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Capital International

Fourth Quarter 2011

Investment Review Innovation, Integrity and Excellence


The last quarter has seen investors recoup around half of the losses from the summer Capital International


Volume: 9 Global Equities: Mild Recovery – ‘We’re half way there’ The last quarter has seen investors recoup around half of the losses that were experienced over the horrendous summer period. 2012, however, still looks like being a difficult year for global equity investors, with the scope for significant gains in the developed markets looking limited. In recent weeks there have begun to be more widespread earnings downgrades to 2012 forecasts, most notably in cyclical sectors such as the banks and engineers. These have been in the region of 5-10% but we will need to monitor the underlying economy closely to establish the accuracy of such revisions. Focus has remained on Europe and we have finally seen evidence that the leaders have grasped the full scale of the problems. Certainly countries such as Italy and Spain have been raising funds at slightly reduced levels, although investors must surely still be concerned by the amounts of cash that European banks are keeping at the ECB. Such credit conditions are not conducive to promoting economic growth. Importantly, from an equity perspective, much has now been discounted with the Euro Stoxx 50 Index down 19% for the year, although it only managed to rally by 4% in the quarter. It currently trades on 10x P/E ratio and an attractive 5% dividend yield. In the UK the worst performers in the FTSE 100 over the quarter have generally been financial related stocks. The insurer, Admiral, is down over 33% whilst Lloyds is nearly 28% down and Man Group is down nearly 25%. The risers are reasonably eclectic with Wolseley the best performer up 30.5% with Rolls Royce continuing its strong run up nearly 25% and on the back of an improved crude oil price, Royal Dutch Shell is up 22%. The P/E ratio has now slipped below 10x with a dividend yield of nearly 4%. Even allowing for the downside risks, there is considerable valuation support at around the 5500 level. In the US, the S&P 500 index is up 10.5% on the quarter with strong performance from oil service stocks such as Nabors, which is up 42% in Q4, although the sector was particularly oversold. On the negative side, the retail sector is looking increasingly problematical with Abercrombie & Fitch losing 22% and Sears is down 42%. We are of the opinion that some of the beneficial tax breaks will fall away in 2012 and the consumer could once again be squeezed. The Japanese equity market has bucked the rally with a fall of 3.5% on the Nikkei; the strong Yen has been the main culprit, inflicting pain on the exporting sector. The Chinese equity market remains in a very protracted downtrend; the Shanghai Composite fell 8% in the period and is now some 38% below its high in 2009. Investors will be nervously wondering if it is an accurate barometer for the future of the economy. Blue chip companies around the world remain in good financial health, although the European uncertainty has inevitably led to a lower amount of merger and takeover activity than we had expected. We are still of the view that 2012 could see this theme re-emerge, as almost pseudo capital expenditure. In the small cap arena, liquidity is hard to come by and with a contraction in the number of brokers/investors there is a real danger of value traps simply staying cheap for years.

Rates & Commodities GBP/USD GBP/EUR GBP/JPY SILVER GOLD EUR Crude Oil US Fed Funds UK Base Rate ECB Base Rate

Price at 30-Dec-11 30-Sep-11 31-Dec-10 1.5509 1.5648 1.5591 1.1967 1.1634 1.1665 119.399 120.7 126.579 1322.980 1222.160 1481.040 1574.50 1629.00 1410.25 107.58 104.26 94.3 0.25 0.25 0.25 0.50 0.50 0.50 1.00 1.50 1.00

% Chg Quarterly -0.89% 2.86% -1.08% 8.25% -3.35% 3.18% 0.00% 0.00% -33.33%

Issue: 4

% Chg 1 Year -0.53% 2.59% -5.67% -10.67% 11.65% 14.08% 0.00% 0.00% 0.00%

7000 6000 5000 4000

FTSE 100 Index 3000 Dec-08 Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 8000 7000 6000 5000 4000

DAX Index 3000 Dec-08 Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 15000

12500

10000

7500

Dow Jones Industrial Average Index 5000 Dec-08 Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 World Indices FTSE -100 Dow Jones NASDAQ S&P 500 DAX CAC 40 Nikkei 225 Hang Seng FT All Gilts

Price at 30-Dec-11 30-Sep-11 31-Dec-10 5,572.28 5,128.48 5,899.94 12,217.56 10,913.38 11,577.51 2,605.15 2,415.40 2,652.87 1,257.60 1,131.42 1,257.64 5,898.35 5,502.02 6,914.19 3,159.81 2,981.96 3,804.78 8,455.35 8,700.29 10,228.92 18,434.39 17,592.41 23,035.45 173.57 166.46 156.38

% Chg Quarterly 8.65% 11.95% 7.86% 11.15% 7.20% 5.96% -2.82% 4.79% 4.27%

% Chg 1 Year -5.55% 5.53% -1.80% 0.00% -14.69% -16.95% -17.34% -19.97% 10.99%

Source: Bloomberg - data as at 31/12/11


UK Economy: Austerity Programme

Fixed Income Review: Groundhog Day

On the surface there is little good news for the UK economy as it enters 2012. The OECD recently stated that the ‘UK economy is teetering on the brink of a return to recession’. The main export trading partner, Continental Europe, is already experiencing a recession and the UK consumer remains squeezed from a number of sides. In the recent Autumn statement, the Chancellor extended the tough restraints on public sector pay for at least a further two years, and with lower than forecast economic growth, was forced to extend the current programme of cuts to 2017 at the earliest. It is arguable that in reality it has only been in the last six months that we have started to see the public sector job cuts actually happening.

Another incredible quarter for the global bond markets has generally seen yields, notably on AAA rated sovereigns tighten even further. The end of the year will see an all time low yield on the 10 year UK Gilt of 1.95%. In essence we have been very wrong on Gilts for a long time but with questions remaining over the UK finances and political discord within the coalition; the ‘safe haven’ analogy seems to have gone just too far. The Bank of England through the QE measures now own over 25% of the issuance and have partly been the cause for the best year of returns since 1998.

The Government and its focus on financial austerity are driven by the current low UK borrowing rates within the global bond markets and they do not want to endanger such market credibility. By 2015, the Government will still be borrowing nearly £80 billion, which is £33 billion more than earlier forecasts. This is primarily because Chancellor Osborne’s GDP growth forecasts were overly optimistic. There have been numerous observers who have questioned the ability of the UK to maintain its AAA credit rating in 2012. Unemployment is likely to climb towards 9% as the private sector is unable to absorb the public sector job losses. On a positive note in the gloom, it finally looks like the elevated levels of inflation will finally decline, with the 2% target potentially met by the end of 2012 and during the next calendar year it could fall to 1.5%. This could lead to a modest increase in consumer spending from mid 2012, with the Olympics potentially boosting the ‘feel-good’ factor. The current consensus GDP growth rate in 2012 is 0.7%, which has been revised significantly down from 2.5%. The Housing market has been relatively benign during 2011, defying many pessimists who had predicted double digit percentage price falls. In actual fact, safe havens such as central London have performed very strongly as international investors pour funds into the capital. Elsewhere it looks like the average UK house price declined in value by 2.1% over the course of the year, slightly more than the 1.6% price fall in 2010. The current consensus prediction for 2012 is for 3% price declines, as unemployment continues to rise and there could be downside risk to these forecasts. On a long run basis the average house price to wages calculation is still running at elevated levels. The disappointment of the current economic cycle has been the muted capital expenditure plans of the corporate sector. Business conditions overall remain sombre and previous plans of capital investment are being scaled back. Whilst the UK banks have made good progress in reducing their funding and liquidity risks, there are still very tough credit conditions facing smaller companies. Such reduced credit availability could soon start to have a real negative impact on the level of both UK demand and output.

