In a new column for Irish Medical Times, financial guru Eddie Hobbs says that many pension funds — including the GMS pension fund — haven’t allowed for double-digit inflation, which is likely in the coming years. What can you do to protect yourself from asset destruction?

It’s hard to get your head around what’s happening in the global economy, such is the blizzard of events over the past year – whatever about interpreting what it means to you and what actions you should be taking to better position yourself for what’s to come. But it is necessary if you are to avoid real losses in balance-sheet value as we enter a new economic age and not a return to the old one with just less wealth!
A few years back I set out to disprove a contrarian theory gathering momentum among geologists, engineers and certain economists. This was that the world, based on access to cheap oil for over 100 years, was facing into depletion as red hot demand from non-OECD economies was outstripping production, a by-product of adding an extra two billion new consumers to the three billion that already made up global consumer markets. Put it this way, you can’t increase the Chinese and Indian car fleet by 25 per cent each year without facing intense competition for limited natural resources like copper, aluminium, silver and, the king commodity, oil.
The beginning of the Age of Scarcity
Fast forward to today and we now have the results from the International Energy Agency’s audit of the world endowment of oil, published last October but lost in the melee over Lehmann Brothers and near collapse of the global banking market. Long a sceptic on peak oil, the IEA report validated much of the peakers assumptions; the depletion rate at 6.7 per cent per year is twice what we’d thought — which means jumbo oil fields like Ghawar are close to exhaustion — and to meet demand, six new Saudi Arabia’s have to be discovered over the next twenty years.
The IEA is praying that a ‘Goldilocks’ solution can be found involving the release of huge amounts of oil from Canadian oil sands, a rapid growth in Natural Gas Liquids (NGLs) and a €26 trillion investment over 15 years in oil and gas infrastructure — half of it needed to make up for a deficit in refurbishing existing assets.
The problem is that Canada can’t become the world’s second largest oil producer without burning up vast amounts of gas reserves needed to heat the sand to release bitumen, there’s been zero growth in NGLs for several years and the infrastructure investment is very iffy as national oil companies focus on feeding domestic demand first before exporting. Internal demand within oil-producing nations is accelerating to a point where shortly, combined, they will exceed the USA as the world’s largest consumer. It’s just a question of when the oil available for export begins to shrink as domestic demand is given priority.
A noted expert, Jeff Rubin, former CEO and Chief Economist of CIBC, a Canadian bank, reckons that crude oil has flat-lined since 2005. All that’s increased in the oil production numbers is propane and butane, by-products of maturing oil fields.
Robert Hirsch, reporting to the US Dept of Energy in 2005,stated bluntly that if action isn’t taken until peak oil is upon us, we face twenty years of severe disruption in global energy markets. This recession and four of the last five years coincided with price peaks in oil. US inflation in 2007 ran up to 6 per cent and was inevitably chased by interest rates, bursting the credit bubble the following year.
So it’s the story of our time — a time of substantial opportunities too if you’re on the right and not the wrong side of this mega-trend — arguably the biggest economic shift since steam technology came together with the printing press to trigger the Industrial Revolution. This time around it’s energy production technologies – clean tech and energy efficiency coming together with a global communications network and the common problem to grow economies sustainably and to do so by using less conventional fossil fuel sources.
What happens when a high inflation cycle arrives?
For starters, many of the assets upon which we’ve relied over the past 30 years of low inflation are at peril in the coming age of scarcity. During the last high inflation decade (1973 to 1983) caused by the OPEC embargo on US oil exports, cash deposits fell against general inflation by 3 per cent per year for 10 years. Common or garden variety bonds declined by 5 per cent yearly, which has implications for the GMS pension fund since it partially relies upon bonds — accounting for about a sixth of its assets.
The trustees need to move quickly into index-linked European Government bonds if they wish to avoid insolvency in the years to come, especially as the huge cohort aged over 55 head towards drawing income from the fund. The problem is that the pensions industry is about the sleepiest bunny around, is the last to innovate and is addicted to high fees and an easy life.
So what about shares? Equities, which account for the lion’s share of the GMS scheme, and the common managed fund just crabbed sideways during the last long-term high inflation cycle giving very modest 2 per cent p.a. real growth because many companies merely increased prices rather than real profits over the period, such was their exposure to high energy input costs.
But this masked huge losses as certain sectors like airlines and pharma stocks took an almighty hammering. So relying on general equity strategies and index-tracking funds isn’t a bright idea.
But the huge transfers of wealth that occurred as oil prices acted like a tax on economies guaranteed spectacular returns for energy titans, meanwhile gold grew 35 per cent p.a. above inflation.
Ideally the Trustees of the GMS pension scheme should be running ‘what if’ scenarios on the model to examine the impact that will occur if inflation hits very high levels. The scheme, which has adopted actuarial smoothing of the downturn to spread out the recent slump in value, is starting from a point of four years of negative bonuses. It could get worse, not better, if the wrong assets are held in the belief that inflation is not a threat because of a consensus within the somniferous Irish pensions industry.
What can you do to prepare?
So what does this mean for you and your money? An era of high inflation, in my view, is inevitable. The huge expansion in global money supply created by vast government borrowing programmes is itself inherently inflationary. The only thing slowing it from hitting us like a train is the tepid speed at which money is circulating, and that will change as the banking system and global economy recovers. But the long-term kicker is a return to a long and volatile commodity bull market. Oil, remember, kicked up fivefold in price from 2001 to $147 a barrel before the demand destruction from the recession.
It’s back hovering at $70 and it’s going to go much higher next time. The IEA itself is predicting a five-year oil crunch even if everything goes well. Meanwhile back at the ranch most investment funds and pension schemes, suffering as they do from mimicry, are steadfastly tied to assets that won’t perform and collectively have just about an 8 per cent exposure to commodities and energy simply to reflect the value of these sectors in global markets.
Here’s the thing the financial industry doesn’t want you to know – 90 percent of the return you make on investment is down to the asset allocation decision and not fancy fund performance. In other words the squillions spent convincing you that fund manager A is better than fund manager B, is bull.
The key decision is yours — whether you put your money into property, cash, bonds, equities or commodities: that’s the driver. Look at it this way, it didn’t matter which three-bed semi-d you’d bought in Dublin as an investment when the crash came, they all got marked down 50 per cent and the same in the rising market. It wasn’t the individual property selection that drove the return but the decision on the first day to invest in Irish property.
During the Tiger, I didn’t invest a cent of client money in Irish assets, and that has nothing to do with patriotism but everything to do with a basic tenet of investment – concentrate on your profession or business, but diversify your assets. With Ireland increasingly acting like a big property hedge fund, diversifying investment abroad made a heap of sense, otherwise you risk income destruction and asset destruction if, as has happened, 1 per cent of the European economy goes off the rails. So what are my top tips moving forward?
l Have a bridge to retreat over if the public finances aren’t repaired, Ireland gets marked down further, and another bank run begins despite the Government guarantee. Set up an on-line demand account with Rabo — one of a handful of banks worldwide with an AAA rating. That gives you same day transfer capability and keeps you out of the queues in the unlikely event of another run.
l Put 15 per cent of your long-term cash reserve and other liquid assets into gold. You can invest in gold these days in a variety of ways, each with their own strengths and weaknesses – Exchange Traded funds, Zurich Life fund or Perth Mint Certificates. Gold is the ultimate reserve currency and responds strongly to high inflation, rising oil prices and a declining dollar.
l Redirect your personal pension portfolio, putting at least one-third of it into energy-related themes like oil and gas, metals, food, water and green energy, and watch out for the inevitable development of energy efficiency and clean tech funds. There are a growing number of these now within fund ranges and switches can be organised free of cost.
l Increase your exposure to faster growing economic regions. Most of the economic growth on the planet is likely to take place in non-OECD countries over the next 20 years, so up your investment in Pacific funds that cover China, India, South East Asia, Australia and New Zealand.
l For older investors seeking to protect rather than grow assets, switch out of ordinary bond funds into indexed Eurobond funds. These are available within a few life office ranges. Lobby the trustees of the GMS scheme to strengthen the board with non-Mercer professionals, and to run studies on what would happen if inflation ran at double digits for several years.
l High inflation, if you can maintain your earnings in real terms, has a positively wonderful effect on borrowings by destroying the real value of outstanding debt — which is why the US is likely to follow a policy of inflating its way out of its vast debt burden. So don’t fret about high leverage, provided you’re making repayments, but don’t hang about: fix your interest rates for as long as you can — even out to ten years. We’re at a historical interest rate lows right now, but as the language of inflation becomes common currency, long-term rates will rise sharply even if short term rates remain flat for the next year. You could be dining out on long-term fixes at 5 per cent with inflation running twice as high in coming years. That’s known as negative real interest rates -getting paid to borrow money is the nirvana of positioning.
l Steer clear of most US assets and same for the GMS pension scheme. The dollar is back to its long-term trend of decline against other currencies, and the fall in its value may destroy any growth in the value of assets held in the US unless these are in really fast-growing sectors like alternative energy and in sector-dominant companies with lots of non-OECD growth exposure. Expect tepid growth from the debt-ridden US economy for many years.
www.eddiehobbs.com
Eddie Hobbs private practice, FDM ltd provides strategic financial advice to professionals and business owners.

