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Stocks Could Post Limited Gains in 2017 as Yields Rise
Rising bond yields, rich valuations, and global turmoil could limit the market’s gains, our experts say.

January 14, 2017

This could be the year the movie runs backward: Inflation awakens. Bond yields reboot. Stocks stumble. Active management rules. And we haven’t even touched on the coming regime change in Washington, which will usher tax cutters and regulatory reformers back to power after an eight-year absence.

Barron’s Roundtable Series
Barron’s 2017 Roundtable — Part 2
Barron’s 2017 Roundtable — Part 3

Put differently, 2017 could be a year of seismic shifts for the markets and, quite possibly, the world. Or, as Goldman Sachs strategist Abby Joseph Cohen said at this year’s Barron’s Roundtable, “We are breaking a lot of trends.”

The 2017 Barron's Roundtable (left to right): Jeffery Gundlach, Scott Black, Felix Zulauf, Mario Gabelli, Meryl Witmer, Brian Rogers, Oscar Schafer, Abby Cohen, Bill Priest Brad Trent
One trend we never break at Barron’s is rounding up some of the world’s best investors in early January and submitting them to a grueling grilling about the prospects for stocks, bonds, commodities, currencies, and more as the new year unfolds. This year’s interrogation took place Jan. 9 at the Harvard Club of New York, and featured a dynamic discussion of myriad issues, from China’s currency to Europe’s bank woes to Donald J. Trump’s presidential agenda, all of which could reshape the global economy and investment landscape in 2017 and beyond.

Typically, our market seers thrust and parry from breakfast till cocktails, but this year a remarkably cohesive consensus emerged (contrarians, pay attention). With the bond bull market seemingly ending after 35 years, geopolitical risks growing more pronounced, and the market richly valued, U.S. stocks could have a tough time generating more than mid-single-digit returns. The group generally expects stocks to perform well through the year’s first half, but sell off thereafter, posting full-year results that could range from down 5% to up 6% or 7%.

Felix Zulauf: Geopolitical Tension Impacts Markets
Felix Zulauf, member of the 2017 Barron’s Roundtable and President of Zulauf Asset Management, feels market will rise in first half of 2017 but geopolitical tensions could result in a 15-20% market decline in second half. Gold could rebound.

Our panelists have a dark view of developments in Europe, from the spread of populism to the persistence of negative interest rates, and some fear the euro’s days are numbered. In Japan, however, they say the sun is finally rising on equity investors, and opportunities could surface.

This week’s Roundtable installment, the first of three, highlights not only the big-picture backdrop, but the best investment bets of Felix Zulauf and Bill Priest. Felix, ever-analytical and ultra-urbane, helms Switzerland’s Zulauf Asset Management, but his gimlet eye takes in the whole wide world. Much about the global economy and political scene worries him, and he expects stocks to have a challenging year—after a robust Trump rally, that is.

Bill, the big cheese at New York’s Epoch Investment Partners, notes that rising price/earnings ratios did the heaviest lifting in recent years to catapult stocks to fresh peaks. That will change if bond yields head toward 3%, as expected. Now, he says, the burden will fall on earnings and dividend growth to propel stocks higher. Bill, who is laser-focused on free cash flow, flags four stocks with sparkling profit potential, including Google, which goes by the updated moniker Alphabet (ticker: GOOGL) and sparkles in multiple ways.

Bill Priest: Stocks With Solid Earnings Potential
Bill Priest, a member of the 2017 Barron’s Roundtable and CEO of Epoch Investment Partners, discusses stocks with double-digit potential for 2017 including Google, Applied Materials and Hexcel.

To learn more about our experts’ outlook and investment ideas, please read on.

Barron’s: The world as we know it is changing, or so it seems, and not only because of Donald Trump’s presidential victory. Mario, enlighten us. What do you expect the new year to bring?

Gabelli: Trump’s victory meant a rebirth of capitalism, with all its flaws, and a defeat for creeping socialism. It meant the U.S. would remain a place where capital would be honored, as opposed to impaled. Republican control of Congress means regulations will be reviewed and reformed, because the implementation wasn’t practical. Our tax policies could be reformed to make U.S. companies more competitive with the rest of the world. Monetary stimulus is ending; fiscal stimulus is coming, and could include spending on infrastructure and revitalizing the military.

The companies and people I’ve talked to see American innovation taking center stage. We are witnessing a wave of optimism sweeping the country. The question is: How much of the good news has the stock market already discounted? Financial companies will have good earnings this year. The oil ecosystem will improve. But currency translation will remain a problem for some companies, given the strength of the dollar. I continue to look for companies that have been ignored by the market, or unloved.

Brian, how does this year look to you?

Rogers: I agree with a lot of what Mario said. The most important person now isn’t the president-elect, but House Speaker Paul Ryan, who will help draft and push through tax reform. Whatever it looks like, in the short term it will have a pro-growth effect. Corporate and individual tax rates could come down, and taxes on corporate cash held overseas could be reduced, allowing for repatriation of that money. Infrastructure spending will also bode well for economic growth. The fact that Paul Ryan will help craft a lot of this means it will have a sane focus.

Zulauf: Will tax reform apply to 2017 income, or take effect only in 2018?

Rogers: My guess is that a lot of the changes will be retroactive, impacting 2017. The backdrop, in general, will be positive for the first six months of the year. But with the stock market selling at around 17 times earnings, the jury is out on how much upside equities will have.

Schafer: From the time Ronald Reagan was elected in November 1980 until he was inaugurated in January 1981, the market was up 9%. It then fell about 30% through August 1982. I’m not predicting that, but we have had a lot of euphoria.

Priest: There are only three components of equity returns: dividends, earnings, and price/earnings ratios. In the past five years, the MSCI World Index was up 87%. Of that 87%, 74 percentage points came from P/E-multiple expansion. Earnings were down two percentage points, and dividends were up roughly 15 percentage points. The market was up because quantitative easing [central banks’ asset-buying programs] effectively lowered the discount rate applied to earnings and cash flow. It had a profound impact. The election was an inflection point, as we can see from the postelection rise in bond yields. P/E ratios now face a serious head wind. It can be overcome with accelerated earnings growth, and tax reform will be a part of that, if it happens. Also, dividends are going to grow, probably faster than people think.

By the way, Jeff made the greatest prediction at last year’s Roundtable—that Trump would win the presidency.

Rogers: What about my Chris Christie recommendation? He looked great last January.

Kudos, Jeffrey. What are you predicting now?

Gundlach: People have forgotten the mood regarding stocks and bonds in the middle of 2016. Investors embraced the idea that zero interest rates and negative rates would be with us for a very long time. People said on TV that you should buy stocks for income and bonds for capital gains. This is when 10-year Treasuries were yielding 1.32%. Someone actually said rates would never rise again. When you hear “never” in this business, that usually means what could “never” happen is about to happen. I told our asset-allocation team in early July that this was the worst setup I’d seen in my entire career for U.S. bonds. It occurred to me that the bond-market rally was probably very near an end, and fiscal stimulus would soon become the order of the day.

Schafer: People were also worried about deflation back then.

Gundlach: Based on a comparison in July of nominal Treasuries to Treasury Inflation-Protected Securities, or TIPS, the bond market was predicting an inflation rate of 1.5%, plus or minus, for the next 30 years. Now, that is implausible, and kind of proves the efficient-market hypothesis is wrong. More likely, the inflation rate would increase not in five or 10 years, but one year, because commodity prices had already bottomed. The Federal Reserve Bank of Atlanta’s wage-growth tracker is now up 4%, year over year. Oil prices have doubled since January 2016, to around $52 a barrel, which likely means that headline CPI [the consumer-price index] will be pushing 3% in April.

I expect the history books will say that interest rates bottomed in July 2012, and double-bottomed in July 2016. At some point, the backup in rates will create competition for stocks. Bonds could rally in the short term, but once the yield on the 10-year Treasury tops 3%, which could happen this year, the valuation argument for equities becomes problematic. When the long bond [the 30-year Treasury] was at 2%, bonds had a P/E of 50. Compared with that, a P/E of 20 on stocks didn’t look all that bad. But if the 10-year yield hits 3%, you could be talking about 4% on the 30-year, which implies a P/E of 25.

Something else happened in 2016: The Fed capitulated, as I predicted a year ago. The Fed gave up on its forecast for higher interest rates and lowered its dot projections for 2017, just when it might have been right. [The Fed’s so-called dot plot shows the interest-rate projections of the individual members of its policy-setting committee.] In December, the Fed had to reverse itself and raise rates.

Priest: For the first time in years, the Fed didn’t lower its forecast for GDP [gross domestic product] growth in coming years. Central banks and the International Monetary Fund have been dead wrong for years with their annual forecasts for world GDP growth. The danger now is that pressure on P/E multiples will be negative. Unless we get tax reform and more growth in the real economy, the chances of a down stock market aren’t insignificant this year.

Gundlach: Fed Chair Janet Yellen suggested a few months ago that running a “hot” economy might not be such a bad idea. But when unemployment is low, wages are rising, and significant fiscal stimulus is likely, inflation could exceed consensus expectations. Jim Grant, the founder of Grant’s Interest Rate Observer, wrote a fantastic article a few years ago likening the current environment to the 1940s and ’50s. Short-term interest rates were at 3/8s in the late 1940s, and long rates were around 2%-2.5%. Inflation was running at 2%. Everyone had been predicting higher inflation rates, but after a long period of 2%, they gave up. Then inflation spiked to 8%. It came out of the blue.

Gabelli: Does the strength of the dollar change your thinking?

Gundlach: A strong dollar keeps inflation lower. It is helpful to the bond market. A weak dollar isn’t helpful to the bond market. However, I brought along a quote from President-elect Trump today because it makes me think. He said, “While there are certain benefits to a strong dollar, it sounds better to have a strong dollar than it actually is.” Is it really a given that Trump will bring us a strong dollar if he is supposed to be helping the forgotten middle class?

Scott, join the conversation and give us your view.

Black: First, it is uncertain what kind of legislation will be passed. Second, the Fed’s internal forecast for real GDP growth of 2.2% might not be so wrong. U.S. growth will be much better than that of the euro zone. Some caveats on corporate earnings: In the aggregate, they will rise sharply as energy companies improve, but the impact of lower tax rates might not be as great as people think. It will help companies in the Russell 2000 and Russell 2500, which are largely domestic in orientation, but it won’t have such a big impact on the capitalization-weighted Standard & Poor’s 500, whose largest components do much of their business overseas. Most multinationals, including Apple [AAPL] and Google’s parent, Alphabet, already have low tax rates—well below the nominal rate of 25% that could be passed.

Schafer: The companies in the S&P 500, on average, pay cash taxes of 23%.

Witmer: Trump is talking about a corporate rate of 15%, not 25%.

Barron’s has recommended a rate of 22% [“Cut the Top U.S. Corporate Tax Rate to 22%,” Nov. 26, 2016].

Cohen: There are many things the president-elect might wish to do, but a lot of these changes come under the purview of Congress, and some require a super-majority. We are likely to see tax reform in 2017, along the lines we have been discussing. Both Republicans and Democrats have been talking for at least five years about the need to reform the corporate tax code. It would have happened sooner, but the Democrats didn’t want to enact it in a vacuum; they wanted to pair it with individual tax reform. That constraint is now gone.

Also, the new president could adjust some of the executive orders that President Obama engaged in. There has already been widespread discussion about repeal of Obamacare. That can be done under budget reconciliation, which requires a simple majority. But replacing it most likely requires a super-majority.

The Fed’s latest policy statement told us two important things: The U.S. economy is growing, and the labor market is improving. GDP growth will probably improve from well below 2% last year to something in excess of 2%. Goldman’s estimate for this year is 2.3%. With global capacity tightening, you would expect inflation and interest rates to rise. But the Fed also told us there is a lot of confusion about the possible impact of policy changes in a growing economy. Some proposed changes might notably enhance— and I don’t mean that in a good way—the budget deficit. The federal budget deficit could double between now and 2020, and the economy isn’t going to grow fast enough to close the gap. We see the deficit going from about 2.5% of GDP to about 5%.

Brian Rogers: In the U.S., “we like large-cap growth, but not small-cap anything.” Photo: Jenna Bascom
Won’t significant spending on infrastructure help to boost the economy?

Cohen: On the infrastructure front, the easy stuff is most likely to get approved in the short term, as part of a corporate tax-reform package. Projects could be funded in part through tax credits or public/private partnerships. Congress is unlikely to approve massive spending on infrastructure, which has been discussed, in the next year or so.

Rogers: The good news is, Jeff is young enough that he still has time to convert and become an equity investor. This discussion raises the specter of crowding out [government borrowing stifling private-sector borrowing]. I am only halfway facetious in wondering whether bonds might become “certificates of confiscation” [as they derisively were called in the 1980s, when yields reached double digits]. It almost sounds like a multiyear bear market is developing in bonds.

Cohen: But we’re starting today at very low yields. In many countries, yields are negative. As I have said in the past, negative interest rates are a fool’s errand. They have not worked to spur growth. The nations that have benefited from negative interest rates have done so mainly through the transmission mechanism of a weak currency, relative to the dollar. They have seen benefits in terms of trade. Negative rates have led to enormous disruptions and haven’t helped the banking systems in various places.

Gundlach: Negative rates are toxic to banking systems. Also, they don’t motivate consumption. They necessitate savings. A 60-year-old who hopes to retire in 10 years and have a 20-year life expectancy beyond that has to save twice as much when interest rates are at zero than when they’re at an old-school 5%.

Nominal GDP is the single best indicator of the secular trend in interest rates. Nominal GDP rose for a couple of decades into the 1980s. Interest rates, as we know, rose in the early ’80s. GDP has been falling annually, with few exceptions, since around 1982. Last year, real [inflation-adjusted] GDP probably grew 2.1%. If fiscal stimulus lifts the growth rate this year to 2.5% to 3%, and you throw an inflation rate of 2% to 3% atop that, conservatively you’re talking about nominal GDP around 5%. How can bond yields stay at 2.4% in that environment?

Cohen: Let’s state the obvious: We are approaching a period of global fiscal stimulus at a very peculiar time. Normally, you would have had fiscal stimulus applied in a more dramatic fashion when the global economy was in recession. Instead, there was a heavy reliance—I would argue undue reliance—on monetary policy. It was the only game in town. A better time to have invested in infrastructure would have been 2009-’10, when the unemployment rate was high, construction workers were looking for jobs, and interest rates were lower for longer. The recession ended in the summer of 2009. It is odd to apply this sort of fiscal stimulus now.

Mario Gabelli, far right: There’s “a wave of optimism. But how much of the good news has the stock market already discounted?” Photo: Jenna Bascom
Gabelli: Except that our bridges are defective and there are potholes everywhere.

Cohen: As a country, we have underinvested in capital and labor. On the capital side, we haven’t invested in public infrastructure, and capital spending has been insufficient in many industries. On the labor side, we haven’t done what is needed in terms of education. Normally, economic growth is related to labor-force growth. Many people believe that one reason economic growth has slowed is because the labor-force participation rate has fallen. Also, there hasn’t been enough investment in innovation. In the golden period of the 1950s and ’60s, the U.S. spent approximately 4.5% of GDP on basic research and corporate research and development. Now, we spend 2.5%. Much of the decline owes to government defunding at the National Institutes of Health, the National Science Foundation, NASA, and other agencies. Companies have picked up some of the slack, but investments aren’t where they need to be.

Priest: It is very hard to get real GDP in developed countries rising by much more than 2.5% a year. The two components of real GDP—growth in the workforce and productivity—are rising at very low levels. Workforce growth is just 1%, and productivity, as measured, is running at well under 1%. But there is a positive outlook for equity markets, provided earnings grow in line with revenue, or better.

Most of you are familiar with the DuPont formula: return on equity equals profit margins multiplied by asset utilization, multiplied by financial leverage. If you substitute technology for labor, profit margins will rise, other things being equal. If you substitute technology for capital, asset requirements will fall, so sales per dollar of assets will rise. The leverage factor measures assets per dollar of shareholder equity. If you don’t need all those assets, that capital can be paid out. Payout ratios could surprise on the upside in the next couple of years, because capital’s best friend is technology—i.e., robotics and AI [artificial intelligence]. One caveat is that robots don’t buy anything, so what you might get on the productivity side, you could lose on the consumption side.

Let’s go back to Scott, whom all of you interrupted.

Black: Thank you. I’m not a macroeconomist, but productivity was enhanced from the Industrial Revolution up until about 2006 by waves of technological innovation. As you look at where venture-capital dollars and Wall Street are going now, there has been an orientation toward technological innovation in social media and gaming. Neither has a real effect on boosting productivity.

Meryl Witmer: ”I have been impressed by Trump’s cabinet picks.” Photo: Jenna Bascom
They usually hamper it.

Black: We need a new growth wave in technology to push us to a different level.

I believe we are mired in a slow-growth economy. Regarding the strong dollar, 44% of S&P 500 revenue comes from overseas. Non-U.S. profits are about 20% to 25% of the total. If the dollar remains strong, that will depress S&P earnings. The Wall Street Journal published an interesting article recently showing that presidential administrations whose appointees have a lot of experience, especially in business, don’t always produce the strongest economic growth. The Kennedy administration’s top officials had the least amount of experience, but the highest growth rate of per-capita GDP, at 4.2%. Reagan and Bill Clinton had more people with experience, and GDP rose 2.5%. The administrations of George H.W. Bush and George W. Bush had people with the most experience, but posted the worst growth, at 0.7% to 0.8%. While Trump might do good things like deregulate parts of the economy, there is no guarantee that America is going to return to an earlier, more robust growth rate.

Gabelli: You are missing the psychological impact: the notion that success will no longer be stepped on.

Scott Black: “While Trump might do good things like deregulate parts of the economy, there’s no guarantee America is going to return to an earlier, more robust growth rate.” Photo: Jenna Bascom
Black: We have had a euphoric rally.

Gabelli: I’m not talking about the stock market. I’m talking about the people in the street.

Witmer: As companies grow and build new plants, and see a 15% tax rate and fewer burdensome regulations, there could be a sea change.

Black: Consumer confidence is at the highest level since January 2004, based on the University of Michigan Consumer Sentiment Index. There is some euphoria built into expectations. Whether new policies are realized or not remains to be seen.

Rogers: Scott, I read the same Journal story. It seemed to me that so much had to do with the environment when a president took office.

Cohen: That would suggest that Democrats generated much more jobs growth because the Republicans who preceded them didn’t do a good job.

Abby Joseph Cohen: “We are approaching a period of global fiscal stimulus at a very peculiar time.” Photo: Jenna Bascom
Witmer: Or the Democratic Congress preceding them didn’t do a good job.

Rogers: Jeff talked about the risk in bonds. In equities, too, there is a big misunderstanding of risk, almost globally. Everything looked good in early January last year. Then there was a growth scare regarding China, and U.S. stocks fell by more than 10%. Scott referred to euphoria, and it feels like there is a bit of that baked into the financial markets right now, maybe not in fixed income as much as equities.

Gabelli: What is risk? Do you equate it with volatility?

Gundlach: No. People are underestimating the risk of loss right now.

Felix, you have been too quiet. Where do you see the markets, and the world, heading this year?

Zulauf: I agree that bond yields have bottomed on a secular basis. The bottoming process historically takes a long time, whereas peak periods for bond yields are relatively short. The last secular peak occurred between 1979 and 1984. I see high expectations for, and even euphoria about, the new president, and I believe Trump is serious about many of the things he discussed in his campaign. He is a businessman; he will do a lot for business. President Obama was antibusiness, but the stock market tripled during his two terms because he had a great starting point—and the central bank was working for him. Trump is starting out with a highly valued stock market, and the Fed won’t be working for him to the same degree. That suggests a different outcome. Future returns for equities will be much lower than what we have seen.

Gundlach: The people whose names have been bandied about as potential Fed chairs under Trump are all pretty hawkish on interest rates.

Zulauf: Bill discussed valuation expansion. The U.S. stock market now is valued higher than it was 95% of the time in the past 100 years. That is a pretty bad starting point for valuation expansion. The Trump era might be much better for Main Street and not so good for Wall Street.

The world is changing dramatically. There are many similarities now to the period before World War I, an unstable time when a new power rose. Germany challenged and provoked Great Britain and France. There was a weak institutional architecture as well, with Austria and Hungary under one roof. Today, China is the up-and-comer. We are exiting a stable bipolar world that had checks and balances. The U.S. and Russia controlled each other, and each controlled its satellites. We had the Pax Americana, a 15-year period in which the U.S. dominated and could do what it wanted.

Under Obama, the U.S. started to reduce its function as the global policeman, and Trump will continue the trend. That creates geopolitical vacuums, and others move in. It happened in Syria, and to some degree in Turkey. Iran is gaining power, too. The world will be much more volatile. Trump’s trade initiatives will reinforce the trend toward a reduction in global trade and globalization in general. Trade declined ahead of both world wars.

What is happening in China?

Zulauf: China did everything right until 2008. It had a wonderful period of 10% growth or more for 25 years. Since 2008, policy makers have gone wild, making one mistake after another to keep the economy growing. The growth rate has broken down; it is now between 6% and 7%, or whatever the government publishes. It will continue to slow, because once an economy reaches the size of China’s, it can’t grow at the same rate as before.

The Chinese are trapped in a debt bubble. Wealthy Chinese have discovered they need to invest outside the country, because business opportunities and returns on real estate and other assets aren’t as great in China as they once were. Although there have been tremendous capital outflows, the wealthy probably have less than 10% of their money invested externally. Normally, for an economy at China’s stage of development, outside investment would total 25% to 40%. That means there will be more capital outflows, which will weaken the currency, the renminbi.

Next fall, the Chinese Communist Party will hold its 19th National Congress. President Xi Jinping needs to stabilize the currency and economy before then. The government has used its foreign exchange reserves to buy renminbi; reserves are down 25% from the peak. China has only two options: Stabilize the currency by tightening monetary policy, which would lead to a recession, or shut off capital outflows, which, with credit expansion at 40% of GDP annually, could lead to rapid inflation.

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Which course will China choose?

Zulauf: They will try a little of both. But the pain for the economy will be too great, so eventually they will let the renminbi go. It could slide to eight or nine to the dollar from about 6.90 now.

The other problem is Europe. As I have argued for many years, the European Union made a mistake by implementing the euro. It strangulated many economies and killed a few million jobs. The centralization of Europe’s economy is inefficient, but the European political leadership won’t change it. They are married to their idea, as it was designed on a piece of paper. The failure of the common currency has led to the rise of populist movements throughout Europe.

There will be an election in the Netherlands in March; the populist party is leading so far. The more important election is in France; the first round will take place at the end of April, and the two winners will move to the second round. There are four candidates who matter: Marine Le Pen represents the far-right Nationalist Front party. She has a socialist economic agenda. François Fillon, the conservative, has a terrific, almost Thatcher-like reform program. He wants to get rid of half a million government jobs and increase the workweek. He won’t be elected in France on that platform. The third candidate, Emmanuel Macron, is pro-EU and wants to further economic integration. That doesn’t ring a bell with most people in France. The fourth candidate, not yet chosen, will represent the Socialist party. I predict the Socialists will drop out in the first round.

And the winner is?

Zulauf: Le Pen has a much better chance of winning than most people think. If she is elected, she has said she will launch a referendum on membership in the EU and the euro zone both. Le Pen would tear down the institutional architecture of Europe, and chaos would ensue. In the first half of the year, the market will focus on Trump and celebrate his moves. But there are many risks outside the U.S.

Cohen: The creation of the euro hasn’t been an impediment to Germany. It has benefited in terms of trade. Given that backdrop, are you surprised by the political tension within Germany?

Zulauf: Germany superficially is a big beneficiary of the current structure. It has doubled its exports to 50% of GDP since the introduction of the euro. But it will lose out on Target2 [a European payment system enabling the settlement of transactions with central bank money]. Germany has claims on 750 billion euros [$797 billion] against other EU countries, with Spain and Italy each accounting for more than €300 billion of those liabilities. If the currency union breaks apart, do you really believe they will pay Germany?

Priest: Italy is the Achilles heel on the European economic front. It is the eighth-largest economy in the world, and it has the fifth-largest amount of sovereign debt outstanding. Its Target2 balances are astonishing. Money has flooded out of Italy, and the banking system is sitting on a crisis.

Zulauf: Germany looks like the big winner. But when you look more closely, and include Target2, things won’t actually work out as they seem.

Gundlach: And the German population doesn’t quite understand this. According to ,a poll by Pew Research Center, 38% of Germans disapprove of the EU’s handling of economic issues. In France and Italy, two-thirds-plus of the population are dissatisfied with the EU. In polling terms, that is enormous. Those countries have almost maxed out on dissatisfaction.

Gabelli: Then there is Europe’s immigration issue, and the fact that these countries always bailed themselves out by devaluing their currencies, which they are currently unable to do.

Zulauf: The immigration problem is just the tip of the iceberg. It isn’t the key problem. Protests against the establishment are growing throughout Europe, but the establishment has no rules on how to break up the European Union purposefully. When it happens, chaos is guaranteed.

How smoothly will Britain be able to exit the EU, now that it has voted to do so?

Zulauf: Discussions will start in the spring, and they will be nasty. The EU will be tough and seek to demonstrate to all members that exiting is not an option. It is very costly. The process will create a lot of turmoil, which isn’t good for global economic growth. Global trade will continue to decline.

The U.S. stock market sold off momentarily after the Brexit vote and then recovered and went to new highs. How will U.S. stocks respond if anti-euro parties gain more power in Europe?

Zulauf: As soon as there is a greater-than-50% risk of the euro’s failure, the markets will sell off, and not just for a day. Capital doesn’t want to get involved in chaotic situations.

Gundlach: U.S. stocks took off on the upside for real in 2012 when Mario Draghi [president of the European Central Bank] largely pushed aside fear of euro-zone breakdown by saying policy makers would do “whatever it takes” to preserve it. There is empirical evidence for what you said.

Zulauf: I expect the dollar to remain strong, not because the U.S. is so powerful, but because the other options are so weak. You can’t put your capital in China or Europe or the U.K. In the U.S. you have a pro-business president and a relatively free market.

Gabelli: And rule of law for capital.

Meryl, what excites you about 2017—and what worries you?

Witmer: For corporations, lower taxes, and less regulation are absolute heaven. If the corporate tax rate falls to 15%, as President-elect Trump has proposed, why would you do business anyplace else? And if business ramps up as I expect, companies will need to hire more people. There are a lot of underemployed people in the U.S. who would like to work. Also, we might see an increase in allowed immigration.

On the other hand, equity valuations are stretched somewhat, although there are pockets of value in the market. I don’t see the market taking off this year, but things could look good if Congress doesn’t screw them up. I have been impressed by Trump’s cabinet picks. Hopefully he will do well, and if so, longer-term, the markets will do well. It is fascinating that Trump can be so effective simply by tweeting.

Gundlach: The shift in sentiment to positive from negative, regarding the efficacy of Trump is one of the biggest I’ve seen in my career. I wonder if sentiment can swing just as quickly the other way. Many people who voted for him think something is going to change for them. They expect their wages to rise, and America to be “great again.” What will happen by July or August if nothing has changed? Put that together with the timing of an interest-rate rise, and we potentially could see a very different psychological environment.

Rogers: The pushback could come in the midterm elections. Trump might get a free pass for two years. But you could almost fantasize—or hallucinate, depending on your leanings—a Democratic resurgence if he doesn’t deliver for the people you described. The Republican majority might hold in the House and Senate, but the party could lose many seats.

Oscar, where do you stand on these issues?

Schafer: Ray Dalio [the founder of Bridgewater Associates] might have put it best when he asked: Will the Trump administration be aggressive and thoughtful or aggressive and reckless? There are so many uncertainties this year. Higher earnings and higher interest rates are yin and yang. It could be a tough year for the market, but a good year for stockpickers.

We’ve heard that one before.

Cohen: But this year, it will be correct. I’m with Oscar on the importance of stock selection.

Let’s put some numbers on all your market pronouncements. By how much will U.S. stocks rise in 2017?

Schafer: The averages will be up 4% from the start of the year. But there will be big winners and big losers.

Black: I like to go by the numbers. At this time last year, the consensus forecast for 2016 S&P 500 earnings was $126. The consensus is predicting that actual results will come in at $108.84. The consensus for 2017 is $130.84, which would imply a 20% increase. There is no way, with 4% nominal GDP and a strong dollar, that earnings will get there, even with energy-company profits improving. My forecast is closer to $123.

The market currently trades for 18.5 my expected earnings for this year. The historical average is closer to 16.5. The small-cap Russell 2000 index and the mid-cap Russell 2500 finished the year, respectively, at 28 times and 24 times 2016 estimates, and 23 and 21 times forward earnings estimates. Small- and mid-cap valuations are in nosebleed territory. That said, there is the potential for more gains because of bullishness about the Trump administration.

I expect the S&P 500 to rise about 5%. Add a dividend yield of just under 2%, and you get a total return of about 7%. I agree that it will be a stockpickers’ year. Many sectors are ahead of themselves. For example, regional banks generate an 8% to 10% return on equity. After a huge rally, they are selling at 16-17 times earnings. Shares of Deere [DE] and Caterpillar [CAT] went way up, while their earnings power went down. You have to be value-oriented. Value will outperform growth again.

Zulauf: Stocks could easily rise another 10% into the middle of the year. But after a soft period, bond yields will rise again, with the 10-year Treasury yield hitting 3% or going a little above it. That will trigger a big correction in equities, just when everyone is fully invested after buying into the Trump rally. I expect the S&P 500 to be slightly negative for the full year.

Gundlach: Did I give you my notes? That is almost exactly my view.

Rogers: Almost every year, the S&P 500 is off at least 10% at some point. With a starting P/E of about 17.5 times expected earnings, it is tough to argue for a gain of much more than 6% or 7%, especially in a rising-interest-rate environment. There are a lot of head winds this year. We could have another China scare, or something else that knocks stocks down a bit in the first half.

Felix Zulauf: “Europe offers value, but is probably a value trap. U.S. investors should stay away. Japan has much better fundamentals.” Photo: Jenna Bascom
Zulauf: It might not be a scare. It might be the real thing.

Priest: Start with what you know. The cash yield on the S&P 500 is 2%. Add nominal GDP of 3% to 5%. Given the current level of P/E ratios and the head winds coming from rising rates, I’m in the 5% to 6% category regarding the market’s potential gain. Geopolitical risks are higher now than they have been in many years, and volatility may well be above average this year as well.

Gabelli: I use a somewhat different model. If inflation rises to 3% and real GDP growth rises 3%, we’re talking about 6% nominal revenue growth for U.S. companies. The gross margin will decrease, due to rising labor costs. But selling, general, and administrative costs won’t rise as quickly, so operating-profit margins might improve slightly for many companies. Lower tax rates will help earnings dramatically.

With interest rates rising, the discount rate on pension plans will rise, leading to reduced cash contributions. I expect cash flow at U.S.-centric companies to exceed reported earnings by a significant amount in the next few years. I also expect increased mergers and acquisition activity. More challenging is how to address the deficit and other structural issues. I see zero to 5% growth for the stock market.

Are you concerned that the deductibility of interest expense might be eliminated?

Gabelli: No, because any change would likely be grandfathered in debt. Let me ask you: A guy from Queens will soon be president. He has been trained in the world of New York real estate. What do you do think he thinks about leverage?

What does Paul Ryan think about leverage?

Gabelli: As Abby said, both parties have been discussing tax reform for years. They are going to get a bill passed, starting with individual taxes. They will increase the earned income credit and recycle money back to the worker.

Cohen: This is the toughest year to forecast. We have a good sense that the economy will grow by 2% to 2.5%. We’re pretty sure that corporate earnings will be up about 10%. But we don’t have a good sense of the geopolitical environment or tax and regulatory changes in the U.S. There are questions about repatriation of corporate cash. My forecast for stocks assumes the first half of the year will look pretty good because economic forecasts are baked in the cake. But questions arise about the latter half, particularly as geopolitical uncertainty outside the U.S. intensifies.

Goldman Sachs forecasts that the S&P 500 could spend much of the year trading in a range of 2300 to 2400. Last year, in giving the house forecast, I said I thought the risks were skewed to the upside. It turned out that was the case. This year, the risks are skewed to the downside. Good things could happen with regard to corporate tax reform, but other things that aren’t so pleasant could occur in the interim.

Zulauf: None of your forecasts include the possibility that if Trump gets tough on trade with other countries, there will be retaliation. It isn’t a one-way street.

Gabelli: China is dumping steel through Vietnam and other countries. This isn’t fair trade.

Zulauf: I am not saying Trump is wrong, only that he could start something that might affect U.S. companies negatively. The Western capitalist model promotes corporate profit. The Chinese model is designed to promote employment. The conflict is growing between the two models. That is the problem.

Gabelli: The reality is that this country was run by people who had no clue how to trade. They didn’t know how to bargain. As that Nobel Prize-winner Bob Dylan said, “The times they are a-changin’.”

Based on your forecasts, the good news isn’t good for stocks, and the bad news is worse for stocks. Do you see any scenario that could produce a double-digit return?

Cohen:Historically, there have been periods when both interest rates and stock prices moved higher, because the rise in yields reflected a strengthening economy.

Gundlach: GDP growth has been unbelievably stable at 2% for the past six or seven years, despite quantitative easing and other nutty interest-rate policies. At last year’s Roundtable, I said the easiest forecast was that the Fed wouldn’t raise interest rates four times during the year. We are going to break out of the land of stability this year, and certainly by 2018, and there will be an inflation surprise. That isn’t going to be helpful for equity valuations.

Like Felix, I look for the stock market to make new highs in the first part of the year, but when rising interest rates bite, stocks will fall. I see a single-digit decline for the full year.

How do you build a portfolio to handle such a wide dispersion of possible outcomes?

Gundlach: Some things should be avoided in a major way because they have risk without rewards. One of the greatest trades of the year could be shorting German Bunds, but I will share more details later. Portfolios need to diversify away from deflation-oriented trades, which worked for a long time.

Zulauf: On the Bunds, a lot of money is flowing from southern to northern European banks within the euro system. The ECB is paying a negative rate on deposits. There has been heated discussion about the problem within the ECB, and it is conceivable that the ECB will remove negative-interest-rate charges earlier than people expect.

Cohen: The underlying theme of a portfolio has to be reflation. In an environment in which rates are likely going up and yield spreads have narrowed dramatically, fixed- income markets are a dangerous place to be. The stock market, in our view, isn’t as expensive as some people think. Using certain discounted-cash-flow models, it looks high, but on an earnings-yield basis, not so much.

The durability of the economic expansion matters, too. If you believe that GDP will grow by at least 2% in the next year or two, and that S&P profits will rise, the stock market doesn’t look overpriced. There are bigger pockets of opportunity within the stock market.

One big change in our industry in the past 20 years has been the move to passive investing. According to Zacks, there have been four new exchange-traded funds launched every day since the end of 2014. According to The Wall Street Journal, Vanguard passive funds held a 5% ownership stake in only three S&P 500 companies in 2005. That number is now 468. Given the incredible shift of money into index-oriented ETFs, I wonder, where is the price discovery? Where is the valuation discovery? Stockpickers have been waiting for this trend to reverse. The chance is high that we will see some sort of reversal this year. We are breaking a lot of trends this year. We are breaking trends about a multidecade bull market in bonds, and trends about equities. The easy work on P/E multiple expansion has been done, as Bill noted. There could be a real advantage to good active management this year.

I am concerned about Europe’s long-term growth rate and political risks. One market that might do better is Japan. Government policies are having some benefit. Fund outflows have stopped, and inflows are growing. Many investors view Japan as a way to participate in growth in Asia without being exposed to accounting concerns and disclosure issues in places like China.

Would you buy Japan on a currency-hedged basis?

Cohen: Currency hedging isn’t a part of my recommendation. The yen has already weakened significantly, relative to the dollar.

Priest: The index-fund trend has been turbocharged in the past five years. When most of the market’s return owes to multiple expansion, indexing is an ideal way to win. If we have entered a new regime, with earnings and dividends starting to drive total return, the opportunities for active management are only going to get better. Lower correlations are good for active management.

Gundlach: People say bonds are in a bubble, that they are over-owned. I agree with that. But anything that is momentum-driven is in a bubble. This passive stuff is in a bubble.

Gabelli: So what is your portfolio mix?

Gundlach: I’d recommend about 30% in fixed income, but you need a fixed-income allocation that is unlike a bond index. I’d also recommend a higher allocation to real assets, maybe as much as 20%. You could buy a commodity fund. Then I’d put 50% in equities, with a tilt away from the U.S. Valuations are out of control here based on the CAPE Shiller P/E ratio [price divided by inflation-adjusted earnings for the previous 10 years]. U.S. investors are provincial. Now is the time to move off your zero non-U.S. allocation. I like Japan and India. It is the new China.

Cohen: India is going through a difficult period because of some anticorruption efforts, including the withdrawal of high-value bank notes from circulation. But the secular growth rate there is approaching 8%.

Gabelli:To hitchhike onto Abby’s comments, inflation is picking up. That means you want to own companies with pricing power. Getting inflation-indexed assets into your portfolio is the way to maintain purchasing power. Also, utilities have done well. If rates go up, maybe the industry will see another round of consolidation. We like companies that could be the object of corporate lovemaking. A proposed reduction in the tax rate on dividends is an interesting dynamic.

Rogers: Regarding portfolio construction, we love short-duration high-yield bonds, but be security-specific. We like floating-rate bonds, vehicle bank loans, and emerging market bonds. We like frontier markets and developed markets outside the U.S., including Japan. Within the U.S. equity market, we like large-cap growth, but not small-cap anything.

Because of the valuation, presumably.

Rogers: Yes. We haven’t talked too much about real estate. There are some unusual things going on in the real-estate world. There is overbuilding in the apartment sector across the country, which is worrisome. Over the weekend, I heard a radio commercial related to house-flipping. It brought back bad memories from the prior decade.

Let’s go quickly around the room. What will we be talking about at this time next year?

Gabelli: We will be discussing the successful reform of regulations that made no sense, that our taxes are being lowered, and that sanctions on Russia will be removed.

Priest: Europe has gigantic geopolitical issues.

Rogers: There will be a renewed focus on the coming midterm elections. Also, an unexpected but positive development could be improved relations between China and North Korea and the U.S.

Cohen: The bloom will be off the rose regarding expectations for policy changes. In some categories, government is moving in a better direction, but progress will be spotty.

Witmer: We might be talking about increases in productivity at U.S. companies because of reduced regulation, and how that will be good for stocks in the following year.

Gundlach: Trouble in the euro zone.

Schafer: We’ll be talking about how right we were at the 2017 Roundtable, and that despite what happens in Congress and with the presidency, America stays on course.

Black: We’ll have to see how Trump’s proposals are implemented. We need to see the notion of American exceptionalism re-emerge. Our geopolitical leadership must improve.

Zulauf: We will ask ourselves whether gold will offer protection from the geopolitical turmoil into which the world is sliding. I suspect it will, but I won’t be a part of the discussion, as I have decided to step down from the Barron’s Roundtable after 30 years. [Sustained applause]

Felix, Barron’s can’t thank you enough for your generosity and thoughtful contributions over the years. Before you go, where do you advise putting money in 2017?

Zulauf: Again, I expect animal spirits to take global equity markets higher into midyear. Then you have to get out. Markets could decline in the second half, probably falling below where they started the year. The best approach is to play sectors and groups and markets that have been performing well since the presidential election. They are all a little extended and could pull back, but then rally again. I recommend buying the Vanguard Value ETF [VTV], a value index, and the small-cap iShares Russell 2000 [IWM]. Value stocks and small stocks could do well.

Schafer: We just heard that the Russell 2000 trades for 23 times forward earnings. Do you think it still has room to rise?

Zulauf: Yes, into the middle of the year. The same goes for financials. They will benefit from the steepening yield curve. They also need to pull back a little, but could then do well into the top I see. I would buy the XLF [ Financial Select Sector SPDR ].

Europe offers value, but is probably a value trap. U.S. investors should stay away. Japan has much better fundamentals. The economy is doing well. The corporate sector has strong balance sheets after 20 years of deflation and restructuring. The trigger for a market rally is that the Bank of Japan has declared that it will freeze the yield curve, which guarantees, at least for a while, easy money and more money-printing than in other parts of the world. The government is actively encouraging the purchase of Japanese stock. The central bank buys about $10 billion a year of Japanese equities and has been encouraging institutions to shift from fixed income into equities. Stock ownership in Japan has been low since 1990.

Are institutional investors doing as told?

Zulauf: They will buy stocks once the currency weakens and fixed-income returns turn negative. The Japanese stock market and the yen are both extended and could pull back. The dollar/yen exchange rate could retreat to 112. Once that happens, it could break out to the upside and go to 125, the high in the prior cycle. The currency ratio is critical for the corporate sector’s earnings power because Japan has a lot of multinational corporations. Japanese corporate earnings have grown about three or four times as much as U.S. earnings in the past five years. The Japanese market is underrated. I would buy the WisdomTree Japan Hedged Equity ETF [DXJ]. It is currency-hedged.

I would short 10-year Italian bonds and German bunds in the futures market. The Italian bond futures trade at €134, and the German bund futures at €163. Yields on both bonds are correcting a little after the recent rise and have more to go. Inflation in Germany is at 1.7% and probably will top 2%. The yield on the 10-year is 25 or 30 basis points [100ths of a percentage point]. Italian 10-year bonds yield 1.90% to 1.95%. If the euro system begins to decay and Europe eventually reverts to national currencies, the Italian bond market will get destroyed. Shorting it is a hedge against European turmoil.

Would you buy gold as a turmoil hedge?

Zulauf: The gold price just had a pop, but gold is in a long-term bear market that started in 2011 at $1,920 an ounce and bottomed in December 2015 at $1,046. A counter-trend rally took the price up to $1,350. Gold is now in the process of falling out of favor again. This is the wrong time to buy gold because nominal and real interest rates are rising. We’ll need to see more turmoil, as well. And India’s recent moves could put a damper on gold. The government took the two largest bank bills out of circulation. Some of those bills had gone into the black market and were used to buy gold. Later this year, or early next year, it will be time to buy gold again on a long-term basis.

Once again, Felix, thank you. Let’s move on to Bill.

Priest: Earlier today, we talked about drivers of total return. The S&P 500 rose 98% in the past five years, and, as I noted, two-thirds of the increase came from P/E multiple expansion. The rest came from earnings growth and dividend payments. The P/E multiple went from 12 times forward earnings in 2012 to more than 18 times in 2016. Now we are going to start to see the movie run backward. P/E expansion will be under pressure, and earnings growth and dividends will have to offset the impact of declining P/Es.

There has been a substitution of technology for capital and labor. Profit margins are expanding, and return on assets is rising as a result. If companies don’t need to pour so much capital into the business, payout ratios will rise. Whether the money is used to pay dividends or repurchase shares or pay down debt doesn’t matter to me. All are forms of capital being returned to shareholders. Rising payout ratios will be a plus for the market. At the end of the day, it is all about capital allocation. There are only five uses of free cash flow: You can pay a dividend, buy back stock, pay down debt, make acquisitions, and invest in the business.

Witmer: Or let the money sit on the balance sheet as dry powder.

Rogers: You could increase compensation!

Priest: But not for long. Sooner or later, that cash is going to be distributed. If you can reinvest capital at a premium to the cost of that capital, you should reinvest in the business or make acquisitions. If you can’t, give the money back to shareholders or pay down debt. We expect to see a continued high level of merger and acquisition activity, although it will start to diminish if interest rates keep rising, because of the premium that can be earned over the cost of capital is going to shrink. That’s my investment backdrop. I want to be U.S.-centric. Japan is a favored non-U.S. market. Europe appears to be in trouble.

And your favorite stocks?

Priest: Alphabet, the parent of Google, is one name we like. Google is the largest search-engine advertising service, and YouTube, which it owns, is the leading online video service. The company has a market capitalization of about $560 billion, and trades for 17 to 18 times earnings, after deducting net cash on its balance sheet. The free-cash-flow yield is on the order of 7% looking out to 2018, also after deducting net cash. The shares have a lot of upside given the double-digit cash-flow rates we expect.

Bill Priest: “Alphabet’s, or Google’s, shares have a lot of upside, given the double digit cash-flow rates we expect.” Photo: Jenna Bascom
Applied Materials [AMAT] is another stock we like and have owned for a while. The company supplies semiconductor-manufacturing equipment. It is a capital-intensive business. The Second Machine Age, by Erik Brynjolfsson and Andrew McAfee, is one of my favorite books. It was published in 2014 and deals with how technology is transforming our economy. Consider Moore’s Law, which stipulated that the performance of a semiconductor chip would double every 18 to 24 months. That has occurred and enabled cloud computing and other advances, including driverless cars. Applied Materials is in the sweet spot. We believe the company will generate $3 a share in cash flow in fiscal 2019. At a 14-times multiple, that suggests a stock price of $42. The stock is at $32 a share now.

A third stock we like is Universal Display [OLED]. The company develops OLED [organic light-emitting diode] materials used in next-generation cellphone screens, TVs, and other applications, and obtains royalties and license fees when companies make OLED screens. It has a monopoly on phosphorescent emitters used in next-generation displays. Our one-year price target is $85; the stock trades around $57 today. There is a long runway to growth; as penetration increases, the stock could top $100 a share over time.

Witmer: Is any company close to being able to compete with Universal Display?

