Word on the Street: Cautious Optimism
Eagle Asset Management
By Eagle portfolio managers
January 21, 2011
Eagle’s portfolio managers gather formally on a semiannual basis to discuss the current market situation, what they are doing in their portfolios and what they see going forward. The managers discussed topics – including healthcare and financial reform as well as mid-term elections – in this most recent roundtable that may set the economic horizon into 2011.
Broad economic data has been mixed through 2010 and eyes around the world remain on the global economic recovery. Our managers discussed the long-term impact of the Federal Reserve’s efforts to stimulate economy, why the United States will not be the “next Japan,” the mood among company executives and how they have investment portfolios positioned.
Present for the most recent roundtable were Richard Skeppstrom (Large Cap Core); Todd McCallister and Stacey Serafini Thomas (Small/Mid Cap Core); Bert L. Boksen and Eric Mintz (Small Cap Growth and Mid Cap Growth); Jack McPherson (Small Cap Core Value); David Blount and Ed Cowart (Equity Income and Value); as well as James Camp (Fixed Income) and Cooper Abbott (Head of Investments), who served as moderator.
Moderator (Cooper Abbott, Head of Investments): Despite some still-sobering headlines and long-term concerns, there are signs of a recovery out there. What are company executives telling you about their perspectives on current business and growth?
Bert Boksen: In 2008 and early 2009, companies got lean and mean and reduced their cost structures and so they have been doing reasonably well in a relatively low-growth environment. Nobody I’ve spoken with is saying the economy is wonderful yet but is getting better.
Stacey Thomas: Most management teams are cautiously optimistic, but I have noticed one dramatic change from where we were a year or two ago: They are now willing to utilize their balance sheets. They want to put their excess capital to work.
In 2008 and early 2009, they were preserving capital. They were aggressively cutting costs, not expanding in any way. Now, we’re starting to see mergers-and-acquisitions (M&A) activity pick up and we’re also just starting to see some management teams increase their capital-expenditure forecasts as well. Now, I haven’t heard any aggressive hiring plans but at least there will be money going to work, which obviously helps.
Jack McPherson: A theme we’ve talked about for a while is that better companies can take advantage of this kind of environment and gain market share. Some of our companies tell us they’re getting calls from tiny companies that don’t have access to capital and they’re looking to sell. The economic weakness is allowing strong companies to gain assets.
The companies we talk to are feeling OK: not bad, not great. They are being very cautious with hiring but they are loosening up capital for some growth opportunities and acquisition opportunities.
Richard Skeppstrom: The same seems to be true among large-cap companies. I think they’re all hopeful. Most were extra-conservative, particularly with cash, and I believe that’s left many companies in better shape than we might have imagined two years ago.
Many management teams likely will remain cautious for some time, though, because there remains this economic dichotomy. Planes are full and New York hotels are booking at $600 a night. Affluent people have decided they’re still affluent and many are taking their vacations because life isn’t on hold while the economy muddles along. On the other hand, many of those same people are business owners who, in that role, remain wary that things still may roll over so they’re hesitant.
David Blount: The most interesting analogy I’ve heard compared the economy to a stock-car race running under a yellow caution flag. Maybe there was a wreck or two; now, most of the debris is cleaned up. All of the cars left in the race have been in the pits. They have full tanks of gas, new tires. They’re ready to go, but nobody has waved the green flag yet.
Moderator: Where do companies stand specifically on hiring? Have things changed for companies fundamentally when it comes to hiring considerations due to the new healthcare laws or increased globalization? Is this a cyclical thing we just must get through or is it a structural change?
McPherson: One of the current questions many companies had was, “What are the rules going to be?” Maybe the mid-term elections will help clarify that. A lot of companies have said, “We just need the government to be clear on where things stand with healthcare and the tax situation. Then, we can make decisions on hiring, on capital spending.”
Some jobs may not be coming back, though. Think about how many jobs were tied to real estate in the last recovery. Those aren’t coming back soon.
Todd McCallister: Okun’s Law, which really is a rule of thumb, suggests that if we continue to grow GDP (gross domestic product) by 2 percent-3 percent annually, it will take five or six years before we trim the unemployment rate to 6 percent. The challenge is that historically, we have seen recoveries with GDP growth in the range of 5 percent-6 percent for four or five quarters. And the best quarter we’ve had is 3 percent. And so we are faced with the question of whether this is a structural issue or a cyclical one.
Ed Cowart: The fact Jack pointed out – that so many jobs in the last recovery were real-estate-related – means we may face a structural obstacle to jobs recovery in some areas.
Moderator: Many of you said in the spring that one of the things you would be watching closely was the mid-term elections. It appears “change” was the theme again. Was the electorate voting for something, or against something? What were these mid-term elections really about?
McPherson: That’s a great question. I believe voters felt we had swung way too far to the left and they were concerned we were just going to continue on the path. That said, I believe it would be a mistake for the Republicans to presume they have a mandate that the country wants to go way right. It just didn’t want to get dragged way to the left.
If we can get some middle ground, which may be naïve on my part, I think it would be a good thing. Having the House tend one way and the Senate tend the other is probably not a bad thing. It might help keep people more honest in Washington.
