CONSUELO MACK: This week on WealthTrack, two investment champions present the case for stocks, despite two years of big market gains. Chuck Lahr of PIMCO’s Pathfinder Fund discusses the deep values he is finding in Europe; Strategas Research’s Jason Trennert why he favors big cap U.S. stocks, next on Consuelo Mack WealthTrack.
Hello and welcome to this edition of WealthTrack. I’m Consuelo Mack. It had to happen sooner or later: a headline-making warning about the heavy indebtedness of the U.S. government. Credit rating agency Standard & Poor’s fired the warning shot earlier this week. While maintaining its current top, Triple A rating on U.S. Treasury securities, S&P lowered its outlook from stable to negative, stating, quote, “We believe there is a material risk that U.S. policymakers might not reach an agreement on how to address the medium and long term budgetary challenges by 2013.”
If no action is forthcoming, S&P warns that the U.S government’s fiscal profile would become meaningfully weaker and it could lose its triple A rating. According to IMF calculations, reported in The Wall Street Journal, the 2010 U.S. budget deficit was 10.6% of GDP, the highest among other major triple A rated countries, with the U.K. a close second, but France, Canada, Australia and Germany’s debt levels considerably lower.
The news of the potential downgrade actually boosted Treasury prices, on the belief it might encourage deficit reduction. But even after two weeks of declines, stock markets were initially hit hard, although they rebounded strongly reflecting positive corporate earnings and manufacturing strength. American investors have become wary of their home market again. U.S. equity funds had a big $7.7 billion dollar outflow in March, particularly from large cap funds, while funds focusing on small company stocks and emerging markets saw inflows.
According to this week’s WealthTrack guests, there is still plenty of opportunity left in stocks, however. Chuck Lahr is co-manager of PIMCO’s EqS Pathfinder Fund (PTHDX). This global deep value fund was named one of the nine best new funds of 2010 by Morningstar. Lahr and his partner Anne Gudefin ran the five-star Franklin Mutual Global Discovery Fund before joining PIMCO. The team has a record of beating the market with far less risk over the long term. Jason Trennert is a top rated Wall Street strategist who launched his own independent firm, Strategas Research Partners, in 2006. Strategas provides original economic, political and market research to institutional clients. I asked them why, after the mammoth two year stock market rally, they still believe in stocks.
CHUCK LAHR: We’ve had quite a run from the bottom in March of 2009, but I think when you actually take a step back and look at the cyclical recovery that we’re having in the economy, despite some headwinds in the long-term, we’re having that really strong cyclical recovery, and when you look at how that’s happening, combined with low valuations in aggregate, even though if I look at the market overall, I may say they’re a risk, they’re individual opportunities in the market driven, again, by this cyclical recovery that I think any value investor would naturally be drawn to.
CONSUELO MACK: So let me ask you about the Pathfinder Fund, you know, especially. So your cash levels now are about what?
CHUCK LAHR: Fifteen percent, thereabouts.
CONSUELO MACK: Right. And at one point in, what, 2008, the depths of the financial crisis, they were almost 50%, right?
CHUCK LAHR: There were a series of events that led us to it, perhaps for a snapshot to have about that level, that’s right.
CONSUELO MACK: So 15%, is that pretty aggressive for you all at the PIMCO Pathfinder Fund, or is that…?
CHUCK LAHR: Fifteen percent is about, I’d say normal, or average. I would say that the trajectory is that it’s going down. You always want to have a little bit of dry powder to take advantage of opportunities, but the pipeline of investment ideas is rather full. You have all these corporate activities that I mentioned. In this type of a backdrop you have companies spinning off assets. There are breakups, not just in the U.S., but really around the world, and these are all the types of events, where as a value investor, sometimes you get an idea actually shaken loose- like I could tell you about CVS, for instance, a stock that we own. Now, this is a combination of retailer, and a PBM, a pharmacy benefits manager. If you take those two different businesses and actually value them discretely, you’re going to come away with a valuation about 18 times in the PBM, say seven or eight times EBIDTA on the retailer of well over $45. The stock trades at $35 right now.
Now, when we bought the stock, we were setting up the PBM at about one times earnings, almost getting it for free. Now, what makes this interesting, or special in this type of environment is that you have a relatively new management team there, but a lot of investors are getting impatient with the combination of these two businesses, so it’s kind of a situation where if you win, you win; or on the other hand, if you lose, you’re still going to win because this new management team is showing that they’re growing earnings, so we may get appreciation out of that, but on the other hand, if they don’t, I know that as a shareholder, and there are a number of shareholders that would like to see this company broken up, in which case you’ll have a hard catalyst and actually receive that $45 with a fair amount of certainty.
