The UK economy

Economic Report

The condition of the UK economy can be evaluated by the use of several different methods. One such method would be by measuring the gross domestic product (GDP) of the country. The GDP is defined as the sum of all products and services produced within the country win one year. There are three ways of measuring this, the output method, income, and expenditure methods, all in theory should produce the same result.

As the graph above shows, the UK economy continued to shrink as a result of the current recession. The graph shows an upward curve in the third quarter of 2009, this however does not mean that the economy is beginning to expand; only that it is contracting at a slower rate than quarter 2. It may be the beginning of a recovery, but it is premature to confirm this. The economy did have a relatively steady growth rate of around 2%-3% up until 2008, but then the effects of the credit crunch began to take effect, pushing the economy into a recession. The credit crunch was born from banks giving credit away too freely, to individuals who could not repay. Now, the banks are not willing to hand out credit so freely anymore.

The UK economy is also heavily influenced by exchange rates. The fluctuating exchange rates affect the import and export market. The UK is reliant on importing vast quantities of consumer goods, and exporting services. The UK is one of the leaders in financial expertise, which companies from other companies pay for. As the £ becomes stronger against other currencies, imports become cheaper, as every £ is worth more compared to other currencies. This helps the economy as it can make consumer goods cheaper, but it has a detrimental effect on the service industry. A strong £ will make UK services more expensive to companies in other countries, and the foreign companies will therefore attempt to switch to service providers from countries such as the USA.

The graph shows the performance of the £ against the . It shows that between 2004 Q3, and 2007 Q4, the rate remained at around 1.40 to £1. This then began to fall in Q1 of 2008, and as of 2009 Q3 currently at 1.1475 to £1. This lower exchange rate makes goods and services produced in this country more appealing to foreign companies, meaning an increase in demand, but possibly a reduction in profitability. As the UK relies on mostly imported goods, they have become more expensive, which in turn has been a factor in the current economic downturn. The unpredictability of exchange rates could be solved by joining the single European currency.

One of the most prominent economic indicators is the inflation rate. The inflation rate measures the increase in price on a basket of goods each year. There are two different methods of measuring inflation; the retail price index, and the consumer price index. The consumer price index is the increase in the cost of goods to households. This is the method used by the government for calculating inflation. Inflation can affect the way in which consumers spend, and how much they spend. An increase in household bills such as energy costs can affect their disposable income. Disposable income is also affected if the inflation rate is higher than wage increases. This affects the buying power of their income. If the inflation rate is higher than wage increases, then it means they can buy less than they could 1 year ago. Currently, inflation rates are low; the CPI at the end of September was 1.4%. Inflation is driven by spending, which in this current economic climate, is low, hence the current rate.

Spending has been reduced as a result of the employment market. It is now harder for individuals to get credit from banks, be it in the form of personal loans or mortgages. This has reduced the consumer's ability to spend. With the reduced spending, businesses' revenues are reduced, and redundancies are inevitable. These redundancies have a knock on effect on the economy. The individuals who have been made redundant now have very little income and will tend to spend very little, meaning less revenue for businesses, and the cycle continues. Increased unemployment also hinders the government's ability to spend. The individuals who have been made unemployed will now claim unemployment benefit from the government, and as they are on benefits, they are not taxable. Therefore, the government's revenues are cut, and expenditure increases. This means that they have less money to spend on capital projects such as roads, schools and hospitals. Government revenues were also recently reduced by the cut in the rate of VAT, from 17.5% to 15%. This was done in order to try and increase consumer spending. If the government had the money to spend on these capital projects, it could stimulate the employment market. The current unemployment rate is 7.8% (2.45 million).

In a bid to increase the availability of credit, the Bank of England has recently cut interest rates to their lowest recorded rate of 0.5%. Interest rates are one of the primary ways to control the economy. They are mainly used by the Bank of England in order to control inflation. Should inflation rates become high; the bank will increase the interest rate to reduce spending. Spending will be reduced as borrowing will become more expensive. The higher interest rates will also encourage consumers to save as their money will work harder for them. The only way for the country to get out of the recession is to spend, and by making borrowing cheaper, spending should increase.