James Camp: I think the expansion of government was on the table. There was a general feeling that government was too expansionary and that it had gone too far.
McCallister: It appears President Obama didn’t understand the timing of some of the things he was pushing. It felt to many people that Obama was trying to implement a style of European social democracy just as four or five of them (e.g., Portugal, Ireland, Italy, Greece and Spain) are really not working. I think the average citizen – forget about economists – said, “We don’t want to do that because it doesn’t seem to be working. America is a land of opportunity.”
Boksen: That healthcare bill really hurt the Democrats and it wasn’t just the bill itself. It was the aggressive pushing at the last minute. And now, there remains all this uncertainty about how it will be implemented.
Skeppstrom: The president lost a lot of the middle ground and independents when he so obviously wasn’t going to compromise on healthcare. It came across to many people as totally partisan and Obama lost credibility. That has not helped him in terms of his standing and I think it also translated to some anti-Democratic votes elsewhere.
Eric Mintz: I think the mid-term election definitely helped boost the confidence of many corporate-management teams. During my meetings with management teams over the past several months, I had begun hearing an increasing amount of unsolicited commentary that harshly criticized the policies of the Obama administration. So, I think there has been a sigh of relief in corporate America that Republicans took the House of Representatives.
Moderator: Obama had talked a great deal about bipartisanship, which never really materialized. Now, Congress is divided and many people say that might not be such a bad thing. What are your thoughts on legislative gridlock in Washington?
McPherson: Gridlock could be a bad thing if it means tax rates go up in 2011. It could be a bad thing if Congress can’t unwind some of the stuff that’s been created. But in general, I think it may be better to have gridlock because it means Congress can’t mess things up as easily.
Boksen: I think one of the things that has led to the stock-market rally is the perception Democrats may now be willing to compromise on tax rates. There likely will still be effects on high-income people but there has been toned-down rhetoric on capital gains and dividend treatments. There likely will be compromise there, and that’s very positive for the market.
Camp: Partisanship or bipartisanship may become the issue that will define whether we as a country continue to have a historically low interest-rate environment. People abroad look at the Federal Reserve’s second round of quantitative easing (the so-called QEII) and talk about extending tax cuts and they say, “They don’t get.” We’re going right down the path of what the Europeans have done.
It will be important for our national legislators to have an important compromise discussion on putting a plan in place that at least starts getting our fiscal affairs in order to reduce our long-term deficit.
Moderator: Healthcare is a sector where the equation clearly has changed due to “Obamacare.” There was some talk – and it may have been mostly election hyperbole – that if Republicans get in, they will dramatically cut the president’s legislation. Do you see that actually happening?
Cowart: The only way it will get repealed any time soon is if the Supreme Court decides to do that, and I think that’s probably unrealistic. The justices would have to say, “You can’t enforce this law.”
The reality is that the healthcare-reform law isn’t fully implemented until 2014. That’s a lot of time for it to be trimmed around the edges. Many people didn’t like the way the whole thing was handled but there are some very popular parts of the law that will stand up because people will howl otherwise.
McCallister: “Obamacare” is essentially a way to have 20 percent of gross domestic product (GDP) be healthcare.
Cowart: It’s not necessarily a bad thing if we decide as a nation that we are wealthy enough to spend 20 percent of our income to be healthier. That’s fine. But I would prefer that to be more of a free-market decision.
McCallister: We adopted a Massachusetts-style healthcare program that hasn’t worked except in one sense: more people are covered.
McPherson: More people are covered but the program has run – depending on what estimates you believe – about four times more than it was supposed to cost.
McCallister: I think that HMOs actually do some good on the margin because many people are being squeezed by medical costs. But it’s not palatable politically.
McPherson: The healthcare industry does face many challenges. A company doesn’t want to be told what it can and cannot make. But maybe there will be a lot more people enrolled in plans at some point and they recover in volume what they lost in pricing.
I do believe everybody realized that something had to be done – or would be done – and so companies that can be part of the solution (vs. adding high-price treatments) are going to benefit in the long run. The problem now is that it’s very hard to build a business or plan for the future if you don’t know what the rules of the game are.
Thomas: I was at a recent conference and a strategist was talking about the breakdown of our GDP. Of course, personal consumption is a percentage of that but government medical costs also get lumped in there. What was interesting is that personal consumption was 62 percent of GDP in 1960; now, it’s 70 percent. But, if you back medical costs out of that, the percentage – 55 percent – is actually DOWN from 1960. And that figure is in line with other developed countries.
The big factor has been increased medical costs, both for the government, by way of assistance programs, and individuals. Private medical costs (exclusive of government medical spending, e.g., Medicare and Medicaid) represent about 7 percent of overall GDP; that figure was about 3 percent in 1960. The government is going to bear a much larger share of that burden as we go forward.
Moderator: The Dodd-Frank financial-reform law also received a lot of press over the last year. Will changes in Congress, particularly in the House, have some effect on how much of that will ultimately be implemented?
Skeppstrom: I don’t know exactly how they will go about it but I think the Republicans will try to gut some provisions of it.