Conor White writes that investing in corporate bonds should be safer than investing in equity and that bonds outperform stocks at certain times in the economic cycle — like now, for instance.
Have you ever heard co-workers talking around the water cooler about a ‘hot tip’ on a bond? Probably not. Bonds do not have as exciting a profile as the stock markets, but do not let the image mislead you.

Bonds are important in tough times, as they smooth out the dips from falling equity markets and continue to provide an income. This is essential when equity dividends are being cut across the market, and investors still require investment income in their wealth portfolios.
h4. A safe haven for your money
In general, investing in corporate bonds should be safer than investing in equity. The reason for this is the priority that debt holders have over shareholders. If a company goes bankrupt, debtholders are ahead of shareholders in the line to get paid.
In fact, the creditors (debtholders) usually get at least some of their money back, while shareholders often lose their entire investment.
In terms of safety and credit default risk, bonds from an OECD government (Gilts or Treasury bonds) are considered virtually ‘risk-free’, if held until they mature.
As a result, Government bonds are often used as a safe haven for funds in times of crisis.
h4. Protecting performance in tough markets
It is not unusual for stocks to lose 25 per cent in a year, particularly in recent times. However, when bonds comprise a portion of your portfolio, they can help smooth out the bumps when a recession comes around, and ease the pain of a falling stock market seriously eroding your wealth.
An equity-only portfolio of European shares over the last 10 years would leave you now with a return of -3 per cent.
By including bonds in the portfolio at 50 per cent, the investment return changes to +45 per cent, greatly reducing the damage from falling equity markets.
[The equity component illustrated here is the total return (i.e. including dividends) from the DJ Eurostoxx 50 and the bond element is the Merrill Lynch over five-year Government bond index.] The balanced portfolio rebalances each year to 50 per cent equities: 50 per cent bonds. It is interesting to note that if you do not include dividends in the equity index, the equity performance is even lower, showing a return of –26.7 per cent.
h4. Predictable returns
If history is any indication, stocks will outperform bonds in the long run. However, bonds outperform stocks at certain times in the economic cycle, like now. There is an inverse correlation between interest rates and bond prices, so as interest rates fall to support economies in recession, bond prices tend to go up. This makes sense as the price of a bond is simply the sum of its discounted future cashflows, or put another way, the present value of its future cashflows. Reducing the rate used to discount these cash flows results in a higher price.
One of the advantages of buying bonds and holding them to maturity is that the future cashflows over the life of the bond, including the redemption amount, are known in advance.
Selling the bonds before they mature may well be part of an investor’s strategy, but this adds market risk to the strategy, as bond prices change from day to day. There are always conditions in which we need security and predictability. This is the case more so now than ever. The question frequently asked in these times is how do we lower our financial risk without over sacrificing potential return?
Retirees, for instance, often rely on the predictable income generated by bonds. If your portfolio consisted solely of stocks, it would be quite disappointing to retire this year or even next.
By owning bonds, retirees are able to predict with a greater degree of certainty how much income they will have in their golden years.
College savings are another good example of funds you want to increase through investment, while also protecting them from risk by including some bonds.
More conservative investors whose investment needs may be somewhere between equity exposure and bank deposit rates are another group for whom bond investment may be suitable.
h4. Returns on bonds
What kind of returns can an investor earn from investing in European government bonds?
The Irish ten-year bond is offering 5.67 per cent at the moment, while the German ten-year Government bond which is seen as the safest haven in European bonds, is trading at 3.06 per cent.
One of the reasons for this difference is because the international markets now have more concerns over Ireland’s credit rating and ease in repaying its sovereign debt.
For an investor buying bonds, this could well be an attractive opportunity to take advantage of these concerns and to lock in an attractive yield.
h4. Bond funds
As with equities, investors can also choose to invest in bond funds or bond ETFs (exchange traded funds). Funds and ETFs diversify across many bonds, and can add to the investment return by incorporating longer dated bonds and corporate bonds into the scenario as well.
There are a number of funds and ETFs to choose from, depending on the customers requirements, appetite for risk and target returns.
Perhaps you are looking for a higher rate of return on a portion of your wealth than offered by a deposit account, but not willing to invest in the equity markets just yet.
One investment strategy that can allow you to do this is to include bonds in your investment portfolio. For many, reducing risk and taking advantage of the combination of capital protection and a steady income is vital to surviving these times!
* Conor White is a Senior Portfolio Manager with Goodbody Stockbrokers. He can be contacted on 01 6419295 or conor.p.white@goodbody.ie
* Goodbody Stockbrokers is the stockbroking arm of the AIB Group. Goodbody Stockbrokers is regulated by the Financial Regulator and is a member firm of the Irish Stock Exchange and the London Stock Exchange.
* This publication has been approved by Goodbody Stockbrokers. The information has been taken from sources we believe to be reliable, we do not guarantee their accuracy or completeness and any such information may be incomplete or condensed. All opinions and estimates constitute best judgement at the time of the publication and are subject to change without notice. The information, tools and material presented in this article are provided to you for information purposes only and are not to be used or considered as an offer or the solicitation of an offer to sell or to buy or subscribe for securities.

Much has been written about tax incentives provided to private hospitals, but how do they work? Conor White of Goodbody Stockbrokers answers the most commonly asked questions
Private hospitals in this country are generally funded by a combination of bank debt, tax equity and promoter equity. The Irish state has decided that it should encourage the provision of private healthcare by allowing certain tax payers reduce their tax bills by using capital allowances.