CONSUELO MACK: So these are the kind of trigger events that you look for as a deep value investor. So let me ask you, Jason, because you wrote a research report recently, and it was titled, “The Top Ten Reasons We Are Far Away From a Major Top”. Far away. So how far away are we from a major top?
JASON TRENNERT: Yeah, I’ll say, it wouldn't surprise me, candidly, to see the market hit a new high some time in the next 12 months.
CONSUELO MACK: You’re talking about the S&P 500?
JASON TRENNERT: The S&P 500. Corporate profits is measured from the GDP accounts are actually past the prior peak. I would say the quality of the earnings is much better than it was when we were at the previous peak because a third of those earnings just came from one sector, which was financials. So you have a much greater foundation. I think the Fed, personally, is going to remain a lot easier, longer than people are expecting.
CONSUELO MACK: So that’s a positive for the stock market?
JASON TRENNERT: It’s good for financial assets. And I think the whole idea that central banks, particularly the Fed, has made the decision that it won't tolerate deflation- makes the asset allocation decisions a lot easier. Now that you kind of know that inflation, or sticking the landing are the two most likely outcomes, the equity allocation decision is just beginning. In my view, that’s the greatest single catalyst. Hedge funds have already moved a lot of assets towards equities, but long-only funds, retail investors, pensions and endowments are just starting to move the turrets towards their equity investments, and that tends to happen over a very long period of time- it doesn’t happen over, you know, two or three months period, which is all we’ve seen in terms of flows into equity funds.
CONSUELO MACK: You think it could reach a new high, as you just said, but you also don’t think that the rally is going to necessarily be long-lived.
JASON TRENNERT: I do think it’s going to be very different than what we saw in the ‘80s and ‘90s. I think the magnitude of the secular problems we’re facing, particularly in terms of the deficit mean almost necessarily that the business cycles will be shorter. That’s, of course, unless we get great policies, which is possible. We’re still holding out hope for that, but it seems unlikely in the middle of a Presidential election that we’ll have a big change. But I do think for the next 12 months the market’s going to reach new highs. I do think, though, for the individual investor, the main thing I would focus on is the importance of active management, of having, and I’m not saying this just because…
CONSUELO MACK: Music to Chuck’s…
JASON TRENNERT: Yeah, Chuck’s ear. I meant to say this, Chuck is here, but having funds that actually make very active asset allocation decisions in terms of the amount of cash they have in the portfolio. I think that’s going to be very important in a period in which it’s, you’re not going to have the ‘80s and ‘90s where multiples went from 6 to 30. This is going to be a situation where the rallies can be very steep, there will be a lot of volatility, but you also have to have your wits about you because things can change relatively quickly.
CONSUELO MACK: Do you agree basically with Jason about the fact, I mean, corporate profits, and that the Fed monetary policy is going to be fairly loose, and therefore for U.S. stocks, that’s a pretty good combination?
CHUCK LAHR: Yeah, I think so. I think it’s a really benign environment, and there’s a couple of different factors there that I definitely agree on. First of all, the Fed is very likely on hold well into 2012, I think just the nature of the recovery that we’re having. But at the same time, you have a lot of joblessness that really makes it almost a political decision, very difficult for the Fed to get too aggressive in hiking rates. You do have, I think, a major stumbling block coming along, and this doesn’t disrupt the long-term view, but in the form of the withdrawal of QE2…
CONSUELO MACK: Right, in June.
CHUCK LAHR: …that could be a source of volatility. The test needs to be played out, whether or not the government can hand off the baton to the private sector, but that said, if you’re a long-term investor, it’s likely to create some good opportunities, and some good values, again, in a path towards higher stock market values.
CONSUELO MACK: So when I hear that, though, when you’re talking as a deep value investor, as a regular investor I'm saying, “Uh-oh, that means that the stock market is going to correct, and that, in fact, if it’s creating opportunities for you at the PIMCO Pathfinder Fund, that’s going to be a problem for my portfolio.” Am I wrong in making that assumption?