McPherson: In the meantime, though, there is confusion about the rules and that is never good for businesses. We were talking to a bank the other day and they said they’re still trying to figure out such things as reserve levels. In addition to potentially cutting the bank’s profits, its managers also are concerned about how the ripples from Dodd-Frank flow outward. If the bank earns less, it has less money to lend. Fewer loans mean fewer businesses have the opportunity to expand. The Dodd-Frank Act potentially fuels a negative cycle that crimps the overall economy even more than it helps protect consumers.
Moderator: The Federal Reserve’s second round of quantitative easing, which has become popularly known as QEII, is underway. What are likely outcomes and what do you think of those who suggest the United States could become the “next Japan” as a result?
McCallister: I hear the Japan story a lot but I’m not sure I buy it because there are significant differences.
Blount: Their real-estate bubble was about eight times larger than ours relative to GDP.
McCallister: Japan’s real-estate market started to crack in the late 1980s, right around 1990. The Japanese actually RAISED interest rates a few years after the real-estate market rolled over and it may have been seven or eight years into the recession before Japan made its QEII-type move.
We haven’t completely cleaned up our banks yet but I believe we’ve done a better job than they did.
Skeppstrom: There also are some cultural differences. At that time anyway, it wasn’t easy for individuals to start a business in Japan vs. starting one here. So, displaced people couldn’t get together in a garage and kick off some enterprise.
Further, the Japanese were savers. They seemingly were content to live off their savings rather than take on debt to re-inflate the economy.
Cowart: There has been academic work looking back over 500 years and the financial crises that have occurred in that time. These things happen. And, in the wake of virtually every one of those, there has been: small growth, reduced leverage and increased savings.
That’s what we, too, are facing. What makes the current situation different is that there never has been a global policy response like what we’re seeing now. I don’t think the Fed really knows what is going to happen but they’re trying. In that sense, it really is different this time around.
There is optimism in some quarters that we’ll see QEIII or QEIV if QEII doesn’t work. Something is going to get the economy going eventually. So it’s a gigantic financial science project that we’re engaged in right now and we’ll see what happens.
Moderator: Treasury Secretary Timothy Geithner has said QEII was not designed to weaken the dollar but, rather, to help rebuild individuals’ wealth. What do you think Fed and Treasury officials are trying to do?
Cowart: It’s kind of the only pill they have left.
Mintz: I definitely think an intended consequence of QEII was to benefit the stock market. It is hard to see a significant benefit to the economy by lowering the interest rate on 10-year Treasuries from 3 percent to 2.5 percent. Interest rates were already so low that it is hard to argue that lowering them further would help the economy. So, they must believe pushing people out on the risk curve and bringing money back into the equity markets is the only way to improve consumer net worth and also confidence.
In fact, Federal Reserve Chairman Ben Bernanke specifically mentioned the stock market’s favorable reaction several times in the Washington Post op-ed piece in which he defended the move. So, I think that’s a pretty good indication of what they’re looking at.
It appears the QEII is working when you consider that Bernanke actually laid out a good bit of his strategy in early August. At that point, the bond market swiftly priced in a good bit of his thoughts before QEII became official and, since then, economic data points have generally been coming in above expectations.
Camp: I think part of the game here is the Fed isn’t explicitly targeting inflation. And you’re not going to have inflation as a problem with 0.5 percent year-over-year consumer price index (CPI) numbers but we’re not going to solve our long-term debt problem. Maybe we can with 2 percent to 2.5 percent growth.
McCallister: It would be better for all of us if the Fed would re-inflate the economy. That’s tough with interest rates already at zero.
Blount: They may be targeting the consumer for some inflation. The correlation of the stock market and holiday retail sales is off the chart. Inflate our portfolios, people will spend for Christmas and it will boost the economy.
Thomas: The nation’s top income earners control 90 percent of the market so maybe, as investors, we target the high end of the consumer market.
Cowart: I believe the only asset that really matters in the big picture is housing prices.
Moderator: Let’s talk about that. The real-estate market broadly remains weak. But, even with historically low interest rates and the Treasury buying back mortgages via QEII, it seems like even qualified people are having trouble getting loans. What is happening in real estate?
Camp: I don’t think lower rates alone solve the real-estate problem but they may be a major stimulus.
Thomas: There are so many people who are not buying and have been afraid even to look for the last year or two. Perhaps, though, lower rates may help middle-income families who have continued to pay their mortgages even though their home values may be under water.
Mintz: I hope so. But the pendulum in the loan-application process has swung so far away from where we were a few years back when just about anyone could get a mortgage.
Skeppstrom: My main concern about real estate is that some analysts suggest there may be as many as 11 million homes coming on the market. Those houses are not just from people who aren’t currently making payments but also from those who may be so far underwater that they decide simply to walk away. That’s a lot in an already soft market.
Camp: That is what we call the strategic default phenomenon, where mortgage holders with significant negative equity behave like investors vs. traditional homeowners. That is, they decide, “OK, I’ve taken a loss but I’m going to cut my losses simply by walking away.”
