Shares digital

By 2012, the year of the London Olympics, the stock market may well have changed beyond all recognition. Tom Sieber checks out the key trends and likely winners and losers of the next four years

BP and Royal Dutch Shell merged to create a super major, oil back below $100 a barrel, England winning the European Championships – these are just some predictions of the Shares team for 2012.

Alright, let’s admit it no-one really knows what the future holds and bold predictions often turn out badly wrong. But we should also remember, surrounded as we are by all the doom and gloom of 2008, that it is easy to lose sight of the bigger picture.

That bigger picture is throwing up plenty of opportunities, with developments including the emergence of new super-powers such as China, or the revolution currently under way in the technology sector, as a new generation of wireless infrastructure is rolled out.

By 2012, the year of the London Olympics, our preoccupation with the credit crunch and the speculative oil bubble will be long forgotten. With this in mind we look to the future and assess which companies will win and lose.

The key themes over the next four years are likely to be success for companies that have effectively integrated into emerging markets; strong performance by utilities, which are insulated against problems in the credit markets; a change in technology and communication, with the digital switch-over and the likely adoption of fourth-generation (4G) mobile phone technology; an increasing emphasis on renewable energy; consolidation and eventual recovery in the UK housing sector.

The interim will involve two very difficult years and two years of gradual transition and recovery running up to the Olympics which, according to your point of view, could either be an expensive anti-climax that leaves the capital with a collective financial hangover, or a unifying event that hastens the return of a feel-good factor to the country.

An easy prediction is that we will see an increasing shift in power from the developed nations, namely the Organisation for Economic Co-operation and Development (OECD) countries, to Brazil, Russia, India and China (or BRIC states). A report from PricewaterhouseCooper postulates that China will overtake the US as the world’s largest economy by 2025.

These changes will lead to the emergence of what the World Bank describes as a ‘global middle class’ of 1.2 billion people – who will buy more cars, consume more durables and increasingly travel abroad. This will provide major challenges in the run-up to 2012 and beyond, and the winners and losers will be decided to a large extent by how they cope with the shift.

The main challenge for companies attempting to break into emerging markets will be adapting to the different cultural and business environments in these parts of the world. It makes more sense to back those firms with a track record in this area – such as banking group Standard Chartered or oil services firm Lamprell, which has a well-established business in the Middle East.

Like the environment, money is green

The UK’s energy needs and the issue of energy security will continue to dominate the agenda. With Russia soon to be responsible for half of Western Europe’s gas supplies, investment in renewable technologies is not just linked to environmental concerns – it is vital to the future of the UK economy. This will involve the construction of massive offshore wind farms – with utility group Scottish & Southern Energy an early mover in this area.

There may be other solutions. In January this year the Welsh Assembly and UK government launched a study into whether using the Severn estuary to generate electricity through tidal power was possible.

The next four years should also see continuing development of the key technological focus of the past 15 years – communication. With the analogue signal due to be switched off and the emergence of 4G mobile phone technology leading to further changes in the way we are entertained, informed and connect with each other.

By 2012 the housing market will have rebounded. The UK’s growing population means the fundamentals behind the industry remain strong – so, once house prices have normalised and the problems in the mortgage market have been addressed, there appears no sensible reason for the market to remain depressed.

We are undoubtedly in choppy waters at the moment but for companies that successfully negotiate these financial currents over the next four years there will be rewards.

30 second - FTSE 100 in 2012

• Biggest company is the newly-created Royal British & Dutch Petroleum

• Several analysts are predicting the index to reach the 7,000 mark

• The first alternative or renewables-focused stock has entered the index

• Biggest sector to remain Oil & Gas though with a smaller weighting than now

• 80% of the index is made up of companies whose main business is overseas

• FTSE 100 firms face stringent regulations on carbon emissions

OLYMPIC EFFECT

There is some debate about what effect an event such as the Olympics can have on the economy of a country. A lot of the time it depends on the size of the country relative to the city hosting the games. On that basis this year’s Beijing Olympics is unlikely to have a huge impact – much as the Atlanta Olympics had little effect in the US in 1996.

On the other hand, while you have to take account of the wider economic context, a look at the headline indexes in Australia and Greece around the time of the Olympics in Sydney and Athens suggests the respective events had a dramatic effect.