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The surprise for Gilts is that they have rallied more than German bunds, largely on the back of current policy measures and the generally weaker economic outlook. The Bank of England is also becoming increasingly dovish on inflation prospects. They now believe there is a 40% chance that inflation will be below 1% in three years time. The quarter was dominated by the widening in spreads of European countries such as Italy and Spain. The 10 year Italian bond began with a 5.8% yield and peaked in late November at 7.52% before ending the year at close to 7%. Given the simply huge sums of debt that need to be refinanced in 2012 and despite the political changes, Italy looks set to dominate sentiment for some time to come. It is estimated that 440 billion Euros of bonds will need to be sold and the level of rates, despite continued ECB intervention, is simply unaffordable. Despite some agreement by the European leaders on increasing the financial scrutiny and rigour by which individual economies are run, there still needs to be concerted action by the ECB in the shape of both further decreasing interest rates and also embarking on a QE programme. This could be as large as 3-4 trillion Euros but is vital to aid the embattled European banks. Bonds would clearly rally sharply on such actions and would go some way to stemming the crisis. US Treasury yields narrowed slightly on the quarter. However similar to the UK, some observers are growing nervous that current yields are simply distorted by the safe haven demand. They are not adequately reflecting either the US economic outlook or an inflation tail risk. Indeed the inflation linked bonds, notably at the long end of the curve have performed very well in recent months. Despite an improved performance over the quarter there remains attractive value in both investment grade and high yield corporate bonds. The implied default rate (over 40% over the next five years for high yield issues) simply remains too high for the relative financial strength of many companies. Once again for investors comfortable with higher risk profiles, the financial sub sector continues to offer yields around the 8% level for medium duration profiles. Emerging markets bonds could still suffer from further investor outflows in the first part of 2012, although could then start to look more interesting but we feel investors will have plenty of time.


5.5 5.0 4.5 4.0 3.5 3.0 2.5

10-15 Year UK Gilt Yields

2.0 Dec-06

Dec-07

Dec-08

Dec-09

Dec-10

Dec-11

The surprise for Gilts is that they have rallied more than German bunds

Source: Bloomberg - data as at 31/12/11

Š Capital International Limited 2012


Country Focus: Ireland - the Recovery starts here... Optimism returned to Irish equity markets despite the ongoing turmoil in the EuroZone as investors became more optimistic that the country would implement its austerity budget and be rewarded by an export-led recovery. This view became more widely-held in the fourth quarter as private equity investor Wilbur Ross tipped Ireland as the first periphery nation to see a recovery while David Vine and Max Watson, economists from Oxford University also expressed belief that the Republic would regain its competitive edge over its troubled Mediterranean counterparts. Key to achieving its economic targets is its labour market flexibility, allowing it to effectively devalue labour costs while the ‘Club Med’ countries are finding reform of their laws much more difficult and therefore their businesses cannot easily cut costs. Ireland’s net debt to GDP is scheduled to peak in 2013 at a maximum of 110% of GDP before declining below 100% by 2015, a rare surprise for watchers of the EuroZone’s peripheral economies. Those in the ‘Austerity’ camp will ascribe this optimistic outlook to Ireland’s adoption of aggressive measures to restore the fiscal balance. Ireland embarked on its current deficit reduction program after it received emergency support of €85 billion from the EU/IMF in late 2010 when its financial sector collapsed and the Irish government was forced to step in and underwrite its domestic banks’ liabilities. As a condition of receiving the funding, Ireland agreed to impose strict budgetary disciplines leading to dramatic cuts in public spending and the disposal of state assets. This position would be more reminiscent of the early-decade Ireland which saw years of strong growth and it saw its reasonable gross government debt burden drop from 38% in 2000 to 27% prior to the impact of the financial crisis.

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Its budgetary position is likely to improve in tandem and, while the government will be much more vigilant regarding its budget deficit than earlier administrations under the new fiscal compact, it is expected to recede from 2009’s alarming 10.4% deficit to 5.2% by 2013. To those sceptical of austerity as an economic tool, Ireland highlights the problems of a modern economy following contractionist policies while needing growth. The country has gained admiration for the speed at which it has implemented its policies but unemployment has remained stubbornly high at almost 10% of the population and has arguably become more pervasive. Whereas the construction industry and connected services bore the brunt of the unemployment during the start of the downturn, austerity has distributed the pain across wide swathes of society. Education, Agriculture and Hospitality are all now responsible for large portions of job losses in Ireland as the construction industry completes its downsizing cycle and cuts are felt elsewhere. Property has remained under significant pressure with both residential and commercial sectors continuing to suffer. Ireland’s fabled ‘ghost towns’ remain unoccupied with 348 developments containing over 90,000 houses officially classed as unfinished and requiring local authority intervention. Houses on these estates still sell at levels more than 50% below the average asking prices of 2005-2007 and the government is under pressure to complete the estates in order to improve the residents’ welfare and improve the marketability of the empty properties. Despite these difficulties, Ireland has been admired for its pragmatic approach to the fallout from the great financial crisis. Its establishment of the National Asset Management Agency or NAMA, was one of the first ‘bad banks’ set up to handle distressed property loans and Ireland was swift to nationalise its troubled banks and safeguard customer deposits.


The net effect is that Ireland is perceived by the markets as rediscovering its dynamism as an economy in the face of adversity. While Ireland has faced high costs of borrowing as a sovereign state since its bailout, it has notably ‘decoupled’ from other peripheral EuroZone states during the most recent phase of rising yields which saw the Italian government pay over 7% to borrow for 10 years. Out of the Italy, Portugal, Greece, Spain and Ireland group of EuroZone periphery nations, Ireland is the only nation to have seen its 10 year financing costs drop over the second half of 2011. As one of the first economies to experience severe difficulty, its quick response to the crisis has helped it become one of the quickest to recover. Although capital markets remain volatile and the recovery will certainly be fragile, there are grounds for hope. The government has its funding requirements met through 2012 and is confident that it will find strong demand when it returns to international capital markets in 2013. Moreover, when Ireland negotiated its bailout financing from the EU in August, the European Financial Stability Facility (EFSF) was to provide the funding. Being quick to arrange the terms has been a cost-effective move as the sovereign crisis deepened and the EFSF itself has found that its own borrowing costs have risen significantly. Estimates of the saving to Ireland are in the region of €2.5 billion to €3 billion. Its competitive corporate taxation regime continues to offer European businesses a gateway to the rest of the world and internet giants Google recently acquired a landmark €100 million tower, Dublin’s tallest property, giving rise to the belief that Ireland’s economy might be experiencing a return to growth once again. Ireland’s equity market is small and has undergone major changes due to the nationalisation of its banks while most of its biggest companies make the majority of their profits overseas or are subsidiaries of other multinational businesses. There are some Irish equities of note however which provide interesting opportunities. As Ireland’s largest listed equity, CRH Plc (CRH ID) has a prominent global position in aggregates for building and construction. CRH has inevitably suffered over the last four years as an Irish company linked to the construction industry but it has also been successful in reducing operational leverage and overheads while making a number of key divestments to ensure its continued independence. It has continued to keep its investment grade rating stable throughout the crisis to present day, rated BBB+ by S&P from 2006.