McCallister: How things shake out depends on which numbers we use. Houses fall down and there are about 1 million new households every year. We may be able to work our way through 3.9 million homes – a common number I see for the existing inventory – for sale in three or four years. But it could take much longer if the “shadow inventory” – those houses in danger of going into foreclosure – is much larger.
Camp: I agree with that time line.
You know, one of the things the market has to deal with is the fact that the average mortgage rate in this country remains close to 6 percent. So QEII and historically low rates have yet to translate to improvements in the real economy. Refinancings, including for the reason Eric mentioned earlier, have not happened. The financial system is still in this balancing act between ensuring it has liquidity and extending credit, which it’s really still not doing for residential mortgages.
The one policy move that has been talked about but not enacted is for Washington to tell Fannie Mae and Freddie Mac, who control more than 90 percent of the mortgage market, “You are going to revalue all mortgage rates unilaterally by a certain percent.” I don’t believe there is a high probability that will happen but it is a way to keep the real-estate doldrums from continuing to linger.
McCallister: Our financial analysts would be busy around the clock for four or five weeks if that happens to discern which firms may do incredibly well under that scenario and which ones likely get smoked.
Thomas: If you bring this back to how housing may affect consumer spending, think about how many people may have been saving $1,000 to $1,500 dollars a month by not paying their mortgages.
Further, I believe there is potential for refinancing activity in the high end of the market and we haven’t necessarily seen any benefit of that yet in terms of spending. Another strategist I spoke with recently said he would ask rooms full of people in various meetings who had refinanced in the last month. And he said usually half the hands went up. Those who have high-quality credit can get sub-4 percent mortgages. That’s pretty darn attractive.
Mintz: It really hasn’t translated yet to spending. Debt levels across the board have come down dramatically in the last two years.
Skeppstrom: A lot of that, though, has just been in the form of loan write-offs.
Camp: Yeah, something like 50 percent of it.
Mintz: It’s still deleveraging.
Moderator: Let’s talk a little bit about QEII and the bond market, which has seen record inflows despite these historically low interest rates. The natural question is: Where do rates go from here and is this the way to help the economy?
Camp: We’ve kicked the proverbial can down the street with interest rates. We liquefied and, perhaps, solved the liquidity problem. We have paid down some private-sector debt levels. But there is still a lot of bad debt out there.
There at least has to be the appearance that there is meaningful discussion going on about our country’s long-term structural debt issues. As yet, we haven’t done anything about that issue. But this is where the challenge is: We are in real trouble if you jump rates on the 10-year Treasury to 4.5 percent. I think that’s what the world is looking at right now.
Mintz: Won’t the economy slow so dramatically if the 10-year Treasury goes to 4.5 percent that bonds would then rally and interest rates would come back in?
McPherson: Isn’t all this information already in the marketplace?
Camp: It’s hard to know. The 10-year Treasury was at 4 percent six months ago and it could easily get right back there. There have been difficult, even failed, auctions in the last handful of cycles. I don’t know which way it is going to break.
Frankly, I think 2 percent on the 10-year Treasury is as likely as 4 percent and we are now waiting for the next thing to tell us which way things will move. I think it could break pretty quickly.
Cowart: My concern is that we may gradually get to 4.5 percent but we look up a week later and we’re at 6 percent. It’s like the answer to the guy who asked his friend how he went broke: “Very slowly at first … and then all at once.”
Mintz: The position is: Don’t fight the Fed. The Fed is going to buy more Treasuries over the next seven months than China owns entirely so it seems like the Fed is going to have its way.
Camp: Until it doesn’t. I agree with that. But they must exercise caution or this will end badly.
McCallister: The Fed is only doing this because of the zero percent interest rate. Apparently, though, people are willing to take zero – or even less than zero – percent interest rates.
Camp: On TIPS (Treasury Inflation-Protected Securities, which are Treasury notes on which the principal adjusts with inflation) they are.
McCallister: This has been a boon, at some level, for the banking system but we continue to muddle along. We need to look forward. This is not 1937; our banking system is intact.
Boksen: It isn’t 1937 but we could see a repeat of the ’70s – 1973 and ’74 – when we had stagflation.
McCallister: One would have to believe that the bond market would make the same mistake twice – that is, allowing itself negative real rates of return on bonds as happened through much of the ’70s – to believe the stagflation theory. And are they that stupid twice?
Camp: I would make a point that the financial markets can recover in this kind of environment; however, people can’t recover. I’m worried. Commodities, bonds and stocks – all three – are up at the same time. I don’t know much but it feels like something is wrong.
Mintz: It is pretty interesting how somber this discussion is given that the market is actually doing quite well.
Moderator: The Fed’s quantitative-easing plan may be as interesting to the rest of the world as it is to us here. China, probably not surprisingly, has criticized it. Others in Europe especially, including Germany, have essentially asked: Why is it that the United States preaches austerity to us but isn’t willing to swallow the same bitter pill to address its issues?
McCallister: The Chinese clearly don’t like this because they want currency values to remain such that they can continue to be massive exporters.
Skeppstrom: QEII was designed, in my mind, to weaken the dollar and it’s scary to hear all the higher-ups in Washington deny it.
Mintz: Well, you can’t have a Treasury secretary promoting a weak dollar policy, right?