The current economic climate has forced share prices to fall across most markets. This had made it an ideal time to invest, as these low share prices allow higher volumes of shares to be bought than previous. The weak £ has also made it more difficult to invest in foreign companies. As the economy begins to recover from the recession, share prices will generally increase as the market becomes stronger and companies begin to return to normal profit levels.

Sector Choice

Lewis Fund Management Ltd had the choice of five sectors in which to invest:

  • Chemicals
  • Construction and Materials
  • Food and Beverages
  • Health Care Equipment and Services
  • Tech - Software & Services

Three of these sectors were chosen to invest in, with two companies from each gaining investment of £187,500 each. Two companies from the alternative investment market would also be chosen to invest in, again each company receiving £187,500. This would mean a total of eight companies receiving £187,500, resulting in a total investment of £1,500,000.

Immediately it was decided that the company would not invest in the construction and materials sector. This sector has been one of the hardest hit by the global recession. According to an article in the Guardian on the 17th of June 2008, house building was at its lowest level since 1945. It was stated in this article that one of the main reasons for this dramatic downturn was that individuals were finding it increasingly difficult to obtain a mortgage. The banks have become reluctant to give mortgages to individuals since the collapse of Fannie Mae and Freddie Mac, two large U.S mortgage providers who had collapsed as a result of individuals defaulting on their mortgage payments. This has led other mortgage providers around the world to be very reluctant to distribute mortgages. This lack of available mortgages has in turn led to the fall in demand for housing currently being experienced by the construction trade.

Another contributory factor has been the decisions made by governments to reduce capital expenditure due to their current debts. This has meant a reduction in the amount of capital projects which the commission. The reduction in demand in this industry has also led to mass redundancies, and building firms going into administration, and eventually folding. As a knock on effect of the poor demand for construction, this obviously directly affects material suppliers. It was deemed that this sector was feeling the brunt of the recession and could not be invested in.

After discounting the construction and materials sector, the Health Care Equipment and Services sector was evaluated. There should always be demand for products in this sector as people will inevitably always become ill. As newer and better ways of patient care are developed, hospitals will purchase the new equipment in order to provide the best possible service for these patients. However, as the investment period was only six weeks, this sector was seen as a longer term investment, where it would allow companies to innovate and get new products into the market place. This sector is also very narrow and specialised, unlike the chemicals, software and food sectors. This lack of mass market appeal was a factor in removing this sector from consideration for investment.

After removing these two sectors from consideration, it was decided that the investment would be made in three sectors; Chemicals, Food & Beverages, and Tech- Software & services. These three sectors offer investment in companies which not only sell direct to consumers, but to other companies in other sectors which may be thriving in the recession. It was this diversity that made these three sectors so appealing against the other two sectors.

Finally there was the Alternative Investment Market (AIM) to consider. AIM was created in 1995 in order to help smaller companies grow by allowing them to gain investment by the sale of shares. This is a market generally made up of small innovative companies looking for investment. AIM gives Lewis Fund Management the chance to get away from the constraints of the available sectors listed above and invest in companies from any sector of the market. Generally oil and gas producers are profitable no matter what economic conditions surround them, so the decision was taken to invest in an oil and gas production company. These companies are always profitable because their products are constantly in high demand, as they are a necessity, not a luxury. In order to continue with the highly diversified strategy of the business, rather than invest in another oil and gas producer, the investment was made in a mining company. The price of gold is currently at an all time high, which makes gold mining companies a very attractive investment opportunity.

Sector Analysis

Chemicals

Investing in the chemicals sector may be considered a risk as the global recession hit the sector hard in 2008. Over recent years, new companies have come into the sector meaning that there is strong competition between companies. Chemicals are used by almost every company in every sector, with basic things such as lubricants and adhesives vital for production. There are chemicals in virtually all consumer products, and as a result the reduction in consumer spending has meant that demand has fallen away significantly. In 2008 the industry was suffering; deals were falling through, and profit margins were getting smaller due to oil prices. However since the beginning of 2009, share prices of the larger chemical companies have begun to recover showing that the sector as a whole may be becoming attractive to investors.

