This is a massive repost from Barron’s 2016 Roundtable. Barron’s does this every year and I read it every year. You have some of the best investment mind in the business debating their ideas and picks.
I merged all three articles so its all accessible with one click. Like I said, it’s very long.
Barron’s 2016 Roundtable, Part 1: A World of Opportunities
Our nine investment pros see lots of cheap stocks, but little chance that the market will rally sharply in 2016. Why global growth is challenged, rates will stay low, and India could prosper.
Serious, substantive, sobering. Alas, we’re not referring to any of this year’s presidential contenders, but to the thoughtful talk of economics, markets, and investments that dominated the 2016 Barron’s Roundtable. Turbulent times demand such an appraisal, and that’s what our nine investment panelists delivered in spades.
Optimism was in short supply at our annual gathering, held last Monday at the Harvard Club of New York, probably owing, in part, to stocks’ horrific swoon the prior week. Opinions were as plentiful as troubled energy bonds, however. Broadly speaking, these Wall Street luminaries see more stock market turmoil, junk-bond mayhem, and global strife in the year ahead. They also see Hillary Clinton winning the White House—except for those who think the vote will go to Donald Trump.
Photo: Brad Trent for Barron’s
Some ’round the table expect U.S. stocks to end the year flat or down, while others see modest gains on the order of 7%. Nearly all agree that judiciously buying undervalued equities will yield far greater returns than sticking with index funds. Our panelists expect the U.S. economy to expand only modestly this year, by a bit more than 2%, while China’s economy will continue to struggle, leading to further devaluation of the Chinese currency and continued pressure on commodities and emerging markets.
The group thinks the Federal Reserve, which finally lifted interest rates in December for the first time in seven years, won’t hike four more times during 2016, notwithstanding its stated intentions. That’s because market conditions simply won’t allow it. Indeed, Fed Chair Janet Yellen might even be forced to ease again after lifting rates one more time, says Jeffrey Gundlach, one of the world’s best bond investors, co-founder of Los Angeles–based DoubleLine Capital, and a newcomer to the Roundtable. The other fresh face in the crowd is that of William Priest, CEO and co-chief investment officer of New York’s Epoch Investment Partners, who boasts a long and successful record of mining macroeconomic trends to identify smart investments.
Gundlach is bracingly bearish, Priest only slightly less so. Brian Rogers, however, chairman of T. Rowe Price and one of this week’s two featured stockpickers, is an optimist by nature. These days, he is buying shares of companies that have been excessively punished by investors, and that sport healthy dividends and strong financials.American Express (ticker: AXP) and Macy’s (M) are high on his list.
Oscar Schafer, chairman of Rivulet Capital in New York, is also a stockpicker, who bargain-hunts among mid- and small-cap names. He notes that the market’s smaller fry have been in a stealth bear market for the past year, even as the Facebooks and Amazons of the world have gone to the moon. Yet Oscar likes the prospects for three smaller stocks, including Calpine (CPN), the merchant power producer, which he highlights in this week’s Roundtable issue, the first of three.
Barron’s: Happy New Year, everyone. It has been a great year so far, if you ignore the stock market, the economy, the Middle East, and anyone running for president. Let’s start with the outlook for the economy. Mario, what lies ahead?
Gabelli: The consumer accounts for 70% of the U.S. economy, and is doing well. Wages are rising, jobs are increasing, and consumer balance sheets are OK, even after the decline in the stock market in the past three weeks. Automobile sales will flatten this year, the consumer will spend, and housing is improving. Consumer outlays for food and fuel will continue to decline, at least through the fall. Congress has passed an infrastructure bill and a tax bill. We’re finally spending more on the military. We will have to deal with the cost of government entitlement programs, and a strong dollar is having a negative impact on exports. But, overall, the U.S. economy could grow by 2% this year.
How do things look in other parts of the world?
Gabelli: ln Europe, Mario Draghi [president of the European Central Bank] has stimulated the economy, and things will continue to improve. In China, the consumer economy, which accounts for about 40% of the total, could grow by 10% a year in the next five years. The balance of the economy will grow at a 3% to 4% rate, and has challenges. I like what India’s prime minister, Narendra Modi, is doing. I like what is happening in Japan. But I don’t have much optimism for most Latin American economies.
What is your view, Bill?
Priest: There are only three drivers of stock-market returns: earnings, price/earnings multiples, and dividends. The Standard & Poor’s 500 index was up 72% from 2012 through 2014, and 56% of that gain came from P/E multiple expansion. Quantitative easing [central-bank asset-buying programs aimed at driving down interest rates] has been the driver of valuation metrics, and that is ending in the U.S. and United Kingdom, and isn’t going to have much more of an effect in Europe or Japan. That means P/Es will be flat or down from here. Earnings are problematic, as well. Many companies are having difficulty generating revenue gains, and profit margins will be under pressure. Dividend yields will rise, but the growth rate will be less than in the past. Markets will struggle this year to appreciate both globally and in the U.S.
The chairman of T. Rowe Price makes the case for American Express and Eaton Corp., both selling for around 11 times earnings.
Larry Summers [a Harvard economist and former secretary of the Treasury] has called the current economic environment one of secular stagnation, and that is an accurate description. It means 2% growth is the new 4% in the developed world. Most of the 34 countries in the OECD [Organization for Economic Cooperation and Development] have an inflation rate below 1%, which presents challenges for policy makers. The issue with China is one of contagion: As the Chinese economy slows, materials producers such as Brazil and Australia will suffer, as will China’s trading partners in the Pacific Rim. In Europe, Germany has a bad cold, and everyone else will feel it.
Brian, what do you expect?
Rogers: I agree with much that has been said. Growth is challenged, and it all goes back to the global financial crisis. Carmen Reinhart and Kenneth Rogoff called it in their bookThis Time Is Different: When you work your way out of a global financial crisis with a lot of leverage, growth is difficult to achieve. We could be looking at growth of 2.25% in the U.S. this year. Europe is improving, and the only thing we know about China is that the government exaggerates economic statistics. If they say the economy is growing by 10%, it isn’t.
When will the economy finally emerge from its post-financial-crisis funk?
Rogers: We’ll get out of postcrisis mode probably in 2017 or 2018. People are still working through personal financial challenges. One sign of this is that investors haven’t regained their animal spirits, even after an extraordinarily long period of slow growth and decent market returns. The individual investor doesn’t really have confidence in the market and is willing to earn one basis point [one hundredth of a percentage point] in a money-market fund.
Black: To repair the economy, we need structural changes in public policy. From 2009 to 2014, gross domestic product grew by an average of 1.4% a year. The normalized postwar rate is 3%. We have had no bipartisan consensus on fiscal policy since President Obama came into office. We need a huge tax-policy overhaul to bring jobs back to America. We need investment tax credits for manufacturers, and a major infrastructure program. Most politicians are appealing to our animal spirits. They are not discussing public policy. This means we will continue to have low nominal GDP growth of 2% to 2.5%.
Gundlach: There is no conversation about these issues. Democracy is government by crisis. Things go along until suddenly there is a call for change. One fundamental problem is demographics. In the U.S., the ratio of people working to those who are retired or want to retire isn’t that bad right now. But things are different around the world. Japan went into a demographic tailspin 20 years ago. China now is where Japan was then. Italy will lose a third of its labor force in the next generation. Russia is on the verge of the greatest implosion of population in the history of the world, absent famine, war, or disease. If you have fewer people working as a percentage of the population, you need that much more economic growth from those who are productive. In the U.S., this issue manifests itself in government policy through entitlement programs. We’re in a fairly level place until 2019 or 2020, but then the moment will come when we realize we can’t keep these programs in place.
Oscar Schafer’s Hidden Gem
The chairman of Rivulet Capital and Barron’s Roundtable veteran thinks the market is missing the earnings power of transaction processor Evertec because it’s based in Puerto Rico.
One thing you can rely on is that growth estimates at the start of the year will be marked down. The World Bank just downgraded its 2016 forecast for global growth to 2.9% from 3.3%. I’m a bond guy, so I look at Fed policy. A zero interest-rate policy for seven or eight years motivated a lot of behavioral changes among investors and led to malinvestment. That is one reason the market’s P/E ratio expanded. In 2012, when I was launching a fund and seeking 7% returns, many financial planners were promoting master limited partnerships as a way of getting a fat yield without taking bond risk. What a disaster: MLPs are down because they were leveraged to energy prices. This is the backdrop to my thinking.
Zulauf: Coming back to the question of when secular stagnation ends, it could last for the next 15 or 20 years. It relates in part to demographics. We’ve had three demographic waves propelling the world economy: The baby boomers went to work, Eastern Europe joined the world economy, and China joined the world economy. That’s all over now.
Another issue is debt. The world economy has levered up since the early 1980s, and economic subjects have hit their borrowing-capacity limits. By definition, that means lower demand. Also, regulation has increased dramatically in the past 15 years, and the trend is toward even more regulation. That is a restraining force on growth. Finally, bad economic policies have focused for decades on demand stimulation. We can’t change demographics. We should restructure debt, reduce regulation, and pursue sounder policies. But none of these issues is being discussed or addressed. That’s why secular stagnation will linger.
The Roundtable panelists look for stocks to outperform bonds and the U.S. to beat most other markets in 2016. China’s woes could keep the pressure on emerging markets. Photo: Jenna Bascom for Barron’s
Listening to all of you, a contrarian might well assume the economy is on the verge of a boom.
Zulauf: Contrarians aren’t always wrong, but they aren’t always right, either.
The U.S. has the best demographics of all the industrialized nations. But what the U.S. housing market was to the world economy in the last cycle, China is in the current cycle. China has a major balance-of-payment crisis, which most experts don’t understand. A balance-of-payment crisis ends with a recession. China’s currency is heading south. The only way to prop it up is to restrict capital flows, but that would create another bubble inside China, leading to even bigger problems. China eventually will let the currency fall in value.
Gabelli: Felix, why not let the currency fall now?
Zulauf: That is the best solution, but a decline of 15% to 30% from here in the value of the yuan has negative implications not just for China’s trading partners but its competitors around the world. China is the world’s largest exporter, and one of the largest importers. Imports will be cut if the currency falls sharply, and prices of exported goods also will go down. We are talking about a major deflationary hit to the world economy. That leads to lower corporate revenue and profits outside China, forcing companies to cut costs. Then you have a global recession. That’s what the whole situation is leading to.
Gundlach: People come to believe things simply because of repetition. They have come to believe that China can grow by 7.5%-plus every year because that is what has happened in the past, at least according to Chinese statistics. They think the government, being autocratic, can push a button or pull a lever every time growth slows, and get growth back up to 7%-8%. Why are we all extolling the virtues of free-market capitalism? Let’s get an autocrat in place and get the U.S. growing by 8% a year.
Gabelli: Just be patient.
Gundlach: People also believe, because of repetition, that inflation will stay at these low levels forever. Based on the price of Treasury inflation-protected securities to ordinary bonds, the market is forecasting inflation of 1.75% for every year from year three to year 30. That’s just not logical. China is growing much more slowly than it admits. That is the message of the market. China represents nearly 50% of global demand for copper, steel, and aluminum, and 70% of demand for coal.
Cohen: Excuse me, did represent.
Gundlach: Exactly, because they are buying less today. Commodities prices are falling every day. That can only be because Chinese demand is weak. Prices for copper and iron ore have been cut just about in half.
Felix Zulauf, right: “The median stock in the S&P 500 was down 22%. But stealth bear markets always turn into real bear markets. That’s how bear markets start.” Photo: Jenna Bascom for Barron’s
Priest: Oil was down 35% last year. It has to be demand-based.
Witmer: The drop in oil is supply-based.
Cohen: Over centuries, the trend in commodity prices has almost always been down because of capacity additions and technological advances. In shorter time frames, supply-and-demand issues influence prices. To Meryl’s point about excess oil supply, there was an excess in capital expenditures in the oil industry, much of it in the U.S., but elsewhere, too.
I see this year as one of divergences. The U.S. has demographic advantages, and has rebuilt its financial system sooner than many other industrial economies. Also, U.S. consumers are feeling better, and balance sheets have been repaired, except with regard to subprime auto loans and student debt. The risks to the global economy aren’t so much the mathematics of what is happening in China, but the psychological impact not just on portfolio managers but business managers. Just 1% of U.S. sales are exposed to China. As the year progresses, investors will have a better understanding of how the U.S. is performing, relative to other economies.
What is your forecast for GDP growth?
Cohen: Something between 2% and 2.5% sounds about right. My colleagues at Goldman Sachs have a forecast of 2.2% growth, a little below the consensus. Keep in mind the absence of some negatives. We had enormous fiscal drag for three or four years. This year, that will be neutral to slightly positive. Also, the sharp decline in energy capex was an enormous drag. If it doesn’t get weaker, by definition, it’s a net positive.
S&P 500 earnings were hit last year by two factors: currency-translation losses and the sharp decline in energy prices. The dollar has been going up since the middle of 2014. On a trade-weighted basis, it is up about 30%. Will it go up another 30%? Not likely. That means currency-adjusted corporate earnings won’t take the same hit. Energy-industry earnings also declined sharply, and that probably won’t happen again to the same degree.
Zulauf: This is a strange thing. People say S&P earnings are better than reported if you don’t include the energy sector. But all other sectors benefited from lower energy prices.
Gundlach: It’s like an underperforming portfolio manager saying to a review committee, “If you take out the stuff that was down, we were up.”
Rogers: Or like a company reporting earnings before expenses.
Cohen: I want to go back to Bill’s point about P/E multiples. With the S&P 500 trading at roughly 16 times this year’s expected earnings, it might not be sensible to argue for additional multiple expansion. Thus, it becomes critical to look at earnings, profit margins, and return on equity.
Priest: Interestingly, from 2008 to 2014, and maybe to 2015, the U.S. was the only source of earnings gains in the developed world. Industrial-production measures for the developed world have been flat since 2008. The only growth in production was in the U.S. To Jeff’s point, China was the marginal buyer of everything, and suddenly it stopped. The collapse in commodities prices and sales volumes is still feeding through the system. I’m not sure what the bottom is for some of these commodities prices, but quite possibly, we haven’t seen anywhere near the bottom yet.
Zulauf: We likely don’t understand fully how big the Chinese investment and credit boom was. During its three best years of economic growth, China consumed as much cement as the U.S. in the past 100 years. It’s mind-boggling. If the yuan falls by 20%, it will have a tremendously deflationary effect on the world, and all the numbers you mentioned today will be wrong. You can’t escape the bust after the biggest boom mankind has seen.
Cohen: The Chinese government has publicly recognized that it must deal with issues of environmental quality and government transparency, which also relate to the economy. I’ll let others talk about the transparency issue, but when the Chinese government admitted at the recent Paris Climate Conference to an environmental problem, that was an enormous directional change. The U.S. economy is roughly twice as large as the Chinese economy, yet China emits 60% more carbon dioxide. China has some of the dirtiest air in the world, and half its water supply in several provinces is too dirty for industrial use. Eighty percent is unusable for drinking, washing, and agricultural purposes.
Zulauf: The people are rebelling. China didn’t agree to the climate-change deal in Paris because other nations asked it to, but because the Chinese people are dissatisfied with the quality of the air and water. The government has to do something about it.
Oscar, where do you see the economy headed?
Schafer: The consumer is in good shape. Companies outside the energy sector are doing well. What worries me about the economy is the possibility of a wild-card event, such as a chemical-weapons attack against a civilian target in Europe. The economy will grow a little bit this year.
Meryl, we haven’t gotten your view.
Witmer: As you know, I try to stick to stock-picking. Companies tell us there isn’t a lot of growth out there. There is no driving force to move things forward. The fracking boom was great for the economy until it ended. It helped move things forward. Housing is OK. Auto sales are probably at a peak. With the dollar so high, many companies are having trouble exporting their goods. The outlook isn’t rosy. It’s just OK.
Brian Rogers: “As an asset allocator, I ask myself, Can you invest in a portfolio of businesses whose value will accrete by more than 3% a year? That is my expected bond yield, and the threshold for an equity investor.” Photo: Jenna Bascom for Barron’s
Gundlach: What I find remarkable is the contrast in central-bank policies between the U.S. and Europe when there is only a 60-basis-point difference in GDP growth rates. It’s like a parallel universe. Economic growth here is trending sideways to down. European GDP is trending higher. The U.S. growth rate is 60 basis points higher now, but maybe in two quarters we’ll be growing at the same rate. Europe has negative interest rates and is talking about expanding QE. We are raising rates and tightening credit conditions, first by eliminating quantitative easing. As of June 2014, everything changed. That’s when emerging markets and commodities started to crash.