Priest: That is debatable, but right now, no. The company has deals with LG Display [034220.Korea] and Samsung Electronics [005930.Korea] and others, which use a lot of its products. Its patents are good. The next challenge is getting the color blue right, or so experts tell me. That is what Universal Display is working on. This is an unusual name for us. The stock appears expensive, based on current cash flow, but we expect cash flow to triple over the next few years. Epoch has a significant position, although we don’t own more than 10%.

Thanks for the disclosure.

Priest: Another pick is Hexcel [HXL], one of the few suppliers of high-grade carbon fibers and advanced composite materials, primarily for aerospace applications. The company has a market capitalization of just under $5 billion, and a modest amount of leverage, equal to about 1.5 times Ebitda [earnings before interest, taxes, depreciation, and amortization]. The management team is solid. The stock trades for 17 to 18 times 2017 expected earnings of about $2.75 a share, and 16 times 2018 estimates of $3.15. There is an eight-year backlog at Boeing [BA] and Airbus [AIR.France]. Production will ramp up in the next few years. Hexcel is a play on the aircraft industry working off that backlog. Its annual revenue could grow by the mid- to high-single digits, given the increasing penetration of composite materials, not only in the main body of a plane, but also the wings and engines. As revenue and earnings rise, Hexcel will probably buy back more shares.

In last year’s second half, the high-flying FANG stocks— Facebook,, Netflix, and Alphabet—were defanged. Do you expect the shares to lift off again this year?

Priest: We aren’t believers in “dream” investing. Tesla Motors [TSLA] is an example. They have no free cash flow. You can look at stocks as you do bonds. When interest rates go down, a 30-year bond goes up more than a 10-year bond, which rises more than a two-year bond. When that discount rate is falling, growth stocks go up the most. Now that rates are starting to rise, there is pressure on growth-stock multiples. We expect value and cyclical stocks to outperform. But we happen to think Google and companies like it that possess rapidly rising cash flows can offset the impact from rising interest rates on their valuations.

Thanks, Bill.

Barron’s 2017 Roundtable, Part 3: 17 Picks From Three Pros
Oscar Schafer, Brian Rogers, and Abby Joseph Cohen share their top investment ideas for 2017.

January 28, 2017

A rising tide supposedly lifts all boats, but that isn’t always the case on Wall Street. Even as the market breached another big, round milestone last week—Dow 20,000, we’re looking at you—plenty of stocks were beached by management missteps, corporate headaches, or industry-related foibles. The masses might be popping corks and the media exulting, but it is these washed-up, washed-out issues that most captivate the members of the Barron’s Roundtable. After all, value lies in stocks that potentially can improve, not in shares already priced for perfection.

Barron’s met with the Roundtable’s nine fabled investors and market seers back on Jan. 9 in New York to glean their views about the economy and financial markets in the year ahead. We reported their big-picture views and the specific investment picks of much of the crew in the prior two Roundtable issues. In this week’s final installment, Oscar Schafer, Brian Rogers, and Abby Joseph Cohen share their recommendations for 2017; the discussion is worth the wait.

Oscar, chairman of New York’s Rivulet Capital, has an impeccable eye for detail, whether it’s the perfect pocket square or the myriad attributes that make a particular investment attractive. He combed the U.S. and Europe this year to find five compelling values, including a John Malone play on Continental cable assets. He analyzes each with precision and panache.

Barron’s Roundtable Series
Barron’s 2017 Roundtable — Part 1
Barron’s 2017 Roundtable — Part 2

Brian chairs T. Rowe Price, and has a notable fondness for big, bruised blue chips like Bristol-Myers Squibb [ticker: BMY]. Their problems are painfully evident, their potential much less so without some digging, which he is more than happy to do. The conventional wisdom interests Brian little, which has long been a plus for clients of the Baltimore-based asset-management firm.

Abby, senior investment strategist and president of Goldman Sachs’ Global Markets Institute, has smarts to match her patience. She also has a practiced eye for picking issues recommended by Goldman analysts that dovetail nicely with her macroeconomic investment themes. She favors equities over bonds this year, and encourages investors to look for opportunities not only at home but abroad. Checking into Shenzhen Airport [000089.China] might be a good start.

For more on this week’s stocks and stockpickers, please keep reading.

Barron’s: Oscar, what are you recommending this year?

Schafer: My first pick is Advisory Board [ABCO], a research and technology company serving the health-care and higher-education sectors, with a market capitalization of $1.3 billion. ABCO’s health-care business accounts for 75% of revenue; it offers performance-improvement solutions to hospitals in the U.S. The stock was hurt by the presidential election. ABCO books up to 50% of its new health-care business in November and December, and given the uncertainty hospitals face under the Trump administration, spending on new products was frozen. Bookings were weak, and the health-care business is unlikely to grow this year.

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What’s to like, then?

Schafer: These issues are temporary, allowing investors to buy a great business with recurring and growing revenue, expanding profit margins, and a good balance sheet for 12.5 times run-rate free cash flow. ABCO derives 55% of its health-care revenue from software and analytics. Another 30% comes from best-practices research. The remainder is from consulting mandates. The consulting business has given ABCO a unique insight into the highest-priority pain points that hospitals are experiencing. The company has leveraged that information to develop its software and analytics offering.

While growth has slowed, the business remains healthy. The software and research businesses are 100% subscription-based, with a 90% renewal rate. Prior to 2016, ABCO had grown its health-care business organically by 10% to 30% a year for more than a decade. We are relatively certain it will return to growth in coming years.

How is the higher-education business faring?

Schafer: This business offers best-practices research and Royall, a platform that helps colleges with recruitment. The population of 18-year-olds is declining, and nonprofit colleges outside the U.S. News top 50 list are going to have more trouble filling their classes. Royall offers data-driven solutions that help colleges know when to send emails, whom to target on Facebook, and such. Management has described the opportunity set in higher education as “health care 15 years ago,” meaning the runway to roll out new research modules and other products is long. The higher-ed business could grow at a mid-teens annual rate.

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Please give us some details on ABCO’s financial health.

Schafer: ABCO has just under $500 million of net debt. Its ownership of Evolent Health, a health-management consulting firm, is worth $100 million. Net debt is less than two times Ebitda [earnings before interest, taxes, depreciation, and amortization]. ABCO is trading for $36 [as of Jan. 6]. The company could be worth considerably more to a strategic or financial buyer. On a standalone basis, ABCO could generate more than $3 a share of free cash flow by 2019. At some point, the stock will trade for $60.

[Elliott Management, the activist investment firm run by Paul Singer, disclosed on Jan. 12 that it had taken an 8.3% stake in Advisory Board. The firm said in a filing that Advisory Board’s shares are “significantly undervalued” and that it is seeking a “dialogue” with management. The shares have risen 24%, to a recent $44, since news of Elliott’s holding was reported. Schafer said in a follow-up email: “The presence of an activist increases the probability that ABCO is acquired in the near term. We believe there are buyers who would pay north of $50, and a strategic buyer could pay close to $60. This also puts more pressure on management to either accelerate growth in health care or take more costs out of the business.”]

My next pick is AA [AA.UK]. It is the leading provider of roadside assistance in the U.K.—like AAA in the U.S., but with a somewhat different model. Rather than outsource repairs to third-party garages, AA owns and operates its own patrol vans and employs its own mechanics. The mobile maintenance stations inside each van are equipped to handle a wide range of issues. About 80% of breakdowns are repaired at the roadside. AA has been operating for more than 100 years and is beloved by customers.

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The roundtable veteran sees big things ahead for a pharmaceutical company, a data center services provider, and the AAA of Britain.

How do shareholders feel?

Schafer: It is a fantastic business with strong pricing power, but the business trades at a modest multiple. There are two reasons for this. AA has a lot of leverage, with debt equal to seven times Ebitda. Also, the management team is spending 130 million pounds [$163 million] to upgrade AA’s decades-old IT [information technology] systems. European investors are uncomfortable with high leverage, and elevated capital expenditures exacerbate the issue. With the spending cycle almost complete, the stock could double in coming years.

The roadside-assistance market in the U.K. is dominated by three players. AA has 40%; RAC has 27%, and Green Flag has 14%. It would be impossible for a new entrant to replicate the density of the AA owner-operated model, which creates a moat around the business. Consequently, AA generates strong, recurring revenue, has 40% Ebitda margins, and requires little ongoing capital reinvestment. While pricing increases have driven growth, membership has been declining for five years. AA is led by Robert Mackenzie and Martin Clarke. Mackenzie had been chairman of Northgate [NTG.UK], which I recommended at the Roundtable three years ago. The stock appreciated considerably when he was chairman.

Why did Mackenzie leave Northgate?

Schafer: He retired in 2015, but was executive chairman of AA at that time. Mackenzie and Clarke attempted to buy one of the big roadside-assistance companies several times in the past decade. They saw in AA a business that had been milked for cash under private-equity ownership and was badly in need of investment. The company didn’t even have a customer Website. Management has promised that its investments will improve retention and return AA to membership growth.

AA posted sequential quarterly growth in membership in the September quarter for the first time in many years. Ebitda is expected to grow by high single digits in the current fiscal year, which ends in January 2018. The company just refinanced its debt, pushing out 90% of its maturities to 2020 to 2025. At a recent £2.78, AA trades for 10 times Ebitda and has a free-cash-flow yield of 10.5% and a dividend yield of 3.5%. Free cash flow will increase dramatically as the company finishes the last of its upgrade spending and continues to pay down debt. The shares could be worth £4.50 this year, which implies a valuation of only 11.5 times Ebitda and an 8% free-cash-flow yield. A year ago, a private-equity firm acquired RAC, the No. 2 player, at a multiple of 13 times Ebitda.

Is AA’s business confined to the U.K.?

Schafer: Yes. Mario will like my third pick, Liberty Global [LBTYK], the largest cable TV operator in Europe. [Gabelli recommended Liberty Braves (BATRK) and Live Nation Entertainment (LYV) in last week’s Roundtable issue. Both stocks are part of John Malone’s Liberty Media (LMCA) empire.] Malone has owned cable assets in Europe since the 1980s, but Liberty Global was officially formed in 2005, when he merged his cable assets with UnitedGlobalCom. Since then, Malone has used Liberty to roll up cable assets across the Continent. After a 10-year run of value creation and stock appreciation, Liberty had a rough 18 months, with the stock falling 40% from its high, to $32. While some of the decline is due to currency, several other issues have weighed on the shares.

Such as?

Schafer: Liberty executed a string of complex transactions involving its Latin America assets, which has been a distraction to the company and a nuisance to investors. But these issues are in the past, and the economic interests of this business are now held by several tracking stocks. Liberty has also fallen short of its operating targets in Europe for the past two years. In particular, its subsidiary in the Netherlands, Ziggo, has seen increased competition from KPN. Additionally, Liberty announced a plan to increase its footprint, a move that will depress cash flow for several years.

The stock is widely held by hedge funds, many of which wrongly assumed Liberty would be sold to Vodafone [VOD] by now. We view European cable as an attractive business. The threat from cord-cutting [canceling cable contracts] is minimal, as most video packages in Liberty Global’s market cost only $10-$20 a month.

What is the outlook for growth from here?

Schafer: Liberty has a track record of organic growth, with contributions from increasing penetration and modest price increases. Recently, annual revenue growth slowed to 3%-4% and operating cash flow growth to 4%-5%. Liberty is planning to reaccelerate growth through the build-out, which will add seven million homes by 2018. The biggest piece will be in the U.K., where its Virgin Media subsidiary plans to add four million homes at a cost of $3 billion. Unlevered returns from this project are forecast at more than 30%. Between the build-out and plans to keep operating costs mostly flat, Liberty management has guided investors to expect growth in operating cash flow of 7% to 9% over the next three years. Targets are being met with skepticism, given the company’s recent shortfalls.

Liberty has taken some interesting strategic steps recently. The company just closed on a deal to combine Ziggo with Vodafone’s wireless business in the Netherlands, which will yield lots of synergies and create a more competitive converged offering. It also leaves the door open for a larger deal with Vodafone. Liberty has announced other deals in the past few weeks to acquire a cable system in Poland and Altice’s [ATC.Netherlands] cable business in Belgium.

Even if Liberty falls a little short of its targeted range for operating-cash-flow growth, it will still generate $3 a share of free cash flow in 2019, with elevated capex [capital expenditures]. Assuming a normalized level of capex to revenue, free cash flow could reach $4.25. The business is highly leveraged at five times Ebitda, but the leverage is appropriate for a diversified cable company. We expect Malone to use excess free cash flow to buy back stock.

Do you have a price target for the shares?

Schafer: We value the shares at $55 by the end of this year. Malone could create additional value through acquisitions.

In the past few years I have recommended Interxion Holding [INXN] on several occasions, most recently in the 2015 Midyear Roundtable. The shares have performed well, and this is an interesting time for an update. As a reminder, Interxion owns a network of carrier-neutral data centers in Europe. They are a critical part of the infrastructure powering some big technology trends, such as cloud computing, streaming video, and social media. Interxion gives me the opportunity to benefit from these broad secular trends without needing to pick individual technology winners and losers. Whatever comes out of Silicon Valley, it is likely to create more demand for Interxion’s products over time.

Another thing I like is the company’s ability to reinvest profits at high rates of return. This is especially important in a capital-intensive business. Interxion does this by constructing new data centers adjacent to existing facilities. Expansion projects are relatively low-risk and leverage the personnel, power infrastructure, and fiberoptic networks already in place. I estimate the company generates north of 20% returns on this invested capital. As long as Interxion can continue this, the stock could compound in value. Finally, it is always nice to own a company with optionality, where you can wake up one morning and discover the business is being acquired for a nice premium.

Are you expecting to wake up to that news sometime soon?

Schafer: Interxion is in a great negotiating position because it doesn’t need to sell the business. There is plenty of organic growth ahead. But the industry is rapidly consolidating, and Interxion looks like a juicy target. It might sell at a price much higher than most people think. A few weeks ago, a private European data center, Global Switch, sold a 49% interest to a Chinese consortium for £2.4 billion. In this case, the buyer paid north of 23 times Ebitda for a minority stake. This transaction showed us that there is a wider pool of buyers for these assets than public U.S. REITs [real-estate investment trusts], and that buyers are willing to pay a high price to own such scarce assets. Even without a deal, Interxion could have 30% upside in the next 12 to 18 months.

I am also re-recommending ANI Pharmaceuticals [ANIP], a producer of generic drugs, which I discussed at prior Roundtables. The stock rose 30% in 2016. This was in an environment where Valeant Pharmaceuticals International [VRX] fell 80% and Teva Pharmaceutical Industries [TEVA] fell 50%. ANI is on course to achieve its short-term goal of generating $100 million of Ebitda. The company has only 11.5 million shares and is trading for $60 a share.

Oscar Schafer: “Interxion gives me the opportunity to benefit from broad secular trends without needing to pick individual technology winners and losers. Another thing I like is the company’s ability to reinvest profits at high rates of return. Photo: Jenna Bascom
The most interesting thing about ANI, in addition to its own product pipeline, is its optionality on a generic corticotropin product. A rival product, Acthar, is manufactured by Mallinckrodt [MNK] and sells for $28,000 a vial. ANI bought an NDA [new drug application] from Merck [MRK] for a similar product, and I hope it soon will file an sNDA [supplemental new drug application] to compete in this $1.5 billion market. The first 12 months ANI’s generic version is on the market, and I’m not sure when that will be, ANI should generate $200 million in Ebitda.

Witmer: What does Acthar treat?

Schafer: It is used to treat infantile spasms and multiple sclerosis. That’s it for me.

Thank you. Brian, let’s hear your ideas.

Rogers: I have five stocks today. In 2013, I recommended Legg Mason [LM], which I’d like to revisit. I call it the other great investment firm in Baltimore. Legg had a challenging year in 2016. The stock fell 24% and currently trades for $31.52. The company has a market value of $3.1 billion. It has 101 million shares outstanding, and a share count that goes down with great regularity. Legg pays an annual dividend of 88 cents a share and yields about 2.8%. It sells for 10 times forward earnings, one of the few companies with a 10 P/E. Legg is a diversified investment-management firm with about $725 billion in assets under management. Western Asset Management is its biggest unit, but there are other interesting parts. ClearBridge Investments is the company’s primary equity vehicle now.

Black: The stock sells below book value.

Rogers: Correct. Acquisitions in the industry typically are done for between 1% and 2% of assets under management. Legg sells for 0.4% of assets. The CEO, Joseph Sullivan, was hired in 2012 and has done a good job. He worked well with Nelson Peltz, whose Trian Fund Management owned a big stake in the company. Last year, Peltz sold his stake to a Shanda Group, a Singapore-based investment firm. Sullivan has embarked on a fairly aggressive stock-buyback program. In the past six to seven years, the company’s share count fell by about 38%. Legg is shrinking its share count at a rate of 6% to 8% a year, which its cash flow allows. From an investment perspective, there is a buyback case and an undervaluation case. Legg could earn about $2.30 a share in the fiscal year ending in March, and $3.10 in fiscal 2018.

Schafer: Why such a big increase?

Rogers:It assumes some cessation of cash outflows and a lot of expense cuts. Legg has taken a meat cleaver to corporate expenses, so there has been a return to stability in the business.

Gabelli: I own the stock. Shanda owns 10% of the shares, and is trying to increase its holdings to 15%. Legg made some big acquisitions last year.

Rogers: It bought an alternative asset manager and a real estate manager. On Shanda, which is run by Tianqiao Chen, the firm has a 15% investment limit and a standstill agreement for three years. It is an activist investor of sorts. Shanda is also investing $500 million in various Legg Mason products and putting two directors on the board.

Gundlach: Why did the stock drop so precipitously?

Rogers: Investors were concerned when Trian sold, and asset managers generally didn’t have a great year last year.

Gabelli: Also, there are concerns that the growth of exchange-traded funds will have a negative impact on active managers like Legg. And there was lingering concern about the two acquisitions, which used up a lot of cash and required debt.

Gundlach: It seems really cheap. Is there anything under the hood?

Rogers: We don’t think so. The stock ought to sell at least in the $40s.

Black: Legg Mason historically has had a low return on equity, in the sub-10% range. Can they ever make a decent return on equity?

Rogers:If they buy back more stock, that will help improve return on equity.

Schafer: Do you expect Legg Mason to be taken over?

Rogers: There is some interesting activity going on in the asset-management business, but that isn’t part of the bet.

Next, we like CVS Health [CVS]. When I was a kid growing up in Massachusetts, the company was called Consumer Value Stores. It was once part of Melville. Like Legg Mason, CVS had a challenging 2016. The stock was down 19% and currently trades for $82. The company reduced its full-year earnings estimate when it reported third-quarter results. High expectations had been built into the stock price. CVS is a high-quality, blue-chip company. It offers a great combination of a retail pharmacy network and Caremark, a pharmacy-benefits manager.

CVS has a market cap of $87 billion. It will probably earn $5.85 a share this year, not the $6.85 previously expected. Again, much like Legg Mason, CVS has been buying back 6% to 8% of its shares outstanding every year, so return on capital is growing. The company increases the dividend almost every year; the current yield is 2.4%. We expect the dividend to go up in 2017. This looks like a classic contrarian play. The sharp drop in the stock wasn’t warranted.

The company lost contracts to Walgreens.

Rogers: But they weren’t super-big contracts. Walgreens Boots Alliance [WBA] will be a formidable competitor. If Walgreens buys Rite Aid [RAD] and gets it out of the marketplace, that will be good for the retail side of CVS’ business.

Schafer: A lot of CVS’ profitability comes from the sale of generic drugs. But prices for generics are under pressure.

Rogers: That is one reason the stock fell.

Gabelli: But cash flow is terrific.

Rogers:And their competitive position is strong. CVS is also a good corporate citizen. After we had riots in Baltimore in 2015, CVS was one of the first companies to begin to rebuild its Baltimore presence. That caught my eye as a local business leader. We see upside for the stock of $100 a share, and there isn’t a lot of downside—maybe to $75.

My third name is Casey’s General Stores [CASY], not my usual cup of tea. The company has 40 million shares outstanding and a market value of roughly $4.5 billion. The stock is trading for $116 a share. Casey’s is based in Iowa and occupies an interesting niche. It runs convenience stores and gas stations in the Midwest, and roughly half its stores are in towns with fewer than 5,000 people. It effectively has a competitive moat because no one else is going to enter these markets. The company has 1,940 stores; it owns 99%, and its best business, interestingly, is pizza delivery.

Casey’s isn’t a value-based investment; it is a growth-oriented company. It is planning to expand into small towns in states including Ohio, Kansas, Tennessee, and Arkansas. It builds new stores or makes bolt-on acquisitions. It buys stores it can remodel. It is adding 60 to 70 new stores a year. Casey’s could earn $5.71 a share in fiscal 2017, ending in April, and $6.50 in fiscal 2018. It is inexpensive, as retailers go, but with a clear growth trajectory.

Gabelli: About seven years ago Canada’s Couche-Tard [ATD.B.Canada] tried to buy Casey’s for $38.50 a share. 7-Eleven came along and offered $43. Management said no to both, and the stock has tripled since.

Rogers: This is a good niche operation with high returns. Mario recommended Viacom [VIA.B] today [see last week’s Roundtable issue], which is the hard way to make money in the entertainment sector.

Gabelli: Nothing in life is easy.

Rogers: The easy way, at least this year, is to buy Walt Disney [DIS]. The stock was flat last year but has come to life recently with the release of Rogue One: A Star Wars Story. It is trading at $109. One of the biggest issues facing Disney is pressure on ESPN, due to the high cost of sports programming and problems with subscriber retention. Disney is one of the world’s great companies and was left behind in last year’s market advance.

Schafer: One great movie release might change investors’ minds and lift the stock.

Gundlach: I never understood why that would be the case.

Rogers: Investors at the margin get all revved up over an exciting movie, but you have to view it within the context of the overall company.

Gabelli: In 1977 George Froley [a Los Angeles money manager] called me from Brentwood [a neighborhood in Los Angeles] and said, “Mario, there are long lines for this release Star Wars. I’ve never seen anything like it.” I bought 20th Century Fox stock on that news. Today, these companies are too big to have a single movie move the needle.

Rogers: Regarding ESPN, competitors such as Fox Sports Network and NBC Sports are coming in and bidding up the cost of programming.

Brian Rogers: “CVS is also a good corporate citizen. After we had riots in Baltimore in 2015, CVS was one of the first companies to begin to rebuild its Baltimore presence. That caught my eye as a local business leader.” Photo: Jenna Bascom
Gabelli: If someone doesn’t like sports, but has to pay $7 a month for ESPN because it is part of the cable bundle, that’s a challenge. There is an alternative to the “skinny bundle”: Adopt a la carte cable programming.

Rogers: Given the networks Disney owns, it probably wouldn’t be in a bad place if the industry went to a la carte pricing. Disney could repurchase $8 billion worth of stock this year. It has a blue-chip balance sheet. The CEO, Robert Iger, who has done a great job, is scheduled to retire in 2018.

He has been scheduled before.

Rogers: Yes, but one never knows if this is the final scheduling. It is probably a good time. He will try to go out on a high note, so the company will be on the upswing. We expect Disney to trade for 20 times our 2018 estimate of $6.50 a share; the fiscal year ends Oct. 1. That implies 20% upside. The downside is $100 a share, or maybe $95.

Gabelli: You guys like big-cap companies. I like the minnows that will be taken over.

Rogers: Health care was the only sector in the S&P 500 that lost money last year. Shares of Bristol-Myers Squibb were down about 15%. The company has a roughly $100 billion market value, $7 billion in debt, and a 2.6% dividend yield. It raises the dividend every year. The shares are a little expensive for a drug company, but Bristol is the go-to company for immunotherapy drugs. The stock dropped about 20% on a single day last August after its leading immunotherapy drug, Opdivo, failed a study that could have led to more widespread use in lung-cancer patients. The shares have recovered a bit since then. In October, the company authorized a new $3 billion stock buyback.

This is an exciting long-term growth story. Bristol and Merck have the lead in immunotherapy applications for different types of cancer, and go back and forth on who has the upper hand. Bristol’s drugs, Yervoy and Opdivo, have had a major positive impact on cancer patients. Bristol’s pipeline also includes compounds for other types of cancer applications. It is also working on prostate-cancer vaccines and hepatitis drugs.

Give us the financial picture.

Rogers: Sales from new products could add about $9 billion to revenue, on top of the $17 billion a year the company already reports. Upside for the stock, which closed at $60 last Friday [Jan. 6], is probably $75 to $80. The downside could be $50, and you collect the yield. There is a remote chance that Novartis [NVS] or Pfizer [PFE] or some other large drug company might express an interest in buying Bristol-Myers if its market cap shrank. We don’t think it will happen, but you can’t fully discount it.

[Bristol-Myers’ stock sank 11% on Jan. 20 after the company said it wouldn’t try for accelerated approval of its Opdivo/Yervoy combination in first-line lung-cancer treatment. The company subsequently lowered its 2017 earnings guidance. In a follow-up conversation, Rogers said he expects the drug combo to be approved at some point.]

Thanks, Brian. Last but not least, it’s Abby’s turn.

Cohen: It is important this year to look at things that benefit from economic growth. Fixed income isn’t appealing, but equities are, and not just in the U.S. Like Brian, I will discuss some stocks that didn’t do well in 2016. Health-care stocks were clobbered after performing well for an extended period. Also, some had idiosyncratic risks, including pricing issues. There is a lot of confusion as to whether the Trump administration will be good for health-care stocks or bad. No one is sure. I have selected stocks that aren’t sensitive to policy but rather demographic trends, including aging.

Eli Lilly [LLY] is in the process of being “reformed.” The stock was down 10%, year on year, through last Friday [Jan. 6]. We are projecting revenue growth of about 5% this year, and earnings growth of about 15%. The stock yields 2.7%. Return on equity will exceed 25%, and 2017’s estimated earnings growth will be followed by double-digit growth over the next several years. Lilly’s earnings could grow by 14% to 15% per annum, versus 10% for peers. We expect profit-margin expansion of 900 basis points [nine percentage points] between now and 2020.

What is Lilly’s stock price?

Cohen: Lilly is trading for $75. Its price/earnings multiple is about 15% below the rest of the industry. The company has a significant product pipeline. New products currently represent about 15% of the product mix. By 2020, they will be more than 45%. The company is working on treatments for many things, including diabetes, psoriasis, and arthritis. It also has a cancer drug in final testing. The risk isn’t so much political as pipeline execution for these new drugs.

Another health-care stock we like is Olympus [7733.Japan]. People think of this Japanese company as a camera maker, but 76% of its sales are related to the medical field. Another 13% are scientific processes, and the remainder comes from cameras. Through last Friday, the stock was down 12%, year on year. Olympus has a 20% global market share in minimally invasive surgical products. Its Thunderbeat surgical energy device is an example. The company is a global leader in gastrointestinal endoscopes, with almost a 70% market share. It is also a leader in endoscopic knives.

As I mentioned earlier today, the Japanese stock market looks interesting. It was under pressure early in 2016, but has been recovering in recent months because of a supportive valuation and positive earnings revisions.

Witmer: Abby, didn’t Olympus have an accounting scandal some years ago?

Cohen: It did. [Olympus executives hid losses through fraudulent accounting for more than a decade; the fraud was exposed in 2011.] In the past few years, there has been a commitment by Japan to enhance disclosure and improve accounting.

Black: What kind of P/E multiple do you expect for Olympus?

Cohen: We expect the stock to trade for 23 times fiscal 2018 earnings. The fiscal year ends in March. Olympus yields 0.7%.

Speaking of minnows, bluebird bio [BLUE] is small and unprofitable. This year could be an inflection point. Bluebird is developing gene therapies to treat rare diseases and cancers. Its current drivers are hematology products for transfusion-dependent patients. Bluebird recently announced positive results for a new immunotherapy treatment for cancer. It is an innovative company.

The stock has fallen to $68 from almost $200 in July 2015. What happened?

Cohen: This is a speculative investment. The share-price decline in late 2015 was tied to disappointing clinical results. The company said it would move ahead with testing of a stronger version of the drug, LentiGlobin, for beta-thalassemia [a blood disorder] and sickle-cell anemia. Clinical results announced in 2016 were favorable, and more news is expected in 2017.

Abby Joseph Cohen: Intuit “could have a dual tail wind: It has a tax rate of about 33%, and earnings would benefit if corporate taxes were cut. In addition, if there is a simplification of taxes, the company might see increased demand for its products.” Photo: Jenna Bascom
Next, we are interested in alternative forms of energy—in particular, electric vehicles. LG Chem [051910.Korea] is the largest chemicals company in Korea. It also makes battery packs for electric vehicles. The stock fell 21% in the 12 months ended Friday. Our analyst estimates revenue could rise by 6% this year, and earnings by 9.7%. The company is No. 1 in lithium-ion battery packs used for cars, and its U.S. subsidiary, LG Chem Michigan, manufactures advanced battery cells for electric vehicles in the U.S. It provides battery packs for the Chevy Volt and the Ford Focus. The company can produce up to 200,000 battery packs a year in the U.S. LG Chem has 14,000 employees in Korea, and 12,000 elsewhere. Of the latter, 3,000 are in research and development, mostly in Michigan. LG Chem also provides advanced materials for electronics.

What are your expectations for the stock?

The stock trades for 266,000 Korean won [$226], which equates to 11.4 times 2017 estimated earnings. That makes it reasonably priced, even for a chemicals company. Our analyst has a price target of KRW335,000 over the next year.

There was much discussion today about a likely simplification of the tax code and a reduction in corporate taxes. Intuit [INTU] would benefit from such changes. Many people are familiar with its products, including TurboTax and QuickBooks. Intuit shares did well in the past 12 months; they were up 21%, to $116. The stock isn’t cheap at 26 times earnings for the fiscal year ending in July 2018. Our analyst expects revenue to rise about 11% next year, and earnings to increase by 15%. The company could have a dual tail wind: It has a tax rate of about 33%, and earnings would benefit if corporate taxes were cut. In addition, if there is a simplification of taxes, the company might see increased demand for its products.

Haven’t some legislators called for tax returns on a postcard?

Cohen: That seems unlikely to happen. Houghton Mifflin Harcourt [HMHC] fell 45% in the past 12 months. The company didn’t execute well. It is a book publisher with some notable children’s book franchises, but the growth is coming from textbooks. Not surprisingly, technology is disrupting this business, and textbook publishers are selling a lot of interactive materials, not just for the students but teachers. Houghton Mifflin didn’t do well in the latest textbook-adoption cycle in California. Our analyst likes it because the company has taken steps to fix things, and is investing heavily to make sure it is better prepared for the next round. A few states, including California and Texas, make the big decisions on textbook adoptions, and the rest of the country follows.

Black: The industry’s accounting has changed. In the old days you sold a book and recognized the revenue. Now, if technology is licensed over three to five years, you might have deferred revenue.

Cohen: Thank you for mentioning that. Last year, Houghton probably lost $1.53 a share. This year, it will lose $1.20. Revenue is expected to be up about 5%.

When do you expect a turnaround?

Cohen: We estimate the turnaround will come in the next two years. The next big cycle is in 2018. If Houghton doesn’t get it right, it has some interesting assets that someone else might find a way to enhance.

Finally, one way to participate in Asia’s growth is through infrastructure stocks. We like Shenzhen Airport. About 80% of airports in China aren’t profitable. This is a profitable airport.

Zulauf: No wonder 80% aren’t profitable. China has too many airports.

Cohen: Exactly. Shenzhen is operating at close to capacity. We expect earnings to rise 18% this year and revenue to be up 11%. If the government allows them to increase their slots, that would be positive. Capacity utilization of existing slots is 98%. There was also an increase in air traffic in Asia toward the end of the year. Shenzhen passenger traffic was up about 10%, year on year, in December. Cargo-volume growth exceeded that. Shenzhen’s focus is not only on the domestic market but Australia and New Zealand. The stock trades for 21 times 2017 estimated earnings.

Thank you, Abby, and everyone.

2017 Roundtable, Part 2: Manual for a Mixed-Up Market
Scott Black, Jeffrey Gundlach, Meryl Witmer, and Mario Gabelli offer investment picks for the new year.

January 21, 2017

The Trump rally looks to be fading, even as the presidency of Donald Trump begins. But if some investors have lost their enthusiasm for stocks following a postelection surge, not so the members of the Barron’s Roundtable. These nine market mavens confessed at our annual get-together, held on Jan. 9 in Manhattan, that they expect the major indexes to post muted gains, if any, in 2017, given today’s rich valuations and a likely rise in interest rates. But they insist the outlook for their picks couldn’t be brighter. That could be especially true if Trumponomics translates into lower tax rates for corporations, less burdensome regulations, and a more robust economy.

Barron’s Roundtable Series
Barron’s 2017 Roundtable — Part 1
Barron’s 2017 Roundtable — Part 3

Last week, Barron’s featured the big-picture views of all our panelists—on equities, interest rates, economics, geopolitics, and more—and the specific investment recommendations of Zulauf Asset Management’s Felix Zulauf and Epoch Investment Partners’ William Priest. This week, we turn the mic over to Scott Black, Jeffrey Gundlach, Meryl Witmer, and Mario Gabelli, whose best bets for the new year range from commodity producers to auto-parts suppliers to closed-end funds to companies bearing the indelible fingerprints of yet another investment maestro, John Malone.

The 2017 Barron's Roundtable, L-R: Jeffrey Gundlach, Meryl Witmer, Scott Black, Mario Gabelli Brad Trent for Barron's
Scott, a numbers whiz who runs the show at Boston’s Delphi Management, favors companies with a high return on equity and lots of free cash flow, particularly if he can scoop up their shares at a discount.

Jeffrey calls himself “a bond guy who thinks about macro stuff,” which doesn’t begin to hint at the enormous success of DoubleLine Capital, the Los Angeles-based fixed-income firm he founded in 2009 and grew to more than $100 billion in assets.

Meryl, a general partner at New York’s Eagle Capital Partners, and a member of the Berkshire Hathaway (ticker: BRK.A) board, has earned a sterling reputation for uncovering value among lesser-known companies in unglamorous businesses, whose financials she masters better than any CFO.

4 Stock Picks From Mario Gabelli
The CEO of Gamco Investors sees two infrastructure plays for the Trump economy, plus a beverage company and a cheap broadcaster.

Mario, head of Gabelli Funds and its parent firm, is a Wall Street legend, for good reason. He’s a shrewd thematic investor with a love of deals, an eye for steals, and an encyclopedic knowledge of multiple businesses and the people who built them.

To learn what this quartet likes now, please read on.

Barron’s: Where are you finding value in this market, Scott?

Black: At Delphi, we like companies that have a high return on equity and generate free cash flow. We look to buy them at low price/earnings multiples. The stock market looks expensive. I’m not counting on price/earnings multiple expansion to drive it higher. But I have five inexpensive recommendations.

D.R. Horton [DHI] is the largest home builder in the U.S. It is based in Fort Worth. Home-building stocks are out of favor, and this one has pulled back to around $28 from the mid-$30s, even though the company has had only one quarterly earnings disappointment in the past five years. Horton’s fiscal year ends in September. This year, Horton will build 44,500 homes—that’s the midpoint of the expected range—up from 40,309 in 2016. That represents 5% of all single-family homes built in the U.S. Horton homes averaged $297,000 last year. This year, they could average $305,000. That’s $13.6 billion in expected revenue.

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Horton aims to generate a 20% gross profit margin. We model an 11% operating profit margin, which leads to $1.493 billion in operating income. The company’s financial-services arm, which finances 55% of Horton’s homes, could generate $98 million in pretax income this year. The pretax margin on finance operations is about 30%. We estimate total profit before taxes of $1.59 billion. Taxed at 35%, Horton could earn $1.03 billion in 2017, or $2.72 a share, fully diluted. Pro forma return on equity is 14.2%. The P/E, based on a stock price of $27.85, is 10.2, and the price-to-book ratio, 1.5.

What kind of cash flow does Horton have?

Black: Most home builders have negative free cash flow as they buy lots and build. But Horton generated free cash of $467 million in the past 12 months, on $886 million of net income. The objective for this year is to generate $300 million to $500 million of free cash flow. The net debt-to-equity ratio is extremely low, at 22%.

Horton operates in 78 markets in 26 states, and has leadership positions in many markets. The company aims to grow revenue by 10% a year in the next three to five years, and profits at a faster pace. As for the product mix, Horton, the middle-priced brand, accounts for 73% of revenue. Express, the lower-price-point line, is 18%, and Emerald, the high-end brand, is about 9%. Horton has done an excellent job of managing earnings. Its supply chain is cost-efficient.

Priest: Scott, what does the company do with its free cash flow?

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Black: Horton pays a dividend of 40 cents a share. It has used most of its cash to make acquisitions and reduce debt. In the old days, the company owned much more land than now. Today, it has 204,500 lots, of which 55% are owned and 45% optioned. Management wants to get to 50/50 in the next two years. Its land supply could support double-digit earnings growth in the next four or five years.

Schafer: You recommended Horton in the 2016 Midyear Roundtable [“ Barron’s 2016 Midyear Roundtable: 24 Investment Ideas,” June 11]. What happened to the stock?

Black: It didn’t work out [the shares fell 14.6% through Dec. 30]. People worried as mortgage rates rose. I expect housing to do better, but there is an affordability issue. Horton tells me that 22% to 23% of would-be customers who want financing don’t qualify. This will become a bigger issue if interest rates back up to 3.5% to 4%.

Zulauf: The situation won’t get better.

Black: My next pick is Fabrinet [FN]. It operates mainly in Thailand. The stock is selling for $36. There are 36.8 million shares outstanding, and the market capitalization is about $1.3 billion. The company doesn’t pay a dividend. Fabrinet is a contract manufacturer to the optical networking industry. It specializes in optical components, including lasers, sensors, and optical switches. The business is growing nicely. Revenue could be up 38% in this fiscal year, ending in June.

Meryl Witmer: Bullish on Trump, Lanamar
he Eagle Capital Partners stockpicker recommends an undervalued auto parts maker.

What is driving this growth?

Black: New business represents 25% to 30%, and demand is growing in existing markets. Revenue could total $1.35 billion for the fiscal year. An operating profit margin of 9.4% translates into estimated pretax income of $127 million. Taxed in Thailand at only 7%, the company could have net income of $118 million, or $3.20 a share. Return on equity is about 19%, after tax. Fabrinet has $254 million in cash and equivalents, but has to set aside $125 million to self-insure; Thailand had massive floods several years ago. Remove that portion and net cash is $2.57 a share. Last year, the company had 26 cents a share in stock-based compensation; this year, it will be closer to 50 cents. We exclude it from earnings, as it is a cost. If you back out the net cash and exclude the 50 cents from estimated calendar-year earnings of $3.40, you get a price/earnings multiple of 11.6.

Fabrinet had $19 million of free cash flow last year. This year, it will be between zero and $5 million, because the company is more than doubling manufacturing capacity in Thailand. North America accounts for 54% of revenue; Asia/Pacific is 36%; and Europe, 10%. To sum up, Fabrinet offers 30%-plus revenue growth and a 19% return on equity, at a P/E of 11 or so.

Sounds appealing. What is your next pick?

Black: Zimmer Biomet Holdings [ZBH] makes orthopedic products. It has been hurt by concerns about rising health-care prices, but in this case, the baby might have been thrown out with the bathwater. Zimmer reported disappointing earnings in the latest quarter. The stock is down 21%, to $105, from last year’s high. Unlike drug companies, which have been raising average selling prices by 8% to 10% a year, Zimmer’s prices have declined by 1% to 3% in the past two years. It can’t be accused of price-gouging.

Management is committed to 10% earnings growth. We expect revenue to grow about 4% this year, to $7.94 billion. The company could earn about $8.70 a share. Zimmer bought Biomet in 2015. It has promised $350 million in savings and has already achieved $225 million. Zimmer is reducing its interest expense, as it has been paying off debt. It has already repaid more than $1 billion in debt from the Biomet merger. In the first nine months of 2016, Zimmer had $910 million of free cash flow and $972 million of non-GAAP income [calculated not in accordance with generally accepted accounting principles]. Return on equity is about 16.3%. The P/E ratio on 2017 earnings is 12.1.

How does that compare with the industry?

Black: Competitors such as Stryker [SYK] and Medtronic [MDT] have substantially higher multiples. In knee products, Zimmer has 36% of the market worldwide. In hips, it has 30%. In sports, extremities, and trauma, or SET, it has 11%. In spine products, including thoracic, it has roughly 14%, due to the Biomet acquisition.

Demographics are working in its favor. Typically, patients who need joint surgery are 65 and older. The world’s 65-and-over population was 7.6% of the total in 2010. By 2020, it will be 9.3%. Joint-related medical procedures are growing by 2% a year in the U.S. Zimmer generates 63% of revenue in the U.S., 23% in Europe, and 14% in Asia/Pacific. It is losing money in its dental business, but has vowed to turn it around.

Gabelli: We own Zimmer. It is a great company and a great business.

Rogers:I have a Zimmer hip. I will do a demonstration later, if anyone is interested.

Black: My next stock, Royal Dutch Shell [RDS.A], is a yield play. It was on the cover of Barron’s last year [“Shell: The Best Big Oil Stock Yields Juicy 6.6%,” July 16]. The stock is trading for $55.79, and the market cap is $226 billion. We recommend the A shares, which yield 6.74%. Individual U.S. investors pay a 15% withholding tax on the dividend, and institutional investors pay zero. The net yield for individuals is 5.73%.

Royal Dutch has upstream and downstream operations [exploration and production, and refineries and distribution]. Earnings are almost impossible to model. The company earned 70 cents a share in the latest quarter; I assume an annual earnings run rate of $2.80 a share. The company produces 1.8 million barrels of oil a day. Oil is up about $7 a barrel from the prior quarter, adding about $1.25 in earnings per share. That brings total earnings to $4.05 a share. Royal Dutch also produces 10.4 billion cubic feet of natural gas per day, and refines about 2.7 million barrels of oil a day.

Is your estimate in line with Wall Street’s?

Black: No. Analysts’ consensus earnings estimate for this year is $3.76 a share, but you could drive a truck through the spread between the low estimate of $2.30 and the high of $5.84. My estimate implies a P/E of 13.8. Many analysts also value the company on discretionary cash flow, which adds depreciation, amortization, and dry-hole expenses back to net income. I estimate it is trading for 7.5 times discretionary cash flow. I add DD&A [depreciation, depletion, and amortization] of $27 billion to estimated net income of $32.8 billion, and subtract capital spending of $25 billion, to get $34.8 billion of free cash. After dividend payments of $10.6 billion, the company will have free cash flow of $24.2 billion this year.

One knock on Royal Dutch is that it leveraged up to buy BG Group last year and hasn’t reduced debt fast enough since. It planned to divest $30 billion of assets, but hasn’t sold off a lot of these properties. Management’s priority now is free-cash-flow generation and cost and debt reductions. The company also wants to increase its production from deepwater plays to 900,000 barrels a day by 2020 from 400,000 barrels now, and expand its worldwide chemical production in the same period from six million to seven million tons of ethylene. The free cash flow gives you a margin of safety, and the stock is reasonably priced. And, you get paid to wait for the shares to rise.

My last pick is atypical for Delphi. It is a value stock, but more speculative than our usual investments. Freeport-McMoRan [FCX] is a major copper producer. For the first time in a while, copper supply and demand are in balance, at roughly 16 million tons. China represents about 40% of world demand.

Where are Freeport’s mines?

Black: Freeport operates seven mines in North America, producing 1.8 billion pounds a year; it has two mines in South America, producing 1.3 billion pounds. And it operates the Grasberg mine in Indonesia, in partnership with the Indonesian government. That mine produces 1.2 billion pounds a year. The company also produces 1.3 million ounces of gold a year as a byproduct of copper mining.

Freeport has lowered its worldwide operating cost from $1.52 a pound in 2015 to $1.14 a pound. The company has restructured its balance sheet and sold a lot of properties. It has raised $1.5 billion through the sale of new shares. The net debt-to-equity ratio, once staggering, is only 1.14 now. If the copper price holds at around $2.50 a pound, the company will earn $1.40 a share this year. The stock is $14.90 and trades for 10.6 times expected earnings. Return on equity is 26%. Management will continue to drive down the debt load, lifting return on total capital to 13% to 14%.

Schafer: Did the company sell these businesses above or below book value?

Gabelli: Come on, you know the answer. They bought them at the wrong time and sold them at the wrong time.

Schafer: That’s why book value is so low and return on equity is so high.

Gabelli: Look through the windshield, Oscar, not the rearview mirror.

Black: Freeport has about $10 billion in NOLs [prior net operating losses, which can be used to offset future taxes]. We expect Freeport to generate about $1.9 billion of free cash this year, much of which will go toward further debt reduction.

Scott Black on Royal Dutch Shell: “The free cash flow gives you a margin of safety, and the stock is reasonably priced.” Jenna Bascom for Barron's
Gabelli: Share the math on the company’s leverage to copper prices and excite us.

Black: OK, for every 10-cent change in the copper price, there is a $410 million change in earnings before interest, taxes, depreciation, and amortization. For every $50 change in the price of gold, Ebitda changes by $130 million.

Gundlach: Scott, the balance sheet has been an ongoing issue.

Black: It has, but Carl Icahn took two seats on the board in 2015 and has been pushing to restructure the balance sheet and sell assets. The process is well along.

Gabelli: How much stock does Icahn own?

Black: He owns about 8%.

Zulauf: Do you buy Freeport because it is a good value, not because you believe in much higher copper prices?

Black: We bought it for both reasons. There has been some inventory destocking; with global GDP growing by north of 3%, the supply/demand situation will work in your favor. But the stock won’t be a runaway freight train, as it was prior to 2015 when copper prices were going through the roof at around $4.50 a pound. Given the current valuation, the stock has a lot of upside potential. If copper prices go up, the stock could shoot up to $20 or $25.