The FTSE/ATHEX 20 was at 703.37 on 31 March 2003, just under 18 months before the games – it ran up rapidly ahead of the games and by 3 January 2005 had more than doubled to 1574.71. The S&P/ASX 200, while not quite as dramatic, ran up from 2704.1 on 14 January 1999 and by 7 November 2000, just a couple of months after the competition was over, it had reached 3372.9.

WHAT HISTORY TELLS US

In terms of where the FTSE All Share might be in 2012 it is instructive to look at the two other major corrections of the past 25 years. In 1987 the recovery was actually relatively swift.

The FTSE All Share peaked on 16 July 1987 at 1,238.6 and bottomed out at 784.8 on 10 November. Obviously, most of that fall occurred on Black Monday (19 October). The index fell from 1,189.9 on the preceding Friday to 1,072.4 on the day itself.

The dot.com crash at the turn of the millennium was a more prolonged affair. The All Share peaked on 1 September 2000 at 3,261.6 and bottomed out at 1,685, constituting a fall of some 48%, on 7 March 2003.

The peak of the most recent bull market was on 15 June at 3,479. As I write it has fallen just 20% from that level to 2782.8 – food for thought.

Nick Clay, a global fund manager at Newton Asset Management, which is known for taking a long-term thematic view of the market, is not predicting a rapid turn-around.

‘It took about six or seven years to create this credit-leveraged bubble, you’re not going to sort it in a few months – it’s going to take a good few years for the market to go back to normality.

‘And when we talk about normality we’re not talking about the kind of conditions we have seen over the last five years.’

FINANCIALS

The banking crisis is far from over and the next two years will be tough – expect consolidation among the smaller banks.

Let’s start this exercise in clairvoyance in the sector blamed for getting the economy into a mess in the first place. Many believe the banks’ reckless lending and the reliance on complex financial instruments to underpin growth have contributed to the slowdown in the real economy.

According to a report from Goldman Sachs, four major hurdles must be overcome to make a recovery in the banking sector possible, which might not occur for six to nine months. Goldman says credit costs must stabilise, banks must complete the process of recapitalisation, consensus estimate ranges for earnings must narrow and the yield curve steepen.

It estimates credit losses resulting from continued deterioration in the mortgage and lending markets will not peak until early 2009, making a broad-based sector rally unlikely before the end of 2008. This may be too optimistic, fundamentals don’t look good for at least the next two years – particularly for banks with an emphasis on mortgage lending and exposure to UK consumers.

The potential consolidation among smaller banks – signalled by Resolution’s bold attempt to take a stake in Bradford & Bingley – is likely to have occurred before 2012 and it would be a surprise if B&B and Alliance & Leicester still existed in their current form by then.

In four years the banks are likely to have a much more conservative approach to risk and it will be important to be exposed to the right markets. This makes it hard to look beyond HSBC and Standard Chartered when predicting the best-placed banks in 2012. Both have a significant footprint in emerging market economies likely to be the main areas of growth.

RESOURCES

Commodity prices have entered a bubble and this should burst in 2009 – long-term trends do seem to support historically higher prices but there are risks to that view.

In his book Hot Commodities, published in 2004, investment guru Jim Rogers explained he didn’t see the end of the commodities boom for at least a decade. Although many things he noted as signalling the end of a bull run – a growing hysteria, a new orthodoxy based on continually rising prices and the feeling that it’s different this time – are all present in 2008.

This is particularly true with oil. At current levels the oil price is already affecting demand destruction in some countries. The International Energy Agency has warned demand for oil imports from China and India will almost quadruple by 2030. Car sales in China are expected to overtake the US by 2015, with India catching up fast. By 2012, 2.3 million new cars will roll out in the country every year.

But these countries are not ‘paying proper economic prices for growth’, says Nick Clay, a global fund manager at Newton Asset Management, particularly given the caps on the costs of natural resources – without these subsidies it is unclear whether we would see the same rate of growth.

The high prices and considerations of energy security will also lead to more serious thought about alternatives. The UK government appears keen to develop nuclear and wind power as viable solutions to the current reliance on oil & gas. Global investment in renewable options and the massive sums all governments will have to spend to bring their infrastructure up to scratch could prop up commodity prices.

