THE GRINCH WHO STOLE CHRISTMAS

My Portfolio : John Walter

Published: December 27 2002 18:22 | Last Updated: December 27 2002 18:22

Although 2002 has been a bad year for equities in general, the opportunities for stock specific investments and short selling have never been better.


I'm expecting more of the same in 2003 and sold most of my portfolio into the recent rally (I am now 80 per cent cash, having been more than 50 per cent invested in stocks throughout 2002) to take advantage of expected volatility.

The only large investment I still hold is RM, because the main factors that will drive growth, namely the education market and management's ability to take advantage of it, remain relatively immune to the wider economy. In addition, with the business still generating large amounts of cash, I am expecting the 5 per cent dividend yield to remain intact. This, and the recent approval to repurchase a further 10 per cent of the share capital, should underpin the share price.

As regards short positions, I am looking at capital-intensive and cyclical businesses with too much debt, as it is difficult for them to cut costs when revenues are falling. I think some of these companies may have to restructure their balance sheets, which will result in serious dilution for shareholders. Most short contracts are between three and six months long and mean that I have to be very confident there will be a short-term event that will drive the share price lower.

I think that Ashtead, which leases plant hire equipment, looks vulnerable with net borrowings of £433m and only £29m of expected pre-tax profits next year. The company had to renegotiate its banking facilities earlier on this year, and if the UK and US economies do not grow next year, I expect the shares to come under pressure. After warnings from JD Wetherspoon, SFI and Yates, it is only a matter of time before Punch Taverns warns. Although Punch's profitability is cushioned by rents from its leased and tenanted pubs, it is not immune to an economic slowdown.

The anecdotal evidence is pretty grim. I understand most publicans in south London are seeing sales down about 20 per cent per cent on this time last year. Punch has debt of £1.4bn, cash interest payments of about £130m a year and £147m of debt to be repaid next year. Given that the business generated some £240m of operating cash last year, there is little left to grow the business (capex and acquisitions were £120m in 2002), especially if revenues fall next year.

I am expecting at least one major stock market collapse as a result of either a geo- political event, such as a Gulf war, or more bad company or economic news. This will create some good buying opportunities. In previous articles I have mentioned Close Brothers and Provident Financial, both of which tend to get hammered when the market and, more specifically financial stocks, come under pressure.

Although Close's asset management business will struggle because of falling equity markets, margins in the loan book, which account for the lion's share of the group's profitability, should be robust, as its lending is low risk and it has few large exposures. As ever, the entry price will be crucial. I think £4.00 to £4.20 represents very good value, as this is close to the book value of the equity and assumes negligible growth.

This is a very conservative view, given that the return on equity has averaged about 15 per cent over the past 10 years. At this level the dividend yield is more than 6 per cent. At £6.00 the investment represents fair value and I would be tempted to take profits.

Provident Financial, which lends to people who cannot get credit from high street banks, tends to get caught in the cross fire when the financial sector comes under pressure. Management announced profits in its insurance business were starting to decline but I believe stronger performance in its international operations, still at an early stage of development, will more than offset this.

An entry price of around £5.50 looks good value and, like Close, the above 5 per cent dividend yield should provide good support for the stock at this level. Although I am not a fan of technical analysis, I have noticed that the stock struggles to maintain any momentum over £7.00, so I would look to sell when it reaches this point.

Finally, I will stay well away from gilts in 2003 because I expect prices to fall and yields to rise, as the government issues more debt to fund its large public expenditure commitments.

John Walter is an active private investor