What is the downside?

Black: The downside is a global recession.

Gabelli: The more interesting question is, what projects are in the pipeline that could increase supply and threaten prices?

Black: Nobody is going to bring on a new mine for under $2.50 a pound. The price would have to approach $4.

Rogers: There has been a lot of irrational behavior in this industry from time to time.

Black:Correct, but companies like Rio Tinto [RIO] have gotten religion, and Glencore [GLEN.UK] isn’t in the best financial shape.

Thanks, Scott. Let’s move on to Jeffrey.

Gundlach: One of the best indicators of the direction of bond yields is the ratio of copper prices to gold prices. It signaled the selloff in bonds that started in July. The copper/gold ratio has come down a little, which supports the recent bond rally. The yield on the 10-year Treasury got as high as 2.64% late last year, and has since fallen back to 2.37%. [Bond prices move inversely to yields.] We expect the yield to fall below 2.25%.

Why is the ratio such a good indicator?

Gundlach: Copper is an industrial metal. A higher ratio suggests more manufacturing activity, and that implies an uptick in inflation and yields. As I explained this morning, I expect interest rates to rise later this year. One way to position yourself for further rate increases is to look for things that don’t have much interest-rate risk. Last year, I recommended the Brookfield Total Return fund [HTR], which invests in mortgage-backed securities. It was trading at a steep discount to net asset value. As luck would have it, it got merged into a new fund at its net asset value, producing a total return of 21.7% on a bond-like investment in a 2%-type year. This year, I am recommending something a little less juicy— Putnam Premier Income Trust [PPT], launched in February 1988. Its longevity is a good sign.

Putnam Premium Income is a one-stop-shopping, low-risk bond-portfolio investment with a decent yield. And it is trading at an 11% discount to net asset value. Unlike the Brookfield fund, there is little chance the price will rise sharply and converge with net asset value, as this closed-end fund has been hanging around with a 10% discount to NAV for a long time. Last year, the discount narrowed to 8%.

What are your return expectations?

Gundlach: You might get a capital gain of 3% this year, and the dividend yield is 6.3%. The portfolio is 80% invested in the U.S. The other 20% is a little spicy, and includes Greek, Russian, and Brazilian bonds. While the higher-risk holdings account for less than 10% of the portfolio, they are probably the source of much of the rich yield.

Jeffrey Gundlach: “I’d short German Bunds. They are yielding 0.27%, and Germany’s inflation rate is 1.7%. The gap is a record. The Bund yield is unsustainably low.” Jenna Bascom for Barron's
The duration of the fund is 0.3, according to Putnam, which means the fund holds allocations to assets, probably floating-rate or lower-credit securities, that dampen interest-rate-related volatility. But almost a third of the portfolio is invested in something liquid and easy to price: Fannie Mae mortgage-backed securities. Given the discount to NAV, you are buying Fannie Mae 3’s [the coupon is about 3%], basically the current coupon mortgage-backed security, at a price 11% below the actual market price, which translates to a yield about 150 basis points above market yields. It is an unequivocal bargain—kind of like buying a 10-year Treasury today at 4% instead of 2.37%. It is a great starting point.

Does the fund use leverage?

Gundlach: The Putnam fact sheet reports no leverage, but when I add up the numbers, leverage looks to be 20% to 25% of net assets. But leverage doesn’t increase your interest-rate risk because you don’t really have much risk. There is a small risk of your spread [between the yield on assets and the cost of borrowed funds used for leverage] shrinking. Maybe the fund is earning a 4% or 5% spread, which is contributing about a percentage point to the yield. If LIBOR [the London Interbank Offered Rate] goes up 100 basis points [one percentage point], you might lose 25 basis points on the yield. But you are still comfortably at 6% in a world where a total-bond-market index fund would have a net yield of around 2½%.The fund has about $600 million in assets. If someone wants to own one bond investment after this rally is over, this is a good one to have.

BKLN, or PowerShares Senior Loan Portfolio, is an exchange-traded fund. It holds bank loans, which have credit risk, but are at the top of the capital structure in bank debt. There isn’t a lot to worry about, even if oil prices fall. I agree with the consensus that oil will hang around the mid-$40s to high-$50s. Energy-company debt represents only 5% to 6% of the bank-loan market.

What does the fund yield?

Gundlach: It yields 4.1%. If you combine PPT and BKLN, you’ll have a 5%-plus yield and little interest-rate risk. Your total return for the year could be as high as 7% or 7.5%.

Next, like Felix, I would short German Bunds. They are yielding 0.27%, and Germany’s inflation rate is 1.7%. Historically, it is very rare to have a Bund yield below the inflation rate. The current gap is a record. The Bund yield is unsustainably low.

Schafer: What is the best way for an individual to short German Bunds?

Gundlach: Short the futures. I agree with Felix that the Italian bond market is deeply troubled. Shorting Italian bonds could potentially produce a massive home run; they are yielding 47 basis points less than 10-year U.S. Treasuries, which represents a full buy-in on the idea that the euro zone will last forever. If the euro zone breaks up, a possibility we have discussed, and Italy has to go it alone, sovereign bonds could yield 1.9%. The current yield is insanely low. But shorting German Bunds appeals more. They are more vulnerable at this point than U.S. bonds.

One argument for U.S. bonds when yields hit a low last July was that they yielded more than German Bunds, which had negative yields. In other words, U.S. bonds were better than something really terrible, but that didn’t make them good. Underlying the argument was the notion that German yields would stay negative forever. Well, forever lasted about a month. Since then, Treasury yields have risen more than German rates, but Bunds could underperform in the next leg of the bond bear market.

Zulauf:In 2012, there were widespread fears about the euro zone breaking apart. Back then, money flowed from the southern countries to the northern countries, and into Bunds. The next time the euro zone looks endangered, money will flow out of the euro completely and into another currency, primarily the U.S. dollar.

Schafer: Do you short in your bond funds?

Gundlach:We don’t short in our bond funds. We run a macro fund [DoubleLine Multi-Asset Growth (DMLIX)] and short markets there from time to time. I have a somewhat nonconsensus perspective on equity markets. U.S. investors are heavily invested in U.S. stocks. The U.S. has significantly outperformed emerging markets in the past five years. Now it looks like things might reverse. I’m not suggesting that investors abandon U.S. equities, and certainly don’t short them. But this is a moment to think about diversifying. Articles often tout the benefits of diversification after huge outperformance by emerging markets or European markets. But you should do just the opposite: Buy the underperformers. Investors ought to decrease their U.S. allocation and increase their allocation to non-U.S. markets.

Do you like specific foreign markets?

Gundlach: I still like India, which I recommended buying last year through the INP [ iPath MSCI India exchange-traded note]. You can also buy it through the iShares MSCI India ETF [INDA].

The iShares fund is less costly and easier to trade.

Gundlach: Then go with that. I’m not a stockpicker. I’m a bond guy who also thinks about macro stuff. India is a long-term play, based on positive demographics and improving fundamentals. It could take 10 to 20 years to play out. Yes, India is plagued by horrific regulations and cronyism. But that just means there is room for improvement. If you had recommended the Chinese stock market 35 years ago, you would have gotten the same pushback.

Because of India’s demographics, there will be a massive increase in the labor force. That runs counter to so many other countries, particularly parts of Europe, Russia, and even China. India could have up to 300 million people in the labor force over time. That will necessitate an economic expansion. But you have to think long-term. There could be a lot of volatility in the market.

Zulauf: India isn’t interwoven much with the world economy. That is a positive.

Gundlach: Japan is another market I like; it seems to be a consensus pick at this Roundtable. The Bank of Japan is engaged in quantitative easing, and the government is encouraging the purchase of stock. There have been three sources of pretty much automatic buying of the Japanese stock market that totaled an annualized $163 billion in last year’s third quarter: pension funds, the Bank of Japan buying ETFs, and corporate buybacks. Together, these buyers are buying shares at an annual rate in excess of 5% of the total market capitalization. Further buying could come from the Japanese public, which is broadly underinvested.

Rogers: How would you gain exposure to Japan?

Gundlach: Buy the DXJ [ WisdomTree Japan Hedged Equity ]. It is dollar-based. Further supporting the case for Japan is the substantial weakening of the yen, now 117 to the dollar. Longer term, it could go to 200. The Japanese economy could get a significant share of global growth.

Priest: Going back to Europe, Italy is the eighth-largest economy in the world. It has issued the fifth-largest amount of sovereign bonds. Most of them are held outside Italy. To me, that is an accident waiting to happen. If the ratio of nonperforming loans to GDP were as high in the U.S., our banks would have $2 trillion of nonperforming loans. Some kind of default appears to be looming.

Gundlach: You could short the bonds in the futures market. But shorting German Bunds could be a more profitable trade right now.

Black: People look at the euro zone from an economic perspective, but the creation of the euro was also about forming a supranational bloc to keep the peace. Remember, Germany went to war with the rest of Europe in 1870, 1914, and 1939. I once went to a dinner with Mario Draghi [president of the European Central Bank] and asked him about the 3% rule. Euro-zone countries aren’t supposed to run a deficit exceeding 3% of GDP. He said countries are evaluated on a case-by-case basis, and that policy makers will do everything possible to preserve the euro, long term.

Gundlach: You have to wonder about the euro-zone concept when everybody broke the rules underpinning it in the first year.

Zulauf: The Maastricht treaty [Treaty on European Union] has been broken 70 times. Every nation does what it wants. The euro zone is decaying in reality, if not in legal terms.

Jeffrey, would you hedge out currency risk on non-U.S. investments generally?

Gundlach: U.S.-based investors should do so. I’m not a big dollar bull. As I said this morning, I’m not sure Donald Trump is a strong-dollar person. If he really wants to deliver for the forgotten middle class, a strong dollar is a hard way to do it. The DXY [U.S. dollar index] is at102.22. It would be hard to for the DXY to get above 120.

The Federal Reserve has barely been mentioned today, in contrast to other years. What is your expectation for Fed rate hikes?

Gundlach: It is refreshing, isn’t it? I got so tired of the world focusing on 25 basis points. I expect the Fed to follow the market. The rise in bond yields after the election gave the Fed the green light to raise interest rates in December, which it did. There is a green light to raise them in June. The Fed probably won’t act at its March meeting, which follows too soon after the inauguration of a new president. I wouldn’t be surprised if the Fed raises rates three times this year.

Cohen: Underscoring Jeff’s comments, there are finally policy players besides the Fed. Central banks, and the Fed in particular, as the central bank to the world’s largest economy, were put in an untenable position because fiscal policy was frozen in so many countries, including the U.S. Now that fiscal policy changes are likely in the U.S., global capital flows are adjusting. It remains to be seen whether the policy changes are favorable to long-term economic expansion. Some other countries are undertaking structural reforms, showing that there are ways to spur economic growth other than through monetary policy.

Rogers: The same political regime has been in place in the U.S. since 1988. Nothing new has really happened. Finally, something is happening with Trump’s election as president. We will find out whether it is good or not.

Zulauf: If the dollar stays strong and the Fed raises rates, that will equate to a dramatic tightening of global liquidity. It could trigger an accident at some point.

Cohen: We have seen that tightening in financial conditions through the dollar’s action. Yet U.S. economic growth hasn’t deteriorated. That is encouraging. There is currently a solid domestic-growth dynamic in the U.S. in terms of job creation and industrial production. Although exports usually are hurt by a strong currency, much of what the U.S. sells abroad is high-value goods and services and isn’t notably price-sensitive, mitigating the impact of the dollar. But I agree with Felix that we won’t have enormous swings in the world’s major currency without a negative impact occurring somewhere.

Zulauf:It hurts Mexico tremendously. Turkey is another accident waiting to happen, and problems there could be reinforced by politics. The countries most exposed to the negative impact of a strong dollar are those that run chronic current-account deficits and depend on foreign financing and capital inflows. Turkey is high on the list on both counts.

Felix, what is your view on Russia?

Zulauf: Putin [Russian President Vladimir Putin] did the right thing by letting the currency fall 50% or so. That helped him balance the domestic economy after oil prices dropped sharply. Now oil is recovering and Russia is doing better, but structurally it isn’t a strong economy, and the long-term outlook isn’t promising.

Gundlach: Russia could see the biggest drop in population in world history, absent wars or famines. The mortality rate is high, fertility rates are low, and the Russian culture is under threat because of demographic trends.

Thanks for your insights, Jeffrey. It is time to hear from Meryl.

Witmer: I am recommending four companies. In three cases, management owns a significant percentage of the shares outstanding. The founders created superior companies from scratch.

Dart Group [DTG.UK] is a U.K.-based airline operator and vacation packager with 148 million shares outstanding and a market cap of 740 million pounds [$912 million]. The stock is trading for 500 pence. While the shares are valued like an airline, the company is an outstanding operator in the leisure travel business. Philip Meeson is a passionate owner-operator. He owns about 38% of the stock.

Dart began as a carrier of flowers between the Channel Islands and the U.K. It evolved into a low-cost airline, and then into one of the largest vacation-package providers in the U.K. The company operates under the brands and Jet2holidays. is rated No. 1 in the U.K. on TripAdvisor. Unlike competitors, it is known for great service. In the U.K., more than 15 million people a year buy vacation packages through companies like Jet2, Thomas Cook Group [TCG.UK], and TUI [TUI.UK]. The British consider vacations somewhat sacrosanct, as the U.K. is a cold, wet, and cloudy island.

Meryl Witmer: Dart Group is valued like an airline, but has become “an outstanding operator in the leisure travel business.” Jenna Bascom for Barron's
Other than that, it is a beautiful place.

Witmer: Customers pay in advance, and the company earns a fee from the hotels booked. This is similar to a franchise model, in that Dart earns a percentage of another business’ revenue without the capital costs. The company owns planes, however, so it makes some capital investments. The after-tax return on capital exceeds 20%. Hotel operators love Jet2holidays, as it delivers customers and pays faster than the competition. In return, Jet2 customers get the best rooms. Some travel agencies are looking to co-brand with Jet2 because of the halo effect of the brand. The travel business has grown from zero passengers in 2007 to 1.5 million in 2016. Vacation-package travelers are about half the travelers on Jet2 planes.

Jet2 is at an inflection point as the company begins to fly out of southern U.K. markets such as Stanstead and Birmingham. That will enable it to attract travelers from the London area. It built the brand by dominating the northern U.K. market. The southern market is roughly twice as large. Jet2 has contracted for 34 new Boeing 737-800 planes over the next few years, which could enable the company to grow by about 15% a year.

Tell us about earnings.

Witmer:In the 12 months ended September, Dart earned about 70p a share. Reported earnings could be lower in the next 12 months as Dart invests in advertising and other costs to build out the southern market. If you add back the one-time costs, adjusted earnings could be 70p or higher. With capacity additions, earnings will grow thereafter at a 10% to 15% annual clip. Dart deserves at least a 10 to 12 price/earnings multiple, which implies a near-term price target of 700p to 850p a share. The shares fetched 700p early in 2016. If the growth plan succeeds, earnings could top 90p in a few years and the stock could then trade around 1,000p.

Schafer: Why did the stock fall?

Witmer: It was hurt by Brexit [Britain’s vote in June to leave the European Union]. Ryanair [RYA.UK] also fell sharply and then rebounded, but this stock hasn’t come back. Only two brokerages follow Dart, and the company doesn’t do earnings conference calls.

Schafer: Has the business been hurt by a weaker pound?

Witmer: No. Dart has hedged out a lot of the fall, and the pound hasn’t fallen as much versus the euro, relative to the dollar.

Black: What is the income demographic of Jet2’s target audience?

Witmer:The company offers everything from two- and three-star hotels up to five-star properties. I’d say they attract a four-star customer. When you buy a package, you also get travel insurance, which is a good deal.

Black: Does Dart have the cash flow to buy 34 new planes?

Witmer: It will borrow some of the money, and use cash flow. The cost is about $1 billion, which they can manage over three years. Dart’s management is financially savvy. The growth has been self-financed.

Zulauf: That’s a great story.

Witmer: My next pick is Linamar [LNR.Canada]. It is a global auto-parts supplier, based about an hour from Toronto. The stock price is 60 Canadian dollars [$45]. There are 66 million shares outstanding, and the market cap is C$3.9 billion. Linamar has two segments: powertrain/driveline and industrial. The former generates about 80% of operating income. The company utilizes precision machining, casting, and forging technology to make powertrain and driveline components for automotive OEMs [original equipment manufacturers]. Linamar focuses on sophisticated components that are lightweight and fuel-efficient.

What does the industrial division do?

Witmer: It makes aerial work platforms, such as scissor lifts, under the Skyjack brand. There are two major competitors: Terex [TEX] and OshKosh [OSK]. Linamar purchased Skyjack in 2001-’02 for $32 million. Skyjack is on track to earn $140 million, pre-tax, in 2016, so it was a good buy. Linamar was founded by Frank Hasenfratz, a remarkable man. An ethnic German, he was born in Hungary and fled to Canada in the 1950s after the Hungarian uprising against the Soviets failed. The Canadian government gave him $5 and sent him on his way. Frank had an advanced skill set as a machinist from an apprenticeship in Hungary, and started a predecessor to Linamar in 1964 in his basement.

In 2002, his capable daughter Linda took over as CEO. She has a chemistry degree and an M.B.A., and started on the shop floor. Together, they own about a third of the stock. They think long-term about growing the business and achieving 20% pre-tax returns on capital. The company is relentless about keeping costs low through process efficiency and product innovation. Every plant manager at its more than 50 plants worldwide is responsible for his or her own P&L [profit and loss]. Despite its growth, Linamar has retained an entrepreneurial culture.

Linamar is benefiting from the trend toward outsourcing powertrain and driveline manufacturing, the last major area of automotive production that is still done partly in-house. OEMs realize they can achieve better and more cost-effective results by outsourcing. Linamar is well-positioned to garner new business as a trusted supplier. It often has sole-source status as a supplier on these critical elements. It can grow through a downturn. If North American vehicle sales fell by one million units, Linamar would lose only about $150 million of revenue. While it is valued like a run-of-the-mill auto supplier, it deserves a higher valuation.

What would you give it?

Witmer: The company projects that with flat automotive production, revenue will grow by about 30%, from C$6 billion to more than C$7.8 billion over the next four years, based solely on new business wins it has already signed. Past projections have been conservative by about C$500 million. We estimate that Linamar will earn more than C$7 a share in 2016, growing to more than C$9 a share by 2020. The stock could trade north of C$90 a share in a few years, based on a pricing/earnings multiple of 10. We’d argue a multiple of 12 is more appropriate, producing a target price of C$110 a share.

Schafer: Have you heard of the company, Mario?

Gabelli: Yes. One of my analysts picked it as his stock of the year for 2017.

Rogers: What are gross profit margins like in this business?

Gabelli: Probably 20%, at best. Pre-tax operating margins are around 10%, which is great.

Witmer: Next, Virtu Financial [VIRT] was founded by Vincent Viola, now chairman.

Gabelli: He’s a military guy. [Viola, an army veteran, has been nominated by Donald Trump to be Secretary of the Army.]

Witmer: Yes, my kind of guy. Virtu is an electronic market maker, operating on more than 200 trading platforms around the world. It came public at $19 a share in 2015 and is trading for $16.50. Assuming conversion of the pre-IPO [initial public offering] partnership interests, it would have 140 million shares outstanding, for a market cap of $2.3 billion. Just over a quarter of the interests have been converted to common equity.

Virtu gets painted with a high-speed-trading brush, but that misstates what it does. Its primary business is making markets as efficient as possible and ensuring it provides the best bid-ask spread for the thousands of securities it trades every day. It doesn’t make directional bets and isn’t front-running trades. It makes money from the bid-ask spread.

Virtu’s management team, led by CEO and co-founder Douglas Cifu, is serious about doing business ethically. JPMorgan Chase [JPM] chose the company as its market maker on the New York Stock Exchange after it was unhappy with its prior representative, signaling Virtu’s trustworthiness. The founders together own about 70% of the company on a fully converted basis. Virtu carefully monitors trading in all securities and will lock down trading and strategies if it is making too much money, because there could be an error in the algorithm from, say, a corporate event like a spinoff. Similar situations have hurt other high-speed trading firms.

What will drive Virtu’s growth?

Witmer: The company will benefit as more markets “electronify” and become more efficient. Pending EU legislation regarding MiFID II [the Markets in Financial Instruments Directive, a law aimed at harmonizing financial-services regulation across 31 European countries] will expand Virtu’s market opportunity as more securities, including ETFs, will be required to trade through liquid, well-regulated markets. Virtu also has been building an agency business to execute trades on behalf of buy-side clients. Its trade execution is in high demand. Brian, you might know something about that. [ T. Rowe Price began sending a small portion of orders through Virtu in 2015.]

Rogers: Yes, I do.

Witmer: Virtu estimates the agency business could account for at least 10% of revenue in the future. The company also is developing technology service deals with additional partners. It recently announced it would be partnering again with JPMorgan to help the bank trade a portion of its U.S. Treasury business. Virtu will provide the market access and order-routing capabilities, and JPMorgan will provide the capital. Virtu’s base business likely earned about 90 cents a share in after-tax free cash flow in 2016. That’s down from $1.30 in 2015, when one-time events generated excess earnings, and $1.06 in 2014.

Volatility and trading volume were unusually low last year. Virtu is relentless about keeping costs low, so as volatility and volume pick up, incremental revenue will drop to the bottom line. Assuming modest growth in the agency business and technology services deals, and a return of volatility and volume to more normal levels, we could see Virtu earn $1.50 to a $1.60 a share, or more, in the next three years. The company pays a quarterly dividend of 24 cents, so you are paid to wait. If everything plays out, the stock could trade for 13 times earnings, or more. That, plus a few years of dividends, could give you $22 a share.

Would losing Viola to Washington be a big negative for the company?

Witmer: Cifu is really running the show.

My last pick is Cooper-Standard Holdings [CPS], a global auto-parts supplier based in Novi, Mich. The stock is trading for $107. There are 19 million shares outstanding, for an equity capitalization of $2 billion. The company went through bankruptcy proceedings in 2009 and emerged in 2010 with a better balance sheet, but with the equity largely owned by debt holders. We looked at it after it emerged and passed, but became intrigued at the roadshow when some large holders did a secondary offering. We were impressed with the management team, especially CEO Jeff Edwards, hired in 2012. He came from Johnson Controls and by all accounts was a star there.

What does Cooper do these days?

Witmer: It has four major product lines. Sealing systems and fuel and brake delivery represent three-fourths of revenue. The sealing business is about half; Cooper is the global leader, with a 24% market share. Its products protect vehicle interiors from weather, dust, and noise. They are the black rubber frames around doors and windows. In fuel and brake delivery, Cooper is No. 2 globally, with a 9% share. Its products are used to deliver and control fluids throughout the vehicle. When Edwards took the helm, he put some resources into R&D [research and development] and the team developed some breakthrough products in materials science.

What distinguishes them?

Witmer:The new materials are significantly lighter than the incumbent materials, and have superior durability and weight characteristics. They save up to 40% in weight, and last years longer. Given stringent CAFE [Corporate Average Fuel Economy] regulations, which admittedly might be loosened under President Trump, we expect the adoption of these products to meaningfully increase Cooper’s market share and profitability as it wins placements on new platforms over time. In the past year it received six development contracts, an indication of OEMs’ excitement about the products.

Since Edwards and Chief Financial Officer Matt Hart took over and implemented their Cooper operating system, they improved Ebitda margins from 9% to 12.5% and return on capital from under 6% to up to 10% last year. Cooper’s operating margins could reach 15%, and return on capital 15% to 20%, by 2020. Cooper has restructured its manufacturing footprint and created a culture of excellence. The company has made some opportunistic foreign acquisitions, including a stake in a joint-venture partnership in China, and repurchased shares at attractive prices. We acknowledge the risk of peak U.S. auto sales, and concerns about the cycle. However, Cooper is a global supplier and gets half its revenue from outside North America. Any weakness in North America can be offset by growth in new products, market-share gains, and strength in Asia, where Edwards has great relationships.

What is your earnings forecast?

Witmer: We estimate Cooper earned $10 a share last year, and could earn $11 this year. Earnings could grow to $12 to $13 a share by 2020. We have a near-term price target of $125, but think $140 could be possible within three years. Both Linamar and Cooper are being lumped with basic auto-parts suppliers. But they have something different, and will gain market share over time.

Gabelli: With the presence of exchange-traded funds, a lot of portfolio moving is taking place. Stocks fluctuate without regard to fundamentals, leaving plenty of opportunities.

Witmer: That’s when you want to be there with a basket. In fact, Cooper traded down to $85 not long ago, and we bought more.

Thank you, Meryl. Speaking of opportunities, how about sharing your ideas, Mario?

Gabelli: To echo my comments this morning, in electing Donald Trump, the U.S. is moving away from creeping socialism toward the reinvigoration of capitalism. We are seeing a wave of confidence in America, which will spark a wave of innovation. Individual tax rates could fall from 39% to 33%; a new tax plan could create only three tax tiers, and the earned income credit could rise, returning money to the working class. Also, regulatory reform could help improve the tone of business. The U.S. consumer had a record net worth of $105 trillion as of Sept. 30. Minus debt, that’s $90 trillion. There are two pockets of concern: Auto loans are up substantially in the past 10 years, and student loans have ballooned to $1.3 trillion. That’s a big drag.

That’s the macro backdrop. On stocks, I recommended CBS [CBS] last year and it rose nicely. I expected CBS to buy Viacom [VIAB], but it didn’t happen. Viacom has 397 million shares. About 50 million are class A, controlled by the Redstone family’s National Amusements. The rest are class B. With the B shares around $38, Viacom has an equity valuation of $15 billion. The enterprise value, including debt, is $25 billion. Viacom’s Paramount movie studio is a great brand, but it lost about $400 million last year. It must revitalize its theatrical and television production, and it will. Viacom could also do some creative financing with Paramount—selling assets, entering joint ventures, and such.

Viacom’s cable TV networks aren’t performing well, either. How can the company turn those around?

Gabelli: The basic business includes Nickelodeon, MTV, and other networks. The new CEO, Bob Bakish, must trim the portfolio and energize product development. We look for Viacom to report $13 billion of revenue in this fiscal year, ending Sept. 30, and $3.7 billion of Ebitda. The stock trades for seven times enterprise value to Ebitda. If I’m Apple [AAPL] and want to get into the entertainment business and have a market cap of $600 billion, Viacom wouldn’t be hard to buy. But Shari Redstone [president of National Amusements] likely won’t sell.

Black:Don’t you think Viacom is a value trap? It has been depressed for several years.

Gabelli: You are correct. The assets weren’t managed right by the previous management team. The company’s ratings are starting to improve. Viacom stations, in the aggregate, have more viewers than ESPN, notwithstanding millennials’ penchant for cord-cutting [cancellation of cable service]. The stock potentially could double in three years. The rules are changing in the media business. The industry will consolidate globally.

Schafer: The problems are priced into the stock.

Gabelli: Thank you. A year ago Congress passed the FAST Act—Fixing America’s Surface Transportation. Stocks like Astec Industries [ASTE] and Gencor Industries [GENC], which make machinery used in highway construction, surged. If we get more visibility on infrastructure spending, vendors to industrial companies will do well. We like the rental-equipment business, the Uber of the industry. It is a $47 billion business in the U.S., growing at 4.5% a year.

Which stock are you picking?

Gabelli: Herc Holdings [HRI], a rental-equipment supplier, was spun out of Hertz Global Holdings [HTZ] on July 1, 2016. The company is a work in progress, but should have a significant tail wind if the Trump administration launches a big infrastructure initiative. Herc has an Ebitda margin of 38%. The stock is trading for $40, and the market cap is $1.2 billion. Herc has $2.1 billion of debt, courtesy of Hertz, but it isn’t overleveraged.

Construction-equipment companies also are well positioned. My pick today is CNH Industrial [CNHI], formerly Case New Holland. The company has 1.36 million shares, and the stock is trading for about $9. Exor, the Agnelli family’s holding company, controls CNH, after it merged with Fiat Industrial in 2013. CNH has a large global presence in the construction-equipment business. It is also known for farming equipment and engines. Profits have been slim in the construction business, but that is going to change. CNH recently struck a deal with Hyundai Heavy Industries [009540.Korea] to make mini excavators. Through the Fiat merger, it owns Iveco, a European truck maker. The class A truck market in Europe is improving. The stock could double in the next two years.

About 10 years ago, I identified the single-serve coffee market as an exciting growth opportunity.

You were hardly alone.

Gabelli: Today, I like the prospects for sparkling water—in particular, National Beverage [FIZZ], which markets LaCroix. The company is based in Florida and has 47 million shares. The stock sells for $49. The CEO, Nick Caporella, is 80.

Sugary soft drinks are perceived to be bad for you, and in some places they’re being taxed. But LaCroix has no sugar or additives. Carbonated soft drinks are a $90 billion business, and sparkling water is the fastest-growing subset. It is growing by 30% a year. LaCroix gets significant floor space at grocers, and has a 13% market share in its category.

Cohen: What are the profit margins on this?

Gabelli: Let me give you the math first. The fiscal year ends April 30. National Beverage has been rolling up beverage companies. It bought the Shasta brand—which is popular in the West—and Faygo, and others. Energy drinks are a small part of the business. LaCroix should generate $340 million in revenue this fiscal year, and $90 million of Ebitda, so the profit margin isn’t as high as you would expect. The CEO is tax-sensitive. The company declared a dividend of $1.50 a share in late November, but it isn’t payable until Jan. 27, after Trump becomes president. If Congress abolishes the estate tax, and the tax on long-term capital gains comes down, would he be likely to sell the company? I doubt it. But eventually Coca-Cola [KO] or PepsiCo [PEP] or Dr Pepper Snapple Group [DPS] will knock on the door.

Rogers: Is LaCroix nationally distributed?

Gabelli: Yes, more or less. National Beverage has significant bottling capacity. LaCroix is their premier brand.

LaCroix’s revenue could rise to $670 million over the next several years, driving overall revenue to more than $1.1 billion. Shasta is doing okay, and the other brands are small. National Beverage is likely to earn $2 a share this year, rising to $2.45 in the year ending April 2018. Capex is de minimis, maybe $11 million. The company doesn’t put money into trucks or delivery routes.

Priest: What is the market cap?

Gabelli: It is about $2.5 billion. We look for new products and new channels of distribution. The one I kick myself for is [AMZN]. If only we’d known Jeffrey Bezos [Amazon’s founder] back when he worked on Wall Street.

Moving on to the booze market, known as spirits in the trade, we own Davide Campari -Milano [CPR.Italy]. It is selling for €9.30 and has 580 million shares. The Garavoglia family owns 50% of the company, but it is professionally managed. Management uses cash flow smartly. Campari will have about €2 billion of revenue in the current year. The company owns a number of brands, including Campari, Wild Turkey bourbon, Aperol, and Skyy Vodka. It recently bought Grand Marnier. Campari acquires niche brands globally; they are huge cash generators with high gross profit margins.

Give us the numbers, please.

Gabelli: In 2017, Ebitda including Grand Marnier could total €470 million. The U.S. accounts for 25% of revenue. Italy is also 25%.

Next, millennials want experiences; they don’t want goods. They are a sharing society. They go to concerts and other forms of live entertainment. They go to Burning Man and Coachella. Think about Las Vegas, which is undergoing a new life cycle. About 50 years ago, it attracted gamblers. Then it went into the family-entertainment business. Now Las Vegas is a big venue for sports. So, how do you play this?

Mario Gabelli: “We look for new products and new channels of distribution. The one I kick myself for is If only we’d known Jeffrey Bezos back when he worked on Wall Street.” Jenna Bascom for Barron's
We’re asking you.

Gabelli: Liberty Media [LMCA], controlled by Dr. John Malone, was launched in 2001 as a spinoff of AT&T [T]. I have prepared a family tree for you, showing every company that has Malone’s fingerprints. [Gabelli holds up a laminated poster illustrating Malone’s corporate “family tree.”] This represents $340 billion of equity value. It’s not as big as Apple or Amazon, but it is significant. If you had bought a basket of everything Malone touched since 2001, it would have grown at a compound annual rate of 13.5%. That exceeds the performance of the Standard & Poor’s 500. Warren Buffett and Malone are the two most tax-sensitive CEOs I have ever encountered. Their philosophy is pay less, pay later, or pay nothing. Buffett doesn’t advertise it, but Malone is upfront about it. Malone has about $7 billion of his own money tied up in Liberty-related companies.

Last April, Liberty created a tracking stock called Liberty Braves Group [BATRK], which represents an investment in the Atlanta Braves. Now you can buy a baseball team at a discount. Liberty Braves also has a real estate business that owns 82 acres in Georgia. The stock began trading around $17. It now trades at $20.

Live Nation Entertainment [LYV] is another play on interest in live events. Liberty Media owns 35%. Live Nation has 201 million shares; it closed Friday [Jan. 6] at $27. The company has about $1.8 billion in net debt. It is a concert promoter and ticket seller. It owns Ticketmaster. The company could have about $700 million of Ebitda in 2017.

Is that all, Mario?

Gabelli: Mueller Water Products [MWA] has 161 million shares, and trades for $13. It has no debt.

Witmer: Do you like the management team?

Gabelli: That’s why I’m recommending it. They just hired a new CEO from Textron [TXT]. He’s taking over a company with $800 million of revenue; $200 million comes from fire hydrants, and $500 million from valves. Ebitda is about $275 million, and capex is $25 million to $30 million. Those are the kinds of things I like. Today, the company announced the sale of its Anvil International piping-system division.

There are so many attractive companies when you think about how a 25% tax rate would boost earnings. We expect more corporate takeovers, too. Romance is in the air.

Let’s leave things there. Thanks, Mario.

Barron’s 2016 Midyear Roundtable: 24 Investment Ideas
Stocks like Alphabet, Nike, and Macy’s could shine in the next year. Learning to love Argentina. Mario Gabelli, Jeffrey Gundlach, Meryl Witmer weigh in.



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June 11, 2016
2016 Midyear Roundtable Report Card

2015 MidYear Roundtable Report Card

2015 Roundtable Report Card

2014 Roundtable Report Card

The stock market hasn’t covered itself in glory in 2016, even after last week’s briefly energetic spurt. But the members of the Barron’s Roundtable are another story this year. For the most part, the investment ideas they shared when the Roundtable met Jan. 11 in New York have performed nicely and then some, compared with the Dow Jones industrials and Standard & Poor’s 500 index. (You could look it up here.) This impressive showing is testament to our experts’ prescience about yet another thing: Most insisted that the broad market indexes would rise little this year, given already lofty valuations and a global economy stubbornly stuck in low gear.

2016 Roundtable members, from left: Scott Black, Meryl Witmer, Felix Zulauf, Mario Gabelli, Brian Rogers, Oscar Schafer, Abby Joseph Cohen, Jeffrey Gundlach, William Priest Photo: Brad Trent for Barron's
Our midyear check-in, by phone, with the wise guys and gals on our panel found their views little changed since January. They still expect stocks to climb by roughly 5% over the course of the year, except for the few who think the market is due for a fall. The Roundtable members say earnings growth, not price/earnings ratio expansion, will be the primary propellant of equity prices, especially as results in the energy sector improve.

Gundlach: Why President Trump Will Be Like Reagan
“He’s Ronald Trump”, says the bond manager. Plus, other surprises from the Barron’s Midyear Roundtable.

To be sure, dangers abound for investors, among them a possible debt implosion in China, more turmoil in emerging markets, and political uncertainty, exacerbated by a most unorthodox presidential-election season. Fears about the leading candidates have been tempered, however, by the hope that sensible fiscal policies will prevail.

All this leaves the optimists doing what they always do: hunting for solid businesses with improving fundamentals and shareholder-friendly policies that, for whatever reason, are woefully underpriced. As for the pessimists, there is always gold. But enough of this preamble. We have lots to relate about deals, steals, dividends, cash-flow metrics, frozen foods, bathroom fixtures, and more. And you have lots to read; we guarantee it.


Mario Gabelli: “Sumner [Redstone] won’t sell Viacom if he is breathing…I don’t want Viacom to be sold yet. It is a great ’beachfront’ property, an easy fixer-upper.” Photo: Brad Trent for Barron's
Barron’s: This year has been a mixed bag for the economy and the stock market. How do you expect the rest of the year to unfold?

Gabelli: The U.S. economy continues to grow at a slow but steady pace. The consumer sector, 70% of the economy, is in great shape. Consumers had a net worth of $87 trillion at year end. Housing looks good. The only troublesome areas are student loans, now $1.3 trillion to $1.4 trillion, up from $400 billion 10 years ago, and subprime auto loans. The government has to do something about student loans, possibly allowing borrowers to pay them off with pretax earned income.

There is uncertainty among corporations about U.S. leadership, and coming tax and regulatory changes. This is creating an air pocket in capital spending. At the federal level, we need fiscal stimulation, which will happen with a new administration. I expect military spending to rise. The dollar is stabilizing, which could help our exports. Even the oil patch will start improving. The rig count can’t get any lower. Corporate earnings will be better in the third or fourth quarter, as there will be less of a drag from energy and currency translation.

Are you bullish on the rest of the world?

China is working to build its consumer sector. Japan has been sputtering, but is trying to grow. Europe is in good shape. Mario Draghi [the president of the European Central Bank] has Germany humming, and Russia is improving. I like the outlook for northern Europe.

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I said in January that the stock market could be up zero to 5% this year, and nothing has really changed. The market won’t finish the year much higher than it is today. But it is a great time to pick stocks, and that’s what we have been doing. We have been helped by deals. There have been seven acquisitions this year in the utility area, for instance. In certain industries, you can try to get ahead of the curve if you have a good sense of who is going to be taken over. We also expect to profit from more military spending, and we like entertainment and media, including Sony [ticker: SNE]. Most analysts follow it as an electronics company, but we look at it as a gaming and consumer-entertainment business.

What do you like about Sony?

The stock is trading for $27.80. There are 1.3 billion shares, and the market cap is $35 billion. Cash and debt are about equal, excluding the finance subsidiary. The PlayStation 4 gaming system has done well, as have image sensors. There is more growth ahead in these areas and virtual reality. If you focus on Sony as an entertainment company, you get all the other businesses for free. The stock could trade up to the mid-$30s, low-$40s in the next several years.

In January, I recommended Millicom International Cellular [MIICF]. I still like it. The stock is around $60, and there are 100 million shares. The company has wireless telecom assets in Africa, South America, and Central America. Part A of what I anticipated has happened: John Malone’s Liberty Global [LBTYA] created a tracking stock last summer, Liberty LiLAC Group [LILAK], for its telecom operations in Latin America and the Caribbean.

What is part B?

Millicom announced it is selling off its African assets, except in Tanzania. The former head of LiLAC’s Chilean business now runs Millicom. I can see Millicom merging into LiLAC a year from now. Millicom is trading for five times enterprise value to Ebitda [earnings before interest, taxes, depreciation, and amortization]. The company could fetch as much as $100 a share in the next several years. We like the prospects for Latin America. Argentina’s new president, Mauricio Macri, is turning the country around. The whole region appears to be bottoming out.

In the 2015 midyear Roundtable I also recommended E.W. Scripps [SSP]. The stock was $24; now, it is $17.

Yikes, what happened?

After Scripps and Journal Communications merged their broadcast businesses last year, Scripps was less than aggressive in explaining the benefits of the deal. The company has scheduled a meeting with investors for June 29. Scripps will benefit this year from a tsunami of political advertising. We estimate that political advertising will increase to $4 billion from $3.2 billion in 2012. Selling broadcast spectrum could also be a windfall for Scripps.

The broadcast industry has been consolidating. Scripps owns 33 stations. In the near term, earnings could accelerate. The stock could rebound to the level where we bought it, plus some. Our managed accounts own 12% to 13%. If an activist investor nominates one or two directors to the board, they would likely have our clients’ vote. Even if Scripps makes no acquisitions in the next few years, net cash per share will be almost $5 or $6 a share by 2020.

Where else do you see opportunity?

There has been a lot of activity in the gas-station convenience-store business. There are barriers to entry because of local gasoline requirements. CST Brands [CST], in San Antonio, has 75 million shares. It was spun out of Valero [VLO] in 2013.

CST management is exploring strategic alternatives. CST just sold its California division, with 79 stations, to Japan’s Seven & i Holdings [SVNDY], known as 7-Eleven here, for $400 million. It bought properties in the Southeast, and has stations in Canada. Seven & i and Canada’s Alimentation Couche-Tard (ATC-B.Canada) reportedly have put in bids. CST is trading at $44. We think it is worth $45 to $60.

Edgewell Personal Care [EPC] was spun out of Energizer Holdings [ENR] last July 1. Edgewell appears to be positioned to be partnered with another entity. There are 60 million shares. The stock is trading at $80, and has a market capitalization of $4.8 billion. The company has about $1.2 billion of debt. It could generate $2.3 billion of revenue in the year ending September 2017, and close to $500 million of Ebitda. It could earn as much as $4 a share. Edgewell sells Schick razors and blades, and skin-care and sun-care products, such as Hawaiian Tropic.

The company has been reorganizing, and has good distribution. A buyer would get it at the sweet spot, and enjoy the benefits of the repositioning. Edgewell could sell for north of $100 a share.

Which military plays are attractive to you?

Harris [HRS] specializes in communication systems, space intelligence, and electronic warfare. The stock is $80. Harris bought a company called Exelis that was spun out of ITT [ITT]. Textron [TXT] is trading for $38. Through its Cessna and Beechcraft divisions, the company sells aircraft to the commercial-aviation market, where we expect a pickup in the next several years. Through its Bell system, it sells helicopters for military and commercial use.

Your clients own a lot of Viacom [VIA/B], and a fight is under way for control of the company. What is the optimal outcome?

Sumner won’t sell Viacom if he is breathing. [Sumner Redstone, Viacom’s controlling shareholder, just turned 93.] His daughter [Shari Redstone] won’t, either. There is no love affair between Redstone’s National Amusements, which owns 80% of Viacom, and Viacom’s management team.

Viacom could generate $4 billion of Ebitda in the year ending Sept. 30. Capital spending is $100 million. The company needs to get into the “over-the-top” business, or Internet-based TV, as the Netflixes of the world have done. Paramount, the crown jewel, is underexploited.

I don’t want Viacom to be sold yet. It is a great “beachfront” property, an easy fixer-upper.

Thanks, Mario.


Jeffrey Gundlach: “The establishment doesn’t like the fact that Trump has made them irrelevant…They don’t seem to get that they are playing checkers, and he is playing chess.” Photo: Brad Trent for Barron's
Barron’s: Help us solve this year’s great mystery. When will the Federal Reserve raise interest rates?

Gundlach: The Fed wants to raise rates. It has basically said so repeatedly. It doesn’t want to be at zero when the next downturn comes. Fed policy makers are looking for a level place in the markets, and hopefully some stability in the economy, before they act. They talked about tightening credit when two goals were met: a specific level of unemployment, and a specific level of inflation. First, they kept lowering the unemployment target as each level was approached, although with unemployment now below 5%, it would strain credulity to move the target again. So, that box is checked.

What about inflation?

For many years, the Fed said its preferred inflation indicator was the core index of the personal-consumption expenditures gauge. When that didn’t move up to 2%, they shifted focus to core CPI [the consumer price index]. That is now above 2%, setting another parameter for tightening. The Fed also talked in the past about targeting the five-year inflation rate, but you don’t hear much about that now because it is in freefall. Also, employment data are weakening. After the May jobs report, it would be impossible for the Fed to raise rates in June. And it is too early to tell if they will hike at the July 27 meeting, since they flip-flop so much.

So, the mystery remains.

When the Fed hikes, the markets won’t like it. We are also attuned to the possibility of a recession. We look at two things in that regard. One is the unemployment rate moving above its 12-month average. When it does so, you’re on recession watch. It doesn’t guarantee there will be a recession, and there have been plenty of false signals. But there hasn’t been a recession without that happening. This indicator isn’t flashing a warning yet, but it probably will do so with the September jobs report. The second thing is Donald Trump’s candidacy.

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You predicted at the January Roundtable that Trump would become president. Are you sticking with this forecast?

I am. Trump beat out 16 candidates, including establishment candidates, despite all the scary things the establishment has said about him. Once he begins campaigning against Hillary Clinton, the media, which is also an establishment institution of sorts, will put out all sorts of pieces about protectionism, a coming recession, and other things that could happen to the economy under Trump. If you combine weakening employment data with poor corporate earnings, a Fed rate hike, and a barrage of scary headlines about Trump, the stage could be set for a global growth scare. Then, to put the cherry on top, summer is a seasonally weak time of year for the market.

When Trump talks about bringing jobs back from overseas, people hear “tariffs.” But he will do what Ronald Reagan did. He is Ronald Trump.

What are you talking about?

Reagan massively increased the debt-to-GDP ratio. It was stable through the 1950s, ’60s, and ’70s. Reagan started massive deficit spending. It had the appearance of working to stimulate the economy, and it will have the appearance of working again. Trump has done a lot of things with debt. He likes playing around with it. If the economy turns south, he could make a deal, repay bondholders less than they are owed. That doesn’t sound good for a bondholder. But if you borrow a lot of money to build bridges or airports or walls, it stimulates the economy.

There is a big downside to all that debt.

