Fasten your seat belts! Our Wall Street stars expect the markets to stay volatile, but offer good opportunities for nimble investors.
What makes a successful investor? Lots of things, including a nose for value, a knack for research, a respect for risk, a contrarian streak, and not least, a little luck. Coaching from even more successful investors, like those who graced the stage at Barron’s seventh annual Art of Successful Investing conference, held last Monday in New York, can’t hurt either — and could help. A lot. That, at least, is the theory behind AOSI, which provides a forum for some of the investment world’s smartest stars to share their big-picture views, best investment ideas and well-honed investment strategies with the public.
Five of this year’s conference participants — Felix Zulauf, Fred Hickey, Scott Black, Meryl Witmer and Oscar Schafer — should be familiar faces to Barron’s readers, as they are longstanding members of the Barron’s Roundtable. Stephanie Pomboy, the maven behind MacroMavens, is no stranger to these pages, either. Our 2011 line-up also includes Brian Rogers, who calls the investment shots at T. Rowe Price; Ron Baron (not pictured), who does the same at Baron Capital; Patrick Neal, an options whiz, and Gregory Valliere, who connects the dots between Washington and Wall Street for Potomac Research Group.
The interviews that follow were adapted from video interviews conducted at AOSI by Barron’s editors Michael Santoli and Kopin Tan. You can find them online at http://www.barrons.com, packed with the same sort of insightful commentary and unique investment advice that follows.
Barron’s: Felix, how will the European debt crisis play out in the short and long term?
Zulauf: In the short term, the European Union will attempt another quick fix. [European Union leaders agreed early Thursday on a plan to write down the value of Greek sovereign debt and boost the EU’s rescue fund.] That probably will bring some calm to the markets for a few months, but the fundamental problems in the EU are such that politicians can’t agree on what the necessary fix is for Greece’s indebtedness and that of some other weaker members. Therefore, the crisis likely will drag on for a number of years, with the result that countries on the EU’s periphery will remain in recession for a long time.
Will Europe’s problems throw the global economy back into recession, and if so, how bad will things get?
We don’t have the preconditions for a recession in the U.S. Usually a recession occurs after a seven- or eight-year economic expansion. That isn’t the case now, but there are structural weaknesses in the U.S. economy caused by deleveraging. The biggest and most important form of collateral for borrowers — housing — is down, and therefore you can’t borrow as much as in the past on a total-economy basis. That is why the U.S. will have very low growth for a long period of time. The weakness in Europe will add to the problems in the U.S. On top of that, emerging economies are slowing as they tighten credit to fight inflation.
What is the best way to invest in this environment?
Investing is very difficult right now. U.S. stocks are bouncing around and probably will continue to do so into early next year. Friendly buyers have to turn sentiment optimistic again before global equity markets have another leg down. Gold is in a longer-term digestion period after a huge run-up. Give it a few months to build another base between $1,475 and $1,750 an ounce, which could be the platform for its next move up sometime next year. Investors should be defensive, look to preserve capital and prepare a list of short-sale candidates for the next leg down. And they should buy more gold on dips.
What is the outlook for other commodities?
Given a greater-than-expected cyclical slowdown in emerging markets, including China, commodity prices will experience a cyclical correction into the second half of next year. But oil could pop to $100 a barrel, and some exchange-traded funds, such as XLE [Energy Select Sector SPDR], OIH [ Oil Services HOLDRS] and XOP [ SPDR S&P Oil & Gas Exploration & Production] could be played as short-term trades.
When will the U.S. stock market bottom?
Stocks will hit a low between the second half of 2012 and the second half of 2013. For the market to turn around, the U.S. will need a fiscal-stimulus program that is inconceivable currently because of the debt constraints. Politicians need to jump over the hurdle of bad economics first.
Barron’s: What is your view of the U.S. stock market?