Its debt position is very manageable and while turnover has been falling due to its large exposure to the EuroZone, its US and International divisions have been an increasing part of its bottom line. Furthermore, the sector is expected to experience a wave of consolidation as investors look to preserve margins and increase market share in expanding economies. Another candidate for consideration is the low-cost airline Ryanair Plc (RYA ID). Headed by the controversial Michael O’Leary, the carrier is rapidly transforming into Ireland’s national airline, replacing the traditional Aer Lingus. Under O’Leary, Ryanair has been transformed from a ‘no-frills’ operator to obscure airports to a significant operator with one of the largest and most modern airline fleets in the world. When Ryanair starts to discuss pricing, aircraft manufacturers pay attention. Moreover, in an industry where making losses is the norm (American Airlines’ parent AMR Corp the latest victim of Chapter 11), Ryanair’s aggressive policy towards optimising its yield, quickly cutting unprofitable routes, has seen it navigate the credit crisis admirably and pose significant headaches to the national flag-bearers. Unsustainable debt has often been the cause of many airline failures and its €2.8 billion of first-lien loans secured against its aircraft puts it in a strong position. The airline entered into a joint design pact in June with COMAC, the Chinese state-owned builder of airliners which is developing a competitor, the C919, to Boeing’s 737 and the Airbus A320Neo. While Ryanair expects to own 300 737’s by the end of 2013 with a further 200 or 300 due by the end of 2018, a sign of its intentions to dominate the short and medium-haul air travel space. The financial crisis has been a spur to many businesses to revisit their business model and Paddy Power Plc (PWL ID) has been particularly successful in growing new sales channels and delivering strong earnings and cash flow in the face of a beleaguered consumer by understanding its customer base and delivering competitive and attractive products. Paddy Power was one of the first big chains of traditional bookmakers to successfully embrace the potential of the internet and develop outsourcing agreements with alternative sales channels such as lottery operators. While a return for 2011 of +30% might leave the stock vulnerable to a spate of profit-taking, its impressive return on capital and strong dividend growth coupled with its relatively young businesses in fast-growing markets should win it further support going forward.

Optimism returned to Irish equity markets despite the ongoing turmoil in the EuroZone © Capital International Limited 2012


Sector Focus: Food & Personal Care The packaged food and personal care sectors have witnessed challenging commodity costs in 2011. However, prices in a number of major agricultural areas have declined from their 2011 peaks, and we have seen manufacturer price increases offsetting at least a portion of the cost pressure. It is expected that rising prices at food outlets will lead to consumers putting increased focus on less expensive products, including various private label (store brand) items. However, manufacturers of higherpriced branded products will generally hold on to much of their market share, helped by brand loyalty among consumers and marketing support by manufacturers. Various food companies are seeking to bolster profits with cost reduction programs, and are looking to offset at least some of the input cost pressure with price increases. However, with consumers likely to be quite price-sensitive, there could be some resistance among retailers and consumers to increased prices from manufacturers. With at least some products, we think that higher prices could adversely affect volumes. In 2012, a moderate increase in overall consumer spending on food in the US and Europe is expected, with much of the rise being from higher prices. Over time, we expect growing consumer and regulatory scrutiny of prospective health concerns and benefits from various foods, beverages and ingredients. Longer term, the packaged food and personal care industries will focus on consumer lifestyles, tastes, health considerations, and demographics, including both opportunities in developing international markets and the interests and needs of an aging global population. We anticipate industry growth opportunities will include further introduction and distribution of products that appeal to consumers’ interest in healthier eating. Rising standards of living in developing international markets should provide packaged food and personal care companies with opportunities for growth.

Year to date through November, the consumer staples sector, which represented 11.4% of the S&P 500 Index, was up 5.3%, compared with a 3.3% drop for the S&P 500. In 2010, the sector index rose 10.7%, versus a 12.8% increase for the 500. There are 12 sub-industry indices in this sector, with Soft Drinks being the largest at 21.6% of the sector’s market value. Global sales volume gains are expected to be driven largely by higher marketing expenditures, and by increased sales in developing markets. However, efforts to at least partly offset higher commodity costs with increased prices are likely to limit overall volume gains, in our view. Also, with U.S. unemployment expected to stay relatively high in 2012, we think less expensive private label goods will remain attractive to many consumers, limiting the sales growth of branded goods companies. The sector’s recent 3.1% dividend yield is well above the broader market’s 2.3%, reinforcing its defensive qualities, in our view. In summary, our positive view of the S&P 500 Consumer Staples sector reflects our belief that investors will favour this high-yielding defensive sector amid on going economic uncertainty.

Sector Positives: • Outperformer during middle-thirds of economic expansions • Defensive sectors expected to show less of a growth slowdown in 2012 • Attractive on a Relative P/E basis • When risk-on favoured, Staples has second-lowest beta behind Utilities

Sector Negatives: • Below S&P 500 median expected growth rate in 2011 and 2012 • Relatively low percentage of companies reporting a positive earnings surprise • Any new stimulus by the fed or congress or evidence we are avoiding recession could cause cyclical to rally and defensives to underperform

PepsiCo Inc PepsiCo Inc is a global manufacturer, distributor, and marketer of food and beverages, owning many well-known brands including Pepsi, Frito-Lay, Tropicana, Gatorade, and Quaker Oats. PepsiCo operates in over 200 countries, with its largest markets in North America and the United Kingdom. Unlike its major competitor, the Coca-Cola Company the majority of PepsiCo’s revenues do not come from carbonated soft drinks. In fact, beverages account for less than 50% of total revenue. Additionally, over 60% of PepsiCo’s beverage sales come from its key noncarbonated brands like Gatorade and Tropicana. PepsiCo’s diverse portfolio can mitigate the impact of poor conditions in any one of its markets. Strong demand growth in international markets, the company serves 86% of the world’s population and international sales account for 48% of revenue, is helping to offset a sluggish domestic market and provide the company with opportunities for continued expansion. PepsiCo is highly exposed to raw materials costs. Prices for the most important input materials, aluminium, PET plastic, corn, sugar, and juice concentrates fluctuate widely. PepsiCo is the largest snack and non-alcoholic drink producer in the United States, with 39% and 25% of the respective market shares. The fall in net income was attributable to two reasons. First, PepsiCo recognized a $346 million mark-to-market loss on derivatives used to hedge its commodity exposure. Next, the company incurred restructuring costs of $543 million in relation to its Productivity for Growth program. PepsiCo operates in six divisions: –– Frito-Lay North America (29% of

Revenue, 43% of Operating Income) –– Quaker Foods North America (4% of

Revenue, 8% of Operating Income) –– Latin America Foods (14% of

Revenue, 13% of Operating Income) –– PepsiCo Americas Beverages (25% of

Revenue, 29% of Operating Income) –– United Kingdom & Europe (15% of

Revenue, 10% of Operating Income) –– Middle East, Africa, and Asia (13% of

Revenue, 8% of Operating Income)