There are several reasons why this approach might be bad for bonds. First, higher GDP tends to be negative for bond yields. Second, there will be a big supply of bonds. And third, the guy says he might haircut you on your payback. I don’t think he means it seriously; he kind of walked it back. In a way, though, it might make sense. If interest rates rose and 30-year Treasury bonds fell to 80 cents on the dollar, perhaps he would launch a fourth round of quantitative easing and buy bonds in the market, which would mean paying holders less than 100 cents on the dollar.

Turning to equities, this has been called the bull market everyone loves to hate. When you look at the charts, it is hard to call it a bull market.

Emerging markets have been down for nine years. They are down sharply from 2007, and from more recent highs in 2015. Japan is about 22% below its high, and Germany is down about 18%. The S&P 500 has been flat for 18 months.

Among individual stocks, Delta Air Lines [DAL] has fallen 20% this year. Toll Brothers [TOL], the home builder, was $42 last August. It is $29 now. While some stocks have risen, there is a lot of rot beneath the surface.

Viewed positively, many stocks are cheap.

I recommend lower-than-normal exposure to equities, but if you are going to take a risk, buy the high-beta stuff [stocks that tend to move more than the market]. If the S&P 500 is going to break out and rally to 2500, that is what will do well.

We talked in January about getting a buying opportunity in stocks during the year. It happened on Feb. 11, when the stock market bottomed. We could get another opportunity later this year. Whether the market turns up again before year end will depend on how it is interpreting the economic reality of a Trump presidency.

I don’t like the idea of adding trillions of dollars to the national debt. But it will help in the near term.

Could Donald Trump end up being a good president?

Sure. Why not? People thought Reagan had a room-temperature IQ. They thought he was a buffoon and a B-movie actor pretending to be someone running for president. Now, all these years later, people want to wrap themselves in the mantle of Reagan in the Republican Party.

What is different now is that Trump isn’t supported by the Republican establishment. The establishment doesn’t like the fact that Trump has made them irrelevant.

What they don’t like is that he has said troubling things.

They don’t like that he treats them with blatant disregard. They don’t seem to get that they are playing checkers and he is playing chess.

Let’s get back to the interest-rate outlook.

The Treasury market has been range-bound for a long time. One reason is because it is pegged to rates in Europe and Japan, which are controlled by central banks. We will continue to see much greater volatility in the credit market than the Treasury market. The volatility has been head-snapping this year. The junk-bond [high-yield] market fell by 25% to 30%, and then rebounded by 12% to 13%. Much of this relates to the oil market.

I predicted that oil’s move from $28 a barrel to $40 would be easy, but the ride from $40 to $50 would be harder. With oil near $50 a barrel, frackers will start fracking wells [extracting oil via hydraulic fracturing] that had been drilled, but not fracked. Inventories are high in the U.S., and supply could remain an issue. The secular argument against oil, oversimplified, is electric cars. We are one innovation away from Elon Musk [founder of Tesla /TSLA] or someone else, but probably Musk, developing a battery that will give drivers a much larger range per electric charge. If that happens, electric cars will gain a huge share of the auto market.

Eighteen percent of high-yield energy bonds are already in default. The percentage could go higher. Volatility will remain elevated in credit. Junk bonds are correlated to equities. If the stock market goes down, there could be a buying opportunity in junk.

What do you recommend in the meantime?

I am recommending a lot of cash. It is dry-powder time in the markets. Treasuries will probably be a buy when stocks drop. I would buy the 10-year if the yield goes into the low-2% area.

I also like gold-mining stocks. The GDX [ VanEck Vectors Gold Miners exchange-traded fund] is up about 80% on the year, but there is more to go. Gold is around $1,220 an ounce. It could rally to $1,400. If it does, you will make a lot of money in gold miners’ shares. The miners are notoriously badly run, but there is room for the stocks to go up.

Thank you, Jeffrey.


William Priest: “We like Alphabet, parent of Google. Ruth Porat, the new chief financial officer, has installed financial discipline and increased disclosure.” Photo: Brad Trent for Barron's
Barron’s: How is the market treating you, Bill?

Priest: We are pretty much where we thought we would be, with a slight gain in the market so far this year. But how we got here was different from what we expected. The market sold off early, into mid-February, and then had a rally. One reason the market is up even a small amount has to do with price/earnings ratios. In the four years ended Dec. 31, the S&P 500 rose 77%. Fifty-eight percent of that 77% was due to price/earnings multiple expansion. With the end of quantitative easing [the Federal Reserve’s asset-buying program], we expected multiples to be flat or down this year.

What is going to drive stocks now?

S&P earnings are likely to be up this year by low single digits, at best. Rising labor costs will put pressure on profit margins. Dividends might not increase to the same degree as last year, but will be a significant driver of total return. The real issue is global growth, which has been disappointing year after year since 2010. We agree with Larry Summers [the former Secretary of the Treasury, now a professor at Harvard University], who said we are in a period of secular stagnation, in which global savings vastly exceed investment opportunities. That means interest rates will stay low for a very long time. It doesn’t mean there won’t be opportunities in the stock market, however. Stocks, with an appropriate holding period, offer the potential for higher returns than bonds.

Is it likely that economic growth will perk up in 2017?

Real gross domestic product is driven by only two factors: growth in the workforce and growth in productivity. There is little growth in the workforce in the developed world, outside of the U.S. Productivity has been disappointing, even though it is probably understated a bit. But the bottom line is: We will be lucky to see real growth of 2% in the developed world.

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That will manifest itself in a lack of inflation. Deflation is the biggest problem facing the investing world, and the thing that keeps policy makers up at night. You will continue to hear people talk about quantitative easing and dropping money from helicopters, but that won’t happen in the U.S. unless there is a significant slowdown in the real economy. We look for the market to muddle through. Downside will be restricted to 5% to 10% in the worst case, and upside could range from 5% to 7%.

Your January picks have done well so far, notwithstanding the subdued backdrop.

Well, we got lucky. To review, CVS Health [CVS] has performed as expected. Benefits from its acquisition of Target ’s [TGT] pharmacy business and Omnicare, a drug distributor, are still to be realized, but CVS could generate close to $5.5 billion in free cash flow in 2016. It has $2 billion of cash, and it could repurchase $4 billion of stock this year.

NorthStar Realty Europe [NRE], a real estate investment trust, is up at a recent $11.50 a share. It yields 5.3%. It is paying down debt, and is about halfway through another million-dollar share buyback. Cushman & Wakefield recently completed an appraisal of NorthStar Europe’s portfolio properties and assigned them a net asset value of $18 a share.

Give us a quick update on Synchrony Financial [SYF] and Vodafone [VOD].

Synchrony reported first-quarter earnings of 70 cents a share, versus 66 cents a year ago. The company is now fully independent from General Electric [GE]. Revenue grew 13% in the quarter; loan receivables rose 13%, and most impressive, spending on Synchrony cards rose 17%. We should learn this month what regulators will allow the company to return in capital to shareholders. We are expecting between 40% and 50% of earnings. Upside on the stock remains in the high $30s. It currently trades for $31.

At Vodafone, revenue is growing due to increased mobile-data consumption. Capital spending is declining. Free cash flow could increase to at least three billion British pounds [$4.3 billion] in the next 12 months. It now covers the dividend, which wasn’t true a short time ago. Down the road, there might or might not be an opportunity for a business combination with Liberty Global.

How about some new names?

Allergan [AGN]’s proposed merger with Pfizer [PFE] fell apart. Allergan sold off sharply, but is a high-quality company. Sales of branded drugs rose 10% in the first quarter, but prices of generic drugs are down by mid-single digits. Allergan will get about $36 billion when the sale of its generics business to Teva Pharmaceutical Industries [TEVA] closes. Allergan has said it will use about $10 billion to buy back shares. The balance sheet will be in excellent shape after the deal, with about $20 billion of cash after debt paydown and buybacks.

Did you start buying Allergan after the Pfizer deal fell apart?

We owned a small amount before that, but accelerated our purchases afterward. We also like Fidelity National Information Services [FIS], a provider of software and outsourcing services for financial institutions. It was created by Bill Foley, who serves as vice chairman and also chairs two other public companies. The stock is trading for $75. There are 326 million shares outstanding, and the market cap is $24 billion. Fidelity National Information has $11 billion of debt, most of which came through the acquisition of SunGard, which closed in the fourth quarter of 2015. We expect free cash flow per share of around $3.80 this year and $4.40 in 2017. Fidelity is nearly four times levered, but will be able to whittle down debt over time with its cash flow.

Next, we like Alphabet [GOOGL], the parent of Google. Ruth Porat, the new chief financial officer, has installed financial discipline and increased disclosure, although Alphabet’s holding-company structure isn’t completely transparent. The company has separated its core business, including search, YouTube, Google Play, and its cloud platform, from so-called other bets, including life sciences and drone delivery. These other businesses collectively had a free-cash-flow deficit of almost $4 billion, or close to $6 a share, in 2015.

Wall Street has long been skeptical of the company’s ancillary businesses. Why would that change?

Opportunities have come from these activities in the past, so I wouldn’t rule out the creativity. Despite its investment in these businesses, Alphabet has a 5% free-cash-flow yield. Cash flow could grow at a mid-teens annual rate, making a one-year stock-price target of $850 reasonable. The stock currently sells for $730 a share.

One overhang is the European Commission’s investigations into its search and Android businesses on antitrust grounds. The investigations could result in several billion dollars of fines, but Alphabet had $75 billion in cash at the end of the first quarter. We are looking through the problem in Europe. It will take months to resolve.

Thanks, Bill.


Brian Rogers: “A lot of bricks-and-mortar retailers hit the wall this spring, but Amazon can’t put everyone out of business…The second half ought to be a good period for retailers.” Photo: Brad Trent for Barron's
Barron’s : How does the second half look to you?

Rogers: Growth has been modest worldwide. First-quarter U.S. GDP is less than 1%, even after being revised upward. U.S. equity markets have advanced at roughly the same pace as the economy, as have corporate earnings. Often, the market performs in line with the economy.

Growth is challenged all over the world. In the second half, we could see more of the same. It is hard to see what leads to an acceleration of the U.S. economy. Conditions are good, but not dynamic. The housing sector is good, the consumer is in decent shape, and corporations are in a strong financial position. But end demand is a challenge for companies in many sectors. The economy might grow a little faster in the second half, but will stay in the sub-2% range. Corporate earnings could look better as we reach the anniversary of the sharp decline in energy-sector earnings. But a lot of the improvement will be cosmetic, not fundamental.

How will the stock market perform as the year unfolds?

We will see more of the same. If the S&P 500 rises between 3% and 4% in the first half and does the same in the second half, that would make for a pretty good year. A 6% to 8% gain, plus dividends, would be better than what you can make in a money-market fund, or an intermediate-term bond fund. A lot will depend on what the Fed signals as the year progresses, and what the bond market does in response to the Fed. A lot will also depend on things like the Brexit vote and economic growth overseas.

What do you expect the Fed to do?

The Fed has always said it is data-dependent. If it is truly so, it will raise rates once during the summer. I suspect there will be a small increase, in July or thereafter.

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Is there anything new with your January picks?

Most have done well; I am replacing one stock.

American Express [AXP] had a tough first half. The stock is up a few points. Management is taking aggressive steps to turn things around. The valuation is more attractive now than in January, and we are sticking with it.

Comcast [CMCSA] is buying DreamWorks Animation SKG [DWA]. Things are going well at the company, and they are smart operators. Anything related to energy has bounced, including Occidental Petroleum [OXY], which I recommended. Occidental still is inexpensive, with a 4% dividend yield, and we aren’t sure the oil rally is over.

Macy’s [M] is our most disappointing investment. The stock fell after the company reported disappointing earnings and weak same-store sales. It looks like business was a little better in April. A lot of bricks-and-mortar retailers hit the wall this spring, but [AMZN] can’t put everyone out of business. With the consumer in good shape, it seems the second half ought to be a good period for retailers. We’re sticking with Macy’s, and we expect the dividend holds. Qualcomm [QCOM] is still performing well and buying back stock. We still like it.

That must mean you are cycling out of Eaton [ETN].

Correct. It is an industrial cyclical, and the stock is up more than 25% since January. There is nothing wrong with Eaton; it is performing well. But whenever I make 25% in six months in a stock like Eaton, I figure it is time to trim my position and invest in something else. I am putting the proceeds into Harris [HRS]. The company’s biggest business is secure communications, including tactical radio products for police and fire departments and the military. The stock sold off in the first part of this year, due to reduced demand in the Middle East and other emerging markets. But Harris is a technology-rich company. It also has a satellite business and defense electronics. The company provides classified products and services to the military, so these things can’t be discussed with investors. The stock sells for about 15 times expected earnings and yields 2.5%.

Is that a depressed multiple for Harris?

The stock has had a 52-week range of $70 to $90. Today, it is around $81. Relative to others in the sector, and given the technology embedded in its operations, it ought to have a much higher multiple. A year ago, Harris bought Exelis, a defense-electronics subsidiary of ITT. It is paying down debt from the deal. It was buying back stock before this transaction, and will resume doing so at some point. Harris generates a lot of free cash. We can envision a $100 stock sometime in the next two years.

Thanks, Brian.


Scott Black: “I am concerned about the economy…The leading presidential candidates mouth platitudes, but don’t have a plan to turn the economy around.” Photo: Brad Trent
Barron’s : The market has been in a funk for much of this year. What gives, Scott?

Black: A couple of things. Consensus estimates for 2016 S&P 500 earnings were $126 in January. They are $114.76 now. That implies a price/earnings ratio of 18.3—expensive on a historical basis. The Russell 2000 [a small-cap index] is even more expensive, at 23.7 times expected earnings. The market is picked over. S&P earnings fell nearly 7% in the latest quarter. Based on analysts’ numbers, a full-year estimate of $114 assumes 19.7% growth in the third quarter and 37.7% growth in the fourth.

Preposterous, both.

They are. The market is expensive, and there is no earnings momentum to carry it higher. We are value investors. We look for good businesses with high returns on equity, strong balance sheets, and sustainable earning power, trading at a discount to what they are worth. It doesn’t seem to be working in this market.

How will stocks perform for the rest of the year?

I am not bullish on U.S. stocks, and I am concerned about the economy. If gross domestic product grows by 2% to 2.5% in the current quarter, that is probably the best we’ll do for the year. We are getting mixed signals from the Fed about whether it is going to lift interest rates. The leading presidential candidates mouth platitudes, but don’t have a plan to turn the economy around.

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The U.S. has $19.2 trillion of debt, equal to 105% of GDP, not including entitlement programs. With few exceptions, no one seems to care. This is the highest debt-to-GDP ratio since the Truman administration, but President Truman inherited high debt levels after the U.S. fought two world wars. If interest rates go up by two percentage points, that is another $380 billion a year in interest payments, which the country can’t afford.

OK, enough with the doom and gloom. What are you buying these days?

I like two mid-caps. D.R. Horton [DHI] is the largest home builder in the U.S. It is based in Texas. The stock is selling for $30. There are 374 million shares, for a market cap of $11.2 billion. The company pays a dividend of 32 cents a share, and yields 1.05%. Horton is in 79 markets in 26 states. It closed on 36,648 homes last year. The company estimates it could close on 39,500 to 41,500 homes this year, up 8% to 13%.

I build my own earnings models. Horton could generate $12.2 billion in home-building revenue in 2016, up 16%. Management expects operating-profit margins in home building of between 10.7% and 11.2%, up 30 to 80 basis points. A lot owes to economies of scale. I use 10.8%, which yields $1.318 billion in home-building pretax income. Horton could do another $297 million in financial-services revenue, such as title insurance and closing costs.

Assuming a 32% margin, that is $95 million in pretax income, for total income before tax of $1.413 billion. Taxed at 35.5%, the company can earn $911 million, or $2.42 a share, in the fiscal year that ends Sept. 30.

What is your earnings estimate for fiscal 2017?

Horton could earn close to $2.70 a share. That implies a P/E multiple of 11.1. Pro forma return on equity is 14.3% for this year. Last year, Horton generated $740 million of free cash flow and $751 million in net income. It expects to have $300 million to $500 million in free cash this year. It is a cheap stock, with a positive earnings record for the past five years, except for one disappointing quarter in 2014.

Management has a good understanding of the housing market. There is a shortage of inventory, and mortgage rates are still cheap. The home-building sector could continue to do well. Horton controls about 190,000 lots, giving it a four-year inventory. Revenue could grow about 10% a year over a cycle, and earnings could grow at a slightly faster pace.

What is your other pick?

Whirlpool [WHR] is a play on home and apartment sales, and emerging markets. The stock is trading for $174. There are 78.1 million fully diluted shares, and the market cap is $13.6 billion. The company pays a $4 dividend, for a yield of 2.3%. Based on my model, revenue will be flat at $20.8 billion this year. Last year, the Ebit [earnings before interest and taxes] margin was 6.9%. The company thinks it could lift margins to 8% to 8.5.% this year. Using an 8% margin would produce pretax earnings of $1.39 billion. Taxed at 23%, that is $1.07 billion of net income, or $13.85 a share. I’m referring to earnings from continuing operations.

If Ebit margins expand to 8½%, Whirlpool will net $1.15 billion after tax, or $14.88 a share. The midpoint is $14.40; the Street estimate is $14.73. I’m below the Street. I estimate the company will earn $17.12 a share next year, which means the shares are trading for 10.2 times expected earnings. Based on this year’s $14.40, return on equity is 23.5%. Return on total capital is 14%, and the net debt-to-equity ratio is 0.69. Whirlpool excels at working-capital management. Inventory turns more than six times a year. Free cash totaled $578 million last year, versus $988 million of net income. This year, it could reach $700 million to $800 million on $1.1 billion of earnings.

What does Whirlpool intend to do with its cash?

The company bought back $225 million of stock in the first quarter, and has a new $1 billion authorization. Whirlpool generates about half its revenue in North America; 27% in Europe and the Middle East; 16% in South America, mostly Brazil; and 7% in Asia. It has a joint venture in China, but is mostly dependent on housing turnover in the U.S.

Whirlpool has had a straight-up earnings record for the past five years, except in last year’s first quarter. Both D.R. Horton and Whirlpool have sustainable earnings power and are reasonably priced.

Thank you, Scott.


Meryl Witmer: “If you buy a good business with a nice annuity stream at around 10 times net after-tax free cash flow per share, you tend to make money. That’s my formula.” Photo: Brad Trent for Barron's
Barron’s : Do you see many values in the market today?

Witmer: When the Roundtable met on Jan. 11, the S&P 500 was at 1923. It has risen about 9% since then, but my feeling hasn’t changed. Back then, I thought fair value was 5% to 7% higher. The stocks we know well are pretty fairly valued. In February, when stocks gapped down, there were some great opportunities to buy. Today, there aren’t tons of bargains. I expect the market to be flat between now and year end.

That should make for a dull year.

We have a good amount of cash because when stocks reach our sell targets, we sell. But I like Wyndham Worldwide [WYN]. I recommended it at the 2014 Roundtable. Wyndham has done everything we thought it would do. It increased its after-tax free cash flow to the level we expected. Management shrank the market capitalization by buying in shares right around the level we expected. The stock went from $70 to $90. Now, it is back at $67. Wyndham has 113 million shares outstanding, compared with 132 million the last time I recommended it. The market cap is $7.6 billion.

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What explains the stock’s round trip?

Wyndham is a lodging company. The market is overly concerned about the impact on Wyndham’s business of Airbnb and the hotel cycle. Wyndham operates in three business segments—hotels, vacation exchange, and time-share. It is the world’s largest hotel franchiser, with more than 7,800 properties, mostly in the economy and mid-scale segment. This segment has consistently generated 25% operating profit margins and grown by 7% to 10% a year through a combination of new franchisees and modest price increases.

At the higher end of the market there has been a lot of building. But Wyndham is somewhat insulated from those head winds, relative to companies that serve the luxury market. The economy and mid-scale markets aren’t seeing the same increase in supply.

What could push Wyndham’s shares up again?

We expect franchise operations to grow by 7% to 10% a year. That business doesn’t require a lot of capital to grow. In the time-share business, Wyndham has been able to accelerate growth by transitioning to a new presenter model. It formerly relied on one-on-one presentations to prospective buyers. Now one person presents to a group of prospective buyers. This has resulted in an improved customer experience and a corresponding revenue acceleration.

The time-share business is asset-light. Wyndham typically partners with property developers, and acts as the manager and sales agent. Time-shares provide a compelling value to consumers, especially families, who can enjoy an apartment-style vacation at affordable rates.

How is the vacation-exchange business performing?

Wyndham operates the RCI exchange network. It acts as a clearinghouse for time-share points and operates a vacation-rental business, primarily in Europe. It is similar to Airbnb, but Wyndham also manages properties for owners. Vacation exchange produces a steady annuity stream.

Wyndham’s chief executive, Stephen Holmes, is a great capital allocator. Since 2010, the company has bought back about 40% of its shares at an average price of less than $50. Management has been disciplined about maintaining an investment-grade balance sheet, and hasn’t stretched to do deals at high prices. Holmes has never sold a share, and bought 25,000 shares in February at $64 a share.

Did he buy in the open market?

Yes. Wyndham could report earnings per share of $5.60 to $5.75 this year. After-tax free cash flow could total $800 million, or about $7 a share, up from $6.46 in 2015 and $6 in 2014. We value Wyndham at 13 to 14 times free cash flow, which implies a stock price of $90 to $98, up 35% to 45% from here. It is trading for 10 times after-tax free cash flow. If you buy a good business with a nice annuity stream at around 10 times net after-tax free cash flow per share, you tend to make money. That’s my formula.

Duly noted, and thanks for sharing it.


Oscar Schafer: “I don’t see much happening to shake up the economy’s slow growth. But the stock market has a way of fooling most people. It could end the year higher than people think.” Photo: Brad Trent for Barron's
Barron’s : How is this year shaping up for you, Oscar?

I said it would be a year for stockpickers. If you were in the right stocks and industries, you did well. If you were in the wrong ones, you’ve had your problems. For example, more than 20% of the energy stocks in the S&P 500 are down more than 40% from their highs, as are 60% in the Russell 2000. The second half will offer more of the same. I don’t see much happening to shake up the economy’s slow growth. But the stock market has a way of fooling most people. It could end the year higher than people think it will.

Your stock picks are likely to offer more excitement than the market.

I recommended CommScope Holding [COMM] in January. Despite the stock’s appreciation, it is still interesting. CommScope is a leading provider of tower-top antennas for wireless carriers. It also offers solutions for deploying optical fiber and cables. Growth is driven by increasing demand for bandwidth. Recently, after five quarters of declining revenue, the book-to-bill ratio [of orders] is strengthening. Management expects the business to grow by the mid-single digits long-term.

Why are things turning up?

There is more demand for wireless and fiber connectivity, and the company is successfully integrating the broadband network-solutions business it bought last year from TE Connectivity [TEL]. CommScope has already increased its synergy guidance from $150 million to $175 million. Also, consensus earnings estimates have risen by more than 10% in the past few months. At $32, CommScope is just too cheap. Using historical average earnings multiples, the stock could be worth $50, giving you 56% upside in a couple of years. Meanwhile, management expects to pay down a billion dollars of debt by the end of 2017, which could be a positive catalyst for the stock.

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Every June, for the past three years, ANI Pharmaceuticals [ANIP] stock has been in the mid-$50s. Last year, I recommended it around the current price. The company has been tarred by the troubles of Valeant Pharmaceuticals International [VRX] and other specialty pharma companies. But ANI is different. Ebitda growth has compounded by 79% a year since 2010, and will continue to grow rapidly. ANI specializes in anticancer drugs, hormones, and steroids. Its products are complex and difficult to manufacture. The company has 81 products in development, with a combined market value of more than $4 billion. ANI paid Merck $75 million for an approved corticotropin product; when ANI markets the product, it will transform the company. Applying comparable multiples to the company’s short-term Ebitda goal of $100 million could result in a stock price of $85. After the introduction of the corticotropin product, which addresses a billion-dollar market, the stock could double or triple.

Have you a new name this spring?

Few sectors have performed as well as consumer staples, particularly packaged-food companies. Consolidation and zero-based budgeting have provided earnings growth, even if top-line sales are barely growing. Valuations are at an all-time high, with the average food company trading for 18 to 30 times earnings. Yet Nomad Foods [NOMD], the market leader in European frozen food, sells at a bargain price. Nomad owns Iglo, Findus, and the BirdsEye brand in Europe, among others. Iglo and Findus are the No. 1 fish-finger brands, and BirdsEye is a leader in frozen vegetables. Nomad has more than 10% of the frozen-foods market in Western Europe. While the brands are old, the company is new. It was formed as a SPAC [special-purpose acquisition company] in 2014 by Noam Gottesman and Martin Franklin, who built Jarden. About 20 years ago, I recommended a company called Benson Eyecare, which was run by Franklin, whom I called, age-adjusted, the best CEO I had ever met. He was in his 30s at the time.

Back to Nomad, the SPAC raised $500 million and came public at $10 a share. Early last year, Nomad bought Iglo for 2.6 billion euros [$2.9 billion], using debt, cash, and shares. Then it sold more stock at $21 a share and bought Findus for 500 million pounds [$713 million].

Where is Nomad listed?

This year, the company moved its stock listing from London to the U.S. Its shares have fallen from $23 to $10 amid negative sentiment about “platform” companies. Also, sales fell 5% to 8%, year-on-year, in each of the past four quarters.

The frozen-food category in Europe faces challenges, including private-label, share gains by discount grocers, and the emergence of “chilled” products. But most of Nomad’s problems have been strategy-driven.

Meaning what, exactly?

In the worst markets, the local management teams took trade and promotional money away from Nomad’s champion brands and spent it promoting new products. The result was limited success selling new products and an erosion of the core products. The new promotional plan focuses on reinvigorating the core products. Nomad’s top-line sales will be flat six months from now. The company could generate $1.10 of free cash flow next year. It will be levered at less than 3.5 times. The shares could trade up to $15 in 18 months, as sales trends stabilize and Nomad begins to realize acquisition synergies.

Thanks, Oscar.


Felix Zulauf: “In the next year there will be an investment opportunity in Argentina, where there has been a fundamental political change after 70 years.” Photo: Brad Trent for Barron's
Barron’s : How does the world look to you, Felix?

Zulauf: Equity markets haven’t done much in the past 12, 18, or even 24 months. In the U.S., the Dow Jones industrials and Standard & Poor’s 500 have moved up and down like a yo-yo, but without much change in price. The MSCI World index is unchanged in U.S. dollars since early 2014. It is almost at the same level as at the 2007 peak. The MSCI Europe index, in dollars, is at the same level as in 1999.

You’re looking backward, not forward. Nonetheless, why have stocks performed so poorly?

Business fundamentals are weak. World markets sold off in January and early February. Then the major central banks made a secret pact at the G-20 meeting in Shanghai that saved the markets. The U.S. said it wouldn’t hike interest rates. The ECB [European Central Bank] and the Bank of Japan agreed not to weaken their currencies further, and the Chinese agreed to keep their currency stable. Once this happened, stocks and commodities rallied.

Who let you in on the secret?

I can’t tell you my secrets, but the agreement seems to have ended. The Federal Reserve is contemplating a rate hike again, and currencies in Asia have started to weaken. The market is wrong in assuming that economic growth in China is reaccelerating, and will help the world economy to reaccelerate. Rather, things are going the other way. The global economy could decelerate in the second half from today’s already low growth rates.

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Why do you say that?

Credit data are pointing downward. Inventories are high in the U.S., China, and Asia’s major exporters. The next step is to adjust production downward. Also, the automobile cycle, which has been an important driver for the world economy, is peaking. In the U.S., car-loan delinquencies are creeping up.

In Europe, there are political uncertainties about a British exit from the European Union. The vote will occur June 23. Polls in other nations, including Portugal, Italy, France, and Spain, show that 50% of the population would like to leave the euro today. What company wants to make long-term investment commitments in Europe if it can’t be sure of the institutional and regulatory framework?

Do you expect a global recession later this year?

We are moving toward one, but I don’t know when it will hit. Almost all asset prices are high historically, due to extremely low interest rates. All forms of carry are compressed. Also, the business cycle has been distorted by the manipulations of the authorities, central banks in particular. The risk is high and rising that something will go wrong in the world economy.

The biggest imbalances exist in China and the emerging markets, especially Asia. The private sector in the emerging world is more levered than in the developed world. Return on equity in the EM [emerging market] universe is below the level of 2009, and those countries are highly indebted in U.S. dollars. I expect a balance-of-payments crisis to occur in those economies. Large capital outflows, rising interest rates, and depressed asset prices could mean big problems for several financial institutions in Asia, probably requiring government bailouts. I foresee a deep crisis in that part of the world. It could begin by mid-2017, at the latest.

What will the catalyst be?

The Chinese corporate sector is running a financial deficit equal to 20% of China’s gross domestic product, something previously unseen. At some point, China will run out of lending capacity. Also, its bond market can’t grow much bigger. At some point, the bubble will burst.

How should U.S. investors prepare?

I am bearish on equities and constructive on high-quality bonds. Also, I expect gold to rally this year to $1,400. U.S. Treasury bonds are considered the highest-quality paper in the world. Yields on 30-year Treasuries could fall a hundred basis points [one percentage point] in the next 12 months. Global bond indexes have outperformed the MSCI World Equity index on a total-return basis for more than 12 months. They have slightly outperformed stocks since 1987, and with much less volatility.

Have you other investment picks?

In the next year, there will be an investment opportunity in Argentina, where there has been a fundamental political change after 70 years of a combination of socialism, conservatism, nationalism, and corruption. This change could be as important as the Reagan presidency was to the U.S.

Mauricio Macri, Argentina’s new president, is open-minded, with an international view. He has a great team of experts in place in finance and economics, and at the central bank. He lifted export sanctions and currency controls. That’s why the dollar/peso ratio shot up to almost 16 from nine. It pushed inflation rates up, but inflation is expected to decline next year as the impact of the one-time devaluation disappears. Argentina also has settled its problems with foreign creditors, and has come back to the capital markets. In addition, Macri has announced a tax amnesty that will bring in more tax revenue.

What is the best way to invest in Argentina’s progress?

I’m bullish on the Argentine peso. You can buy it against the dollar on a one-year forward basis. The interbank forward rate is 17.31 pesos to the dollar, versus the spot rate of 13.95 pesos. This gives you a carry of 19.4% for 12 months if the spot price stays unchanged.

Argentina has recently issued $16 billion of dollar-denominated bonds with maturities of three, five, 10, and 30 years. I bought the three-year, which carried a coupon of 6.25%. The yield has already fallen to 4.5%. If you are more adventurous, you can buy five-year debt.

In the near term, things aren’t easy in Argentina. The economy is in recession. The inflation rate is 40%. There are demonstrations and strikes. The next nine to 12 months is critical, until people see that inflation is normalizing. But Argentina has little government debt. It couldn’t tap the capital markets for a long time.

There are benefits to everything. Thanks.


Abby Joseph Cohen: “If the economic data look a bit more robust and interest rates start to rise, bondholders could experience significant capital losses.” Photo: Brad Trent
Barron’s: What is your economic forecast?

Cohen: There have been some uncomfortable data points, including the May employment report. But overall, U.S. data aren’t bad. The unemployment rate is below 5%. Personal income has been growing at a 0.4% rate for the past two months. Wages are up, year-over-year. Baseline U.S. GDP growth is 2% to 2.5%. That is much better than baseline growth in Europe and Japan.

Assuming there is no negative fallout from the coming presidential election, the U.S. will do OK. Real GDP can continue to grow by 2% to 2.5%. Personal-consumption spending could surprise on the upside. Head winds from a strong dollar and lower oil prices could start to fade.

Why, then, has there been a bull market in gloom?

The political cycle at home and abroad is affecting attitudes. There is nervousness about the future role of the U.S. in the world, given certain campaign rhetoric. Consumer-confidence data in the U.S. aren’t quite tracking economic data, as usually happens during a presidential election campaign. Demand for commercial and industrial loans, and loans for small business, has weakened recently. Nevertheless, the U.S. is a magnet for global capital flows. We have seen significant flows into our fixed-income market, and a sharp decline in interest rates.

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I am concerned that bonds might be overvalued. If the economic data look a bit more robust and interest rates start to rise, bondholders could experience significant capital losses. Many investors, and especially individual investors, believe that bonds are a safe investment—fixed income, if you will. If bondholders experience capital losses, that could damage their purchasing power.

Will the Fed raise rates this summer?

Our economics team thinks the odds of the Fed moving in June probably have been reduced to zero, due to May’s disappointing employment data. But the Fed will be looking at new data as they become available, and we can’t rule out a possible rate hike in July or September.

Are the stock market’s prospects likely to improve?

Many non-U.S. investors have stayed on the sidelines. They have moved funds in the U.S. from the equity market to the fixed-income markets. Individual investors haven’t been happy about putting new money to work in equity mutual funds and exchange-traded funds Until we have greater clarity in coming months, the market could be stuck in its recent trading range. David Kostin, our U.S. equity strategist, has an S&P 500 forecast of 2100 for this year and 2200 for 2017. The S&P could move above 2100 before year end, based on economic data and increased comfort with the presidential campaign. He has built in a decline in the P/E ratio. To me, one of the most important things an equity investor needs to think about is whether the economic growth cycle is imperiled. Is there a danger from rapid inflation? That is how cycles typically end in the U.S. Inflation spikes, and the Fed raises rates dramatically. We don’t see a surge in inflation or rates posing a problem for the economy.

Which types of stocks could do well in the second half?

I have a few investment themes. One is that the global economy isn’t going into a ditch. My first recommendation is a Japanese company, Toto [5332.Japan]. It is a leader in sanitary ware, with about 10% of the global market.

Sanitary ware? What a lovely euphemism for toilets.

Toto makes high-quality sanitary-ware—toilets, bidets, faucets, and the like. It gets awards for craftsmanship and design, and sophisticated use of ceramics. It also gets awards for the environmentally friendly aspects of its products, tied in part to the manufacturing process. China is moving toward water-saving requirements, and the products Toto sells there already exceed required standards. Toto’s sales in China rose about 2% in the past year. The company has also seen strong growth in other countries where living standards are just beginning to rise.

Toto sells mainly high-end products in North America. Do-it-yourself stores such as Home Depot [HD], account for about 30% of its sales. The retailer reported good results in the latest quarter. Despite weaker employment data, people are spending on home renovations, and home sales are rising.

What are the challenges Toto might face?

If the yen falls a bit, that would be problematic for a U.S. shareholder. If growth in China remains lackluster, that would affect Toto’s plan to expand there. Interestingly, sales in Hong Kong are up 18% in the past year.

Sealed Air [SEE] is best known for bubble wrap, but the company makes a lot more. It is a major packaging producer around the world. Food packaging is a big business for Sealed Air. This is primarily film packaging, used to prevent oxidation and inhibit the growth of pathogens. Sealed Air’s packaging products extend the shelf-life of food and reduce food waste dramatically. Demand is growing in wealthy countries as more people try to move away from food preservatives.

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How does revenue break down by business?

Food care accounts for 56% of sales. Bubble wrap and its cousins are 26%. Sealed Air also sells cleaning and hygiene products to institutional customers. The company is a beneficiary of online shopping. It partners with companies that produce cardboard boxes.

You might wonder whether the jump in oil prices affects costs, but oil is still relatively low, and resin is in oversupply. Like Toto, there is an environmentally friendly aspect to the story, in both products and process, and a focus on innovation.

Will this also be true of your next pick?

Yes, in a different way. Shares of Nike [NKE], which needs no introduction, have been under pressure in recent weeks. Its fiscal year ended in May. It is a new era for retailing, and Nike is reorienting operations. It is lessening its dependence on stores and moving more toward selling online via its own Website and those of other companies. Nike investors have gotten nervous about the weakness at some sporting-goods retailers and Sports Authority’s bankruptcy filing. But the focus now is on more direct engagement with consumers. Nike ships a billion units a year. It is building a new European distribution facility in Belgium that will run on 100% renewable energy.

When the financial crisis and recession hit, many investors didn’t prioritize sustainability, but survivability. Now, the focus on environmental awareness could increase. Nike is demonstrating leadership in this regard. It has reduced its carbon emissions and lowered its water use per unit.

That is nice, but it isn’t the reason to own the shares. Why buy Nike now?

There is an opportunity for growth. Because of its strong brand, Nike could be a leader in Internet retailing. The company generates good cash flow. It is trading at a lower P/E than in the past, although it isn’t a low multiple. Nike historically has been a growth company, and that growth could resume. It is a beneficiary of higher global consumer spending, and is building out its brand.

Stryker [SYK] is a medical-technology company with a focus on orthopedics. It is benefiting from the aging of the baby- boom population and the fact that boomers are staying active longer and often need joint replacements. Second, the company has a first-mover advantage in the use of robotics for joint replacement.

Stryker also has good relationships with hospitals, which are adopting new technologies. It has built a body of clinical data on the use of robotics in joint replacements. Recently, investment capital has been migrating away from the biotech sector and into medical technology. The stock has performed well, rising about 12% in the past three months. It trades for 19 times this year’s estimated earnings. The long-term growth rate looks appealing. Compounded annual growth for some joint implants could be on the order of 30% between now and 2020. It is hard to argue with the demographics, but the products must be good.

Very true. Thank you, Abby.

Healthcare by mcsqrmcsqr, 18 May 2015 03:42

33 Savvy Picks
Final 2015 Roundtable issue with Marc Faber, David Herro, Oscar Schafer, and Mario Gabelli discussing their approach to investing.

January 31, 2015
Barron’s 2015 Roundtable: Part 1
Barron’s 2015 Roundtable, Part 2

Variety is not merely the spice of life, but the very essence of the annual Barron’s Roundtable. While the 10 market seers on our panel are united in seeking to profit from mispriced assets — and help you do the same — each approaches the challenge from an idiosyncratic angle. That is nowhere more apparent than in this week’s third and final installment from our memorable daylong confab, held on Jan. 12 in New York.

Part 3 features the 2015 investment picks, pans, and musings of Marc Faber, David Herro, Oscar Schafer, and Mario Gabelli — four pros who have spent years on the Street, each taking a different path to success. A fearless big-picture thinker with an emerging-markets perspective, Marc is betting against the ability of the world’s central banks to put global growth back on a sustainable path. That means a vote for gold and its precious cousins, as well as long-dated U.S. bonds, whose yields he reckons are destined to stay superlow. Marc is no bear on Asia, however, and that includes the Russian bear, as you’ll see from his forthright comments and eclectic recommendations.

David, Harris Associates’ go-to guy for international investing, and manager of the Oakmark International fund, is a value investor who searches for blue-chip companies with temporarily tarnished shares. They are harder to find these days than questionable outfits with nosebleed valuations, but in his first Roundtable appearance, David makes the case nicely for an even four. Underlying his bottom-up analysis is a keen understanding of social, political, and economic trends around the world, whether in China, where the authorities have cracked down on extravagant gift-giving, or in Japan, where the moribund corporate sector could use a deafening wake-up call.

A veteran hedge fund manager, Oscar cares little for the macro outlook. You’re far more likely to find him in the trenches, digging through the financials of lesser-known companies with promising prospects, savvy managers, in-demand technologies, and underappreciated shares. He, too, has been known to comb the world for value. But this year, he finds it closer to home, in companies such as Canada’s Maple Leaf Foods (ticker: MFI.Canada), which could soon enjoy the fruits of a strategic transformation.

Mario, head of Gamco Investors, famously goes where the action is; he favors companies like Graham Holdings (GHC), the former Washington Post, that own a multitude of disparate assets that can be merged, purged, or otherwise rearranged in a value-enhancing and tax-efficient manner. The practice is known as financial engineering, and few do it better than billionaire media investor John Malone, whose praises Mario sings to the skies, and in whose companies he seeks to invest.

To learn why, please read on.

Barron’s: Where in the world should we invest this year, Marc?

Faber: If I could find a way to short central banks, that is what I would do. This is the year that people will lose confidence in central banks, mostly because of the failure of Abenomics in Japan. [Abenomics, the economic policies advocated by Japanese Prime Minister Shinzo Abe to reignite Japan’s economy, encompass monetary easing, fiscal stimulus, and structural reforms.] One way to short central banks is to go long gold. I recommend buying physical gold, silver, and platinum. If you are looking for bigger gains, I suggest either mining-company stocks or the Market Vectors Junior Gold Miners [GDXJ] exchange-traded fund. In last year’s first half, when gold rebounded by 15%, the Junior Gold Miners ETF rallied by more than 40%.

Secondly, the U.S. market is expensive. Yet, the whole world seems to think it is the only game in town. That suggests it may be vulnerable to a selloff. I hate to short individual stocks because an activist could step in and send a stock soaring. Instead, I would short the SOX, or Philadelphia Semiconductor Index, through the iShares PHLX Semiconductor ETF [SOXX]. I would also short the Global X Social Media ETF [SOCL] and the iShares Nasdaq Biotechnology ETF [IBB].

While people think U.S. stocks are the only game in town, U.S. bonds are still attractive. Can someone on this panel explain to me why investors are bullish on the dollar, yet buy low-yielding European bonds instead of U.S. bonds? The market doesn’t believe the dollar will stay strong.

Zulauf: European banks are buying European government bonds, financed by free money from the European Central Bank.

Couldn’t they buy U.S. Treasuries with that money?

Zulauf: If they buy Treasuries, they have currency exposure. If they hedge the currency exposure, that deducts from the interest-rate advantage.

Faber: Nevertheless, it is a puzzle to me. Japanese government bonds now yield 0.27%. Japan’s government debt exceeds 200% of gross domestic product. Compared to these dynamics, U.S. Treasuries are cheap. Last year, I recommended the 10-year Treasury note. This year, I recommend buying 30-year U.S. government bonds.

Clockwise from top left: David Herro, Marc Faber,Oscar Schafer, Mario Gabelli. Photo: Brad Trent for Barron's
Zulauf: The Japanese central bank already owns about 40% of all outstanding Japanese government bonds. Eventually, it will own a lot more, as the Bank of Japan is buying 70% to 80% of all new issues.

Faber: Yes, that is why I want to short central banks. Eventually, they will go bust massively. I have always diversified among gold, bonds, equities, and real estate. On the equity side, I have recommended some Singapore real estate investment trusts in the past. They remain attractive as an asset class, but I would shift from the office-REIT market to hospitality trusts, which own hotels, and to health-care trusts. While office REITs will come under pressure in 2017 because of supply coming on-stream, I am a believer in the growth of tourism in the area. Also, hospital medical expenses are tiny there, in relation to the rest of the world.

In Singapore, I like CDL Hospitality Trusts [CDREIT.Singapore] and Far East Hospitality Trust [FEHT.Singapore]. Health-care trusts own hospitals that are leased to hospital operators. In that market, I like Religare Health Trust [RHT.Singapore], Parkway Life REIT [PREIT.Singapore], and also aFirst REIT [FIRT.Singapore].

Moving on to currencies, the U.S. dollar was in a bull market between 1981 and 1985 that exceeded expectations. If that happens again, which seems possible, I would short the Australian dollar. Australia — and Canada, too — have overvalued currencies. Mining expenditures for minerals, oil, and gas accounted for 3% of Australian gross domestic product in the 1980s and ’90s. Today such expenditures are more than 7% of GDP.

There is a colossal housing bubble in Australia, fed mostly by rich Chinese. Also, bank loans for real estate are 60% of total loans, the highest ratio in the world, followed by Norway. At the moment, the bullish consensus on the U.S. dollar is at a record, and bearish sentiment on the Aussie dollar is high. Many small speculators are short the Aussie dollar. It is possible the situation will reverse in the near term, and the Aussie dollar will rise 3%-5%. That is when I would short the Aussie dollar.

The Chinese stock market has been on a tear. What do you see ahead for Chinese stocks?

Faber: I predicted in October that the Chinese economy would weaken but the stock market would go up. The Chinese stock market is in a similar position to the U.S. market in 1982. At that time, the U.S. market hadn’t done much for a while, and investors were bearish and underweight stocks. Then the market suddenly took off. There has been huge trading volume in Chinese stocks, and many people are opening investment accounts. The real estate market is done in China; it isn’t going to rise substantially in the near future, so speculators are moving into stocks. The market has shot up about 50% in the past three months. It will correct a bit, and then go higher.

Marc Faber: “The real estate market is done in China; it isn’t going to rise substantially in the near future, so speculators are moving into stocks. The stock market has shot up about 50% in the past three months.” Photo: Jenna Bascom for Barron's
Bank stocks, especially, can move up from here. The sector is widely hated and has huge problems, but Chinese banks also have a big customer base. Gaming and lodging companies tied to Macau were hit hard in the past 12 months and are also worth a look. In December, gaming revenue was down 30%, year on year. The stocks have corrected by 40% to 50%. In the next six months, there will be buying opportunities in the industry. You are paid to wait, because many of these stocks yield about 5%.

Roundtable Report Cards
2014 Roundtable Report Card

2014 Mid-Year Roundtable Report Card

Most members of the Barron’s Roundtable are active money managers who trade their positions and change their investment opinions as market conditions warrant. For those keeping score, here’s how our panelists’ 2014 picks and pans performed through Dec. 31.

Are the yields safe?

Faber: Most gaming companies will be able to maintain their dividends. Only 1% of Chinese have been to Macau. About 10% of Americans have been to Las Vegas at least once. If 10% of China’s residents go to Macau, that is huge volume. More facilities will be built. Macau is going to be a huge success. In the next six months, I would accumulate some Macau-related gambling shares.

Do you have any favorite bank or gambling stocks?

Faber: I would buy Bank of China [3988.Hong Kong]. It is a play on China and Macau.