Food & Beverages

The food and beverages sector has traditionally been described as a defensive sector to invest in, i.e. when the economy begins to slow, investment switches to this market. This is done as there will always be demand for products in this sector as they are necessities rather than luxuries. Companies in this sector have been affected a lot less by the recession than for instance the automotive sector. This has been reflected in the steadily increasing share price for companies in this sector. This sector reflects favourably against most other sectors, and is viewed as a safe investment area.

Software & Services

The software and services sector was hit hard by the recession. With many businesses around the world cutting costs, and not have sufficient funds to continue investing in their IT infrastructure, this had a severely detrimental effect on the sector. However, some companies within the market were still profitable and reporting surprisingly strong results. There was also the possibility of takeovers within the market as companies who were strong could take-over the weaker companies who were struggling. Investment in this market was viewed as a gamble, but one that could pay back handsomely, if growth expectations by certain companies were fulfilled.

Strategy

The investment strategy of the company was to try and invest in companies who held a diverse portfolio of products in different markets around the world. This was done in order to try and spread the risk as effectively as possible. This was felt to be very important as the current economic conditions are unstable. A highly diverse investment portfolio is the best way to significantly reduce risk, so by investing in companies with diverse portfolios, the risk factor would be further reduced. This strategy was applied to the Chemical and Food sectors. The Tech. Services and Software sector is highly specialised, and therefore it became difficult to apply this strategy to these companies. The companies chosen in this sector were both market leading companies. The sectors of the AIM market, mining and oil & gas, were chosen because they are generally profitable markets no matter what economic conditions were.

Company Report - BASF

BASF is one of the world's leading and most successful chemical companies. They also strive to be as ethical and sustainable as possible. Although the company is traded in the chemicals sector of the market they also have a diverse portfolio of products ranging from plastics, to agricultural solutions and from performance products such as adhesives, to oil and gas. During the period when the chemical sector was hit hardest by the recession, BASF suffered as profits dropped from 4.3bn to 3.3bn. This was due to a fall in demand combined with the high fixed costs of a company as large as this. Although the 2009 accounts have not been published, the share price has continued to rise throughout the year. This steadily climbing share price, combined with the strength of the company's product portfolio was the main reason for investment. The steadily climbing share price continued throughout the period in which investment had been undertaken. Shares were purchased on the 19th of October for a price of 40.11 (£35.86), and sold on the 27th of November for 40.68 (£39.17). Although the actual share price only slightly increased, the falling exchange rate resulted in a far more significant return for a 6 week period of approximately £17,000 (9%). In terms of the future, BASF have placed themselves in prominent positions in emerging markets such as Africa in order to be even more profitable in the future. The graph shows that initially the share price climbed, and took a substantial dip to 36.49. After this dip the price began to recover and eventually peaked at 41.70, before falling to 40.68 on the final day of trading.

The earnings per share figure for BASF fell between 2007 and 2008 from 4.16 to 3.13. For the year end 2008, BASF had a profit/ earnings ratio of 8.9. This has been slowly declining since 2004, when this was 14.5. The PE ratio did climb in 2007, but due to the difficult economic conditions it fell in 2008. Although the PE ratio is not the biggest, BASF is a large international, market leading company, with a diverse portfolio of products. Within the chemicals sector there is not a company that can offer an investment as relatively secure as BASF. If the investment had been made over a longer period of time, ideally 3-5 years, BASF would have been a worthwhile investment.

