With the Merger and Acquisition frenzy still running at an outrageous pace it may be a suitable moment just to step back and consider what really has been happening. The FTSE All Share Index hit an all time record high last week, and the FTSE 100 was also ascending to heights not scaled since the end of the tech boom in 2000 when the Index peaked at the end of December 1999 at a level of 6930.

However, with these new levels being attained, we seem also to have forgotten some of the issues that led us to that turnaround resulting in the three year crash that followed thereafter. Now an exact repeat is unlikely but there are some similarities which I think we would be wise to take note of. Last year about half of the growth in the FTSE 100 rise of some 602 points can be accounted for by the effect of takeover speculation, and this year the same appears to be happening – but for how much longer? This sort of gain is speculative and thus leads many of us who have seen it before to feel somewhat queasy.

Throughout 2005 we saw some huge names disappear as buying British became quite the fashion. This of course may be very flattering but we are not necessarily dealing with a level playing field as I have mentioned before, with others like the Spanish having tax incentives to carry out an almost sponsored Armada against UK plc. BAA went to Ferrovial ($23.9bn), Scottish Power to Iberdrola ($23bn), Gallagher Group to Japan Tobacco ($19bn) and most recently Corus by Tata ($13bn). In fact the total value of UK assets being purchased rose from £41.9bn in 2005 to £61.6bn in 2006. 

Mind you, before we get too weepy over the lost assets of the nation, we should recall that this is exactly what we as an expansive capitalist nation have done to the rest of the world since Sir Walter Raleigh. Our overseas acquisitions have recently trailed those of the inward investors but nonetheless still totalled over £37.5bn in 2005 and nearly £22bn in 2006.

So into 2007 the pattern has continued with more names being slated as potential targets. As well as J Sainbury, Cable & Wireless, Morrison and ICI have all been mentioned in the muttering as the fervour of private equity funds swirls around like a shark frenzy. This leads to some superb churning of valuations but hardly a sustainable value - unless any of the sharks actually bites and devours the prey.
 

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Yet this concern is certainly not a unanimous view and among various stockbrokers I still hear the call that the market valuations are cheap – after all, they say, you only have to look at the Price/Earnings ratios. These stock punters would have us believe that as the 10 year PE ratio for the market is 17, and the current level is only 12, then the market can’t be overvalued - and in fact it is undervalued compared to the longer term, and therefore it must be a “time to buy”.                                                                                                                                                                     

In fact some research evaluated by my colleague Alex Scott has revealed that when it comes to market PEs, all is not quite as it would appear at first glance. The overall PE figure for the market actually masks some very significant discrepancies. It seems that it is the largest “mega” caps in the index that in effect bully the other stocks into submission. Because these larger companies have a greater weighting in the overall market index, their minority influence will very heavily outweigh the effect of the majority of smaller companies. Thus it is the low PE ratios of the larger companies which dwarf the higher PEs of the rest of the Index. It has been these sectors of smaller companies where PEs have risen significantly – owing mostly to the takeover frenzy especially in the constituents of the FTSE 250. So strip away the leadening effect of the company corpulents and then we see a PE ratio which more effectively indicates the higher value expectations of the market and the risks we are in fact running – closer to a PE of 20 and therefore not so cheap. Thus beware the sirens calling the stock market cheap – only birds go cheep – not stock markets. 

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Last week’s figures from HSBC contained a particularly unpleasant shock in the form of its bad debt provisions. The bank’s decision to dive into the “sub prime” market meant that it was inevitably opening itself up to the weaker end of the housing loan sector in the US and thus would be hit by any slow down. Well as we know the US housing market has slowed and accordingly HSBC has had to raise its bad debt provisions to £5bn, which is about the same level as their first half income.  This was significantly higher than expected and gave a nasty shock to the Hang Seng Index and left the Bank with “sub prime” all over its face.  

This, in the weeks to come, may be seen as an interesting straw in the wind and I would expect further bad debt issues to come to the fore with other banks, not just in the US but also in the UK as repossessions continue to rise.

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And finally….. two interesting Chinese tales. Beijing has just announced that the 11th of every month will from henceforth be “voluntarily wait in line day” in an attempt to educate the population into waiting patiently and politely before the Olympics begin. The marketing slogan will apparently proclaim “It’s civilised to queue, it’s glorious to be polite”. Quite right too – I wish someone would tell that to the citizens of Shepherds Bush waiting for the 94 bus.

Also, there was a delightful tale of confusion when at the inauguration of the new cricket stadium in Grenada (in the Caribbean) which had been paid for by Beijing, the local band managed to play the wrong national anthem – that of Taiwan – the other China. Much embarrassment all around and reminiscent of that delightful Australian film “The Dish” when the “Hawaii Five-0” theme was played as the American anthem. Much better anyway.
 

Have a good week,
 

Justin A. Urquhart Stewart
Director
Seven Investment Management