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Soaring food and energy prices, the housing slump and a weakening job market have impacted on consumer spending in North America, even in the typically recession proof drinks and snacks market. Emerging markets such as China, India, Eastern Europe and Latin America present strong growth opportunities for PepsiCo. Pepsi purchased WimmBill-Dann Foods, a Russian food and beverage company, for $5.4 billion. Wimm-Bill-Dan is the leading producer of dairy products in Russia and they also have a large market share for juice, so the purchase significantly expands Pepsi’s presence in Eastern Europe and Central Asia. In addition to making international acquisitions, PepsiCo is investing significant resources in expanding their manufacturing capabilities in developing markets. The company has pledged to invest $3.5 billion in China through 2013, mainly through the construction of 10 to 12 new manufacturing facilities (in addition to the 27 it currently operates). In China, Pepsi is also pursuing a strategy of buying back stakes in its Chinese operations from local partners. These acquisitions will give the company greater control over its operations while increasing profits. Unlike the saturated North American market, China’s carbonated drink market is growing at almost 20% annually. In the past two years, the company invested in two other manufacturing plants in Vietnam, and it currently operates five plants in the country. In Latin America, the company has pledged $3 million over the next three years to create an agriculture research centre in Peru, which will focus on the discovery

of new potato and other vegetable varieties. PepsiCo expects their global nutrition business will be worth $20 billion by 2020. In the domestic beverage market, the Coca-Cola Company is PepsiCo’s main competitor. Coca-Cola has a higher worldwide share of carbonated soda beverages, but PepsiCo has a more diverse product line and leads the industry in non-carbonated soft drink innovations. PepsiCo’s revenues are also substantially higher than CocaCola’s, due to PepsiCo’s snack and convenient foods business, a market in which Coca-Cola does not participate. PepsiCo’s presence in the snack and convenient food industries, as well as its industry-leading innovations in the non-carbonated soft drink segment, give it a somewhat more balanced portfolio than Coca-Cola and provides the company with some protection against further declining demand for Carbonated Soft Drinks. Pepsi also pays the Dr Pepper Snapple Group for the rights to sell its products, along with Coca-Cola Company. PepsiCo’s Frito-Lay and Quaker brands compete in various parts of the larger food industry. Its snack foods manufactured by the Frito-Lay segment hold a commanding share of the U.S. market, accounting for around 39% of domestic snack food sales. PepsiCo’s main competitor in the food market overall is Kraft Foods. Kraft’s products include snacks, cheese, diary, and cereal products, which puts it in competition both with Frito-Lay and Quaker products. Much like the Coca-Cola Company, Kraft does not participate in both the food and soft drink markets, giving PepsiCo the advantage of having a more diverse offering of products.

When it comes to international presence, Coca-Cola easily trumps PepsiCo. Coca-Cola’s impressive global footprint puts it in a better position to benefit from strong growth across the globe, particularly in the developing world. Furthermore, because Coke generates so much of its revenue abroad, it stands to benefit greatly from the continuing weakening of the dollar as sales denominated in foreign currencies are suddenly worth more dollars back home. At the same time, PepsiCo’s heavy dependence on North America makes it much more susceptible to a slowing US economy. Another important distinction between the two companies is their product offering. While Coca-Cola is essentially a one-product company that focuses on beverages, PepsiCo has a much broader product base that includes beverages, foods and snacks. Coca-Cola’s heavy dependence on beverages, particularly carbonated beverages, makes it more susceptible than PepsiCo to a growing aversion to soda which is perceived as fattening and unhealthy. On the other hand, PepsiCo’s extensive portfolio of beverages, foods and snacks puts it in a better position from the trend to healthier eating. The shares have traded in a 52-week range of $58.50 to $71.89. Its market capitalization is $102.45 billion, its trailing P/E is 16.43, its trailing earnings are $3.99 per share, and it pays a dividend of $2.06 per share, for a dividend yield of 3.20%. Recommendation: BUY

© Capital International Limited 2012


Sector Focus: Food & Personal Care (cont’d) Unilever Unilever was formed in 1930 when the Dutch margarine company Margarine Unie (which had itself been created through a series of mergers in the 1920s) merged with the UK’s Lever Brothers Ltd (which had been founded by William Hesketh Lever in 1885 to produce soap and had subsequently diversified into fish, ice cream and canned foods). For a variety of reasons (including tax), the two companies pooled their interests through a business merger instead of a legal merger. Today, Unilever is a leading global supplier of consumer goods across a wide range of food, home and personal products categories. In 2010, the group had sales of close to $59 billion and an underlying EBIT margin of 13.3%. The food businesses, accounting for 51% of sales and 53% of operating profit in 2010, consist of two broad product areas: Savoury, Dressings & Spreads and Ice Cream & Beverages. The home and personal care areas accounted for 49% of sales and 47% of operating profits in 2010. Major brands include Cif, Domestos, Snuggle, Surf, Omo, Axe, Dove, Pond’s, Lux, Suave, Lifebuoy, Sunsilk, Signal and Vaseline. In home care, according to Unilever, it is the leader in laundry products in developing and emerging markets, while holding second position in fabric cleaning in much of Europe.

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The group sold its underperforming North American laundry business in mid-2008. In personal care, Unilever believes it is the global leader in skin cleansing and deodorant products, and a leader in daily hair care in developing and emerging markets. Unilever has been operating on the basis of an underlying sales growth target of 3% to 5% with a targeted operating profit margin in excess of 15% by 2010 (after charging 50 to 100 bps of “ongoing” restructuring costs). These targets were confirmed in August 2007 when the company announced an accelerated restructuring program together with the intention of disposing of businesses with a combined annual sales of over $2.5 billion (including its North American laundry operations, subsequently sold in 2008) and various ungeared cash flow targets (based on free cash flow before financing costs). However, since February 2009, Unilever has eschewed giving earnings guidance (either short or medium term), arguing it is “inappropriate” in a climate of economic uncertainty. After a significant slowdown in the company’s sales volume/mix growth in 2008, Unilever has focused on improving its volume performance (including market shares) while seeking to protect its margins. In October 2011, Unilever announced an agreement to sell its Culver Specialty Brands division for $325 million.

That business was part of Unilever’s earlier acquisition of Alberto Culver Co. Also in October, Unilever said it had agreed to acquire 82% of Concern Kalina, a Russian personal care products company. In August 2011, Unilever said it had agreed to sell the Alberto VO5 brand in the U.S. and the Rave brand globally. In June 2011, Unilever said it had completed the sale of its global Sanex business. Unilever’s organic sales growth in 2008, 2009 and 2010 was 7.3%, 3.5% and 4.1%, respectively, with volume/mix contributing 0.1%, 2.3% and 5.8% of these percentages. The EBIT margin excluding gains and losses on business disposals rose from 12.3% in 2008 to 13.3% in 2010; helped by restructuring benefits (the “One Unilever” program). Further improvement in the EBIT margin to 13.8% in 2011 is expected. Unilever’s return on invested capital fell from 13% in 2008 to 12.1% in 2009, due to a rise in the average effective tax rate. However, it rose to 13.5% in 2010, and improvement to 14.9% in 2011, led by increased margins and tight asset control. The shares have traded in a 52-week range of $28.45 to $34.55. Its market capitalization is $92.46 billion, its trailing P/E is 16.46, its trailing earnings are $2.00 per share, and it pays a dividend of $1.23 per share, for a dividend yield of 3.80%. Recommendation: HOLD