Despite this backdrop, estimates from Deutsche Bank suggest metals prices are due to peak around the end of the year and should be softening by 2012. For example, the price of copper is expected to reach $8,598 a tonne by the last quarter – in 2012 the price is expected to be $5,512.

UTILITIES

Despite recent political pressure to tackle rising energy bills the importance of consistent energy supply means utilities will be prominent in 2012.

Utilities companies are probably the least vulnerable to what happens in capital markets and the economy, and will be able to pass a big chunk of the rises in raw material prices on to customers.

The investment needed around the world, and in the UK, to improve energy infrastructure is huge – with the UK not far off seeing the kind of power shortages witnessed in South Africa recently. Finally, a lot of investment is needed to modernise the country’s water systems, something the industry regulator is pushing for.

There are few pure water plays on the market – Severn Trent, Pennon and Northumbrian Water are the most obvious examples – and if the situation on the credit markets stabilises these will again attract interest from private equity players or infrastructure funds.

Green energy is another potential major area of investment as discussed above, and Scottish & Southern Energy, already putting a fair amount of faith in wind energy, could prosper. (CS)

TECHNOLOGY

Changes in the way we communicate and receive entertainment should reach their crescendo in four years’ time – creating opportunities for companies with the appropriate focus.

The telecoms and broadcasting industries should see seismic technological shifts in 2012. In broadcasting, analogue television signals are due to be switched off completely by the end of 2012. Equipment suppliers such as Pace should be able to capitalise on the switch-over to digital, by providing analogue-to-digital converters for non-digital televisions or upgrading existing set-top boxes to digital.

Proposed UK digital switch-over schedule

2008 Border

2009 HTV Wales, Granada, West Country

2010 HTV West, Grampian, Scottish Television

2011 Anglia, Central, Yorkshire

2012 London, Meridian, Tyne Tees, Ulster

Source: Ofcom

2012 could also see the launch in the UK of fourth-generation (4G) mobile telephony services, partly facilitated by an auction of the broadcasting spectrum freed up by the digital switch-over. Around 700Mhz of spectrum is due to be auctioned by telecoms regulator Ofcom in 2009.

Incumbent mobile telecom operators such as Vodafone and 02 are among the likely bidders, as the spectrum is ideal for data communications. Operators will be seeking to use 4G to offer more data-rich services, such as mobile music, video and mapping, to boost average revenue per user (ARPU).

Vodafone’s shares could come under short-term pressure as the market digests the prospects for 2009’s auction, even if this is unlikely to be anywhere near as frenzied as 2000’s 3G equivalent. Long term, the telco should benefit from rising data revenues, although ARM Holdings could also benefit from 4G and the ongoing rise of the mobile internet. The Cambridge firm’s chip designs feature in 80% of the world’s smartphones today and royalties per unit can run at up to ten times the $0.05 to $0.06 seen today in basic phones. ARM has already sold 44 Cortex A9 and 65 ARM11 licences yet they generate just 3% of ARM’s royalty income, so a rich harvest awaits. (RM)

CONSTRUCTION & HOUSING

The long-term imbalance between supply of housing and growing demand should ensure that by 2012 the disasters of 2008 are consigned to the history books.

In four years, today’s housing woes will be forgotten, largely because of the sheer imbalance between housing demand and supply in the UK. For a recovery to take root, though, UK house builders will have to recapitalise, and the government will have to make the planning process easier to negotiate.

House builders should also have tweaked their land acquisition strategy, being more cautious in what they buy, and reduced their debt levels. There is likely to be considerable consolidation between now and 2012. Redrow and Bovis Homes, being small players, may no longer exist and it would not be a surprise to see Barratt Developments taken out. When making an acquisition, though, companies will be wary of paying too much so, in the interim we can expect fierce and lengthy bid battles.

Elsewhere, preparation for the Olympics and other infrastructure work should ensure a steady stream of work. (CS

PHARMACEUTICALS & HEALTHCARE

An ageing population means increased demand for care solutions and medicines, but benefits may not be as full for some established players.