Tax equity is how investors purchase capital allowances. In Ireland, most schemes, including hospitals’ schemes, only allow investors to offset capital allowances against their rental income tax bill, and not against any other income.
Capital allowances arise when the cost of a certain asset (in this case, a private hospital) is ‘written off’, or offset, against tax. This means that if you owe tax on, for example, €100,000 of your income, you can offset this with capital allowances of the same amount.
h4. Accelerated capital allowance
However, the key issue here is just how long does it take to write off a given asset against tax? In this country, we refer to most tax-based transactions as ‘accelerated capital allowance’ transactions.
This is because the capital allowances can be claimed over seven years (in the case of a hospital or a hotel), whereas the life of the asset is much longer (a hospital can have a life of 50 or even 100 years or more).
This might seem strange to most people. However, governments have been using this type of transaction all over Europe for many years. They do it to incentivise investment in assets that they consider desirable.
Most industries in Europe can offset the cost of machinery against tax in this way. In Germany, for example, the cost of aircraft, locomotives and other equipment can be offset against tax.
In Scandinavian countries such as Sweden and Norway, individuals can offset capital allowances for ships against their tax because their governments wanted to encourage the building of ships.
In the United States, the government decided it wanted to encourage the sale of aircraft and locomotives and therefore they allow certain taxpayers capital allowances for these assets, which they can then offset against their tax.
h4. Analysed by example
The key aspects of the capital allowances regime in Ireland are best analysed by reference to an example. If we say that a private hospital is to cost €100 million, of this, perhaps €90 million will qualify for capital allowances. Then the capital allowances will be available over seven years as follows:
Years one to six @ 15 per cent = €90 million x 15 per cent = €13.5 million per annum capital allowances.
Year seven @ 10 per cent = €90 million x 10 per cent x top tax rate = €9 million capital allowances.
There are very few individuals that would have rental income of €13.5 million. Therefore, capital allowances have nearly always been divided amongst a number of investors. In recent times, however, the Irish Government has limited the use of capital allowances.
In the case of an individual, the maximum allowances that can be offset against rental income (if this is the individual’s only income) is €250,000.
Where an individual has other income, a higher limit applies. In the case of an individual who has Schedule D income of €500,000 and rental income of €500,000, then all of the rental income of €500,000 can be shielded by capital allowances.
The limitation in recent years, does, however, mean that overall the number of investors in a typical transaction has increased quite a lot.
This has given more investors access to this type of investment, rather than it being limited to a very small number of very wealthy individuals.
In the case of an employee in a hospital, for example a doctor, a nurse or another employee, it is worth bearing in mind that they cannot avail of tax allowances for a hospital to which they are ‘connected’.
The term ‘connected’ is very broadly defined in the legislation – but it certainly would cover a situation where the employee has a practice in or the employee is employed by that hospital.
h4. Capital allowances
It is worth bearing in mind that doctors and other employees can avail of capital allowances in hospitals where they are not connected, by way of employment or by having a practice there.
In a typical deal, the value of the capital allowances is shared approximately equally between the developer of the private hospital and the tax payer. This results in an effective tax rate of approximately 23 per cent for the tax payer on their rental income, rather than on their top tax rate.
Now that interest rates are falling again, tax payers who have a number of properties are likely to suffer higher effective tax rates on their rental income. The only way of reducing this tax burden is to buy capital allowances.
h4. Largely phased out
Unfortunately there are relatively few transactions in the market at present, as the capital allowances are largely phased out for hotels and are generally only available for very small deals in crèches and in nursing homes. Because of their size, they cannot bear the cost of a great deal of tax and legal due diligence.
Investors should always take professional advice on the quality of such deals and ensure that they work only with reputable providers.
* This publication has been approved by Goodbody Stockbrokers. The information has been taken from sources we believe to be reliable, we do not guarantee their accuracy or completeness and any such information may be incomplete or condensed. All opinions and estimates constitute best judgement at the time of the publication and are subject to change without notice. The information, tools and material presented in this article are provided to you for information purposes only and are not to be used or considered as an offer or the solicitation of an offer to sell or to buy or subscribe for securities.
* Conor White is a Senior Portfolio Manager with Goodbody Stockbrokers.
He can be contacted on 01 6419295 or conor.p.white@goodbody.ie
* Goodbody Stockbrokers is the stockbroking arm of the AIB Group. Goodbody Stockbrokers is regulated by the Financial Regulator and is a member firm of the Irish Stock Exchange and the London Stock Exchange.

Last year was a ‘once in a lifetime’ year. The developed world economy fell into recession in the second half of 2008 for the first time since the Second World War. As a result, all risk assets had one of their worst years on record. There has also been a dramatic change to inflation expectations.
In the middle of 2008, we were worried about inflation, sparked by rapidly rising commodity prices. But investors are now concerned about deflation, as commodity prices retreat and economies fall into recession.

