Four rules to remember in the age of austerity

Written by Bloomberg | Updated: Jul 29 2010, 02:52am hrs
Matthew Lynn

One thing has become clear during the sovereign-debt crisis: governments everywhere are going to be cutting their spending savagely over the next five years. They may do it under the direction of the IMF, like Greece. Or voluntarily, like the UK and Germany. Or slowly and reluctantly, like the US. One way or another, it has to happen. You cant run deficits of 10% of GDP or more forever. But what does that mean for investors

The UK stock market has already priced in earnings shocks from companies that have run into trouble because of reduced government spending. And, in most developed countries, the cuts are only just starting. Well see a lot of corporate-profit declines across Europe and the US in the next couple of years.

To survive that you need to short companies that depend on government spending; think about the regions that will avoid the worst of the pain; and focus on businesses that can save the government some money. Follow those simple rules and your portfolio should make it through the years of belt-tightening.

There is already plenty of evidence from the UK about the impact that the austerity drive can have on share prices. Cable & Wireless Worldwide, the telecommunications provider, said last week that spending cuts by David Camerons new coalition government would lower earnings. Its shares dropped 17% on the day. Last month, Connaught, which maintains social housing, told shareholders the same message. Its shares dropped as much as 41% on the day.

Its no great surprise that austerity drives will hit a lot of companies hard. State spending accounts for 30% to 50% of the economy, depending on which country you look at. Start hacking away at half of your GDP and a lot of people will find life much tougher. So how should you steer your portfolio through the age of austerity Here are four principles to keep in mind:

One: Keep away from government contractors. In the last decade, the state has outsourced a lot of its work. There have been big contracts awardedand, as we know, governments are very bad at getting value for money, so most of those contracts came with fat profit margins. Likewise, defence companies will do it toughwars are a real luxury when you need to cut public spending by a quarter. You dont want to be holding shares in companies such as defence manufacturer BAE Systems in that kind of environment. All of them are going to suffer. Clear them out of your portfoliothen short them.

Two: Focus on regions. Government spending is always concentrated in particular areas, either because they are poor or because it is where the governing partys voters happen to live. In the UK, that is Scotland, Wales and the north of England, the heartland of the Labour Party, which held power for the last 13 years. But every country has a region of high public spending. Avoid them, because they will be hit hardest. But other places such as prosperous London and the south-east of the country will do fine. Invest in businesses that focus on those places and you wont regret it.

In the UK, take a look at Ocado Group. The online grocery retailer got a rough ride in its initial public offering last week. Yet the wealthy shoppers of the south-east of England who make up its core market are going to get through the austerity drive better than most people.

Three: Look for better mousetraps. Governments wont just be able to cut their way out of trouble. The deficits are just too big for that. They will have to innovate as well, finding new ways of doing the same things more cheaply. The private sector is much better at that than the public sector. So look for companies in healthcare, education or outsourcing that can come up with new, more-efficient ways of doing things. They will have plenty of demand for their services.

One example. Capita Group, which provides a criminal-records service for the UK Home Office, is pitching money-saving ideas to the British government. If they are good, they can expect an enthusiastic reception.

Four: Dont forget about growth. The historical record shows that times of austerity are also ones of great entrepreneurial energy. During the 1930s, new industries such as consumer electronics and plastics were created. In the turbulent mid-1970s, the personal-computer industry was born, as companies such as Microsoft and Apple were founded. When times are hard, a lot of smart people dont have any choice but to set up their own business. And they will have to do it on the cheap as well, which is usually the best way.

So dont be too defensive. Even amid austerity, there will be some terrific new companies getting started. It is a good time to be looking for businesses to back.

Where should you be looking How about Nathaniel Rothschilds new mining company, Vallar, which has just listed its shares in London The best brand name in global finances should be able to open a few doors, and resources are a growth industry. Some of those investments may do well, others badly. But stick to those four principles and your portfolio should survive just fine. Ignore them and you can expect to get burned.

The author wrote Bust, a forthcoming book on the Greek debt crisis