Marc Faber’s Picks
Company/ Ticker Price 1/9/15
Gold (spot, per ounce) $1,223.25
Silver (spot, per ounce) 16.51
Platinum (spot, per ounce) 1,233.31
MarketVectors JuniorGoldMiners ETF / GDXJ 27.48
30-Year U.S. Treasurybonds 2.53%
Bankof China / 3988.Hong Kong HKD4.44
WynnMacau/ 1128.Hong Kong 20.55
SJMHoldings / 880.Hong Kong 11.62
MarketVectors Russia / RSX $15.21
CDLHospitality Trusts / CDREIT.Singapore S$1.76
Far East Hospitality Trust / FEHT.Singapore 0.83
Religare Health Trust / RHT.Singapore 1
ParkwayLife REIT / PREIT.Singapore 2.35
First REIT / FIRT.Singapore 1.28
iSharesPHLXSemiconductor ETF /SOXX $92.63
GlobalXSocialMediaETF / SOCL 18.16
iSharesNasdaqBiotechnology ETF / IBB 313.32
Australian dollar* 1AUD=$0.82
*Short after Australian dollar rises by 3%.
Herro: To Marc’s point, the Chinese government has held Macau demand back. It has held back visas and transit permits. Even if they opened things up just a little, all the supply that has been added in Macau would be filled. And, there is limited space for more casinos. You are on good ground recommending Macau.

Zulauf: What is the best way to play Macau?

Faber: Wynn Macau [1128.Hong Kong] is a good bet. So is SJM Holdings [880.Hong Kong], which is controlled by Macau tycoon Stanley Ho.

Russia will not do well, but will survive. There is very low leverage in both the household and government sectors. The Russians know how to tighten their belts.

Witmer: The Russians feel that good times are an anomaly, right?

Faber: That is a good point. The Market Vectors Russia ETF [RSX] is moving into buying range. The Europeans will break from the U.S. and ease sanctions against Russia. A deal will be done in the next six months. Americans don’t realize that Europe has a lot of trading relationships with Russia. A lot of capital flows between them. An embargo on Russia won’t work.

Those are my recommendations.

In that case, thank you. Let’s move on to David.

Herro: We are long-term value investors looking for low-priced, quality businesses. In some cases, a macroeconomic issue allows you to buy a stock at a low price. In others, there is a temporary industry setback. Some blue-chip European stocks are going to be able to take advantage of the drop in the euro’s value. After many years of currency head winds, the currency will act as a tail wind. Also, some other factors have negatively impacted two of my stocks. China’s slowing economy and a crackdown in China on graft and gift-giving have hurt Cie. Financiére Richemont [CFR.Switzerland].

Richemont is a Swiss luxury-goods company best known for the Cartier brand. About 40% of its profit comes from outside the developed West. I would much rather buy established companies with good exposure to the emerging world, especially companies whose brands are extremely hard to compete against. Cartier is a unique brand and generates a lot of cash flow.

What are some of Richemont’s other brands?

Herro: The company has quite a few brands, including IWC, a watch brand, and Montblanc. Richemont’s growth recently has slowed, but we view the slowdown as temporary and tied to a cyclical slowdown in the emerging world. The Rupert family controls the company through supervoting shares. Richemont is worth 15 or 16 times Ebita [earnings before interest, taxes, and amortization], as opposed to its current multiple in the low double digits. Management is proactive with the balance sheet, using it to expand stores where it makes sense to do so, and buying back stock. To me, Richemont is the perfect example of a quality business hurt because of its location in Europe and exposure to the corruption crackdown in China, but helped by its hard-to-replicate brands.

David Herro: “It is important to try to get big Japanese companies to behave like profit maximizers. Toyota has started to do that, even without government pressure.” Photo: Jenna Bascom for Barron's
Diageo [DEO] presents a similar situation. It is the world’s leading spirits company. The number of people who consume beer has been falling, while sales of spirits and wine have been going up. Diageo has done a good job of building its portfolio. Marc probably doesn’t like the company’s Scotch because it is too bottom shelf. Diageo sells Johnnie Walker, as well as various vodka and tequila brands, and Captain Morgan rum. The company is good at holding down costs and allocating capital, and has seen good profit-margin progression over time. It is selectively buying more brands to layer into its monster distribution system.

How exposed to emerging markets is Diageo?

Herro: It has gone into the emerging world in a big way. The company bought up local brands in India and China, and really knows how to market liquor. The demographic trend is in its favor, as well. But, like Richemont, Diageo has been affected by the crackdown on gift-giving in China. The company has 30%-plus operating profit margins, and ought to be growing in the mid-single digits. But the situation in China and the recent strength of the euro have hurt it. In the next year things could revert to a more positive trend. We value Diageo at 15 times Ebita, versus its normalized 11 times today.

Black: We sold the stock last year. Top-line growth has been terrible in the past few years. Guinness has been a big problem for Diageo in the U.K.

Herro: But Guinness accounts for only 8% or 9% of Ebita. The only beer companies growing today are craft brewers and beer companies exposed to emerging markets.

Black: How do you get to 11 times Ebita?

Herro: You have to normalize emerging-market currencies and the U.S. dollar [adjust for exchange rates, tax rates, and sales levels]. When you do that, you’ll see a much greater lift in revenue and profit.

Faber: David, I agree with you that Richemont has a lot of good brands, but I see two problems. First, the company is catering to the economy of the superrich, and that economy could be vulnerable, especially if asset markets no longer rise in value. No. 2, many luxury chains have to pay very high prices for stores in the best locations, whether it is in Hong Kong or Zurich, or at the airports. Airport shops cost a fortune. Luxury-goods companies have high fixed costs, and they have to sell a lot of merchandise to cover them.

Some luxury manufacturers, such as Prada [1913.Hong Kong], have had disastrous results of late. I agree that luxury-goods companies are attractive investments long term, as people will buy Cartier and other brands. But I would be relatively careful about these brands and companies in the near term. Tiffany [TIF] just reported that fourth-quarter sales were disappointing, and its shares are off sharply today. [Tiffany fell 14% on Jan. 12.] There could be some disappointments among luxury-goods manufacturers.

Herro: There have been disappointments. The things you are talking about have happened. That’s where the value is.

Moving on, Toyota Motor [TM] is tied to the global consumer. Although the company is based in Japan, more than 30% of its output is exported. It has good exposure to emerging markets. Toyota has increased its dividend. It is sitting on a huge pile of cash and is the world leader in low-cost automotive production. Sales of its luxury brand, Lexus, are rising again after sinking for a while. Toyota added some pizazz to its Lexus models. The brand is hugely profitable, by the way. Assuming a normalized operating margin on industrial operations of 8.5% and no change in the value of the yen, the stock could have 45%-50% upside. It could trade at 8.5 to nine times enterprise value to Ebita, although enterprise value gets reduced by that pot of cash.

What will Toyota do with its cash?

Herro: We want the company to use the cash to create shareholder value. Japanese management teams have been atrocious capital allocators. Cash accounts for 30%, 40%, 50% of the market capitalization of many Japanese blue chips, and it is earning only 15 or 20 basis points [hundredths of a percentage point]. Companies don’t look at that money as the stockholders’, but things are slowly starting to change.

Rightly or wrongly, there has been a lot of pressure put on Japanese companies to earn a better than 10% return on equity. ROE would increase if Japanese companies deployed cash more efficiently, by buying back stock, paying more dividends, and engaging in smart mergers and acquisitions. When Japanese companies’ ROE is 6% to 7%, aiming for 10% is a good idea. But I fear that the Japanese are doing it for the wrong reason. They are quintessential box checkers. They should hit a 10% ROE target not just to check the box, but because it creates value for the owners — the shareholders.

David Herro’s Picks
Company/ Ticker Price 1/9/15
Cie. FinanciéreRichemont/
CFR.Switzerland CHF 90.05
Diageo/DEO $110.89
ToyotaMotor/TM 126.08
BNPParibas / BNP.France € 44.94
Source: Bloomberg
Getting Japan’s moribund corporate sector to wake up starts on the micro side. It is important to try to get big Japanese companies to behave like profit maximizers. Toyota has started to do that, even without government pressure, as a result of the quality crisis it had a few years ago, and the Japanese earthquake.

To sum up, Toyota is the world leader in efficiency; it has good exposure to emerging markets, and it appeals not just to rich people, although the Lexus line is doing well. It seems a good place to put your money, long term, especially if you don’t think the yen is going to rally any time soon.

Cohen: Several years ago, Toyota got a lot of credit for repositioning its production facilities. For example, most of the cars it was selling in North America were produced in North America. It was producing in dollars and selling in dollars. Is that still the situation, and if so, how does the company benefit from the yen’s weakening?

Herro: In the past 25 years, Toyota has done more to align costs and revenue. But it still has a huge manufacturing footprint in Japan. It tries to keep intellectual property and research and development in Japan. Many expenses are still allocated to Japan, and the company is still an exporter. It exports a million-plus vehicles a year, although that number used to be around two million.

With my last stock, I am throwing some controversy into the conversation. BNP Paribas [BNP.France], France’s biggest bank, has been hurt by regulatory actions. It was fined nearly $9 billion by the U.S. for doing business with Sudan and Iran. Yet, even after paying this fine, the bank will have a Tier I capital ratio of more than 10%. It hasn’t cut the dividend. The bank has well-diversified businesses, each of which it runs quite well. It bought the Belgian bank Fortis during the financial crisis at a fire-sale price. Fortis accounts for roughly 20% of profit, and corporate banking in France, 15% to 20%. BNP Paribas also has an investment bank that does well, and some exposure in the U.S. Loan losses haven’t grown materially and costs continue to fall. This is a well-run financial institution.

What is the stock price?

Herro: The stock trades for 44.94 euros, or 8.5 times next year’s expected earnings, and below book value. The bank should be able to achieve a return on equity of 13% to 15%. If you apply a multiple of 1.5 or 1.6 times book value, there is decent upside in the shares, and a dividend yield of 3.5%. The bank hasn’t lifted its payout because of the fine. Hopefully, there won’t be any more fines, and the dividend will start rising.

Is BNP Paribas well reserved against nonperforming assets?

Herro: It hasn’t had a big problem. Residential real estate loans in France and Italy have a loan-to-value ratio of 15%, 20%, 25%. People own their own homes, or have inherited them. Real estate assets aren’t highly leveraged, and the savings rate is relatively high. As a result, the nonperforming portfolio is somewhat stagnant. BNP Paribas owns Bank of the West, which isn’t seen as a core asset. Some Japanese banks have been sniffing around and might want to make a bid for it. In a sale, it might go for as much as two times book.

Gabelli: Great ideas, David. Welcome to the panel.

Hey, that’s our line. Thanks, David. Now let’s hear from Oscar.

Schafer: I’m ready. My first pick, Cogent Communications Holdings [CCOI], is a company with a long history of growth, run by a fantastic owner-operator. Cogent is an Internet service provider that operates one of the largest Tier 1 fiber networks in the world. The stock was down 12% in 2014, although we believe the company’s issues are temporary and that the stock could double in the next few years.

Cogent has two product lines, both focused on selling a single broadband product. In its corporate segment, the company provides 100-megabit Internet connections to midsize corporations in high-rise office buildings. Its ’Net-centric business offers data-transport services to telecom carriers, media companies, and other large users of Internet bandwidth. Cogent meets these customers in any one of the 720 carrier-neutral data centers on its network, and offers transport on its 85,000 miles of metro and intracity fiber. Cogent is led by Dave Schaeffer, who founded the company in 1999. Schaeffer has a long history of creating value for shareholders.

Oscar Schafer: “In the Roundtable I recommended Maple Leaf Foods. The situation is even more interesting today, as the business will complete a five-year-plus transition this year, boosting…free cash flow.” Photo: Jenna Bascom for Barron's
Witmer: Is he your brother?

Schafer: No relation. He created the company by assembling a network on the cheap, after the Internet bubble bust. He spent $60 million on 13 acquisitions that had collectively raised $14 billion and already deployed $4 billion into property, plant, and equipment. Schaeffer continues to be opportunistic. He repurchased Cogent’s convertible bonds at 50 cents on the dollar during the financial crisis.

Cogent is unique in the telecom world in that it has always operated on the principle that broadband is a commodity. Whereas most telecom companies live in fear of becoming a “dumb pipe,” Cogent has embraced this destiny as a business model. As optical-switching equipment has improved, Cogent has been able to carry more bits at lower prices. The company has aggressively passed these savings on to its customers, typically guaranteeing a price 50% lower than the competition. The company has effectively driven down the price of bandwidth by 24% annually for a decade and a half. Yes, that is a cumulative price decline of 98%. Furthermore, the company’s focus on selling a single product has allowed it to minimize subscriber-acquisition costs. Cogent employs a call-center-based sales force that is significantly more efficient than its competitors.

So why is the stock depressed?

Schafer: The financial results of Schaeffer’s strategies have been impressive. The company has grown revenue by an average of 16% a year in the past 10 years, and Ebitda [earnings before interest, taxes, depreciation, and amortization] margins have expanded by about 200 basis points [two percentage points] annually, into the mid-30% range.

There are two key investor concerns that drove the share price lower in 2014. First, as a bandwidth provider to Netflix [NFLX] and other large content-distribution companies, Cogent has been caught up in the past year in a high-profile dispute between Netflix and several large carriers about Internet peering, or demands that Netflix pay certain Internet service providers directly for carrying its data-heavy content. Based on our research, we expect the issue will be resolved favorably from Cogent’s perspective, and that these carriers eventually will upgrade their peering ports to allow for a return to the previous status quo, or so-called neutral peering. Meanwhile, the issue has impacted only 5% of Cogent’s revenue.

Secondly, Cogent’s top-line growth rate has slowed in the past three years from the high teens to around 10% annually. The company has taken appropriate steps to address the issue, hiring a new head of sales and significantly expanding the sales force. The CEO has also tied his compensation over the next three years to targets of 15% revenue growth and 20% Ebitda growth. As growth reaccelerates and capital spending on fiber deployment slows, management is committed to returning a substantial amount of capital to shareholders. The company has increased its dividend in each of the past nine quarters.

What is the current dividend?

Schafer: Cogent pays $1.24 a share, and yields 3.2%. Between regular and special dividends and share buybacks, Cogent plans to return $450 million to shareholders in the next nine quarters, representing nearly 30% of the current market cap. By 2017, the company will be generating $3 a share of free cash flow. We expect the shares to trade north of $60, compared with $34 today.

My second stock is NICE Systems [NICE]. It offers investors at least 50% upside as a result of recent management changes. NICE is a $3 billion market-cap software company based in Israel. It is comparable to Verint Systems [VRNT], which I have discussed here in the past, and whose stock has nearly doubled in the past 18 months. NICE’s biggest business is call-center monitoring software. This is a mature but stable market. It could grow as higher-priced analytical software allows companies to utilize big data. Currently, mid-single-digit revenue growth is being driven by NICE’s financial-fraud and compliance products, as well as video-surveillance analytic software.

By any metric, NICE is a cheap stock. It is trading for $50 a share. Excluding cash, it trades for only 13 times estimated 2015 free cash flow of $3 per share, and five times recurring maintenance revenue, which is about 45% of total revenue. That is a valuation more typical of a legacy enterprise-software company that is declining than a company that is growing.

What is happening in the management suite?

Schafer: The business has been undermanaged for years. NICE’s new CEO, Barak Eilam, offers a catalyst for significant value creation by focusing on the company’s bloated expense structure and over-capitalized balance sheet. In the past five years, NICE doubled revenue with minimal improvement in operating profit margins. Operating margins are 18%, compared with Verint’s 23%. As far as the balance sheet goes, $8 per share, or 20% of the company’s value, is in cash. NICE could add at least $1.50 a share of cash flow from Eilam’s initiatives, which could result in a potential gain of 50% in the stock.

In the midyear Roundtable [“Picking Up the Pieces,” June 16, 2014], I recommended Maple Leaf Foods. The situation is even more interesting today, as the business will complete a five-year-plus transition this calendar year, boosting operating margins and free cash flow. Putting a typical industry multiple on the new margins could drive the stock up between 50% and 75%.

Where is the stock trading now?

Schafer: Maple Leaf is based in Canada. Shares are trading for 19.40 Canadian dollars [US$16.35] and the company has a C$2.7 billion market cap. It controls the No. 1 and No. 2 retail pork brands in Canada, with a combined market share of nearly 50%. Maple Leaf produces branded ham, hot dogs, sausages, and poultry, and it has a small hog-raising business. Despite strong revenue and a dominant market share, profit margins historically languished below U.S. peers’, as the company’s manufacturing and distribution systems had never really been modernized. Ebitda margins in the meat business were 4% to 6%, versus 10% at Hormel Foods [HRL], ConAgra Foods [CAG], and Hillshire Brands. But in 2009, Maple Leaf announced a plan to spend nearly C$800 million to modernize the meat business. This involved a 12% workforce reduction companywide, the implementation of SAP [SAP] software, five new manufacturing plants, and the consolidation of 17 distribution centers into two.

Oscar Schafer’s Picks
Company/ Ticker Price 1/9/15
Holdings / CCOI $33.99
NICESystems/ NICE 50.06
MFI.Canada C$19.40
RealD / RLD $11.07
Source: Bloomberg
How did things work out?

Schafer: The transition will be complete by the third quarter of this year. When that happens, margins immediately could climb to about 10%, and the business could achieve a run rate of at least C$300 million in Ebitda. With US$500 million of idle cash on the balance sheet and the ability to add two to three times that in leverage, Maple Leaf has the balance-sheet capacity to repurchase about 50% of the company. Valuing the company’s new earnings stream at more than 11 times Ebitda and 20 times earnings per share — multiples comparable to peers — yields a stock price in the mid-C$30s. If Maple Leaf were to be acquired at the recent industry-takeover multiple of 17 times Ebitda, there would be significant upside from here.

Gabelli: Michael McCain, who controls Maple Leaf, is unlikely to sell. But he could be open to a tax-inversion strategy.

Schafer: RealD [RLD] is another stock I talked about in the midyear Roundtable. The stock is down a little since then, but there have been several positive developments at the company, and the shares are even more interesting now. It was a down year for Hollywood, and the summer box office was particularly bad. RealD, which licenses 3-D-film-related technologies, takes a percentage of ticket sales for 3-D movies. The 3-D market has stabilized after several years of decline. Also, the company recently announced cost cuts above and beyond initial reductions that were announced at the end of 2013.

In October, Starboard Value, an activist investor that owns 10% of the stock, made an offer to acquire the rest of RealD for $12 a share. The board rejected the offer, as the company disclosed in its most recent conference call. We agree with the company’s decision to reject the bid and believe the shares are worth materially more. But we also think the presence of an activist investor with a stalking-horse bid is motivating the management team to act quickly to create value for the shareholders.

What more can management do?

Schafer: Substantial research-and-development spending has been allocated to products that don’t contribute to revenue. The company has announced that it has hired advisors to explore strategic alternatives for this product portfolio. Within the next year, management will either cut the remainder of the expense or demonstrate a clear route to commercialization of the products. Most important, the company likely will announce a large share buyback in the near term. RealD has net cash on its balance sheet and is trading at an attractive valuation ahead of a strong wave of 3-D films.

The 2015 slate of 3-D films looks to be the best in years, with sequels to Avengers, Jurassic Park, and Star Wars hitting theaters. The following year looks just as strong, with the much-anticipated sequel to Avatar, the most successful 3-D movie of all time, set for release. [Release of the Avatar sequel has been delayed to 2017.] Of the top 20 highest-grossing films of all time, half have 3-D sequels scheduled to come out in 2015 and 2016. With no share buyback, RealD is trading for eight times estimated free cash flow for the year ending in March 2016, excluding the monetization of R&D assets. If the company buys back $150 million of stock, or 35% of its shares outstanding, the multiple drops to seven times. Again, that is before additional cost cuts or the benefits of monetizing R&D assets.

RealD continues to make theatrical installations in China and Russia, where 3-D viewership rates are high in local-language films. We think the shares will rise 50% in the next 12 to 18 months, from a current $11.07.

Thanks, Oscar. Mario, you’re last but by no means least. And you’re immensely patient.

Gabelli: Oscar’s ideas are splendid. Thanks for recommending Maple Leaf. There is a lot going on there.

Schafer: You own it.

Gabelli: My clients do. My first idea today is Graham Holdings, which used to be the Washington Post. There are 5.8 million shares, including a million A shares, which have 10 votes apiece and elect 70% of the directors. The B shares have one vote and elect 30% of the board. The company is controlled by the Graham family, which sold the Washington Post to Jeffrey Bezos in 2013. Last year, in a so-called cash-rich spinoff, Graham swapped its ownership in a Miami television station, and cash, for Graham stock owned by Warren Buffett’s Berkshire Hathaway [BRKA]. Graham also sold some other assets separately.

Mario Gabelli: “Kaplan’s non-U.S.-college business has done OK. Based on deals done for comparable companies, Kaplan could be worth as much as $800 a share.” Photo: Jenna Bascom for Barron's
Today, the company holds cash, cable-TV assets, television stations, the Kaplan education business, a marketing company called Social Code, some real estate, and other assets. Graham has $120 a share in cash. The TV stations are worth about $250 a share. Cable ONE, its cable business, is worth $500 a share. Altogether, that’s $870 a share in assets. Graham has announced a spinoff of Cable ONE, which will occur sometime this year. If Cable ONE is bought by another company after the spinoff, shareholders avoid a double tax.

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Schafer: How does that work, exactly?

Gabelli: If Graham sold the cable business, it would pay a tax on the proceeds, and shareholders would pay a tax on the gain. If the business is spun off and then sold, there is only a tax at the shareholder level. A cash-rich spinoff is a terrific tax benefit, too. John Malone [chairman of Liberty Media (LMCA)] and Buffett have done well with cash-rich spinoffs. Graham has an overfunded pension fund, so it has assets to buy other businesses.

Graham is trading for $870 a share. Shareholders are getting the Kaplan business for free. In addition, the cable asset is going to be monetized. Broadcasting Ebitda was about $190 million for 2014. That will drop to $160 million this year because of a decline in election-related advertising spending. Next year, however, there will be a tsunami of spending on political advertising. Graham’s TV stations are in markets such as Houston, Detroit, Orlando, San Antonio, and Jacksonville. They could also get a benefit from spectrum auctions.

The cable business has about $300 million in Ebitda. It will be spun off with about $450 million of debt.

How much is Kaplan worth?

Gabelli: Kaplan is the wild card. It runs a for-profit college. In the U.S., the for-profit education industry is facing challenges. Kaplan also has a test-preparation division, which has about $30 million in Ebitda. Kaplan’s non-U.S.-college business has done OK. Based on deals done for comparable companies, Kaplan could be worth as much as $800 a share.

Next, I was looking for a company with a database of Christian contemporary and country and western songs. I found Gaylord Entertainment in Nashville. After selling a lot of assets and acquiring new management, the company changed its name to Ryman Hospitality Properties [RHP]. It converted to a REIT on Jan. 1, 2013. Our clients got $6.84 a share in cash and stock on the conversion. We have been one of the largest shareholders for a while.

Thanks for sharing that.

Gabelli: Ryman has 50 million shares outstanding. The stock is selling for $54, and the market cap is $2.5 billion. The company has two businesses — Hospitality and Opry and Attractions, which includes two entertainment venues and some other assets. The hospitality business includes hotels and convention centers operated by Marriott International [MAR] near Dallas, Orlando, Nashville, and Maryland, outside Washington, D.C. MGM Resorts International [MGM] has a license to build a casino megaplex in that area. Ryman generated about $200 million in funds from operations in 2014. It pays an annual distribution of $2.20 a share and yields 3.9%. Apply an appropriate capitalization rate [rate of return, achieved by dividing yearly income by total value] to the REIT, and you get a value of $55 a share.

Ryman also owns WSM, a radio station in Nashville famous for country music. Ryman is likely to engage in financial engineering and spin off the entertainment assets. In the right hands, the entertainment assets could be worth as much as $15 a share. Ryman shareholders could benefit from rising occupancy and room rates, and financial engineering. We value the company at $70 per share.

Next, why would you give your money to Steve Schwarzman or Henry Kravis, or David Rubenstein? [All three run private-equity companies.]

You mean, instead of giving it to Gabelli?

Gabelli: I mean, why would you pay 2-and-20 [management fees equal to 2% of assets and 20% of profits] and tie your money up for 10 years? When I buy what John Malone controls, I am buying at a discount. I am not paying 2-and-20, and I have liquidity. Malone has his fingerprints on $115 billion of equity value, with investments in companies that include, among others, Liberty Media, Liberty Broadband [LBRDA], Discovery Communications [DISCA], and DirecTV [DTV]. His personal net worth in these companies is about $8 billion, marked to market. I like following Malone, and have been doing so for 35 years. He is now getting involved in an old-line British company that I started following in the early 1990s because I wanted exposure to Hong Kong. I am talking about Cable & Wireless Communications [CWC.UK], which owned Hong Kong Telecom, which it has since sold.

Cable & Wireless is selling for about 49 pence. The stock trades in London, but the company has relocated its headquarters to the Miami area, as it provides telecom and video service in the English-speaking Caribbean, including Barbados and Jamaica. There are 2.75 billion shares outstanding, and the market cap is about $2 billion. Cable & Wireless has about $200 million of debt.

Mario Gabelli’s Picks
Company/ Ticker Price 1/9/15
GrahamHoldings /GHC $870.47
RymanHospitality Properties / RHP 54.33
Cable&WirelessComm./CWC.UK 49 pence
Chemtura/CHMT $23.20
Post Holdings / POST 41.33
Kinnevik / KINVA.Sweden SEK 247.90
Patterson Cos. /PDCO $50.43
Source: Bloomberg
What is the company’s connection with Malone?

Gabelli: A transformative transaction is in process. Cable & Wireless is buying privately held Columbus International, in which Malone is a large shareholder. Columbus provides voice, video, data, and everything that you heard Oscar talk about with regard to Cogent Communications.

Columbus gives Cable & Wireless an expanded footprint in the region. When the deal is done, Cable & Wireless will issue 1.5 billion of new shares and have $1.7 billion of added debt. Pro forma, Cable & Wireless will have 4.3 billion shares outstanding, and an enterprise value of about $5.6 billion. Columbus adds $600 million of revenue to Cable & Wireless for the year ending March 31, 2016. Cable & Wireless is becoming an interesting Caribbean play.

In exchange for his Columbus shares, Malone will acquire Cable & Wireless shares with a put. Tax structure is fundamental to everything he does. Scale and consolidation and deal structure are in Malone’s DNA. Malone will own 13% of Cable & Wireless after the deal closes; he will have a $250 million stake in the company, which isn’t a big piece of his net worth, but he isn’t going to ignore it. He loves these sorts of dynamics. John Risley, one of the founders of Columbus, will own 20% of the combined company. The company could have significant growth in the next three or four years. You could double your money, or do even better than that.

It’s good to have John Malone on your side.

Gabelli: Now I am revisiting Chemtura [CHMT], which I recommended last year. It came out of bankruptcy protection in 2010. The CEO, Craig Rogerson, said that Chemtura would sell its AgroSolutions unit. It did so, for $950 million, and has used the proceeds to reduce debt and buy back shares. Following a Dutch auction, Chemtura had 72.7 million shares outstanding, and $50 million of debt. The company is buying back $200 million of stock, and by the time we see the next published share count, it will have about 67 million shares. Chemtura has two remaining businesses: an oil-lubricants business and a bromine business that generate about $2 billion of annual revenue.

Schafer: That is the old Great Lakes Chemical.

Gabelli: That’s right. There is overcapacity in the bromine business, which is causing a short-term hiccup for the company. Chemtura could generate $400 million of Ebitda three years out. Chemtura still has $650 million of NOLs [net operating losses from prior years that can be used to offset future taxes]. It will be able to shelter [from taxes] about $80 million a year of earnings.

The balance sheet is wonderful. The CEO is doing good things with the company. Notwithstanding the current air pocket, he is committed to growing Ebitda, getting a high stock market value for it, and buying back a significant amount of stock.

Next, I have talked about Post Holdings [POST] in years past. It was spun out of Ralcorp three years ago. Post is in the cereal business, which has lost some pricing power in the short term. Cereal as a breakfast option has been replaced by protein. The company has increased its market share to 11% of the cereal industry. There has been some talk of consolidation in this market. I have called Bill Stiritz, the chairman, a “cereal acquirer.” In the past two years, he has bought 12 companies for $4.4 billion. Most recently, he acquired Michael Foods, which sells egg whites, among other food products. Post could benefit from buying something in the organic area.

What are the numbers for Post?

Gabelli: Post has about 62 million fully diluted shares. The company posted revenue of $2.4 billion for the fiscal year ended last September. Helped by acquisitions and organic growth, revenue could climb to $4.5 billion in the current fiscal year. Ebitda this year will be about $575 million, growing nicely in the next three or four years due to synergies and consolidation. Post is rolling up food companies with a management team that understands financial engineering. Earnings will march higher in the next few years, helped by lower interest expense. Post could earn $2.10 a share for fiscal 2017. The company could have some near-term challenges, but it has good longer-term prospects.

Black: From an operating standpoint, didn’t Post have disappointing revenue and operating earnings in the past few years?

Gabelli: Stiritz has been buying companies in the private-label food business that fit into Post’s distribution network. He has also been buying branded products and companies in the nutritional-foods business. When you buy 11 or 12 companies in a short amount of time, you will have some short-term challenges. This is true in any roll-up business. It is worth looking two or three years down the road.

In the midyear Roundtable, I recommended Kinnevik [KINVA.Sweden]. The company is based in Stockholm and run by Cristina Stenbeck, a granddaughter of one of the founders. There are 42 million supervoting A shares, of which the controlling family owns 34 million. There are 235 million B shares that have one vote apiece. The stock is selling for 248 Swedish kronor [$29.98]. When a company in Sweden owns more than 10% of another company and sells its stake, it doesn’t have to pay a tax on the profits. That isn’t the case in the U.S., where you would have to engage in all sorts of financial engineering to avoid the tax.

Kinnevik owns other companies, and has a marked-to-market portfolio worth about SEK300 a share. One of its biggest holdings is a stake in Millicom International Cellular [MIICF], a wireless telecom company serving Africa and Latin America. It could be an attractive asset as the industry consolidates.

Remind us what else Kinnevik owns.

Gabelli: Kinnevik has been investing in Rocket, an e-commerce business incubator. Rocket is an investor in many e-commerce companies. Rocket went public three months ago. Kinnevik is selling at a significant discount to its holdings. It is constantly juggling its assets.

Last, but not least, I want to talk about pet care [puts on a baseball cap that says “WOOF”]. VCA [VCA] handed out these hats when it went public. There are 96 million companion cats and 83 million dogs in the U.S. Spending per animal is rising. You don’t have to worry about the Affordable Care Act when you take care of your dog or cat. AmerisourceBergen [ABC] announced today [Jan. 12] that it is tendering for MWI Veterinary Supply [MWIV] at $190 a share, or close to 20 times Ebitda. In the past, I recommended Patterson Dental, now called Patterson [PDCO], which distributes dental and veterinary supplies. There are 104 million shares, and the stock is around $50. The market cap is $5 billion.

On the dental side, Patterson is the exclusive distributor in the U.S. for Cerec, Sirona Dental Systems ’ [SIRO] industry-leading dental CAD/CAM system. Patterson’s exclusive relationship with Sirona and Cerec could end as early as 2017. In addition, lumpiness for dental-equipment buying patterns has caused lumpiness in reported revenue and earnings.

Patterson could earn $2.30 per share in the year ending April. Earnings could top $3 in the next three or four years. Based on those earnings and Ebitda assumptions, Patterson could command a price of more than $80 per share. The MWI acquisition price puts a focus and a valuation baseline on Patterson.

Thank you, Mario, and everyone

22 Smart Invesment Ideas
Felix Zulauf, Abby Joseph Cohen, Brian Rogers, and Scott Black share their best investment bets in this week’s Roundtable installment.

January 24, 2015

If you’re looking for raging bulls or rabid bears, you’ve come to the wrong section of this esteemed publication. But if you’re seeking ways to make sense of perplexing economic times, and money in a market that offers slimmer pickings than in recent years past, stay right where you are.

Clockwise from top left: Scott Black, Brian Rogers, Abby Joseph Cohen, and Felix Zulauf. From Chicago to Singapore, the Roundtable panelists see opportunities to win at the investment game. Photo: Brad Trent for Barron's
The great big picture — global economics, interest rates, currencies, politics, and markets — was the focus of last week’s Roundtable issue, the first of three to distill the daylong conversation of the 10 Wall Street seers whom we convened in New York on Jan. 12. In this week’s installment, panelists Felix Zulauf, Abby Joseph Cohen, Brian Rogers, and Scott Black put their mettle to the pedal to drive home the case for specific investment ideas. None expects a year of robust stock-market gains; indeed, Felix looks for U.S. stocks to correct by 15% or so in the first half of 2015. Hence, the urgency of finding companies likely to outdistance the crowd through savvy management and shareholder-friendly maneuvers.

Felix, who runs money for two Swiss investment firms, is the odd duck in this week’s lineup, but we mean that only in the most affectionate way. He’s no stockpicker, but rather a tactical trader at home in nearly every asset class, who can explain eloquently not only when to buy gold or short currencies, but why. For the record, he expects long-term U.S. Treasury bond yields to keep heading south, and calls an interest-rate hike “off the table” for 2015.

Abby, head of Goldman Sachs’ Global Markets Institute, travels the world, observing and advising. When she returns home, or at least to her Roundtable perch, she comes armed with practical insights about business and economics, and a bevy of stocks favored by Goldman analysts that embody her macro views. This year she’s especially bullish on companies that will benefit from cheaper oil and rapidly rising spending on cybersecurity.

Brian captains a big ship known as T. Rowe Price, but remains surprisingly well-informed about the goings-on in other companies’ boardrooms and balance sheets. An optimist by nature, he favors concerns that have gone astray in various ways, but could soon get themselves and their beaten-down shares back on track. General Electric [ticker: GE] and Mattel [MAT] are two that fit the bill.

Scott Black, founder and boss of Boston’s Delphi Management, builds his brief for stocks meticulously, by modeling all the relevant financial data. One could learn a lot by listening to his dissection of an income statement. We learned, for instance, why he favors Viacom [VIAB] and a nifty small bank with big ambitions.

Want to know more? Please read on.

Barron’s: Felix, we hope you’ve brought us some winning ideas today.

Zulauf: I am re-recommending the iShares 20+ Year Treasury Bond exchange-traded fund [TLT], which I recommended last year. The world economy is slowing. The deflationary process is gaining traction, and the commodity cycle remains bearish. The pressure on bond yields is to the downside. The yield on the 30-year Treasury is at 2.53%, near its 30-year low. I expect the 30-year bond to break that low decisively, and yield 2% or even less than 2% when the stock market sells off. The major stock-market indexes are in for a correction of 15%. Large-cap stocks are overvalued.

What will spark a correction?

Zulauf: Earnings estimates will come down. The dollar is strong against foreign currencies, and foreign earnings will be weaker than the market expects. I am looking for a big selloff, probably in the first half of the year. During that selloff, the TLT will rise dramatically and the yield will fall sharply. When that happens, I will sell the ETF. I sold it in mid-October when the stock market fell sharply and bond prices spiked up, and I bought it back shortly thereafter.

The TLT is the biggest position in my portfolio, by far. U.S. bond yields are the highest in the world. Italy’s 10-year bond yields 1.9%. Spain’s yields 1.7%. France is at 0.8%, and Germany is at 0.49%.

The U.S. bond market is mispriced, and that will change as soon as the market accepts that the U.S. economy is slowing, not accelerating.

Cohen: It is not the U.S. that is mispriced, but rather those other markets.

Zulauf: The others are mispriced, too, but it is a relative world. I don’t know what the right price is.

I’m just saying that U.S. bond yields have more to go on the downside.

Gross: If European bonds are mispriced, would you short them?

Zulauf: I wouldn’t short them yet, although yields are close to the lows, because the European Central Bank is likely to enter the market soon and buy 500 billion euros of government paper, driving yields down further. I don’t want to go against the central bank. [The ECB launched a €1 trillion-plus bond-buying program Thursday.]

If I saw serious fiscal-stimulus programs in European countries, I would short their bonds, but that isn’t the case yet.

When do you expect the Federal Reserve to start raising interest rates?

Zulauf: A Fed rate hike is off the table because the U.S. economy will disappoint. The Fed will postpone its plans to raise rates this year. Perhaps it will do so in 2016. I don’t see how the Fed can justify hiking rates when economic growth will disappoint, employment growth will fade, and inflation will overshoot on the downside.

My next recommendation is to buy the U.S. dollar. The dollar was strong against every major currency in the world last year. That hasn’t happened in at least 25 years.

Mainstream economists are telling us that the dollar is strong because of growth differentials among countries, and an impending interest-rate hike in the U.S. They don’t understand the true reasons for the strong dollar.

Enlighten them, and us, please.

Zulauf: The Federal Reserve, under [former chairmen] Alan Greenspan and Ben Bernanke, pursued a monetary policy that kept interest rates too low. It weakened the U.S. currency, which became a funding currency around the world. Corporations issued dollar-denominated debt. According to the Bank of International Settlements, there is $9 trillion of dollar-denominated debt outstanding in the private sector around the world. That is the short position. Whatever the reasons for the recent firming of the dollar, the true firming eventually will occur when all issuers of dollar-denominated debt see their liabilities rise. They will have to hedge their positions and buy dollars, creating demand for the dollar.

Felix Zulauf: “The world economy is slowing…The pressure on bond yields is to the downside.” Photo: Jenna Bascom for Barron's
At the same time, the current account deficit of the U.S., which is the way the U.S. supplies dollars to the rest of the world, has been shrinking in recent years. Therefore, there is a diminishing supply of new dollars. At some point this year, the market will realize that interest-rate hikes in the U.S. are off the table. When that happens, the dollar will have a correction. I expect that correction to start in the first quarter and end before midyear. Then, the dollar will strengthen again, probably into late 2016. I don’t want to buy U.S. dollars at today’s level, but an investor who wants to establish a dollar position should do so in phases as the dollar corrects.

What is the best way to bet on the dollar?

Zulauf: You can do it in different ways. You can buy the U.S. Dollar Index, which is listed as a futures contract. [It measures the value of the dollar against a basket of foreign currencies]. You can also buy the dollar and short individual currencies. I recommend buying the dollar and shorting the Singapore dollar, which is perceived as a sound and strong currency. Within Asia, other economies have been burdened by the devaluation of the Japanese yen, including the Singapore economy, which is closely connected to China through trade. The Singapore banking system is extended; the loan-to-deposit ratio is about 120%.

Investment / Ticker 1/9/2015
iShares 20+ Year Treasury Bond ETF / TLT* $131.07
U.S. Dollar Index Future (Mar. ’15)** 92.15
Buy U.S. dollar / Short Singapore dollar** $1=S$1.33
Market Vectors Gold Miners ETF / GDX* $20.71
Gold (spot, per ounce)
* $1,223.25
Market Vectors Retail ETF / RTH $72.05
*Sell after stock-market correction. Zulauf expects the U.S. stock market to correct by about 15% in the first half of the year.
Buy in phases as the dollar corrects.Zulauf expects the dollar to correct in the first quarter and then rally into late-2016.
*Hold only until the middle of 2015.
Buy after U.S. stock-market correction.
Source: Bloomberg
Investors bought Singapore dollars because they believed the Singapore monetary authority was pursuing a gradual strengthening of the Singapore dollar. Singapore has a policy of matching its currency to a basket of currencies, although it doesn’t disclose which currencies they are. The Singapore government is one of the best in the world.

Now, however, values in Singapore’s real-estate market have fallen sharply. Singapore must choose whether to provide more liquidity to the financial system or fix its currency to other currencies. It can’t do both at the same time. The world hasn’t yet realized that Singapore is changing from a currency to a liquidity target. That means the government will have to weaken the Singapore dollar. The Singapore dollar will lose some of the glamour it had in recent years, and shorting it is a good way to play the strength of the U.S. dollar and the weakening of other currencies.

Where is the Singapore dollar trading?

Zulauf: It traded down from 1.70 Singapore dollars to the U.S. dollar to S$1.20 in the summer of 2011, and has traded sideways since then in a range of S$1.20 to S$1.30. Recently, it broke above that range and moved up to S$1.34. It now trades at S$1.33. If I am right that China will continue to slow and the world economy will weaken further, Singapore, like nearly all other Asian economies, will need to become more expansive in its monetary policy. Singapore will celebrate the 50th anniversary of its statehood in August. It doesn’t want to have major real-estate problems then, and will provide the necessary liquidity. Going long the U.S. dollar and short the Singapore dollar is a two-year trade.

Faber: I disagree somewhat about the outlook for the Singapore dollar, although I don’t disagree that the government has embarked on a policy of lowering its value. There was a huge speculative bubble in Singapore real estate. The government implemented measures in some areas to cool real-estate prices. They have fallen 30% or 40% from the peak in places like Sentosa Island, but that is after they went up about 20 times.

Real-estate inflation is a problem in Singapore and many countries as a result of increased financial liquidity. Ten or 15 years ago, Hong Kong and Singapore were reasonably priced, or inexpensive. Today, prices are so high that there is social unrest. Ordinary people’s salaries aren’t going up, but the cost of living has risen greatly.

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The Singapore government has tried to lower the value of the Singapore dollar to make the country more competitive, more attractive to tourism, and so forth. But the economy is still in good shape, and Singapore’s banks are some of the strongest in the world. Yes, they have exposure to China. But they also have exposure to Singapore and other Asian countries. I am not that negative about the Singapore dollar. It might go down somewhat from here, but there are other currencies that are much weaker.

The Hong Kong dollar was undervalued, relative to the Chinese renminbi. This created a huge boom in Hong Kong, but with the U.S. dollar strengthening, there is an adjustment process. The Hong Kong dollar won’t be devalued against the U.S. dollar unless the Chinese renminbi really goes down against the U.S. dollar.

Roundtable Report Cards
2014 Roundtable Report Card

2014 Mid-Year Roundtable Report Card

Most members of the Barron’s Roundtable are active money managers who trade their positions and change their investment opinions as market conditions warrant. For those keeping score, here’s how our panelists’ 2014 picks and pans performed through Dec. 31.

Zulauf: I don’t disagree with much of what you said. However, Singapore and its banking system are closely tied to China these days, and China is weakening. If the U.S. dollar strengthens, countries like Singapore, with current account surpluses and low interest rates, could be the first to see a weaker currency. Sicker and weaker economies will suffer later.

When the dollar corrects in the first half of the year, there will be a rally in gold, although it won’t last all year. In the past few months, gold has withstood the strengthening of the dollar, and put in a bottom for a good rally. Bullion could rally about 10% into the middle of the year. Then, I will exit gold. You can also invest in the GDX, or Market Vectors Gold Miners ETF. This isn’t the beginning of a sustainable multiyear run in gold; it is a trade into the middle of this year.

Black: Why would gold rally if inflation is close to zero in the euro zone, and 1.4% in the U.S.?

Zulauf: Gold is a protection against extreme deflation, as well as inflation. It is protection against systemic risk.

Schafer: Felix, don’t people also own gold as a hedge against currency risk?

Zulauf: Yes. Gold has been a fantastic currency. Last year, it was the second-strongest currency, after the U.S. dollar. It has risen against all other currencies and has fulfilled its function to protect against currency debasement.

Gross: If real interest rates come down, as you expect, won’t that push the gold price up?

Zulauf: Historically, falling interest rates have been a plus for gold, but that has always been in times of inflation. Now the risk is toward deflation. Gold doesn’t pay any interest, and there is a minimal cost to hold it. It is more attractive to hold gold in a world of zero interest rates than when rates were 4% or 5%. Gold could run to the mid-$1,300s from today’s $1,223.

Once the U.S. stock market corrects, I would also buy the Market Vectors Retail ETF (RTH). U.S. retailers benefit from a stronger dollar, as it allows them to buy foreign goods at cheaper prices and expand their profit margins. The ETF’s three largest positions are Wal-Mart Stores [WMT], Home Depot [HD], and CVS Health [CVS]. Retailing stocks have always been among the best performers when the dollar has strengthened considerably.

Thanks, Felix. Abby, what do you favor this year?

Cohen: From an asset-allocation standpoint, 2015 will be a better year for U.S. equities than bonds. It is possible that the Fed will wait even longer to raise interest rates because of its concerns about the impact of a strong dollar, the deflationary consequences of falling energy prices, and so on. Nevertheless, equities are more attractively valued than fixed-income assets. My suggestions presume that the economy continues to grow.

Many parents in this room might recognize the name Carter’s [CRI]. The company sells a variety of apparel and other products under the Carter’s, OshKosh, and other brands, for children from birth through about age 12. It sells through a variety of channels, including its own stores, a Website, department stores, and discounters. Carter’s was founded in 1865. It is a North America-centric company; the U.S. accounts for 89% of sales; Canada, 7%, and the rest of the world, 4%.

Abby Joseph Cohen: “FedEx benefits significantly from online shopping, which is here to stay.” Photo: Jenna Bascom for Barron's
Carter’s could face moderating costs, including the cost of cotton, which represents 15% of its cost of goods sold. Cotton prices have fallen about 30% from their high last spring. The company also is benefiting from a strong dollar, as some of its products are sourced outside the U.S. Carter’s will soon exit a period of heavy investment in its Website and stand-alone stores. Selling, general, and administrative expenses are expected to fall.

Also, U.S. birth trends have improved. We haven’t seen a new baby boom yet, but the baby dearth seems to be ending. Carter’s has a 20% share of the apparel market for children two years and under.

Has the company been growing?