CHUCK LAHR: Well, if you’re invested in stocks, if you’re invested in a fund like Pathfinder, it’s sort of a… it’s a prerequisite to have a long-term approach. Stocks are volatile. There is very little that you can do to avoid the volatility in equities, especially if you’re a long-term value investor. But when these events come along, it’s very difficult to see with many of the names that we own, this being anything more than mark-to-market issue. So volatility may drive the stock market down, but the long-term value, the intrinsic value of the equities that we own are still there. So it’s really the market serving up a blue light special to you, and telling you to go out and buy some more.
CONSUELO MACK: So, Jason, Strategas is an institutional research and strategy shop. So what are the big trends that you’re telling institutional investors, your clients, to watch, that you think should be affecting their investment decisions, in addition to the Fed?
JASON TRENNERT: Yeah, the good news, I would say, is that last year, you had 40% of the S&P 500 in front of Congress, and that’s over. That storm cloud has passed, so a lot of the regulatory headwinds that we’ve been facing, that in my view really limited employment, probably limited economic growth, the good news is that’s unlikely. Regulation can help and it can hurt, I would say in my view, with the fact that the absence of regulation right now is going to be very helpful. I think that’s another thing that I’m watching very closely.
I also think that you’re at a point now where the natives are getting restless. Guys like Chuck, institutional investors are saying, “Listen, it’s okay in a period of great financial stress to hold on to a lot of cash.” But I think you are getting to a point now where there’s a sense that you have to use it, or lose it. You have to do something to enhance shareholder values. So you’ve seen a big pick up in M&A, you’ve seen a lot of companies actually institute dividends that never had them before. All those things are very, very important for the individual investors.
CONSUELO MACK: So stock buy-backs…
JASON TRENNERT: Stock buy-backs …
CONSUELO MACK: … all shareholder enhancing. So, lets’ talk about if we were to look where in the world you’re investing because you are a global investor, Chuck Lahr. So I’m looking at the Pathfinder portfolio, and I see a lot of European names.
CHUCK LAHR: That’s right.
CONSUELO MACK: Why Europe?
CHUCK LAHR: Well, as a value investor, you know, distress often brings opportunity. Distress gives you low valuations. Some stocks get sold for the right reason, and many have in Europe, but others are sold indiscriminately. The market tends to be an emotional mechanism, and a lot of quality assets have been thrown out without any real regard for the underlying attractions, the intrinsic value. I could give you an example in Danone…
CONSUELO MACK: We love examples. Right, the world’s largest yogurt maker. I’m a big client.
CHUCK LAHR: Absolutely.
CONSUELO MACK: Or consumer.
CHUCK LAHR: The problem with Danone is that we don’t have enough Americans eating yogurt yet. America is almost like an emerging market to Danone. If you compare America with the rest of the developed world, the CEO of Danone will actually refer to the U.S. as one of his emerging market plays, because yogurt consumption is so much lower here. But you just had them report sales today for the first quarter, 8 ½% growth, expectations were around 6%. The stock is very cheap for the quality of asset that you get, and importantly- and this is a theme that we could probably talk about a little bit more- is that this company has pricing power, so the inflation that you’re seeing in input costs is being passed along directly to the consumer, and even though the market worries about the ability of this company to maintain its margins, because of its pricing power, their margins are going to be protected. The consumer is going to bear it, these are products that we all want in the yogurt, and the water, et cetera, and it adds up with a very sustainable free cash flow generation pattern, attractive dividend, and a stock that I think is worth quite a bit more than it is today.
CONSUELO MACK: So we just described kind of the backdrop for the U.S., and one of the big positives was that the Fed will continue to ease. You look at the ECB, it’s exactly the opposite, so you know, they just raised interest rates 25 basis points, a lot of the governments in Europe are tightening fiscally, so isn’t that a negative for European stocks?
CHUCK LAHR: I think if you look at what the ECB is doing, and you’re absolutely correct, they’re taking a very hawkish stance on interest rates, there are different stocks that we affected in different ways. The big picture macro of looking at increased rates in Europe may be a negative for the overall market, but again, this early in a cyclical recovery, like Jason said, generally you get a correlation as rates go up, equities will go up. Most of the companies we own, though, are said to be net beneficiaries of higher rates, or on the other hand, just won't be affected at all. It would take a real, quite an increase in rates to affect the consumption of a company like, say Danone.
JASON TRENNERT: European equities are very interesting because I’m personally convinced that the ECB is making a policy error, and yet the equities, when you look at them just on an equity risk premium basis, are very cheap. A lot of the local markets are very cheap. They tend to be very, very good plays on the emerging markets. And one of the other themes that we have at Strategas is the idea that you want to play the emerging markets at this stage of the cycle through large cap multinational corporations in the developed world rather than in the local markets, and the developing world itself.
