Foreign & Colonial Investment Trust AGM

In his presentation speech to investors fund manager Jeremy Tigue outlined his thoughts on the credit crunch and where markets are going this year: "2007 was one of our best years in the last one hundred and forty but that is history now. Today I will explain what we are doing this year to continue making you money in the future.

The first quarter of 2008 was the worst quarter for equity markets for more than five years, when we were still suffering from the fallout from the dotcom boom.

There was nowhere to hide as all markets went down amidst some very high profile problems such as a rogue trader at Societe Generale, several hedge fund blow ups and the Federal Reserve organised takeover of Bear Stearns.

Our own performance suffered as we increased gearing into a falling market as we have done so successfully in previous difficult markets. After a very good year choosing stocks in almost all markets in 2007, the first quarter saw a reversal in all countries except the UK. As a result we underperformed our benchmark and our close peer group.

So our net asset value per share fell by 12.4% and the share price by 11.8% to 281.25 pence at 31 March.

The share price hit a low of 270 pence on 17 March, St Patrick's Day, and I think the most important day of the year so far. On that day it was announced that Bear Stearns, the fifth largest investment bank in the US, had been taken over for next to nothing in a Federal Reserve orchestrated takeover to prevent it going bust.

If this could happen to Bear Stearns who would be next? The answer appeared to come two days later when the HBOS share price collapsed. Fortunately the rumour was not true but the Bank of England went to unprecedented lengths to make that clear.

I think Bear Stearns and HBOS were twin turning points.

There is now no chance that a major bank will fail. Governments and central banks will do whatever it takes to prevent that happening. There is not going to be a systemic financial collapse. There will be no Armageddon.

But there is a price to pay for this and bank shareholders are the ones who are starting to pay it. After the £12 billion Royal Bank of Scotland rights issue last week there has been the £4 billion issue from HBOS this week. There are bound to be more.

Since 17 March there has been a sharp recovery in share prices and a significant reduction in market volatility. Emerging markets have bounced back sharply while the US and Japan have been relatively weak. Most of the market moves in the last six weeks have been good news for us and the share price reflects that. By yesterday's close it was 302.5 pence, 12% above the low six weeks ago.

We have been very successful over the years in managing our short term gearing to minimise our interest costs and borrow in currencies that have fallen against sterling. For most of the last ten years most of this has been in Japanese Yen but this changed last summer.

Since then, Sterling and the US dollar have been the two ugly sisters competing to see which can be the weakest currency so I have moved all our short term borrowings into sterling and dollars as I expect UK and US interest rates and exchange rates to fall further. That perennial Cinderella currency, the Japanese Yen, has been transformed in the last six months but it is not yet clear if the transformation will last after midnight.

So what is the economic and market outlook? Have we just seen a dead cat bounce or is this the start of the next bull market?

Now that financial Armageddon has been averted the biggest risk is inflation.

The oil price is up about 50% in six months, there are huge pressures on food supplies and gold has been very strong. Yet the pressure on official inflation measures, rather than the ones we all experience day to day, has been very muted. If inflation remains confined to a relatively small number of items it can be contained but if it expands across the whole range of consumer goods then there will be problems. This is now the biggest risk to stockmarket investors

I think the power of the internet and the long term trend towards globalisation are the best ways of preventing inflation from taking hold and mitigating this risk. In the immediate future the effect of the credit crunch will also suppress inflationary forces.

The US economy is either in recession or close to it. The UK is several months behind but is heading in the same direction and for similar reasons. American house prices have already fallen about 15% from the peak and many analysts think the total fall, peak to trough, will be about 25%. UK house prices have only just started to fall and in the last bear market fell 20%. I have no idea how far they are going to drop this time but the fall will be substantial, painful and prolonged. The UK economy is going to have an increasingly tough year during 2008 and into 2009.

In the rest of the world, that is those countries where there was no property boom, prospects are better. I do not believe that the rest of the world is immune to a US slowdown but I do believe that growth elsewhere will be better than in the US. So we will stick with our policy of being overweight in emerging markets and Asia and I want to buy more in these markets if the opportunities look right.

Given my caution about the US and UK economy and the fragile nature of financial markets isn't it dangerous to be bullish?

I don't think so for three reasons.

Firstly, and as I said earlier, there is not going to be a general systemic collapse. That risk has gone, so now the opportunity is greater than the threat.