Black: I have a bifurcated view. The Standard & Poor’s 500 closed last Friday [Oct. 21] at 1238. S&P 500 companies are expected to earn $97 this year. That means the market trades for 12.8 times earnings, which is cheap by historical standards. There is more good news: In the third quarter, earnings should have advanced approximately 15% year over year. The bad news is that the macroeconomic environment in both the U.S. and Europe seems to dominate the fundamentals of individual stocks at this point.
Yet you recommended individual stocks today, such as Oracle [ticker: ORCL].
We try to buy good businesses at cheap prices. We look for companies with high returns on equity, low price/earnings multiples and tons of free cash. Oracle fits that description. Revenue and earnings have grown at a compounded annual rate of 18% in the past five years. The company has $17 billion, or $3.35 a share, in net cash and equivalents. If you subtract that from the stock price, the P/E drops to 11, and that’s for a company with a 32% return on equity that generated more than $10 billion in the latest fiscal year in free cash and $8 billion in reported earnings. Oracle is a powerhouse of a company.
You also recommended Endo Pharmaceuticals [ENDP]. What is the investment case for Endo?
It is the Rodney Dangerfield of pharma. The stock sells for five times next year’s earnings. The company has borrowed heavily and has made three major acquisitions in the past three years. It has a net debt-to-equity ratio of 1.5-to-1, which probably doesn’t appeal to a lot of people. It is essentially a one-product company, with Lidoderm, a topical anesthetic, accounting for roughly 30% of revenue. Yet Endo could see organic profit growth of 10% or 12% in the future. It is strong in painkillers and urologics, and just bought a small medical-device business.
What is the bullish case for Digital Realty Trust [DLR], another of your picks?
It is a surrogate play on cloud computing. If you can’t buy a Juniper Networks [JNPR], which is selling for 15 times next year’s earnings, this is a smart way to invest in the business. Digital Realty hosts data centers for servers. It has 98 facilities around the globe, and operates in Asia, Australia and England, as well as the U.S. Its facilities cover about 17 million square feet. The stock yields 4.5%, and the implicit capitalization rate [the properties’ net operating income divided by total capitalization] is about 7.5%. Revenue will grow by 11% or 12% next year, which means an implicit cap rate of 8%.
It is rare that you can find in today’s market an implicit cap rate of 8% with a 4.5% yield. Digital Realty is structured as a REIT [real-estate investment trust]. The company has prestigious customers such as Facebook, Amazon.com [AMZN] and AT&T [T].
You’re a serious collector of Impressionist and contemporary art. Is this a good time to buy art, and if so, how should a relative novice begin?
If you live in New York, go to the galleries in Tribeca and Soho and Chelsea. Even if you can’t afford Impressionism or modern and contemporary art — prices seem to be in the stratosphere today — it is smart to have a look, and see what you like. Then buy the best thing you can afford and put it on your walls. If it goes up in price, fine. If it doesn’t, you’ll still enjoy it. I never bought art as an investment. I bought it purely to build a collection of something I enjoy. The fact that prices went up is an afterthought.
Is there a particular art genre that is a good value now?
If you are looking at established art, Old Masters probably represent the best value. Impressionist and modern art doubled and tripled in price in the past five or six years. Many private-equity investors and hedge-fund people have funneled their money into the contemporary art market and the prices are out of sight.
Barron’s: You have been talking about two tiers of technology stocks. Can you elaborate?
Hickey: The technology sector has been in a secular bear market for 10 years. It began in 2000 with the great crash. At that time, 40 tech companies were among the top 100 companies in the world as measured by market capitalization. All their shares fell and none have recovered. We saw valuations drop in many cases to levels never before seen. Barron’s noted last week that Hewlett-Packard [HPQ] now has a price/earnings multiple of five [« Tech’s Top 10, » Oct. 24]. There are many single-digit-P/E stocks in the large-cap area. These companies have been around the longest, and they are depressed.
Examples are EMC [EMC] and Microsoft [MSFT]. Microsoft has a 10 P/E, but excluding its cash the P/E is 8. The company will do well in the future. EMC has a 14 P/E based on next year’s earnings. It is in the data-storage business, which also will do well.