Country Focus: Canada Canada is one of the world’s wealthiest nations, with a very high per-capita income. It is a member of the Organisation for Economic Co-operation and Development (OECD) and the G8, and is one of the world’s top ten trading nations. Canada is a mixed economy, ranking above the US and most western European nations on the Heritage Foundation’s index of economic freedom. The largest foreign importers of Canadian goods are the United States, the United Kingdom, and Japan. In the past century, the growth of Canada’s manufacturing, mining, and service sectors has transformed the nation from a largely rural economy to an advanced, urbanised, industrial one. Like many other First World nations, the Canadian economy is dominated by the service industry, which employs about three-quarters of the country’s workforce. However, Canada is unusual among developed countries in the importance of its primary sector, in which the logging and petroleum industries are two of the most prominent elements. Canada is one of the few developed nations that are net exporters of energy. Atlantic Canada possesses vast offshore deposits of natural gas, and Alberta also hosts large oil and gas resources. The immense Athabasca oil sands give Canada the world’s second-largest proven oil reserves, after Saudi Arabia. Canada is additionally one of the world’s largest suppliers of agricultural products; the Canadian Prairies are one of the most important global producers of wheat, canola, and other grains. Canada is the largest producer of zinc and uranium, and is a leading exporter of many other natural resources, such as gold, nickel, aluminium, and lead. Many towns in northern Canada, where agriculture is difficult, are sustainable because of nearby mines or sources of timber. Canada also has a sizable manufacturing sector centred in southern Ontario and Quebec, with automobiles and aeronautics representing particularly important industries. The economy rebounded strongly in Q3 with a 0.9% quarter on quarter rise in real GDP (3.5% annualised rate). Much of the strength in the quarter reflected a recovery from Q2 when there was a 0.1% contraction caused by temporary factors which hit oil extraction and car production in particular. A better guide to the recent underlying trend is the quarterly average of Q2 and Q3 of 0.4%. But the recovery is likely to slow into 2012 as the external environment deteriorates and commodity prices decline. Easier policy is on the cards sometime next year. Above trend GDP growth in Q3 was driven by an especially strong rise in goods exports which were up 4.1%, the fastest in seven years. But this followed a 2.4% drop in Q2, underlining the catch up element of growth in the third quarter. The outlook for exports is deteriorating, especially to the US where the economy is expected to be particularly weak in the first half of the next year. Three quarters of Canadian exports go to the US. A strong exchange rate is a subsidiary negative influence on the export outlook. Meanwhile domestic demand is already on a slowing trend, averaging 0.5% a quarter in the first three quarters of this year compared with 1% through 2010. Indeed in Q3 domestic demand slowed to a quarterly rate of just 0.2%. Consumer spending increased by 0.3%, which is below the recent average. To some extent this reflects a squeeze in real incomes caused by elevated rates of inflation, in Q3 headline annual CPI inflation averaged 3% while nominal wages increased by 2.7%, implying a slight fall in real wages. © Capital International Limited 2011


Country Focus: Canada (cont’d) A fall in the savings ratio was necessary to support even the modest gain in consumer spending. The savings ratio fell to 8.8% of disposable incomes in Q3, from 9.4% the previous quarter. However, inflation may fall back in coming months, providing a modest boost to real wages. But the labour market has deteriorated in recent months with employment falling in two out of the last three months. Consumer confidence has been on a declining trend throughout this year and in October touched a two year low. Elsewhere there was a 2.9% quarterly fall in machinery and equipment investment in Q3, the first for two years. Other investments did increase and in total investment was up by 0.4%. But again this was considerably below the recent quarterly average of 2.4%. The weakening prospects for final demand point to modest gains at best in investment spending in coming quarters. At its meeting in December the Bank of Canada left interest rates unchanged at 1%. The bank considered that recent growth in Canada had been stronger than it had expected but that a slowdown was still expected due to external weakness. There was no signal that policy would be tightened or loosened in coming months, although the bank statement emphasised that low interest rates and a functioning banking system meant that monetary policy was highly accommodative. Broad money growth is rising by over 5% a year, much faster than in most developed economies. The S&P/TSX Composite Index underperformed the S&P 500 in the first nine months of the year, largely because of the Canadian market’s exposure to commodities. Not surprisingly, the S&P/TSX Small Cap Index underperformed the broader market as is usually the case during stock market corrections. Investors become concerned over the quality and liquidity of small-cap stocks during market downturns and as long as uncertainty in the market prevails, small-caps tend to underperform and become oversold. On the other hand, small-cap stocks generally lead the markets on the upside and outperform large-caps. Several Canadian banks increased their dividends during the quarter. Technology bellwether Research in Motion retreated after reporting disappointing earnings. M&A activity slowed over the summer but started to pick-up moving into quarter-end with Minmetals acquiring Anvil Mining ltd. The sharp slowdown of the global economy exacerbated by policy paralysis in Europe to resolve the sovereign debt crisis as well as the political impasse in the US surrounding the debt ceiling and the S&P downgrade of US Treasury bonds to AA+ resulted in a flight to quality. Risk aversion rose as a Greek default became an actual possibility. As investors rotated towards more defensive assets, fixed income was the best performing asset class in the third quarter.

The speed at which yields dropped in the stronger countries has rarely been seen. The DEX Universe Bond index returned 5.12% in the third quarter and 7.43% since the beginning of the year. Long-term government bonds provided impressive returns. Canada 30-year bond yields dropped to levels not seen since 1945. High yield bonds in Canada and the US had the worst performance as investors shied away from risky assets. The market for corporate bonds became very illiquid during the quarter and credit spreads widened relative to government bonds. Corporate bonds performed well during the quarter mainly as a function of the lower yields on the underlying government bonds. However, corporate spreads remain very wide.

Research in Motion The stock enjoyed a meteoric rise and in August 2009, Fortune Magazine named RIM as the fastest growing company in the world with a growth of 84% in profits over three years despite the recession. However recently things have not been so good. Sales have slowed in the face of fierce competition from rival smart phones. In June the company announced a drop in revenue for the first time in nine years and also unveiled plans to reduce jobs. This impacted on the share price, which dropped to its lowest level since 2006. Since June 2008 to June 2011, RIM’s shareholders lost almost C$70 billion or 82% as the biggest decline among telecommunications equipment providers, from $83 billion at 3 years before to current C$13.6 billion. RIM reported November quarter revenue of C$5.16 billion which was below the consensus estimate of C$5.26 billion, which accounted for 5.9% Year on Year decline and 24% sequential growth. EPS of C$1.27 was above the consensus estimate of C$1.19. Gross margin was 27.3% and operating margin was 6.3% in the November quarter. The major negative was the guidance and sequential decline expected for handset shipments as channel sell thru slows down. The company is on a declining trajectory and there is little reason to think this is going to change under the current management and with the current strategy. It is possible that the ecosystem keeps breaking down and doesn’t recover with the carriers focusing on other hardware; customers’ viewing the brand as yesterday’s phone, and developers moving on to other platforms. A major concern is that RIM is not well positioned from a cost structure and management perspective to be an ongoing leader in the entry level smart phone market, which is likely to see competition ratchet up next year. Also, the company has lost the high end of the smart phone market. It is also difficult to see the company as a takeover target as its market capitalisation is still sizeable and management are expected to be reluctant sellers. Transitions to new platforms such as Blackberry 10 (BBX) are always painful and developer support, which is already shaky, could lag even further during the process. It is too soon to tell if the company can rebound and future downward revisions would be a concern. Recommendation: SELL

