Taking stock of domestic affairs

While the Irish market defied this week's turmoil, it is acutely vulnerable to the property downturn because it does not offer diversification, writes Arthur Beesley.

It's been a torrid week for investors on global stock markets, yet Irish shares have gained ground since a mammoth sell-off by international investors on Monday prompted an emergency rate cut in the US.

This is hardly a cause for celebration, of course, as the Irish market at large lost no less than 27.45 per cent of its value last year as the property market came off the boil. After heady years of handsome growth, the dismal performance brought Irish shares to the bottom of the international league.

While the market managed to defy this week's turmoil, it is a given that there is a considerable distance to go before its more recent heights come into view again. Heavily weighted in favour of financial stocks, which are acutely vulnerable to the property downturn, the Dublin market does not offer the diversification that enables others to ride out sectoral fluctuations.

"International investors have clearly been concerned about financials and real estate, in all their markets. We bore the brunt of that sectoral view. Within it, domestic concerns were not what was driving the market," said a senior Dublin stockbroker.

But with little prospect of the malaise in the property market coming to an end soon, investors may have to wait for the disconnect between housing supply and demand to resolve itself before valuations start to rise again.

For all that, brokers see some positive signs in Liam Carroll's share buying in McInerney Homes, the accumulation of a €112 million stake in Kingspan by Los Angeles group Capital Research and Management, a share buyback at CRH and the decision of Grafton executive chairman Michael Chadwick to increase his stake in the group.

While worries about the financial wellbeing of credit insurers - who guarantee bond repayments - weighed on international financial stocks this week, the exposure of Irish financials to that particular problem seems minimal.

NCB Stockbrokers said Anglo Irish Bank's exposure is limited to a single €10 million bond. NCB also said Bank of Ireland's exposure represents around €120 million of its total assets (six basis points). The broker noted that AIB had remarked that it had "no direct exposure to monoline credit insurers" and said that its indirect exposure via bonds held was immaterial.

Some observers say the decline in major Irish stocks in 2007 points to difficulties down the line for other property-heavy markets such as Spain, which has lost significant ground this year.

"Straight off we would have been making a lot of noise towards the end of last year for Spain to be outperforming Ireland by 30-plus per cent when it has the same property issues as Ireland and maybe even more. In 2006, Spain was building one in every three houses in the eurozone. It's not just Ireland. We felt that that gap would close," said Gary McCarthy, managing director in Dublin of brokers Collins Stewart.

McCarthy sees opportunities at the moment in "value stocks" such as CRH, DCC, IAWS and Ryanair - "great franchises with multi-year track records", as he puts it.

Still, it is clear the bank sector is operating in a more constrained environment. For example, private equity firm Ion Equity said this week that the squeeze on bank funding for private equity deals meant trade buyers are in a stronger position.

Banks are also reducing the level of debt they are prepared to commit to buyouts by up to 20 per cent, Ion said. With the property downturn already curtailing borrowers, the upshot of that is that fewer chunky commercial transactions are likely to come on the blocks.

So what is the outlook? "Without being too specific to Ireland, possibly one of the most crucial calls that investors will have to make is when is it right to go back into financial stocks. The feeling is that it's probably a bit too early as of yet," said Richard Reid of Citigroup in London.

Citing debt exposure, credit market volatility, weak housing lending in the US and concern about corporate earnings, he said there was a growing body of opinion at least one or probably two more US rate cuts were required before investors turn again to financial stocks.

"As a general comment, we're not sure of the extent to which a general easing of interest rates will filter back into the economy as banks want to rebuild margins."

If the Irish market's avoidance of the worst of the sell-off this week suggests international concerns about the market here are already priced into the market, the impact of any further deterioration in the domestic economy remains to be seen.

"It doesn't look like Ireland is going to be a significant underperformer. It would be a big surprise to be an underperformer again in 2008," said one broker. After years of outperformance, it's a modest enough ambition.