CONSUELO MACK: Because?
JASON TRENNERT: Because the Fed is really… I don't want to say “uncaring”, but doesn’t really care that much that it’s exporting inflation, if you will, and that’s a big problem for local emerging markets, because so much …
CONSUELO MACK: Right, India, China, Brazil, they’ve all complained about it.
JASON TRENNERT: Well, of course, which is, you know, in some ways very rich to be lectured by China about what we’re doing to, you know, with our policies, but that could be a subject for another day…
CONSUELO MACK: That’s a whole other show.
JASON TRENNERT: …but I would say that in those countries, commodity prices make up a much, much greater portion of their inflation, so in China, 35% of their CPI is food. In India, 53% of their inflation is food and energy. And so those local markets are going to have a very difficult time overcoming that, and yet there are large cap equities in the United States and in Europe that are very, very good derivative plays on global growth.
CHUCK LAHR: What Jason points out, again, and is right on the money, that there’s almost a quasi-arbitrage to be had in developed market equities, these multinational companies that have substantial exposure to emerging markets. And that’s a theme that we’re playing rather tangibly in the Pathfinder Fund. If you look at our top ten exposure, there is a substantial, or perhaps 30 or 40% of the actual income stream coming from emerging markets, which is much higher growth, and ultimately that’s going to a developed market company to the bottom line cash flow that’s distributed to you as a shareholder. Emerging market pure plays overall- the equities are cheaper than they were, that’s for sure. We think the secular story in EM is very supportive. As far as actually…
CONSUELO MACK: As far as the consumer society.
CHUCK LAHR: Absolutely. Absolutely. Relatively unencumbered sovereign balance sheets, the ability to grow, low bank penetration in many of these markets.
CONSUELO MACK: High savings rates, low debt levels, right.
CHUCK LAHR: Absolutely.
JASON TRENNERT: So they can make all the mistakes that we made in the developed world over the next 50 or 60 years.
CHUCK LAHR: And hopefully you can get in on some high quality equities along the way. At this point, I don't own any in the Pathfinder Fund. Again, the…
CONSUELO MACK: Any emerging market, direct pure plays.
CHUCK LAHR: No pure plays.
CONSUELO MACK: Wow.
CHUCK LAHR: Again, that quasi-arbitrage that we talk about is so compelling in going to developed markets where you have a structure of shareholder culture, shareholder bylaws, protections, of property rights, et cetera. That just, to me, seems to be a better way to play it right now.
CONSUELO MACK: So, Chuck, let me ask you about, again, when I look at the Pathfinder Fund, I’m looking at the, you know, financials, what, are about 25% of the portfolio?
CHUCK LAHR: That’s right.
CONSUELO MACK: And what consumers, not discretionary, but the consumer staples, the more defensive issues are like 24%?
CHUCK LAHR: That’s right.
CONSUELO MACK: Which seems kind of diametrically opposed because I think of financials these days being more risky, and then the consumer staples being defensive.
CHUCK LAHR: Most consumer staple stocks are thought of as boring, sleepy, low growth. Like I said with Danone, you actually have a situation where it’s a relatively high growth company with a lot of pricing power. So investors, I would say, don’t do the same amount of work in actually understanding what the trajectory of the company’s profitability, and the stock market path is, as well- a lot of attractive merchandise to be looked at there.
Financials, on the other hand, as you know, you can get your hands burned but at the same time, if you do the work, and actually try to exploit some of these themes, and focus on undervalues assets, you can find some real gems. And, you know, that factor multiplies when you look globally. Another example would be AIA. This is the life insurance company domiciled in Hong Kong, spun out of AIG. What you have here is you have kind of a 50/50 mix of developed Asia, and emerging Asia. Now, the developed Asia, Hong Kong and Singapore, is relatively low growth. Emerging Asia, China, Thailand, is rather high growth.
CONSUELO MACK: So they’re buying life insurance? The high growth emerging Asian countries…
CHUCK LAHR: The consumers are. Yeah.
CONSUELO MACK: Consumers are buying life insurance.