Camp: The only way to grow the economy is to export but the hard part is that everyone everywhere is trying to do the same thing.
Moderator: Do budget deficits matter? Are the markets focused on that? How big a deal is the deficit situation we’re facing right now?
McCallister: Mike Goldstein of Empirical Research Partners did a great report that showed, relative to history, we have a mid-to-high level of government deficit to government total debt. And he indicated there have been plenty of eras when countries have grown just fine for many years with our level of debt. And there have been cases where countries’ economies turned south. So I guess it depends.
I kind of still live with one foot in the economics world. I read trade blogs and they say, “Look, we have 2.5 percent interest rates. Why can’t we spend money like crazy and get this thing going again?” Their attitude is that we’re going to repeat the 1930s if we don’t just spend a lot of money on infrastructure.
Cowart: I think that’s what frustrates so many people, though: We’re not spending on infrastructure. I think the country could sustain a very high budget deficit for perhaps many years if people saw it was going to do something productive: building roads and dams and things like that. You can still look around this country and see projects from the 1930s. There are post offices, the Appalachian Trail, the Hoover Dam … things that had lasting value.
McPherson: For how many years have we been hearing about the crumbling of the infrastructure of roads and bridges? And yet the government hasn’t done anything to fix those things? In my area, we’re repaving roads that were repaved two years ago. What does that accomplish?
McCallister: Martin Marietta Materials is a company that supports what you’re saying. Housing has played a big role in its growth over the years but somewhere between a third and one half of its business is in road-building and yet sales growth in that segment has been flat.
Skeppstrom: We are borrowing in excess of one trillion dollars and essentially transferring it in non-productive ways, which is madness.
Camp: It is. We built 6,000-square-foot homes that are non-productive and the government’s moves now are aimed at propping up that market. That’s the issue: They’re levering for non-productive activities.
Moderator: Before we start talking about the specific portfolios you run and how you have them positioned, let’s touch briefly on the idea of “quality.” There has been some talk about low-quality/high-risk companies mostly fueling the rally we’ve seen.
Boksen: My position on quality is simple: A “high-quality” company is one that goes up.
That said, the rally shouldn’t come as a surprise. The companies that have snapped back the hardest are the ones that were most highly leveraged in 2008 and 2009 and they were barely holding on.
Skeppstrom: I agree. The more cyclical companies have the first run but it peters out when economic growth becomes steadier. I think we are within a few quarters of that, depending on how the economy progresses.
McPherson: Fundamentals matter at some point. Valuations matter. We may be seeing some validation by the number of takeovers under way.
Moderator: Let’s talk now about how you have your portfolios currently positioned. Are there areas you are giving special attention?
Boksen: We generally don’t have big macroeconomic views because it’s too risky to build our portfolios that way if we guess incorrectly on a macro trend. However, we are overweight in energy and materials not only because of growth in places like China and India but also because of the devalued dollar.
In financial services, we have a little bit of an overweight position in interest-rate-sensitive stocks, which should benefit from wider spreads. We recently purchased LPL, which is a smaller Raymond James Financial Services. We believe interest rates will eventually rise and they will make a lot of money.
When rates go up, earnings are going to go up meaningfully for these companies. Think about some firms that have been carrying money-market funds over the last couple of years at essentially a break-even, or even a loss, basis. If we move interest rates even to 100 basis points, those companies will soar.
Mintz: On the energy side, one of the really interesting dynamics that’s going on is the increase in the number of North American drilling rigs that are drilling for oil by applying new technologies to drill horizontal well bores. We have two companies that we believe will benefit. One is Lufkin Industries, which makes pumps that are put on oil wells after they begin producing. The other is Robbins & Myers, which makes equipment used in the increasingly popular horizontal rigs.
We also have kept our eye on the Bakken Shale oil deposit in North Dakota and Montana because it has proven to be exploitable on a profitable basis. One of our core holdings is Continental Resources, which holds the largest acreage position there.
We also have had a positive bias toward oil vs. natural gas over the last couple of years, which has worked out well for us.
In materials, we favor the fertilizer group. There are some global issues that will help the industry. Here in North America, corn yields were significantly lower for this planting season due to weather while Russia’s wheat harvest was negatively impacted by severe drought conditions. So, there are real supply issues supporting these higher crop prices.
Fertilizer company CF Industries, which has been a long-time holding for us, should benefit from increased corn plantings. Intrepid Potash – potash is a key plant nutrient – is another company that may thrive in this environment.
Boksen: I want to add something about technology, where we’ve recently benefitted from two takeovers (ArcSight and Netezza). It’s not by accident that there are takeovers in tech because there is a lot of cash in the industry right now. We may be looking to increase our exposure if the right names come along that meet our investing philosophy.
Thomas: We have slightly overweight positions in basic materials, industrials and technology. We believe emerging markets are going to continue to drive demand for raw material.
Solutia, a specialty chemical company, is a holding we believe can take advantage of this dynamic. We’ve owned the stock, which is one of our larger holdings, for about 18 months and I recently met with them. They laid out their five-year goals and forecast 13 percent organic growth that should translate, due to some margin improvement, to 17 percent-18 percent bottom-line growth. That kind of growth is extremely scarce in this environment but what’s more amazing is that the company trades at a discount to its peer group!
