The Sceptre UK Fund was down by 0.3% in May which compares to a decline of 0.6% for the FT All Share Index – a marginal outperformance in a continuingly volatile market.

We are very excited by the opportunities currently being given to us by the market and really believe that we are in the middle of one of those rare periods when companies are being valued at large discounts to their real values. The existence of an economic cycle will work with similar leverage on stock prices in an upturn and it is only necessary to be invested in companies with solid balance sheets, good business models and experienced management to be able to take advantage. These opportunities are appearing in many sectors and particularly within the mid and small cap stocks which are usually the first to be abandoned by investors in a sell-off. The uncertainty continues to be when this turnaround will happen but, whether we have past the trough or are yet to see it, we believe we are close to the market bottom.

The three sectors that continue to be in the news are Banks, Housebuilders and Miners with the latter being a consistently good performer over the past few years with share prices of the leading FTSE 100 miners doubling in the past 2 years – whilst Iron ore prices have also doubled in the same time, it is interesting (if not repetitive) to note that the prices of Copper and Aluminium are currently at the same level as they were 2 years ago. Copper, Iron Ore and Aluminium have extremely large reserves and over a third of all new metal consumption of Copper and Aluminium is from scrap or re-cycled metal. We do not know where the price of the underlying metals is going to go and do not therefore have a method of valuing the companies and are content to continue to have no money invested in the sector.

The Banks continue to show that their own knowledge of the value of their investments is perhaps little better than we can glean from public available data and that their “good” returns have been derived more from the leverage of mediocre returns than from solid investing. In many cases their book values certainly bear little relation to the current liquidation values and most of those banks will have to raise more capital and face lower expected future returns. We do not see this sector offering us any investment opportunities at present.

Many of the Housebuilders’ stock prices have declined by over 80% in the last 12 months and are discounting a very large reduction in new property sales and in selling prices as mortgages have become more and more difficult/expensive for potential buyers. The two big issues for the companies is the reduction in volume and the size and cost of their landbanks. Throughout the 80’s and 90’s housebuilders held about 3 years of land (with planning) which allowed them to plan forward schedules and developments, in the past 2 or 3 years some of the larger housebuilders have built their landbanks to 5+ years of new property volumes and this has had a big effect on land prices which up to last year had more than doubled since 2004. With volumes and prices (house and land) now declining the housebuilders own “overvalued” houses and land as well as having higher fixed costs than required. It is the housebuilders with high debt that will be the hardest hit by this scenario and some still (surprisingly) have forward agreements in place to buy building land at prices agreed last year. At these times cashflow is their biggest problem.

We have been watching this unfold over the past few months and have always thought that there would have to be book writedowns for the landbanks and the possibility of Rights Issues for those builders with high debt levels. (see our article from October 2007: Articles) This is now even more probable and, we believe, will provide an opportunity for investment when it happens.

House prices and volumes may continue to decline for a year or more but those builders with low/no debt and shorter landbanks will be best placed to take advantage of the eventual upturn when it happens and the upside from an investment perspective should be substantial.

Chris Broadhurst