Nominal GDP is a fantastic indicator of bond yields, on a secular and short-term basis. Nominal GDP is very low, and might be headed toward 2%. The Fed has raised interest rates 118 times since 1945 or so. On 112 occasions, nominal GDP was higher than 5.5%; it averaged 8.6%. Twice since the 1940s, the Fed has raised rates with nominal GDP below 4.5%. The last time they did so was in 1982. They had to reverse course almost immediately.
Schafer: They never raised rates when the ISM [Institute for Supply Management index of business conditions] was below 50, as it is now.
Gundlach: That’s true. It is unprecedented for the Fed to be raising interest rates with nominal GDP at or near 2%. The Federal Reserve Bank of Atlanta publishes something called GDPNow, which forecasts real GDP [adjusted for inflation] every day. It is at 1% now.
Cohen: I see one enormous difference between the U.S. and Europe: U.S. financial institutions are in a much stronger position relative to their European counterparts. There hasn’t been the same sort of balance-sheet adjustment in Europe, and that could make European institutions much more vulnerable to economic shock, management error, and so on. Also, while the Federal Reserve has tightened, conditions aren’t really tight. Interest rates remain extremely low. We can argue about nominal versus real growth, but the boost in rates hasn’t had a negative impact on credit-sensitive sectors, such as housing and autos.
Gundlach: If conditions were too rocky to raise rates on Sept. 17, why are we talking about raising interest rates four times this year? The investment forecast with the highest probability of success is that the Fed won’t raise rates four times this year.
Zulauf: Central bankers have no clue about what’s going on in the world. They had no clue that markets would be so ugly in January, and they don’t understand what the situation in China means for the rest of the world. I am not an admirer of zero-based interest rates, but the timing of the Fed’s rate hike was completely wrong. They didn’t raise rates based on the facts, but because they felt they needed to do so.
Black: If you look at companies on a case-by-case basis, the industrial economy is rolling over. We have a bifurcated economy. On the consumer side, personal income, retail sales, and the savings rate are all in the plus column.
Gundlach: Retail sales are up simply because of auto sales. Ex-autos, the number is negative.
Black: But we added 2.5 million jobs last year. Across the board, things look good. On the industrial side, however, new factory orders and rig capacity utilization are rolling over. There is no earnings momentum. As an investor, you want to buy companies with sustainable earnings power. But that is difficult because the industrial sector is in bad shape. Fed Chair Janet Yellen had to put a positive spin on her speech about the U.S. economy after she raised rates in December, but had she looked at industrial companies, she would have seen that they aren’t doing well.
Abby Cohen: “My colleagues have a year-end price target of 2100” on the S&P 500. Jenna Bascom for Barron’s
Priest: When you walk into an auto dealer’s loan office, you take out a 78-month or 84-month loan and they give you a car. In many ways, there is more debt outstanding today on a global basis than in the past. The gross amount of debt per dollar of GDP is way up. Rates are low, so it is easy to service that debt, but it was the extension of credit that allowed for real GDP growth. One reason retail spending isn’t as high as expected is because people have to pay down this debt.
Gabelli: In the sharing economy, you don’t need to own a car, thanks to the Ubers of the world. Across industries, all sorts of structural changes are going on.
Cohen: What is the impact of these changes on the economy? It is entirely possible that government data on retail spending are incorrect, in part because so much is happening online. We might be mis-measuring productivity and capex and GDP, as well. Our economy is undergoing a major shift, as industries incorporate digital technologies, whether in health care, auto production, or many other industries. Sometimes, investments that we might think of as capital spending get counted as operating expenditures. To borrow an example from Michael Porter at Harvard Business School, when Amazon.com [AMZN] decides to build its Amazon Prime business at a loss because it wants to attract new Amazon shoppers, is it really a loss, or a form of 21st century capital spending?
With regard to China, the gap between the published data and reality could be as much as two percentage points. But there are also gaps in our data systems because our data systems haven’t kept pace with the structural changes in our economy.
So, if we were counting things correctly, how fast would the economy be growing?
Cohen: I don’t know for sure, but some studies suggest an additional one-quarter to one-half percentage point of growth.
Let’s go back to interest rates. What is your year-end forecast for the 10-year bond, Jeffrey?
Gundlach: I had strong views on the 10-year for ’14 and ’15. In 2014, I was sure rates would fall. In 2015, I thought they’d go nowhere. This year, there could be a big move in interest rates, based simply on the coiling action of the market. The 10-year has been trading in a narrower range. It yields 2.17% now, exactly what it yielded at the end of 2014. From a chart perspective, there could be a significant move. While I don’t have nearly the conviction that I had in 2014, I’d say the yield on the 10-year is going up.
How can I predict that when I don’t expect the Fed to raise rates, commodity prices are low, and the junk-bond market is in turmoil? U.S. interest rates have been rising for several years. Treasury yields bottom gradually, then suddenly. We are in the gradual phase now. The two-year Treasury bottomed almost five years ago at 15 basis points. Five- and 10-year Treasuries bottomed in July 2012. The 30-year Treasury bottomed a year ago. One reason rates could rise in this environment is because of liquidation [of Treasury bonds] by foreign holders. People have been worrying about this for the past 15 years. Liquidation by central banks and sovereign wealth funds seems to be overwhelming the flight-to-quality demand for Treasuries.
When I called for lower interest rates in 2014, I gained some new friends among the doom-and-gloom crowd. When I said interest rates would rise last January, they felt betrayed. But my base case isn’t a deflationary bust. My guess is interest rates will move higher in 2016 without a lot of conviction. The Fed will be less likely to raise interest rates in a sequential fashion because the markets, particularly the junk-bond market, are throwing a fit.
If you own a broad bond-market index fund, will the rise in yields be enough to offset the loss in bond prices?
Gundlach: Last year, rates rose a little, and investors earned around 50 basis points in a broad bond index. The rise in yields was so little at the low end [among short-term bonds] that it saved the market from a negative return. But the duration of a total bond-market index is 5½ years. If rates rise by 40 basis points, which is possible, it would take away all the gain.
Priest: What do you think the yield curve will look like this year?
Gundlach: If the Fed does what I think, the curve will steepen. When the Fed tightens, the curve reliably flattens. Financial conditions started tightening in June 2014, and the yield curve has been flattening ever since.
Priest: A flattening yield curve is death for certain types of financials. You are seeing that in the stock market today, with financials selling off.
Gundlach: That’s because the Fed hasn’t dialed back its rhetoric about four rate hikes this year. Here we have the worst first week of the year in history for stocks, and two Fed governors have come out and said, “We’re on track for four rate hikes.” This is why the markets are in trouble. Underlying positive fundamentals aren’t there. Junk bonds are really in trouble. The junk-bond ETF [ SPDR Barclays High Yield Bond ETF/JNK] is trading at a lower price now than three weeks after Lehman Brothers filed for bankruptcy in 2008. Think about how the world was feeling then.
I expect the Fed to hike early in the year and then ease. It will go up, then down. But the Fed needs to dial back its rate-hike rhetoric because the markets are throwing a fit. The question is, how long will this take, and how much more will junk bonds have to suffer? The junk-bond market will be populated increasingly by EMM—energy, materials, and mining issues. Even if oil prices stage a major rally to $40 a barrel, the clock will run out on a lot of energy companies.
A huge percentage of North American energy companies are losing money. We are going to see an incremental rise in defaults, and triple-B, and even A-rated companies will be downgraded by credit-rating agencies. We have already seen a significant turn in the upgrade/downgrade ratio as more corporate bonds get downgraded. Troubled sectors could go from 20% of the junk-bond market to perhaps 35%. Probably the worst investment is a junk-bond index fund, because it will get overexposed to defaults. Simplistically, the junk-bond market is a bet on oil. If you are betting on oil, then bet on oil. If your thesis for owning junk bonds is that oil is going back to $70, buy oil!
Rogers: Junk bonds can be great investments. But junk bonds and ETFs aren’t made for each other.
Cohen: Brian, wouldn’t you agree that most bonds and ETFs aren’t a good blend?
Rogers: Many things and ETFs don’t match, but I digress. Going back to interest-rate guesstimates, we won’t see four rate hikes this year. The Fed will act twice, because it isn’t going to act only once. It wasn’t “December and done,” unless there is a material downturn in the world economy in coming months. The yield on the 10-year Treasury will approach 3%, which means you’ll probably lose 3% or 4% on the bond. I see a gentle upward move in rates, with the federal-funds target [the rate banks charge one another on overnight loans of funds maintained at the Fed] moving up to 0.75%-1%. That’s two hikes from here. The Fed has never hiked once and then stopped.
Zulauf: There are many things that never happened that are happening in this cycle.
Cohen: The Fed’s rhetoric has been far more nuanced than people seem to think, even if you examine Janet Yellen’s statement in December when the Fed first raised rates. The Fed made it clear that anything it does in the future will be data-dependent. Its actions will depend in large part on how the labor markets are performing. As December’s terrific jobs report shows, the labor market is getting better. Household incomes are rising, and the savings rate was up to 5.2% in the latest reported quarter.
We don’t fully understand the consequences of the negative interest rates we’re seeing in many countries. It is one thing for this to last a short period of time, but negative rates in much of Europe and elsewhere have peculiar effects on individuals and corporate decision-making. The Fed is trying to move to a more normal level of between 0.5% and 1% on the fed-funds rate, based on the economic data. That might not be such a bad idea, given that the zero-limit bound is something we don’t have much experience with, especially on an extended basis.
Schafer: I have no great view on interest rates. But low interest rates are like the shot clock in basketball. Before the shot clock, you could delay and delay a game. Once it came into use, you had to make decisions. With low interest rates, there is no opportunity cost for companies in doing nothing. Thus, rising interest rates would help the economy in a way.
Priest: I see only one more rate hike coming, because the world isn’t in great shape. If you consider what Honeywell [HON], 3M [MMM], and Staples [SPLS] said when they reported earnings for the latest quarter, all were pretty darned negative. They all lowered expectations. The first two are global companies, and Staples is the largest office-supply retailer in the U.S. None of them said life is getting better. I heard a great definition: The plural of anecdote is data. Now you have data about the global economy. This year is going to be remarkably disappointing for real growth.
Zulauf: I’m the odd guy out here. I say the Fed won’t hike rates this year because the economy will surprise on the soft side. Therefore, it doesn’t make sense to lift interest rates. It is clear that the Federal Open Market Committee [the Fed’s policy-making committee] wants to return to normalcy on the rate front, but circumstances pose a problem. I agree with Jeffrey that some foreign central banks are selling large quantities of Treasuries to support their currencies. It isn’t just China, but the Saudis and Omanis and some others, too. These sales are being felt in the Treasury market; that’s why bond yields didn’t fall as much as you might expect, given what has happened to commodities prices. It tells you the downside potential in yields is probably limited.
However, there is a trade here. Yields could first fall on 10-year and longer-dated Treasuries, but then rise again, because later in the year the U.S. dollar could have a big correction against the euro, and maybe even the yen. It is going to be a tricky year. The bottoming process in yields and interest rates could stretch out for another few years.
Cohen: The decline in energy prices has put pressure on the current accounts of energy exporters. But some countries might benefit from it. Doing a back-of-the-envelope calculation, today’s energy prices could produce a net benefit of about $100 billion for China. That’s not chicken feed.
Zulauf: China’s current account is probably running a surplus of $300 billion or so. But what counts in the current situation is the capital account, which is running a deficit of roughly $1 trillion.
What does all of this mean for the performance of stocks in 2016?
Black: The market is going nowhere this year.
Gabelli: From Friday’s close, or from Jan. 1?
Black: From Jan. 1. The S&P 500 finished last year at 2043.94. Analysts expect S&P 500 companies to post earnings from operations of $125.56 in 2016, up from an estimated $106.39 last year. That implies 18% growth, which isn’t in the bag. I see 4% growth in earnings per share from net income and 3% from stock buybacks, which takes you to about $114. Based on Friday’s S&P close of 1922.03, the market is trading for 16.9 times estimated earnings. By historical standards, the market is slightly overvalued.
Many of us specialize in small- and mid-cap stocks, which did very poorly last year. As homogeneous risk classes, both are still expensive. The mid-cap Russell 2500 index is trading at about 21 times expected earnings, and the small-cap Russell 2000 is at roughly 22 times. It is hard to find great values in individual stocks, and hard to be bullish on the U.S. stock market as a whole. It is a market that favors individual stock selection.
Meryl, do you agree with that?
Witmer: Scott is starting from the beginning of the year. I would start from Friday’s close. Based on that, I could see the market easily going up 5%, 6%, 7% for the year. Companies will have some cash accretion and pay down debt. As I’ve said, there is no great driving force in the economy. But valuations at the beginning of the year were brought down by a bad selloff in stocks. There are opportunities out there.
Schafer: We had a stealth bear market last year. Despite the fact that the averages didn’t do much, 70% of stocks in the Russell 2000 are down more than 20% from their 52-week highs. That is also true of 49% of the S&P 500, and 68% of the Nasdaq Composite. It really will be a stockpicker’s market, because a lot of stocks that are down 30% or 40% are buys now.
Zulauf: The median stock in the S&P 500 was down 22%. But stealth bear markets always turn into real bear markets. That’s how bear markets start.
Schafer: We are in a bear market now. But within that bear market, you can still buy good stocks. David Tepper [founder of Appaloosa Management] has a saying: There are times to make money, and times not to lose money. This is a time not to lose money.
Gundlach: I agree, and that’s not even a prediction. It’s an observation. The market’s breadth is terrible. Beyond that, the divergence in the performance of junk bonds and the S&P 500 was giving a monstrous sell signal when the Fed raised rates in December. You must pay attention to that sort of divergence. It happens maybe 10% of the time, and sends a signal that is never wrong.
Schafer: There have rarely been times in my career when there have been so many uncertainties, whether it’s interest rates or terrorism or China or the economy, or all the other things we have been discussing.
Gundlach: We started getting worried about geopolitical issues three or four months ago because of the lame-duck presidency and the time window leading to the next presidential election. It is the perfect time for bad actors, and, unfortunately, things are playing out as we feared.
Zulauf: In Europe, the rifts between the euro-philes and the anti-euro members are growing, as are the rifts between those who are for and against multicultural societies.
Gundlach: Felix, it seems to me [German Chancellor] Angela Merkel has been keeping the whole thing together. What happens if she loses her grip on power?
Zulauf: She has been a great moderator, but she has never taken a big stance on political issues. That is how she has remained in power for so long, riding a middle-of-the-road populist policy. Now the German people are becoming uneasy about the influx of refugees from the Middle East. Merkel could be in trouble. She has lost influence not just in Germany, but throughout Europe. She can’t fulfill the role of the moderator within Europe as she did in the past.
Priest: We look at three kinds of contagion: financial, economic, and political. Europe is the locus of political contagion. I agree with Felix: Merkel’s political popularity has slipped, but is still around 57%-58%. She has kind of lost touch with the people on the street, and the Cologne attacks [sexual assaults blamed on migrant gangs] aggravated that. Felix, what will happen to the Schengen agreement, which allows for free movement of labor across the European Union? If that ends, the whole euro structure will fall apart.
Zulauf: Schengen is dead. On the positive side, the EU could adjust its goals and become less centralist. That would keep things together. Alternately, if the bureaucrats in Brussels stiffen in its resolve to bring other nations into line, there is a risk the euro zone will break apart. The European economy surprised on the upside last year. At least it surprised me. Some major factors driving that growth are going to disappear. The euro won’t decline further against the dollar; the rate of change in oil prices will slow, and countries have loosened up on austerity. The European economy could soften this year.
Rogers: Every day, for 40 years, Thomas Rowe Price, the founder of my firm, said, Today is the most difficult day to invest.
Gabelli: He was right.
Rogers: Troubling stuff is always out there. As an asset allocator, I ask myself, Can you invest in a portfolio of businesses whose value will accrete by more than 3% a year? That is my expected bond yield, and the threshold for an equity investor.
Gabelli: It depends on your starting price.
Rogers: Correct. If earnings are up 4% this year and you add the S&P’s 2.2% dividend yield, you get about a 7% total return. I assume P/E multiples will be flat because I don’t really know. This suggests investors will have a tough year, but a decent one. Last year wasn’t all that bad. The S&P was up 1%, and the Nasdaq Composite, 6%.
Zulauf: The S&P rose because of a handful of companies with very rich valuations. I expect the bear market to continue, leading to opportunities to buy later in the year. We’ll probably have a better market in 2017. Let’s talk about it when the S&P reaches 1600.
Gabelli: I’m glad you said that before we ate lunch.
Priest: To me, stocks still are much more attractive than bonds, but your holding period has to be measured in years, not 12 months.
Nonetheless, where will the market end the year?
Priest: It will be flat to down slightly.