What about the other tier? Presumably it includes some younger tech companies.
Many younger companies, such as Salesforce.com [CRM], are in cloud computing. A number got hit recently, such as F5 Networks [FFIV] and Riverbed Technology [RVBD], but some still sell for more than 100 times earnings. Salesforce.com has a 100 P/E, and that is based on non-GAAP earnings [earnings not in accordance with generally accepted accounting principles]. Based on GAAP numbers, they have operating losses, and those losses are growing. These stocks are dangerous, and before tech shares hit rock bottom they will get slaughtered.
One of the arts of successful investing is not to lose big. You think investors in Fusion-io [FIO] will do just that. Why do you disagree with Barron’s positive appraisal of the company in last week’s Tech Outlook cover story?
The company has a P/E of 148, and that is based on this year’s estimated earnings. The P/E used to be even higher. The company has had earnings only for a couple of quarters. I have seen highfliers like this before. The company is in a commodity market — SSD, or solid-state drivers. Competitors like Violin Memory will be entering this market. Fusion-io shares will continue to rise. Momentum investors will continue to pile in, and then, sometime in December or January the insiders will sell out when their lock-up agreements [prohibition against selling shares in the months after an initial public offering] end. That would probably be the time to take the other side of this bet and sell the shares short.
You like Nokia [NOK]. What appeals to you?
Nokia’s market value went from $289 billion to $24 billion, but it is still one of the world’s leading companies in mobile phones. It shipped 106 million to 107 million phones in the latest quarter. It sold 17 million smartphones in the quarter — as many as Apple [AAPL]. And that is with an operating system the company is abandoning. Nokia has decided to embrace the Microsoft Windows operating system. Its designers are excited about it; the phones have tremendous features and capabilities. Introducing Windows phones could give Nokia a lift, and if the phones are successful, as I expect, this could be the bottom for Nokia shares.
Barron’s: You didn’t mince any words in declaring that stocks are in a bear market. How will they get out of it?
Schafer: One thing that might end the bear market is reduced volatility. The individual investor is less willing to invest in the stock market now because every day brings volatility. The election cycle is adding to the volatility, which means it could continue for another 12 to 18 months.
Even in volatile markets, your job is finding good companies to own and maybe not-so-good ones to short. You have been investing in companies that are less economically sensitive than the market perceives, such as Hertz Global Holdings [HTZ]. What is Wall Street missing here?
My case for Hertz is fivefold. No. 1, the industry is consolidating. There are now four big players. There might be three if Dollar Thrifty Automotive [DTG] gets absorbed by Hertz. No. 2, historically this business was characterized by lots of excess fleet, driven by the automobile manufacturers’ persistent overproduction and need to dump these cars into the car-rental channel. Following bankruptcy and management changes, the Big Three have stopped dumping cars into the rental channels, leading to improved profitability for the car-rental companies.
No. 3, strength in the used-car market has been driven by a dearth of leasing during the recession that has significantly lowered car-rental depreciation costs.
No. 4, Hertz owns a good equipment-rental company, and No. 5, it is going in a new area.
The company has a very large opportunity to gain share in the $10 billion off-airport/insurance-replacement market. When you have an accident, and your car goes in for repairs, your insurance company will pay at least part of the cost for a rental car. This business is dominated by Enterprise Rent-A-Car, but Hertz recently forged deals with a few insurance companies. All these things are going to mitigate Hertz’s sensitivity to the economy.
Where is the stock valued?
The shares trade for $11 apiece, or under 10 times next year’s expected earnings, and the company can grow profits by 15% or 20% from here.
If Hertz doesn’t get regulatory approval to buy Dollar Thrifty, is the bull case still intact?
Yes, although with the Dollar Thrifty acquisition, the shares could rise by $3 to $5 because of synergies. [Hertz withdrew its offer for Thrifty Thursday night but indicated it is still interested in buying the company.]
