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Sunday Telegraph: Savvy investors are picking up blue chips

By Iain Dey, Sunday Telegraph
Last Updated: 2:17am BST 29/07/2007

The moment many feared and predicted finally came on Thursday, when shares took their biggest tumble since the dark days of 2003. In this series of articles, we look at what the wider knock-on effects are and find it’s not all bad news.

BUYING OPPORTUNITIES

While the FTSE was falling through the floor last week, a number of savvy investors were picking up large stakes in British companies at knock-down prices. Collapsing share prices were not a sign of impending doom for everyone in the market, but a buying opportunity.

“I have been quite busy over the past few days buying shares that have been unnecessarily hit,” says Neil Woodford, who manages the highly regarded Invesco Perpetual High Income fund. “There are plenty of large cap companies that can cope with the ripples. I have had a nibble at Capita and plenty of other FTSE stocks that have reported good numbers recently. Rolls-Royce recently peaked at around 570p but last week was under 500p – that is good enough for me.”

Woodford also increased his positions in British Energy, BG, British American Tobacco, Imperial Tobacco and ICI last week. And it is easy to understand why.

Much of last week’s sell-off is thought to have been prompted by forced selling on the part of hedge funds. Investment banks were making “margin calls” on a number of major funds. That means they have to stump up extra cash as collateral against their trading positions. Many of the hedge funds stung by the collapse of their investments in structured credit vehicles, have been selling equities to raise this money. So falling share prices were not about a loss of faith.

Since Friday July 13, the FTSE 100 has fallen about 8 per cent. Cold analysis of the facts suggests Britain’s biggest companies are now dirt cheap. The FTSE 100 is trading on less than 12 times forecast earnings, and is projected to produce a yield of about 3.6 per cent.

According to Robert Parkes, UK equity strategist at HSBC, that means shares in British companies are now cheaper than they have been for 15 years or more.

“You’ve got to look for stability before you look to top up your positions, but the fundamentals look sound. The earnings season is going well, with companies in general beating expectations. The global economy is still fine. M&A activity is still there – we may not see many more leveraged private equity deals but there are still deals going on, such as the merger between Resolution Life and Friends Provident announced earlier in the week.”

Parkes cites oil companies as among his preferred picks. Like many other market gurus, he reckons the share prices of oil majors do not account for crude oil changing hands at prices north of $70 a barrel.

BP is trading on about 11 times its forecast earnings, with a yield of almost 4 per cent. Royal Dutch Shell, its arch rival, is rated similarly. Analysts at Morgan Stanley also recommend shares in the big drug companies such as GlaxoSmithKline and AstraZeneca – which are similarly cheap.

Of course, these valuations only hold true while the outlook for the global economy remains sound. Robert Talbut, the chief investment officer at Royal London Asset Management, is among those concerned about the impact of rising inflation, rising interest rates and soaring bond yields.

He says the sell-off in corporate bonds is the “canary in the coal mine” and the full impact of America’s troubles has yet to feed through. But prophets of equity doom seem to be in the minority at the moment.

“Within our UK funds we are still very heavily weighted to equities,” says Richard Batty, global equity strategist at Standard Life Investments. “We still like UK equities. The 8 per cent fall suggests there has been a substantial change in the fundamentals and that the rising yields in the corporate bond markets and the problems in the US are really going to spill over into equity markets. But the equity fundamentals look sound. If you look at p/e ratios, the FTSE looks good value.”

http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2007/07/29/cnmarkets629.xml

Related article

The era of mega deals is over – now it’s ‘small is beautiful’

By Helen Power, Sunday Telegraph
Last Updated: 2:17am BST 29/07/2007

The moment many feared and predicted finally came on Thursday, when shares took their biggest tumble since the dark days of 2003. In this series of articles, we look at what the wider knock-on effects are and find it’s not all bad news.

PRIVATE EQUITY

It’s the end of the mega private equity bid as we knew it – at least for the moment.   

“The days of the $100bn deal are over. Forget it. Talk of a private equity bid for the likes of Vodafone is over,” says the managing partner of one of the biggest private equity firms in London.

“We’ve now reached the top of a cycle that has never been seen before,” agrees Jon Moulton, the managing partner of Alchemy.

Cadbury Schweppes decided on Thursday to delay the £7bn sale of its US soft drinks arm as “extreme volatility” in the debt markets made it difficult for interested private equity bidders to raise finance for their offers. This capped an equally volatile week for investment bankers. Earlier in the week, bankers working on the financing of the Alliance Boots takeover were left holding at least £5bn of loans they had hoped to unload.

The news has prompted questions about whether the cheap era of financing that has fuelled the recent spate of takeovers by private equity groups and underpinned share prices of potential takeover targets is over.

“With the debt markets quickly moving to ration credit, the probability of companies being taken out is plummeting in our judgment. Equity investors should discontinue their speculation regarding takeovers,” Richard Bernstein, the Wall Street chief investment strategist at Merrill Lynch, said in a note to clients last week.

“Banks’ appetite for [our] debt has fallen to nothing,” admits a partner at a top UK private equity house.

“Looking at them trying to deal with the debt they are already holding is like watching a python with an elephant clearing the way through its system.”

While many financiers admit that the huge volume of big deals done in recent months is unlikely to be repeated, it is not all doom and gloom. It could be a case of small is beautiful for the banks.

“For the next few months you will see a situation where the big and mega-sized deals won’t happen, but the small ones will continue,” says the managing partner.

Other private equity houses that operate in the £50m-£500m range agree. “We just haven’t been affected by this at all,” says one partner.

But Moulton, whose biggest deal to date, at £360m, is well below the £1bn-plus bracket where our managing partner plies his trade, says banks are renegotiating the terms on even relatively small deals.

He says anyone who ultimately relies on so-called collateralised loan obligations (CLOs) for funding will be hit. CLOs – which are often put together by investment banks – consist of parcelled-up debt from lots of different companies sold on to institutional investors such as pension and insurance funds.

“Sixty per cent of the funding for the leveraged buyout [private equity] market comes from CLOs and at the moment that funding is nearly nil,” says Moulton.

“The critical question is whether the deal depends on syndication in the CLO market. But that number is around £150m at the bottom end of the CLO market,” he adds. He says investment banks have massively cut back on CLO creation.

“The CLO warehouses at investment banks probably total around £300bn and they are all closed for business. That’s a bit like a light being switched off.”

Yet private equity continues to raise money and must spend it somewhere. Figures from the Private Equity Intelligence Service show that a total of 211 buyout houses are seeking to raise $223bn of new funding globally. And buyout firms worldwide already have between $300m and $350m of cash burning a hole in their pockets – enough to last them between 12 and 18 months at the rate they have been doing deals.

So how will those deals change in the future, apart from being smaller?

“There will be less leverage [debt] and it will be more expensive to do deals,” says the managing partner.

“Our view is that leverage multiples [debt levels] were being pulled towards unstable levels and it was an aberration. We’re just returning to the status quo,” adds the partner at the UK private equity house.

However, before deals can start being done again private equity houses and the big investment banks that buy and sell on their debt must agree the new market rates for interest and the sort of terms on which money is lent. But with the markets still volatile, this is proving very hard to do.

“There are two scenarios. Either we’ll settle down at a reasonable level in a couple of months and then we’ll be able to get trades done. Or – and I’m pretty worried about this – we’ll carry on getting the sort of volatility where I come in in the morning and [interest] spreads have widened by 10 basis points in a couple of hours and we can’t think about anything new,” says one investment banker, who had left the City to take a holiday for a few weeks.

http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2007/07/29/cnmarkets229.xml

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