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Set the Bar High
The Ups and Downs of Flying
I am a very nervous flyer. Whenever there is a
little bit of turbulence, I look out the window, see shaking wings, and start
to wonder whether they’ll keep holding the plane up. Then my rational self
kicks in, and I tell myself that statistically it is safer flying than driving,
that the pilot’s incentives are aligned with mine (it is not like he has a
private parachute). Eventually the turbulence subsides and I go back to
whatever I was doing. That said, I do like flying, as it is probably my
most productive time, since there are so few distractions. I put on my
headphones and start typing (this is how I think). I wrote two chapters
of the Little Book on the plane to Italy this past summer. The iPad made
my travel experience even more productive – unlike a laptop, an iPad has a 10-hour
battery life. I cannot type on glass, thus I bring an external
keyboard.
On Monday, my brother Alex and I are flying to
the VALUEx conference in Zurich/Davos, then on February 7th I am giving a half-day
seminar at the Value Investing Center in Frankfurt. I am not going to be
writing another book for a long, long time (if ever), and I don’t have any new
thoughts for another article, so to keep my brain cells going I came up with
this idea: email me your questions, and I’ll try to answer
them while I spend 20 hours in the air (I did Q&A with FT readers last year; it
was a lot of fun). I don’t promise to answer all questions, but I’ll give
it a try. I’ll post the answers online and will also send them out in my next
email.
One last thought. The Little Book was light on
tables and charts, so I have come up with supplemental tables, charts, and even
a spreadsheet of how Tevye valued Golde (sorry, you have to read the big or the
Little Book to know what I am talking about), and you can find them here.
Set the Bar High
The world today is riddled with unique economic, political,
and demographic risks. Finding attractively
priced assets that will perform well in spite of these challenges is excruciatingly
difficult. For investors, though, one
segment of the market – the highest-quality stocks – still offers attractive
risk-adjusted returns.
First, it’s important to understand the risks that make most
other asset classes perilous in the current environment.
Where to begin? China, the world’s second largest economy,
is facing an enormous overcapacity bubble in commercial, industrial, and
residential real estate. Japan, the
world’s third-largest economy and second-most-indebted nation (Zimbabwe holds that
title) is in a debt bubble, addicted to unsustainably low interest rates and able
to borrow at rates normally reserved for near-riskless borrowers. However, its significant
indebtedness and horrific demographic profile (every fourth Japanese is over 65
years old) should barely qualify it as a subprime borrower.
Although the US economy is steadily recovering (unless you
are unemployed), the rate of growth in this recovery is unsustainable, as it is
propelled by government intervention (such as QE2) and stimulus – neither of
which can be relied upon as a long-term driver.
These are the top three global economies, and all face huge
challenges going forward, which is why I’ve been skeptical about the health of
the global economy for a while now (and I haven’t even mentioned Europe being
rampaged by PIIGS).
It is hard to tell if we’ll have inflation, deflation, or
both; but problems in China and Japan will likely lead to higher global
interest rates, since they are the largest foreign holders of the US debt, and as
their respective bubbles burst they’ll be forced to become net sellers. Over the next few years, global GDP growth
will be lower than in previous decades, as consumer deleveraging will be
followed by government deleveraging, which will also force higher
taxation.
There is no safe place to hide; every shelter carries a
different risk. Bonds will do great if
we have deflation, but they will be decimated in case of inflation. Gold is not a cash-generating asset, and nobody
really knows what it is worth. (“Higher price” is not a valuation metric.) China is the
incremental buyer of industrial commodities (here is a factoid: it is
responsible for two-thirds of global demand for iron ore), so even if we have
inflation, commodity prices will still decline with plummeting demand when China
cuts back. Exposure through bonds or
equities to the countries that have fared the best so far – the likes of Canada,
Australia, and Brazil – will not protect you in the future, since those
countries have been the primary beneficiaries of the Chinese bubble.
Before I depress you further, don’t despair and reserve a
space in a cave, stocked with canned food and ammo. Instead, this is the time to own high-quality
stocks – no, the highest-quality stocks – with strong balance sheets, so higher
interest rates will not dent their profitability. Their businesses need to have a competitive
advantage and the power to raise prices for their goods or services in case
inflation hits, or maintain their prices in case of deflation.
And they need to be noncyclical businesses. Let’s pause for
a moment, because this point is paramount.
For a long, long time, the street yawned at cyclical stocks –
they never received high valuations; in fact, the only time they would trade at
above-market P/E is when declines in earnings (usually during recession)
outpaced declines in price. The street’s
indifference was understandable: if the company in question was a commodity
producer its fortunes were at the mercy of a very volatile commodity; if it was
a capital equipment maker it went through feast-and-famine cycles of the
economy. However, in the late 2000s the market
perception towards cyclical stocks changed – they had grown earnings at double-digit
rates for six years, and even in 2008 – the year the US economy entered the
Great Recession – their earnings still went higher. They were not marching to the drum of the US economy,
but to the beat of the Chinese drum. They
were no longer priced as cyclical
stocks, but as secular “growth”
stocks. They sported high valuations on top
of very high earnings, with profit margins at multi-decade highs. The global financial crisis changed the street’s
perception of them briefly; but today, only a few years and a few trillion in stimuli
later, these companies are reclaiming their “growth” status, and high valuation
that comes with it.
I cannot recall a single instance in history when the same
bubble was reinflated twice in a row, but this is exactly what has happened to cyclical
stocks: the pre-Great Recession bubble is being reinflated today. Coordinated global stimuli will do that.