Cohen: My colleagues think S&P earnings could be pretty good this year, albeit not as high as the consensus estimate. We’re at $117, a gain of $10-$11 from 2015. Some of that growth reflects a pickup in energy-company earnings, and some, the absence of currency translation. Assuming the price/earnings multiple stays the same, my colleague David Kostin [Goldman Sachs’ U.S. equity strategist] has a year-end price target of 2100. But to summarize today’s discussion, you don’t buy the S&P. You are buying specific securities.
Rogers: Last year, in terms of fund flows, the S&P is all that anyone bought.
Cohen: I’m talking about the people at this table.
Gabelli: I’m in Meryl’s camp. From the day of this panel, stocks will rise and be flat for the year. Whether China moves quickly or slowly to devalue the yuan, currency translation will help my companies incrementally this year. Second, there will be some sort of surprise that lifts oil prices. In an election year, we will address issues like tax reform and corporate regulation. We’ll also have to address the issue of tax inversions. Heading into 2017, things will look OK.
Witmer: How should we address that issue? By lowering corporate taxes?
Gabelli: We’ll have to move from taxing company earnings globally to taxing them territorially [applying a 35% corporate tax rate only to income earned in the U.S.]. If that happens, the effective tax rate will be materially lower. No one is baking that into 2017 forecasts.
Gundlach: In equities, there has been a tremendous move toward passive investing. It is the opposite in fixed income. Index investing in fixed income was popular 20 years ago. When the Fed raised rates sharply in 1994, there was great turmoil in the bond market, and people doing wacky or creative things had horrible returns. Now we have moved into the world of uber-active management in fixed income, represented by unconstrained bond funds. Yet they have been a debacle. They are generating negative returns. It is interesting how the pendulum swings in this business. Do what you want, but just don’t tell me. Essentially, that’s what an unconstrained bond fund is.
The problem is, they end up turning into credit funds with relatively low interest-rate risk, which is exactly the wrong thing to own right now. Credit is doing poorly, and even with rates up last year, bonds delivered a positive return. I am worried about what might happen in the aftermath of the Third Avenue gating [Third Avenue Focused Credit fund barred shareholder redemptions last month as it moved to liquidate]. Here was an open-end 40-Act mutual fund that was supposed to allow redemptions daily. Then, without even telling the Securities and Exchange Commission, it froze investor assets. The fund said it was down 30% for the year, but that doesn’t seem correct. If you’re down 30%, sell your holdings and give the money back. It is possible the fund was down more.
Let’s say I’m invested in a similar fund, leveraged once. If the Third Avenue fund was down 50%, I’m wiped out. If I get a statement next month saying my fund was down 30% for the quarter, I’m going to say, “Get me out.” If I don’t get out first, I’ll be left with pay-in-kind energy bonds worth zero. I can see a redemption cycle occurring in credit hedge funds.
Gabelli: Where does this end?
Gundlach: We will see a higher default rate in the junk-bond market. Junk-bond issuance used to represent about 1% of GDP. Then it rose to 2%. It was something of a stimulant to the economy. Also, the stock market has been buyback-driven to an extent, and higher borrowing costs will make that more problematic.
Investment-grade bonds also have been dropping in value. The LQD [ iShares iBoxx $ Investment Grade Corporate Bond ETF] consistently dropped in price through 2015. When interest rates rose, it was challenged by interest-rate risk. When the world looked problematic, it was challenged by credit risk. It seems like there is almost no way to win. When investment-grade credit is downgraded, it falls into junk territory, which makes it un-ownable for a large number of institutional investors. The credit market is sending a message, and the stock market, at least until recently, was whistling through the graveyard. When junk bonds fall 20% in price and the stock market sits at a high, something is wrong with the picture. These markets are moving like alligator jaws. Ultimately, they will move together.
In other words, you’re not too bullish on stocks.
Gundlach: If stocks stay where they are, junk bonds must go up. If junk bonds stay where they are, stocks must go down.
Cohen: But wasn’t the junk-bond market skewed toward industrial issues?
Gundlach: I am leery of arguments for taking out the bad stuff, which makes everything else look good. That’s just trying to sugarcoat the rot at the center. The credit market is clearly signaling a default cycle. Junk bonds have been weakening for 17-18 months. No wonder stocks had a bad start to the year.
You haven’t said much today about emerging markets. Felix, is your outlook dismal, or worse?
Zulauf: Emerging markets are satellites of China. Those in Northeast Asia are subcontractors, and those in Latin America are suppliers of commodities to Asia. Both are doing badly as China struggles. Brazil is in a virtual depression, and there are no signs of improvement. Economically, the business cycle is turning down. EM currencies began sliding ahead of China’s, and the decline isn’t over yet. Most are experiencing a balance-of-payments crisis. I would avoid emerging market currencies, bonds, and equities.
Gundlach: Emerging market equities are correlated to commodities prices. I can’t come up with a single good argument for owning emerging market equities versus U.S. stocks.
Cohen: One emerging economy that might move in the opposite direction in 2016 is India. The country has been moving forward with reforms. Structural issues are being addressed correctly, albeit slowly.
Gundlach: India is facing many potential positives that China faced a generation ago. Its labor force could see tremendous growth, whereas China’s labor-force growth will be zero. I have no idea what will happen to Indian stocks this year, but India is the thing to buy for your grandchildren’s education. Put your statements in a shoe box and don’t open it.
Cohen: We have talked today about the things investors might want to avoid in 2016. But from an asset-allocation perspective, where should you put your money? The dollar is an appreciating currency. It wouldn’t be surprising to see capital flow to the U.S. That could push P/Es higher than our models might otherwise suggest.
Priest: India has a major corruption problem.
Gundlach: There are all kinds of negatives. That means there is room for improvement.
Rogers: If people collectively feel there is no reason to invest in emerging markets, that could be reflected in their valuations. If Brazil is in a depression, perhaps that is when you want to buy.
Zulauf: Brazil hasn’t addressed its problems. It just fights the symptoms. As long as that is the case, the darkest hour hasn’t yet arrived.
Has Argentina turned the corner?
Zulauf: The new president and his team are excellent, but they have to restructure the economy. There will be layoffs and less welfare support for citizens, and the country will have to deal with foreign creditors. But, sometime this year, Argentina could become more attractive to investors.
Time for a quiz; we’ll grade you next year. Who is going to be the next president of the U.S.?
Black: Hillary Clinton.
Gundlach: Donald Trump.
Gabelli: Trump wins.
Cohen: One of the nominees will win. I expect them to be Hillary Clinton and Paul Ryan.
Priest: I agree with her on the nominees. Hillary Clinton is going to win.
Rogers: Chris Christie will be the Republican nominee and beat Hillary Clinton in a tight contest.
Schafer: Hillary Clinton will win.
Felix, you’re not a U.S. citizen, so you can’t vote. But you are permitted an opinion.
Zulauf: Hillary Clinton will probably make it despite her lack of integrity. Donald Trump would be good on a few points, but extremely dangerous for the world economy. He would close our doors to the world. Trump is a reflection of how upset the people are with the political establishment. You see the same development in Europe, which is bad news, because eventually it will put more populists in power. And that creates a much less stable world.
Witmer: I expect a Republican to win.
Gundlach: Hillary is going to lose badly. She is the opposite of what Felix discussed: the antiestablishment mood. The populist momentum is unstoppable. If Trump wins the nomination, he will own her in the debates.
Zulauf: Will the Republican Party allow a guy like Trump to run for the presidency?
Gundlach: He is running right now! The outcome of the election will be highly dependent on geopolitics and the economy, and neither is going to be supportive of the status quo.
Quiz over! Now, how are investors going to make money in what looks to be a devilish year? Brian, tell us where you see value.
Rogers: These are my criteria, particularly in the context of today’s discussion, where the most bullish commentary was that U.S. equities might rise by upper-single digits in 2016. That seems like a wide leap, based on where the market sits now. I have sought to identify a handful of companies with staying power, but with some controversy reflected in the share price. There aren’t many triple-A-rated companies anymore, but there are companies that have been through cycles and will last through other cycles. I look for management that is either strongly incentivized, under pressure, or feels some need to improve performance. Lastly, these companies present good valuation opportunities. Listed alphabetically, the first is American Express [AXP].
When I think of a blue-chip company, I think of American Express. It has a great legacy and innovative management, and develops great leaders. Also, the stock has been under tremendous pressure. Analysts rarely mention American Express without mentioningCostco Wholesale [COST], with which AmEx had an exclusive co-branded charge-card arrangement until last year. The separation takes effect March 31. The stock was a sloppy performer in 2015, and sold off to the point where we’ve got a low multiple on a historically high-return business.
How far did American Express fall?
It was down 25%, and closed Friday [Jan. 8] at $63.63. There are 985 million shares. Our earnings estimates are $5.30 a share for 2015, moving up to $5.50 this year. The dividend yield is 1.8%. The company raised its dividend last year, and probably will raise it again in 2016. It is giving guidance that earnings will be back to a 12% growth trajectory by 2017, which gets you to $6.35 a share next year.
Spending on leisure and business travel is up, and credit losses are down. Interestingly, the company has been hurt by lower prices for gasoline and airline tickets. But it doesn’t take a huge leap of faith to assume that if American Express maintains its P/E ratio, now about 13, and earnings come through in the next 18 months, you could be looking at an $82 stock. If you put a 10 multiple on earnings 18 months out, below today’s multiple, you have a $60 stock. So there is limited downside, decent upside, good management, and a board that is under a lot of pressure. There has been speculation that if the company’s fortunes don’t improve, there could be a management change. Management continues to buy back stock, and is shrinking the share count by about 5% annually.
Witmer: How is the balance sheet?
Rogers: The balance sheet is great, Meryl. Keep in mind, American Express is a bank now. Its dividend and buyback plans have to be approved each year by the Fed. The risks here are an uptick in credit losses, more adverse regulation than we’ve already seen, and a general economic slowdown. The stock went through its own bear market in 2015, which was unwarranted. By this time next year, people won’t be thinking about Costco.
Zulauf: What makes the loss of Costco such a big problem?
Rogers: The deal with Costco generated a mid-single-digit percentage of American Express’ revenue. They lost the contract.
Gundlach: Mid-single digits came from that, and the stock is down 25%? That’s out of line.
Rogers: That’s what we think.
Zulauf: The AmEx card isn’t as widely accepted by merchants as other cards, because American Express charges merchants a higher fee.
Black: That is more of an issue in Europe than the U.S.
Gabelli: This has been an issue since forever. But the number of cards in force keeps going up.
Rogers: Moving on, Comcast [CMCSA] is the only stock I’ll mention that didn’t have a bear-market decline last year. It was down 2.7%. The business is two-thirds cable TV and one-third NBC Universal. If the hurdle is a bond yield of 3%, Comcast’s value will accrete by more than 3% in almost any given year. Comcast could earn $3.70 a share in 2016, probably going up to $4.15 in 2017. There are 2.5 billion shares. Chairman Brian Roberts and his family control about 33% of the stock.
There was a lot of excitement around the stock last year when the company attempted to acquire Time Warner Cable [TWC]. The deal fell apart in April, and Comcast then turned its attention to accelerating share repurchases. It bought back about 3% of its capitalization in 2015 and will continue to buy back shares in 2016. We look at Comcast as an asset-rich company, whether it’s the Universal theme parks, the Philadelphia Flyers, or the value of NBC. We try to apply a P/E multiple or a multiple of enterprise value to Ebitda [earnings before interest, taxes, depreciation, and amortization], or a price-to-free-cash-flow multiple to these assets. In doing so, we come up with a stock price of $69, versus Friday’s close of $54.67. Using bearish assumptions, we get a stock price of $50; putting in bullish assumptions, we get a price of $78. Some other folks have done valuation work based on multiples of cable and NBCU Ebitda, and come up with a price of $80. There is no China risk here, and less economic cyclicality risk than in some other companies.
But there have been widespread concerns about cable-TV subscribers canceling service or “cutting the cord.”
Rogers: Subscriber growth has been holding. Comcast has introduced a fancy X1 interactive product, and will continue to roll out X1 products in the next couple of years. After 2017, cash flow will improve as the company will be making less of an investment in the X1.
Comcast management made good decisions last year. The Time Warner Cable decision was made for them by regulators, but buying back stock was probably at least as good as an investment as TWC would have been.
Witmer: Doesn’t Comcast make most of its money from providing broadband Internet service?
Gabelli: Yes. The video part of cable has become a marginal contributor.
Rogers: We talked today about the lack of momentum in industrial America. That brings me to Eaton [ETN], which closed Friday at $49.17. The company makes electrical, hydraulic, automotive, and aerospace products. Eaton bought Cooper Industries in 2012. It was a really good deal.
Eaton’s stock was down 23% in 2015, after falling 11% in 2014. The company has a $23 billion market value. It has good businesses, but a challenged earnings outlook has caused the stock to weaken. Eaton could probably earn $4.25 for 2015 and $4.30 in 2016, so I’m bullish on about five cents. Management raised the dividend to $2.20 a share last year. The stock yields 4.4%, and the payout ratio is almost 50%. They could take the dividend up to $2.40 this spring, for a yield of nearly 5%. The company was profitable even in the last downturn, in 2008 and 2009, when other industrial companies were challenged. Eaton has peak earnings power of somewhere in the $6-$7 range. It bought back 2% of its shares last year, and will buy back stock this year. It is cutting costs aggressively.
What is the company worth?
If you put multiples that aren’t particularly high on the electrical, hydraulics, aerospace, and vehicle businesses, and subtract debt, you get a hypothetical stock price in the $65-$75 range. The CEO, Sandy Cutler, who has been running the company for a long time, will retire in the spring, and Craig Arnold, another Eaton veteran, will succeed him. Eaton is a good business, with strong financials, cyclical head winds, and decent profitability. The stock has significant upside if and when the economic environment improves.
Schafer: Will there be any change with the new management?
Rogers: I don’t expect so. Cutler has been a good leader. Some people might say the company could have used a breath of fresh air, and should have hired an outsider to replace him. But Arnold has been there for years, and will do a fine job. It’s steady as she goes.
Black: Eaton has no revenue growth. There is no inflection point that I can see in the next three to six months.
Rogers: That’s why the stock is down 30%. It’s anyone’s guess when Eaton will return to peak earnings power.
Gabelli: They’ve got great businesses that they are running well.
Rogers: And I am convinced the dividend yield is safe. This is like a bond with a call option.
Witmer: Why would they pay out so much in dividends?
Rogers: They generate a lot of cash flow and don’t have many things to invest in.
Schafer: You’d rather they spend the money on dividends than a dumb acquisition, which many other companies do.
Rogers: Absolutely. My next recommendation is my most controversial. Macy’s has been in the news a lot more than it might have wished. The company announced recently that it was taking earnings guidance down. On the day it announced, the stock went up a bit, which I consider a good sign. Macy’s operates 770 Macy’s stores, 50 Bloomingdale’s, and Bloomingdale’s outlets. The company has a $12 billion market cap and annual revenue of $27 billion. Management reduced its earnings outlook for the year ending this month to $3.85 a share. The stock closed last Friday at $35.89.
Forecasting earnings here is tricky, as Wall Street expected Macy’s to earn $4.25 a share for the year. A bold guess for the fiscal year ending in January 2017 would be that earnings are flat, although that could prove optimistic. Macy’s raised its dividend last year to $1.44 a share, giving the stock a 4% yield at today’s price. The stock is inexpensive at 9.3 times earnings, and 5.5 times enterprise value to Ebitda. Macy’s has been making progress on its Internet businesses, both at macys.com and bloomingdales.com. But it had more competition from other online retailers in the fourth quarter, and suffered from bad weather.
Cohen: You mean good weather. They weren’t selling enough coats.
Rogers: Warm weather in the winter is bad for Macy’s. Likewise, a strong dollar reduced tourist traffic at the stores. These things are reversible, and management responded by saying it would close some stores and cut costs. The company has cut its capitalization faster than its store count. Share count has been reduced to 330 million shares from 540 million 10 years ago.
Starboard Value, an activist investor, has been involved with Macy’s, and claims the company’s assets are worth $21 billion. Relative to its market value, that is a big gap. The company has been invigorated by this investor and is examining different possibilities for change. At nine times earnings, and with a 4% yield and potential changes in how the company is run, this seems like an intriguing situation.
Could the changes involve new management?
Gabelli: No. Terry Lundgren [Macy’s CEO] has done a great job.
Black: Brian, are you buying this on earnings power or potential monetization of the real estate assets?
Rogers: I am buying it because there is a lot more value in Macy’s than the $12 billion market cap reflects. Lundgren has done an excellent job, and the chief financial officer is outstanding. They know the pressure they’re under, and are trying to do the right thing.