Company Report - Yule Catto

Yule Catto is a chemicals company based in England, with factories across the world. The company operates in 3 divisions; Polymer chemicals, Pharmaceutical chemicals and Impact chemicals. In comparison with BASF, they have a small product portfolio, but they are a much smaller company. With an employee base of 2,485, Yule Catto is a fraction the size of BASF who employ 97,000. Being such a small company has helped them during the current global recession. As they are a small company they do not have the large overheads that BASF do, and are not left as exposed when the economy slows down. This has enabled them to increase their overall profits from £497,879,000 in 2007 to £584,373,000. At the beginning of the year, in an article for the Investors Chronicle, it was stated that brokers believed investing in smaller chemical companies rather than large ones such as BASF would be the best option. At the time this was true, as BASF's profits were falling, and Yule Catto's were rising. BASF would appear to have recovered now with the increase in their share price. The share price for Yule Catto has almost tripled since the beginning of the year, as is shown in this graph.

Based on the broker recommendations, the rising profits, and the rising share price, Yule Catto appeared to be an excellent investment opportunity. On the 16th of October 127,584 shares were purchased at a cost of £1.47 each. The price then peaked on the 21st of October at a price of £1.815 per share. If the shareholding had been sold at this point it would have returned a profit of around £44,000. By the end of the six week investment period the share price had fallen to £1.575 per share, which meant an eventual gain of 10.5p per share. The share price performance is shown on the graph below.

Yule Catto has a significant amount of debt, around £135.5m at the beginning of 2008. The company are taking effective steps to reduce this, and during 2008 the figure was reduced to £114m. The aim is to have this below £100m by the end of 2009. When the debt reduction is combined with the rise in profits, the result is an increased earnings per share. At the end of 2007, the earnings per share were 17.9p, and this increased to 22.2p at the end of 2008. The combination of the rising earnings per share, rising profits, reduced debt and the company's position within the market were the main reason for deciding to invest in Yule Catto.

Company Report - Unilever

Unilever is a global consumer goods group. The company employs 179,000 people, and has management personnel from 24 different companies. Unilever operate in three separate markets; Food, Personal Care, and Home Care. Within these three areas, Unilever controls some of the most popular and recognisable brands such as Hellmann's mayonnaise, Sure deodorant and Persil. Unilever are the world leaders in many markets such as ice cream and deodorant. Unilever is reliant on consumer's purchasing their products, and from the recent fall in consumer spending, Unilever could have been suffered. With reducing disposable incomes for consumers, they will tend to find cheaper alternatives to products. This was reflected in the first quarter of 2009 with fall in volume sold of 1.8%. It was then forecast that the company's output volume would fall further, but it actually increased by 2%. According to Unilever this was due to a fall in commodity prices, allowing a reduction in production costs, meaning that they could reduce prices in order to compete with lower prices 'supermarket brands'. Since the announcement of the second quarter results the share price of the company has increased. The share price increase continued throughout the year. The share price performance for the investment period is shown in the graph below.

Lewis Fund Management invested £187,500 in Unilever at a price of £18.17. The share price peaked for the period at £18.66 on the 23rd of October. The price then gradually returned to around the price of investment, sometimes higher, sometimes lower, but then dropped to £17.75 on the 19th of November. The price quickly recovered but eventually finished at £17.92, a loss of 25p per share. One of the main reasons for investing in Unilever was that the earnings per share had consistently grown since 2005. EPS growth in 2005 was at 25%, 602% in 2006, 11% in 2007 and 35% in 2008. This continued EPS growth combined with the growth in output in 2009 were the reasons behind investing in Unilever.

Company Report - SABMiller

SABMiller is one of the largest brewers on the world. Based in South Africa, they distribute products to six continents. SABMiller operate with a similar business model to that of Unilever. SABMiller controls several leading alcohol brands around the world, including Grolsch, Miller and Castle who dominate the South African alcohol market. The portfolio also includes the world's most popular beer, 'Snow'. Although not well known outside China, it is the most popular lager in the world. Six of the brands in the company's portfolio are in the top 50 in the world. The company is the second largest brewer in the world behind Anheuser-Busch InBrew. The reason for investing in investing in SABMiller rather than their main competitor is that SABMiller are more prominent in growth markets. This was highlighted in a BBC News item on the 19th of November. The BBC reported that although total lager volume had dropped slightly, SABMiller was very well placed in the growth markets of Africa and Asia. The global recession has hit the brewery industry, but not as hard as it has hit other markets. The drinks market is a relatively stable market as there is always demand for alcohol. Although profits and sales have dropped slightly, the share price has increased by 60.51% in the past 12 months. This price increase is partially due to the company's afore mentioned position in African and Asian markets. It is also due to the reaction to the recession. With profitability significantly reduced in the Eastern European market, investment was moved from there to Africa and Asia. The share price continued to perform well in the 6 week period in which investment was undertaken, as shown below.

