“We Have Never Been as Cautiously Positioned”
September 17, 2013
Let me ask you about one other economy that you did not touch on in that list, which is Japan. You have a relatively large exposure to small-cap stocks in Japan. Does their high debt-to-GDP ratio concern you? What will be the impact of Japan’s aggressive attempt to devalue the yen – “Abenomics” – on your positions? Are you concerned about the effects the unwinding of emerging markets in general could have on Japan and its currency?
Some people, including Kyle Bass, have expressed tremendous concern about the extent of the debt-to-GDP ratio in Japan. But they have looked primarily at the government debt-to-GDP. In fact, a lot of the government debt in Japan is held by the government itself, so you have to look at the net government debt as opposed to the gross government debt. You also have to be aware that both households and especially corporations are huge savers. A lot of the excesses at the government level, in terms of debt, are offset by the fact that corporations are huge savers.
In the long run, one should be worried because the demography in Japan is not good. Unless they start making more babies going forward or they’re willing to allow more immigrants, in 20 or 40 years they will have a bit of a problem.
Japan now exports more to China than it does to the U.S., and if the Chinese economy does experience a hard landing, short-term that will hurt Japan. But we feel, despite the rally in Japanese equities that has taken place over the last nine months, they are still cheap enough and companies in Japan are so strong financially – many of them are flush with cash – that they will still do well relative to emerging market stocks, if things get worse for many emerging economies. And because so many companies in Japan have excess cash, we would like to see them improve capital allocation (increase dividends and share buybacks). We think this is what would rerate Japanese equities over the long-term.
A lot of the stocks that we own in Japan today tend to be smaller, more domestic, less export-oriented companies. We own Yahoo! Japan, a subsidiary of Yahoo! It’s a pure Japanese business. We own Temp Holdings, which is a temporary staffing business in Japan; it is not an export company like Canon.
We have mitigated the risk of the yen weakening further by being 50% hedged on the currency. If the yen weakens we are only hit to the tune of 50%.
You have a relatively large exposure to French stocks. How do you handicap the policies of France’s government? Is the relatively narrow spread of French to German debt justified?
Regarding your second question, France still has a big problem with the size of its government debt and associated budget deficits, and unlike Japan, it is not as if the private sector saves enough to offset the excesses at the government level. I am surprised that French debt does not trade at a higher spread versus German debt.
In terms of the French companies themselves, many of which we own, many of them are global companies. We own Sodexo; it is a food catering company, and 40% of its earnings are right here in America. Many years ago, they bought Marriott Services. They have a significant presence in Brazil and they have some operations in India. We own a tiny little company in France called Robertet. They make flavors and fragrances. Even though it is a tiny French company – family-controlled, by the way – 35% of its sales are right here in America.
So far, the socialist government in France has not done things that are too adverse to these French companies. As long as the stocks are cheap enough, we are happy to own them.
Another example of a French company that we own is Teleperformance. It is the leading call center operator in the world, and 85% of its earnings are right here in America. In fact, the founder of the company lives mostly in Florida, so from many standpoints that company should not even be listed in France.
We would ideally like to own more stocks in Germany. We own Siemens, for instance. But if you look at the industrial fabric of Germany, you will notice that most companies in Germany are privately held or family-owned. They are not available in the public stock market. We know that Germany is a strong economy and it has some wonderful businesses, but unfortunately, most of them are not available in the stock market.
You are a student of the Austrian school of economics. What do you see as the effects of zero-interest-rate policies and quantitative easing? What are they doing to economies and the market? Specifically, how do you adjust your investment process to deal with those policies?
There’s a school of thought, to which we subscribe, that believes that a lot of the excesses that took place in emerging markets were the result of those ultra-loose monetary policies. Ultra-low interest rates have helped create many or bigger bubbles, such as those in China, Indonesia and elsewhere. If you artificially manipulate interest rates, that has consequences and leads to bad capital allocation.
Another consequence of those policies is that you set up interest rates that are lower than inflation. Financial repression is the equivalent of a tax on savers. Many older people in the United States rely on income to live and enjoy their retirement. Now that interest rates are less than inflation rates, they are in a pickle. Understanding the side effects of quantitative easing is very important, and the big debate is, how successful has it been?
There are signs of the economy stabilizing in Spain right now. The U.K. is doing a little better. But it begs the question of whether countries are better off accepting some pain, as opposed to postponing and delaying things by too much quantitative easing.
Given the amount of sovereign debt that is outstanding, aren’t the consequences of raising interest rates almost as unthinkable as keeping them low forever?
That is why policymakers, especially in the U.S., do not seem eager to raise rates. But if interest rates are not raised, if and when they have to be, it will be interesting to see what happens in many emerging countries. You will run the risk of inflation. In a way, if inflation is the end result of all those policies, owning equities is the best thing to do, except that these equities are so much more expensive than, say, they were in 1970s.
What question should investment advisors be asking themselves at this time?
Advisors should respect the fact that we will be in a very-low-return world for a long time and they should be able to convey that to their clients, which is not an easy conversation. Some individuals do not want to amend their lifestyle (i.e. save more and consume less) and may not want to be told that at best, the return on their financial assets may be 3% to 5% in the next 10 years, and even less once you adjust for inflation.
Advisors should remember history and understand that sometimes there are 20-, 30- and 40-year cycles, during which interest rates go down as they did from 1982 until recently. But then there are 20-, 30- and 40-year cycles during which inflation rears its ugly head and interest rates go back up. They should be mindful of that and understand the consequences and effect it has on different asset classes.
For the past three or four years, we have tried to be very vocal and remind people that you cannot just equate high economic growth to good stock market performance, particularly with respect to emerging markets. It is more complex than that. High economic growth in China does not necessarily mean that Chinese stocks will offer good performance. One has almost has nothing to do with the other. Conversely, just because Japan has stopped being less relevant in the world economy, one should not refrain from investing in Japan.
Advisors should avoid simple generalizations. They should understand that the devil is in the details, and that oftentimes you have to do what hurts. Today, interest rates are low, so everybody is chasing yield. They want to own REITs, MLPs and emerging-market debt funds.
Investing is about having the fortitude to resist the temptation of these things. Investing properly is often psychologically painful.
Thank you very much.
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