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Bank of Nova Scotia (Scotiabank) Scotiabank, formally known as The Bank of Nova Scotia, is one of Canada’s Big Five banks , the third largest bank in Canada by assets (behind the Royal Bank Of Canada and Toronto-Dominion Bank ), and the second largest by market capitalization (behind Royal Bank of Canada). It is also the country’s most international bank, having over 1,850 branches in 48 countries. Unlike its competitor, Royal Bank of Canada, Scotia bank has avoided banking operations in the United States. Instead, it has built a network in the Caribbean, Central America, and Mexico. Scotiabank, like the rest of the Canadian banks, was negatively affected by the 2008 Financial Crisis. For FY 2008, the bank wrote down C$1,211 million before taxes. Decline in Collateralized debt obligation (CDO) valuations led to C$516 million in write downs. Scotiabank was also one of Lehman Brothers’ creditors, so Lehman’s downfall cost Scotiabank upwards of C$120 million. Despite Scotiabank suffering write downs of C$1,211 million from the 2008 Financial Crisis, the bank competes in a highly regulated Canadian banking sector that has limited Leverage and required conservative lending practices, which has left the Canadian Banks relatively unscathed. Canadian banks only accounted for 2% of the estimated C$720 billion in write downs by global banks and brokers during 2008. In fact, the Geneva-based World Economic Forum placed Canadian banks as the soundest in the world. Canadian banks average a Tier 1 Risk-based Capital Ratio of 9.8%, or twice that of the average American investment bank and three times greater than the mean of European commercial banks. The Canadian Government issued C$75 billion in mortgage issuance to keep the international playing field level as other countries (especially the US and European nations) provided guarantees to bank asset. Canada requires banks to maintain a Tier 1 capital ratio of at least 7%. The ratio is a measure of equity and retained earnings to risk-adjusted assets and provides a general guide for determining a bank’s financial health. Scotiabank had a Tier 1 capital ratio of 9.3% at the end of 2008. That compares with a ratio of 10.5% posted by Canadian Imperial Bank of Commerce. Scotiabank has the ability to easily issue about C$800 million ($648.8 million) in notes, adding about 30 basis points to its Tier 1 capital ratio.

Canada has announced that the Tier 1 requirements will increase to 10% to prevent a credit crisis. Royal Bank announced that it will issue as much as C$2.3-billion in common equity to bring its Tier 1 capital ratio above 10%. Scotia bank must raise C$2.255-billion to get to 10%. Pre Tax Pre Provision Earnings decreased in 4Q11 due to a surge in expenses (partially due to acquisitions) and the net interest margin (NIM) also compressed. While the overall net interest margin decline was only 1 bp, underlying margins in the Canada and International Banking segments contracted meaningfully (-7 bps and -9 bps, respectively). Loan growth was a bright spot for the quarter, reflecting healthy business and government demand which should continue into 2012. With slowing retail demand and a difficult NIM and capital markets environment, however, the overall outlook remains challenging. Year to date the stock has underperformed its peers, dropping -13.70% and is currently trading on a P/E of 10.69%. For comparison the Royal Bank of Canada is down -2.75% YTD and Toronto Dominion Bank is up +2.79% YTD. Ongoing risks to the share price include integration risk regulatory and accounting risk and the company’s exposure to Canadian real estate, which may not result in direct credit losses but a slowdown in economic growth and thus earnings growth for Scotiabank. Slowness in the recovery of the overall US economy and in the international economies could negatively impact the Canadian economy, possibly resulting in lower balance sheet growth and potentially lower earnings. Fluctuations in the Canadian and US dollars could also negatively impact the foreign currency translation of revenues from the company’s foreign operations. It is expected that weaker fixed income, currency and commodity trading and underwriting and advisory revenues will drive lower sequential pre-tax, pre-provision earnings and EPS. Into 2012, earning power as well as multiples and consensus estimates are expected to contract and Canadian banks as a group could underperform in the near term. However any surprise on the upside regarding the European situation and economic recovery would have a positive impact on the share price. Recommendation: HOLD

© Capital International Limited 2012


Europe clearly has the worst economic momentum of any global region Capital International


Global Outlook: Economic Growth

Europe: EuroZone Review

There are many and varied challenges for the global economy in 2012. The austerity actions undertaken by heavily indebted Governments at a time when many consumers are deleveraging are clearly not positive. The very action of fiscal restraint could make matters in the short to medium term even worse for economic growth prospects. It remains very difficult to see inflation picking up and we remain of the view that deflation should be viewed as more of a concern. For instance, much of the outcome of the various quantitative easing programmes has simply been excess reserves in the banking system rather than surging credit conditions. The elevated levels of unemployment should also ensure that wage growth remains muted.

The latest European summit has been described by President Sarkozy as one that would ‘go down in history’; however sceptics would argue that the focus on constitutional elements does not really tackle the core worries of the markets and investors. For too long the European leaders have been more than aware of the constraints imposed on the European Central Bank by the Maastricht Treaty. In the fact that it cannot act as ‘lender of last resort’ in the same way the Bank of England or the Federal Reserve can. There also needs to be some form of Europe wide bond issue to back up the increased fiscal union. The short term ‘sticking plaster’ approach has led to a series of downgrades from the credit rating agencies and the jury is still out following the latest summit.

A key determinant for global economic growth will be the outcome of China and what type of ‘landing’ the economy achieves. Growth is already under major downward pressure and there are real fears that the huge real estate bubble that has developed in recent years will pop, in a very nasty way. Some estimates put the level of unsold houses at 70 million units across the country. The Chinese authorities have already started to take action to boost the levels of domestic demand. Hopefully with inflation back to the 4% levels, the more stable domestic prices (notably food) should allow for a boost to the real level of wages. This shift towards boosting domestic consumption is at the heart of the current five year plan. The current consensus for 2012 is for GDP growth of 7%, although we have seen some pessimistic forecasts of only 3-4%, which would be very negative indeed for global prospects.

Moody’s have left the door open to further ratings changes with the menacing quote ’Unless credit market conditions stabilise in the near future, our ratings of all EU sovereigns will need to be revisited’. Standard & Poors are also monitoring the situation with France potentially on the downgrade list. The level of bond yields has real underlying consequences for the individual countries finances and certainly when Italian 10 year yields went over 7%, this was simply an unsustainable situation.

Our core view for the US economy is that it will be difficult for growth to significantly exceed 2.5% in 2012, once again a relatively low figure given the level of economic stimulus provided by the Federal Reserve. Recent economic data has been reassuring investors, notably the level of consumer spending. A note of caution here, given that real income growth has not been keeping pace and the savings rate has declined from 8.4% in 2008 to a current reading of only 3.5%. There needs to be some dramatic progress in Congress on the level of debt reduction and tackling the budget deficit. Any spending cuts could lead to a fiscal drag of approximately 1.5% in 2012 and probably more in 2013. Europe clearly has the worst economic momentum of any global region and on a best case scenario it is forecast that GDP across the area will decline by 1% in 2012, however it could be a lot worse. The full ramifications of a Euro break up are too terrible to consider but there are equally problems with 17 leaders trying to speedily enforce structural changes. The ECB lies at the heart of an upside scenario and certainly from an equity viewpoint, valuations are beginning to look ‘cheap’. Much will also depend on the level of growth that Germany can achieve, however similar to China, the challenge will be to boost domestic demand rather than relying on exports. Asia is probably the hardest region to predict with Japanese GDP forecast to grow at nearly 2% on the back of continued domestic reconstruction efforts. However commodity related economies such as Australia and Malaysia could falter if a global ‘hard landing’ scenario becomes likely. Preference would be for those economies which are still experiencing healthy levels of domestic demand such as India and Indonesia.

