 39.4m of the 226m shares in issue will be repurchased by the company, this means anyone buying LMS shares now at 74.5p is in effect guaranteed a 19.5 per cent profit on 17.4 per cent of their holding. In addition, there is scope for the share price discount to book value to narrow further. That’' because some investors will undoubtedly use the cash proceeds from next month's tender offer process to buy back the LMS shares they tender at book value of 89p, but at a lower price in the open market.
Double-digit returns
As regular readers of my columns will know, LMS is a long-term favourite of mine. I first recommended buying the shares at 54.5p in February 2011 ('Capital returns', 11 February 2011), and repeated that advice when the price was 64p ('Time capitalise on LMS', 25 Jun 2012) and at 66p ('Happy capital returns', 17 December 2012). Following the first-quarter trading update last month, I reiterated the advice again at 71.5p ('Target price smashed', 15 May 2013).
If you followed the initial recommendation, the carrying value on your retained shares is 48p after adjusting for the tender offer last year at 84p. So, at the current price of 74.5p, the return on the net capital invested is 55 per cent in the past 28 months - more than double the 25 per cent total return on the FTSE 250 in the same period.
The key point to note here is that next month's tender offer will provide another capital return to existing and new shareholders and will reduce the carrying value of holdings once again. Clearly, there will be wind-up costs when the company finally sells off all its assets, but with net asset value around 19 per cent above the current share price you can realistically expect a healthy double-digit return on your capital over the next 18 months. In a low-growth, low-interest-rate environment that type of return is attractive and LMS shares remain a low-risk buy at 74.5p.
Netplay TV takes a punt on Big Brother
Aim-traded interactive gaming company NetPlay TV (NPT: 17.5p) has taken a punt on the new Big Brother 2013 show on Channel 5. The company's SuperCasino.com brand is the headline sponsor of the reality television show, which will be aired every night for 11 weeks. SuperCasino.com branded bumpers will be shown from 9pm onwards on all coverage, including all Big Brother and Big Brother support programming, online and video on demand.
Charles Butler, boss of NetPlayTV, notes: "Television airtime continues to be a very effective new customer recruitment tool for the company and we have sought to boost this exposure though the sponsorship of Big Brother 2013. This high-profile sponsorship will allow SuperCasino.com to significantly increase brand awareness and new customer reach." He has a point, as earlier this year The Celebrity Big Brother series had peak viewing figures of 4.3m in its launch week and regularly had audiences of between 2m and 3m per show.
I have been a big fan of Netplay, having first advised buying the shares at 12.5p in February, although a surge of buying meant that most of you bought in around 13.75p in the five trading days after I published my article ('A share to hit the jackpot', 11 February 2013). I then reiterated my buy advice when the price was 16.5p ('Another roll of the dice', 13 March 2013). At the time, I noted: "Even after the recent re-rating, NetPlay's shares are still deep into bargain basement territory and, in my view, my 18p target price is likely to prove very conservative. Ahead of the forthcoming results on 9 April, I rate the shares a trading buy and have lifted my target price to 20p." In the event, the shares peaked out at 19.8p so the target price was almost hit.
I last advised buying in early May when the price was 16.5p ('A golden nugget', 2 May 2013). At the time I upgraded my target price to 21p. This has yet to be hit. However, with the company set to release a trading update on 9 July, and with a likely boost to business from the Big Brother sponsorship deal, I feel we could be in for some positive newsflow in the coming months, not to mention potential earnings upgrades.
Strong earnings growth
Currently, analyst Amisha Chohan at broking house Sanlam Securities forecasts calendar 2013 pre-tax profits of £4.6m, rising to £5.2m in 2014, to produce EPS of 1.5p and 1.7p, respectively. But with the business generating huge amounts of cash, the net cash pile is expected to rise to £15.8m by the end of 2013 - the equivalent of 5.4p a share. And if NetPlay hits those 2014 estimates, the cash pile is expected to swell to £20m by the end of 2014, or almost 7p a share. Johnathan Barrett of N+1 Singer has similar forecasts for the next couple of years.
In other words, strip out net cash from the current share price and Netplay TV is trading on a modest 2013 PE ratio of 8, falling to a bargain basement six times 2014 earnings estimates. There is a decent dividend, too, as the board paid out 0.375p a share in 2012, or a third of EPS of 1.2p. On that basis, the historic yield is 2.1 per cent with the payout covered over three times. But with so much cash being generated by the company, analysts believe there is scope to increase the payout sharply. In fact, Mr Chohan at broking house Sanlam forecasts a payout of 0.5p a share this year, rising to 0.6p a share in 2014. On this basis, the prospective yield is 2.9 per cent and 3.5 per cent, respectively.
Ahead of the trading update in three weeks' time, I continue to rate the shares a trading buy on a bid-offer spread of 17p to 17.5p and am maintaining my target price at 21p.