Secondly, although there are severe problems in the banking sector share prices are starting to reflect this. We expect to take up our rights in Royal Bank of Scotland because we will be buying shares at 200 pence rather than the 650 pence they were trading at this time last year.

Thirdly, and I think most importantly, share prices globally are not high relative to company earnings and dividends nor in relation to other assets.

In 2000 the FTSE100 index had a price earnings multiple of 28 and a dividend yield of under 2%. Today the multiple is under 12 and the yield just under 4%. I do not know of any bear market that has begun with valuations at these levels.

The key difference from previous bear markets is that the main problems are in the debt markets not the equity markets. Equities are suffering collateral damage but they are not at the centre of the problem. They have far better prospects than property and bonds.

Falling property prices and over aggressive lending by banks are the causes of the current problems. This is a completely different situation to 2000 or 1987 when bear markets occurred when share prices were hugely overvalued. This time round it was property prices and low quality debt products that were overvalued, not equities.

The biggest losers in the credit crunch will be the biggest borrowers, personal and corporate. The least affected will be those with cash or low levels of debt. The vast majority of quoted companies fall into this category. They have modest debt levels, strong cash flows and should always be able to borrow.

Almost the only quoted companies with very large levels of debt are the banks themselves. Now that the banks are starting to repair their balance sheets there could be some attractive buying opportunities.

At the moment we have relatively little exposure to banks, but we have significantly increased our exposure to private equity which is also very exposed to the effects of the credit crunch.

We invest in private equity because we expect to earn higher returns than we get from the quoted portfolio. On the other hand, the bear case for private equity is that all these superior returns come from financial engineering and excessive levels of debt with nothing coming from better management.

I don't agree with this negative view. Our own private equity portfolio is hugely diversified by sector, geography and age of investment. These are great strengths in difficult markets. I believe we are invested in top quality funds and I think there could be some serious money making opportunities in the next two years. There will probably be lots of forced sellers of private equity funds and some exciting buying opportunities for our managers. This has happened in each previous market cycle.

Private equity made a large positive contribution to our results in 2007 and the first quarter of 2008. When quoted company share prices recover as I expect, private equity prices will lag behind so the rest of 2008 and possibly 2009 are unlikely to be so good. By then we will have 10% of our portfolio invested in private equity and should be very well placed for the next upturn.

So in summary, I expect a short term difficult period for private equity which will lay the foundations for renewed growth in the medium term.

In the last ten years your annual dividend has more than doubled and over £70m has been added to the revenue reserve. This reserve is now nearly three times the size of the annual dividend.

There are concerns that many companies are going to be forced to cut their dividends. Going back to Royal Bank of Scotland, we think the dividend will be cut by more than 50% following the rights issue. In the very worst case this will cost us about £700,000 in 2008 or just over 1% of our total revenue. In 2009 the impact will be larger - probably about £1.4m. This is unpleasant but very manageable. Meanwhile our largest holding BP is increasing its dividend by 31%.

In the US in the Great Depression dividends fell by 50% before starting to recover. That is the worst case I can think of and on that basis we could maintain our 2008 dividend until at least 2011. I think that would put us in far better shape than most other investment trusts or companies.

To recap, I don't think this is an equity centred bear market; shares around the world are almost as cheap as they were in March 2003, dividends are still rising and there is huge nervousness and uncertainty around.

Life doesn't get much better than that if you are the fund manager of Foreign & Colonial.

We can take a long term view and we can increase our borrowings to take advantage of forced selling and general nervousness. We repaid all our short term borrowings last summer before the credit crunch and have been gradually increasing gearing again since the crunch began in July. From a low point of about 5% then, gearing had risen to 11.1% at the end of March, compared with 10.8% on the day the US invaded Iraq in 2003.

The massive efforts from central banks to ensure the financial system survives and the associated injections of liquidity are big positives for equity markets. Share prices are not expensive in absolute terms and look cheap compared with other assets, especially property.

We have a global portfolio, overweight in the fastest growing and most dynamic parts of the world, wide diversification, robust dividend paying potential and huge flexibility in our gearing policy.

I do not know of any other one hundred and forty year olds which are in such good shape and can look to the future with such confidence."

Jeremy Tigue, fund manager, Foreign & Colonial Investment Trust