As with the other investments undertaken, £187,500 was invested at a price of £16.36 per share. The share price climbed to a peak of £18.09, and eventually ended with a price of £17.84, a profit of £1.48 per share. As a performance measure, the earnings per share had been increasing year on year up to 2009, when due to the slight fall in profits, EPS fell by 4%. Despite this fall, the investment was made based on the growth potential of the company in emerging markets.

Company Report - Aveva

Aveva is a software and services company which leads the market for software supplied to the offshore and marine industries. During 2009 the company had a high cash figure of over £126m in the bank, and were actively seeking to acquire another company in the sector, according to chief executive Richard Longdon. As the company seemed in a strong financial position, and was actively seeking to grow in the near future, Aveva appeared to be a reasonable investment. After initially increasing the share price during the investment period, it then slumped significantly. The price fell to £8.75 on the 3rd of November, nearly £1.50 below the initial purchase price. The price then recovered, but the decision was taken that the shares in the company would be sold on the 16th of November. The market was thought to be too unstable to continue the investment, and a small loss was made on the sale of the shares. The full details of this sale are explained in the 'Summary of Trading on 16th November'. Below is a graph showing the performance of the share price over the period.

From the company's accounts, Aveva looked like a strong investment. In 2009 pre-tax profits had increased by £15m compared to 2008, despite the economic climate. Even though the profit/earnings ratio had fallen, the earnings per share had again improved. The share price even looked strong with a 67% rise over the previous 12 months. These were the reasons the investment was undertaken, but the share price failed to increase further, as the investment had been made at close to the 52 week high.

Company Report - Misys

Misys is software and services company which specialise in supplying software to the banking, healthcare and other financial industries. It is one of the largest software companies in the world and has been very profitable. The banking crisis that sparked the recession had impacted slightly on the company, but they had come through it well by acquiring new clients. Pre-tax profits in 2009 were £94.2m, an increase from £48.9m in the previous year. With management forecasting growth across the company, it as Aveva did, looked like a very good investment. The profit earnings ratio had continued to increase as a result of the increasing profits. The increase in the share price was also very impressive, a 94% increase in 12 months. The performance of the company is very similar to that of Aveva, and as with Aveva, the price peaked just after investment, and then dropped and never recovered to the price at the time of investment. Misys was sold on the 16th of November. The price changes are shown on the graph below.

Company Report - Mwana Africa

Mwana Africa is the only African owned and managed mining company currently being traded on the alternative investment market (AIM). The main activities of the company are mining for gold, nickel, cobalt and diamonds. They do this in South Africa, Ghana, Democratic Republic of Congo and Zimbabwe. Due to the price of gold being very high at present, it seemed that a company that a company which was exploring new markets for gold would be a reasonable investment choice. The company has suffered in recent years due to the situation in Zimbabwe. Hyper inflation and political sanctions imposed on the country, caused by the Mugabe political regime, had forced the company to stop selling gold as they were not getting the true value of the gold, even though gold prices had hit an all time high. This resulted in a fall in share price from 80p to just 2p. Mwana survived as the company was fully funded and had sufficient cash within the business to cover the next 18 months. With the share price now up to 14p, it seemed a wise decision to invest as the company was recovering. The Altman system of Z scoring produced a result of less than 1, but this was due to the company posting losses due to the abandonment of gold mining in Zimbabwe, and the political factors already outlined. This low price of 14p meant that by investing £187,500, small fluctuations in share price would result in significant changes to the value of the shareholding. If the company were to discover a new source of gold, or renew previously profitable gold mines, the share price would dramatically increase. This was the reason for investing in this company, but in the short six week period this failed to materialise, and by the time the period had ended, the price had returned to 14p. The price peaked on the 18th of November at 16.75p, which would have returned around £36,000. In the long run this may have been a more profitable investment. The price changes over the period are shown in the graph below.

