Managers’ Reports currently run the risk of looking absurdly out of date only hours after they have been written. In general, we are waiting to see more blood on the streets before we spend the cash we have. What could cause this? Well, any number of factors clearly – most of which are continually highlighted in the financial press – but we would add three more: the announcement of poor inflation data around the world would, we assume, really kick nervous bond markets in the teeth and, in one move, take away the most important crutch for equity weightings; any loss of confidence in the China story; and mounting fears of a consumer lead recession in the US

The sub-prime mortgage crisis in the US made it to the front pages of the financial press in August and the related difficulties of Bear Stearns, the US investment bank, were analysed in depth. We will spare the reader the very dull technical details surrounding the arcane subjects of mortgage securitisations, collateralised debt obligations and equity tranches. Instead we will make just a few pithy observations.

• Many commentators have warned investors to watch out for any deterioration in ‘liquidity’. While ‘liquidity’ has many definitions, the most relevant seems to be related to the availability of debt

• One possible, and even probable, consequence of the sub-prime crisis is that there will be fewer buyers of mortgages wrapped up and magically turned into bonds

• Another consequence is that the Federal Reserve has warned banks in the US to tighten up their lending criteria when providing mortgages to customers

• Both these points suggest there could be significantly less debt, or at a minimum less growth in debt in years to come

• However, despite this likely deterioration in ‘liquidity’, market commentators are not recommending panic. Instead they talk about the problem being ‘contained’. When should we panic?

• It seems very unlikely that Bear Stearns are the only holder of mortgage securitisation vehicles suffering. Who else is taking the pain? Other large US banks? Hedge funds? Insurance companies? Pension funds? Barclays? This is a very opaque market and the bodies may be discovered in very strange places

• With many sub-prime and prime mortgages customers in the US (and in the UK) only just resetting to higher rates, having been on attractive 2 year fixed rate mortgages, higher interest rates are still to have their full effect on the sub-prime crisis, the housing markets and the economy overall

We also have one extra point to make about possible contagion from sub-prime assets to other asset classes.  Most commentators assume the contagion will be minimal as there is no direct economic link from sub-prime assets to, say, high yield bonds and that with corporate balance sheets in rude health, fixed interest markets may well have over-reacted to a very specific problem. This argument may be spot-on (in which case assets such as high yield bonds are screaming buys). However, we believe what’s more important than spotting an economic linkage is to be aware of any factors which might link financial markets.

For example, picture a hedge fund holding an array of fixed interest assets ranging from derivative products of sub-prime mortgages, high yield debt, payment in kind notes (‘we can’t pay you now but we hope to pay you later’) and so on. Post the blow up in sub-prime assets, the fund manger may receive a call from his bank questioning the value of his collateral and requesting the repayment of some debt. The hedge fund manager can liquidate the sub-prime assets but may find them too lowly valued or illiquid so may have to sell an alternative asset on the portfolio. Repeat this exercise across a plethora of hedge funds and very quickly, ‘contagion’ can set in. Of course, one could argue that providing the fundamentals have not changed, the fire sale of unaffected assets might create a buying opportunity. This might be correct but a) that assumes they were correctly priced previously and b) ignores quite how much buying of these assets has been carried out with borrowed money and therefore how big the potential supply could be.

For us, despite the best efforts of the great and good to identify the worst case scenario for the sub-prime crisis, it is all effectively one big guessing game. However, investors continue to remain relatively confident that the problem can be ‘contained’. Let’s hope they are right.

There has been a great deal of coverage in the media over the ‘phone-in scams’ which have been uncovered at various TV companies. The most commonplace appears to have been to encourage viewers to phone-in - for a fee and in an attempt to win a prize - even after the competition officially closed. We will never know who in these companies did and didn’t know about these practices, but it is worthwhile trying to understand some of the motivation for them. Executives of both listed and private companies (and even publicly owned organizations) are rewarded for good performance, typically relative to some benchmark. In addition, management of companies listed on the stock market have usually guided investors to expect a certain level of profitability and there is great pressure to meet or even beat these expectations. It is not too hard to imagine that as advertising revenue has declined for ITV in recent years that they have been forced to find a number of ways to avoid disappointing investors and phone-in scams were possibly one of them.

We have been long term holders in ITV, believing that the fears over the structural decline of terrestrial TV channels were overdone and that the company had brought some of the damage on themselves by stinting on spending on new programmes. We thought that this forced the knock-on effect of encouraging advertisers to spend their budgets on other mediums. Ironically, we also believed that if the TV regulator could be persuaded that ITV’s problems were mainly structural, then some of the harshest regulations that work against ITV could be lifted or lessened.

The recent appointment of Michael Grade as Chief Executive of ITV gives us increased confidence that high quality programming is central to the new strategy and together with our views on a better regulatory backdrop we are hopeful we have now seen the worst of the company’s share price performance.

It is interesting to return to the subject of earnings disappointment. For many years Northern Rock has been regarded as a quality play in the bank sector: a low cost operator with good management, consistent earnings growth and a strong consumer franchise. For these reasons, the bank’s shares have generally been more highly rated than those of its peers.

However, Northern Rock was recently forced to downgrade investors’ profit expectations. Part of the downgrade was due to the bank having sold a large number of fixed rate mortgages to customers without having locked in place the necessary funding to guarantee a good level of profitability on the mortgages sold. When interest rates moved sharply higher, the bank found themselves in the uncomfortable position of having to lock in much less attractive funding rates than originally expected.

Obviously, the management of Northern Rock have not admitted they lost a bet on interest rates but that is certainly one way the facts could be interpreted. Why would they do this? Well, Northern Rock’s consistency of earnings over the last few years has earned them the right to trade at a higher rating than other UK banks. Their ‘earnings visibility’ has been lauded. It was vital that this record of consistency was not lost.

The reduction of profit forecasts triggered a swift share price reaction and was accompanied by comments that ‘earnings visibility is now low’. That may be true and isn’t really surprising for a highly geared financial institution (the average bank has the ratio of £100 of loans made, backed by £5 of its own money, generating approximately £1 of profits – with that combination how can visibility be anything but low?). The real problem for the Northern Rock share price was that in moving from almost £11 at the end of May to under £8 by early August, it surrendered its ‘quality premium’ as it moved from being perceived as a well run company to something more average.

This is a good example of why we are reluctant to pay a premium for management quality. That quality can be transient and, if it proves to be so, can result in significant share price falls. Instead we would prefer to be in companies perceived to be run by poor management (but not ‘dodgy’ management). Perhaps the management isn’t poor and the market perception is wrong? Perhaps, poor or not, they will hit a run of good luck soon? Or perhaps they are poor and will be replaced? And perhaps the assets, sales, market share and franchise of the company are far more important to the value of a company than a management team just passing by?

We currently have no exposure to Northern Rock

This article is not investment advice or a recommendation to buy any share or fund mentioned directly or indirectly, and should not be relied on in making any investment decision.

Please note that the opinions expressed in the above article are the opinions of the author alone, and do not necessarily represent the views of Investec Asset Management or its associated companies.

Investec Asset Management, or any of its associated companies or employees (including the author), may hold positions in any of the securities mentioned in the above article or in related securities.