Occidental Petroleum [OXY] is a large independent oil producer. It has a market value of about $48 billion, and is the largest producer in the Permian basin. The CEO, Stephen Chazen, is stepping down this spring, and Vicki Hollub, who has been with the company for several decades, will succeed him. Occidental was once viewed as the low-quality company in the sector. Management has done a great job of selling assets, monetizing assets, and investing in the right sectors. The company is financially strong, with a single-A credit rating.
We’ll see what happens if oil falls further.
Rogers: Estimating the value of Occidental is tricky. In 2013, the company generated Ebitda of $14 billion. In 2015, it will be $5 billion. Earnings have been similarly volatile. A few years ago, the stock was trading above $100 a share and the company earned eight bucks. For 2015, it could earn all of 28 cents. You don’t buy a company like Occidental based on its current earning power. The dividend was increased last year to $3 a share; the stock yields 4.7%.
Is the dividend safe?
Rogers: In its most recent investor presentation, Occidental talked about growing the dividend on six out of eight pages. When a company does that, I am willing to bet the dividend is safe for at least two or three years. They can certainly cover it out of operating cash flow.
Do you feel the same about the dividends of most of the oil majors?
Rogers: The majors can maintain their dividends for a few years. It isn’t a foregone conclusion that they can maintain them forever, no matter what happens to oil prices. In Occidental’s case, the company is cutting capex from $9 billion in 2014 to $4 billion this year. Chevron [CVX] is also cutting capex and using the money to help fund the dividend. This isn’t a good long-term strategy, but in the short term, it is defensible.
Zulauf: If more companies cut capital spending dramatically, that would be bad for GDP this year.
Rogers: You aren’t going to have growth coming from the energy sector, that’s for sure.
Priest: Few oil companies can maintain their dividend at current levels if oil stays at $30 a barrel. Dividend payments can be sustained by capex cutbacks for a while, but that is scary. Depending on how much leverage a company has, a weird thing could unfold, whereby the present value of the asset side of the balance sheet is collapsing, while nothing is changing on the other side. There is an insolvency problem brewing in that whole industry. We happen to own Oxy, but the whole environment is volatile.
Rogers: Occidental has production growth and will be a survivor. If dividend cuts are coming, Oxy won’t be in the first wave. It is an intriguing situation if you are a true contrarian.
Lastly, we like Qualcomm [QCOM]. This is a cash-flow-return-to-shareholders story. Qualcomm makes chips for smartphones and licenses intellectual property to almost every smartphone manufacturer. The company has disappointed shareholders for the past few years. The stock lost 32% last year.
Qualcomm has $70 billion in market value and $10 a share of net cash. The stock closed Friday at $45.88. In the year ended in September 2015, Qualcomm earned $4.60 a share. They will probably earn $4.90 in the September 2016 year.
What is the dividend?
Rogers: They pay $1.92 a share, and the stock yields 4.2%. The former CEO, Paul Jacobs, became executive chairman a few years ago, and Steven Mollenkopf was promoted to CEO. Steve is focused on shareholder value, and stock buybacks and dividend growth have picked up. We think the licensing business is worth between $40 and $43 a share, based on a 20-year discounted cash-flow analysis, and the chip-making business is worth $16 a share, based on a multiple of 12 times earnings. The two businesses, plus the net $10 a share of cash—we only count the accessible cash that isn’t overseas—gets you to a $69 stock price.
There are many risks here, and opportunities. Jana Partners became involved last year as an activist investor, arguing for the company to be broken into two separate businesses. Qualcomm opted not to do that. The company has had a lot of licensing disputes with Asian governments. When we add up the cash flow from licensing and the earnings from chip-making, the stock is selling at too big of a discount to underlying value. This is an interesting situation for an income-oriented investor.
Last year, a lot of the action was in the FANG stocks— Facebook [FB], Amazon, Netflix[NFLX], and Google [GOOGL], now called Alphabet . Many good companies were down between 10% and 30%, not just in the oil patch. I look for out-of-favor companies with good dividend yields and long-term staying power.
Thanks you, Brian. Oscar, you’re on.
Schafer: I have three stocks, all down about 30%. The first is Evertec [EVTC], the dominant transaction-processing company in Puerto Rico. It processes 75% of all merchant transactions, and more than 70% of all ATM and debit-card transactions. It also provides bank-processing services, predominantly for Banco Popular, which is owned byPopular [BPOP], Evertec’s former parent. It was carved out of the bank in 2010.
Evertec is expanding across Central and South America, to countries such as Colombia, Costa Rica, Peru, and the Dominican Republic. Revenues are recurring, returns on capital are high, and the business generates a lot of free cash flow, which it regularly returns to shareholders. Despite these attributes, the stock sells for less than 10 times earnings, while similar businesses in the U.S., Europe, and South America all fetch 20 to 25 times earnings.
Why the steep discount?
Schafer: The knock on Evertec is its location. Puerto Rico accounts for more than 80% of its business. It is burdened with an overwhelming level of government debt, a high unemployment rate, and a shrinking population. Its economy has been in a recession for nearly a decade. I can’t tell you when the Puerto Rican debt crisis will be resolved, but it sounds like a restructuring might finally take place. Anything that improves the economy would help make Evertec a home run, but we don’t need an improvement in Puerto Rico for the stock to do well.
Why is that?
Evertec is benefiting from a secular shift from cash transactions to electronic payments. This transition is still is in the early innings. Only 50% of the population of Puerto Rico is banked, versus more than 75% in the U.S., and card-usage levels are relatively low. Last year, Evertec’s board hired a new CEO, Morgan Schuessler, tasked with managing the business in Puerto Rico and re-accelerating the growth in other countries. He is well suited for the job, as he executed a similar playbook at Global Payments [GPN]. He has already announced a key win with the second-largest bank in Puerto Rico, and the company’s first acquisition in Colombia.
If new management can accelerate growth, Evertec could trade in line with U.S. peers, or for double the current price of $15. Eventually, it could be attractive to large, global payment companies for its regional footprint and favorable tax rate. A few weeks ago, Global Payments agreed to acquire Heartland Payment Systems [HPY] for 30 times earnings.
What is Evertec’s market capitalization?
Schafer: It is $1.2 billion. Calpine’s shares, like Evertec’s, have fallen to $14 from $23. Calpine has a $5 billion market cap. It is an independent power-producer generating 27,000 megawatts of power from natural-gas-fired and geothermal plants in California, Texas, and the Northeast. As a wholesale power company, it sells into competitive markets. As a result, it doesn’t earn the steady, guaranteed returns of a typical regulated utility. It is a tough business, and I often view the industry as a cautionary tale about deregulation, overbuilding, and bankruptcy.
Calpine took a spin through bankruptcy court.
Schafer: It filed for bankruptcy protection in 2005. At the time, it had the dubious distinction of being the eighth-largest bankruptcy in U.S. history. To steal a line from my friend Howard Marks [co-founder of Oaktree Capital Management], there aren’t any bad asset classes, just bad prices. In the case of Calpine, the stock is too cheap to ignore. Calpine is trading for only five to six times our estimate of 2017 free cash flow per share, and at less than half of replacement value. The management team is uniquely focused on creating value for shareholders.
When your readers are finished with this week’s Barron’s, I would encourage them to read the first few pages of Calpine’s 10K, where management lays out its investment philosophy.
You mean if, not when.
The stock is down for two reasons. Mild weather has led to low power prices, and investors are worried about the long-term impact of competition from renewable energy sources, such as solar and wind. I can’t predict the weather, and I expect renewables to continue to grow and disrupt the power and utility industries, which is a wonderful thing. But for the foreseeable future, most energy will be from the least environmental, least flexible, and most expensive sources, mainly coal-fired and nuclear generation. I expect Calpine to continue generating strong cash flow, which management will allocate in intelligent ways. The shares could double in the next one to two years.
Does the company have much debt today?
Schafer: It is levered five times to Ebitda.
Will management use any of the free cash flow to pay down debt?
Schafer: It depends on the stock price.
I love to seek out management teams with which I have had success in the past. I particularly like investing with a team that confronted a similar fact pattern that led to significant gains in a prior period. That is the case now with CommScope Holding[COMM]. The company is a leading provider of cell-tower antennas for wireless carriers, and provides fiber solutions for residential networks and data centers. The business has grown by 3% or 4% a year, and should continue to benefit from increasing demand for bandwidth.
CommScope’s business can be lumpy, quarter to quarter, or even year to year, as its largest customers are the major telecoms around the world. This lumpiness has hurt the stock. Nonetheless, management has done an excellent job of improving profit margins. In the past 10 years, operating margins doubled to 20%.
In August, CommScope closed its third major acquisition. Having watched this management excel at integrating and optimizing prior acquisitions—Avaya Connectivity in 2004 and Andrew in 2007—I am confident that there is significant opportunity for earnings accretion in the next three years as the company integrates its newest purchase, the telecom, enterprise, and wireless business of TE Connectivity [TEL]. Based on the stock’s valuation, many others don’t agree.
What is the stock price?
Schafer: CommScope is selling for $23.36, or 10.5 times analysts’ 2016 earnings estimates and 8.5 times 2017 estimates. The company is levered at 4.6 times trailing Ebitda, but given the strong secular tail winds, I am not as concerned as I might be with a cyclical industrial company. The stock has at least 50% upside, and closer to 75% in the next 18 months.
Last year, I recommended NICE-Systems [NICE], an enterprise-software company. The stock has risen 10% since then, but there could be 40% upside from here. New management has an opportunity to create significant value for shareholders by optimizing the company’s bloated expense structure and overcapitalized balance sheet. In the past year, NICE expanded its profit margins, sold two noncore businesses, and generated a lot of free cash flow. The stock is selling for $55, and the company has $14 a share of net cash. It will probably earn $3.50 a share this year, so it is cheap at 12 times earnings, excluding the cash. NICE has a growing revenue stream and continued optionality around business-model enhancement and cash deployment.
Barron’s Roundtable, Part 2: 31 Savvy Investment Ideas
Abby Cohen, Felix Zulauf, Mario Gabelli, and Jeffrey Gundlach offer their best bets for 2016 in this week’s Roundtable installment.
Mario Gabelli, Jeffrey Gundlach, Felix Zulauf, Abby Joseph Cohen Photo: Brad Trent for Barrons
A funny thing happened last week at the local Trader Joe’s. Your hungry Roundtable editor popped in for some dinner provisions, and got an unbidden earful of market talk from a cheerfully bearish cashier. Stocks will fall a lot further, he predicted. The Baltic Dry Index, which measures the cost to ship stuff like grain and steel around the world, has collapsed. Inventories are piling up, deflation is looming, and the Federal Reserve might weigh a fourth round of quantitative easing.
It was like déjà vu all over again: The 2016 Barron’s Roundtable, convened Jan. 11 in New York, was heavy on the same worrisome talk, and last week’s frequently dismal stock action only confirmed the prescience of our assembled market seers.
While big-picture prognostications dominated the first Roundtable issue, published Jan. 18, they also feature prominently in this week’s installment, the second of three. But, happily, the four experts showcased in the pages ahead also have plenty to say about specific investments that could yield rich returns in the year ahead, notwithstanding the troublesome backdrop.
Sharing the bear’s lair this year are Roundtable veteran Felix Zulauf, the sagacious Swiss investor who helms Zulauf Asset Management, and newcomer Jeffrey Gundlach, co-founder of DoubleLine Capital, a mostly bond-focused shop whose returns have dazzled since its formation in 2009. Both riff at length on the potential calamity facing emerging markets due to China’s cooling economy, and think U.S. stocks haven’t seen their lows yet. Felix offers a bevy of short-selling ideas to profit from the pain, while Jeffrey combs the fixed-income universe for mispriced assets, such as closed-end funds and a mortgage REIT, that could reward investors in multiple ways. A consummate contrarian, he also sees opportunity in Puerto Rico’s distressed debt.
Abby Joseph Cohen, a standout strategist and public policy guru at Goldman Sachs, also shares her best bets for the new year, in the form of seven stocks favored by the firm’s analysts that amplify her current investment themes. Cautious about the industrial economy, she is tilting toward health care, retailing, and housing plays that could benefit from the consumer’s improved finances.
Mario Gabelli, the master of Gamco Investors and a shrewd guide to corporate deal-making, rounds out this week’s quartet with a look at media companies that could enrich shareholders by buying, selling, or rearranging valuable assets. There is a lot to chew on in his calculations and commentary—and in the rest of this meaty Roundtable segment.
ABBY JOSEPH COHEN
Barron’s: Abby, what are you recommending today?
Cohen: As we discussed earlier in this session, capex [capital spending] has weakened among U.S. companies. But there has been a great deal of capex in some industries. While spending is weak in energy and chemicals, and among some heavily industrial companies, it is quite robust in industries such as digital technology and medical technology. Philips,based in the Netherlands, is a capex beneficiary, but not in the usual cyclical sense. Philips is selling for 10 times 2016 estimated earnings, below the sector P/E [price/earnings ratio] of 12.5 times. Its European shares have fallen 7% in the past 12 months, to 22.15 euros [closing price on Jan. 8] and yield 3.6%. Our analyst expects Philips to earn €2.21 a share [$2.39] this year, well above the consensus estimate of €1.64.
I started looking at Philips after thinking about one of my picks from last year’s Roundtable— Acuity Brands [ticker: AYI], a maker of LED lighting. New energy-efficient technologies, like lighting, have a long road ahead in terms of growth. Philips has been around since 1891 but is always reinventing itself, and has a history of innovation in many categories, from traditional lightbulbs to Blu-ray discs. While the company is typically viewed as an industrial, it has a robust consumer business. It also has a robust lighting business.
Philips has a first-mover advantage in providing equipment such as lighting and ultrasound services to its customers. Philips’ lighting is used in public and industrial spaces, but the area that intrigues me is health care.
Cohen: The company makes CT scanners and MRI scanners. It has used its digital expertise to build a pretty robust business in hospital management and information management in the health-care industry. The stock trades in Amsterdam [PHIA.Netherlands] and via American depositary receipts [PHG].
Which security do you recommend buying?
Cohen: If you are dollar-based, buy the ADR.
Zulauf: Would you hedge the currency?
Schafer: The company does a lot of business outside the European Union. If the stock is going to work, it will go up 50%. The currency isn’t going down 50%, so you can afford to be wrong on the currency.
Cohen: My next two names are in the health-care sector, which performed well last year, but ran into hard times toward the end of 2015. There were significant outflows in the fourth quarter from health-care mutual funds, and from many stocks, particularly pharmaceuticals. AbbVie [ABBV] was one. It has a yield of 4%. In the 12 months ended Friday, the stock was down 18%.
The chief concern has been the high concentration of Humira, a treatment for arthritis, in its total business model. Humira has dominated AbbVie’s revenue, and investors are concerned that a biosimilar drug will be launched, posing competition. Our analyst believes the launch of a biosimilar probably won’t happen until 2020, and, if that is the case, AbbVie still has good earnings growth ahead. Earnings could grow at a compound annual rate of 13% from 2015 through 2020. [Subsequent to the Roundtable, AbbVie had a major patent win on Humira.]
AbbVie has some promising things in its product pipeline. It is working on a number of vaccines for HIV and hepatitis C, although the hepatitis product is off to a slow launch.
Priest: Abby, we own AbbVie. It has been in a negative trend for a few weeks, and I can’t explain its significant underperformance versus many other names. Maybe it is concern about potential competition to Humira.
Black: The Food and Drug Administration has warned that the company’s hepatitis C treatments could cause liver toxicity in people with cirrhosis. This is a big plus for Gilead Sciences [GILD], which makes the leading hepatitis C treatments. The news took down AbbVie’s stock.
Cohen: Our second name is Mylan [MYL] which was hurt because of its failed bid last fall for Perrigo [PRGO]. Both are makers of generic drugs. Mylan’s stock fell 13% in the past 12 months. It is trading for 9.8 times 2016 estimated earnings, below the rest of the industry.
Although investors are upset about the failed bid, more consolidation is likely in the generic-drug industry. Mylan is likely to be an acquirer, and seems to be benefiting from previous deals. The company bought some generic products from Abbott Laboratories[ABT], and is working them through its sales and distribution system. Also, a competitor had a problem with its own version of Mylan’s EpiPen [an epinephrine auto-injector used to treat life-threatening allergic reactions], so Mylan is benefiting from that.
How large is the EpiPen market?
Cohen: It could be as big as 24 million people, larger than Mylan previously thought. Mylan’s application to sell a generic version of Copaxone [a multiple sclerosis treatment] is now before the Food and Drug Administration; it doesn’t seem to have any problems. The company also has a generic version of Advair [an asthma treatment] on track, and has built a new manufacturing facility to produce it. Mylan has some temporary issues, but our analyst sees good value in the stock.