The politicians simply have been unable to create a well financed, firewall from the crisis. One aspect that became evident however, was the isolation of the UK, and it remains a real possibility that in the coming years the country will leave the European Union altogether. International companies trading with the region are likely to reconsider investing large sums in establishing any large scale UK presence. Maybe Mr Cameron will be proved right and the UK will become just a big version of Switzerland! What has become clear in recent weeks is the duration and reality of the crisis that will be enforced in individual economies. The focus now is clearly on budget discipline and austerity. Although many would argue such severe austerity is not the answer and will only exacerbate the situation further, similar to Greece. In Italy, the new ‘technocratic’ Prime Minister, Mario Monti, is putting the finishing plans in place for his emergency budget. This will contain tax rises and spending cuts which will total some €30 billion and involve a radical reform of the Italian labour market. The unions are already planning a series of strike action days. Investors will continue to focus on Europe in 2012 and it is highly likely to continue to be the main source of negative shocks. There are large amounts of sovereign debt to be rolled over and it will only take one poor auction for bond yields to once again rise. A Euro breakdown at some point is starting to look inevitable. The economic data has also continued to worsen as 2011 has progressed, with Germany slowing rapidly. The current consensus GDP growth rate for the region has been downgraded from 0.4% to a decline in 2012 of 0.2%. Greece will almost certainly leave the Union and it will be fascinating to see if any other ‘fringe’ areas leave. On a positive note, Croatia is still looking to join in 2012! Maybe as investors we should be thankful for ‘small’ mercies.

© Capital International Limited 2012


Country Focus: China - Hard Landing China has become increasingly important to global capital markets over the last decade and the value of its equity markets has surpassed those of the UK, Germany and France to rank as the world’s third largest. As the world’s largest exporter and holder of the world’s largest foreign currency reserves, China plays a pivotal role in global capital markets but its post-Communist society makes analysis difficult. The country’s shift from a planned, agrarian community to a market-driven, urban and industrialised society has created enormous wealth but it has also brought far-reaching imbalances. Having grown its GDP at an impressive 14% average rate annually over the last 20 years, investors are now concerned that a slowing Chinese economy will delay or wreck any hopes of a sustained global recovery. One of the key areas of concern is the rapid rise and equally fast slowdown in Chinese real estate. Early warning signs emerged back in August this year when the country’s biggest developers reported that unsold inventories had risen by almost 50% to US$50bn in value. Following three years of strong gains, indications are that property values are sliding heavily in China. As we saw in the western financial crisis, the construction industry was one of the first sectors to suffer and over the last quarter, Shanghai’s construction industry sector has fallen at twice the pace of the broader equity index. Years of light monetary policy had enabled speculation on a large scale in real estate aimed at taking advantage of the huge urbanisation programme sweeping China’s farm labourers out of the fields and into the steelworks and factories of Beijing and Shanghai. Over the period of 1990 to 2001, China’s rural population ratio fell from 74% to 64%. China demographics experts predict that if current trends hold, then China’s city dwellers will number over one billion by 2030. The effects of a ‘hard landing’ scenario in China would have major implications for global markets due to the size of its growing financial sector and status as a global engine of growth in a world of low demand and weak consumption. Following the global financial crisis and the decimation of the Western banking sector, Chinese state-owned banks have overtaken their European and US counterparts as the deleveraging of bank balance sheets continues in order to meet new legislation. China’s largest banks are majorityowned by the Chinese state and so have relatively small free floats but as shown in the chart, would be amongst the largest banks in the world on a market capitalisation basis.

Capital International

When the Industrial and Commercial Bank of China (ICBC) was prepared for its IPO in 2006 by the Chinese Ministry of Finance, it had a non-performing loan ratio of 19.4%. The State then injected funds prior to its flotation of 20% of the equity in Shanghai and Hong Kong to bring the bad loan ratio down to below 5%. Clearly, restructuring a bank of ICBC’s size is only really feasible with the support of State entities. With a $2 trillion balance sheet and $30 billion of income, ICBC will remain an asset of the Chinese government for some time but illustrates how the ‘hard landing’ scenario would ripple out across the globe. ICBC, in addition to the other major Chinese banks, has been instrumental in financing a range of high value infrastructure projects outside China.


For example, ICBC loaned $400 million for a dam in Ethiopia and has partnered with China’s Ministry of Railroads to provide financing for an ambitious network of railways for the United Arab Emirates. It also owns 20% of the South African Standard Bank Group, giving it a strong position in the gateway to Africa. An enforced retrenchment in lending due to economic troubles in China would inevitably impact destinations far removed from China with an associated curtailment in global growth. A sharp retraction in the Chinese economy would hit Australia hard; China is Australia’s largest export destination and sent Iron Ore of over A$ 40 billion to China in the last year. On the import side, Australians bought A$8 billion of Chinese clothing and electronics. As one of the areas perceived to have a solid banking sector, a Chinese economic reversal would hurt Australia badly. Most significantly, the biggest impact would be seen in China’s major trade partner, the USA. For the last 20 years, China has been effectively operating a form of vendor financing with its export partners utilising a controlled currency regime. By not allowing its currency to float freely against the USD, China has maintained an artificially weak currency to ensure its competitive edge in exports. This in turn has led to an almost permanent bid for US Treasuries, driving down the cost of borrowing for the USA, giving it the financial firepower to continue importing goods from overseas. China and Hong Kong together own $1.24 trillion of US Treasury securities as at the end of October 2011, making them the largest non-US holder of US government debt. With the USA running a substantial trade deficit and China accumulating an equally large trade surplus over the last 20 years, the imbalance between the two nations has never been wider and the US administration has been gradually exerting pressure on the Chinese to adjust the value of their currency to limited effect. All the while China has been accumulating the world’s largest foreign exchange reserves of over $3 trillion. There are some ominously familiar signs; an overheating property market, a rise in lending and bad loan provisioning and a disproportionately large banking sector. All these give ample reason to be cautious regarding China and the potential for contagion if it develops problems. Equally, there are grounds for optimism that China will be able to manage its economy during a downturn in its domestic situation.