We’ve been a little overweight in tech for a while, especially in the software services industry. We have seen a great deal of M&A activity; in fact, our holdings Sybase and Hewitt both have been take-over targets so we’re certainly benefiting.
McCallister: We continue to be underweight in financial services and particularly in commercial banks, which until recently we continued to view as very expensive. We also favor trading exchanges in the sector.
One bank we have purchased is PNC, which we view more as a diversified financial-services company. It owns BlackRock and a large chunk of VISA and it’s heavily involved in transaction processing. Further, its 2008 government-engineered takeover of National City is starting to pay off. And finally, we believe it’s in a solid position with its capital reserves.
McPherson: As always, we’re looking at companies’ specific situations rather than macroeconomic themes. That said, we believe the market’s wholesale swings into certain areas creates opportunities in individual companies. And, like others have mentioned, we’ve had takeovers this year as well.
We recently bought Dolan Media, which has a mortgage-foreclosure-processing division that likely will benefit from some of the continued problems we were discussing earlier.
We also are paying close attention to chemical companies in the basic materials space. We own Westlake Chemical, which we believe has some company-specific rebound potential in addition to benefitting from some supply-and-demand dynamics in its markets.
Skeppstrom: We remain tilted toward an economic recovery because we believe things are generally continuing to improve, if slowly. I believe the third quarter was the first quarter in a long time where we saw real increases in capital spending, which ultimately will drive a more normal recovery.
We have been pulling back our overweight position in consumer discretionary because we believe we have made what money we will safely make there because valuations have largely normalized. Meanwhile, we’ve been very slowly raising our underweight position in consumer staples, a sector that has been fraught with terror for investors this year because many companies have been missing earnings estimates.
This year has been a little frustrating for us. We have stocks like Microsoft that continue to do well in terms of their market share and earnings numbers. And yet, the market has totally ignored them because there’s not enough spice to their story when we’re in a momentum-driven environment.
I believe our Large Cap Core portfolio has an enormous amount of value just waiting to be realized when some stocks are selling at 10 times earnings, excluding cash, or close to it and their products continue to sell. At some point, the market will rediscover its religion on stock prices and these companies will jump.
Cowart: With respect to the Value portfolios, we also are somewhat overweight in energy for the same reasons Eric and Bert mentioned. The International Energy Agency recently bumped up again its estimate for global oil demand, which it seems to have done every six months or so for the last couple of years based on increased use by countries like India and China. Further, there are geological declines in existing reservoirs that are not being totally offset by new drilling.
We don’t currently own any of the big, integrated energy companies in Value portfolios. Instead, we have a couple of companies – ConocoPhillips and Devon Energy – that had designs a few years ago of joining the Chevrons and ExxonMobils of the world. But they took stock of things last year and decided they would be better off to scale back; sell assets; return cash to shareholders through higher dividends and stock buybacks; pay down a lot of debt; and, perhaps, grow at a more rapid rate.
We also are overweight in industrials. It seems there is a global move to substitute machines for men to increase production while decreasing costs. Historically, one of the first things that happens when cash flows grow rapidly is that companies buy new tools and machinery.
I wanted to talk also about financials, which make up a large part of the traditional value-oriented benchmark indices. We’re underweight there for a couple of reasons but the primary one is that we believe there remain significant headwinds.
We thought last year that, by this time, regulations would be firmly in place with respect to such things as capital levels, which would allow companies to get their houses in order and move on. But those things haven’t been locked down yet so it creates uncertainty.
That’s not to say, though, there aren’t financial companies we like. One is financial-services company Lazard, which we believe is going to be a recipient of the M&A boom we’ve discussed today because of its focus in that area. It is more economical at times for companies to buy rather than build so a firm like Lazard can help put deals together. Ameriprise, a financial-services company spun out of American Express a few years ago, has consolidated several other large investment managers. We believe it can grow its business pretty well.
My final remark on financials is that if you look back over several decades, sectors that reach 25 percent to 30 percent of a benchmark’s market capitalization – think energy in the ’80s, technology in the late ’90s and financials earlier this decade – fall hard once the bloom is off the rose. They might have a little bounce, which we’ve had in financials, but then they just move sideways for a while and, in some cases, for many years. We are going to move carefully here.
Blount: We are bumping up our weighting in utilities. One interesting company we own is National Grid, a United Kingdom-based regulated utility. About 60 percent of its operations are in the United Kingdom and the balance are in Northeast U.S. utilities. It has a dividend of more than 6 percent and it trades at a discount to both U.K. and U.S. utilities. The United Kingdom is trying to go more “green” and many of those transmission centers are in rural locations. National Grid is in the business of transmission lines so we believe the move to “rewire” England stands to benefit the company.
We are positive but cautious in healthcare, where we just went to a slightly overweight position by buying one company: BD (Becton, Dickinson & Co.), a diversified medical-supply and diagnostic company. What we liked so much about this company is it has paid a dividend for 37 consecutive years, it has a very inexpensive valuation and excellent free cash flow. We had shied away from healthcare stocks for years because growth rates of the large pharmaceuticals – the healthcare companies that historically pay dividends – continued to decline. We believe we’re now at a point where valuations in respect to growth rates are low enough to be attractive to us again.
