UPDATE: THE SECRET PM

LATEST ON HSBC AND IMI

HSBC

HSBC is a long term investment – in 5 years or perhaps longer we will know how good the investment has been. The central thesis is that every profit line at HSBC has been hit over the past 10 years. Regulation has hurt the fee earning businesses as card swipe fees have been regulated lower and overdraft charges have been regulated lower. Ultra low interest rates in the US have hurt the retail and investment bank spread earning businesses since surplus deposits are earning zero return.

Finally the US subprime housing collapse hurt credit costs as default rates soared. Pre-provision pre-tax profits are down from roughly $40bn in 2007 to just $23bn in 2014. Interestingly at the start of the horrible decade the company was valued north of $200bn, today it is valued at $120bn. The point is that profit drivers have moved from highs to lows and valuation has also moved from highs to lows. As the current economic cycle matures and interest rates in the US move from zero to 3% plus HSBC’s profits will grow ahead of global GDP growth, reaching as high as $24bn.

That puts the stock today on a PE ratio of 5x potential profits. In the short term the stock has been caught up in the negative sentiment produced by the (historically) horribly managed Standard Chartered and the general negative momentum in European banks, providing an excellent opportunity to big a decent sized stake in the company.

 

IMI

IMI is a long term investment – in 5 years we will know how successful we have been. The central thesis is that the business has a very strong set of products, but management has consistently under-invested in growth opportunities. Part of the reason for the low level of investment was that the management were previously focused on divesting non-core business lines. From 2010 through 2012 despite a strong industrial economy IMI was spending just 2.7% of sales on organic capex.

Compare that to Weir plc which spent nearly 5% of sales on capex in 2012. R&D spending was similarly low. The big change happened in mid 2014 with the appointment of Mark Selway as CEO. He has a track record of investing for growth. Mark’s plan is to double IMI’s operating profit by 2019 through strong organic growth investments and acquisitions. So far Mark has executed on his plan as expected. In the short term IMI, being a company selling mechanical products, has obviously been affected by the huge fall in the price of oil and the subsequent cut back in industrial investment.

The huge profits currently being earned by refineries, for example, mean they are delaying all but essential maintenance and investment. Moreover, investments into the business that Mark is conducting – R&D has most doubled as a percent of sales – mean the profit decline from reduced revenue is exaggerated.

So long as you appreciate the industrial cycle for what it is – a cycle – then the price on IMI’s shares present an extraordinary investment opportunity: you are paying around GBP 2bn for a business that has the aim of producing profits around GBP 0.4bn, a PE ratio of 5x. Our Strategy note in 2015 H1 Strategy Note made it very clear that 2015 was not a good time to be aggressively buying stocks: “Looking ahead in 2015 the risk from equity exposure trumps the potential reward. Given the dearth of return available from financial assets cash is currently not a severely disadvantaged holding. Investors are thus probably best served in 2015 by booking profits and holding cash. Investments in stocks should be limited and very selective, focusing on companies that have already endured a profit downturn resetting investor expectations.”

So with that big picture thesis in mind I have been slowly and steadily adding to IMI as profits and investor expectations have reset lower, it is now a reasonably big position with an average price around GBP 9 per share.