Xerox [XRX] is another misperceived stock. The copier business is declining by 1% or 2% a year. But the mix of copying is switching from black-and-white to color, which is four times more expensive. Therefore, the mix of declining businesses is such that top-line growth for the whole company would be 2% or 3%. Operating income will rise in the high single digits this year, and the company is repurchasing 20% of its shares. That will elevate earnings growth to high double digits — say, 15% to 17%. But copiers are only 50% of Xerox’s business. The other half is outsourced services, which is somewhat government-sensitive but not cyclically sensitive.
What is your price target for the stock?
Xerox trades at $7, where we originally bought it, and it rose to $12 before retreating. It could rebound to $12 to $15 a share.
Barron’s: Life must be interesting these days for a provider of macroeconomic research, as the big picture is calling the market’s tune. Why are you so bearish on the U.S. economy and the performance of the Federal Reserve?
Pomboy: We have yet to sow the seeds of a sustainable recovery, meaning employment gains. Here we are, three years after the financial crisis, and Federal Reserve Chairman Ben Bernanke has brought unprecedented monetary policy to bear. Yet we are still tapping our fingers, waiting for employment to pick up. The S&P 500 has been dead money since the end of the financial crisis, just like the economy in real terms, adjusted for inflation.
Main Street sees that, and it mirrors what you see in consumer-confidence measures. Main Street didn’t feel the recovery. Consumer confidence is at or near the crisis lows.
Residential-real-estate prices are still deflating. How would you fix that problem?
Most people are gurgling underwater in their mortgages, which is a major obstacle to getting the U.S. out of its post-bubble funk. With every day that passes, home prices continue to decline and the consumer gets even more oppressed financially.
When the housing bubble first burst, we were looking at massive surplus inventory. The U.S. had 4.5 million houses available for sale, versus a normal inventory of about two million. Had the government gone out and bought 2.5 million homes and set them on fire — yes, I know this sounds crazy — it would have been a substantially cheaper solution than trying to work through the mortgage mayhem.
Is QE3, or a third round of quantitative easing by the Fed, imminent?
Yes, because we haven’t cured the disease. QE1 and QE2 created some financial-asset inflation, which has helped to offset some of the effects of a slower economy, but not enough.
The Fed needs to keep huffing and puffing until the wealth effect eventually starts to work and creates jobs. We need high-end consumers to spend. Eventually that will force corporations to start hiring.
One chart you displayed today showed retail stocks hugely outperforming financial stocks. The charts are practically going in opposite directions. What accounts for this divergence?
I was mystified when I first saw this, and thought it was crazy that people were betting on retail. This is a consumer economy where spending is only as good as your access to credit. For as long as I have been around, it has worked that way.
Then it struck me that if people stop paying their bills — if they default on their mortgages or don’t pay their credit-card bills — that frees up much more cash to spend.
How should an investor be positioned at such a challenging time?
I’m neutral right now because we are waiting to see what happens in Europe. There will be some kind of de-risking [the selling of or avoidance of riskier assets] in the near future, which will make it hard for anything to go up.
But for the long term I still like hard assets, specifically gold and oil. I would veer away from U.S. consumer-oriented companies and look for companies that will benefit from growth in the emerging world, such as large-cap multinationals.
Barron’s: Brian, how do you reconcile all the crosscurrents at play in the stock market? Stocks are just about flat for the year, yet corporate profits have been strong and the global economy still is growing.
The year started off strongly for stocks, but enthusiasm began to wane in the second quarter and into the third. Standard & Poor’s downgraded Treasury debt. The debt-ceiling debate upset investors, and concerns about the euro zone re-emerged. It has been a real tug of war this year, and after 10 months, we don’t have a lot to show for it in terms of the market’s progress.
Or, to be fair, in terms of a market decline. Where do you find good values for your funds?
The economic performance of most companies has been quite strong. Earnings and cash flow have been strong. Corporate balance sheets are in great shape, yet prices have fallen sharply. That sets up investors to take advantage of some good price opportunities. Also, when you compare the equity market to yields in the fixed-income market, equity markets globally look like a solid value.