Cohen: Yes. The stock is rated Buy by Goldman’s analyst, who is forecasting annualized sales growth of about 9% in the next couple of years, and a return on equity of 23%-25%.

Carter’s is generating strong free cash flow, and a number of retailers are telling us they are seeing good demand for its products in their stores. Our analyst estimates that the company will earn $5.10 a share this year, notably above the consensus of $4.58. The price/earnings ratio is 16.6, based on Friday’s [Jan. 9] close of $84.81. The shares trade for 22 times last year’s estimated earnings, so earnings growth is an important part of the story.

My next few stocks are beneficiaries of the decline in energy prices. FedEx [FDX] provides transportation and business services, typically in the form of shipping, delivery, and package freight. The company’s freight division operates 62,000 ground vehicles, and energy costs are a substantial portion of its cost of goods sold. FedEx executed well during the holidays, its peak shipping season. It benefits significantly from online shopping, which is here to stay, and there has been a shift in its business mix.

How so?

Cohen: For a while, there had been a shift away from so-called priority shipping toward cheaper forms of shipping. Now there is a shift back to more expensive forms of shipping, which is good for profit margins. It could enhance FedEx’s margins by three percentage points in the next three to four years. Our analyst estimates that FedEx’s earnings CAGR [compound annual growth rate] could be substantial in the next few years. Goldman has a 2015 earnings estimate of $9 a share, versus the consensus estimate of $8.98. The shares sell for 19 times estimated earnings.

Company / Ticker 1/9/2015
Carter’s / CRI $84.81
FedEx / FDX 172.66
Quest Diagnostics / DGX 68.39
Acuity Brands / AYI 151.5
Siemens / SIE.Germany € 93.10
Palo Alto Networks / PANW $125.82
Source: Bloomberg
On the negative side, the stock has been a strong performer in recent months, and is already owned by a number of big U.S. mutual funds.

Black: FedEx has a pristine balance sheet.

Cohen: My next pick, oddly enough, also benefits from the decline in crude prices. It is Quest Diagnostics [DGX]. Quest has a 26% share of the independent laboratory market in the U.S. It is the low-cost provider of blood-testing services. It also does work for pharmaceutical companies. Ultimately, the Affordable Care Act will be a net positive for Quest. The company’s volumes are rising organically, and it has been active in making acquisitions, leading to a growing market share. In the current and coming health-care environment, it is good to be the low-cost provider with substantial volume growth.

Quest also has several growth initiatives. It offers drug monitoring for pharmaceutical companies. It is also involved in what it calls esoteric testing, including genetic and other specialized testing. This work tends to have higher profit margins.

What is the connection with lower energy prices?

Cohen: Quest operates 2,000 patient locations. It transports fluid samples for testing. It also produces much of the material it uses, including plastic tubes made of oil-based resins. Labs and services has been the worst-performing subsector of the health-care sector in the past year or two. It is possible portfolio managers will look to rotate into it.

In addition, Quest’s size makes it easier for the company to absorb some of the regulatory costs that have been imposed on the industry.

Quest is opening a new facility in Massachusetts that will give it more geographic reach. The company has a free-cash-flow yield of about 9%, and might be able to lower its costs further. Our analyst estimates 2015 earnings of $4.68 a share, versus the consensus view of $4.40. The stock yields 1.9%.

My next name is Acuity Brands [AYI], a major provider and distributor of LED lighting.

Black: That’s the old Lithonia Lighting, which was owned by Erwin Zaban’s National Service Industries.

Cohen: That’s right. Acuity works primarily through electrical wholesalers. As Scott indicated, it sells a number of lighting brands. We are seeing enormous demand for LED lighting, particularly in new construction and industrial projects. Many individuals and companies are finding LED lights well worth the upfront cost, as they consume electricity far more efficiently than less expensive incandescent lights.

LED bulbs don’t need to be replaced as frequently, either, so they offer labor savings. LED lighting is a higher-margin business for Acuity than traditional lighting.

Here are the numbers: Our analyst estimates Acuity will earn $5.49 a share in the fiscal year ending in August. The consensus is $5.36. The price/earnings multiple isn’t low at 28 times, but gross profit margins of 42% are impressive.

Acuity’s LED lighting sales were up 75% in fiscal 2014. Even though sales of traditional lighting are declining, overall sales rose 13%. LED lighting accounts for 42% of sales.

Siemens [SIE.Germany], my next stock, is a beneficiary of a rising dollar. The company is based in Germany and was founded in 1847, proving that it isn’t only companies founded in the past five years that provide interesting things.

Siemens is a conglomerate; it has businesses in electronics and electrical engineering, gas power, electric utilities, wind power and other energy renewables, building technologies, such as fire safety, security, and automation, and more.

Siemens also has financial activities. One attraction is that the company is pruning its portfolio. The stock hasn’t performed well. It has underperformed its sector and yields about 4%.

Schafer: In what currency?

Cohen: That’s in euros; I was referring to the German shares. Siemens also trades in the U.S. via American depositary receipts [SIEGY].

Our earnings estimates aren’t much different than the consensus, but we are interested in how the company will address its diversified portfolio of business activities. Eighteen percent of current contracts are unprofitable. Total sales were flat in 2013 and 2014. We forecast that they will be up just a smidgen in 2015. As Siemens begins to rationalize its operations, the stock could become more attractive. The company will also benefit from the decline in the euro, relative to the dollar.

Zulauf: Siemens has been a disappointment for as long as I can remember. The former CEO was ousted, and the chief financial officer took over. He is trying to slim down the company and increase profitability. It might work; there is enough waste to cut. But it is difficult to cut out the fat in some European countries, due to labor laws.

Herro: Do you have earnings-per-share estimates for Siemens?

Cohen: We estimate that Siemens could earn 7.12 euros in 2015. It could earn €7.69 in 2016. The stock is trading at €93.10.

My last name is in the technology sector, which has performed well. It is Palo Alto Networks [PANW], a specialist in cybersecurity.

How timely. It seems that ISIS has just hacked the Twitter account of the U.S. Central Command.

Cohen: We are all learning the importance of cybersecurity. Palo Alto provides an enterprise-security platform, including firewalls. It also sells subscriptions to software products that protect against malware.

We surveyed hundreds of companies around the world, asking how they plan to spend their 2015 IT [information technology] budgets. Cybersecurity was the No. 1 target by far for accelerated IT spending. Beneficiaries will include some of the big data-management companies, and specialty concerns, such as Palo Alto. The U.S. Department of Justice recently advised that companies need to pay more attention to cybersecurity at the board and chief-financial-officer level. Many companies need to update their firewalls.

Palo Alto’s results were above consensus forecasts for the past few quarters. Forecasts have been moving higher. We expect the company to earn 74 cents a share this year. The company’s business has been largely domestic, but management is planning to move into other parts of the world. Palo Alto has a new partnership with a company that will give it more distribution flexibility. We see good top-line growth and better operating leverage, although we have some concerns. Everyone knows that cybersecurity is important, so large companies such as Cisco Systems [CSCO] and Juniper Networks [JNPR] are trying to move into the area. Also, the stock has doubled in the past 12 months.

Black: And it trades for 115 times this calendar year’s expected earnings.

Cohen: Palo Alto’s fiscal year ends July 30. We are not saying that it is a cheap stock, but that there is a possibility that profit margins and revenue growth will continue to outperform.

Black: I recently visited Check Point Software Technologies [CHKP] in Silicon Valley. It has much greater penetration of big companies and government agencies than Palo Alto. If you back out its $19 a share of cash, Check Point sells for 15 times earnings, well below Palo Alto’s multiple.

Cohen: Palo Alto is a cybersecurity pure play.

Rogers: There aren’t too many plays in this business.

Gabelli: Palo Alto has built up a sales force and is doing extremely well on new conquests. I don’t own any of the stock; it is not my core competency. But it is a good story.

Black: You know the old joke: We’re not here to buy stories, we’re here to buy businesses. This is an overpriced business.

Rogers: To each his own.

Well said, Brian. Let’s get your ideas.

Rogers: I have nothing selling for 115 times earnings. To put my stocks in context, I believe it will be harder to make money in 2015 than in 2014. Relative valuation will be important. Income could be important. The market might well have the correction that Felix talked about, but between now and the end of the year, it could reward companies that perform well fundamentally with reasonable returns. It is going to be a volatile year. I am looking at companies that have had performance issues and therefore are relatively inexpensive. Our bet is one of mean reversion.

Brian Rogers: Boeing’s cash flow will exceed earnings for a couple of years. Photo: Jenna Bascom for Barron's
Boeing [BA] is one of the world’s best companies. The stock was down 5% last year, but up a lot the year before. The shares are selling for $131, and the company will probably earn $8.75 a share this year. It sells for 15 times earnings. Boeing and its chief competitor, Airbus Group [AIR.France], are serving a steadily growing marketplace. Even going back to 2001-’02, the commercial airliner business has been flattish to growing slightly. It never had a major downdraft. And Boeing is the industry leader, with good secular growth and a decent valuation. Something interesting is going to happen here regarding cash-flow conversion.

Something positive, we presume.

Rogers: Yes. Boeing capitalized development expenses on the 787 Dreamliner. Now that the company is starting to deliver so many 787s, cash flow will exceed earnings for a couple of years. As deliveries of the 787 continue, cash expenses per unit will be much lower than accounting costs per unit. Once Boeing reaches the tipping point in deliveries, cash flow will really start to grow.

How do we know this is happening? Let’s look at Boeing’s dividend history. In December 2013, the company surprised investors with a 50% dividend increase. This past December, it blew the market away again with an above-consensus dividend hike of 25%. The company now pays a dividend of $3.64 a share, yielding 2.8%. Boeing has a nine-year backlog on the 787. It is going to be in business for a long time.

The company is aggressive about returning cash to shareholders not only through dividends, but also through stock buybacks. Boeing bought back about $6 billion of stock last year and has a continuing buyback authorization.

There is a lot of debate about whether the drop in oil prices is good or bad for the company.

What could be bad?

Rogers: Bears would say that with the price of oil going down, no one buys new fuel-efficient planes. At the same time, lower oil prices make for a much stronger airline industry.

Abby recommended Siemens today. The American version of Siemens is General Electric. Abby said Siemens is reshuffling its portfolio, and GE is undergoing a similar reshuffle. It took Synchrony Financial [SYF] public last year and will spin off the rest of that company toward the end of 2015 in a stock swap. GE yields 3.8%. After the company disposes of the rest of Synchrony, it will own a group of mostly industrial businesses generating 70% or 75% of revenue. These arguably are higher-multiple businesses than financial services.

Company / Ticker 1/9/15
Boeing / BA $131.54
General Electric / GE 24.03
Hess / HES 71.12
Loews / L 40.05
Mattel/MAT 29.1
Vulcan Materials / VMC 68.29
Source: Bloomberg
GE currently trades for $24 a share. The downside is probably $22, plus the dividend. If you put a multiple of 18 times on industrial earnings, which isn’t too high for a world-class business, and a multiple of 12 on the remaining financial-services business, you end up with a $29 stock. GE is a way to do reasonably well in what could be an uninspired market.

Cohen: Brian, what is the catalyst for GE?

Rogers: The company is reducing its financial-services exposure. The shares could be re-rated upward, based on the remaining higher-quality, higher-multiple industrial businesses.

What is the outlook for dividend growth?

Rogers: GE increased the dividend in December. It now pays 92 cents a year. At some point in the next 18 months, we will probably see a dividend of a dollar a share, which would support a $30 stock price.

Is currency a head wind for GE?

Rogers: It is a bit of a head wind, but we have built that into our estimate of $1.75 a share in earnings for 2015.

Next, given the selloff in energy stocks, you have to own an energy name. My pick is Hess [HES]. The stock previously traded above $104 and is now in the low $70s. Hess has undergone a transformation in the past few years, after Elliott Management launched a proxy battle. The board was restructured to include people from Elliott’s slate. For a CEO whom investors doubted, all I can say is, John Hess has gotten religion.

The company has been pruning its portfolio. You’ve got to love a company that sold its Russian business two years ago for $2 billion. Today, it would be worth only $1 billion. Hess has pruned about $8 billion in assets. It has become serious about capital allocation, and has taken the share count down by repurchasing $4.7 billion of a $6.5 billion buyback authorization. The company has raised its dividend by 150%. It is in an interesting resource position. Having sold many of its old businesses, it is now concentrated in the Bakken and Utica shale formations. It is an energy exploration-and-development pure play. The company has shed its terminal business and its gas stations.

Does it still make Hess toy trucks?

Gabelli: If you want a Hess truck, you’ll have to buy it online.

Cohen: That is another plus for FedEx.

Rogers: Hess has cleaned up its balance sheet and took its debt down to $5.7 billion from $8 billion two or three years ago.

Gabelli: I have to say this: That’s the good side of investor activism.

Rogers: Mario, you’re right. Everyone would have to agree that the company is in a better place today because of the proxy battle. In a sector under tremendous siege, Hess seems like a high-quality, well-managed, financially safe company that has cleaned up its act. Recent estimates have put the company’s valuation at $100 to $105 a share, compared with an asset value of $135 last summer. It shows you how quickly things can change.

Black: The Bakken isn’t profitable with oil selling at $50 a barrel. I just sold all my Bakken plays. How do companies operating in these areas make any money at current oil prices?

Rogers: I concede that forecasting earnings per share is virtually impossible.

My next idea is Loews [L] — not the retailer but the holding company. It has a shareholder-friendly management team and owns lots of interesting assets. Every sector in which Loews operates is under siege, except for the hotel business. Loews offers exposure to CNA Financial [CNA], the insurance company, which is a well-run business that trades for a moderate multiple. Loews also owns majority stakes in Diamond Offshore Drilling [DO] and Boardwalk Pipeline Partners [BWP]. Then there’s the Loews hotel chain, and about $5 billion of net cash.

When you work through the numbers, each share reflects two-thirds of a share of CNA, 0.19 of a share of Diamond, 0.35 of a share of Boardwalk, $5 of the hotel business, and about $9 of net cash. That is a $51-a-share pool of assets, for shares selling at $40. The Tisch family owns 21% of the company. Loews has bought back 70% of its shares in the past 40 years. No one will claim that the value of CNA or Diamond Offshore is at peak levels, so there are a few ways to win here. The company could continue to buy back shares. You are making a bet on the capital-allocation decisions of CEO Jim Tisch and his family. Loews, by the way, has lagged the Standard & Poor’s 500 index in each of the past five years, so there is the possibility it will revert to the mean and advance.

Hasn’t the stock always carried a conglomerate discount?

Schafer: It has always traded at a discount to the underlying asset value, but Jim Tisch has done a great job.

Witmer: I agree, especially when it comes to buying back shares.

Rogers: My next pick was a Murphy’s Law stock for us in 2014. Anything that could go wrong did go wrong. Now, it sells at a price that the rest of you can afford. I am talking about Mattel, which fell 35% last year. As a shareholder, I didn’t see the trouble coming. Sales are expected to be down 8% but up a bit at the retail level. The company has been liquidating inventory.

Mattel has great product lines, including Barbie, Fisher-Price, Hot Wheels, and American Girl. Earnings are under pressure, and will probably fall from $2.58 a share in 2013 to a $1.80 in 20l4. They could rebound to $2.30 in 2015. The stock sells for $29. Mattel has a $9.7 billion market cap. Sentiment on the stock is awful; more than a dozen analysts follow the company and there is only one Buy rating. We see downside to $25. The company pays a $1.52 dividend and yields 5%, which I would assume is 75% safe. If the dividend holds and earnings rebound to $2.30 in 2015, you could see a total return of 30%. Mattel isn’t for the faint of heart. But the company is financially strong, so it is unlikely to get into much more trouble than it already has.

What could drive earnings higher?

Rogers: Cost-cutting is a big part of it. The company will probably cut selling, general, and administrative expenses, as a result of a recent acquisition. We hope there will be a restocking of the Barbie line in the next year. Mattel is losing a Disney contract, which will hurt in 2016, but the company has a lot going for it.

Black: Didn’t Mattel miss the secular shift among young people from toys to electronic games?

Rogers: To some degree, yes. My last pick is Vulcan Materials [VMC].

Gabelli: I owned that one.

Rogers: We have all owned it from time to time. Vulcan is the largest producer of aggregates in the country. Its business has a south-central and southeastern tilt. Shipments are down roughly 50% from the peak in the mid-2000s. Interestingly, Vulcan has never experienced a price decline in its aggregates business. The company tries to co-locate its rock and aggregates facilities in key markets because it is expensive to ship concrete and gravel and sand. Vulcan is a bet on a continued recovery in the Southeast. It is also a bet on a potential new highway-funding bill, since spending on roads has fallen a lot. The stock sells for $68. It was up 10% last year, the best performer among my current picks. The company doesn’t pay much of a dividend; it yields 0.4%.

Vulcan has a lot of upside leverage. We expect the company to earn $2.58 a share in 2015. Earnings could rise to $5.10 in the next few years. The stock sells for about 10 time cash flow.

The company has irreplaceable sites, and thus a big moat around its business, to employ one of Warren Buffett’s favorite phrases. Vulcan faced head winds for five years after the financial crisis. It is now positioned to benefit from tail winds. A new management team led by Tom Hill is doing many positive things. Full disclosure: T. Rowe Price owns 13% of the shares.

That’s conviction. Thank you, Brian. Let’s move on to Scott.

Black: We are moderately constructive on the stock market, although I agree with Meryl that it is increasingly difficult to find a lot of cheap stocks. I have a handful here that might be OK. My first stock, and my only large-cap today, is one that Mario has owned forever. It is Viacom. The company has two divisions. Media networks accounts for 73% of revenue, but contributed 95% of last year’s operating income. The filmed-entertainment unit, which includes Paramount Pictures, contributed 27% of revenue last year, but only 5% of operating income.

Scott Black: There aren’t many quality media companies selling for Viacom’s inexpensive 11.5 times earnings. Photo: Jenna Bascom for Barron’s
Viacom’s cable-TV networks include MTV, MTV2, VH1, CMT, Nickelodeon, Spike, and so on. Most reach up to 95 million homes. Viacom has 11 of the top 50 cable networks. It has eight of the top 30 that reach the best age demographic — 18 to 49. Seventy percent of their MSO [multiple-system operator] fees are locked in for the next three years, with built-in escalators.

Explain that, please.

Those are the fees Viacom receives from cable-TV providers and other content distributors. You can’t guarantee the theatrical business, but Viacom is trying to cushion results with animated movies. Animation has a big release planned with Monster Trucks. Recent and planned films include Selma, Project Almanac, Mission Impossible V, with Tom Cruise, and Terminator Genesys, in which Arnold Schwarzenegger has a cameo role.

Viacom CEO Philippe Dauman notes that the Nielsen ratings don’t capture the new market, or viewership of movies and TV shows on handheld electronic devices. He is right about that, although new services are starting to measure this market, which could help Viacom’s ratings.

The shares closed recently at $71.67. Viacom has 422 million fully diluted shares, and a $30 billion market capitalization. It pays a dividend of $1.32, and yields 1.84%. We estimate that network revenue will rise 5% in the year ending in September, to $10.68 billion. Filmed-entertainment revenue could rise 10%, to $4.1 billion. After eliminations, we put total revenue at $14.66 billion, operating income at $4.339 billion, and profit before taxes at $3.75 billion. Add $60 million of equity interests, apply a tax rate of 33%, and you get net income of $2.55 billion.

What is that on a per-share basis?

Black: Viacom has an ongoing stock-buyback program. In the past three years it repurchased $11 billion worth of shares. It still has a $6.24 billion authorization. We estimate that the company will spend $2 billion to buy back 28 million shares this year. That gets us to an average of 408 million shares, and earnings per share of $6.25. Wall Street’s estimate is $5.97. The stock is selling for 11.5 times estimated earnings. There aren’t many quality media operations selling at that sort of multiple. Based on enterprise value to projected Ebitda [earnings before interest, taxes, depreciation, and amortization], Viacom is selling at a multiple of about nine. Walt Disney [DIS] has an EV/Ebitda multiple of 12, and most other media companies are between 11 and 12.

Company / Ticker 1/9/2015
Viacom / VIAB $71.67
Microsemi/MSCC 28.02
Customers Bancorp / CUBI 18.25
Ares Capital / ARCC 15.84
Source: Bloomberg
Viacom’s free cash flow and earnings are about the same. Return on equity will be 59% this year, and return on capital, just over 14%. The company is levered about 3.1 to 1. The interest coverage ratio [earnings before interest and taxes, divided by interest expense] is 7.8 times. You can’t pencil in how Paramount will do, but you don’t have to worry that Viacom’s buybacks are imperiled.

Witmer: What percentage of revenue does Paramount contribute?

Black: The company doesn’t break out those numbers. It is pretty small. I’ve been conservative in using 5% top-line growth for the media networks. With Viacom’s acquisition of Britain’s Channel 5, network revenue could rise 6% or 7% this year.

Witmer: The stock is down from the $80s.

Gabelli: The big question is: What will happen to the A shares, the voting shares, when Sumner Redstone [Viacom’s founder and controlling shareholder] passes?

National Amusements, which he controls, owns 40.5 million of the 50 million A shares. Redstone is still spirited, even at 91, but what would Dauman do if Redstone’s estate or National Amusements were seeking liquidity and wanted to sell Viacom? Speaking for my church, how do you protect the other A-class shareholders if a buyer doesn’t give them the same price that it offers National Amusements?

Witmer: Is there protection for minority shareholders? Consider what is happening at Sika [SIK.Switzerland], the Swiss adhesives company.

Gabelli: Another company [ Compagnie de Saint-Gobain (SGO.France)] is trying to buy Sika’s controlling family’s stock at a premium, squeezing the other shareholders.

Black: My next company, Microsemi [MSCC], was once looked upon as a semiconductor supplier only to the U.S. Defense Department. The P/E multiple is low because that is still the perception, although it isn’t accurate. In 2010 mixed-signal chips contributed 29% of revenue, and discrete components, 71%. The mix has changed dramatically since the purchase of Actel. Mixed-signal now generates 26%; discretes, 32%, and field programmable gate arrays, 24%. Last year, Microsemi bought Symmetricom, a leader in timing for network virtualization, which is now 18% of the business.

Who are Microsemi’s other customers?

Telecom companies account for 36% of revenue; defense and security clients, 27%, commercial aerospace outfits, 14%, and the industrial sector, 23%. Geographically, only 14% of revenue is exposed to Europe. U.S. and Asian revenue is dollar-denominated. The stock is $28.02. There are 95 million shares outstanding, and the market cap is $2.66 billion. The company doesn’t pay a dividend.

Much of the discussion at this year’s Roundtable concerned oil prices, interest rates, currency wars, and the troubled outlook for Europe. The group met Jan. 12 in New York. Photo; Jenna Bascom for Barron's
Minimally, revenue will rise 10% in the fiscal year ending Sept. 30. That’s 8% unit growth, and 2% from the Symmetricom acquisition. Profit before taxes could total between $266 million and $281 million. The tax rate is 8%, in part because the company has about $60 million of net operating losses from prior years [NOLs offset a portion of current taxes]. We estimate per-share earnings of $2.65, against last year’s $2.19.

Excluding stock-based compensation — which is the appropriate thing to do — we get earnings of $2.23 and a P/E of 12.5. Return on equity is 20.3%. Microsemi has a net debt-to-equity ratio of 0.48; its return on capital is 13.7%. The coverage ratio is outstanding at 16.5. We estimate $271 million this year in free cash flow.

The valuation is reasonable, and the stock isn’t well-known.

Good attributes, both.

Black: Next, I like Customers Bancorp [CUBI], based near Philadelphia. Yes, net interest margins are getting killed with interest rates so low, but this is a special situation. Jay Sidhu built a little bank outside Philadelphia into Sovereign Bank. He left in 2006, before the Lehman Brothers debacle. He took control of Customers in 2009, when it had $350 million in assets and $22 million in equity. Now it has $6.5 billion in assets.

Customers is a wholesale bank, with just 5% of revenue from consumers. We are expecting more-controlled asset growth of 10% a year in the future. The bank’s total risk-based capital ratio is 11.2, and its capital adequacy ratio is 8%. The net interest margin is around 280 basis points [each equal to 1/100th of a percentage point], but Sidhu hopes to lift that to 300 basis points, long-term. In the next few years, he’d like to achieve a 1% return on assets and an after-tax return of 12% on equity. The bank’s efficiency ratio [costs minus interest expense, divided by revenue] is 54% and he’d like to drive it down to the mid-40% range.

How good is loan quality?

Black: We study reserves against nonperforming assets. Customers has reserved $31.1 million against loan losses, but has only $9.9 million in non-accruals. That is a coverage ratio of 3.1. Many of the bank’s loans have been made to high-net-worth families, with personal signature guarantees. The company also warehouses loans [extends short-term lines of credit] to mortgage brokers. The mix of loans is 39% for multi-family dwellings, 20% for owner-occupied commercial and industrial construction, 10% for non-owner-occupied commercial real estate, 8% consumer loans, and 23% warehousing.

Customers has a great idea for gathering new funds — BankMobile, a mobile and tablet banking platform. It has signed up 1.2 million students for the service at 800 colleges around the U.S., and taken in $250 million in balances so far. Sidhu hopes that when these customers graduate, he will convert them to customers of the traditional bank. Customers has only a handful of offices in the Northeast, from Princeton, N.J., to Boston. This isn’t branch banking. The bank has hired from places like JPMorgan Chase [JPM] and Sovereign.

It sounds intriguing. Give us the numbers.

Black: The bank could have $7.03 billion in average earning assets and $197 million in net interest income this year. We are modeling $6 million a quarter in loan-loss provisions, versus $5 million previously, because the loan portfolio is growing. Net interest income after loan-loss provisions is an estimated $173 million. Non-interest income is only about $6 million a quarter, or $24 million a year, and non-interest expense is $108 million. Thus, profit before taxes is an estimated $89 million. Taxed at 35%, that’s $57.85 million.

Divide by 27.8 million shares, and earnings per share would be $2.08. Company guidance is $1.95 to $2. Sidhu doesn’t expect to raise funds in the capital markets this year, but that might be necessary in the future to bulk up equity.

Customers is trading for $18.25. It sells at 1.19 times book value and 8.8 times earnings. Most regional banks on the East Coast sell for 12 to 14 times earnings, and many of them are under-reserved.

Could this bank become an acquisition target?

Black: Sidhu is going to build it before he sells it. He took Sovereign from nothing to a huge bank, and eventually sold it to Spain’s Banco Santander [SAN].

Rogers: Where does he find so many students with money to deposit?

Black: They direct-deposit their student loans into their online bank accounts. Ultimately, they have to pay out the money, but there are transactional balances.

My last pick, Ares Capital [ARCC], is a yield play. It is a business-development company. The shares are trading for $15.84. Ares pays a $1.52-a-share dividend and yields 9.6%. BDCs can leverage up 2-to-1 to make small-business loans. Ares stays under 0.85 to 1. Its sweet spot in loan size is $10 million to $20 million.

How big is the loan portfolio?

Black: Ares currently has a loan portfolio of $8.78 billion, and has lent funds to 205 companies. Only one of its companies, Lonestar Prospects, is tied to the energy industry; it sells sand for fracking [hydraulic fracturing of oil and gas wells].

About 38% of Ares’ loan book is unitranche debt [a hybrid of senior and subordinated debt, with a blended interest rate]. The company has a unitranche joint venture with GE. Another 23.2% is loans to the health-care industry; 17.9% is to services providers, and 11.5% is for business services. The average Ebitda margin of the companies in Ares’ portfolio is greater than 20%.

Ares grades its loans at the end of every quarter. The No. 1 category, or worst-performing loans, totaled $15.7 million, or 0.4% of the loan book, at the end of the third quarter. The second category encompassed $90.3 million, or 2.2% of loans. The company will have $1.1 billion of total investment income this year. Pretax profit could total $511 million this year. Subtract a 5% excise tax — the company pays no income tax — and you get $485 million.

Ares harvests capital gains from time to time, which is hard to model. It realized $40 million of capital gains in the first three quarters of 2014. Being conservative, I gave them $50 million for all of this year, taking income back up to $535 million. Divide by 314 million fully diluted shares and you get $1.70 a share. Last year, the company likely earned $1.46. The Street forecast for 2015 is $1.60. The P/E is 9.3. Book value is $16.71.

Can you explain the tax structure in more detail?

Black: Business-development companies have a pass-through tax structure. They must distribute at least 90% of their taxable income as dividends to investors. That’s why the yield is so high. They don’t buy back shares.

Ares’ portfolio looks bulletproof, and the company seems to be smart in negotiating credit lines. It pays a commitment fee of three-eighths of a percent and borrows from a consortium of more than 12 banks. Plus, you get paid while you wait for growth.

Thank you, Scott

[M* Analysis]
[A SEQUX Holding]

Barron's Article (Jan 17, 2015):

Shares of Precision Castparts were smacked around last week, but this knee-jerk, emotional reaction could be an attractive opportunity for a long-term investor.

The Portland-based firm (PCP) warned Thursday that lower demand in oil and gas markets and further aerospace destocking at a single customer, among other issues, had hurt its December-ended fiscal third quarter. The maker of high-tech castings, forgings, and fasteners for planes, jet engines, turbines, and oil and gas equipment said it expected $2.42 billion to $2.47 billion in sales for the quarter and earnings from continuing operations of $3.05 to $3.10 per share, both significantly below analyst projections. The $28 billion company will release full quarterly results Jan. 22.

Plunging energy prices have taken a toll on many stocks, but nearly 70% of Precision Castparts’ business comes from growing aerospace markets. Sales to power markets, of which oil and gas is just one part, are about 18% of the total.

The stock is down about 27%, to $199.63, from a high of $275 last summer. Another worry has been that cheap jet fuel will let airlines keep fuel-guzzling older planes around longer and delay new orders.

With the broad market already reeling from crude concerns, the market probably overreacted to this announcement. Investors seem to have forgotten Precision Castparts’ strong track record through thick and thin, and the robust air travel growth expected in coming years. The market is missing the forest for the trees here, says Christopher Tsai, president of Tsai Capital, which has bought PCP shares lately.

Air travel is expected to rise 7% this year and at a robust average annual clip of 4.1% over the next two decades, according to the International Air Transport Association. That will require plenty of new aircraft in the future, Tsai says.

Precision Castparts is a “very healthy” business, with high barriers to entry and high switching costs for its customers, the plane manufacturers. For example, customers want more engine thrust and lower carbon emissions. That, in turn, requires that parts makers be big and resourceful enough to supply more-complex products that can withstand higher and higher temperatures and pressures. It also means more revenue per part, Tsai observes.

Precision Castparts enjoys a significant competitive advantage, is a leading supplier to all plane manufacturers, and is generally No. 1 or No. 2 in most of the business lines in which it competes, he points out. Over the past decade, Precision Castparts’ prowess has led to consistently strong double-digit percentage growth in earnings per share (EPS), and a return on equity around 18%, he adds.

Investors might not know the history of this publicity-shy but industry-leading outfit. CEO Mark Donegan has installed a strong culture of efficiency and made numerous bolt-on acquisitions that have improved the company’s place in the supply chain. It’s doubtful one in a hundred investors realizes Precision Castparts was the seventh-best performer in the S&P 500 index from 2000 to 2014, up 3,570%, topping companies like Apple (AAPL).

At $275, the stock wasn’t inexpensive, but now it is, relative to its history, Tsai says. At 12.8 times consensus analyst EPS estimates of $15.60 for fiscal 2016, which ends in March of that year, the valuation has fallen to levels below the historical median P/E of 17 and the average of 15.2. Admittedly, the profit projections will fall soon, perhaps by 50 cents to a $1, but even at $14.50, the forward P/E would be 13 times.

Moreover, this stock has dropped sharply comparatively few times in the past decade. If the shares simply returned to their historical valuation in the next 12 months, they’d be worth almost $220, or 10% higher.

Precision Castparts has fans other than Tsai Capital. Warren Buffett’s Berkshire Hathaway (BRKA) had a 1.5% stake as of Sept. 30. As oil prices stabilize, the stock’s bargain price will attract new investor.

Precision Cast Parts (PCP) by mcsqrmcsqr, 17 Jan 2015 23:55
Industrial Stocks
mcsqrmcsqr 17 Jan 2015 23:51
in discussion Soap Box / Stocks » Industrial Stocks

[ Precision Cast Parts (PCP)]

Industrial Stocks by mcsqrmcsqr, 17 Jan 2015 23:51

Barron’s Roundtable: Masters of the Game

Our experts predict sluggish economic growth and subdued gains for stocks. Where to find value around the world.

January 17, 2015

Whether you favor tarot cards, tea leaves, or crystal balls, it’s hard to predict the future. Just ask anyone who correctly forecast that oil prices would fall more than 50% in the past few months — and good luck finding anyone who did.

Rising to the challenge of divining economic trends, market moves, and especially the actions of the world’s central bankers, the members of the Barron’s Roundtable took their usual seats last Monday at the Harvard Club of New York and gamely got down to the annual business of making sense of the world for investors, notwithstanding some good-natured grumbling about the perils of the forecasting trade. Whether these market seers ultimately get it right or wrong, or get some things right and others wrong, they are worth a serious listen.

In a day-long session that covered everything from macroeconomics to their investment picks for 2015, the Roundtable members debated the causes of crude’s plunge and its effect on consumers; euronomics and Abenomics; the limits of leverage; and much, much more. On the whole, they expect interest rates to stay unnaturally low, and the U.S. to lead the world in economic growth. Yet, they doubt that will translate into robust gains for the stock market. Scott Black’s expectation that the Standard & Poor’s 500 will return 10% this year — an 8% price advance and a 2% dividend yield — was as rosy as it got. Marc Faber, we feel compelled to warn you, thinks the market already has made its high for 2015.

If you have taken the time to peruse this year’s spiffy artwork, you’ll note a new face in the crowd, that of David Herro, Harris Associates’ chief investment officer, international equities, and manager of the renowned $28 billion Oakmark International fund (ticker: OAKIX), among other Oakmark offerings. David traverses the globe every year to learn about countries and companies, and wasn’t the least bit shy in sharing his common-sensical perspective on Europe, Japan, and China and other emerging markets.

The first installment of this year’s Roundtable begins with the macro and concludes with the micro: the top investment picks of Bill Gross and Meryl Witmer. Bill has changed homes since last year’s confab, dramatically decamping from Pimco, which he co-founded and ran, and taking up residence at the far smaller Janus Capital Group (JNS), where he manages the Janus Unconstrained Global Bond fund (JUCAX). He might have a new business card, but he has the same old smarts and style, displayed to superb effect in his disquisition on the debt supercycle’s demise and the bond market’s response. He also sang, literally, the praises of four fixed-income funds — yes, including one of Pimco’s — that will help investors “hang on to what you’ve got.”

There is no dislodging Meryl, a partner at Eagle Value Partners, from her home in the fine print of financial filings, where the truth about companies often lurks if you know how to find it. Meryl understands business just as well as finance, which makes her a formidable analyst and investor. Her picks this year involve underpriced makers of packaging, textbooks, and supersoft underwear. For the juicy details, please read on.

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Barron’s: It should be obvious from recent trading that oil’s not right with the markets or the world. Take the plunge in crude, a veritable bolt from the blue, which has rattled companies, governments, and investors around the globe. Felix, you accurately predicted last year that economic growth would be sluggish, the dollar would rise, and commodity prices would fall. So tell us, please, how 2015 will unfold.

Zulauf: Mainstream economists forecast normalization last year, which I took to mean a return to economic growth rates before the great financial crisis of 2008. That didn’t happen. Today’s mainstream forecast calls for a decoupling, or an acceleration of growth in the U.S., with the rest of the world still sluggish but catching up later this year or next. The consensus has it wrong again. Europe is still in crisis, and policy makers are doing everything wrong. They are talking about purchasing 500 billion euros in government bonds, €100 billion in asset-backed securities, and so on, to add liquidity to the financial system and spur economic growth. Feeding the system with cheap money won’t solve Europe’s problem.

In Asia, China’s big investment and credit boom is slowing. You should probably cut the country’s official numbers in half to achieve a realistic picture of economic growth. It is more like 3% or 4% than 7% or 8%. Japan devalued its currency by 50% in the past two years against the U.S. dollar, which is hurting competitors in the region. Now, with oil prices falling 50% in six months, the U.S. fracking industry will be hurt. Instead of accelerating, U.S. growth could revert to a postcrisis trend of 2% to 2.5% per annum.

Aren’t you ignoring the positive impact of lower energy prices on the U.S. consumer?

Zulauf: The oil-price slump will hurt the economy dramatically in terms of capital spending and employment, and a lot of oilfield jobs are high-paying jobs. Yes, lower oil prices will bring down the cost of energy, which is good for consumers, but the private sector is going to save this money, instead of spending it.

Japan’s yen devaluation is negatively affecting the price of all globally traded goods. Inflation is diminishing even in weak-currency countries. In Europe, it is below zero. It could approach zero in the U.S. this year. At some point, this will hurt the stock market. There will be a crisis in the junk-bond market, where spreads [between junk-bond and Treasury yields] are widening. In the past, when Treasury-bond yields went down and the yield curve flattened, a recession usually followed. I’m not forecasting a recession, but I am expecting the world economy and the U.S. economy to be much softer than the consensus view.

Does anyone care to challenge this gloomy forecast?

Cohen: While I agree with Felix in some areas, he might be too pessimistic about the U.S., and the impact of the decline in oil prices. Yes, the U.S. is an oil producer, but it is also an oil importer. On the negative side, there has been a notable decline in the consensus view of 2015 profits for companies in the Standard & Poor’s 500 index. The estimated growth rate has fallen to 8% from 12%, mostly because of the drop in energy prices. A lot of capital spending in the U.S. in the past three to five years has been linked to the oilfield, and Goldman Sachs’ commodities team expects that to adjust. The impact on energy supply will be gradual, however. It is hard to see how energy prices could rise sharply from here, except on a trading basis.

But there are big benefits to the U.S. from a decline in energy prices. Assuming crude oil stays around $50 a barrel, that equates to a $150 billion tax break for consumers. It is possible, as Felix suggests, that this will be saved, at least in the beginning, as people are skeptical about whether low oil prices will hold. If our team’s view that prices will hold between $45 and $50 becomes the conventional wisdom, the consumer could start to spend. We are seeing other positive trends in the U.S. The labor-market news, while not totally rosy, is a lot better than six to 12 months ago. The unemployment rate is down substantially. Lastly, while it is possible that headline inflation could be zero in 2015, due largely to the drop in energy prices, some other measures of inflation could be closer to 1.5%. Core consumer-price-index inflation was probably 1.8% in 2014. It could be 1.6% this year.

At their annual grilling by the editors of Barron’s, the Roundtable members predicted modest gains for the S&P 500 index, but saw pockets of opportunity in individual stocks. Photo: Jenna Bascom for Barron's
Zulauf: When the difference is that small, the numbers don’t matter. It is the deflationary process that counts.

Cohen: The transportation and utility industries are major consumers of energy, and will benefit from lower oil prices. Energy accounts for 17% to 18% of their total costs. Our U.S. strategy team believes that the decline in energy prices will boost S&P profits in 2015.

Gabelli: What percentage of S&P 500 earnings is tied to energy?

Black: In the third quarter, 12.2%.

Gabelli: Why are the Saudis allowing oil prices to fall? Why aren’t they cutting OPEC [Organization of the Petroleum Exporting Countries] production?

Black: The Saudis are holding back for political reasons. They fear both Iran and ISIS [the Islamic State], and this is a way to break Iran’s economy. Saudi Arabia has $750 billion of reserves and can tolerate low oil prices for six to nine months. So can the United Arab Emirates and Qatar. While low oil prices hurt our shale business, my sources think there could be tacit consent from the Obama administration.

From left: Marc Faber, Bill Gross, Meryl Witmer, Scott Black, and Felix Zulauf. Says Gross: “Capitalism is being distorted.” Photo: Jenna Bascom for Barron's
Rogers: I disagree with Scott. The Saudis are out to send a message to the Russians. Interestingly, a year ago, no one saw the decline in energy prices coming. This gets to the issue of forecasting. The world in general isn’t much good at forecasting anything.

In that case, shall we adjourn?

Rogers: It is conceivable that we are just one OPEC meeting away from a rebound in oil prices. The financial system was shocked in the past 12 months by unexpected developments. There is a chance that unexpected things will happen in the next 12 months that will lead to radically different outcomes.

Zulauf: What might have started as a political move also has an economic rationale. In recent years, crude oil, and particularly OPEC oil, has lost market share among energy sources. It is important for the Saudis to ensure that their most precious asset, crude oil, has a good market, long term. Therefore, they have to kick out some of the marginal players to ensure the market share of crude in the energy equation. Natural gas and alternative energy have been gaining share. To be successful, the Saudis will have to keep prices down for at least a year. It has only started. The spot price has fallen, but the effects haven’t been felt through the real economy yet. A lot of production has been hedged. Those hedges will run off by summer.

Gabelli: Unlike some in this room, I fill up my own car with gas. The impact of lower spot prices hits right away by giving consumers more cash in their pockets or lower credit-card bills. It was only around Thanksgiving that the price at the pump collapsed. The effect is appearing on credit-card statements now. The consumer accounts for 70% of gross domestic product. His costs are going down. Food will be the next thing that falls in price. This is an extraordinary after-tax saving, and it will start working in the real economy.

Faber: With low oil prices, you would expect discretionary spending to be picking up. Not so. Of the S&P consumer-discretionary companies that offered earnings guidance for the fourth quarter, 89% issued negative guidance. This is the worst reading in the data series going back to 2006.

From left: Abby Joseph Cohen, Brian Rogers, Oscar Schafer, Mario Gabelli, David Herro. “It’s about time” China slowed, Herro says. Photo: Jenna Bascom for Barron's
Gabelli: These are lagging figures, put together by people who don’t go to gas stations. I talk to the guys who are pumping gas, and they say the consumer is buying more beer.

Herro: Lower oil prices also have a positive impact on the emerging world because it is a huge importer of energy. Governments have subsidized it, so either governments are going to save on subsidies, or the consumer will face lower fuel prices. Two major events occurred last year from a global macroeconomic perspective: falling fuel prices and a realignment of currencies. The euro was overvalued for way too long. In fact, oil was overvalued for way too long, as was the yen. We’re finally seeing a realignment that reflects reality and might counter some of the inflationary fears people have.

Gross: When a country devalues, it exports deflation. That is what Japan is doing and what other countries are trying to do, relative to the U.S. They are trying to export deflation and import inflation.

Cohen: Japanese exports are up, and Japanese multinationals that depend on exports have become more competitive. We could see more growth in Japanese corporate profits. This could help with job creation.

Zulauf: If exports aren’t up after you’ve slashed your currency by 50%, something is wrong. But you can’t build a case that that’s why the world economy will do well. Actually, Japan is an exception. Most exports in Asia are down and declining.

Faber: Japanese exports are up in yen terms but down in dollar terms, just to clarify.

Brian, even though you just dissed forecasting, what do you see ahead for the U.S and the global economy?

Rogers: The U.S. has been a true economic engine for five or six years, and has tried to pull other economies up. Our bond and equity markets benefited from a massive flight to quality in 2014. The economy is in a decent place right now. My big worry is: How long can we continue to be the engine, given what is happening elsewhere in the world?

Mario Gabelli, center: “Financial engineering will continue, and activist investors are another spur to specific stocks.” Photo: Jenna Bascom for Barron's
When I talk to many S&P 500 companies about their businesses in Asia and Europe, there aren’t many rays of hope coming from some of those markets. There is a general consensus around 3% GDP growth in the U.S. I wouldn’t be surprised to see downward pressure on that estimate as 2015 unfolds. It just feels like too many things are going to drag on us, including a decline in energy prices. One of my Roundtable stock picks, perhaps not surprisingly, is an oil company. You have to buy when things look really bad. That said, the U.S. could have a tougher year than people expect.

Oscar, what is your view?

Schafer: First, in relation to forecasting, I’d like to paraphrase Woody Allen: I’m astounded by people who want to “know” the macro when it’s hard enough to find your way around Chinatown.

Perhaps we’ll invite him next year.

Schafer: Also, as Seth Klarman [founder of the Baupost Group, an investment firm] put it brilliantly last summer: Is the market nearly triple its spring 2009 low because things are better, or do things feel better because the market has nearly tripled? None of us predicted the oil-price plunge. I expect U.S. economic growth to slow due to the knock-on effects of the energy price decline. A decent percentage of employment growth in the past four or five years came from the oil patch. At the same time, with interest rates so low, central bankers have little powder left to try to help the economy. Even so, there will be pockets of opportunity for investors on both the long and short sides of the market.

Scott Black, left: “Small- and mid-caps did poorly last year, but they are still expensive.” Photo: Jenna Bascom
Gabelli: I’m going back to the consumer. His net worth is at an all-time high. Wages are starting to rise in certain industries, but the psychology is fantastic. When the consumer buys gas every week, he feels good.

Schafer: You spend a lot of time at gas stations. How many cars do you have, Mario?

Gabelli: You city guys send someone else to fill up your car. Go talk to the guy who fills it up. You learn a lot by asking. Capital investment accounts for 12% of the economy. The government is going to examine ways to improve infrastructure. The midterm election resulted in a Republican-controlled Congress, which has a clear vision of less regulation and improving the rate of return on investment. Capital spending by the major oil companies and the independents could drop below $600 billion this year from an estimated $725 billion last year, which will be a challenge, but it’s not a big deal. The housing recovery has traction, and local-government spending is up. The U.S. economy could grow by 2.75% to 3.25% this year, in real terms.