As a result, bond markets have had a very strong year. The ’credit crisis’ remained with us all through 2008 and it is disappointing that the money markets, although improving, remain dysfunctional at year end.
All asset classes were taken by surprise by the speed and the extent of the economic slowdown in the latter part of the year. The money markets, which went into disarray in the last quarter of 2007, have continued to deteriorate and this eventually had its impact on real economies, as we migrated from Wall Street to Main Street. Consumer sentiment dropped rapidly along with industrial production and employment levels.
In the space of a few months, we have seen a number of economic indicators fall to levels we normally see at the trough of recessions and we are likely to see some further bad news in the near future.
h4. Economics poor and getting worse
Of course, the deterioration in the economic background has led to significant policy response. Just as the recession is unfolding as one of the worst we have seen, so the policy response has been the most extreme we have seen.
Interest rates are now at post-World War II lows and governments across the world are targeting large budget deficits to allow for significant fiscal boosts.
While the international banking system is still stressed, authorities across the world have taken the unusual step of directly investing in their respective banks and in the case of the US, the Central Bank has started lending directly to the private sector. It is probable that we will see more of this during 2009.
A key difference that emerged in the last quarter of 2008 was that policy responses were co-ordinated across the globe. Interest-rate cuts were implemented in several regions at the same time and governments have been intervening in their banking markets simultaneously. This is a big change from the first half of the year, when more Central Banks increased interest rates than cut them.
Authorities have now woken up to the fact that this is a global problem and all are singing off the same hymn sheet.
In the middle of 2008, the European Central Bank (ECB) and the Bank of England were still talking about inflation pressures and thus increasing interest rates. This has now changed and both Central Banks have since cut interest rates by significant amounts and we believe that they will cut further. We now forecast that both the ECB and the Bank of England will cut rates to one per cent by the middle of 2010.
Added to these policy boosts has been the fall in commodity prices, which will also aid consumers’ and corporates’ spending power going through 2009. While these developments have had little impact thus far, we should see some response to them as we travel through the year.
They may not turn economies around, but there is a good chance they will halt the deterioration. As the US economy was the first to experience difficulties (its housing downturn started in 2005), we expect it to be the first to experience improvement. Not only is chronology in its favour, but the authorities have been much more aggressive in monetary policy (interest rates at 0.25 per cent and the Fed lending directly to the corporate sector) and fiscal policy (another package coming in Q1 2009).
The US consumer is also more geared to the oil price and thus, the recent falls will give them a proportionally larger boost. We expect this to also underpin the US dollar and would expect further strength over the next year.
h4. At least bonds like it…
Economic developments have been good news for the bond market. We expect that headline inflation will turn into negative territory in 2009 as commodity price declines impact. We also believe that core inflation will head towards zero per cent.
In the recession in the early 2000s, core inflation in the Eurozone went as low as 0.7 per cent and it should go lower in this recession.
With this inflation background, 10-year bond yields should be able to move below three per cent and in times of a real deflation scare, to go below 2.5 per cent.
In the last recession, the ECB cut rates to two per cent and the 10-year bond yield fell to three per cent. If, as expected, the ECB cuts rates to one per cent, then we believe that the 10-year yield can move to 2.5 per cent.
h4. But not equities
The weakening economic background has taken its toll on equity markets, with ratings dropping to the lowest levels we have seen since the early 1980s. With inflation, interest rates and bond yields at or forecast to fall to 50-year lows, that leaves scope for a re-rating.
Post recent falls, equities now yield more than 10-year bonds across the major markets, a phenomenon we have not seen since the 1950s as the world was recovering from the horror of World War 2 and was entering the fear of the Cold War and the nuclear arms race. The private equity (PE) is lower than at the start of the last two recessions. So, while we may be looking at a more severe recession equity, markets are attempting to price this in.
Currently, the Eurozone equity market trades on a PE of 7.8x, exactly half the 20-year average. So if we are to get back to the 20-year average, earnings need to fall 50 per cent. In the last four recessions, profits fell by an average of 38 per cent peak to trough with a range of 31-41 per cent. One would expect the declines on this occasion to be larger than average due to the lack of inflation and the potential impact of the higher than normal level of debt in the world economy. However, there is a reasonable margin of error built into the current valuation.
h4. Retrenchment
This recession started with a rolling over in property markets which led to strains in the financial system and then moved on to consumer retrenchment and then recession. This is similar to what happened in several countries including the US, the UK, Finland and Sweden in the late 1980s and early 1990s.
Outside of the US, these recessions tended to last longer and the smaller the economy, the deeper the recession. In the US and UK, the equity markets hit their low in Q4 1990, just as the recession was arriving.
The UK remained in recession until Q4 1992, but still the equity market hit its low as the recession arrived.
In the Scandinavian economies, where debt levels were higher and construction made up a bigger proportion of the economy, the equity markets did not bottom until the economy was beginning to recover. We think this time round that the US will behave something like it did in the early 1990s, but Ireland and the UK will be more like Scandinavia.
The one difference for the UK and Ireland today is that Sweden and Finland faced rising interest rates in the early 1990s, whereas Ireland and the UK will face falling interest rates. Thus, the turn in their equity markets might come sooner.
* This articlehas been approved by Goodbody Stockbrokers. While the information has been taken from sources we believe to be reliable, we do not guarantee their accuracy or completeness and any such information may be incomplete or condensed.
All opinions and estimates constitute best judgement at the time of the publication and are subject to change without notice. The information, tools and material presented in this article are provided to you for information purposes only and are not to be used or considered as an offer or the solicitation of an offer to sell or to buy or subscribe for securities.
* Conor White is a Senior Portfolio Manager with Goodbody Stockbrokers. He can be contacted on 01 6419295 or conor.p.white@goodbody.ie
* Goodbody Stockbrokers is the stockbroking arm of the AIB Group. Goodbody Stockbrokers is regulated by the Financial Regulator and is a member firm of the Irish Stock Exchange and the London Stock Exchange.

Berna Cox writes that children who, until now, have been reaping the benefits of their parents’ Celtic Tiger lifestyles will have to learn how to squirrel away some savings for a rainy day.
Sometimes, when I indulge in a bit of navel-gazing and take to pondering life’s great questions, I think I’d like to be a squirrel. I reckon squirrels have it good. Their lifestyle appeals to me. When winter hits, they hole up in a nice comfy tree and totally opt out.

A whole season of a laid-back Sunday morning. A three-month-long duvet day. I have a mental image of Mr and Mrs Squirrel tucked up in their cosy little drey, just lazing the winter away.
Every so often, Mrs Squirrel will give Mr Squirrel a nudge and tell him it’s his turn to get the nuts. He’ll swear he went last time, but she’ll persist and she’ll win. He’ll eventually wrap his little squirrel duvet around him, shuffle his way to the squirrel larder and come back with a little feast.
h4. Squirrel radio
They’ll turn on their squirrel radio when they’re having their little banquet and they’ll be totally unconcerned about the weather forecast. It can do what it likes out there. They don’t care. They have nowhere to go in the morning. When they’ve had their fill of nuts and brushed all the crumbs out of the squirrel bed, they’ll snuggle up again and sleep for another while. I know it all sounds a bit Beatrix Potter-ish and Disney-fied, but wouldn’t it be lovely? Doesn’t it sound a bit appealing? But I could never be a squirrel in any incarnation.
I’m missing one very important squirrel trait in my make-up. There’s a particular squirrel quality that enables this laid-back lifestyle they lead and I just don’t have it.
h4. Forward planners
Squirrels have an innate ability to save. They’re forward planners. For the portion of the year that they’re out and about and working, they plan for the winter. They gather up a goodly supply of nuts, stash them away and then live off their savings. I would, therefore, be a very unsuccessful squirrel. I’m not a good saver.
But squirrels don’t always have it easy, it seems. Take Cyril. Cyril the Squirrel is the cute little face of An Post’s savings stamps scheme for children and, for a while there, Cyril was living on his wits.
In the Annual Report of the Comptroller and Auditor General (CAG), poor Cyril gets it in the nuts, so to speak. The CAG is required to audit the National Treasury Management Agency (NTMA) and they are not at all happy with Cyril.
The NTMA pays fees to An Post for managing various saving accounts including the Post Office Savings Bank and the fee it pays in relation to Cyril’s stamps is, it would seem, deemed to be a bit hefty.
Cyril operates by selling savings stamps to children that they can buy at school, as part of a group scheme, or at the post office as individual savers. The stamps are affixed to savings cards, which are eventually used to open Post Office Savings Bank accounts or are added to existing accounts.
Since 2004, the NTMA has paid €4 million to An Post to manage the scheme. Average sales of stamps in that period amounted to between €4 million and €4.5 million per year. They consider Cyril to be a needy little beast.
They want him out. They suggested turfing him out before, but he was spared. It was argued that his true value was that he encouraged children to develop a saving habit. He had several reprieves using that argument.
Last year, the squirrel-unfriendly agency pushed again and sought ministerial approval to abolish the saving stamps scheme. But the bold and hardy Cyril survives. And is, indeed, going from strength to strength. Never was it more important for us all to know the value of cultivating a squirrel-like savings habit and where better to start than with the children?
Children who, up to now, have no experience of penny-pinching, have been used to extravagance and have seldom heard the word ‘no’.
h4. Financially prudent
Cyril is reinvigorated and is gung-ho to get busy helping these youngsters to get savvy with their dosh. He’s gone online at www.savingwithcyril.ie and is hell bent on educating the upcoming generation to be financially prudent and to understand the value of a buck.
And, according to the experts, he’s going about it in just the right way. Greg R. Smith is a best-selling author and children’s money guru in Australia, who founded the children’s website www.kidsmoney.com.au.
Smith is Australia’s answer to Eddie Hobbs, but he has a particular interest in educating children about money. As an economist and financial planner, he deplores the lack of education among adults on financial matters.
A survey he conducted revealed that 72 per cent of financially-strapped adults said they weren’t educated about money when they were children and 68 per cent said they were afraid of passing on bad money habits to the next generation. Smith, therefore, is on a mission to make children financially aware.
Top of his list of tips for educating the 7–12 age group about money is to ‘encourage them to participate in the school banking programme’. This, he says, will give them a sense of regular commitment to savings.
h4. Bank paperwork
They should also be encouraged to examine the statements of the account, follow the lodgments and keep track of the balance. This will get them used to scanning bank paperwork, he says. He cautions, though, that parents shouldn’t rely solely on school programmes to educate children about money. Parents need to take part, too.
He suggests that parents should show their children the family bills and explain in a positive way that bills have to be paid to keep the family show on the road. In addition, therefore, to Cyril’s efforts, parents need to reinforce the financial lessons by including children in the household budgeting process and conveying the message that saving is a good thing to do.
Smith suggests that parents will benefit from engaging in this type of financial relationship with their children – it will help to keep them financially grounded as well.
So that’s an expert endorsement of Cyril’s squirrelly activities. The inexpert endorsement comes from me. The only time in my life that I have ever successfully saved money was when I was a small child buying savings stamps in the post office. They were 6d in old money. (And ‘old money’ here is pre-decimal. Back in the day when there were 20 shillings in a pound and 12 pennies in a shilling… dinosaur stuff).
h4. A pure fortune
The sixpenny stamps were a bright orange colour and the saving book was green. A full page in the book represented five shillings. A pure fortune. Whatever it was about it, it worked for me. I always had a few bob in the book.
There was no cute Cyril at that time to offer me encouragement or incentives but there was a nice man in the post office who always praised me when I bought my stamps and told me I was a wise child. I glowed with the praise. I felt all grown up and responsible.
Coming up to Christmas every year, though, I’d clean the account out and blow it. But that’s what saving is about, surely. Being able to have a blowout – but without debt and the associated guilt.
Unfortunately, I outgrew the stamps at some point and probably considered myself much too sophisticated for such childish habits.
The truth of it is, I’ve never had a spare bob in my life since. It goes out as quick as it comes in. Since I relinquished that little green book, I’ve never had that comfortable feeling of knowing there’s a little bit ‘put by’. No spare nuts in my larder.
I think I’ll head for the post office and sign up with Cyril. I’ll tell lies and say it’s for my grandniece and nephew. But it will be for me. I need to rediscover that wise inner child. And I want the blowout – without the guilt.
And nuts to the National Treasury Management Agency. Cyril rocks.