Next, the U.S. consumer had a tough time for a while, but is doing far better now. That brings me to Signet Jewelers [SIG], which operates stores in the U.S., the U.K., and Canada under a variety of names. Signet acquired Zale in 2014. In the U.S., Signet operates 1,400 stores under the Kay Jewelers and Jared the Galleria of Jewelry brands. The Zale division has 1,600 stores in the U.S. and Canada. The company had a good holiday season. Maybe people weren’t buying a lot of coats, but they were buying jewelry.
How has the stock done?
Cohen: In the past 12 months Signet’s shares have been flat. The stock closed Friday at $126.93, and yields 0.6%. For the fiscal year ending in January 2017, our analyst has an earnings estimate of $8.07 a share, roughly in line with the consensus. The company has had some issues: It was sued for gender discrimination. But Signet is held in high esteem by customers, and has a good distribution network.
Zulauf: Are they selling upscale products, or a range of products?
Cohen: They cater to middle- and upper-middle-income buyers, and sell a lot of diamonds.
Lowe’s [LOW] also could benefit from a stronger consumer, and a strong housing market. It benefits from the renovation market, in particular. The stock was flat in the past 12 months, and yields 1.5%. We are optimistic about the housing market. Demographics favor a pickup in household formation, which will help Lowe’s.
Why do you prefer Lowe’s to Home Depot [HD], another housing beneficiary?
Cohen: Lowe’s has a cheaper valuation. It sells for 18 times this year’s expected earnings.
Bharti Airtel, based in India, provides mobile telecom services in India and elsewhere. It trades on the Bombay Stock Exchange [BHARTI.India]. The company is spending to expand its 3G and 4G telecom networks. The stock was down about 10% in the year ended Jan. 8, but our analyst, based in India, has an earnings forecast for this year that is dramatically above consensus. He expects the company to earn 19.89 rupees [29 cents] versus the consensus forecast of INR16.91. The stock is trading for 16 times expected earnings for the fiscal year ending in March 2017, and yields 1.4%.
Lastly, Ocado Group is an online supermarket company based in the U.K. The shares trade in London [OCDO.UK]. The stock did poorly in the past 12 months, falling 29%. The company was formed in 2000 and has invested heavily in distribution and inventory-control systems. There have been concerns thatAmazon.com [AMZN], which has launched in the U.K., will hurt them. But Amazon is based in London, which is J Sainsbury ’s [SBRY.UK] territory more than Ocado’s.
Rogers: Does the company do business as Ocado?
Cohen: Yes. It also provides deliveries for Morrisons, a well-known supermarket chain in the U.K. Ocado has a lower-cost model than other supermarkets in the U.K. It has very little product waste, which keeps its costs down. Here, too, our analyst has above-consensus estimates—3.43 pence [five cents] for the fiscal year ending in November, versus the consensus estimate of 2.98p.
This isn’t a new industry, but an example of an old industry trying to take advantage of some newer technologies. Macy’s [M], which Brian recommended today [Rogers’ picks were featured in last week’s Roundtable issue] is also building a significant Internet platform. To the extent that old-line retailers can adapt successfully to the Internet, they should do well.
Thank you, Abby. Let’s hear from Felix.
Zulauf: As most of you know, I am a macro guy. I invest based on my analysis of macroeconomic trends, and try to figure out where we are in the economic and financial cycle. My base case is this: The developed economies have had a disappointing recovery since the financial crisis, but the emerging economies had a big boom until a few years ago. That boom went bust in 2012-’13. Now we are in a down cycle that will end with crisis and calamity. China’s troubled economy is to the global financial market what the U.S. housing market was in the prior cycle. Many people don’t understand this. While the U.S. is widely analyzed, China often is misunderstood, as the economic data published by the Chinese government are of poor quality.
In the past 12 months, China tried to reignite its economy. Debt has risen dramatically, to more than twice gross national product, with almost no impact on the real economy. China has reported annual growth of nearly 7%, but the industrial complex is in a recession, and I estimate the service sector is growing by only 4% a year. In reality, then, growth is probably around 2%, and slowing.
Priest: Doesn’t China have a huge percentage of the world’s debt?
Zulauf: It does. China has doubled its debt in a few years’ time. In boom times, the corporate sector in China and other emerging markets made all sorts of mistakes. Companies overexpanded, took on too much debt and staff, and raised labor costs excessively. Officially, Chinese corporations have issued $1 trillion in dollar-denominated debt. Unofficially, it could be as high as $3 trillion.
When wealth is created during a boom, there is no need to diversify into other economies. Once the boom is over, however, the wealthy want to diversify outside the country. By looking at what happened in other economies when boom times ended, we can estimate that about $3 trillion in wealth wants to leave China. That is a huge amount, and outflows have been increasing.
How did you figure it out?
Zulauf: Foreign-exchange reserves fell to $3.3 trillion last year from $4 trillion. The current-account surplus is $300 billion, so that means $700 billion has flowed out of the country on a net basis. The gross outflow is about $1 trillion. If we assume $1.3 trillion of China’s reserves are illiquid, only $2 trillion remains. If money continues to leave the country at the current rate, China could lose all its foreign-exchange reserves in a little more than a year.
To prevent that from happening, China eventually will stop intervening in the currency markets to prop up the value of its currency, the yuan, and let it fall. The government has other options: It could raise interest rates, which would be dreadful for the Chinese economy, or tighten capital controls, which would postpone the problem of capital flight, but cause bigger problems in the future. That is why China will have to let the currency fall. China has a balance-of-payments crisis, which usually ends with a recession in the real economy. The currency overshoots on the downside, and interest rates rise to extreme levels. That is what lies ahead.
That is some base case. What are the implications for the rest of the world?
Zulauf: China’s Asian trading partners will also let their currencies fall. It is conceivable that Singapore, which has attracted a lot of foreign capital over the years because of its image as a strong-currency state, will be extremely exposed to the situation in China. Singapore’s banking-sector loans have grown dramatically in the past five or six years. Singapore is now losing capital, which means the banking industry is losing deposits. When that happens, carry trades go awry, which is usually a prescription for disaster. I expect a banking crisis to develop in Singapore and to spread eventually to Hong Kong.
What will happen to the Hong Kong dollar?
Zulauf: The Hong Kong Monetary Authority has said it will defend the Hong Kong dollar. During the first stage of the crisis, capital flowed from mainland China to Hong Kong, which depressed interest rates in Hong Kong. In the past few days, the reverse has happened; capital has flowed out of Hong Kong and shorter rates [interest rates on shorter-term government debt] have gone up. The Hong Kong dollar is pegged to the U.S. dollar.
Rising interest rates will be deadly for the Hong Kong stock market and real-estate market. Eventually, as their currencies lose value, China and the emerging-market countries will reduce their imports, which will exert a contractionary force on the world economy. They will try to export more by cutting prices, which will influence the pricing mechanism throughout the industrialized world.
Are you talking here about a currency war?
Zulauf: Some call it a currency war.
Gabelli: Government-owned enterprises in China are already dumping steel.
Zulauf: In Asia, as well as the U.S., there has been a large buildup of inventories, and inventory levels are too high. The corporate sector in both regions overestimated final demand. Now it has to cut production. Companies also overestimated their debt-carrying ability. Remember that cutting costs is cutting someone else’s revenue. Thus, the global economy will continue to weaken.
Investors are pretty fully invested in equities around the world, because equities have been the only game in town. The slogan was TINA: There is no alternative to stocks. Among U.S. households and institutional investors, equity allocations are approaching the 2000 and 2007 peaks. Investors are extended and vulnerable, and don’t have a lot of cash.
At the same time, the monetary backdrop is changing. The U.S. Federal Reserve hiked interest rates in December, and at the margin is shrinking its balance sheet. The People’s Bank of China has shrunk its balance sheet dramatically because it is losing foreign-exchange reserves. The European Central Bank won’t engage in further quantitative easing [buying assets to drive down interest rates] beyond its current round, which means QE is finished as a policy tool for now. [Mario Draghi, president of the European Central Bank, suggested Thursday that the ECB might ease monetary policy further in March.] The Bank of Japan will continue with QE reluctantly, but is unhappy with the government of Prime Minister Shinzo Abe because it isn’t delivering on reforms. The BOJ will increase QE when bond yields rise, buying more bonds to push yields down. In sum, the big monetary push we have seen in years past is over. Global liquidity is deteriorating. To complete the picture, the geopolitical backdrop will deteriorate further.
Zulauf: Investors should stay as defensive as possible. If you have to stay invested, stick with sectors such as consumer staples and utilities. My first recommendation is in money markets. I don’t expect the Fed to hike rates further this year. Instead, Fed officials will bring their dots down. [Members of the Fed’s policy-making committee publish their expectations for the federal- funds rate on a chart called the dot plot.] The Eurodollar futures market is predicting two more rate hikes. They won’t be executed because the world economy will turn much softer. The U.S. dollar remains too strong versus emerging-market currencies. It doesn’t make sense to hike rates and make the dollar even stronger.
The U.S. economy will surprise on the downside. I recommend buying December 2016 Eurodollar futures. [Eurodollars are timed dollar-denominated deposits held outside the U.S. The futures contracts are traded on the CME.] Friday’s closing price was $98.94. The implied yield is 1.06%, or 100 minus the price. The actual yield is 0.62%, which means a further rate increase of 44 basis points [hundredths of a percentage point] is priced in. That won’t happen. If the Fed hikes one more time by 25 basis points, you would still earn 19 basis points on the contract, or 44 minus 25. The notional size of the contract is $1 million, and the term is three months. If you buy one contract and earn 44 basis points, that’s $1,100. You can buy 100 or 1,000 contracts, and make your money that way.
How would you lose money on this?
Zulauf: You would lose money if the Fed hikes rates by 25 basis points more than twice.
Do you buy the futures or options on the futures?
Zulauf: We buy both, but I like the futures. In equities, I would short the EEM, or iShares MSCI Emerging Markets exchange-traded fund. [Short sellers sell borrowed shares in the expectation of repurchasing them later at a lower price.]
I recommended this in the June Midyear Roundtable, as well [“2015 Midyear Roundtable–Top Stock Picks,” June 15, 2015]. The ETF is selling for $29.50. The 2008 low was $18.24. I expect it to hit that low again.
Second, I recommend shorting S&P 500 futures. The U.S. corporate sector has a relatively weak balance sheet. Companies have loaded up on debt. The stock market is vulnerable, and prices could go much lower. The average bear-market decline is 22%-23% for U.S. indexes. I am prepared for a decline of more than 20%. People will be surprised by how low the market goes.
Cohen: What is the timing of your projected decline?
Zulauf: It started last spring with a stealth bear market. The first leg down occurred last summer, and a recovery attempt failed. Now the second leg down has begun. There might be a bounce, but then the selling will resume. I expect three down legs from last year’s highs. I am not saying the S&P 500 will fall 50%, but 1600 is my minimum downside target, and I expect the market to hit it this year. This is a global affair; European markets will fall, as well. I would short the weakest market in Europe—Spain, via IBEX 35 index futures. Spanish companies have a lot of exposure to Latin America, Brazil in particular, and Spanish banks will suffer badly.
I mentioned the potential for a banking crisis in Singapore. I don’t recommend shorting Singapore bank stocks, but rather the EWS, or iShares MSCI Singapore ETF. In this case, an investor will benefit from both declining local stock prices and a decline in the Singapore dollar against the U.S. dollar. Finally, in Europe, I recommend shorting the German DAX index and the Euro Stoxx 50, both via futures. My minimum downside target for the DAX is 7500.
Schafer: Where is the DAX trading now?
Zulauf: It is around 9000. I also would short emerging-market currencies, particularly Asian currencies. I would buy the dollar against the CNH, the Chinese yuan offshore. The yuan offshore is priced at about $6.60, and could shoot up to $8.
Cohen: What is your time frame for that?
Zulauf: I expect it to happen this year. This will be an extremely bad year for investors. Hopefully, it will yield many investment opportunities in 2017. You will hear me sounding bullish then.
We don’t believe you.
Zulauf: I would buy the U.S. dollar against the Singapore dollar, which is trading for $1.43-$1.44. I would also buy the dollar against the Korean won and Taiwan dollar. South Korea is the most highly leveraged industrial economy in Asia.
Schafer: Where does gold fit into your investment portfolio?
Zulauf: Gold will be a tremendous trade at some point this year, but we are in a deflationary environment, which isn’t good for gold. When systemic risk thrives, gold could become an important investment, but gold isn’t entering a new bull-market cycle. The price could break below $1,000 an ounce first, and then run to $1,400, so I don’t want to recommend it today. You’ll have to time your entry during the year.
The same is true for bonds. There will be a safe-haven run into U.S. Treasuries, pushing the yield on the 30-year Treasury bond down to 2.50% or so from 2.91%. Then yields will rise again, as the markets assume the authorities will expand the deficit once the economy turns sour. Governments will try to support the system, but we need a calamity to occur first.
Thanks for your thoughts, Felix. Mario, you’re next.
Gabelli: We have talked today about the impact of China’s weakening economy on the commodities market, and how problems in the industrial sector will hurt Standard & Poor’s 500 earnings. I am going to discuss something unrelated: a company I have followed for some time that has grown more exciting [puts on New York Knicks cap]. I am referring toMadison Square Garden [MSG], which owns the greatest sports arena in the world—Madison Square Garden, in New York. The company has 25 million shares outstanding, selling at $154 each, for a market capitalization of $3.8 billion. It has $1.5 billion of net cash, and has committed to buying back $500 million worth of stock.
Madison Square Garden owns several sports franchises, including the New York Knicks, New York Rangers, and New York Liberty women’s basketball team. As a group, its sports franchises could be worth $1.7 billion. In addition to the Garden, the company owns properties such as the Forum in L.A., and the Chicago Theatre. It leases Radio City Music Hall and the Beacon Theatre in New York.
And it is a real-estate play.
Gabelli: That’s right. From Manhattan’s West 34th Street south along the High Line, there has been a construction renaissance. There have been many discussions about renovating Penn Station. The air rights over Madison Square Garden, which sits atop Penn Station, could be worth as much as $500 million, and the company is starting to look at ways to monetize that asset. The combination of cash flow, asset values, and stock buybacks allows me to put a value on the stock of $200 to $300 per share. Another way to look at it is, if you buy the stock, you get the Knicks for free.
Through its 4.5 million B shares, the Dolan family controls the company. There are a lot of ways to make money here by monetizing the company’s assets.
Next, Griffon [GFF] is a small-cap stock. The company has 48 million shares. The stock sells for $16.60. Griffon is involved in several industries. Through its home and building-products division, the company is involved in the U.S. garage-door business. It is a $1.8 billion market, and Griffon’s Clopay unit has a 25% market share. It competes with Overhead Door, and others. It sells mostly through Home Depot. This is a good business, and it is improving. The company has added a few product lines in its home division, including True Temper garden and snow-removal tools.
What are Griffon’s other businesses?
Gabelli: The company is a component supplier for diapers. Procter & Gamble [PG] accounts for half of Griffon’s diaper business, and is gaining share. Griffon’s costs have fallen as resin prices have come down, and these cost savings are passed on to customers. But, on balance, this too is a good business for the company.
Griffon also develops and sells equipment for the military through its Telephonics unit. It makes submarine-monitoring hardware for helicopters, and is a first-tier supplier to Lockheed Martin [LMT]. Military spending will increase in 2016, ’17, and ’18, given China’s more aggressive posture in the South China Sea, North Korea’s reported test of a hydrogen bomb, and the events in the Middle East. The U.S. has underspent on its military, and we’ll have a new president next year, which means spending will rise.
Here are the numbers. Griffon generated revenue of about $2 billion for the fiscal year ended Sept. 30. Ebitda, or earnings before interest, taxes, depreciation, and amortization, was about $171 million. In the current fiscal year revenue could rise to $2.05 billion, and Ebitda, to $180 million. Griffon earned 73 cents a share in its latest fiscal year. It could earn 85 cents a share this year, and $1 in fiscal 2017. Goldman Sachs owns more than five million shares.
Is there any chance Griffon might break itself up or spin off businesses?
Gabelli: We would prefer that they don’t break things up. We’d like management to focus on using the company’s cash flow to grow the businesses it is in, and make a few tuck-in acquisitions. To me, Griffon is in the right businesses.
Kaman [KAMN], based in Connecticut, ties into two themes: higher military spending, and the struggles of the energy, metals, and mining industries. Kaman has about 30 million fully diluted shares. The stock is trading for $38. Pro forma, with two acquisitions, net debt is $435 million. Kaman acquired Timken Alcor Aerospace Technologies from Timken[TKR] for $45 million.
Kaman sells JPFs, or joint programmable fuzes, used to program precision-guided bombs aboard military planes. The U.S. Air Force has placed orders for Kaman’s JPFs, as have other nations. One small but important concern is that the U.S. Navy just awarded a fuze contract to another company, which will be phased in starting in 2021.
Witmer: Which company is that?