The U.S. is expected to be 22% of the global economy this year. The European Union is expected to be 25%. But, in relation to the oil surprise, what is [Russian President Vladimir] Putin going to do? Is he going to help the Saudis deal with Iran? A year ago, nobody thought about oil, or Putin invading Crimea, or the spread of Ebola. Nobody thought about the psychological impact of these events, which prompted investors to seek refuge in the U.S. bond market, driving down yields. My bet is that U.S.-centric companies do well this year.

Does anyone think oil is going lower?

Zulauf: Yes. The Saudis have a game plan and want to see their goals achieved before they change policy. This will not happen in three months’ time. The next OPEC meeting is in June. Perhaps there will be an emergency meeting before that if the Saudis achieve what they want to achieve. The Russian situation is unclear. Putin was expecting to be hit with sanctions for his invasion of Ukraine and annexation of Crimea, but he wasn’t prepared for the oil-price decline. It is creating a difficult situation for him. Also, internally, he might come under pressure from the oligarchs. Russia is a wild card, but Russia won’t start a war.

Schafer: In July 2008, oil was $147 a barrel. In December 2008, where was oil?

Faber: At $32.

Schafer: Exactly! In six months, the price fell 78%. I got that from your latest newsletter, Marc.

Faber: Thank you. I go occasionally to Saudi Arabia. It would surprise me if they purposely decided to lower the oil price, given how much lower prices hurt the region. The oil price collapsed because of a lack of demand. Suddenly, Asian demand stopped growing. Asia was taking excess U.S. supply. U.S. oil supplies rose in the past five years to 9.3 million barrels a day from five million barrels. Asian demand, and particularly Chinese demand, has slowed considerably.

Black: The Saudis are keeping the price low for political reasons. There is also oversupply because of fracking activity in the U.S. Plus, Libya and Iraq came back into the oil market last year. If the Saudis wanted to, they could put supply and demand back in sync. I would not bet on that this year.

Let’s get Meryl’s take on the world.

Witmer: Like Oscar, I am more of a stockpicker than an economist. But I would note that a lot of large capital-spending projects, planned and ongoing, that were predicated on using natural-gas liquids from fracking might be put on hold. They would have been stimulative to the economy. Even in Europe, there were a lot of energy-related projects in the works, and they are likely to get put on hold. There was a lot of job growth from the energy industry. To the extent that capital spending is reined in, the U.S. economy probably will be weaker than people think.

Zulauf: With a much lower oil price, fewer petrodollars have been created — possibly $1.5 trillion less, on an annualized basis. Petrodollars were reinvested in a variety of things. In the past, they financed other countries’ current account deficits. Now that money isn’t there. Lower oil prices have implications not just for the fracking industry, but for the financial world.

Marc, a petrodollar for your thoughts.

Faber: I look at the investment world in three parts: the Americas, Europe, and the emerging-market bloc from Turkey to the Far East, and to South Africa. I am used to Americans being optimistic about America, especially with the bull market now more than five years old. The economic expansion also is more than five years old, lengthy by historical standards. Consider this data, however, from the Institute for Supply Management: In December 2014, the purchasing managers’ manufacturing index fell one percentage point from the prior year. New orders were minus 7.1 percentage points. Production was minus 2.9 percentage points.

I don’t buy that all is well in America. If it were, why are home-ownership rates falling, whereas home prices have been going up? There is an affordability issue. Many young people finish college with huge student-loan debts. The labor-participation rate is also down, and it is low-paying jobs that are being created. The growth of high-paying jobs is anemic. Many people can use Facebook and wait on tables, but there is a lack of skilled labor. For these reasons, I recommended 10-year Treasuries a year ago. I thought the economy would disappoint, and it will disappoint this year. Growth will be about 2%, at best, but there could also be a contraction.

There is no growth in Europe. Plus, there is an unpleasant political climate and an entitlement society. It is hard to see how the European economy will grow much, although some companies will do well. In Asia, there has been a meaningful slowdown, although a transition is occurring. The two best whiskeys in the world now come from Asia. One is Yamazaki, a Japanese brand, and a Taiwanese whiskey has been elected the best single-malt. Unlike Mario, who spends a lot of time in gas stations, I spend time drinking whiskey.

Good for you, but what is your point?

Abby Joseph Cohen: “Assuming crude oil stays around $50 a barrel, that equates to a $150 billion tax break for consumers.“ Photo: Jenna Bascom for Barron's
Faber: Even if Asia doesn’t grow much this year, economic power is shifting to Asia. The Indian economy could grow by 5%-6% in 2015, although the Indians would say I am too pessimistic. Nonetheless, a 5% growth rate is enormous, compared to zero in Europe.

Gabelli: Is growth in China slowing to 5%?

Faber: It is slowing to 4%, maximum. Exports are hardly growing. Imports are down.

Zulauf: Industrial capacity has been built up, based on 10% growth in China. The corporate sector in Asia is unprepared for this slowdown.

Faber: Unlike the optimists, I believe Japan will contract, as well. The population contracted last year by more than 200,000, the largest contraction since 1947. The population won’t increase unless Japan welcomes foreigners, but Japanese culture is unlikely to do that. The currency has weakened significantly. Approximately 50% of food expenditures in Japan are for imported food. Food prices are rising, but wages aren’t, so real income has tumbled in the past three months.

Cohen: One outcome of the recession in Japan is that the government suspended plans to tighten fiscal policy. It suspended a plan to raise the consumption tax.

Herro: Gross domestic product is a function of population growth and productivity growth. If you don’t have population growth, the way to get economic growth is through productivity increases. The aim of some of the reform initiatives, which have stalled, is to increase the efficiency and productivity of the Japanese economy. Both Europe and Japan have had slow population growth and have been slow to increase productivity. Companies need to have more freedom to hire and fire workers. Hopefully, this is something Japan will tackle. I don’t see Japan bouncing back strongly, but it seems to be looking at the right things.

Zulauf: Abenomics [the economic policies advocated by Japanese Prime Minister Shinzo Abe] is based on three arrows: currency devaluation, fiscal stimulus, and structural reform. The first two have occurred, but the third hasn’t, because it is difficult politically. Reform means taking away something from somebody. Europe faces the same problem. Germany is moving backward on reform. Italy and France aren’t moving at all. Most European governments can’t pass necessary reforms. Introducing the euro, which acts as deflationary straitjacket for at least half the members of the European Union, was the dumbest thing they could do. I see no hope for Europe. It is going the way Japan did.

Rogers: Quantitative easing is the only option left to the European Union. It is a Hail Mary pass.

Zulauf: But QE just takes the pressure off politicians to do what is necessary. Only a major crisis will allow European governments to introduce reforms.

Gabelli: Your conclusion is to bust up the euro because the common currency makes no sense. That’s where you’re going.

Zulauf: Europe will hold on to it for several more years, but people in some countries eventually will say that’s enough. A third of all seats in the European Parliament are held by members opposed to the euro and against the centralization of Europe. And the number is growing.

[Barron’s checked in with Felix late last week to get his take on the Swiss National Bank’s surprise decision to decouple the Swiss franc from the euro, a move that shocked the currency market and came just ahead of likely quantitative easing by the European Central Bank. Via e-mail, he said, “Full support (for franc/euro parity) would have meant that the SNB must pursue the same monetary policy as the ECB, which is completely unnecessary as the Swiss economy has performed well. More monetary stimulus would have had counterproductive effects and inflated assets such as real estate and equities, creating major risks later on. The removal of the euro cap is beneficial as it will force the Swiss economy to become more productive and move into higher-value-added industries. But first, the Swiss economy will most likely –suffer a recession.”]

Cohen: European policy makers are hoping that a combination of quantitative easing plus euro devaluation will spur economic growth. It will help nations like Germany, which export beyond the euro zone. But the implementation of the euro has prevented some weaker countries from devaluing their currencies, as they might have done in the past when their economies suffered. As David intimated, nations either have to bolster their labor productivity, as Ireland has done, or devalue their currency.

Faber: May I finish my remarks? In addition to the slowdown in Asia, people overlook what has happened to global oil outlays. With production and prices rising, the world spent $4.2 trillion on oil in 2007, up from $250 billion in 1999. Outlays have since fallen to $2.5 trillion. In other words, $1.7 trillion went back to the consumer. Also important, sovereign wealth funds rose to $6.8 trillion as of September 2014, from $3.2 trillion in 2007. Of that growth, 59% came from oil, gas, and related revenue. As oil prices fall, what will happen to the growth of sovereign wealth funds, which have been buying financial assets around the world? Their funding is going to evaporate, and they might be forced to sell.

Herro: Norway accounts for a big chunk of that money. It is a small country. There won’t be a catastrophe because of falling oil prices.

Faber: Norway has a colossal housing bubble and an overpriced economy.

Herro: That’s true, but the country has only five million people.

Faber: So declining assets in sovereign wealth funds have no impact on the world?

Herro: You have to look at the net impact of lower energy prices rippling through the global economy.

Gross: The Saudis, Norway, and other sovereign wealth funds bought not only stocks, but bonds with their oil money. Now there is less to spend. What might be the substitute? Quantitative-easing programs in Euroland and Japan, and continued monetary easing in the U.S.?

Rogers: The money doesn’t vanish just because the oil producers don’t get it. It goes into consumers’ hands.

Faber: My point is, assets in sovereign wealth funds won’t double again, as they did since 2007. Therefore, one source of demand for financial assets won’t be there.

Zulauf: More central banks will buy bonds this year. You can’t just declare your currency lower; you have to print more of it. That money must be invested, and it goes primarily into fixed-income assets. That’s why interest rates will stay low, and go even lower this year. There won’t be any rate hike in the U.S. That’s off the table.

Before we continue this fascinating debate, let’s hear David’s macro forecast.

Herro: Like Marc, I divide the world into broad geographies. Regarding North America, I am not as bearish as some people here. The impact of lower energy prices, an improving labor market, a better feel-good factor, and perhaps a deal on tax reform will mean acceptable rates of growth in the world’s largest economy. The euro zone has many maladies and needs structural reform, including the right to hire and fire. It needs to end the defense of the welfare state. But you can’t lump all of Europe together; some economies are doing better than others.

The emerging world is led by the China region and India. China is slowing, which isn’t tragic but necessary. It’s about time. It needs to stop overinvestment and focus on consumption. Reforms being enacted in China hopefully will mean more-sustainable growth down the road. There’s a question about how legitimate the reform is, but China’s leaders are thinking about the right things and saying them publicly. India wants to do well, but it is a tough place to do business, even if you’re the government. India could be one of the bright spots in the next few years. It has roughly the same population as China, but consumes one-tenth the amount of steel and cement. If India grows, it could pick up some of the slack from China’s slowing.

Japan technically is the world’s third largest economy. They’re trying, but don’t know what to do with the third arrow. Japan is aggressively changing the asset allocation in its $1.3 trillion government pension fund, and putting more than 50% in equities from 100% Japanese government bonds. It is using the fund as a battering ram against the corporate sloths of Japan, and trying to increase productivity and profitability. This is a good sign. Abe-san [Shinzo Abe] has been aggressive in putting his people on the pension board to make sure that they use that as a weapon. To sum up, the world isn’t booming, but led by the U.S., with a little help from emerging markets, we could make up for what is lacking in Europe.

Gross: You think that’s a good sign that the government captured the pension fund? Herro: They didn’t capture it, per se.

Gross: They rolled the monetary, fiscal, and pension authority into one.

Gabelli: Oh, stop. Who runs the Social Security lockbox in the U.S.?

Gross: There is nothing in the lockbox.

Zulauf: Japan is discussing whether to dictate that all private pension funds change the asset allocation. It’s not about being right or wrong in terms of allocation, but in relation to government interference.

Gabelli: I would use the word “encouraging.”

Gross: Doesn’t that smell of desperation?

Herro: It was all bonds. Who wants that?

Gabelli: You’re talking to a bond guy!

Herro: Encouraging the pension fund to be properly diversified is how I would put it.

Cohen: One part of Abenomics is womanomics. In a nation where the population isn’t growing and the labor force has been shrinking, women are a good potential source of workers. They haven’t been encouraged to be in the labor force, and certainly not in a highly professional capacity. Getting more women into the labor force would be helpful in the years ahead.

Gabelli: The Japanese also have robotics and artificial intelligence.

Cohen: The women have natural intelligence.

Bill Gross: “Is a zero percent real rate of interest a fair return on your money? It isn’t, but it might be an acceptable rate in a world where there is too much debt.” Photo: Jenna Bascom for Barron's
Gross: Human organisms want to grow. The nature of things is to grow. It is interesting to ask, why don’t economies grow? Why don’t people get hired? Why don’t corporations expand? Why don’t governments produce real growth? Typically, in the past 30 or 40 years, the answer has always been that inflation got a little too high, central banks raised interest rates to restrict credit, and recessions were produced. Today, it is different because we have no inflation. So why don’t we grow?

It is because we are at the end of a debt supercycle. In the past 20 to 30 years, credit has grown to such an extreme globally that debt levels and the ability to service that debt are at risk, relative to the private investment world. Why doesn’t the debt supercycle keep expanding? Because there are limits. Interest rates have reached zero, and governments still don’t want to borrow for infrastructure investment. Companies still don’t want to borrow for private investment. They simply want to buy their own stock at a 15 times earnings because investing in the real economy is too risky. Interest rates are so low and the amount of debt is so high that there are limits to the ability of monetary policy to influence what it has influenced for the past 30 years.

What are the implications of the end of this supercycle?

Gross: The implications are much lower growth, less inflation, lower interest rates, and less profit growth. Barter economies couldn’t grow rapidly, but once someone decided to save and invest and extend credit, growth became possible. Well, we overdid it. Now there is a limit not only to lenders’ willingness to extend credit, but their willingness to do so at an unacceptably low rate of interest.

I have called this slow-growth, low-inflation environment the new normal. Larry Summers [the Harvard economist and former Treasury Secretary] calls it secular stagnation. It is tied to high debt levels, low population growth almost everywhere in the world, and technology that promotes job destruction. We applaud U.S. growth of 3%, but it is an aberration. Structural growth in the U.S. is really just 1.5% to 2%, and in Euroland and Japan it is zero to 1%. We brought consumption forward and issued one giant credit card for the past 30 years. Now the bill is coming due. Investors need to get used to low returns, and low growth, inflation, and interest rates for a long time.

What is your interest-rate forecast for 2015?

Rogers: There are some glimmers of hope. The U.S. is five years into healing from the 30-year extension of credit you’re talking about.

Gross: In the household sector, yes. Corporations are levering up.

Cohen: They are levering up at very low interest rates, often for money they don’t need.

Gross: So long as they don’t buy back stock.

Rogers: Investment opportunities are limited because global growth is so low. That is why companies are buying back stock. The debt position in the corporate world and the U.S. consumer market is very different from five years ago. But I don’t want to trump Bill’s rate forecast, which we are all eager to hear.

Gross: The global interest-rate forecast depends critically on what central bankers are now beginning to understand as the natural rate of interest. To forecast where the 10-year Treasury yield belongs, you need to ask where the federal-funds rate [the interbank overnight lending rate on funds maintained at the Fed] will be five years from now. Until now, central bankers have based the policy rate on the so-called Taylor rule, developed by John Taylor, a professor at Stanford University. It posits that the policy rate should be 2%, plus the rate of inflation. Central bankers in the U.S. and elsewhere relied on this rule for more than 20 years, and it worked pretty well. But it doesn’t work now because of the structural problems I have outlined.

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Meryl Witmer: At Houghton Mifflin, the sale of digital education products improves profits. Photo: Jenna Bascom for Barron's
A policy rate of 4% nominal growth and 2% real [inflation adjusted] growth is 200 basis points [two percentage points] too high. Once the U.S. economy normalizes, the Fed should be shooting for a policy rate of 2%, not 4%. The real rate should be zero, not 2%. How do I know that? I don’t. Goldman doesn’t. No one knows it, which is the problem. We are feeling our way, and that is what the Federal Reserve will do this year. It will feel its way in gradually raising rates and seeing how the economy responds. If a 2% nominal rate is about right, the 10-year bond is decently valued at 2%, as well. Is a zero percent real rate of interest a fair return on your money? It isn’t, but it might be an acceptable rate in a world where there is too much debt.

Interest rates will be lower than the market thinks. Policy makers at the Fed have indicated that the policy rate will be 3.75% to 4%, longer term. They are dreaming. Money is being stolen from bond holders because of the repressive policies of central banks. That is what happens in a deflationary environment when a debt supercycle ends. The savers pay the price.

Zulauf: In Europe, things are even worse. Institutions have to pay the bank to hold their cash.

Gabelli: That sounds like good, sound banking.

Gross: If the new neutral rate is 2% nominally and zero after inflation, as I am suggesting will be the case for the next five years, it pays to borrow as opposed to lending. You can borrow at 2% in the future (and now even lower at 0.25%) and lever that into a 4% to 5% return.

Cohen: Some of the highest-quality corporations are selling long-maturity bonds. On the consumer side, household balance sheets are in dramatically better shape than five or eight years ago, but some households have big problems. Subprime debt no longer is a problem in the housing market, but is becoming one in the car market, and could have an impact on future auto sales.

Rogers: I’d like to challenge Bill. This is a roundtable, after all. Based on the Taylor rule, if 2% is the nominal yield on the 10-year Treasury, that barely covers the rate of inflation. There is no risk premium. Yet, you ought to be compensated for taking duration risk. Thus, the return can’t be zero. Long term, an investor will demand 50 or 100 basis points of return. Maybe the bond won’t yield 4%, but it could yield 2.5% or 3%.

Gross: I admit that my premise suggests a distortion of capitalism, but capitalism is being distorted. Money is moving to the financial economy, not the real economy.

Zulauf: The best capital allocator is the free market. In recent years, and probably for a few years to come, central-bank policy has distorted all that. Capitalism won’t function as we knew it in the past. We will also see the yield curve flatten as investors move into longer-dated bonds to capture a more attractive return. This is happening throughout the world.

Let’s turn to the stock market, which had a good year in 2014, despite all of the problems we’ve been discussing. Abby, your 2014 forecast was close to accurate. How will the U.S. stock market perform in 2015?

Cohen: I gave a somewhat tongue-in-cheek forecast last year that the S&P 500 would end 2014 at 2088. The index hit 2090 a few days before year end, and then sold off. Goldman’s forecast for GDP growth in 2015 is a little above the consensus, partly because we expect the decline in energy prices to provide a boost to the economy. Also, U.S. companies took advantage of a lower dollar in the past few years to become more competitive. The economy isn’t as sensitive to a higher dollar as many investors think because U.S. companies sell mostly high-value-added goods and services to non-U.S. markets, not commodity-type products.

We expect S&P 500 revenue to rise 4% this year, and earnings to increase 8%. Our U.S. portfolio strategy team is estimating S&P earnings of $122, below the consensus at $125. For 2016, the team is using $131, and the consensus is $140. Our interest-rate view is somewhat different from Bill’s, although I take to heart many of his comments. If the U.S. economy performs better than in the past few quarters, the Federal Reserve will seriously consider raising interest rates in the second half of the year, although not by much. But the Fed is unlikely to move unless it sees that the labor market has gotten better, not just in terms of the unemployment rate but job creation and wage improvement. The Fed might also be encouraged to wait to tighten policy because of energy prices.

2014 Roundtable Report Card
Most members of the Barron’s Roundtable are active money managers who trade their positions and change their investment opinions as market conditions warrant. For those keeping score, here’s how our panelists’ 2014 picks and pans performed through Dec. 31. To see the 2014 mid-year Roundtable report card click here. Data include both price changes and total returns.

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Based on these estimates, the house forecast calls for the S&P 500 to end 2015 around 2100, which implies a single-digit percentage gain. However, if 10-year Treasuries don’t move much this year, we could get to 2300. To be fair, David Kostin, Goldman’s chief U.S. equity strategist, thinks the market could be higher during the year, and then fall. His concern is how the market will respond to the first phase of Fed tightening. The risk to this forecast is that interest-rate increases could be pushed further into the future, which would be much better for equity valuations. Picking a point target simplistically, I could say the market will end the year at 17 times our 2016 earnings forecast, or 2233.

You could, but is it right?

Cohen: If there is a risk to the Goldman forecast, it is that share prices will be higher, not lower, based on an improving economy and quiescent inflation and interest rates. Using a dividend discount model, the S&P could have been at 666 in March 2009 only if profits declined by an average of 8% a year in the next five years. That wasn’t correct; the recession ended two months later. Priced into the S&P 500 on Dec. 31, 2014, were five years of flat earnings, which doesn’t seem right either. The components of the S&P 500 performed well as companies and securities in 2014. One question now is whether investors will rotate away from S&P 500 companies and toward small-cap stocks.

Rogers: So Goldman is expecting a return of just 3% or 4%.

Cohen: Plus dividends. It also assumes there is no active management. If the Fed doesn’t tighten, you could see a more optimistic forecast from Goldman.

Brian, where do you think stocks are headed?

Rogers: I agree with much of what Abby said. It is hard to be precise. If you factor in the loss of some earnings momentum from the energy sector, a gain of 5%, 6%, 7% in corporate earnings seems reasonable. I expect that a move by the Fed to raise rates will be perceived favorably by U.S. investors. It has been well communicated. If the first 25-basis-point increase in the fed-funds rate comes in the spring or summer, it will be viewed by the market as a statement that the Fed sees decent economic activity.

Corporations have a lot of liquidity. Dividend and buyback activity will be strong again this year. The relationship of earnings yields and bond yields is supportive of a good environment for equities, although the market’s price/earnings multiple makes me a little queasy. When you look at negligible money-market returns and a 2% yield on the 10-year note, a total return of 5% to 8% on stocks looks good. Investors are unlikely to squeeze another great year out of the Treasury market.

Oscar, do you agree with that?

Schafer: I agree with Brian that multiples are high. But if we agree with Bill that inflation, interest rates, and growth will stay low, we have a TINA market: There is no alternative to stocks. I expect stock multiples to rise. We will see more divergences among equities, as we saw last year with large- and small-caps. In contrast to 2014, this will be a stockpicker’s market. The averages won’t do much, but within the market, there will be great opportunities on the long and short side.

Marc, what is your market view?

Faber: In the U.S., some stocks were up 10% last year, and some were up 40%. But an equal number were down 10% and down 40%. It has been a mixed bag. A year ago, portfolio managers were universally bearish about bonds. Yet, the 30-year Treasury had a 30% total return. The 10-year had a near-12% total return. Utility shares, which had been shunned, rose 30%, and real estate investment trusts, which no one paid attention to because they were too boring for the Facebook crowd, were up 26%. Active managers underperformed the indexes badly, and hedge funds did exceedingly badly, especially when you consider that they complained about low volatility in the first half of the year. Then, when the euro and yen and oil prices collapsed in the second half and volatility spiked, they did even worse. I don’t know what they were drinking.

Schafer: Japanese whiskey.

Faber: In the U.S., people think the market did well. But in dollar terms, the Indian market rose 34%. Pakistan was up 32%-plus; Sri Lanka, 23%; Philippines, 22%; Thailand, 15%; Indonesia, 20%; Vietnam, 20%. Shanghai did poorly until June, and then went ballistic. Don’t ask me why. Lots of things are difficult to explain because the free market has been distorted by central-bank actions to stimulate economies, lower currencies, and such. This year, we have already seen the high for the S&P 500. That was also the case in January 1973. This market is similar to the Nifty 50 market of the early 1970s, in that just a few stocks are driving strong growth in the indexes. International Business Machines [IBM], [AMZN], and General Electric [GE] were all down last year, but Apple [AAPL] was up 38% and has the biggest weighting in the S&P 500. Ideally, the S&P will go to 3500 and then collapse 50%. Then, everybody will be right.

Stocks haven’t had a correction of more than 11% since October 2011, which is unusual. Yet, the uptrend isn’t supported by the real economy. Policy makers have created an environment in which a corporation with a lot of cash isn’t going to build a factory or a business. It is going to buy back shares or take over another company. In each takeover, staff is eliminated and there is no capital spending. Mario likes this because he is an activist investor, but the real economy can’t rebound because it is easier to make money in trading, financial assets, and real estate.

Meryl, how does the market look to you?

Witmer: It isn’t easy to find a lot of undervalued stocks. Usually, when we have trouble finding cheap stocks, the market doesn’t go up much. This market is pretty fully valued.


Black: Small- and mid-caps did poorly last year, but they are still expensive. The Russell 2000 [a small-cap benchmark] is trading for 22 times expected earnings. The Russell 2500 is trading for 21.1 times. There is better value in the larger names. S&P 500 revenue has grown by 4.9% to 5.5% in the past few quarters, and will continue to grow. There will be more stock buybacks. Earnings could come in around $126 this year, up 8%. Operating profit margins have been at a record high of 10.1%, and some improvement is possible. Based on Friday’s close [the S&P 500 closed on Jan. 9 at 2044.81], the market is selling for 16.2 times this year’s expected earnings. It is fairly valued. For deep value investors like Meryl and Delphi, it is increasingly difficult to find good stocks.

I agree with Bill that Fed Chair Janet Yellen will be highly accommodative, and that interest rates will remain low. We might get 8% appreciation in the S&P 500 this year, and a total return of 10%, compared with 13.7% in 2014. The problems in Europe and Asia won’t derail economic growth here, but it might slow it. I am moderately constructive on the year.

Felix, we have a hunch that doesn’t describe you.

Zulauf: In the past 100 years, stocks have been up in the fifth year of the decade with only one exception: 2005. In the third year of the presidential cycle, the market has been up 70% of the time. Combining the two, stocks were up at least 20% in 1915, 1935, 1955, 1975, and 1995. The caveat is that none of those years had a lame-duck president. To find the same combination with a lame-duck president, you would have to go back to 1875, and the market ended down that year.

Forget about 1875. Just tell us about 2015.

Zulauf: The biggest thing going for stocks is paltry bond returns. If I am right that the economy will struggle, equity investors could be disappointed. The major U.S. stock indexes haven’t declined by 10% for the past 3½ years. Extreme readings of investor sentiment reflect a lot of complacency, which usually makes a market vulnerable. A lot of multinational growth stocks are extended on the upside, and cyclicals are extended on the downside. Usually, this situation ends in a big correction. I expect a decline of 15% or so moving into the spring. It could be worldwide, and probably triggered by earnings disappointments in the U.S., due to the strong dollar. I assume central-bank monetary policy will get even easier in the face of this decline. Thereafter, markets could rally, perhaps into 2016. There will be a lot of volatility. It will be a trader’s dream, but an investor’s hell.

Gabelli: I’m looking at the moving parts. The euro is $1.18 today. It was $1.37 a year ago. For S&P 500 companies operating in Europe, the currency will be a drag. Energy earnings will be a big drag. On the other hand, if interest rates go up in the spring, that will help banks’ net interest margins. Companies are going to maintain profit margins as best they can. With the Republicans gaining control of the Senate and the House, the rest of the world is saying this socialist president won’t gain any more traction. Thus, the U.S. is a good place to put your money. A lot of money is moving into the U.S. market, and it isn’t going into small-caps. It is going into large-caps. Foreign investors are sector allocators. Financial engineering will continue, and activist investors are another spur to specific stocks. Putting it all together, the market could rise 2% or 3% this year.

David, how does the year look to you?

Herro: I’m a bottom-up value investor, focusing mostly — although not exclusively — on international markets. I see better value outside the U.S., but there are good places to look here, too. Mario talked about the negative effect a strong dollar will have on multinational earnings for American companies. On the flip side, European-based multinationals struggled for a long time with a strong local currency. The pressure is easing on those companies, and they could record higher profits in their home currencies. The macroeconomic problems we have been discussing have hit European equity valuations. No one wants to invest in European companies, even though many generate sales and cash flow all around the world. Therefore, Europe is probably the most fertile market for value, and its stocks could perform best in the next 18 months.

European multinationals have a big presence in the emerging world, which is undergoing more of a cyclical than a structural downturn. Structurally, emerging markets have a long-term growth story, as more and more people from the lower and middle classes move into the middle and upper-middle classes. There are speed bumps; this doesn’t happen in a straight line. But India and China will eventually find their footing. It could happen in two or three years. That will be good for the corporate earnings of companies exposed to Asia.

Are you bullish on emerging-market shares?

Herro: Shares of quality companies based in emerging markets are too expensive. State-owned companies in these markets look cheap, but low price alone doesn’t determine value. We have very little direct exposure in emerging markets.

In a nutshell, it will tough for the U.S. to keep performing well, as valuations are stretched. Europe has done poorly but will benefit from weaker currencies, lower energy prices, and perhaps a recovery in emerging markets. Investors must be highly selective in emerging markets. The Japanese market has doubled in the past few years. It has benefited from a weaker currency. There isn’t much room for growth left.

Gabelli: One more thing: The combination of lower interest rates and new U.S. mortality tables, as people are expected to live longer, will crimp cash flow as companies put more cash into defined-benefit retirement plans.

Bill, you predicted in your latest outlook that there could be minus signs in front of many asset classes this year. Does that include stocks?

Gross: It is possible. Rather than dissecting valuations, let me note that liquidity is decreasing. The Fed has ended its quantitative-easing program. This reduces the liquidity that helped drive price/earnings ratios higher and helped investors get in and out of the market. Liquidity is becoming increasingly at risk for the stock market, and even more so for the bond market. At some point, it could get harder to sell assets, so be careful about getting out at the appropriate time. I would put a bit of a minus sign on stocks this year, if only because the liquidity premium is increasing.

We have talked today about the difficulty of forecasting, and the fact that nearly every market prognosticator missed the swoon in oil last year. That begs the question: What could you be missing this year?

Cohen: The U.S. economy could show sufficient momentum to override the impact of central-bank tightening and a strong dollar. We know from history that when central banks first begin to raise interest rates, equity markets, at least in the U.S., get a new lease on life. A rate hike is a sign that the economy doesn’t need that much help anymore. That isn’t true of Europe. While valuations are appealing, the European banking system hasn’t been fully repaired. While the U.S. could look a lot better, the impact could be mixed around the world.

Zulauf: There is the potential for many black swans when the world economy is growing insufficiently. The risk of conflict goes up. The war cycle is rising. There could be potential conflicts in Eastern Europe, and in the South China Sea. That could scare away investors.

What do you mean by the war cycle?

Zulauf: You measure conflicts over the course of history, and give them ratings according to degree. When you smooth out the numbers, you find a repeating cycle. We are in the rising part of the cycle now.

Gross: A low-probability event but a possible one might be a one-two punch of debt defaults in Ukraine and Greece. That would lead to widening yield spreads on Europe’s periphery. Also, there is a small chance that the Chinese might devalue their currency. The renminbi has been appreciating against the dollar for a long time.

Zulauf: A Chinese devaluation would be horrible for the world economy.

Gross: But the Chinese might view it as a form of self-defense.

Schafer: If we knew what we were missing, we wouldn’t miss it. That said, everyone seems to believe interest rates are going down. A big spike in rates would be shocking. Likewise, no one is predicting that the economy will fall into a deep recession.

Rogers: I’ll be surprised if we have two quarters of 4%-plus growth in the U.S. in the year’s first half and the Fed raises short-term rates three times in the second half. I’ll be surprised if the yield on the 30-year bond rises to 3.5%.

Won’t we all?

Gabelli: Interest rates could rise faster than we anticipate. Also, we are assuming that U.S. banks are in solid shape, despite the sudden drop in oil. What if a bank unexpectedly goes bust in the U.S.? Third, there are natural disasters. There hasn’t been a really good hurricane season for a long time, or a big earthquake. Bill, you had your own earthquake about 60 days ago.

Gross: It was one of the biggest, and I survived.

Herro: One surprise could be strong growth from ICI — India, China, and Indonesia — in the second half. These countries are home to almost a third of the world’s population. My extra-credit answer is that better cooperation between the U.S. president and U.S. Congress brings forth meaningful tax reform.

Faber: By far the biggest hypothetical shock mentioned would be a devaluation of China’s currency. If China lets the currency go, prices will plummet and corporate margins will fall apart.

Black: I see two potential surprises. The drop in energy prices could have a deleterious effect on the housing market in states such as Texas and Colorado, which have seen big gains. Outside the U.S., we must consider the destabilizing effect of ISIS. The U.S. is providing air cover for bombing, but doesn’t have a dog in this fight. ISIS intends to seize leadership of the Muslim world from Saudi Arabia. It is well organized. Iran is another potentially destabilizing player, and it produces 2.8 million barrels of oil a day. In the event of a wider Mideast conflict, oil prices could run up instantaneously.

Cohen:ISIS is not only well organized but well financed, because it establishes itself as a tax authority in the territory it seizes. It is also active in the kidnapping and ransom business.

Zulauf: A lot of fighters who have joined ISIS from other countries are trying to leave. They have had enough. The group also has a financing problem because of the drop in oil.

Cohen: You talk to people who left ISIS?

Black: My sources have a different view. They say the Europeans joining ISIS might be thugs, but the people running the organization are well educated and intelligent. They have established local and provincial governments, and issued passports. If ISIS’ attacks spill over into Saudi Arabia, the United Arab Emirates, and Kuwait, the U.S. will have to act.

Witmer: My surprise is something on my wish list. Even environmentalists now agree that ethanol isn’t good for the environment. The government could reduce the amount required to be added to gasoline. If that happens, it might help the oil price, but corn prices could be hurt, leading to lower prices for farmland.

Faber: Many surprises could occur in the next 12 months. The president, for whatever reason, might not finish his term. China’s president, Xi Jinping, doesn’t speak as much as Obama, but when he speaks, he makes sense. He is a powerful person. In the past 45 years, China has pursued a policy of nonintervention in other countries’ domestic affairs. But that might change because of its oil interests in the Sudan. China is the largest supplier of troops to the U.N. peacekeeping forces. Its troops are conveniently placed next to Sudan’s oil facilities. China also has a large interest in the Iraqi oilfields. If ISIS moves toward southern Iraq, which it currently can’t do, China will protect its interests. The Chinese are becoming more assertive in their geopolitical ambitions. They must ensure a supply of natural resources, such as oil, copper, and iron ore. In their view, the Americans have no interests in Southeast Asia and eventually will have to move out. It is unclear how this will be achieved, or when, but it probably won’t happen peacefully.

On that note, let’s move on to your investment picks. Bill, since you were kind enough to state in your latest investment essay that you’ve been reserving your 2015 picks for the Roundtable, you can go first.

Gross: It is possible that the Fed will nudge the fed-funds rate higher in late 2015, as Goldman predicts. While the Fed would like to focus on inflation, it is perhaps more concerned with the potential for inflating financial assets. It would like to normalize interest rates to the extent that it can, which could mean a 25-basis-point increase in the fed-funds rate, or maybe a 50-basis-point increase in the next 12 months. A small increase won’t threaten the bond market so long as the Fed uses the right language, which Janet Yellen has tried to do in communicating Fed policy to Wall Street. Mario Draghi [president of the European Central Bank] is the master of verbal manipulation. He has manipulated European interest rates down and into negative territory merely by talking. He deserves an award.

Bill Gross’ Picks
Fund/Ticker 1/9/15
Janus Flexible Bond / JFLEX $10.62/3.0%
Pimco Municipal Income / PMF 14.41/6.7
BlackRock Build America / BBN 22.40/7.0
SchwabU.S. TIPS / SCHP 54.68/1.0.*
Source: Bloomberg
Given this backdrop, the 10-year Treasury is attractive at a yield a bit below 2%. At some point, there will be a bear market in Treasuries, but not in 2015. Investors are more likely to be threatened this year by credit quality than interest-rate movements. I am going to recommend high-quality investments that could provide a 4%, 5%, 6%, 7%-type return. You can skip the guffaws, but one of my picks is a Janus fund.

We’re shocked, shocked.

Gross: It isn’t the Janus Global Unconstrained Bond fund, which I run, but the Janus Flexible Bond fund [JFLEX], a total-return fund run by Darrell Watters and Gibson Smith. It has done well in the past few years, and performed well during the credit crisis. The managers focus on credit quality, instead of taking a macro approach, as I do. The fund has $9 billion, and the management fee is only 61 basis points. It typically yields 3% to 3.5%, but the total return is dependent upon credit selection and interest-rate changes.

I like closed-end funds that provide steady income. To prove I am not biased, my next idea is the Pimco Municipal Income fund [PMF]. It is a closed-end municipal-bond fund. There are a lot of closed-end municipal funds that sell at surprisingly solid discounts to net asset value and yield 5% to 6%. Some have Puerto Rico bonds, but this one doesn’t. I own this fund. Since inception in 2001, Pimco Municipal Income has maintained its dividend rate. You can’t find many closed-end funds that have done that.

What does this fund own?

Gross: It holds an assortment of municipal bonds from across the country. None have the poor credit quality of Puerto Rico. The fund currently yields 6%, and it is tax-free. Typically, muni bonds are yielding 2%, 3%. 4%. The fund’s yield is higher because like most closed-end funds, Pimco Municipal Income uses leverage. Leverage is dangerous if credit quality falls or interest rates rise. If the fed funds rate jumps to 1% or 2% next year, this wouldn’t be an attractive holding, but that is not my bet. The fund sells at an 8% premium to net asset value, as most Pimco closed-ends do.

Next, I like the BlackRock Build America Bond Trust [BBN], which I have recommended previously. It is a levered closed-end fund that owns Build America bonds, which were issued in 2009 and 2010 to fund construction projects. Build America bonds were an Obama administration initiative. Although the bonds aren’t government guaranteed, the government provides 35% of the interest expense.

Witmer: If a project goes under and an issuer defaults, does the investor still get 35% of the interest payment?

Gross: No. You get 50, 60, 70 cents on the dollar. These bonds aren’t completely risk-free. The fund typically trades at an 8% discount to net asset value, and the 7% yield is taxable. Build America bonds have provided a fairly consistent dividend stream since they were issued. These are long-term bonds, and you might ask how they compare with 30-year Treasuries. They yield a lot more than a 30-year Treasury. Also, because they are corporate bonds, they don’t appreciate as much as Treasuries when rates go down, or fall as much when rates rise.

Black: Have there been any defaults in the fund portfolio?

Gross: Not that I know of, although some marginal Build America bonds have defaulted and are expected to default.

Rogers: How much leverage do these closed-end funds have?

Gross: The Pimco fund has the potential to leverage 35% of the portfolio, as does BlackRock Build America. It really went for the fences, and that is why it yields 7%.

My last pick is a Four Seasons pick. I am not referring to the hotel, but Frankie Valli and the Four Seasons. Remember when they sang [snaps his fingers and sings],

“Let’s hang on to what we’ve got

Don’t let go, girl; we’ve got a lot…”

Gabelli: Can you do that again?

Gross: Go see the play [Jersey Boys]; it’s good. You won’t be impressed by the potential return of this pick, but there is a twist; it offers a free call option on oil. It is the Schwab U.S. TIPS exchange-traded fund [SCHP]. It is a $500 million fund that invests in a potpourri of TIPS [Treasury inflation-protected securities] with typical maturities of five to seven years, although it has some long- and short-term TIPS. The fund charges only seven basis points. A five-year TIPS is yielding only 15 basis points. TIPS are sensitive to inflation. The fund hasn’t done well in recent months as the price of oil has come down and the expected inflation rate has fallen to 1.3% or 1.4% from 1.8%.

A five-year TIPS trades at 99 cents on the dollar. The U.S. guarantees that an investor gets back 100 cents on the dollar. That is a nice guarantee. Because of the inflation sensitivity, if oil rises to $60 or $65 a barrel from current levels, the fund will appreciate 2% or 3%. Is that a big deal? No. But the fund does just what Frankie Valli advised: It lets you hang on to what you’ve got. It yields more than a money-market fund and charges almost nothing.

Thanks, Bill. If these don’t work out, you have a future on Broadway. Meryl, you’re next.

Witmer: Gildan Activewear [GIL] manufactures basic family apparel, such as T-shirts, underwear, fleece, and socks. Its market capitalization today is $6.7 billion, and it has $100 million of net debt. At a current $55, the stock offers long-term investors an attractive entry point. Gildan has two segments. Print-wear is two-thirds of revenue and has mid-20% operating margins. It is growing by mid-single digits. Gildan supplies distributors who then sell the products to screenprinters, who imprint them with logos.

Meryl Witmer’s Picks
Company/Ticker 1/9/2015
Gildan Activewear / GIL $55.52
Graphic Packaging /GPK 13.93
Houghton Mifflin Harcourt / HMHC 18.87
Cengage / CNGO 23.00*
*As of 1/8/15
Source: Bloomberg
What is the second segment?

Witmer: It is branded apparel, which Gildan sells under its proprietary Gildan and Gold Toe labels, and under licensed labels such as Mossy Oak, a camouflage brand, and Under Armour. This business is growing by 20% to 30% a year. Because it is in investment mode, operating profit margins are only in the high single digits now. We see the branded business reaching margins north of 20% as it grows and captures the benefits of its investment in cost reduction, lower cotton costs, and the leveraging of SG&A [selling, general, and administrative] expenses. Gildan’s key competitive differentiator is its low-cost, vertically integrated manufacturing. By continually investing in manufacturing facilities, it has been able to increase capacity and reduce costs while also improving quality. Its North Carolina ring-spun cotton facilities, which opened last year, will be the largest globally.

What is ring-spun cotton?

Witmer: It is a thin, soft cotton used in many fashion brands. Gildan’s Anvil brand will drive the company’s penetration in fashion-oriented basics and further differentiate its branded products. Evidence of the strategy’s success can be seen in the underwear business, where Gildan has captured 7.8% of the market since November 2013. Its market share could reach 10% this year.

In December, Gildan provided 2015 guidance of $3 to $3.15 a share in earnings, better than 2014’s $2.94, but below the Street’s estimate of $3.50. The stock traded down more than 10% on the news. Gildan decided to take strategic pricing action to reinforce its leadership and to help it get into segments of the print-wear market it hadn’t previously served. The pricing action is costing it around 70 cents a share. While the market reacted negatively, the company’s moves have enhanced its long-term prospects. Gildan also announced plans to buy back 1.5 million shares.

Co-founder and CEO Glenn Chamandy is one of the best operators we have encountered. He is concerned with long-term earnings, Gildan’s market position, and the success of its customers. In addition, his ownership of six million shares keeps his incentives aligned with ours.

What will Gildan earn in 2016?

Witmer: Gildan can earn $3.85 to $4 a share in 2016 and grow by at least a mid-teens rate from there. This earnings momentum could start to show in the third quarter of this year. Given Gildan’s pristine balance sheet and growth outlook, we apply an 18 price/earnings multiple to future earnings to get a target price of $70 a share in one year and $80 in two years, up from $55 now. There is upside potential from acquisitions and the continued deployment of free cash.

Gildan is based in Montreal. It trades on the Toronto Exchange and in New York. Most of its operations are in Honduras, and some are in the southeastern U.S.

Black: Does the company benefit from the depreciation of the Canadian dollar versus the U.S. dollar?

Witmer: No. Only its corporate headquarters is in Canada. But it could benefit from more money in the consumer’s pocket and lower energy costs. My next name, Graphic Packaging [GPK], is a vertically integrated paperboard manufacturer. The stock is $14, the market cap is $4.4 billion, and the enterprise value is $6.5 billion. Graphic Packaging makes boxes for cereal, beer, detergent, and other branded consumer goods. While the container itself costs little, the value is in the brand marketing and protection of the contents. Graphic’s customers are reluctant to switch suppliers, so there is good stability to the revenue and earnings stream.

Graphic’s mills are some of the lowest-cost in the industry. The company has two virgin-paper mills and four recycled-paper mills producing 2.3 million tons of paper annually. It also has more than 40 converting plants located near customers in the U.S. and Europe, where it converts paper produced in its mills into packaging. Graphic is only one of two producers of stronger virgin paper, with a market share of 55%. MeadWestvaco [MWV] is the other. It’s a leader in the recycled-board market, with a 35% share. CEO Dave Scheible is a long-term thinker who has been with the company since 1999. He has been CEO since 2007. He has done a fantastic job of integrating acquisitions, paying down debt, and disposing of noncore businesses.

What do the financials look like?

Witmer: In the past few years, Graphic has transitioned from a highly levered company to one that is appropriately capitalized. The company has nearly $900 million of net operating-loss carryforwards, which could allow it to shield earnings from taxes for the next 2½ years. In our base-case model, Ebitda [earnings before interest, taxes, depreciation, and amortization] can grow 5% a year organically. We assume that the cash simply builds up on the balance sheet. Even though Graphic won’t pay much in corporate taxes until 2017, we use a 35% pro forma tax rate to get $1.45 a share in after-tax free cash in 2016. Plus, there is a buildup of $3 a share in excess cash. Using a 12 multiple and adding the excess cash gets us a target price of about $20 a share in two years.

The company will likely redeploy the cash to make opportunistic acquisitions, repurchase shares, and implement a dividend. The CEO seems to have a knack for making $1 worth at least $2. Plus, with the decline in energy prices, the consumer could add a tail wind to our growth assumptions. Our upside two-year target is north of $23 share.

My next picks, Houghton Mifflin Harcourt [HMHC] and Cengage [CNGO], publish textbooks and other educational material. Both have come out of bankruptcy protection.

You have invested successfully in other companies coming out of bankruptcy.

Witmer: It is a good place to look. Houghton is focused on pre-K to 12th grade, and Cengage, on college students. Houghton has a market cap of $2.7 billion and an enterprise value of $2.3 billion, and about $2 a share of excess cash. Cengage has a market cap of $1.8 billion, an enterprise value of $3.6 billion, and some debt. Both companies are benefiting from the conversion of educational materials from print to digital. Given the complexities of GAAP accounting [accounting based on generally accepted accounting principles], this change is being overlooked by the market. Reported earnings are also greatly obscured by noncash amortization charges.

