The European banks’ "Stress Test" sounds like Animal Farm "Double Speak" ("All Banks are Stress-Free But Some are More Stress-Free Than Others")? But whatever "comb-over" the Brylcreem Boy bank regulators wear this time, the latest turn in the European debt crisis has made us re-think our investment strategy. Possible Euro-zone contagion via Italy, Spain etc forces us into some "back to basics" navel-gazing.

The trouble is, our navels seem to end up in the same place as they started, just above our guts. Please read on for why.

In equity terms, we’re as insulated from Euro-Blow Back as any equity investor could hope to be. We have no banks anywhere and no European financials. We probably won’t hold a bank till after we retire. We have no construction or real estate companies and no geared businesses or pure domestic consumer plays (OK, Tesco, but it’s 30% dominant in the UK, becoming so in India and China, setting up training academies in Asia, getting into banking, turning around Fresh & Easy in the US etc).

We have zero invested in the vague hope that somehow, someday, Europe will be a better place in the future than it is today (though we are sure that it will). The Euro-companies we hold (eg Nestlé, Diageo, Unilever, BAT) do as much business as they can in places where it’s not safe to drink the tap water (sometimes, they’re the ones who sell the tap-water) or are companies that would cheer if Europe and its dodgy currency fell further into an economic quagmire so they can export more goods to people in faraway countries who are having a far better time than they are (eg Swatch and most of those above). In all cases, the companies we own are dominant and, when the man next door to you is losing his job or trying to get yours, dominance matters.

But we’re not fooling ourselves either. In this age of instantaneous, digital, media over-reaction, no stock, no matter how saintly, gets out on the town with a pink ticket. So do we reduce equities and hide in cash? (The thinking goes... Is a guaranteed zero return better than a possible negative return?...or...Didn’t you learn anything from 2008? ...hard questions, hard thinking).

We think running to cash now in Europe is the wrong thing to do. Put simply, our reason is "you have to invest somewhere" (by the way, cash counts as an investment)...and we are more than aware of the short term risks to this creed as we face a potentially torrid summer. As our friend David Fuller is fond of reminding us, "Equities are part of a global beauty competition for the marginal dollar". Even in Europe, equities still shine in a line-up with the other 4 major asset classes -- even if the Euro Stoxx Q2 earnings season doesn’t weigh in like Q1 or Q4 2010, it should be enough to produce high single digit eps gains.

Cash yields remain derisory in major markets (under 0.5%). The ECB (which has already tightened) is on a different course from the Fed, but won’t hike for some time, given what’s going on. Even including the ECB with its paranoid DNA, no Central Bank wants to strengthen its currency or harm the West’s sub-par recovery with unnecessary rate rises.

Bonds (many coupons of 2-4% in Europe are below current inflation rates) are certain to lose money in the long term for the simple reason that real inflation runs at 3%+ in the long term. A 30 year bond bull markets has lulled people into thinking "safe" bonds can’t lose money. When 10 year yields approach 5%, we’ll look with fresh eyes on bonds. (We admit Euro bonds will do better than Euro equities if there’s an equity bear market, defined as a 2 day confirmed close below EuroStoxx 50 2545 level).

We should add gold to the pile, as we’re known to be partial. Gold shines in a fiat-currency world plagued by sovereign debt crises, and few investors can yet boast portfolio weightings over 5%. Gold’s best days may still lie ahead but a rise of 6x over 10 years means gold is no longer "undiscovered". Our policy is to gradually reduce into strength. But not quite yet.

Hedge Funds, post Madoff, have issues of transparency, fees, capital protection and manager skills. Investors have noticed that many follow markets down like sheep but only limp along behind the bull. The attractions of equities in a recovery (this would be the shortest recovery on record if it ends now) argue for a lower exposure to "hedged" risk assets. We hold none.

Equities still yield 10x more than cash. 10x is a lot. For faint hearts, we advise joining the "Dividend Aristocrat" bandwagon (high yielding Blue Chips, some above), particularly those earning more than 25% of their earnings in Emergia (not Sclerotica).


This diary (the "diary") is published by Global Thematic Investors Limited, a company domiciled in Hong Kong and incorporated under the Hong Kong Companies’ Ordinance on the 15th September, 2005. The diary is not intended for private customers and is written to be read solely by sophisticated investors, such as family offices, business corporations, banks and financial intermediaries. Statements are completely personal and may change without notice, are often forward-looking and therefore subject to uncertainty and risk. The predictions and forecasts implied may not subsequently be achieved. The diary is composed of information and opinion believed to be accurate, though this information may not have been verified. Funds or collective vehicles may only be open to certain persons in certain jurisdictions and may follow strategies that are speculative and involve a high risk of loss and may go up as well as down (a favorable performance record is no indication of future performance).