Take Caterpillar, the maker of big tractors and giant
earthmovers. CAT is at a higher price
today than in 2008. It is trading at 16 times
its 2011 earnings of $5.80 a share, the highest earnings in its history, and
its profit margins are close to an all-time high. Caterpillar is a great company, but it is not
a high-quality stock - It is highly
cyclical, has large amounts of debt ($15 billion of net debt), and, like a home
builder, the products it sells today have a very long life and compete with
tomorrow’s sales. In a slower-growth
global economy, or a world in which China will no longer be able to afford to
build empty cities, the world will need a lot fewer earthmovers. Suddenly
investor will discover that CAT’s earnings power is not $5.80 but $2 or $3, and
the stock is not worth $90, but $30. In
the past, deeply cyclical stocks like CAT were never considered high-quality
stocks, but today they are mistakenly
considered as such.
For a company to be truly high-quality, its business has to
be insensitive to the health of the global economy. Interestingly, historically there was usually
a premium built into high-quality company valuations, as investors are willing
to pay more for their high returns on capital, strong balance sheets, lower
risk, and the certainty of their cash flows. Deeply cyclical stocks have
traditionally traded at a discount to the market. Not today – low quality is expensive and high
quality is cheap. Dirt cheap!
By way of example, what follows are a few companies that I consider
to be highest-quality, and I own these stocks in our accounts. The first two
are in healthcare. Though the uncertainty
that Obamacare brought is behind us and its impact on the industry will be relatively
small, healthcare stocks did not get the message. Pfizer (PFE), the largest pharmaceutical
company in the world, is trading at less than eight times earnings. It is generating enormous cash flows, pays a 4.5%
dividend (which it just raised), and will be debt-free in the not too distant
future. Yet the market puts zero value
on its enormous pipeline of drugs in development and the $10 billion PFE spends
annually on R&D. Medtronic – the
maker of pacemakers – is trading at 10 times 2011 earnings. If you look at its stock chart for the last decade,
you’d think MDT’s business had stagnated; it has not. MDT has grown sales and earnings 14% a year
over the last 10 years. Both PFE and MDT
have an enormous tailwind behind them: baby boomers around the world will be
consuming more drugs and more medical devices over the next three to five
years, no matter what happens in China or Japan.
We recently bought Cisco Systems (CSCO) and Computer
Sciences (CSC). Cisco – the maker of
internet plumbing – disappointed Wall Street, gave lower guidance, and its
stock suffered huge losses as a result.
Today it is trading at about 11 times next-year’s earnings, or less than
nine times if we adjust the price for the $25 billion of net cash it has on its
balance sheet. Though there is some
cyclicality to Cisco’s business, as we consume more data and video over the Internet,
the demand for Cisco’s products will increase more than enough to overcome the
business cycle.
Finally, the most boring of this bunch is Computer Sciences,
an outsourcing company for large corporations and the federal government. It is trading at nine times next year’s
earnings, and the company has announced a stock buyback of close to 12% of its
shares. It is a very stable and growing
business, as the trend toward outsourcing non-core functions continues. CSC has about $1 billion of net debt that it
can pay off in about a year if it chooses.
CSC is the only public business in its field: due to the attraction of high
recurrence of revenues, every public competitor has been bought by someone else
– Affiliated Computers by Xerox, Perot by Dell, EDS by Hewlett Packard. Though our CSC purchase will work out without
it, in the world of QE2 and (artificially) very low interest rates, CSC becomes
an easy acquisition target.
I am asking you to see things that have not happened yet,
because success in investing comes not from drawing straight lines, but from
the ability to see around the corner.
Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of The Little Book of Sideways Markets (Wiley, December 2010). To receive Vitaliy’s future articles by email, click here.
Copyright Vitaliy N. Katsenelson 2010. This article may be republished only in its entirety and without modifications.
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CSC the only one of the four with a positive target, +37%
http://stockcharts.com/freecharts/gallery.html?csc
Hah, Cisco is self-financing its customers, a recipe for disaster waiting to happen. Buy it now, sell it in 2 years time 80% lower.
Buying a portfolio of the best value equities in the U.S., without acknowledging that they are ALL denominated in a green variant of toilet paper, is unprofessional and dangerous to the reader. It's also in the same category of rearranging the deck chairs on the Titanic.
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Dude, the fucking ship is going down. Enough discussion of the Feng Shui of the deck chairs.
True, true, Geoff. On the other hand, I will be dead in 15 years but it is not stopping me from trying to make a bundle in the mean time.
All well and good but all choices are keeping the books in USD, so currency risk with a revaluation is way too high for world-class, worry-free, top quality choices, IMO. I suggest NVS & NVO with PFE. NSRGY, NHYDY and RDS.B are among the global giants for food and energy. RDS invented scenario planning so they just might have an eye open for a better way to do things in this complex mix of chaotic markets. BAYRY has a most excellent record of survival as does DuPont- DD. All world class, to be added to the suggestions here after your own due diligence. DuPont and Bayer are part of a long-standing global "understanding" in manufacturing and marketing that serves both of them very well.
Disclosure: Interests in all.
Well thought out understanding of where our economy stands now and realistic approach to longer term investing rather than the usual short term alogarithm and anomoly approach dominating trading in everything that fits into a casino . Surprised did not include some integrated energy giants that have cash ,earn dividends and will always have customers . Same for utilities. Again, these are good places to park your money to ride out volitile and uncertain times that are sure to be with us until systemic problems are addressed and real growth retuns---the alternative is to gamble with the greedy and ride the ponzi
You needed to speculate in March 09. Not now. But go ahead and buy high, Cramer.
A nice article about what is not easily seen. So often we overlook the diamonds in our own backyard because we won't be still long enough to dig for them.
It will be interesting to watch the comments and see who gets shredded, the author or the traders who can't see past the end of their noses.
DaddyO