The West is seeing a dramatic shift in demographics with fewer children born and people living for longer. According to the Office for National Statistics the median age in the UK is projected to rise from 39 years in 2006 to 41.8 years by 2031, and the ratio of working-age people to those of pensionable age will fall from 3.3:1 in 2006 to 2.9:1 by 2031.

This will present healthcare challenges and opportunities. The big pharmaceutical companies face a stern challenge from so-called ‘generics’ – unpatented drugs – that have driven growth at companies such as Middle-East-focused Hikma Pharmaceuticals.

The lack of new ‘blockbuster’ drugs with which to dominate the market means the sector could look quite different, with consolidation a potential solution.

The travails at care home provider Southern Cross Healthcare, illustrate the dangers of getting carried away with the demographic story – particularly as local authorities have proved keen to take the cheaper option of offering care within the community. But it is likely that by 2012 there will be increased demand for respite care and private health services.

INVESTING

We asked James Clunie, investment director for UK Equities at Scottish Widows Investment Partnership (SWIP), about some of the key themes likely to emerge in investing over the next four years.

The first he identifies is for 130/30 or short-extension portfolios to become a mainstream vehicle for private investors. Effectively a short-extension strategy adds short positions to a ‘traditional’ portfolio and buys additional long positions as well.

Instead of a 100% long portfolio this results, for example, in a 130% long and a 30% short portfolio. Consequently, the net exposure to the stock market remains 100%. At present these types of products are only really available to institutional investors.

Clunie explains: ‘In the hands of a good fund manager these can work very well but in a lot of cases they will disappoint due to their complexity.’

‘Once they have become established over the next three or four years, though, there is likely to be an increasing clamour for them to be available to retail investors.’

Clunie also sees structured products, an investment tool he personally doesn’t favour, as moving increasingly into the mainstream. Such products are generally created by varying the amount of exposure to risky investments, and often include the use of various derivatives. Clunie raises concerns about a lack of understanding among private investors on the products and the risks attached to them.

Taking a more optimistic view, another investment theme he identifies as being to the fore in 2012 is a preference for diversified portfolios. ‘My hope is that investors will be cleverer and more diversified, with a mix of equity, bonds, property and cash in their portfolios.’

Another positive change that Clunie highlights for 2012 is the increasing prominence of risk-adjusted performance measurement – a sophisticated way of gaining an understanding of risk.

‘In a general sense I just hope that we are better at thinking about risk, rather than just focusing on reward.

‘If that happens, we may have a more stable, less reactive market, which would be a good thing for everyone.’

THREE TO LOOK OUT FOR

Zenergy Power 197.5p BUY

In four years’ time Aim-listed Zenergy, a developer of technologies based on high-temperature superconductors (HTS), will have come of age and be registering juicy profits.

The company has developed an exciting technology to make wires that are exponentially more efficient than the common copper ones, and is already applying the technology successfully on industrial applications.

Big players are getting excited about Zenergy’s technologies and as soon as the firm moves to a full commercial phase, sales and profits will soar. In four years Zenergy could be valued at least as much as its competitor on Nasdaq, American Superconductor, which is worth almost $1.5 billion, even though it is not yet profitable. (CS)

RM 180.3p BUY

Market-leading RM provides software and IT infrastructure to schools. This an area of significant potential, with information technology expected to play an increasingly prominent role in the classroom by 2012. Indeed, RM has won ten contracts, twice as many as its nearest rival, to participate in the Building Schools for the Future programme, which aims to refurbish every school in the country.

Mark Westwood, UK fund manager at Threadneedle Asset Management, is positive on the stock and says: ‘If you take a four or five-year view this looks fairly well set. It is building sales for the future and, as the government is very unlikely to cut back on education significantly, it has good defensive qualities.’ (TS)

PV Crystalox Solar 163.3p BUY

A potentially good play on the renewables story is PV Crystalox Solar. Already a FTSE 250 constituent, the company, which floated last year in a £500 million IPO, manufactures multi-crystalline silicon ingots, a key constituent of solar panels, for the solar energy industry.

This industry is likely to be offered financial incentives to expand over the next four years. Especially as the UK government needs to do a lot more to meet its target of 10% of electricity being produced from renewables by 2012 – let alone its actual deadline of 2010. (TS)