One stock we like is Northern Trust [NTRS]. It is a high-quality institution. It has a nice dividend yield of 2.8%, and a good dividend history. Shares aren’t selling at a high multiple of earnings, and many competitors have been struggling during the year, either with management turmoil or some investigation into how they do business. Northern Trust is a share-gainer. It is a conservative institution based in Chicago, and has a great long-term record. The risk/return tradeoff is good.
You’re a fan of emerging markets, which seems almost contrarian these days. What’s to like?
Emerging markets have been bloodied this year. Investors are fixating on what has happened in China and what is going on in Brazil. Prices are down about 20% this year in most of the major developing markets, though growth has been pretty good. There will be deceleration in gross-domestic-product growth in China, although in the U.S. we would kill to have growth like China’s. Long term, the outlook for emerging markets is good. Many have tightened credit in the past few years and will begin to ease monetary policy in the next year or two. I see a three-year investment opportunity.
Barron’s: As a longtime options trader, you see plenty of interesting trading opportunities in this market. One you mentioned involves shorting Europe by using put spreads on the FXE, or CurrencyShares Euro Trust exchange-traded fund. Aren’t Europe’s problems well known by now?
The problems are well known, but in order to achieve a solution the European Union needs to do things that perhaps aren’t so well known. Within the euro region, countries like Greece need to have the opportunity to restructure their debt. They need to have the opportunity to devalue their currency and potentially monetize some debt. The difficulty is that such opportunities would require a rewrite of some of the rules with respect to the construct of the euro. This could be a good outcome in allowing for the kind of support European banks and sovereign nations need.
The alternate scenario is that there is no agreement on restructuring Greece, and that would be relatively dire for the euro. In both of these scenarios, the first being much more likely, the euro will begin a downward trajectory over the very long term. To take advantage of that, we like January put spreads on the FXE. [A bearish put spread involves buying put options at a specific strike price while selling the same number of puts at a lower strike price.]
You’re also short luxury retailers, and have used put spreads to short Coach [COH]. What is your beef with the luxury chains?
They are at an inflection point. Easy money and fiscal policy created a positive wealth effect among high-end consumers. This started after the first bout of quantitative easing, or QE1, in 2009. The outperformance of stocks such as Polo Ralph Lauren [RL], Coach and Tiffany [TIF] relative to a Target [TGT] has been astonishing.
Now we are entering a new phase. The indebtedness of the private sector has been transferred to the public sector’s balance sheet, and it is time to pay the bill. We’re looking at austerity and higher taxes, and a reversing of the wealth effect and more wealth redistribution. The high-end retail customer is going to slow, and positive comparable-store sales gains will be difficult to maintain.
Lest everyone think you’re bearish on the market, you have recommended a somewhat bullish trade involving Potash Corp. of Saskatchewan[POT], the fertilizer company. Why?
Potash is a way to play a long-term secular theme: the globalization of better diets, which are reaching emerging markets. Better diets mean an increase in higher-quality protein. If you upgrade from chicken to pork to beef, this requires multiple-times more feed input to generate that same unit of protein. Currently, fertilizer use is low relative to what would be scientifically optimal. Supply-and-demand dynamics are favorable and Potash is trading at a discount to where it should be.
Also, farmers are flush right now, with the money to spend on fertilizer.
That’s right. An uptick in Potash shares would be impeded if fertilizer were too expensive, which it isn’t, and if farmers didn’t have the cash to spend, which isn’t the case. Given the robust crop market and higher crop prices, farmers’ balance sheets are solid. I expect the uptick to work. My preferred trade is January call spreads.
Barron’s: You’re predicting a slow-growth economy. How does that affect your investment decisions?
Witmer: We don’t mind slow growth. It could be Nirvana for the stock market because companies are growing and generating free cash, and they don’t have to invest much in capital spending or inventory. They can pay their cash out to shareholders or buy in their shares. A slow-growing economy creates a lot of opportunities for smart capital allocation. In the course of my career, corporate managers have gotten a lot more logical about what they do with the company’s money. In fact, the capital-allocation ability of the CEO is probably our No. 1 investment criterion.