Company Report - Gulfsands Petroleum

Gulfsands Petroleum is an oil and gas producer based in London with production facilities in Syria, Iraq and the Gulf of Mexico. The financial figures for the company over recent years have been poor with reducing revenues, eventually resulting in a loss of £11.6m. After this loss the company was completely overhauled according to an article in the Investors Chronicle in August 2009. The company's headquarters were moved from the US to London and staff costs were reduced. The relocation was partially motivated by the exchange rate, as this had be a factor in the loss made. The management of company was changed in order to exploit the maximum return from the oil and gas fields in the Middle East. The company have high growth potential in Syria mainly due to a new oil field that could produce 8,000 barrels per day of oil, and another site could produce up to 15m barrels of oil. With the new management in place and the potential for growth, Gulfsands could deliver substantial returns in the long term. In the short term, the investment did reasonably well. Despite a fall to £2.28 per share, the price recovered and at the time of sale was trading at around £2.40 per share.

Due to the poor financial results of recent years, there was no profit/earnings ratio. The earnings per share were also poor due to the loss. However this will improve now that the company has been restructured. The Altman Z scoring system also did not give a fair reflection of the company's position.

The decision was taken on the 16th of November to sell shares in two companies. These two companies were both in the Tech. Services and Software sector. Both companies were performing poorly, as can be viewed in the company reports for each company on the previous pages. After initial share price increases, both company's share price drastically fell. These low share prices were having a detrimental effect on the portfolio and although Aveva began to recover, the decision was taken to sell shares in both companies, and pull out of that sector completely as it did not seem that it could become profitable. The gamble of investing in an unpredictable market, with companies forecasting growth had not resulted in a profit. After its recovery, Aveva made a loss of £1652 when sold, and Misys made a loss of £7700. Once deciding not to re-invest in the tech. Services and Software sector, there was a decision to be made on where to re-invest.

After considering other sectors, the decision was made to invest in sectors which were currently in the portfolio, and were showing profits. The two sectors that received the investment were the Chemicals sector and the Food & Beverages sector. Although it is a risk to narrow an investment portfolio in an unstable economic environment, it seemed a risk worth taking as both chemical companies in the portfolio were increasing their share price steadily. The decision to invest in a third company in the Food and Beverages sector was based upon the fact that in the run up to Christmas, these companies are at their busiest. At the time of investment there were also reports circulating that a rival company was bidding to takeover Cadburys. As with more takeovers, reports of a takeover pushed up the share price, and it was hoped that continued speculation about a takeover would further inflate the share price, therefore making the investment more profitable.

Company Report - Bayer

Company Report - Cadbury

Biblio

  • http://www.telegraph.co.uk/finance/newsbysector/industry/6576058/Mwana-Africa-has-dug-deep-to-bring-mining-back-from-the-brink.html
  • http://www.guardian.co.uk/business/2008/jun/17/construction.housingmarket
  • http://www.investorschronicle.co.uk/MarketsAndSectors/Sectors/article/20090120/c8314b3c-e325-11dd-81b9-00144f2af8e8/Brokers-view-Chemicals.jsp
  • http://www.investorschronicle.co.uk/Companies/ByEvent/Regulatory/Inbrief/article/20090902/70d61068-97aa-11de-b57d-0015171400aa/Aveva-considers-returning-cash-.jsp
  • http://www.investorschronicle.co.uk/Tips/Buy/TipsOfTheWeek/article/20090421/bda2c40a-2da0-11de-8da9-00144f2af8e8/Gulfsands-reinvents-itself.jsp

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