Markets: Credit fall-out

Less than three months ago the FTSE 100 was at multiyear highs. Andrew Dewson looks at which stocks have suffered most and which have proved resilient since the credit crisis took root
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The Independent Online

Three-quarters of the way through the year and, barring dividends, anyone investing in the FTSE 100 on 1 January would be marginally out of pocket.

But that does not tell the whole story – in spite of yesterday's 146.6 point gain, the market has endured a rotten summer as the collapse of the US sub-prime mortgage market and failed hedge funds have magnified the usual holiday season blues. The UK market closed at a high of 6732.4 on 15 June – and since then safe havens have been few and far between.

Banks were poor performers in 2006, and the trend has worsened thanks to the summer credit crisis as the sector fell 12 per cent from the high. It would have been worse if London had much exposure to investment banking, but despite the huge amounts of money the investment banking industry generates for the City of London, the UK market itself is light on such banks. Despite the best efforts of HSBC, only Barclays derives any meaningful profits from investment banking activities.

However, the mortgage banking industry has been hit even harder, and it will come as no surprise to find out that Northern Rock, the Newcastle-based mortgage lender, is the worst-performing blue chip since the market peaked.

Although the worst of the crisis looks to have passed, investors are still unwilling to back Northern Rock. The shares began the year trading at more than 1,200p, but thanks to what seems to have been little more than negative speculation, the stock remains languishing at just 672p, down 43 per cent since the start of the year and 34 per cent worse since 15 June. Rival HBOS, the UK's largest mortgage lender, is down by more than 12 per cent since June, while Alliance & Leicester has escaped the worst of the selling, albeit still recording a dismal 16 per cent loss.

Clearly, some people believe there is now some value to be found in the financial sector – on Monday, the Bahamas-based investor Joe Lewis became Bear Stearns' largest single investor, buying up more than 7 per cent of the Wall Street investment bank. Bill Mott, fund manager at the Psigma Income Fund, believes that the summer sell-off has created an excellent buying opportunity. He said: "Nine times out of 10 the Armageddon scenario does not occur, and it is unlikely that the news will be as bad as the market is pricing into the financial sector. For example, Lloyds TSB raised its dividend by 5 per cent for the first time in years – that is not the action of a business that believes it is about to implode."

Elsewhere in the blue chips, it has also been a miserable summer for property investors, caught out by the bullish end to 2006 when the conversion to Real Estate Investment Trust saw the sector soar on what turned out to be a false dawn. Profit-takers moved in en masse after January, encouraged by higher interest rates and a glut of commercial property, particularly in London and the South-east. The real-estate sector is down by more than 13 per cent since June. The main offenders are Hammerson, down 20 per cent since June as takeover speculation died down, and British Land, 13 per cent over the same period.

Although not strictly property, the second-worst individual performer in the blue chips since June is Intercontinental Hotels, as it shed 29 per cent of its value. Like many of the worst-performing blue chips, Intercontinental has suffered as investors took profits brought about primarily by bid speculation.

The erosion of the bid premium priced into many large cap stocks has accelerated as private equity firms have failed to come up with the bids many expected and the market had priced in. With the credit crunch expected to have plenty of legs left in it, the chances of any significant leveraged buy-outs appear to be slight, in the short term at least.

Intercontinental isn't the only blue chip languishing due to the erosion of the bid premium. With the benefit of hindsight, the confectioner and soft drinks maker Cadbury Schweppes should have accepted the bid it received for its US drinks arm last year, and although it is still working on a sale or demerger, falling margins have magnified its problems, and investors have been heading for the hills. What with last year's salmonella scare, it has truly been an annus horribilis for Cadbury, and the stock is more than 20 per cent lower since the market peaked. Even the food retailer J Sainsbury, in the middle of another bid having rejected one back in March, is almost 6 per cent worse, and the long-term malaise in general retailing continues, with the sector down 14 per cent.

Georgina Taylor, European portfolio strategist at Goldman Sachs, believes the summer correction does not mean the end of the structural bull market, but that the market is still hostage to further negative newsflow. She said: "We still like mining, and telecoms and luxury goods offer value because they are less exposed to global risk. Looking forward, the market will be driven by fundamentals rather than bid speculation overriding everything – but even though the market looks decent value overall, that is partly explained by low valuations in financials which reflects current uncertainties."

That said, in spite of credit woes the private equity industry is far from dead. Even if money is more expensive and bankers are more reluctant to back highly leveraged deals, the industry still has a huge amount of cash burning a hole in its pocket. Having raised record funds within the past two years, the likes of the Blackstone Group, the Carlyle Group, Kohlberg Kravis Roberts and Apax Partners must spend the money raised or they won't get as much next time around – but with billions in debt still to find a home, the industry will probably take a breather for the rest of the year.

There are few sectors that have managed to hold their value since the market peaked. Oil and gas services are just about in the black, as is the chemical sector, although the takeover of ICI has propped the sector up artificially. Classic defensive sectors such as oil production, tobacco, beverages and pharmaceuticals have outperformed the markets, despite marginal losses, proving that selling addictive products makes for a sound business model.