Conor White gives us an overview of the telecoms sector, which is better insulated than most against a worsening economy, and reports on some of the major players in the sector such as KPN.
The European telecom sector is down 36% so far this year despite robust earnings resilience (only -5% downgrade to FY08 consensus earnings) versus -42% for the market.

The first half of the year saw the sector under-perform due to:
1) a de-rating, as at the start of the year, the sector stood at a 25% premium to the market on a 2008E PE basis,
2) poor newsflow from the US, where both AT&T and Comcast commented about weakening economic conditions, driving an acceleration of fixed-line disconnects (the company has since indicated that this is getting worse),
3) M&A concerns. Deutsche Telecom’s acquisition of OTE (announced in March) followed by France Telecom’s interest in TeliaSonera (first mentioned in April) and;
4) uncertainty as to the EC’s treatment of termination rates in the EU, with the date of a final judgment continuously pushed out. As a result, the sector valuation has been brought down to a 10% premium to the broader market and, if one excludes financials, it would trade in line with the market.
Moreover, since June we have seen this trend of under-performance reverse somewhat, which has received an extra boost as we travelled through the reporting season — a trend we expect to continue.
The current rating ignores some attractive features of the sector. Earnings resilience and visibility will become increasingly important as we travel through the upcoming earnings recession. We could see a 20-30% downward revision to market earnings growth expectations for 2009 (currently at +10.5%).
Earnings for telecoms are not immune from the outside world, but are better insulated than most against a worsening economy. The dividend yield in the sector currently stands at 7.1% for 2008E, rising to 8.1% for 2009. Not only are telecoms one of the sectors yielding the highest dividend, they also offer good cover (ranging from 1.5x to 3.0x depending on the company).
Balance sheets are strong with the sector carrying a historically low level of debt (only 2x EBITDA) and only 23% due to be refinanced before 2011. To gain exposure to the sector, we would currently recommend KPN.
h4. KPN €10.52
KPN is the incumbent telecoms operator in the Netherlands, with the leading share in both fixed and mobile. The company also owns the third-largest mobile operator in Germany, E-Plus, and the number three mobile player in Belgium, BASE. The fixed market faces intense competition from cable, though KPN is fighting back through its own digital terrestrial offering (Digitenne).
The Netherlands accounts for 70% of revenue and 69% of EBITDA. KPN has 6.3 million fixed-line phone customers. However, KPN’s IP migration is at an advanced stage, the group has regulatory clarity on fibre and is well placed to take advantage of the resulting cost reduction opportunities.
Its mobile division is the market leader in Holland. The Dutch market has seen another leg of consolidation, leading to three players that should allow for rational competition.
In the recent Q3 results, Dutch EBITDA grew for the second quarter, 3.3% before additional one-offs, up from 2.1% in Q2. In fixed, the pace of line losses continues to moderate (30,000 lines lost in Q3 2008 versus 40,000 in Q2 2008 and 100,000 in Q3 2007).
Meanwhile, broadband share was sustained at 44%. KPN’s fibre roll-out will allow the company to compete more effectively with cable, potentially increasing market share of broadband from the current 44% to 50% long term.
New regulation in fixed line will be introduced on 1 January 2009, allowing KPN total flexibility to price products and therefore allowing different prices by region, depending on the competitive environment.
This new regulation opens the door for market share gains and perhaps price increases in certain areas. The company reiterated that the Netherlands EBITDA has now bottomed and can grow in 2009 and confirmed 2010 objectives as stated in its ‘Back to Growth’ strategy.
It is the number three in Germany via E Plus (20% revenue 22% EBITDA). E-Plus was a poor performing asset until 2007. Since then, it has seen steady growth in profitability despite a shrinking in the overall market. In the last quarter, E-Plus added 105k post-paid customers and increased service revenues by 6.4%. Margins came in 2% above expectations at 40%.
Overall, KPN reported a solid set of Q3 results with no obvious adverse signs from the dwindling economy. Management maintained its confident tone in terms of its expectations for delivering on its longer-term guidance, which is for sales of €15bn, EBITDA of over €5.5bn and free cash flow of €2.4bn by 2010, based on the turn around of the domestic business.
KPN was in transformational mode in 2006/07, starting migration to an all IP network and moving to a customer-centric structure. This process has laid the foundation for future earnings growth driven by three key pillars. The first is the turnaround of the domestic business (‘Back to Growth’ strategy). Fibre roll-out, ruthless cost cutting and mobile market repair will drive growth forward in the Netherlands.
The second is further value creation in Germany as E-Plus’s profitability increases, driven by market share gains and a larger mobile revenue pie in Germany.
The third is KPN’s unrivalled capital discipline. Shareholder returns are currently c.10% of 2009 market cap with upside for more. Strong management, assets with high strategic value and attractive shareholder returns provide good downside protection for the stock. KPN has an excellent long-term track record and the current share price provides a good entry point in what we consider a quality defensive story.
* Stock prices: Prices in share recommendations are quoted from the close of business on 18 November 2008.
* This publication has been approved by Goodbody Stockbrokers. The information has been taken from sources we believe to be reliable, we do not guarantee their accuracy or completeness and any such information may be incomplete or condensed.
All opinions and estimates constitute best judgement at the time of the publication and are subject to change without notice. The information, tools and material presented in this article are provided to you for information purposes only and are not to be used or considered as an offer or the solicitation of an offer to sell or to buy or subscribe for securities.
* Conor White is a Senior Portfolio Manager with Goodbody Stockbrokers. He can be contacted on 01 6419295 or conor.p.white@goodbody.ie
* Goodbody Stockbrokers is the stockbroking arm of the AIB Group. Goodbody Stockbrokers is regulated by the Financial Regulator and is a member firm of the Irish Stock Exchange and the London Stock Exchange.