You’re an investor in Macquarie Infrastructure. Tell us about it.
The ticker is MIC. The stock is trading at about $25. It is one of our largest positions. The company has four assets. IMTT is in the business of liquid bulk-storage tanks. Atlantic Aviation is an FBO, or fixed-base operator, meaning it operates terminals and gas stations for private planes. The company also owns a utility in Hawaii, and a fourth company that is too small to discuss in detail.
Meryl Witmer: With Macquarie, « I can buy a dividend-paying company with the likelihood of huge dividend increases in the future. »
Macquarie pays a dividend of 80 cents a share and yields 3%, and all the yield is coming from the two companies I have barely talked about. In the next several years they will get another $2.50 or maybe $3 of incremental cash flow from IMTT and Atlantic Aviation. They will be able to pay out a lot of those earnings. I can foresee getting $2.50 or $3 a share in dividends in two to four years, with more to come as they continue to grow. I like management. I absolutely love the assets, particularly IMTT. This is a great situation.
Is Macquarie the sort of company that passes through whatever income its assets earn?
They have a choice about how much to pass through. The company and the family that owns the other half of IMTT are in arbitration about profit distribution but this will get sorted out. MIC should receive distributions at least equal to earnings. Eventually there will be a lot of dividend payments. The 10-year Treasury bond is yielding 2%. You’re getting nothing in money-market funds. If I can buy a dividend-paying stock with the likelihood of huge dividend increases in the future, I am pretty happy.
Based on an expected yield of $2.50 or $3, where should the stock trade?
We have a price target of $40, but there will be dividends in the interim.
Barron’s: Potomac Research advises investors about how developments in Washington affect the markets. Advise us, please, what you meant by saying the cupboard is bare when it comes to both fiscal and monetary policy.
Valliere: There won’t be any new stimulus spending. The scandal surrounding Solyndra [a solar-panel maker that received stimulus funds and subsequently filed for bankruptcy protection] has made that pretty difficult. Nor will there be a big tax stimulus before year end. On monetary policy, the Fed is done for a while. There isn’t any imminent move for a QE3. The Fed is reluctant to add even more debt to its balance sheet.
Gregory Valliere: « More and more people are saying that we may need to have a change in leadership » in the White House.
Can President Obama get re-elected with the unemployment rate at 9.1%?
It is an uphill fight. In addition, a really astonishing percentage of Americans think we are in either a recession or depression. That is a tough climate in which to get re-elected. Then there is the necessity of getting to 270 Electoral College votes. He might not win a lot of the states he won three years ago, such as Indiana, Florida, even Wisconsin.
Now take us ahead to December 2012. What can we expect?
What a story December 2012 will be for investors. You’ve got the Bush tax cuts expiring and President Obama might try to veto any extension for the wealthy. You’ve got the possible need for another debt-ceiling extension. The deal Congress struck in early August runs out in December 2012. Then there is the possibility of deep budget cuts under the « sequester » if the Joint Select Committee on Deficit Reduction doesn’t come up with cuts now. Clients can still make money with good companies that have good earnings. Corporate balance sheets look great. But the Washington outlook will remain polarized, with continued real anxiety over our inability to get control of our deficits.
What, if anything, is the solution to these problems?
More and more people are saying that we may need to have a change in leadership. Even some Democrats I talked to say that might be required. Whether Mitt Romney, the likely Republican nominee, will provide that change of leadership, that jolt of confidence, remains to be seen. But his policies toward business, and toward Wall Street, would be a vast improvement. The Democrats, on the other hand, are taking a big gamble in embracing populist, anti-business rhetoric. Some Democrats have even embraced the Occupy Wall Street movement, which is risky. If you want to win centrist voters in Columbus, Ohio, this is a miscalculation.
At least it will make for an exciting year.