We are underweighted in financials in Equity Income. We have a small position in JPMorgan Chase but we are pretty much out of the large domestic banks for the reasons Ed discussed. We’ve sold US Bancorp and Wells Fargo and moved north to Canada. We bought the Bank of Nova Scotia (also known as Scotiabank) and the Bank of Montreal, which have higher capital levels than U.S. banks as well as higher returns on equities and higher dividend yields (4 percent vs. nothing – or virtually nothing – for domestic large-cap banks).
Much of our financials exposure has been real-estate investment trusts (REITs), a fantastic category responsible for most of our outperformance this year. We have stuck with the high-quality players with the best assets: Simon Property in shopping malls and Boston Properties in office buildings. Rents have come down a bit in capacity-constrained markets such as New York City and Boston but Boston Properties is still doing well and drawing new tenants. Apartment-complex owner Avalon Bay did really well in a year that apartment rentals – for the various housing-related issues we discussed earlier; why buy when you can rent? – had booming business.
We are dipping our toe in the technology sector but by way of a REIT: Digital Realty Trust, which owns specialized facilities for internet and data centers. The company has grown its dividends 15 percent over the last five years and it has a fairly high barrier to entry because the buildings are so specialized.
Speaking of technology, many people know Equity Income portfolios historically haven’t held tech stocks because those companies haven’t paid dividends. We don’t currently own any technology but, for the first time, we are starting to look. There are some technology companies that now pay dividends; in fact, Intel raised its dividend. So, we can see ourselves buying some tech.
Moderator: James, tell us about what you’re seeing – and doing – in the fixed-income market?
Camp: Of course, most of the recent news has been about the effects of QEII, which we discussed here earlier. The Treasury market has sold off somewhat but that may be healthy.
The major themes for us on the taxable side are a dramatic overweight in the corporate area, which includes industrial, technology and pharmaceuticals, where balance sheets are great. For the first time in the last 2½ years, the market has more upgraded bonds than downgraded bonds so it appears fundamentals are improving.
We do not currently own financial names because we still have balance-sheet concerns on a lot of the big financial names. A company like Bank of America has an untold number of home-equity loans on their books that are probably worth zero. We’re just very skeptical of those types of names at this point.
We have reduced our overweight position in agency mortgage-backed securities (MBS), which we no longer view as having a good risk vs. reward profile. We’ve also diversified away from debt from the GSEs (government-sponsored entities; e.g., Fannie Mae and Freddie Mac) and into non-traditional agency securities, include German-government bonds, covered bonds in Switzerland and some bonds in Canada, all of which have what we believe is infinitely better credit quality.
On the municipals side, the market has been as volatile recently as it has been in a long time. Part of that is the non-renewal of the Build America Bonds program, which has put a lot of pressure on the long end of the curve. There are areas – troubled states such as California – that we are avoiding but there are still opportunities for us to buy solid bonds.
Moderator: OK, let’s take a look ahead. What do you see coming in the next year or so in the markets and how will that affect your portfolios?
Camp: I do have some concerns about the debt super-cycle and some of the GSEs’ unresolved problems. I believe the financial-market recovery is going to continue in earnest and the human recovery will hasten when employment numbers strengthen. I believe valuations are fair in bonds but I would stress that diversification remains key. I don’t know that there will be any massive problem with all the massive policy intervention/manipulation that has gone on, but there will bumps in the road.
Nevertheless, we are on the road to recovery and we have made greater strides in our financial-market recovery than I thought we would when we started these roundtable discussions two years ago in the midst of the economic crisis. So I think that’s the good news.
Thomas: I recently saw a chart that looked at the percentage of the S&P 500’s market capitalization that’s attributable to the present value of future earnings. Over history, the range has been from 100 percent (current prices account for all future growth) to a low of 50 percent in the 1999-2000 boom. The 2010 number is 115 percent, which is basically saying that we’re going to have declining earnings in the future for S&P 500 companies.
McCallister: But there has been a 50- or 60-year trend of the economy grinding out a 2 percent to 3 percent earnings-growth rate. So, the math looks good for the market. And increasingly, the S&P 500 gets the majority of its earnings overseas so domestic companies have exposure to worldwide growth.
Thomas: I think the market is attractive because stocks are very inexpensive. There continues to be a lot of risk-averse behavior out there by investors, virtually all of whom decreased their equity exposure down over the last couple of years. I think that’s an opportunity.
I think the other opportunity is in growth stocks, especially as we go into 2011 and 2012, because real growth will be scarce; consequently, the market will reward those companies that exhibit real growth. Value stocks tend to do well in an environment where margins are increasing, which we’ve obviously seen throughout 2009 into 2010. I think that has largely run its course. So I think that growth is probably going to outperform value in the next year or so.
McCallister: In some sense, stocks have been kind of an ignored asset class recently even though there have been record flows into exchange-traded funds (ETFs). However, we view ETFs not so much as long-term investment tools but, rather, vehicles that allow people to pop in and out of the equity market.