Gabelli: It’s Orbital ATK [OA]. Kaman also is a subcontractor to Lockheed Martin for cockpits for the Black Hawk helicopter. It has an aerospace-structures business. But the crown jewel is a business that manufactures tapered rolled bearings for commercial aircraft. As the ramp rate rises on new planes from Boeing [BA] and Airbus Group[AIR.France], Kaman benefits. This business has been particularly strong. Including recent acquisitions, bearings revenue could reach about $300 million this year, and $320 million in 2017. Ebitda could rise from $105 million in 2016 to $120 million in 2017. The JPF business is operating at capacity. Growth can be accommodated by machinery and labor.
What is happening on the industrial side of the company?
Gabelli: That business faces challenges. Kaman generates about $1.2 billion in annual revenue from its distribution segment, which mainly includes the sale of MRO [maintenance, repair, and overhaul] supplies. About 20% of distribution revenue is tied to EMM—energy, mining, and metals. The company acquired a business with operations in Pennsylvania, near the Marcellus Shale. That has become an air pocket: Revenue in the distribution segment declined at an accelerating rate in the fourth quarter, as energy prices fell, and will probably continue deteriorating.
Kaman generates a lot of cash. It is reasonably well-managed, and the defense side of the company will get more traction in coming years. Charles “Chuck” Kaman founded the company in the 1940s. As an aside, the first time I visited his office, the guy’s dog, Otto, came over and put his head on my lap. I didn’t ask any aggressive questions after that.
Chuck Kaman was a smart man.
Gabelli: I expect Kaman to earn $2.90 a share this year and $3.10 in 2017.
Auto-parts stocks were a tale of two cities last year. O’Reilly Automotive [ORLY] was up 31%. Pep Boys—Manny, Moe & Jack [PBY] was up 87%. Genuine Parts [GPC] was down about 20%. Genuine Parts is trading for $78 and has 150.8 million shares. The company has raised the dividend annually for the past 59 years. It has four operating segments. The automotive business, conducted under the Napa name, contributed $8 billion out of a total $15 billion in 2015 revenue. We expect revenue of closer to $16 billion this year and $16.5 billion in 2017.
Why has the stock underperformed peers?
Gabelli: About 25% of automotive revenue comes from Canada, Australia, New Zealand, and Mexico. Revenue was up nicely in local currency last year, but down significantly when translated into dollars. At some point, the currency head wind will flatten out and the negative impact will disappear.
Genuine Parts also has an MRO business, which sells repair parts. It competes withFastenal [FAST] and W.W. Grainger [GWW]. Annual revenue for this business is about $4.5 billion. It has been declining sequentially in the past few months, but the business is OK. I expect Genuine Parts to earn $4.50 a share for 2015, $5 this year, and $5.50 next year. The company pays an annual dividend of $2.46 a share, which it is likely to raise again this year.
Shifting gears [everyone groans], people are uncomfortable with the outlook for emerging markets, but I like Kinnevik [KINVB.Sweden], a Swedish company that has several emerging-market subsidiaries. I recommended it last January. If you give $1 billion to a private-equity fund, they take fees and 20% of profits, and you have no liquidity. In Kinnevik’s case, you can invest in a basket of companies selling at a discount to net asset value; management doesn’t take two-and-20 [2% in fees and 20% of profits], and you can get your money out.
What is the stock price?
Gabelli: Kinnevik has 277 million A- and B-class shares. The stock was priced at 238 Swedish kronor [$28] last Friday. Kinnevik has investments in e-commerce operations. The business I am focused on is Millicom International Cellular [MIICF].
Millicom has 60 million wireless customers in Africa and Latin America. In Africa, it is cash break-even. At some point, Millicom will be able to monetize its African business. The Latin America business operates in Costa Rica, Honduras, Guatemala, El Salvador, Bolivia, Colombia, and Paraguay. The company already has sold off its Asian operations.
How will it monetize the Latin American portion?
Gabelli: John Malone [chairman of Liberty Media /LMCA] recently merged Columbus International, a telecom provider in the Caribbean and Central and South America, into Cable & Wireless Communications [CWC.UK], in which he has a stake. Last summer Liberty Global [LBTYA], which he controls, created a tracking stock called Liberty LiLAC Group [LILAK] to track its operations in Latin America and the Caribbean. Next, Malone is likely to use Liberty LiLAC to further consolidate operations in that part of the world. Millicom is likely to be sold at the right price. The current CEO of Millicom previously ran the Chilean operations of Liberty LiLAC.
What could Millicom be worth in a break-up and sale?
Gabelli: Let me put it this way: If I were running Millicom, I would first sell off the African business for a couple of billion dollars. It has about $200 million in annual Ebitda. Then I would consolidate Latin American operations with Malone’s. This is going to be a big winner. Here’s the math: Millicom has 100 million shares. The U.S. shares are trading for $52. The company could generate $7 billion in revenue this year, and $2.3 billion in Ebitda. Next year revenue could hit $7.4 billion, and Ebitda, $2.4 billion. Annual capex is $1.2 billion, so the business is cash-flow positive.
Next, CBS [CBS] has 38 million class A shares, of which Sumner Redstone’s National Amusements owns 30 million. There are eight million in public hands. Our clients own about four million of the A shares. The A shares are selling around $50, and the B shares, at $46. There are 474 million shares in all. CBS has an equity-market capitalization of $22 billion; $8 billion of debt, and an enterprise value of $30 billion. The company operates television stations and produces content for TV.
CBS had $13.8 billion in revenue last year, going up to $14.6 billion this year. Election-related and Super Bowl 50 advertising will bolster revenue in 2016. Ebitda was $3.1 billion, and could rise to $3.4 billion. The company might be harvesting assets through the spectrum auction later this year. The prior spectrum auction generated proceeds of more than $40 billion, although this auction won’t generate close to that, due to buyer exhaustion.
What is CBS likely to generate in earnings?
Gabelli: The company earned $3.30 a share last year, and could earn $3.90 this year and $4.25 next year. The stock is selling for 11 times next year’s estimate. The broadcasting business accounts for almost $9 billion of revenue. On the programming side, I like Ray Donovan better than Downton Abbey, and I like The Walking Dead.
Gundlach: That’s a lot of TV.
Gabelli: In addition to big sources of advertising and the spectrum sale, there is CBS All Access, the company’s “over-the-top” or streaming service.
Black: The stock is cheap statistically, but [CBS CEO] Leslie Moonves makes north of $50 million a year and hasn’t delivered much top-line growth.
Gabelli: Come on, hedge-fund managers make a lot of money. This guy [points to Gundlach, sitting to his right] runs $63 billion in fixed-income portfolios, and makes a lot.
Give us the range of outcomes at CBS.
Gabelli: Redstone is 92. When he passes from the scene, will his family hang on to Viacom [VIAB], which he also controls, and sell CBS? A lot of organizations and individuals might like CBS.
Lastly, Discovery Communications [DISCA] has 645 million shares outstanding: 223 million A shares have one vote, seven million B shares have 10 votes, and 415 million C shares don’t get a vote. Malone is involved with this company, too; he owns about six million of the B shares. Discovery has $7.3 billion of debt, and a $25 stock price. It has a market cap of $16 billion and an enterprise value of $23.7 billion. The company’s various cable-TV channels generated $6.4 billion of revenue in the latest year, about half outside the U.S.
Revenue could climb to $6.8 billion this year and $7.2 billion next year. We forecast Ebitda of $2.6 billion for 2016, and $2.9 billion for 2017. The company earned $1.80 last year. It could earn $2.15 this year and $2.55 next year. Neither CBS nor Discovery has much capex. They are great cash generators. The big issue for Discovery is how to migrate its content to global platforms, including smartphones. The CEO, David Zaslav, is terrific. Discovery won the non-U.S. broadcast rights for the Olympic Games from 2018 through 2024. That’s it.
In that case, thank you. Jeffrey, it’s your turn at bat.
Gundlach: Felix laid out a lot of facts that I have also been observing. I agree that the Fed won’t be able to raise interest rates according to its dots, particularly if you follow the dot plot to the end of 2017. It suggests the Fed will hike rates eight times, by 200 basis points in all. Based on the deterioration in stock prices, commodities, and junk bonds, I have been waiting for the Fed to start dialing back its rate-hike rhetoric. We got a little of that today, when Dennis Lockhart [president of the Federal Reserve Bank of Atlanta] said the Fed might not have enough data to move rates up in March.
According to some fixed-income managers, the step-function decline in junk-bond prices has created an overwhelmingly attractive opportunity. At DoubleLine, we are not of that opinion. While junk bonds tied to the commodities complex are due for a rally, it will be a rally within a correction. Like Felix, we believe China is growing at a much slower rate than the government claims and people want to believe. The World Bank recently dropped its global growth estimate for 2016 to 2.9% from 3.3%. Since China is 16% of the world economy, global growth might be only 2%.
In this environment, currency devaluation becomes the only tool to spur growth for many countries experiencing negative GDP. In Brazil, the largest economy in South America, GDP growth is negative 4%, even if the country’s finance minister says it is negative 2%. Again, like Felix, I recommend shorting the iShares Emerging Markets ETF.
We allow doubles.
Gundlach: The correlation between the emerging-markets ETF and commodity prices is incredibly high, and the gap today between commodity prices and the ETF price is remarkably wide. This suggests further downside in emerging-market stocks. The MSCI Emerging Markets Index, which the ETF tracks, is now around 700. If commodities prices stay at current levels, history suggests the index should be around 450. It would probably overshoot to the downside, so you could be looking at a 40%, or possibly 50% decline.
How much worse could things get in the junk-bond market?
Gundlach: I expect it to remain challenged. It would require a big rally in commodities prices to avoid a debt-default cycle. However, a portion of the credit market has a safety cushion large enough to absorb another 200- or 300-basis-point widening in junk-bond spreads versus Treasuries. I’m referring to closed-end bond funds, which trade on the New York Stock Exchange. Closed-ends are one of the best plays on the Fed not raising interest rates. I like them better than the Eurodollar futures idea Felix discussed.
Closed-end funds are leveraged, and investors have been afraid to own them because they fear that the Fed has launched a tightening cycle. Also, based on daily data going back 20 years, they have traded at a 2% discount, on average, to net asset value. Recently, however, the sector traded at a 10% to 12% discount to NAV. It has traded at such a steep discount only 5% of the time. In the past 20 years, the discount has been wider than that only during the financial crisis in 2008-’09.
Rogers: Are you referring only to fixed-income closed-ends?
Gundlach: Yes. If history is any guide, discounts would widen further only in a 2008-type scenario, which is possible, although doubtful so soon after the prior crisis. Under current circumstances, you have about two percentage points of downside, and 10 points of upside to return to the historical discount. That makes a basket of closed-ends attractive. If you bought a junk-bond-oriented closed-end trading at a 12% discount to NAV, some of the bonds would be trading at a 15% discount. This isn’t a bad idea, but I prefer Brookfield Total Return fund [HTR]. It is trading just as poorly as some other closed-ends, but is vastly safer.
Brookfield’s NAV is $25.75 a share. It is trading at $21.77, for about a 12% discount to NAV. It pays a monthly dividend of 19 cents, which it hasn’t changed for more than seven years. While investors have been crushing anything that is interest rate-exposed, there is also little ability in the closed-end fund market for institutional investors to arbitrage the discounts. For example, at DoubleLine, we manage $85 billion. You thought it was $65, huh? $85, bro.
Gabelli: I said $63. My estimates are always low.
Gundlach: There is no way I could buy these institutionally without the discounts instantly disappearing, because the volume is so low, relative to the amount I would have to buy to make a difference on DoubleLine’s $85 billion in assets. Closed-ends are a good opportunity for the retail investor.
Brookfield Total Return yields 10.47%. It is leveraged 35%; hence, the worry about interest-rate risk. Junk bonds and commodities are Ground Zero of the bond market’s and the economy’s problem, but only 8% of this fund’s portfolio is corporate credits. Another 2% is preferred stocks, and the rest is mortgage-backed securities. MBS are immune to the problem of lower commodities prices. Lower oil prices actually help homeowners put extra cash in their pockets. That makes it more likely they will make mortgage payments.
Gabelli: Having seen The Big Short, I’m nervous about MBS.
Gundlach: Trust me, there aren’t a lot of MBS from North Dakota [a major shale-oil region]. The MBS are non-government-guaranteed, so defaults could be an issue. Yet with housing prices having risen for four years and consumers getting a break on oil prices, the fundamentals are favorable. While I like HTR, an investor could put together a basket of closed-ends yielding 10% and 12% and selling at a 10% to 15% discount to NAV.
Priest: With respect to closed-end funds, if you assume that the management fee is a perpetual claim on net asset value, the present value of that stream of future claims will almost always lead to a market price below the funds’ NAV. Historically, that discount can vary, but 8% to 10% is not uncommon.
Gundlach: Your argument makes mathematical sense, but historically that discount has been 2%. A reversion to the mean isn’t unheard of; based on recent discounts, it would amount to a 10% gain in the price.
Witmer: With the yield, the return would be 20%.
Gundlach: I was getting to that. The S&P 500 yields 2%. Either the credit market has to improve, or stocks have to fall further, because there has been a yawning gap in the performance of these markets in recent months. If the S&P rises 10%, closed-ends could return 20%. If the stock market falls 30%, a decline is already priced into these funds. I look at closed-end funds as a good place to put your risk money.
What is the best way to assemble a basket of quality closed-ends?
Gundlach: You have to decide which sectors you are interested in, and look up the discounts to NAV because they aren’t homogenous. [Barron’s publishes weekly data onclosed-end funds in the Market Data section of Barrons.com.]
Priest: In my prior life, we ran many closed-end funds. We decided to adopt a novel policy: Charge investors based on market value, rather than the net asset value. Yet the discount to net asset value didn’t change at all.
Gundlach: I’m not surprised. Closed-end funds aren’t well understood.
Priest: It seems logical to invest in liquid fixed-income closed-ends, rather than those equity closed-ends with a preponderance of illiquid private placements, where values aren’t determined by the market or an independent third party. Moreover, for some funds, frequent rebalancing of the portfolio may cause large capital gains. Low-turnover equity closed-end funds make sense.
Witmer: Who lends closed-ends money?
Gundlach: A fund manager can establish a bank line of credit or do a reverse repo [reverse repurchase agreement].
Black: What happens to the mortgage portfolio if interest rates rise?
Gundlach: It is a bond portfolio, so it will go down. But priced at a 12% discount to NAV, it is trading at what it would be worth if rates were 150 basis points higher. That’s the cushion of safety. You have to ask yourself, in what context would rates rise? The economy would be doing OK, and the backdrop would be less deflationary. The discount would absorb some of the impact of higher rates. The discount is the secret sauce here. If you can acquire a $100 bill for $85, I recommend that you do so, assuming you consider a $100 bill attractive to begin with.
It wasn’t so long ago that people would do just about anything to get a 7% yield. Those who bought master limited partnerships lost a lot of money. Now there is plenty of yield out there, and people say they’re afraid of the Fed. Fears that the Fed will raise rates significantly are overblown. This brings me to Annaly Capital Management [NLY], one of the largest mortgage REITs [real-estate investment trust]. It has an $8 billion market cap and has been trading at a 25% discount to book value for some time. It is probably riskier than HTR because it is leveraged about six times, so there is significant exposure to borrowing costs that could rise over time.
Schafer: What is the stock price?
Gundlach: It is selling for $9.41. A few years back, it sold for $18. These sorts of stocks have step-function moves. They don’t move by a few percent; they go from $18 to $12 and from $12 to $9, and if the yield curve is inverted, and they have to cut their dividends, things get really bad. But a discount of 30% to book value is the widest ever for Annaly, and historically very wide for a mortgage REIT. Annaly is paying a dividend of 30 cents per quarter. It yields 12.75%. The environment for Annaly has improved.
Schafer: Didn’t Annaly cut its dividend?
Gundlach: Management cut it in 2013, but it has been at this level for a while. When rates rose sharply during the “taper tantrum” in 2013, after the Fed hinted it was going to reduce asset purchases, Annaly appropriately got scared and reduced its leverage. When you reduce leverage, you reduce your earnings power, and then you have to cut your dividend. Annaly primarily owns government-guaranteed mortgages and tries to hedge the interest-rate risk. This is challenging, but they survived the credit crisis by doing so. You have to give them credit for that. The discount to net asset value got as wide as 30% back then, in a far more challenging environment. At today’s discount, a lot of bad things are priced in. If the Fed doesn’t raise interest rates much, the stock should go higher.
Black: At Annaly, there used to be a mismatch between funding the assets and liabilities.