CHUCK LAHR: And that’s a trait of markets really around the world when per capita income gets to a certain level. You buy insurance because you want to protect what you have, you want to protect what you’re passing on to your family. And life insurance is experiencing rapid growth in these markets, and what’s really interesting about AIA is that essentially this company has been untouched for so many years. A lot of the agencies have been run by families that have done very well selling simple spread products. So they’ve ridden the back of the secular wave, and the secular growth. You have a new CEO at AIA, Mark Tucker from Prudential U.K., who has a really strong track record there. And his mandate and plan really is to kind of recast the distribution system, incentivize them to sell more complex products, higher margin products to the company, and actually use the excess capital that they have to drive this growth.
So it’s not just systematic growth that you’ll get, but actually bottom up idiosyncratic growth, as well. So at the end of the day, if you take the stock, it trades at 1.1 times embedded value, which is kind of a proxy for book value on a global scale, if you were to value the individual businesses in this company, discretely, based on the countries where they’re located, you’d walk away thinking it’s worth two times embedded value. So there is a lot of upside here, as Tucker shows delivery on the restructuring story.
CONSUELO MACK: But Jason, let me ask you, your top sectors that you are recommending your clients overweight are energy, technology, industrials, and materials. Why?
JASON TRENNERT: So it’s a very reflation-oriented portfolio. Now, those have done very well certainly in the beginning part of this year, which I guess makes us somewhat nervous. But really, again, if I know, let’s say, or if I’m relatively confident that money growth is going to pick up, that the Fed is going to be easy, it seems to me that there is going to be an underlying bid in the price of commodities, far in excess of what the equities are already discounting, and so energy I think is a perfect example where the earnings estimates for the sector probably are discounting $85 or $90 and the average price of oil this year, it’s very likely to be meaningfully higher than that. It may not be as high as where it is now, but I think you’re going to get earning surprises there.
Murphy Oil is one exploration and production company that we like quite a bit. It fits two of our screens, that we’re trying to play here. One is that it has a great ability to grow dividends. It’s on our dividend growers list. It’s also in our quality data portfolio, so we’re looking for quality companies that also won't hurt you if the market goes up.
CONSUELO MACK: It is that famous time for the One Investment, that something that each of us should own in a long-term diversified portfolio. And we always say you can’t recommend your own fund, so, Chuck, what would your One Investment, what should we all own in a long-term diversified portfolio?
CHUCK LAHR: Well, I’ll give you an individual stock then. ING, the Dutch Financial conglomerate (ING). This is a very interesting story, and it has an ADR that trades in the U.S. What you have today is really this bank and insurance company being offered at about 70% of book value, five times earnings. And, you know, I talked about a breakup before in CVS, and there are lots of assets that can be broken up. With ING, there is a forced breakup. The European Commission has mandated that they have to sell off all of their insurance assets, as well as some other assets by 2013, so buying the stock today, you’re buying the bank, but you’re getting all of the insurance assets for free, and when those assets are sold, when that capital is actually brought back in, you’re going to be sitting on a pretty profitable bank with likely excess capital, and again, just trading at about five times earnings.
CONSUELO MACK: All right. Jason?
JASON TRENNERT: I think I’m going to go back to Murphy Oil (MUR).
CONSUELO MACK: All right.
JASON TRENNERT: Because it’s an E&P company in the energy sector, and of course, we pay themes. We’re top down people. But the thing that’s interesting about Murphy Oil, though, is it satisfies two of the great themes that we’re trying to capture. One is quality data, so companies that have very strong balance sheets, that aren’t going to hurt you, that have a lot of free cash flow, but also have higher than average data so that you can participate on the upside. Also, Murphy Oil, though, is in that dividend grower basket that I talked about before.
CONSUELO MACK: Thank you both so much. Great ideas. And great exchange of ideas, as well. So Jason Trennert, from Strategas, great to have you back on WealthTrack. Chuck Lahr, your maiden voyage, we are delighted to have you and hope to have you back again, from PIMCO Pathfinder Fund.
CHUCK LAHR: My pleasure. Thank you.
CONSUELO MACK: I hope you can join us next week. I’ll be talking to one of the new generation of Great Investors. Thirty seven year old Michael Hasenstab, Morningstar’s 2010 Fixed Income Manager of the Year runs the venerable Templeton Global Bond Fund but his approach is anything but traditional. You’ll find out why.
In the meantime, to see this program again, please go to our website, wealthtrack.com, and while you are there, check out WealthTrackExtra, where we show extended interviews and podcasts with other Great Investors and Financial Thought Leaders. Thank you for taking the time to visit with us. Have a happy Easter weekend and make the week ahead a profitable and a productive one.