Conor White writes that now might be the time to buy equities, as equity markets normally bottom as economies enter recession. The worst that could happen is that you just get your dividend yield.
It has been a ‘white-knuckle ride’ in financial markets over the last couple of months and we have seen a reset in market expectations. At last, financial markets have conceded that there will be a recession across the developed world and have moved asset markets to reflect that. In the past weeks, we have seen some recovery in share prices but it has been somewhat anaemic.

h4. Recession is arriving
In recent weeks, we also got a sample of what it is going to be like as we get recessionary readings from the economies. In the US, the industrial production fell 4.5 per cent year on year (YoY), which is recession territory. There was some short-term impact from the hurricanes and the Boeing strike. But even excluding this, production was down almost two per cent YoY. Retail sales growth slowed significantly, down to 1.6 per cent YoY, which is the level of retail sales consistent with recession.
In the UK, unemployment spiked up to 5.7 per cent, which is the highest level since the recession of 2000. The ZEW from Germany was back to a level not seen since the post-unification ‘bust’.
h4. Feeding through into the markets
For much of the last year, we had seen significant falls in financial share prices and some consumer-related sectors, but in other sectors, the falls in share prices had been modest enough. Equity markets recognised a problem with the financial system but had not factored this into a broader economic outlook.
This has changed over the last couple of months, as we have seen the greatest weakness in cyclical areas of markets across the globe and equity markets have moved to price in a recession and, in fact, nigh on depression conditions.
h4. Policy response
The Troubled Assets Relief Program (TARP), which is a plan for the United States Treasury to buy distressed debt from United States banks, has been passed. More and more European governments, including our own, have guaranteed the deposits of their respective banking systems.
We have also seen several European governments inject capital directly into some of their local banks. All of this has been followed by co-ordinated reductions in short-term interest rates by seven major central banks including the European Central Bank.
h4. Valuations adjusted
The Euro-Zone currently trades on an historic PE of 8.0x against the 20-year average of 14.6x. Hence for the multiple to get back to the 20 year average earnings would have to fall 57 per cent which would need depression conditions to be achieved. There is no doubt that profit forecasts are too high at the moment but the valuation on the market is already saying that.
The dividend yield is giving out the same message. The Euro-Zone equity market is now yielding 5.5 per cent a full 1.5 per cent above the ten-year Euro bond, which means that over the long run, dividends are going to decline. The current valuation is indicating that we are moving towards depression and that economies will not be able to self-adjust.
Enormous damage has been done to the financial system and this should have an impact on the real economy, but valuations would appear to have discounted this.
h4. Newsflow will be poor
Over the next number of months, the newsflow is going to be poor and there should be cuts to economic forecasts and as a result to earnings expectations. Unemployment will rise and consumption should slow. There is, and will continue to be, much discussion about the depth of the recession and the strength of any recovery.
There is most likely going to be continual reference to a broken financial system which will not lend and a consumer so indebted that he will not borrow, nor will he spend. But equity markets try to anticipate events.
Looking at the recessions in the United States and the United Kingdom in the early 1990s, which have many similarities to the current one, equity markets actually hit their low points just as the economies were moving into recession. This would suggest now is the time to start buying equities.
h4. Tougher this time
Now the point can be made that there are greater stresses and higher levels of indebtedness today than there was back in the early nineties and thus, the evolution of equity markets will be different. But the valuation is materially lower.
Heading into the recessions of the early nineties, the UK market was on a multiple of 12x as against its current 8.4x and the US was on a multiple of 13x as against the current 11.4x. This is despite bond yields being six points lower in the UK and five points lower in the US.
The last few weeks have been the most bruising in equity markets for quite a number of decades. If the prices are correct, then the world economy is unable to right itself in the normal one- to two-year time span.
If you believe that the economic system does have the flexibility to overcome its problems and fiscal and monetary policy will remain growth-oriented, then one would be buying equities now, as valuations are now discounting depression and equity markets normally bottom as we enter the recession.
The worst that could happen is that you just get your dividend yield, but even that is higher than a bond yield now.
* Conor White is a Senior Portfolio Manager with Goodbody Stockbrokers. He can be contacted on 01 6419295 or conor.p.white@goodbody.ie
* Goodbody Stockbrokers is the stockbroking arm of the AIB Group. Goodbody Stockbrokers is regulated by the Financial Regulator and is a member firm of the Irish Stock Exchange and the London Stock Exchange.
* This publication has been approved by Goodbody Stockbrokers. The information has been taken from sources we believe to be reliable, we do not guarantee their accuracy or completeness and any such information may be incomplete or condensed.
All opinions and estimates constitute best judgement at the time of the publication and are subject to change without notice.
The information, tools and material presented in this article are provided to you for information purposes only and are not to be used or considered as an offer or the solicitation of an offer to sell or to buy or subscribe for securities.

Conor White outlines the benefits of establishing self directed retirement portfolios, which allow professionals to have an effective tax management plan in place for minimising tax on earned income.
A self-directed retirement portfolio allows medical and other professionals to accumulate an investment portfolio for retirement in a very tax-effective way, and with wide investment flexibility.