Gundlach: That is always a challenge. They are buying mortgages with an instability aspect to them, as they don’t know exactly when the mortgage holders will pay them off. The hedges are largely Treasury- or swaps-based [interest-rate swaps], and they don’t have the same instability. That is why these stocks can be volatile. But there are a lot of ways for this to go right, and if it doesn’t, you’ll just have to cry your way to the bank, clipping a 12.75% yield.
Why buy Annaly, as opposed to another mortgage REIT?
Gundlach: It is highly liquid. I have even been able to buy some shares in our institutional business. Also, I know the company and have talked to management several times.
A third way of getting income is pretty risky, but I like it a lot. I’m talking about Puerto Rico GOs [general-obligation bonds]—the 8% GOs due in 2035. The general-obligation bonds have the highest constitutional protections, which means borrowers must be paid first, ahead of other commonwealth debt holders. Puerto Rico has shown a willingness to default on some of its debt, but defaulting on this would be tough.
My thesis for owning Puerto Rico debt has a lot to do with Florida. There are many voters in Florida with ties to Puerto Rico, and Florida is a critical state to win in the presidential election. I started buying the bonds around 80, and bought more at 71. The bonds are triple tax-exempt, meaning interest payments to U.S. citizens aren’t taxed at the federal, state or local level. In a high-tax state such as California, an 11% or 12% yield is equivalent to 23%, taxed. Maybe I won’t get back 100 cents on the dollar. Maybe the government will let Puerto Rico go. But President Obama spoke in the Puerto Rico statehouse with the U.S. flag sewn together with the flag of Puerto Rico. It doesn’t guarantee anything, but it is a reason to take a flyer. Even if the debt is restructured, you might get 70 cents on the dollar, and you’re getting eight points of coupon per year. This particular issue is a few billion dollars.
Gabelli: If you were running the country, what would you do to help Puerto Rico?
Gundlach: I would extend them the ability to file for bankruptcy protection, and restructure what they can. I might extend them some sort of lifeline economically. I am not advocating this, and I don’t care what shape a restructuring takes. But at 73 cents on the dollar, you’re going to make decent money, particularly if you’re a taxable investor. It is a speculative investment.
Next, investors often use diversification to justify buying things that are up a lot, but bond investors who haven’t diversified beyond the U.S. might consider doing so. The DoubleLine Core Fixed Income fund [DBLFX] was 100% dollar-denominated since 2011, when the dollar was at a low. For the first time ever last week, I started to buy a diversified basket of non-dollar-denominated fixed-income assets of developed countries. The dollar is overvalued. It rose 25% in a year. People think a stronger dollar accompanies the start of a Fed tightening cycle, but history suggests otherwise. It is possible, even likely, that the Fed wants to dial back some of its rate-hike rhetoric. If that is the case, the dollar could weaken about 10% against a basket of currencies.
Schafer: Being long the dollar is a crowded trade.
Gundlach: Everyone is on one side of the boat, and they justify it by saying the Fed is going to tighten.
Zulauf: So you are buying the currencies of other industrialized economies?
Gundlach: Yes—even the Canadian dollar, which looks like death because of the drop in oil prices. We are overdue for a commodity rally.
What is the best way to execute this investment?
Gundlach: BWX [ SPDR Barclays International Treasury Bonds ETF] would do the job. One reason Treasury yields bottomed in July 2012 was because Europeans were buying dollars like crazy. They did that by buying bonds. You had a monstrous move in the U.S. bond market that took the 10-year Treasury yield down to 1.38%. Now it is nearly 100 basis points higher. I am advocating diversification into developed-country currencies.
Finally, while I regard U.S. equities as a much better bet than emerging markets, I recommend buying the India stock market through the iPath MSCI India exchange-traded note [INP]. Indian equities could have a hard time as emerging markets sell off, but the labor force is growing. India will be the China of the next generation, in terms of equity returns. Things are bad. India has a lot of corruption. That means things might get better.
You made a high-profile negative call on Apple [AAPL] a few years ago. What are your thoughts now?
Gundlach: I recommended shorting Apple in April 2012 at $600 a share [prior to the company’s 7-for-1 stock split]. The stock rose to $700. That’s when everyone mocks you. But I insisted it would fall below $425. It did, and we bought it at $405. Then we sold it too soon. I don’t have a position or a strong view now. The stock isn’t expensive, but I have an allergy to high-market-cap stocks in general, because I don’t understand how they can compound when they are already so big. [Apple’s market cap is $533.9 billion.]
Barron’s 2016 Roundtable, Part 3: 12 Stocks That Could Outperform
Scott Black, William Priest, Meryl Witmer like the undervalued, including Foot Locker, CVS Health, Axalta.
While stock market selloffs are painful, there is an upside to all that downside: a fresh profusion of bargain-priced shares. Just ask the three top-notch investors featured in this final installment of the 2016 Roundtable—Scott Black, William Priest, and Meryl Witmer. Value investors all, they suddenly see ample opportunities that didn’t exist a few months ago to invest in companies with attractive prospects, strong financials, and invitingly cheap shares.
Scott, the founder and president of Boston’s Delphi Management, told our Jan. 11 gathering of Wall Street savants that he’s on the hunt for companies with accelerating earnings growth. He appears to have found them in multiple and diverse industries, ranging from semiconductors to sneakers to generic drugs. Scott builds financial models the way Gaudi must have built his architectural models: piece by exacting piece. One could learn a lot from his process about how companies prosper and grow.
Bill, a new face at our annual confab, captains New York’s Epoch Investment Partners, which he co-founded after doing time, and doing well, elsewhere on the Street. At Epoch, he’s all about free cash flow—how companies generate it, and how they return wealth to shareholders. No raging bull, he recommends staying defensive in rock-solid issues, like CVS Health (ticker: CVS), one of his four favorite picks for the new year.
Meryl, a general partner at New York’s Eagle Capital Partners, is hungry for knowledge and contrarian to the core. Once she finds a company, typically little-known, whose outlook is appealing and stock mispriced, she burrows into the business and its financials until she understands them better than the boss. That could well be the case with her current recommendations, including a specialty-coatings company and a Belgian industrial conglomerate. Want to know about liquid-fertilizer production techniques? You have come to the right source.
As readers of earlier Roundtable issues know, the focus this year was on disquieting trends in the global economy that could halt the bull market’s advance. In the dictionary, opportunity precedes trouble, but as this issue’s stellar stockpickers remind us, in markets the opposite pertains.
Barron’s: Scott, what appeals to you in this crazy, mixed-up market?
Black: I have five stocks whose underlying theme is sustainable earnings power—rising earnings power, in fact. We are deep value investors; all five have low valuations on an absolute, not a relative, basis. Townsquare Media [TSQ], based in Greenwich, Conn., sells for $10.48 [closing price on Jan. 8]. There are 27.4 million shares, fully diluted, and the market capitalization is $287 million. The company doesn’t pay a dividend. Townsquare is the third-largest radio-station operator in the U.S., with 309 stations in small markets. The company also has more than 325 companion Websites.
Townsquare bought North American Midway Entertainment, the largest runner of state and local fairs in the U.S., last year, for $75.5 million, or 6.7 times Ebitda [earnings before interest, taxes, depreciation, and amortization]. North American Midway runs 650 live-music and non-music branded events, with more than 16 million annual attendees. It is the No. 1 provider of rides, games, and food at fairs and festivals. Townsquare’s CEO, Steven Price, is a finance person
Black: Townsquare had $478 million in revenue last year, including North American Midway. This year, with the help of $10 million in political advertising and 12% growth in live events, we estimate revenue will rise to $520 million. We foresee radio Ebitda of $121 million, based on 30% margins, and Ebitda of $22 million in the rest of the business, based on margins of 18.5%. If operating income is $90 million and interest expense is $30 million, profit before tax would be $60 million. Taxed at 39.6%—although it doesn’t pay taxes, due to net operating loss carryforwards [a tax benefit stemming from prior losses]—Townsquare could earn $36.2 million, or $1.32 a share. The stock is selling for 7.9 times this year’s expected earnings.
Witmer: How long does the tax shelter last?
Black: It lasts through 2018. Townsquare has $606 million in net debt. Free cash could total between $1.82 a share and $2.19 this year, well above reported earnings. The stock is selling for 6.2 times estimated discretionary cash flow.
Management is aiming to deleverage the balance sheet. Gross debt currently equals 5.7 times Ebitda, and the company plans to reduce it to five times Ebitda this year. The goal is to get down to four times Ebitda in the next year or two. In the latest quarter, the Ebitda-to-interest ratio was 3.9 times. Townsquare also has a $50 million bank line of credit, which it hasn’t tapped.
Witmer: Has it been public for a long time?
Black: It came public about 18 months ago.Oaktree Capital Group [OAK] owns 45% of the stock. Because Townsquare’s stock is so cheap, Oaktree is likely to hold it long term, which means more than two picoseconds.
My second stock, Foot Locker [FL], is one of the few bricks-and-mortar retailers doing well. It is a leading seller of athletic running gear and apparel. The stock closed Friday at $62.70; there are 140.9 million fully diluted shares, and the market cap is $8.8 billion. The company pays a dividend of $1 a share, and the stock yields 1.6%. The store count has barely increased in the past four years, and stands at 3,432. Earnings have grown in that period at a compounded annual rate of 35%, from $1.07 a share to $3.56. Sales per square foot are up 8%, compounded, to $490 from $360.
The company generates about 70% of its sales in the U.S., and 30% overseas, mostly in Europe. Online growth has run at 12% of revenue, but will probably trend higher. Nike products represent 70% of revenue.
What will drive growth from here?
Black: By adding some new stores and remodeling others, Foot Locker plans to grow square footage by 2% to 2.5% in the next few years. It has set a goal to lift revenue to $10 billion by 2020 from $7 billion now. It wants to take sales per square foot up to $600, and Ebit [earnings before interest and taxes] margins from 11.4% to 12.5%. Management’s stated objective is to grow earnings by 10% or more per year.
Foot Locker will finish the January fiscal year with revenue of $7.41 billion and earnings per share of $4.27. These are my estimates, not the Wall Street consensus. I budgeted for 4% same-store sales growth in fiscal 2017, and 2% square-footage growth. Ebit could total just over $1 billion. Taxed at 35%, the company could earn $658 million in fiscal 2017, or $4.75 a share. It plans to buy back $300 million of stock, or five million shares. The stock sells for 12.1 times fiscal-2017 estimated earnings, excluding $5.31 a share in net cash.
Operating sources of cash could total $838 million next year. We’ve got capital spending at $275 million, including $50 million in expenditures to relocate corporate headquarters. That leaves free cash flow at $563 million. Return on equity is 20%; return on capital, 20%-plus.
How is the competition doing?
Black: Finish Line [FINL] has been struggling.
We have had few tech-stock recommendations today. One tech stock we like is Lam Research [LRCX]. The company is a semiconductor-equipment maker focused on front-end chip production. The stock is trading for $70.48. There are 174.4 million fully diluted shares, and the market cap is $12.3 billion. Lam pays an annual dividend of $1.20 a share, for a 1.7% yield. Lam is strong in two areas: wafer etch, where it has a 50% market share, and chemical vapor deposition, where it has a market share in the high-30% area. Lam also is involved in wet-clean and photoresist, another component of semiconductor manufacturing, in which it has a smaller market share. Lam is the only semiconductor-equipment manufacturer whose revenue and earnings grew last year.
Why was it such a standout?
Black: It serves faster-growing markets, and it has gained market share. The company is benefiting from 3-D NAND memory and finFET, or multilayer chip technology. Its current business mix is 72% memory, 18% foundry, and 10% logic. Lam reports in dollars, even though most of its sales are in Asia. In the latest quarter, Taiwan accounted for 28% of revenue; Japan, 18%; Korea, 17%; China, 16%; Southeast Asia, 8%; and the U.S., 9%. Lam struck a deal last year to buy KLA-Tencor [KLAC], a leader in chip-inspection tools.
In the year ended June 2015, Lam reported $5.26 billion in revenue. We expect revenue to rise 11% in the current fiscal year, to $5.86 billion. Operating profit could total $1.3 billion, and profit before taxes, $1.22 billion. The company has a low tax rate of 15%, yielding net income of $1.036 billion. Divided by 172 million shares, that’s $6.02 in earnings per share. The company has $11.30 a share in net cash, although that will disappear when the KLA deal is completed. Lam sells for 9.8 times fiscal-2016 estimates. Pro forma return on equity and return on capital are 18.5%.
What is your earnings forecast for 2017?
Black: After adding deal-related cost savings, deducting additional interest expense, and adding another 80 million shares that Lam will issue, we get earnings power of $7.60 a share in fiscal 2017, a dollar more than Lam was projected to earn before the deal. This is a smart, highly accretive acquisition, in a complementary business. It is hard to believe that a company with so much proprietary knowledge sells for only 10 times expected earnings. Many of Lam’s scientists have ties to Stanford University. Lam funds all sorts of research-and-development projects at Stanford. The CEO, Martin Anstice, has done an excellent job.
Give us your thoughts on the company.
Black: The stock closed Friday at $49.42. There are 514 million fully diluted shares; the market cap is $25.4 billion, and there is no dividend. Mylan has approximately 1,400 products. It has 40 manufacturing sites worldwide, and has more than 260 ANDAs pending.
Black: It stands for abbreviated new drug applications. Mylan plans to seek approval for a generic version of Advair [a GlaxoSmithKline (GSK) asthma treatment] and Copaxone [a treatment for multiple sclerosis sold by Teva Pharmaceutical Industries (TEVA)]. Advair is an $8 billion drug; Copaxone is $3.3 billion. Mylan also sells the high-margin EpiPen [an epinephrine auto-injector used to treat life-threatening allergic reactions]. It has a 95% market share.
Last year, the company bought Abbott Laboratories ’ [ABT] generics business, primarily focused on Europe, for $5.3 billion. The unit’s earnings are a bit of a black box, but here are the numbers. In the past four years, Mylan grew revenue at a compounded annual rate of 9.1%. Operating income grew by 17%, and earnings per share climbed 36%, to $2.34, from 68 cents. In August 2013, Mylan detailed a new five-year goal of 13% annual revenue growth. It expects to earn a minimum of $6 a share in 2018. The company generates 48% of its revenue in North America, 28% in Europe, and 24% in the rest of the world.
One question we ask is, Will the government reduce the price paid by Medicaid and Medicare for generic drugs?
How do you answer?
Black: It is unlikely, but the company has built up a huge reserve in the event this happens. It was $592 million at the end of last year. We expect Mylan to report revenue of $9.67 billion for 2015, rising 10%, to $10.64 billion, in 2016.
Schafer: On what basis do you make estimates like this? I have never owned these companies because it is too hard to figure out how they are going to grow.
Black: Historically, Mylan has grown annual revenue between 9% and 10%. It is filing for all sorts of new drugs, and management has run the business well. Gross margins this year could be around 58%, producing $6.17 billion. We model pretax profit at $3.02 billion. The tax rate is only 18% because the company redomiciled abroad; it is headquartered in the United Kingdom. But this gets you to net income of $2.48 billion, or $5.02 a share. The Street is at $4.95 to $4.96. The stock trades for 9.8 times earnings. Return on equity is 24%.
My last name, U.S. Bancorp [USB], is based in Minneapolis. It is probably the most conservative big bank in reserving for loan losses. The stock trades for $39.70; there are 1.766 billion shares, and the market cap is $70 billion. The company pays a $1.02 dividend, for a yield of 2.6%. In 2014, U.S. Bancorp had the highest return on equity among the majors, at 14.7%. It had the highest return on assets, at 1.54%, and one of the best efficiency ratios, at 53.2%. As of third-quarter 2015, return on assets was 1.44% and the efficiency ratio, 53.9%.
Where does the bank rank in asset size?
Black: It is No. 5 in the U.S. in assets. The bank is targeting 5% to 7% annual growth in net interest income, 7% to 9% growth in noninterest income, and 3% to 5% growth in noninterest expense. It won’t meet those targets this year, due to the low interest-rate environment, although for every 50-basis-point [half-percentage point] uptick in rates, net interest income will increase by 1.7%, because assets reprice faster than liabilities. The bank aims to grow earnings per share by 8% to 10% a year, with an efficiency ratio in the low-50% range.
U.S. Bancorp operates in four business segments. Payment services and credit cards account for 30% of revenue, wealth management is 11%, consumer and small-business loans is 42%, and the wholesale banking and commercial real estate unit is 17%. The bank operates in 25 contiguous states from the West Coast to the Midwest. Net interest margins have been stable at 3.04%. The bank’s Tier 1 equity ratio is off the charts, at 9.2%. The most impressive fact is that U.S. Bancorp has the best reserve for loan losses to nonperforming assets of any major bank in the U.S., at $3.965 billion. The nonperforming assets, including other real estate loans, are $1.525 billion. The coverage ratio is 2.6 times.
Priest: What is the book value?