ETFs generally hold good companies and bad so everything moves in lockstep, regardless of fundamentals. Meanwhile, there are all these quality companies out there with stable cash flows. People will start to pay attention to that again because owning those companies is the way to make money in the stock market over time.
Many people think the corporate sector – from all the press about the Enrons, the Tycos, the Lehman Brothers – is not well-run overall. But I don’t believe that’s true at all.
Boksen: I think we’ve clearly been in a bull market since March 2009, which feels like ancient history but it has been only about 18 months. Look, the bar was set so low for so many companies whose valuations were totally distressed so it shouldn’t really shock anyone the market is up.
I believe valuations today are fair: neither incredibly cheap nor incredibly expensive. And there is wind at our backs as investors. There is still a ton of cash that can go into the equity markets. Businesses are holding it and so, too, are retail investors, who have been buried twice in a decade – first with the internet bubble and then the financial crisis – in the stock market and so they have all their money now in fixed income. That money will start coming in to equities. I think it’s a trickle now but will build some momentum.
The bar is set low for next year for companies to beat their earnings estimates. Large-cap companies are buying small-cap companies. So from an asset-class perspective, small- and mid-cap stocks look pretty good to me.
If this rally continues, we obviously will have some corrections. The political landscape isn’t perfect but it is better. I’m feeling pretty good and enjoying a bull market. Maybe we’re in the third inning of a nine-inning game right now.
I think people in this environment are almost afraid to make money. You can’t be afraid to make money. The market moves quickly and we are in a bull market. You do not want to be waiting on the sidelines and then suddenly realize a great bull market got by you.
Mintz: My mantra now is, “Don’t fight the Fed.” It is clearly determined to do anything and everything it can to bring back our economy. Companies are loosening the purse strings and so that, along with other factors, leaves me optimistic. Of course, there remains a fair amount of bearish sentiment – people are still concerned – but bull markets have climbed walls of worry.
McPherson: I think we might be a little bit more cautious. The backdrop is reasonably OK – some data points are positive – but this recovery is going to have fits and starts. So, as we move forward, we are keeping our expectations in check. Look at how this year has gone: Things were looking dire at the end of August but they’ve been good since then. It was all wine and roses through April and then it turned bad quickly.
We’re not bearish but we are trying to be cognizant of the risks and volatility we believe will continue. We’re optimistic but realistic and trying to proceed cautiously.
Cowart: I think what we all need to keep in mind is the strength of the corporate sector right now, both in terms of balance sheets and profit margins. Yes, there will be some macroeconomic events that will create some short-term sell-offs but the overriding consideration is the strength of corporate balance sheets.
Eric was right: You don’t fight the Fed, which wants asset prices to go up and they likely will. All the money it has created is going to go somewhere. And the good news for us is that high-quality large-cap stocks are the one asset that hasn’t been inflated in the last 20 years. It’s due.
Consider this: In 1998, the S&P 500 earned $45 dollars a share and it was priced almost exactly where it is today. We’re looking at earnings for this year in the mid-to-high $80s range and perhaps in the low $90s next year. So, we have an asset class whose underlying earnings have doubled in 10 years but the price is the same!
I may be a little bit more optimistic about valuation than Bert. Historically, when inflation or interest rates have been at this level, the market sold at 16 times or 17 times earnings and right now, we’re seeing prices at 13 or 14 times earnings. In fact, if you believe forward earnings, this is the cheapest the market has been since 1990.
Again, we feel pretty optimistic. The wind may not be at our back but it’s not in our faces.
Blount: Strategists at many brokerage houses are now pitching to advisors large-cap dividend-paying stocks. Of course I’m biased, but I do believe they are right. We have a lot of things on our side, including demographics. Baby boomers need to save and the kinds of companies we like to own in Equity Income currently have a higher yield than many bond portfolios and that yield is growing.
Corporations are in better shape than ever, particularly as it relates to cash on their balance sheets. They’re looking for places to use it and I believe a lot of my companies will buy a lot of Bert’s companies that’s the easiest way to grow right now.
Historically, if the market’s monthly returns are up 2½ percent or lower – which has happened about 60 percent of the time – the one-third of dividend payers will outperform non-dividend payers. We believe our portfolio is perfectly positioned: Companies are in great shape, the economic outlook is getting better and dividend yields are very attractive.
Head of Investments: It is worth noting that active management, skillfully applied, can identify companies that can grow at rates in excess of the global or U.S. gross domestic product (GDP). There is no substitute for experience, especially in unprecedented times such as these. Thank you for your insights.
Past performance does not guarantee future results.
Opinions and estimates offered constitute Eagle’s judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. The meeting of Eagle’s portfolio managers occurred Nov. 18, 2010. Under no circumstances does the information contained within represent a recommendation to buy, hold or sell any security and it should not be assumed that the securities transactions or holdings discussed were or will prove to be profitable. Any Index is referred to for information purposes only; the composition of each Index is different from the composition of the accounts managed by the investment manager. An index is unmanaged and has no expenses, and it is not possible to invest directly in an index.
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