A sharp retraction in the Chinese economy would hit Australia hard

The Chinese government has shown itself to be astute in developing its economy and it will be keen to avoid a financial crisis as the Fourth Generation of Chinese leadership headed by Hu Jintao seeks a handover to the next term, likely to be headed by current Vice-President Xi Jinping during 2012. Its technocratic style of governance has helped it successfully navigate the global financial crisis while enabling reforms of a scientific and economic nature while maintaining a singleparty political system. Late in the fourth quarter, it announced the first cut in the central bank regulated reserve ratio back to 21.0%, a small cut of just 0.5% but an indication that the huge economy may be capable of swift action when necessary. The cut was an acknowledgment of the potential stresses building in the financial sector and aimed to reverse a series of increases earlier in the cycle when concerns were focused on an overheating property sector. The amount of financial firepower Beijing has to tackle problems at home is enormous; the $50 billion of excess housing stock is dwarfed by the nation’s currency reserves and while growth has definitely softened, it remains at levels envied by US and European Governments. These currency reserves can be used to stimulate activity in the most desirable areas of the economy. Air travel, new roads and rail network expansion are likely to be targets for new infrastructure investment during any pause in the Chinese economy. The current government led by Hu Jintao has a good record in infrastructure investing; along with eye-catching projects such as the Beijing Olympics in 2008, its earlier investments in technological infrastructure are paying off; for example broadband in China costs just US$10 a month. In Brazil it is $27 and in India, $30 a month. The country also has more internet users than the USA and Japan combined at 457 million. All this work is intended to create a more diversified, knowledge-based economy which is self-dependent rather than export-driven. China’s GDP is still continuing to expand at a rate of 9.1% annually and with inflation at 4.2% and unemployment at 4.1%, it will need to experience a severe contraction in order to fall into recession. Investing in China will remain a volatile experience suitable only for those with the highest tolerance for risk, regardless of the direction of the economy; the Shanghai stock market rose 200% during the two years prior to the financial crisis before falling 65% in 2008 so the pattern of volatile markets is set to continue. Although China’s future path is not clear, investors will be scrutinizing the data coming out of Beijing in the months ahead and looking for signs of further weakness. At present, the signs are that China will undergo a correction in property values but there should be enough capacity in the country’s reserves to ensure that non-performing loans do not create a Eurozone-style contagion with devastating effects.

© Capital International Limited 2012


Focus on New Materials: Graphene The ‘Holy Grail’ for most technology investors is to identify and invest at an early stage in the next ‘disruptive’ technology. Many of these new technologies are often difficult to identify in the first place and even more difficult to find investable opportunities since they are often closely-held by university or military research labs or are off limits to all except long-term venture capital or private equity funds.

In 2010 the Nobel Prize for Physics was awarded jointly to a team of Russian scientists working at the University of Manchester for their ‘groundbreaking work’ on the material graphene, a form of graphite with potential to revolutionise modern life in ways which are only just being envisaged. The appeal of graphene is being realised after almost quarter of century of research and more than 60 years after it was first theoretically envisaged. The material is essentially carbon in another form, in much the same way as carbon can take other forms; both coal and diamonds are forms of carbon for example. At present, full commercialisation is some years away but among the most likely applications for which it will be developed is in the markets for displays and sensors. Due to its molecular structure, rollable or foldable displays become reality and therefore newspapers or books could conceivably contain screens which provide moving content in much the same way as websites do today. A less visible but equally important use is in the formation of carbon composite materials. The material is extremely light and strong and has high thermal and electrical conductivity; it is believed that a one metre square sheet could support the weight of a cat with the sheet weighing less than one of the cat’s whiskers. In practice, nanotechnology cat bedding could be many years away as Graphene set a record in 2008 as being the most expensive material on Earth at the equivalent of US$100,000 per cm² for a one-atom thick layer!

Many of the major technology investment successes of recent years have ended up in the hands of private equity which have been able to finance the activities of businesses in segments as diverse as social media, telecommunication, biotechnology and renewable energy. By the time the mature businesses come to the market in a formal IPO, the biggest gains have already been made so the potential offered by a new technology is intriguing.

As well as the price tag, it holds a number of other ‘records’; the world’s thinnest and strongest material; the best thermal conductivity of any material and the most impermeable material known to science. Its production cost should be reduced dramatically as companies race to commercialise these properties. As an extremely light and strong material, it could be added to carbon fibres for strengthening and reducing weight. As airliners such as Boeing’s 787 Dreamliner show, this technology can deliver important cost benefits and manufacturers would be keen to utilise graphene on a massive scale.

Largest Listed Owners of Graphene Patents Samsung Sandisk Teijin GrafTech Canon Intel IBM General Electric Dow Chemical Texas Instruments Bayer BASF

Capital International

Country South Korea USA Japan USA Japan USA USA USA USA USA Germany Germany

Area of Research Electronics, Display Panels Memory/Storage Advanced Magnetic Film Integrated Circuits Display Panels Integrated Circuits Semiconductors Material Production Material Production Semiconductors Material Production Material Production

Market Cap($) 129.0bn 11.6bn 3.1bn 1.9bn 58.1bn 118.7bn 222.4bn 175.3bn 30.0bn 32.0bn 48.1bn 61.1bn

P/E 14.0 9.8 10.6 9.8 17.2 9.9 14.6 12.7 9.1 11.3 19.7 7.6

Dividend Yield 0.54% 0.00% 2.43% 0.00% 1.77% 3.60% 1.59% 4.10% 3.94% 2.42% 3.36% 4.30%

YTD Return 6.95% -3.03% -28.82% -33.20% -19.36% 10.84% 41.96% -9.19% -25.66% -13.72% -19.27% -14.32%


Its flexibility and conductivity make it suitable for largescale, flexible, touch screens and Samsung have already demonstrated a 63cm working prototype of a flexible display, currently the world’s largest. It is possible that a commercially available display may reach the market by late 2013. The product of graphene research may well result in applications that are not even being considered yet in much the same way as silicon was initially developed to be used in semiconductors but was also found to be suitable for making solar panels. With regard to finding investable opportunities, the high price of the material demands that only businesses with substantial research and development budgets can develop it so this naturally leads us towards some of the big listed technology and specialty chemical companies. Analysis of patent applications in the EU and US provide some insights as to which companies are driving the development of graphene. The diversity of applications cited in the patents suggest the enormous range of potential applicants and a gauge of which areas companies see niche markets forming. Samsung (005930 KS) holds the most patents in graphene with 61 followed by Sandisk (SNDK US) with 31 separate ‘families’ of patents. The two businesses appear to have developed markedly different approaches towards commercialising graphene with Korean Samsung working in collaboration on most of their projects while the American Sandisk has developed its own research capability. The Sandisk approach is the method favoured by Japanese Textile and Film manufacturer Teijin Ltd (3401 JT) with 28 patent families. The company has worked in conjunction with US chemicals giant DuPont on polyester films used in magnetic media but has so far not collaborated with external parties on graphene. Furthermore, Samsung’s approach has differed by activity across the full spectrum of imminent graphene applications such as batteries, displays, composite materials and integrated circuits. Sandisk and Teijin have restricted their research to their core business areas of memory/storage and materials/films respectively. Fujitsu, Canon, IBM, Intel and Texas Instruments are all conducting significant research on graphene in their respective product lines. History shows that bringing scientific innovations to the market can have frustratingly long lead times and some scientists estimate that it will be up to a decade before graphene starts replacing existing materials in any significant measure. Should the material live up to its potential as a genuinely disruptive innovative technology, it would transform the industrial and technological era and bring nanotechnology out of the laboratory and into our homes and workplace.

Graphene, a form of graphite with potential to revolutionise modern life © Capital International Limited 2012


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awards for

excellence

CIL - Quarterly Update Q4-2011 - V1.02-01.12

Capital International


Capital International Investment Review 2011 - Q4