Since the liberalisation of the tax regime governing retirement funding some years ago, self directed has become the vehicle of choice for investors who wish to have an effective tax management plan in place for minimising tax on earned income.
h4. An integral part
Retirement funds are now an integral part of personal and family wealth and retirement investors (as opposed to ‘pensions buyers’) are no longer comfortable with the arms’ length, default nature of traditional managed fund options.
The immediate tax advantage is that your investment is allowable against income tax, within limits which have increased substantially in recent years.
Investment income and gains accumulate in your portfolio tax free. The exemption from capital gains tax substantially increases the effect of compound interest on your returns over the long term.
Deposits earn a DIRT-free return, and dividends from Irish resident companies are not subject to Dividend Withholding Tax.
h4. Extensive freedom
You have extensive freedom in how your retirement portfolio is invested. You can invest in equities, property, bonds, structured product, etc. Stockbrokers can source and assess ‘best of breed’ external products to meet your specific criteria and many of these options come with capital security, if that is what suits your particular circumstances.
There is only one principal restriction on your investment choices in that investment in certain assets that could be connected with you or used by your or your family are not allowed by law.
Your allowances in respect of sheltering your private income are in accordance with a revenue scale (see below). The principal service that stockbrokers provide initially is to help you work out the optimum level of funding to maximise the tax advantages for you.
For maximum allowable contributions as a percentage of net relevant earnings see table below. In addition, the earnings limit for pensions tax relief purposes has been increased to €275,238 for the tax year 2008.
You can draw on your retirement portfolio at your normal retirement age, which is usually when you are aged between 60 and 75. When you do draw on your portfolio, you can take 25 per cent tax free and transfer the balance of your portfolio assets to an Approved Retirement Fund (ARF), where it will continue to enjoy investment flexibility and tax-free investment growth in retirement.
Making a pension contribution now, before 31 October 2008 (or 16 November, if you are paying and filing tax on ROS), is particularly attractive. This is because you can opt to backdate it, for tax-relief purposes, to the 2007 tax year if you have unused capacity, which may help you to reduce any balance of tax that you are due to pay for 2008.
h4. Reduce your income tax
Alternatively, you can have the pension contribution counted in the current 2008 year and, in doing so, possibly reduce the amount of preliminary income tax you might otherwise have to pay for 2008.
The advantages of Approved Retirement Funds as a wealth creation vehicle can be summarised as follows:
* It builds inheritable assets outside your estate;
* Assets are built from pre-tax income;
* Spouse inherits ARF tax-free;
* Children over 21
* Pay the standard rate of income tax- currently 20 per cent;
* Retain a full inheritance tax threshold.
ARF portfolio
Any assets left in your Approved Retirement Fund portfolio on the event of your death can, therefore, be passed on to your dependants, subject to a basic rate tax charge only for your children (aged over 21).
Goodbody Stockbrokers has a wealth of experience in the design, establishment and management of self directed retirement portfolios.
We will work with you to create a unique structure for you to maximise your tax allowances and to ensure that the underlying investments reflect your personal preferences.
We can help if:
* You have not been using your allowances to the full;
* You want investment flexibility;
* You have existing arrangements but you want an alternative to the traditional fund options;
* You want to bring your existing funds under your own control. Our service to you includes a full review of any existing arrangements and offering appropriate recommendations.
* You want accountability and transparency on pricing and performance;
* You want advice on your retirement options.
* Conor White is a Senior Portfolio Manager with Goodbody Stockbrokers. He can be contacted on 01 6419295 or conor.p.white@goodbody.ie
* Goodbody Stockbrokers is the stockbroking arm of the AIB Group. Goodbody Stockbrokers is regulated by the Financial Regulator and is a member firm of the Irish Stock Exchange and the London Stock Exchange.
l This publication has been approved by Goodbody Stockbrokers. The information has been taken from sources we believe to be reliable, we do not guarantee their accuracy or completeness and any such information may be incomplete or condensed. All opinions and estimates constitute best judgement at the time of the publication and are subject to change without notice. The information, tools and material presented in this article are provided to you for information purposes only and are not to be used or considered as an offer or the solicitation of an offer to sell or to buy or subscribe for securities.

Asset allocation looks at the question of how much of one’s savings one should invest in different asset classes. There are four main asset classes (cash; bonds; equities; property) and a growing band coming under the name of ‘other’ (includes metals, oil, agricultural products and hedge funds).
At times, the decision about which asset you hold can be more important than which particular equity, bond or property that you hold. The last year has been such a period and indeed, has been a challenging one for asset allocation. The returns which the different asset classes have generated over the last year have been quite different.

As most people are aware, the last year has seen housing markets decline in many of the developed economies. What has happened in Ireland would be typical of what has happened in the UK, the US and some other developed economies. This has had implications for banks in these countries, but from an asset allocation perspective, it has had a material impact on economies.
At the start of 2007, people would have expected the Irish economy to grow by 5.6 per cent in 2007 and three per cent in 2008; the Eurozone by 2.1 per cent in 2007 and 2.3 per cent in 2008 and the US by 2.4 per cent in 2007 and three per cent in 2008.
The out-turn is now looking somewhat different. Ireland grew by six per cent in 2007 but is now expected to decline by over two per cent in 2008; the Eurozone grew by 2.1 per cent in 2007 and should expand by 1.4 per cent in ’08 and the US expanded two per cent in 2007 and will probably register growth of 1.4 per cent in 2008.
As a result, profits for 2008 will turn out materially lower than would have been expected at the start of 2007. In the Eurozone, the forecast for profits in 2008 are now 11 per cent below January 2007 expectations; in the US it is 25 per cent lower and in Ireland, it is down 20 per cent. Hence the falls we have seen in equity markets. Profit growth is an important determinant of equity returns and profit growth is sensitive to economic growth (see graph 1).
But profit growth is not the only determinant. Equities are also affected by valuation, which we call the PE (price/earnings ratio). It is merely the index level divided by the level of earnings.
As mentioned above, equities were under pressure due to declining profit growth over the last year. But they got no help from valuation, either. Indeed, the declines in markets were greater that the decline in expected profits. Hence the valuation of equities also declined during the period.
h4. Interest rates
The valuation does not always stay constant but is dependent on what has happened to interest rates and in particular, longer-term interest rates. We find these in the bond market, by looking at the ten-year interest rate or yield. This has increased slightly over the last year from four per cent to 4.2 per cent and thus would imply a lower valuation for equities than 12 months ago.
This would be regarded as a somewhat unusual outcome for the bond market. When recession looms, bond prices usually go up (which is the same as bond yields going down). Investors like the certainty of Government bonds, when the economic environment is very uncertain. Normally when recession approaches, inflation starts falling – and bonds like falling inflation.
h4. Inflation expectations
Bonds have fixed money (or nominal) payments and a set nominal redemption value. Thus, the lower the rate of inflation in the future, the higher the ‘real’ value of the bond payments. If people believe that inflation is going to fall, then they will pay a higher price for bonds today.
But over the last year, things have not worked as normal. As economies have slowed, we have not seen inflation subside – in fact, it has gone the opposite way and has been accelerating over the last year. As a result, we have seen bonds record a slight loss over the last year. The reason we have seen inflation accelerate is the large move we have seen in commodities: oil; metals and foodstuffs. Consequently, inflation expectations have risen slightly over the last year (see graph2).
h4. Rising interest
The second factor that has held back bond markets is interest rates. In the past, during those times when economies have slowed, central banks have responded by cutting interest rates. But this time around in Europe, interest rates have actually gone up. This feeds into the interest rate in the bond market (called the yield). If rates are rising, there is pressure for bond yields to rise (which means bond prices fall). If you can earn four per cent in an overnight deposit, there is little incentive to hold a ten-year bond on a yield of four per cent. If the ECB then increases rates, the probability is that bond yields will rise also. Over the last year, the ECB has moved interest rates up 0.25 per cent and thus the increase in bond yields over the same period (see graph 3).
It has been a challenging year for asset allocation. The divergence in the performance of the different assets has been high and almost all assets types are down in value. The next 12 months will be equally challenging. Just as one tries to foresee the start of economic difficulties, one also has to try and see when these difficulties end. When will inflation subside and allow central banks to cut interest rates, as weakness in economies suggests they should? When will economies stabilise and at what level of growth will they level off?
* Conor White is a Senior Portfolio Manager with Goodbody Stockbrokers. He can be contacted on 01 6419295 or conor.p.white@goodbody.ie
* Goodbody Stockbrokers is the stockbroking arm of the AIB Group. Goodbody Stockbrokers is regulated by the Financial Regulator and is a member firm of the Irish Stock Exchange and the London Stock Exchange.
* This publication has been approved by Goodbody Stockbrokers. The information has been taken from sources we believe to be reliable, we do not guarantee their accuracy or completeness and any such information may be incomplete or condensed. All opinions and estimates constitute best judgement at the time of the publication and are subject to change without notice. The information, tools and material presented in this article are provided to you for information purposes only and are not to be used or considered as an offer or the solicitation of an offer to sell or to buy or subscribe for securities.