Black: Book value is about $23 a share. I have modeled a 4% increase in net interest income for 2016, to $11.5 billion. After provisioning for loan losses, it is $10.3 billion. Noninterest income is $9.6 billion. Noninterest expense could increase by 3.5%, to $11.5 billion. Profit before taxes of $8.4 billion, taxed at 27%, gets you to $6.13 billion in after-tax earnings. We assume the bank will spend $2 billion to buy back 50 million shares, which puts earnings per share at $3.52. The price/earnings ratio is 11.3—low for a quality bank.
Thank you, Scott. Bill, are you ready?
Priest: Sure! We put out a piece toward the end of last year, stating that we expect equity markets to struggle to post positive returns in 2016. Global growth is poor. There has been a modest tightening in monetary policy, which I don’t expect to last, and there is a real risk of a blowup in emerging markets, particularly China, which contributed 46% of the growth in the world economy in the past five years. Money managers focused on emerging markets are hemorrhaging assets, and the bottom in these markets isn’t near. Given this backdrop, investors need to be defensive. That means sticking with consumer-staples, health-care, and some technology stocks. In general, I would stay away from materials and most energy companies, and be wary of the industrial sector.
Give us the details, please.
Priest: CVS sells for around $93. The market cap is a little over $100 billion. The company’s free cash flow and earnings are almost identical. CVS could report $5.20 a share in earnings for 2015, probably $5.80 in 2016, and $6.50 in 2017. Free cash flow could go from $5.30 to a range of $4.90 to $5.50. The company runs one of the largest retail-pharmacy chains in the U.S. Annual revenues are just over $150 billion. It is also one of the largest pharmacy-benefit managers.
CVS is benefiting from several tail winds. One is the expansion of health-care insurance coverage under the Affordable Care Act, or Obamacare. Also, like many companies, it is benefiting from the aging of the baby boomers. Sales of specialty pharmaceuticals and generics are increasing, and, last year, CVS made two strategic acquisitions. It bought Omnicare, a leader in the institutional-pharmacy market, with a 40% market share; Omnicare probably took some business away from McKesson [MCK], which lowered its fiscal-2016 earnings guidance today [Jan. 11]. CVS also acquired 1,672 pharmacies from Target [TGT] for $1.9 billion in cash. That’s very cheap; they couldn’t build this business for that price.
Are you referring to the pharmacies within Target stores?
Priest: Yes. They will be rebranded as CVS pharmacies. CVS has provided 2016 guidance for revenue to be up more than 17%, and for adjusted earnings to come in between $5.73 and $5.88 a share. The company continues to return a large amount of free cash flow to shareholders. CVS generates close to a 6% shareholder yield if you combine a 4% yield from stock buybacks and a yield of almost 2% from a cash dividend.
Witmer: Do you mean the company is shrinking its share count by 4%?
Priest: On a net basis, yes, although this leads to another point. Some companies buy back their shares, but the impact on share count is offset by share issuance in connection with the exercise of employee stock options. That isn’t the case at the companies in which we invest. We are careful in measuring the net effect of buybacks.
My next stock, Synchrony Financial [SYF], was spun out of General Electric [GE]. It is the largest private-label credit-card company in the U.S. Synchrony has a little more than 800 million shares outstanding, and the stock sells for $29. Tangible common equity is just over $13 a share. The company could report $2.60 a share in earnings for 2015, and could earn $2.80 in 2016 and $3.10 for 2017. [Synchrony reported on Jan. 22 that it earned $2.65 a share in 2015.] Synchrony has a 40% share of the $100 billion private-label credit-card market.
Retailers like private-label cards because they bypass the networks and their costs are lower. They have access to more customer data than they receive from a general-purpose card used in their stores. Also, retail partners receive a portion of the profits of the card portfolio. Spending on Synchrony credit cards is growing at a faster rate than the industry. Account balances are also growing faster. Synchrony receivables are growing by double digits compared to a growth rate of 4% for private-label cards and 3% for the industry in general.
Gabelli: The company has its own clearing network.
Priest: Private-label cards at large merchants account for 70% of Synchrony’s revenue. The company also has a consumer-credit business at smaller merchants, which contributes 20%. And it provides financing for elective medical procedures and veterinary procedures. Synchrony is a pure play on the American consumer. The most troubling aspect of these sorts of companies is the percentage of receivables tied to borrowers with low FICO credit scores. Throughout the industry, it is about 20%. We would like to think Synchrony has a good handle on its borrowers, but if credit risk increases among consumers, these companies might feel it a bit. In short, with Synchrony, one has a highly liquid, well-capitalized balance sheet and a motivated management. We expect a share-buyback program and a cash dividend later this year.
NorthStar Realty Europe [NRE] is a tiny company with a $680 million market cap, about $1.8 billion of debt, and $320 million of cash. There are 63 million shares outstanding, and the stock yields 5.5%. NorthStar is a New York Stock Exchange–listed real estate investment trust. It invests exclusively in European commercial real estate, nearly all Class A space in the U.K. and on the Continent. It is trading at a large discount to net asset value. This portfolio was assembled before the European Central Bank embarked on its current, expansive monetary policy, which means all the properties are likely going to be revalued upward, given the lower discount rate that now exists.
David Hamamoto, the chairman of NorthStar Realty Finance [NRF], is the key executive behind this entity, as well. He is a smart guy who previously worked at Goldman Sachs. NorthStar Realty Europe is selling for $10.53 a share. Net asset value at cost is $16 per share, but at today’s value, it is closer to $20. One may receive meaningful price appreciation from the current price, plus a dividend.
Black: I owned NorthStar Realty Finance. It almost wound up in bankruptcy protection in 2007-08, due to a mismatch of assets and liabilities. How do you know that won’t happen again?
Priest: Hamamoto learned his lesson.
Rogers: A brush with bankruptcy is all it takes.
Priest: NorthStar Realty Finance spun off NorthStar Realty Europe last year. It has been transparent about what is happening at NRE.
Next, Vodafone Group ’s [VOD] Nasdaq-listed shares are trading around $32. The market cap is $85 billion. Vodafone is one of the top three wireless telecom providers. It is a low-risk, modest-total-return story, with upside of 10% to 12%. We don’t see much downside. The current yield exceeds 5%, and the company is transitioning from a negative free-cash-flow position to a positive one in the next few years. Capex growth peaked in 2014-15. It is going to trend down in the future. Growth, if it comes, will come from more 4G data consumption. Europe accounts for 70% of Ebitda, and the regulatory regime there is improving. India contributes 10% to 11% of revenue, and South Africa, 8%. Vittorio Colao, the CEO, owns 11 million ordinary shares, worth about 25 million pounds [$35 million]. Periodically, there are rumors they will link with another telecom company, which could produce significant synergies, depending on the terms.
Gabelli: Buying Liberty Global [LBTYA] would be a logical next step. Vodafone is a cheap stock and a good way to play currency movement between Europe and the U.S.
Thanks for your thoughts, Bill—and Mario. Meryl, we know the wait will be worth it.
Witmer: The market has fallen sharply and quickly, creating some good opportunities for us. Axalta Coating Systems [AXTA] is one. It trades for $25 a share and has about 245 million shares outstanding, including options. The company manufactures specialty paints for cars, trucks, and industrial machinery. The management team, together with Carlyle Group, bought the business from DuPont [DD] at the beginning of 2013, and took it public in the fall of 2014 at $19.50 a share. Our investment thesis begins with management, which has done an exceptional job in continuing to build the company. DuPont milked it for cash, but Axalta’s chief executive, Charles Shaver, and chief financial officer, Robert Bryant, transformed the business by bringing in top talent, implementing accountability across the organization, and investing for growth.
How fast is Axalta growing?
Witmer: Ebitda has increased by more than 30% since 2012, to an estimated $865 million last year, even with flattish revenue due to currency head winds. Management has undertaken initiatives to add another $100 million to pretax earnings in the next two years. The crown jewel is the automotive-refinishing business, which is No. 1 globally with a 25% market share. Barriers to entry are large, given its distribution, scale, technology, and relationships with key customers. Axalta provides both the paint and color-matching technology, and works with body-shop owners to move vehicles through quickly. It helps the owner manage productivity and profitability.
The auto-refinishing industry is consolidating in the U.S., and Axalta is well positioned, with a 44% share of the market supplying the top multisystem operators. As these operators buy more body shops, Axalta gets more business. The refinishing business is driven by collisions, which tend to increase as more miles are driven and more cars are on the road. It is an annuity stream.
The light-vehicle paint business has a 19% global market share. Since the LBO, the company has invested in new plants in Germany and China to expand production. It has won more than 30 new contracts with barely a loss. The contracts will continue to drive revenue in 2016 and beyond.
What do you figure Axalta is worth?
Witmer: We assume modest top-line growth of 3% to 4%, with profit-margin expansion just from cost-savings initiatives. We also assume most of the free cash flow in coming years is used to pay down debt, which enhances the value of the equity. We see earnings per share increasing from $1 a share in 2015 to about $1.95 in 2018. In addition, Axalta has $309 million in noncash depreciation and amortization expense. Capital-spending needs are about $80 million a year. The difference amounts to 94 cents a share, which we add to earnings, to arrive at $2.85 a share in after-tax free cash flow in 2018. A business of this quality deserves at least a 14 multiple of free cash flow. We have a target price of about $40 in two years.
Schafer: We also own Axalta. It has one of the best management teams I have ever seen. The company’s success also speaks to the poor job done by DuPont.
Witmer: Different things spur us to look at potential investments. One is the sale of a company by DuPont.
Gabelli: Ouch! In this case, management bought it for a cheap price and flipped it as an initial public offering.
Witmer: Management made a good return on the IPO because they increased profitability dramatically, not because they loaded the company with debt.
We started looking at my next recommendation, Tessenderlo Chemie, because it bought a small company from DuPont. It is controlled by an industrialist, Luc Tack. At the end of 2015, Tessenderlo [TESB.Belgium], based in Belgium, announced the acquisition of the industrial assets of Picanol Group [PIC.Belgium], another Belgian company controlled by Tack, for 26 million Tessenderlo shares. Pro forma, the combined company will have 69 million shares outstanding. At a current 25 euros a share, Tessenderlo will have a market cap of €1.8 billion [$2 billion]. Net debt is only €90 million, for an enterprise value of €1.9 billion. The combined company will have four segments. Agro will generate about half of Ebitda. A weaving-machine business acquired from Picanol will account for 30%. The other segments are Bio-Valorization and Industrial Solutions.
Witmer: The Bio-Valorization business buys animal hides and bones and processes them to make pharmaceutical-grade collagen and food-grade collagen. Another part of the business processes animal fats.
In the Agro business, Tessenderlo produces liquid fertilizers, mainly in the U.S., and other fertilizers in Europe. It also has a niche crop-protection business. We are particularly excited about the liquid-fertilizer business. The company combines sulfur, often sourced from the waste stream of oil refineries, with either nitrogen or potassium to produce a liquid fertilizer.
Sulfur is a major nutrient required by crops. Historically, sulfur supplementation was unnecessary because gasoline and diesel fuel released sulfur into the atmosphere, and it was deposited onto farmland by rain. Government regulations taking sulfur out of fuel diminished the amount of sulfur content in the atmosphere. Also, less coal being burned by power plants; that’s contributed to sulfur deficiency in the soil. A field deficient in sulfur might yield a much smaller crop.
Gabelli: Is this the business they bought from DuPont?
Witmer: No, that is in the niche crop-protection business. Interestingly, in China, there is no need for sulfur fertilization.
Schafer: Who else is in this business?
Witmer: Kugler, a privately held company. Also, Koch Industries is probably going to add 10% capacity to the industry by getting the sulfur from one of its owned refineries. That is the best and cheapest way.
Gabelli: If this is such a nice business, why would Tessenderlo’s controlling shareholder add a more mundane business, diluting its impact?
Witmer: It is possible the deal will get voted down because he is valuing one business at more than people think it is worth and the other at less. But it is possible he is combining these assets because he has his eye on a bigger deal and wants critical mass. There are other ways to achieve that. The shareholders I know are voting against the deal.
Tack has an exceptional track record as an investor and a business operator. He became CEO of Picanol in July 2009 after a rights offering. In 2008, Picanol reported €282 million of revenue. Ebitda was negative, and the company had €40 million of debt. He quickly cut costs, invested in research and development to improve the product pipeline, and used free cash flow to pay down debt and build up cash. By 2010, the business was profitable, and it probably generated €450 million in revenue and €89 million in Ebitda last year.
When did he get involved with Tessenderlo?
Witmer: In November 2013, Tack acquired the French government’s 27.5% stake in Tessenderlo for €192 million. Through a rights offering and open-market purchases, he has increased his stake to 33%. He became CEO in December 2013 and he has been working to improve and grow Tessenderlo’s businesses by reducing operating expenses, making smart capital expenditures, and changing the culture of the company.
To value the business, we normalize 2015 earnings, adding back some one-time charges. Then we add Piconal’s earnings, to get €2.11 in fully taxed pro forma earnings per share. Plant expansions could add around 40 euro cents per share, which puts future earnings at €2.50. The company deserves a multiple of at least 13 times earnings, as it is essentially debt-free. The Bio-Valorization unit didn’t make money last year, but could be profitable in 2016, adding €3 per share of value. Net operating loss carryforwards are worth a few euros per share. Add it up, and we get a target price of €37, and growing from there. If the merger with Piconal is voted down, using the same valuation criteria, our target price for Tessenderlo is €40. We are voting no. [On Jan. 25, the exchange offer for Piconal was withdrawn by Tessenderlo’s board.]
Black: Have you met with management?
Witmer: I haven’t met them, but we have spoken with them. That wasn’t so easy to do; we e-mailed them requesting a conversation several times, and they turned us down.
But we are excited to find a business of this quality run by a great operator, with no debt, and in a nice niche business.
My next pick is Navigator Holdings [NVGS]. The stock is trading for $12 a share. The company has 55 million shares outstanding and about $500 million of debt. It operates a fleet of 29 semi-refrigerated handysize ships [handysize vessels are of moderate size, with a capacity between 15,000 and 35,000 DWT, or deadweight tonnage], designed to carry cargo ranging from liquefied petroleum gases, or LPGs, such as propane and butane to ethane, ethylene, and ammonia. Compared with a large gas carrier, which is three times the size, a handysize ship is more flexible in terms of the cargo it can carry and the ports it can serve.
In addition to the high degree of technical competence required to handle its various cargos, Navigator has excellent operational and commercial capabilities, which allow it to run at more than 95% utilization and quickly adapt to changing circumstances. It has a great management team, with significant ownership of around 2.5 million shares, and discipline regarding capital allocation.
What drives the business?
Witmer: Navigator’s business is supply- driven. The more butane, propane, and such that needs to be moved over water, the more demand there is for its services. Drivers of supply are natural-gas drilling, which in turn is driven by U.S. gas fracking [hydraulic fracturing] and the global buildup of liquefied natural gas, and increased shipping of ethane and ethylene. The U.S. has access to extremely cheap ethane, which is used to produce ethylene. As the U.S. increases its supply of ethylene, and as the plants and ports required to move it come on-stream in the next few years, the opportunities for Navigator will continue to improve. Inexplicably, the stock trades with the price of oil. When oil was $80 a barrel, Navigator was generating about $1.60 a share in after-tax free cash flow and trading in the $20s. Since then, oil has fallen by more than 50%, and Navigator’s after-tax free cash flow has increased by more than 25%, to over $2 a share, and the stock is down, not up.
How do things look for the company next year?
Witmer: Navigator recently disclosed that it has already contracted a significant portion of its capacity for 2016 at rates higher than those in 2015. Navigator has nine ships ordered that will be delivered over the next year and a half. With those at current day rates, after-tax free cash flow could be about $3 a share. Even if shipping rates decline 20%, the company would still earn about $1.65, with all 38 ships. Based on announced export capacity expansions, we believe the supply of seaborne LPG, as well as ethane and ethylene, should keep the industry at a healthy utilization rate. We consider Navigator a real bargain, and have a price target of at least $25 a share.
Black: In the short term, the company will have negative free cash flow because it is spending $44 million per ship on new ships. Once they get to that steady state in a year and a half or so, they will generate free cash.
Witmer: They don’t have negative free cash from operations. It is because they are growing the fleet. To calculate maintenance capital spending, we take the replacement cost of the entire fleet, less scrap value, and divide by the average life of the ship. In 2016, we charge them for $30 million of capital spending when actual spending for anything beside new ships is $5 million.
Black: To me, that is operational.
Gabelli: I don’t see it as operational.
Black: As Warren Buffett said, the tooth fairy doesn’t pay for capital expenditures.
Gabelli: The stock is cheap. Buy it.
Black: I already own it.
Gabelli: Buy more.
Witmer: I’m going to stop here.