What led to the companies’ bankruptcy filings.
Witmer: In the middle of the past decade, private-equity firms purchased and levered up textbook publishers, including Houghton Mifflin and Cengage. The money for textbook purchases comes primarily from state and local tax revenue, and the recession forced a sharp pullback in spending in pre-K-12. The college-textbook market was challenged by the growth in online textbook-rental companies. Given their leverage, both Houghton and Cengage were forced to declare bankruptcy and restructure. It was your classic example of “good business meets bad balance sheet.” Houghton came out of bankruptcy protection in 2012 and came public in 2013. Cengage emerged in the middle of 2014.

The K-12 and college markets each have three competitors with most of the market. This is an attractive industry structure. Schools and professors are rapidly accelerating their use of digital materials in the classroom. In Texas, 70% of Houghton’s best-selling math program was sold as digital content. At Cengage, digital content was 19% of total sales in 2014. According to professors and research studies, students learn better using digital content. In the college market, many classes have required purchases of digital material for homework and at-home quizzes. The shift improves profitablity as you don’t need to print and warehouse books.

How does the GAAP accounting work?

Witmer: When a print textbook is sold, the revenue and costs are recognized in today’s income statement. When a digital product is sold, revenue must be deferred over the lifetime of the contract, usually six years, while most of the cost is incurred in the current period. In the first three quarters of 2014, Houghton’s GAAP revenue has increased 3%. Billings, which combine reported revenue and deferred revenue, are up 25%. As a significant part of deferred-revenue growth comes from digital-product sales with minimal incremental costs, reported earnings significantly understate true earnings power. The correct adjustment is to add back most of the increase in annual deferred revenue, less estimated costs and taxes.

GAAP also penalizes the reported earnings of these companies with large amortization charges. These are accounting charges and don’t involve the outflow of cash. They are tax-deductible. We add back the charges, resulting in a 2014 estimate of $1.60 to $1.80 a share in after-tax free cash flow for Houghton Mifflin. The company has said that it will generate close to $2 share in cash in 2014.

What are reported earnings?

Witmer: They were a negative 20 cents for the first nine months of 2014.

Demand for textbooks in 2014 was higher than industry expectations. But national spending per student in the K-12 market is near historic lows. Spending is about $55 per student, up from a postrecession low of $47, but below a 10-year average of $62. With 55 million students and a market share of 42%, an incremental $5 per student could add 30 cents a share to Houghton’s earnings. A $5 increase is reasonable as municipal budgets improve. Houghton is also working to sell supplemental learning materials directly to parents. This could be a big and profitable business. We value Houghton at 14 to 15 times adjusted earnings. Our target price is $26 to $28 a share, up from $18.50.

Cengage’s adjusted earnings are about $2.60 per share. The stock is $23. The company recently paid a special dividend of $3.85 a share dividend. We value the business at 12-13 times earnings, or $31 to $34 a share.

Black: Does Houghton still have a trade-book division?

Witmer: Good memory — they do. This pick is really about the growth of digital revenue, with 20% fewer associated costs, and the drought of spending reversing in pre-K to 12.

Thank you, Meryl

Closed-End Funds on the Cheap

January 10, 2015

“When the year is done, there will be minus signs in front of returns for many asset classes. The good times are over,” declared Bill Gross last week in his monthly missive from his new digs at Janus Capital. As for more specific recommendations, he said he was saving them for the Barron’s Roundtable, which convenes this week. The product of its labors will be offered for your pleasure and enlightenment, beginning next week.

Of course, most strategists have penciled in returns on the order of 8% to 10% for 2015 from equities, as they seem to every year. Last week’s violent action, however, served to remind investors that a roller coaster winds up where it started, which provides excitement for some, nausea for others, but minimal progress overall.

Given the prospect of such a trip through 2015, it’s better to pocket income regularly, says Mark Grant, managing director for taxable fixed income at Southwest Securities and, in his ever-self-effacing estimation, “the guy who got it right” for insisting last year that bond yields would fall and not rise, as virtually every major Wall Street seer had predicted.

With Mark still seeing the odds tilting to lower, not higher, intermediate- and long-term interest rates, he says getting and cashing the monthly dividend checks from an array of high-yielding closed-end funds is the best bet for investors reading these scribblings.

To be sure, Mark opined in much the same vein in this space about three months ago (“Running Out of Bullets,” Oct. 6). Since then, however, the junk market got hit by the downdraft in oil, which hurt many leveraged energy credits. That only makes the funds he recommended better buys, he contends. Their streams of income have continued, and one of his picks, the Babson Capital Global Short Duration fund (ticker: BGH), paid a handsome extra distribution of 58.73 cents per share at the end of the year. That’s in addition to its regular payout of 16.77 cents per month, which provided an annual yield of 9.8%, based on Thursday’s close.

In that assessment, he is joined by the veteran market seer, Byron Wien, who put out his 30th annual list of “surprises” last week, from his perch at Blackstone Group. He writes in his widely read tally that “the year-end 2014 meltdown in the high-yield market, as a result of the collapse in the price of oil, creates a huge buying opportunity.” As junk-bond yields fall back and their prices rise, “high yield becomes the best performer of the various asset classes as the U.S. economy continues to grow with no recession in sight.”

Mark is rather less sanguine about the economy, especially because of prospects abroad, and again departs from the consensus that the Federal Reserve is certain to rachet up short-term interest rates. His bottom line is that in a world of continued low yields and high uncertainties, the bird-in-the-hand income from closed-end funds yielding upward of 9% is unbeatable.

It is obligatory to reiterate the quirks that make closed-end funds alluring to investors and simultaneously less interesting to the Wall Street marketing machine. While mutual funds or exchange-traded funds may continuously issue and redeem shares, CEFs issue shares in an initial public offering, at which point the cash is locked up. After that, investors can buy and sell shares on a stock exchange, where the price can be above or below the CEF’s net asset value (more likely the latter.) Many are small-cap stocks and trade that way; limit orders are highly recommended when buying or selling, denizens of this corner of the markets advise.

The ability to buy assets at a discount to their dollar value is one of the great attractions of the asset class. So, too, is the ability to use leverage; that is, to borrow to buy more, higher-yielding assets and thus boost returns. That, of course, is a double-edged sword when prices decline or borrowing costs rise, moves that tend to happen simultaneously.

Mark, whose day job is to service his big institutional clients, emphasizes that he is personally invested in these funds. Moreover, he says, he is indifferent about price appreciation, per se; their generous flow of income in a yield-parched market is what he’s after. But, he adds, after seeing 40 years of cycles, he expects high-yield spreads to tighten (that is, yields to fall and prices to rise) after concerns about shale plays dissipate.

Among the names he’s willing to share with Barron’s readers is Prudential Global Short Duration High Yield (GHY), a fund with a 7.28% discount from NAV and a yield of 9.42% as of Thursday’s close, reports Over 59% of its portfolio was U.S-based as of Nov. 30, according to the fund’s Website, with the bulk of the holdings in the middle of the junk range (double-B and single-B ratings).

Pimco Income Strategy II (PFN) yields 9.75% with a discount of 3.05%. Also, it’s managed by Mohit Mittal and Alfred T. Murata, the team that took over the fund from Gross when he departed for Janus last year. Unlike the flagship Pimco Total Return open-end fund, PFN has few constraints other than a limit of 20% on securities rated triple-C or lower, found at the nether regions of the junk market.

Mark also has made a point to diversify away from the high-yield sector, while maintaining income. That drew him to NexPoint Credit Strategies (NHF), which can hedge its holdings, which are in equities, bonds, and asset-backed securities. The fund’s shares yield 6.36% and trade at a steep 14.76% discount.

Another diversifier is Brookfield Global Listed Infrastructure Income (INF). With a 6.7% yield and a 6.04% discount, the shares have been under pressure, owing to the portfolio’s energy exposure via long-haul pipelines and master limited partnerships, its two largest sectors, as of third-quarter filings.

Finally, Mark also likes the BlackRock Municipal Target Term Trust (BTT), whose discount has widened to 13.13% for a positive reason—the share price has lagged behind the steady rise in the NAV. The federally tax-free yield of 4.67% translates to a taxable equivalent of 7% to an investor in the 33% tax bracket and 7.73% for one in the top 39.6% bracket. This CEF differs from most in that it has a termination date—Dec. 31, 2030—when it aims to return $25 a share to investors, analogous to a bond’s payment at maturity.

None of these funds provides the excitement of high-beta babies in the stock market. But after a week like the past one, that might be more than welcome

2015 Update by agrawalsagrawals, 16 Jan 2015 20:22
Ideas by agrawalsagrawals, 13 Jul 2014 15:45
mcsqrmcsqr 07 Sep 2013 16:13
in discussion Soap Box / Stocks » Microsoft


Lenovo Attacks

Lenovo came out of nowhere to become the global leader in PCs. Now it's got its sights set on Samsung and Apple in smartphones and tablets.

Yang Yuanqing has succeeded where many others have tried and failed. In just eight years, the chairman and CEO of Beijing-based Lenovo Group has transformed the company from a little-known maker of personal computers into the No. 1 global PC brand, displacing a half-dozen would-be challengers along the way, including Acer, Asustek, Toshiba, and Sony . And even in a now-fading $200 billion PC industry, Lenovo (ticker: LNVGY) continues to gain market share at the expense of former leaders Hewlett-Packard (HPQ) and Dell (DELL).

At the same time, while Dell, HP, and others have struggled to gain purchase in smartphones and tablets, Lenovo has pushed itself into the No. 2 spot in China in smartphones, after Samsung Electronics (005930.S.Korea) and ahead of Apple (AAPL). Now Yang is out to conquer the world — again.

As of June, according to researcher IDC, Lenovo had a 7% share of the global "smart interconnected device market" — smartphones, tablets, and PCs. That's well behind Samsung's 24% and Apple's 14%, but it's almost twice that of the next largest player, HP, with 3.6%. "They've clearly broken away from the pack," says Bob O'Donnell of IDC.

Even as PC volume is expected to shrink to 315.4 million units this year, 9.7% below 2012's total, analysts see Lenovo's earnings rising 19%, to $758 million, or $1.40 per American depository receipt, on $37.3 billion in revenue, as sales shift to higher-margin products. For the fiscal year ending March 2015, analysts forecast earnings growth of 17%.

Lenovo is best-known in the U.S. for its ThinkPad laptops, the brand that it bought from IBM (IBM) for $1.75 billion in 2005.

Two years ago, Lenovo introduced its first tablets, under the ThinkPad name for enterprise customers and IdeaPad for consumers. Next year, it's expected to launch its first U.S. smartphone, further broadening its reach here.

But emerging markets are Lenovo's main source of growth. "In both tablets and smartphones, the market is shifting from the premium space to the mainstream and entry-level space, and from mature markets to emerging markets," Yang told Barron's in a recent interview. "In mature markets, the refreshment cycle becomes shorter and faster. This trend favors Lenovo because we are stronger in mainstream, we are stronger in emerging markets, and our development cycle is much shorter than our competition's," a benefit in mature markets.

For investors, Lenovo presents a rare proposition: a play on China's long-term growth; a computer company that's gaining scale, share, and profitability, even as it transforms itself into a maker of higher-priced, more profitable devices. That puts the company on the cusp of a change that will bolster margins and returns for investors. Lenovo ADRs, which have quadrupled in recent years to a recent $20, could climb to $25 in the next year as demand steps up for the company's smartphones and tablets. Barron's, it should be noted, was early in recognizing Lenovo's potential, having first written bullishly about the company two years ago, when the ADRs were just above $10 ("From China, the Next Great Tablet," April 25, 2011). Each ADR represents 20 Hong Kong–traded shares (992.Hong Kong).

MUCH OF YANG'S VISION depends on China, which accounts for 42% of Lenovo's sales and the bulk of its profits. It was there, too, that Liu Chuanzhi, a Chinese Academy of Sciences engineer, and 10 buddies founded the company in 1984 as a computer reseller, one of China's first entrepreneurial ventures. Ten years later, he promoted Yang, a 29-year-old salesman from the impoverished city of Hefei, to run the fledgling PC division, a hiring that the founder would later call a "risky decision." It paid off. Lenovo introduced its first laptop in 1996, then began distributing IBM software in China. Yang dumped direct sales and started using local distributors; he also cut prices to just above cost. Eventually, he was the major driver behind Lenovo's purchase of IBM's personal-computer division, which was three times as large as his company at the time.

Lenovo has thousands of retail outlets in China. Its PCs are available everywhere, and it's the top-selling brand by far. Its smartphones are sold through the same ubiquitous retail channels and via carrier agreements.

Like tablets, smartphones are a fairly recent addition to Lenovo's product line. They were launched in China in early 2010, but not made a priority until 2011.

"In China, they have deep distribution all the way down to Tier 6 cities. So it's not surprising they already have a significant position and are giving LG and Samsung a run for their money," says Roger Kay, president of Endpoint Technologies, a Massachusetts-based market-intelligence firm. "With phones in China, right away it gets growth across the revenue footprint," even if PC sales are challenged.

Yang has shifted his "attack strategy," which had a devastating effect in the PC market, to mobile devices. Last week, Lenovo introduced the Vibe X, a premium phone, at a trade show in Berlin.

Lenovo, which makes phones using Google's Android operating system, has introduced a number of firsts that made it popular with Chinese carriers. For example, it was the initial manufacturer to pitch smartphones at women. Apparently, Chinese women prefer big phones, which make their faces look smaller and "more beautiful." And with China Unicom, Lenovo pioneered smartphones priced below $200; China Mobile and China Telecom followed suit. That helped Lenovo compete against domestic rivals, including Huawei Technology (002502.China), ZTE (0763.Hong Kong) and Yulong, a unit of China Wireless Technologies (2369.Hong Kong), says James Wang, a Shanghai-based analyst for market researcher Canalys.

Lenovo has constantly upgraded components, taking chances on partners like chip maker MediaTek (2454.Taiwan), which supplied it with powerful new processors for its smartphones before shipping its chipsets to other customers. "By taking the risk of adopting the new system on a chip first, Lenovo enjoyed first-mover advantage to local competitors," relates Canalys' Wang. One popular phone, the K900, a huge device that some wags dubbed a "phablet," has made the leap from China to India. Observers speculate that this phone may be one of Lenovo's entrants in the U.S. market.

In China, consumers frequently upgrade their phones, and that taught Lenovo a lesson it brings to its ventures in new markets. The life of a phone is "maybe half a year," says Liu Jun, Yang's protégé, point man on phones, and leader of one of Lenovo's two new divisions that are driving the company's transformation. "That's why it's a much, much bigger market than PCs."

In the past year, Lenovo introduced more than 40 smartphone models in China. "We launch more new models every month," says Yang. "And most of them are manufactured in-house, which gives us a cost advantage and also a time-to-market and time-to-volume advantage."

In the fiscal first quarter, Lenovo produced 11.4 million smartphones, up threefold from the same quarter a year earlier, and 1.5 million tablets — quadruple the number a year earlier. For the full year, the company says it expects to sell 50 million smartphones and 10 million tablets. Lenovo says its new factory in Wuhan has the capacity to turn out 100 million smartphones and tablets a year.

Lenovo's ThinkPad tablets use Microsoft's Windows 8 operating system, while the IdeaPad uses Android. The company says that it would consider making a smartphone using the Windows Phone OS, depending on demand. Asked about last week's acquisition of Nokia's mobile-phone unit by Microsoft (MSFT), Yang comments, "We've said before that we expect industry consolidation. Microsoft is, and will continue to be, an important strategic partner. We will also compete with each other. This is the nature of our industry."

YANG, 48, HAS BEEN an able steward of what is arguably China's first global brand, ensuring that the halo from IBM's premium products didn't wear off. The company kept Lenovo as the brand for its consumer products; high-end enterprise PCs sport the ThinkPad brand. And he hired a roster of capable Western executives to help run the company. The corporate integration was so successful it was lauded by the Harvard Business Review.

Committed to leading a global company, Yang began learning English right after the IBM deal, studying with a tutor and watching endless hours of CNN. He brought his family to live near Morrisville, N.C., the site of IBM's former PC headquarters — and now one of Lenovo's two headquarters. English is the company's official language.

Known as YY to Lenovo's 30,000 workers, Yang is a popular leader. At a recent meeting in nearby Raleigh, attended by thousands of Lenovo's sales employees in the Americas, workers were enraptured by Yang's vision for the company. "It's your turn" for applause, he told them. He also has the populist touch. Last year, he gave his $3 million bonus to employees. He did the same again just last week. He can easily afford to: His 7% stake in the company now is worth $700 million.

It was Yang who yanked Lenovo back from the brink with his Protect & Attack strategy, introduced right after the 2008 crisis. Under Protect & Attack, Lenovo would protect markets like China that were cash cows, and attack fast-growth geographies and new products. Attack businesses are expected to grow at twice the market rate, but even protect categories must grow faster than the market. Lenovo requires profitability only once a category has reached double-digit share.

For employees, Protect & Attack would become a mantra, a way to organize business planning. Says Beau Skonieczny, a computing analyst at Technology Business Research: "One of the biggest changes in the last couple of quarters is they shifted PCs into the protect mode," which will create cash to fund other operations.

Under Yang's new strategy, known as PC-Plus, Lenovo has shifted its "attack markets" to mobile devices. This spring, Yang reorganized the company to address its "attack markets" head-on. Yang believes that even the strongest contenders aren't invincible. Samsung successfully attacked the Apple ecosystem, demonstrating that Android could win. Gerry Smith, a former senior executive at Dell who now heads Lenovo's Americas group, says he and his colleagues knew what to do from there. "We know the playbook; we've done it on PCs," he says. "When I've seen Samsung be successful over the past couple of years, I've just smiled and said, 'This is great,' because this gives us an opportunity to go after the market leader. We can attack on scale. We'll attack on cost efficiency and speed. We can attack these guys from the bottom, and put a lot of pressure on them from a product portfolio, pricing, time-to-market perspective."

Samsung did not respond to a request for comment.

BY THE END OF THIS YEAR, Lenovo plans to introduce a raft of new products; last week it began with a new premium phone, the Vibe X. It has been pushing convertible devices like the IdeaPad Yoga, a tablet and PC amalgam: The IdeaPad is heavier than a tablet and has a shorter battery life, but offers more computing power. In the U.S., Lenovo sells it through Best Buy and Staples, where it dominated the Windows 8 personal-computer market late last year, with 29% of the $700-and-above machines and 49% of the $900-plus.

Lenovo maintains that tablets are transitional devices that will eventually converge with smartphones: Yang thinks anything with a seven-inch screen will be dubbed a tablet, while anything with a smaller one will be called a smartphone. That means consumers will choose products based on functionality (such as portability), rather than type of device.

While the global market for PCs may have peaked, demand is stabilizing in China, and enterprise customers need to refresh their machines. Yang expects an additional quarter of weakness in the global PC market, perhaps two, and then stability.

In the U.S., the PC remains the primary computing device for most people. A recent IDC study showed that individuals spend half of their time on PCs, versus 30% on smartphones. And 54% of the Millennials — people born between 1977 and 1994 — plan to purchase a PC in the next year. "We sold black boxes to CIOs; now we're selling to 18-to-24-year-olds," says David Roman, Lenovo's chief marketing officer.

"You can't call the PC irrelevant," says Tim Bajarin, president of Creative Strategies, a San Jose, Calif., consulting firm, who also serves on an advisory council for IBM and Lenovo. "It's such a workhorse in business, in education, and it plays a role in people doing their bills, kids writing reports, managing their media, stuff you could never do with a tablet."

The rap against Lenovo is its razor-thin profit margins. Its operating margin is 2.4%, under the 5.4% of troubled Dell and far, far below Apple's 29%. Yang has vowed to add at least a point. And earnings will pile up as the company continues to drive PC-Plus. Smartphones are a fatter-margin business than PCs, and people buy them more frequently.

Servers and storage, which account for just 3% of Lenovo's sales, could also boost profits. With Lenovo's goal of getting to a double-digit share in each of its businesses, an acquisition seems inevitable. Lenovo was negotiating to buy IBM's low-end X86 server system this year, which has much higher margins than Lenovo, but it's understood that Big Blue wanted a much higher price than the Chinese outfit was willing to pay. Those talks appear to be on ice for now, but could revive.

LENOVO BULL JAMES WEIR, a portfolio manager at Guinness Atkinson Funds, says the performance of the company's core businesses is heartening. "They are gaining market share in a very flat market for both desktops and notebooks. The potential for rerating is in the smartphone and tablet businesses," which accounted for 14% of revenue in June, up from 11% in December. Profitability in the businesses — Lenovo is already in the black in Chinese smartphones — will drive earnings higher. "If Lenovo can keep growing this, they can earn the right to be rated with Apple and Samsung as a sexy consumer electronics player, not just a PC box seller. What P/E would investors pay for a 'Chinese Apple'?" Weir asks.

Yang points out that Lenovo has a market value of $10 billion. "What is Apple? $400 billion?" (A recent run has put it closer to $450 billion). That puts the U.S. tech giant at 45 times Lenovo's market value. Some who believe in Lenovo's strategy argue that the company can eventually rival Apple or Samsung in size

Preposterous? Perhaps not.

Muses Peter Hortensius, an IBM veteran who oversees Lenovo's high-end PC-Plus efforts: "If you thought back to 2009 and heard us say, 'Hey, we are going to take on HP and Dell,' people would have said, 'C'mon, no way.' Four years from now, we'll be sitting here, and the battle will have been fought. I'd like to think we'll be successful at it."

Lenovo by mcsqrmcsqr, 07 Sep 2013 16:13

//At less than 12 times projected profits of $2.76 a share in the company's fiscal year ending in June 2014, Microsoft's shares look appealing. The effective price/earnings is even lower since Microsoft is sitting on net cash and investments of $72 billion, or more than $8 a share. The stock yields 2.9%.

Microsoft is expected to lift its dividend in mid-September. It also will hold its annual financial analyst meeting on Sept. 19. Investors will be watching to see whether the dividend gets boosted more than the expected 15%, which would be viewed favorably, and whether the company is willing to commit to a more ambitious share-repurchase program than the modest plan now in place.//


It's the Shareholders, Stupid

Microsoft's reputation for overpaying for big acquisitions seems sadly intact with its $7 billion Nokia deal. How a disciplined financial leader could create enormous value for shareholders.
Just when it looked as if Microsoft might be on the verge of focusing more on shareholder returns than on dubious strategic initiatives came the news last week that the company is paying $7 billion for Nokia's ailing mobile-phone business.

That deal deflated Microsoft shares (ticker: MSFT), which had appreciated in late August on the surprise announcement that Steve Ballmer, the longtime CEO whose many missteps and high-handed approach with investors made him unpopular on Wall Street, would be stepping down ("The Long Goodbye," Aug. 26, 2013).

Microsoft shares fell 7% last week, to $31.15, below their recent high of $35 reached after the Ballmer news.

CEO Steve Ballmer's acquisition of Nokia's mobile-phone business will saddle his successor with $19 billion in new costs and 32,000 new employees.

Investors shouldn't despair because beneficial change appears to be coming at Microsoft, albeit more slowly than many shareholders would like. An activist investor, ValueAct Capital, was recently offered a board seat, and it's a good bet that the firm will push for a larger return of capital to shareholders through a much larger share- repurchase program and a higher dividend.

At less than 12 times projected profits of $2.76 a share in the company's fiscal year ending in June 2014, Microsoft's shares look appealing. The effective price/earnings is even lower since Microsoft is sitting on net cash and investments of $72 billion, or more than $8 a share. The stock yields 2.9%.

Microsoft is expected to lift its dividend in mid-September. It also will hold its annual financial analyst meeting on Sept. 19. Investors will be watching to see whether the dividend gets boosted more than the expected 15%, which would be viewed favorably, and whether the company is willing to commit to a more ambitious share-repurchase program than the modest plan now in place.

"Investors have wanted Microsoft to reduce its exposure to a declining consumer space and focus on its stronger enterprise business and pay out more cash in the form of share repurchase and dividends. Management succession was thought to help in this regard, but the Nokia deal doubles down on the cost structure for the consumer business and makes it more difficult to reduce costs," wrote Nomura analyst Rick Sherlund in a client note.

Sherlund told Barron's that "not even a mother could love" the Nokia deal, which gives Microsoft ownership of its cellphone partner; Nokia's Lumia smartphones are powered by Microsoft's Windows Phone operating system. Without Nokia, the Windows Phone OS likely would have gained little traction. As it is, Windows has just 4% of the smartphone market, which is dominated by Apple and Google's Android platform.

Nokia's mobile-phone business is losing money. Microsoft is projecting the deal will dilute earnings in its current fiscal year by eight cents, or almost $700 million, after taxes. Microsoft hopes the business can break even in fiscal 2015, but that assumes market-share gains and cost-cutting initiatives that may be tough to achieve.

THE NOKIA DEAL ALSO raises the prospect that Stephen Elop, the Nokia CEO who previously ran Microsoft's successful business division, could succeed Ballmer. Elop, who will rejoin the software giant, isn't an investor favorite, due in part to Nokia's weak financial performance. One potential CEO candidate with a strong operational background who likely would play well with investors is Sanjay Jha, the former CEO of Motorola Mobility, which was sold to Google in 2012. Jha was dealt a tough hand given Motorola's wireless-phone woes, but he played it well and orchestrated the Google sale at a nice price.

What bothers many investors is that Microsoft continues to make strategically and financially questionable acquisitions when it could be aggressively buying back its own shares. "The most attractive thing Microsoft can buy is its own shares," says an investor.

The company paid $8.6 billion for Skype in 2011, and it's unclear what kind of returns that has produced. Another large deal, the $6 billion purchase in 2007 of aQuantive, an Internet marketing and advertising company, was a bust, with Microsoft writing down the purchase price in 2012. An investor likens the Microsoft acquisition strategy to "science experiments."

Microsoft's share buyback has been modest at $5 billion in each of the past two fiscal years, relative to its earnings power of more than $20 billion and its enormous cash reserves of $77 billion; it has just $16 billion of debt. Microsoft also has $11 billion of equity and other investments. The buybacks have made only a small dent in Microsoft's share count, which stood at 8.4 billion at the end of June.

Microsoft has returned about 60% of its earnings to shareholders in the past two years via dividends and buybacks.

ONE MODEL FOR MICROSOFT is IBM, which been able to generate nice shareholder returns from a low-growth business due in part to heavy share buybacks. IBM bought back $12 billion of stock in 2012—more than double that of Microsoft—with a smaller earnings base. Over the past three years, IBM (IBM) has returned about 100% of its profits to investors via dividends and buybacks.

It has been tough for investors to influence Microsoft management because of the company's sheer size and the difficulty in amassing a meaningful stake. That is changing with ValueAct's emergence in the spring as a Microsoft holder. ValueAct holds less than a 1% stake, but that investment understates its influence because it appears to have the support of some large Microsoft holders.

ValueAct and its chief investment officer, Jeff Ubben, haven't unveiled a Microsoft playbook—the firm prefers to operate quietly—but Sherlund thinks it may involve a push for Microsoft to borrow heavily against its overseas cash hoard to fund a large share-buyback program and a willingness to pay U.S. taxes on foreign-sourced income in order to pay a higher dividend.

One reason investors aren't crazy about the Nokia deal is that it adds 32,000 employees and a roughly $19 billion annualized cost base to Microsoft, which already has nearly 100,000 employees and about $50 billion of annual expenses. The added staff and expenses will make it tougher for Ballmer's successor to cut expenses.

Microsoft's independent directors may be receptive to the ValueAct agenda, Sherlund says. A key director among the current nine could be Seagate Technology CEO Steve Luczo, who joined the board last year.

The Bottom Line

Microsoft could be attractive if it follows the lead of outside director Steve Luczo, CEO of Seagate, and aggressively returns cash to shareholders.

Seagate (STX), one of the two leading makers of disk drives along with Western Digital (WDC), is similar to Microsoft in that it's in a relatively mature business threatened by declining PC sales and potential new storage technologies. Luczo's financial strategy has been to aggressively return cash to shareholders through its dividend, now nearly 4%, and a large share-repurchase program. Seagate shares have responded, tripling in the past three years.

There's an enormous amount of value that could be realized in Microsoft despite its well-documented challenges. What the company needs is a leader who will make disciplined financial decisions and deliver for shareholders. One of its own directors has even shown the way

mcsqrmcsqr 07 Sep 2013 12:18
in discussion Soap Box / Stocks » Microsoft

Bottom Line: Fair value for Nokia's stock is about $7 per share, analysts say, but that seems conservative.

Barron's | International Trader - Europe| SATURDAY, SEPTEMBER 7, 2013 | By JONATHAN BUCK

Sans Phones, Nokia Could Be a Winner Again

The company has a chance to prosper as a wireless-equipment maker.

Nokia's shares jumped last week following the sale of the Finnish company's handset business to Microsoft —and they could go higher still.

How much higher will depend on the strategic direction Nokia (ticker: NOK) decides to take when the deal with Microsoft (MSFT) is completed. It also depends on what Nokia decides to do with the 7.8 billion euros ($10.23 billion), from the deal—along with the cash it already has on its balance sheet—which will swell its coffers. The company will probably use some of that cash for acquisitions, but it has indicated that "excess capital" will be returned to shareholders.

Investors can expect a special dividend or a return to regular dividends, but they shouldn't get too excited: Nokia has served up more than its fair share of disappointment in recent years. However, if Nokia sets aside about €5 billion for acquisitions and investments, it could return €2.5 billion to shareholders. Based on the number of shares outstanding, it would be equivalent to a yield approaching 15%.

At midday Friday, Nokia's American depository receipts were trading at $5.35 in New York, up about 37% on the week. It's a juicy return for short-term investors, but it's scant consolation for anyone who has held the stock over the longer term. The ADRs fetched more than $50 in 2000.

JUST A FEW YEARS AGO, NOKIA held a dominant share in the global market for handsets, but technological missteps have turned it into an also-ran behind nimbler smartphone makers Apple (AAPL) and Samsung (005930.Korea), whose devices offer slick operating systems with a variety of cool apps. Nokia hitched its wagon to Microsoft to promote a Windows-based operating system, but this has been slow to catch on. Microsoft will soon have sole charge of the hardware, as well as the software.

Nokia shareholders should be happy to let Microsoft go it alone. Nokia's handset business has been burning through hundreds of millions of euros in free cash flow every quarter for the past 18 months. History shows it is hard to play catch-up in the technology sphere—a message not lost on BlackBerry (BBRY). Nokia has reinvented itself before; it can do so again.

With the completion last month of the purchase of Siemens' (SI) stake in their joint venture Nokia Siemens Networks, Nokia is becoming primarily a provider of wireless equipment, competing against L.M. Ericsson Telefon (ERIC) and China's Huawei Technologies. It also will retain its mapping and location-services business, and technology-development and licensing operations, which include its portfolio of patents.

Fair value for Nokia's stock is about $7 per share, analysts say, but that seems conservative. The bulk of Nokia's worth is made up of the anticipated cash pile and the value of the Nokia Solutions & Networks (NSN), as it is now known. Société Générale ascribes zero value to the mapping business. Even though its software is available in four of five cars with pre-installed mapping devices, it generated profit of only €3 million in the first half of 2013.

The patent portfolio is equally difficult to put a price on. Nokia has an estimated 20,000 granted or pending patents. Nortel Networks (NRTLQ) sold about 6,000 patents in 2011 for $4.50 billion. That suggests Nokia's patents could be worth as much as three times that amount. Nokia currently earns about €500 million a year from licensing its patents to rival handset makers.

NOKIA'S SALES ARE ESTIMATED at about €14 billion in 2015, the first full year of operation without the handset business. That's down from previous estimates of more than €26 billion. In spite of that, Credit Suisse reduced its profit forecast only 18% because the network-gear business is more profitable. Sales were over €30 billion in 2012, and Nokia lost 84 European cents a share.

Nokia Solutions & Networks is a key supplier to carriers in Europe and developed markets in Asia, including Japan and South Korea, but it lacks scale in the U.S. and China. Nokia could remedy this by spending some of its war chest on Alcatel-Lucent's (ALU) wireless business, which looks like a good fit for NSN. Alcatel-Lucent is a major supplier to the U.S.'s three largest carriers, Verizon Wireless, AT&T (T), and Sprint (S), as well as to China Mobile.

The timing could be perfect for Nokia. Alcatel-Lucent this summer announced a strategic overhaul that will include the sale of some operations. On Aug. 28, it appointed a former investment banker as its new chief financial officer, raising the possibility of a breakup. Investors expect Nokia to take a closer look: Alcatel-Lucent's ADRs climbed about 20% last week, in anticipation of a deal with Nokia.

NOKIA by mcsqrmcsqr, 07 Sep 2013 12:18

The Return of the 5% Muni Bond


The recent selloff in the bond market has left municipal bonds at strikingly attractive levels. How to find yields equivalent to 8% on taxable bond.

[ Recommedations and Symbols]

The sharp selloff in the municipal-bond market has produced 5% yields on many long-term issues, up from about 3.5% at the start of this year.

Yields are even higher—at about 7%—on many closed-end muni funds that boost their yields with some financial leverage. Intermediate-term munis with 10-year maturities are yielding about 3%, and so is the largest muni open-end fund, the Vanguard Intermediate-Term Tax Exempt (ticker: VWITX).

Munis look good relative to U.S. Treasury bonds, high-grade corporates, and junk bonds. Perhaps more important, absolute muni yields finally are looking appealing.

"If you have a diversified portfolio, you probably should have a fixed-income allocation, and munis offer some of the best relative value in the bond market, especially given higher tax rates this year" says John Loffredo, a co-manager of the MainStay High-Yield Municipal Bond fund (MMHAX).

He points out that a key index of triple-A-rated munis with 30-year maturities was yielding 4.33% last week, versus a 30-year Treasury yield of 3.85%. Most long-term munis yield appreciably more than this index. It's unusual for munis to yield more than Treasuries—they often yield roughly the same, or even less, thanks to the tax advantage.

In the nearby table, we show two high-grade long-term issues that last week yielded about 5%—a California 5% general-obligation bond due in 2041 and a Los Angeles airport 5% revenue bond due in 2040. Just last week, a new muni issue from the Philadelphia Water and Waste Water Authority had a top yield of 5.22% for a 30-year issue. Loffredo and others say 5% muni yields often stimulate interest from retail investors.

And remember, a 5% muni yield is equivalent to more than 8% on a fully taxable bond for someone in the top 39.6% federal tax bracket (we aren't even including the 3.8% Medicare surcharge). That's more attractive than junk bonds, where yields now average about 6.3%.

Junk bonds do have shorter maturities, but many 10-year munis are yielding over 3%, which is equivalent to 5% on a taxable bonds. Long-term munis also stack up well against stocks, assuming total returns on stocks (appreciation plus dividends) revert in the coming years to their historic norm of 7%. That equity return is before any taxes on dividends or capital gains.

Now, a word of caution: The muni market has never been especially liquid, and trading is even trickier in the wake of new, postcrisis regulations for Wall Street firms. The upshot: wide bid-ask spreads, especially for relatively small trades of less than $1 million. As a result, many pros advise individual investors to stick with mutual funds or exchange-traded funds. Another alternative is to buy new-issue munis (which don't carry any commissions) and hold them until maturity.

The recent drop in the muni market reflects a decline in the Treasury market, persistent outflows from muni open-end funds, and credit jitters in the wake of Detroit's bankruptcy. But as Loffredo points out, muni credit quality has generally been improving, thanks to stronger tax revenues nationwide. There have been some important recent credit-rating upgrades, including California and the Atlanta water system.

Under Pressure

The iShares municipal-bond ETF is down nearly 10% since the start of the year.

LONG-TERM MUNI-BOND funds have been hit this year, often declining 5% or more. The losses have been even steeper among closed-end funds, which are traded like stocks, with most changing hands on the New York Stock Exchange. Many closed-end funds are down 15% to 20%, hurt by the drop in muni-bond prices, financial leverage, and widening discounts to net asset value. The typical muni closed-end fund has about $3 in assets for every $2 of shareholder equity, meaning a dollar of borrowings.

A group of Nuveen closed-end funds, including the Nuveen AMT-Free Municipal (NEA) trade at roughly 10% discounts to NAV and yield about 7%. Investors would have to buy a speculative junk bond yielding 11% to 12% in order to get a similar tax-equivalent yield.

The largest muni ETF, the iShares National AMT-Free Municipal (MUB), offers fairly good liquidity, thus facilitating traders. The ETF can, however, trade at a discount to its NAV in difficult markets like those recently. It traded on Friday at about $102 and yielded about 3%.

Loffredo says munis are in the "eighth inning" of their decline. In fact, they already appear to be anticipating higher Treasury yields. This suggests that further downside may be limited, absent a big drop in the bond market. In short, this could be the time to dive into munis.

Grupo Televisa (TV)
RakeshARakeshA 19 Aug 2013 10:38
in discussion Soap Box / Stocks » Emerging Markets

A Terrific Story of Its Own

Grupo Televisa, a global power in Spanish-language TV melodramas, offers a lot to investors, including a big stake in Univision. Televisa's shares could hit $35, 27% above its recent quote, if Univision goes public.

With strong cash flows and solid prospects, Televisa looks cheap.

Recent Price $27.50
52-Week Chg 17%
Market Val (bil) $15.8
EPS 2013E $1.13
EPS 2014E $1.20
P/E 2014E 22.9
EV/EBITDA 2013E 7.0
E=Estimate Source: Thomson Reuters

For the first time, the television network most watched in the month of July by the most coveted viewers — 18-to-49-year-olds — was the Spanish-language broadcaster, Univision Communications. ¡Que!

Known for its wildly popular telenovelas, or prime-time romantic melodramas, and its variety shows and sports programs, upstart Univision beat bigger English-language rivals ABC, CBS, NBC, and Fox. Univision and its original programming benefited from those broadcasters' heavy reliance on summer reruns, and the absence of regular NFL games, which won't resume until September. Still, the fifth-ranked broadcaster in terms of overall viewers is making inroads. It's the only major broadcaster attracting new viewers — and for the first time ever in any first quarter, Univision was No. 4 among the 18-to-34 set, ahead of NBC. (Image:
Racy telenovelas, filled with sex, romance, and melodrama, have figured heavily in the success of Univision, 38% of which is owned by Mexico's Grupo Televisa.)

In another first, Univision ranked No. 1 among 18-49-year-olds on Friday nights in the first quarter, well ahead of No. 2 ABC. As Hispanic America's favorite broadcaster, the privately held, Manhattan-based Univision is in a sweet spot. Called the "new influentials," Hispanics equal 17% of the U.S. population and have accounted for more than 55% of its growth since 2000. Advertisers increasingly are courting them.

This is great news for shareholders of Grupo Televisa (ticker: TV). The Mexico City–based media conglomerate owns 38% of Univision. It also produces those beloved telenovelas, including the hit Que Bonito Amor, about a Los Angeles car dealer, falsely accused of money-laundering, who finds love under a new identity as a mariachi singer in Mexico. Many expect Univision, which was taken private in 2007 by investors including its chairman, Haim Saban, Madison Dearborn Partners, and Providence Equity Partners, to go public again in a few years, a potential bonanza for Televisa.

"Univision is an enormous hidden asset" of Grupo Televisa, says Larry Haverty, portfolio manager of the Gabelli Multimedia Trust closed-end fund, which owns Televisa shares. He sees them hitting $35 if Univision goes public — 27% above the recent quote of $27.50.

With an average weekday prime-time audience share of a whopping 70%, Televisa is Mexico's largest TV broadcaster. Its four main networks generate almost half of its operating profits, which totaled roughly $1.4 billion last year. It's also the globe's largest provider of Spanish-language content, followed by TV Azteca and the Telemundo unit of Comcast (CMCSA), exporting programming to 50 countries.

Using the enormous cash flow generated by its broadcasting side, Televisa has become a force in the pay-TV market, as well. Cable and satellite contribute about one-third of total operating profits, generate a recurring revenue stream, and boast strong growth potential. Through Sky Mexico, a direct-to-home satellite venture with DirecTV (DTV), as well as stakes in cable firms Cablevision (CVC), Cablemas, and TVI, Televisa's share of its homeland's pay-TV market is about 75%. The media giant also has a 50% stake, acquired last summer, in cellphone provider Iusacell.

Total revenue has been steadily rising and should hit about $5.7 billion this year, up from $5.4 billion in 2012. Profits should come in at $1.20 a share in 2014, up from $1.13 this year. Last year, the company earned $1.17.

Mexico is striving to be more attractive to foreign investors. And, says Christopher Marangi, a Gabelli & Co. analyst: "Televisa will be a surrogate for growth in Mexico."

Televisa's shares look cheap, compared with those of other content-rich media outfits such as Walt Disney (DIS), Twenty-First Century Fox (FOXA), Discovery Communications (DISCA), and CBS (CBS). Televisa fetches about seven times enterprise value to Ebitda (earnings before interest, taxes, depreciation, and amortization), while its peers trade at 10 times or more. Comcast, in contrast, commands about 7.5 times EV/Ebitda.

Televisa is Morgan Stanley analyst Michael Morin's top pick among Latin American tech, media, and telecom stocks. He argues that the shares would be fairly valued at $32 on a sum-of-the-parts basis and possibly as much as $41 if Iusacell narrows its losses, Univision's ratings keep rising, and Univision's debt load is shrinking. Morin suggests that Televisa also may boost its Univision stake above 50%.

Weighing on Televisa is concern about reforms aimed at adding competition in Mexico's telecom and media markets. New rules obligating it to distribute its over-the-air channels to pay-TV providers without charging retransmission fees will crimp revenue. Still, with Televisa's large grip of the pay-TV base, the rules are likely to lower its costs and boost margins. And if two new national broadcast networks are created, as currently envisioned, they'll need programming, and Televisa could sell them some of it. And telecom reform probably will enhance the value of Televisa's investment in Iusacell, at the expense of Carlos Slim's American Movil (AMX), which now dominates Mexico's mobile and fixed-line networks.

Viva la Televisa!

Grupo Televisa (TV) by RakeshARakeshA, 19 Aug 2013 10:38
Strayer Education STRA by RakeshARakeshA, 28 Jul 2013 22:40
RakeshARakeshA 28 Jul 2013 17:23
in discussion Soap Box / Stocks » Chinese Stocks

Beijing's Gift to Banks, Brokers |Emerging Markets | By SHULI REN | MORE ARTICLES BY AUTHOR

At last there's some reprieve for China's brokers and bankers from the unremitting headlines about a devastating credit crunch. Beijing is going to relax some investment restrictions and is expected to reopen the local markets to initial public offerings, which should be welcome news to investors in the country's shares, particularly financial stocks.

On July 12 the government said it would nearly double the quota for the Qualified Foreign Institutional Investor program, which allows foreign investors to buy stocks and bonds of mainland companies traded in Shanghai, also known as A shares. The limit will rise to $150 billion from $80 billion. That isn't a huge portion of the market, but marks a substantial leap forward, considering the limit was just $20 billion in 2011, almost a decade after the program's inception in 2002.

Beijing also said it would permit financial institutions in Singapore and London to raise money in renminbi, via so-called dim-sum bonds, and use the proceeds to invest in China. A British bank, for example, could raise money in renminbi that it could use to create wealth-management products for its clients. Currently, only Hong Kong and Taiwan have such privileges, which help expand and diversify China's funding sources.

THROUGH THESE MEASURES, China hopes to revive its domestic stock markets. The benchmark CSI 300 Index lost 32% of its value from its mid-2009 high to 2012. The CSI has fallen another 10.9% this year, but rallied 1.4% after the news.

At the same time, China is expected to reopen the IPO market as soon as the end of July after shutting it last November to limit supply and tighten up on due diligence. Already, more than 700 companies are queued up for public listings. JPMorgan estimates the monthly capital demand is about 30 billion to 37.5 billion renminbi ($4.86 billion to $6.11 billion) in the next 12 months, at least 12% above 2012's level of equity underwriting.

More capital inflow means more business and better earnings for brokers and large banks that take deposits and clear transactions in renminbi overseas. China Galaxy Securities (ticker: 6881.Hong Kong), the largest securities broker measured by client accounts, is the purest play on the securities business in China. Galaxy trades at 13.3 times its consensus 2013 earnings per share, cheaper than its Hong Kong-listed competitors, Haitong Securities (6837.Hong Kong), which trades at 17.4 times 2013 estimates, and Citic Securities (6030.Hong Kong), which trades at 23.4 times.

Compared with its peers, Galaxy has a simpler business model and cleaner balance sheet, generating 77% of its total net revenue from its brokerage business and little from proprietary trading—an important measure of safety. In a bullish initiation of coverage last month, JPMorgan estimated Galaxy's earnings to grow by strong double digits in the next three years, reversing a 10% decline in 2012. JPMorgan sets a December 2013 price target of 5.70 Hong Kong dollars (73 U.S. cents) for Galaxy, about 15% above its current market price.

Analysts like China's four big banks for their balance-sheet resilience to nonperforming loans and implicit "too big to fail" government backing. Based on liberalized capital rules, ICBC (1398.Hong Kong) and Bank of China (3988.Hong Kong) are the best bets. ICBC, which trades at just 5.6 times 2013 earnings, was appointed as the settlement bank for Singapore; Bank of China, trading at five times, will handle the Taiwanese clearing business for China. Analysts' consensus is that each bank's shares are worth 20% more than recent levels.

Brokerage/Banks by RakeshARakeshA, 28 Jul 2013 17:23
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