Conor White examines the stock prices of Bayer and Colgate and finds them both to be in good shape, despite the challenges of the current economic climate
BAYER E52.79
Bayer is a diversified group consisting of three primary businesses: Healthcare, Crop Science and Material Science. Healthcare accounts for 46 per cent of group sales and 57 per cent of underlying earnings before interest, taxes, depreciation and amortisation or EBITDA (margin of 26.9 per cent).

The business breaks down into two main sub-segments: (1) Pharmaceuticals (69 per cent of divisional sales), and (2) Consumer Care (31 per cent of sales). Bayer recently announced it had entered into supply agreements with Barr for the latter’s generic version of Yasmin and Yaz for a fixed percentage of revenues.
This outcome is better than had been expected and reduces a key uncertainty for the stock. Nexavar for cancer is the key new drug. This differs from chemo as it specifically attacks cancer cells without attacking other growing cells and comes in tablet form. Treatment for kidney cancer was approved in early 2006 and for liver cancer last year. Peak sales are forecast at E600m-E1bn excluding China (where incidents are highest).
Xarelto has the highest economic value in their pipeline with key sales estimates of E2bn by 2013. One indication is the prevention of thrombosis after orthopaedic surgery, a $150m market. The other indication is stroke prevention. This is a longer-term therapy, with filing likely in 2010 and first significant sales in 2011.
h4. Crop Science
In the Crop Science business (20 per cent of group sales and 22 per cent of underlying EBITDA), Bayer is the world’s largest manufacturer of agrochemical products, marginally ahead of Syngenta, with a 19 per cent market share.
Applying peer group multiples to the Healthcare and Material Science divisions, Bayer’s current share price is implying a multiple for Crop Sciences materially below Syngenta and Yara. Material Science accounts for 30 per cent of group sales and 21 per cent of underlying EBITDA (margin of 14.9 per cent).
The business breaks down into two main sub-segments: (1) Materials (28 per cent of divisional sales), and (2) Systems (72 per cent of sales). Materials is suffering due to weak volumes and pricing in polycarbonate. This is used in DVDs, CD roms, car highlights, bullet-proof windows, etc.
The Systems business is proving more resilient with pricing holding up, despite fears over increasing capacity. This is used in fridge insulation, dash boards and furniture bedding.
Earnings per share (EPS) for Q2 were 7 per cent ahead of consensus. The company is in a positive earnings revision cycle and offers superior earnings growth over the next two years of 11 per cent per annum, which is not reflected in the rating of just 12x 2009 earnings. Pharma newsflow should accelerate through the next 3-6 months. As the Healthcare sales increase as a proportion of group sales, Bayer should be able to re-rate towards the healthcare sector multiple.
In 2008, Healthcare is expected to benefit from realisation of synergies from the Schering integration (target of €800m by 2009). Crop Science will benefit from strong ongoing fundamentals in the agrochemical industry.
h4. Material Science
The Material Science cost savings programme (targeting €300m p.a. by 2009) should help offset some of the decline in profitability anticipated in this division over the next few years. A combination of steady growth, the maturing of the pharma pipeline, the ongoing strength of Crop Science and strong cashflow generation provide scope for a re-rating alongside the prospect of steady EPS growth.
h4. COLGATE $76.23
Colgate dominates the oral care markets of Latin America and Asia, with toothpaste value shares approaching 80 per cent. The company markets toothpaste, toothbrushes, laundry products, liquid and bar soaps, deodorants and dishwashing liquid under such brand names as Colgate, Kolynos, Palmolive, Ajax, Mennen and Soft Soap.
Colgate also sources 10 per cent of sales from specialty pet food under the Hill’s Science Diet and Prescription Diet brand names.
In late July, Colgate reported 2Q08 EPS of 98c, which exceeded the consensus by 4c on better than expected organic sales growth of 9.5 per cent and operating expense control. The company indicated that full year EPS could be up in the mid-teens despite a tougher gross margin outlook.
Driven by double-digit organic growth in Latin America, Asia and Hill’s, Colgate sales rose a better than expected 16.4 per cent, helped by 7 pts of currency. By geography sales in North America increased 6.5 per cent, in Latin America 23.5 per cent, in Europe/South Pacific by 14.5 per cent and in Greater Asia/Africa by 17.5 per cent.
Sales for Hill’s Pet Nutrition increased 19.5 per cent on 6.0 per cent volume growth, an 8.0 per cent increase in pricing, and a 5.5 per cent favourable foreign exchange impact.
h4. Funding the Growth
After last quarter’s revision to margins that took some by surprise, Colgate’s Q2 gross margin was 15bps better than forecast at 56.8 per cent. This is despite raw materials pressure of 430bps. The offset was ‘Funding the Growth’, which generated 160bps of savings.
Agricultural commodities are now 80 per cent hedged for 2008, so some of the variability of materials costs has been eliminated. Restructuring savings were only 40bps in the quarter, well below the $100ml annual run rate of expected savings. This should reaccelerate in the back-half of the year. Advertising spending increased 20 bps as a percentage of sales to 11.7 per cent.
The growth rate in advertising spending represents a sequential acceleration from the 16 per cent seen in the previous quarter. Colgate generated $812 million of free cash flow through 2Q08, a 16 per cent increase over the same period last year.
At a little over 17x FY09 EPS, the stock is trading about in line with its typical premium to the market, but is well below its historical 8.5 per cent premium to the Personal Care peer group suggesting that the stock could see some multiple expansion from here. Colgate’s Q2 results were among the best we have seen by a Staples company, which is especially impressive considering just how challenging the current environment is proving for most consumer-exposed companies with commodity pressure.
The key for Colgate shares is convincing the market that its strong results are not simply a function of a good geographic footprint and defensive categories. Rather, Colgate continues to deliver owing to its ability to generate savings and efficiencies through its core business improvement programmes as it is still in the sweet spot of a restructuring programme.
h4. Reinvest in advertising
This enables it to reinvest in advertising at a fast pace, despite 430bps of commodity cost pressure in the quarter. Following the unforeseen gross margin collapse last quarter, investor scepticism about the sustainability of the defensive Colgate three-legged stool of gross margin expansion driving higher advertising spending driving top-line growth was called into question, with some investors fearful of a developing markets slowdown.
After the Q2 release, many of these concerns were assuaged and we view the stock as a high quality defensive holding.
• Conor White is a Senior Portfolio Manager with Goodbody Stockbrokers. He can be contacted on 01 6419295 or conor.p.white@goodbody.ie
• Goodbody Stockbrokers is the stockbroking arm of the AIB Group. Goodbody Stockbrokers is regulated by the Financial Regulator and is a member firm of the Irish Stock Exchange and the London Stock Exchange.
• This publication has been approved by Goodbody Stock-brokers. The information has been taken from sources we believe to be reliable, we do not guarantee their accuracy or completeness and any such information may be incomplete or condensed. All opinions and estimates constitute best judgement at the time of the publication and are subject to change without notice. The information, tools and material presented in this article are provided to you for information purposes only and are not to be used or considered as an offer or the solicitation of an offer to sell or to buy or subscribe for securities.
• Stock Prices: Prices in share recommendations are quoted from the close of business on 27 August 2008.