Picking Up the Pieces
Our investment experts see little growth for the market averages, but plenty of opportunities among stocks.
Say goodbye to sunny skies and ditch the rose-colored glasses.
That's the collective advice of the investment seers who populate the Barron's Roundtable, and whose market forecasts for the back half of 2014 range from meh to feh. Specifically, the bulls in the bunch see a meager 5% gain in the Standard & Poor's 500 in the months ahead, while the rest see a volatile rout in late summer that could leave stocks 10% lower, at least.
Equities aren't wildly overvalued, according to our experts, but neither are they charmingly cheap. Meanwhile, economic growth at home and abroad is lacking, darkening the outlook for consumer spending and corporate-revenue gains. When the bond market is the only party in town, it pays to be cautious -- or find another town.
No matter the backdrop, however, the redoubtable Roundtable crew hasn't lost its appetite for bargain-hunting, or its aptitude for money-making. That was abundantly clear when our 10 panelists last met as a group on Jan. 13 in Manhattan, and is evident in the performance to date of many of their January picks.) It was also apparent in telephone chats in the past two weeks, when they shared their best investment bets for the next six months -- as varied a collection of stocks, funds, and alternative assets as any we can recall.
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Yes, the pages ahead are filled with sobering talk on weighty subjects, including the forces that could impede economic vigor in the near term and for decades to come. But you'll also get the skinny on nearly three dozen investment ideas, from fracking to food plays, metals to movies, Clippers to Knicks, that could carry you profitably through the rest of this confusing, contradictory, topsy-turvy year.
MARIO GABELLI
Barron's: What will the back half of 2014 bring, Mario?
Gabelli: There have been several unanticipated dynamics in the first half -- Putin invading Crimea and reigniting the Cold War, for instance. We have also been surprised by the big drop in yields on 10-year Treasury bonds. We never expected the 10-year to retreat to 2.5%. In another surprise, last year's poorest stock market performers, utilities and gold shares, have been among the brightest stars of 2014. Utilities are strong, in part, because of the decline in interest rates. Finally, corporate love-making is unfolding in 2014 with even greater visibility than I imagined.
Hey, this is a family magazine. We assume you mean mergers and acquisitions.
That's right. Many companies have become involved in takeovers, spinoffs, and other forms of financial engineering. I haven't changed my view of the broad market since the start of the year. Stocks will be flat to up 5%, at best, in 2014. There is no margin of safety, but stocks aren't overpriced. Hopefully, interest rates will climb as the economy improves. The U.S. consumer's net worth is at an all-time high, suggesting the Federal Reserve's goal of reflating stock market assets and home prices, and lowering the dollar to help exports, has worked. Several investment themes are playing out.
Mario Gabelli's Picks
Company/Ticker 6/11/14 Price
Kinnevik/KINVA.Sweden SEK264.90
International Flavors & Fragrances/IFF $101.85
Interpublic Group of Companies/IPG 19.69
Chemtura/CHMT 25.10
Weatherford International/WFT 22.46
Madison Square Garden/MSG 57.33
Source: Bloomberg
Such as?
You can invest in the rising middle class in China and India by owning companies that sell to Boeing [ticker: BA] and Airbus Group [AIR.France]. Organic and natural foods is another area we like. In health care, we like diagnostics companies, and in energy, hydraulic fracturing, or fracking, of shale formations, has been a game changer. Pricing power also makes for good long-term investments. That's why some consumer-branded companies interest us.
Given your muted market outlook, will it be tough to make money in the second half?
No! If you are buying an index fund, you won't make a lot. If you are looking for companies whose values get a boost when a comparable company is acquired, that's another matter. Valero Energy [VLO] spun out its retail unit last year as CST Brands [CST], and Murphy Oil [MUR] spun out its convenience-store business as Murphy USA [MUSA]. Marathon Petroleum [MPC] announced last month that it would buy Hess ' [HES] retail business for 16 times Ebitda [earnings before interest, taxes, depreciation, and amortization]. Suddenly, two companies trading at seven or eight times next year's Ebitda -- CST and Murphy USA -- look a lot more attractive. When a strategic buyer pays well above the market price, the market starts to focus on the industry's underlying fundamentals.
Today's deals aren't driven by tax inversions [reincorporating overseas to reduce taxes on income earned abroad] or low interest rates, but the desire of companies to grow. Activist investing could continue to have a significant influence in the second half of the year.
Mario Gabelli Photo: Brad Trent for Barron's
Let's talk about your current stock picks.
I recommended Kinnevik [KINVA.Sweden], a Swedish investment company, last June, and will do so again. It was founded in 1936, and the executive chair is Cristina Stenbeck, a granddaughter of one of the founders. Kinnevik invests in other public companies, but unlike the U.S., Sweden has an enlightened tax policy. In Sweden, if a company owns more than 10% of another company and sells its stake, it doesn't pay a tax on the proceeds. Kinnevik trades for 253 kronor, up from SEK173.70 a year ago. I estimate its private-market value at about SEK350 a share ($52.80).
What are some of Kinnevik's holdings?
The company owns 38% of Millicom International Cellular [MIICF], which provides telecom and e-commerce services in Africa and Latin America. Millicom is trading for about $90 a share; we like it, too. Kinnevik also owns about 25% of Rocket Internet, a German e-commerce venture-capital firm that is planning to go public. Kinnevik has a stock-market value of SEK71 million, and a solid balance sheet. It is a surrogate for global growth, particularly in e-commerce.
International Flavors & Fragrances [IFF] is based in Manhattan. It is working on substitutes for salt and sugar. The stock trades for $100 and there are 81.5 million shares. The company has an $8 billion market capitalization and about $600 million of net debt. IFF will have $3.1 billion of revenue this year. Revenue is growing 5% to 6% organically. Earnings could total $5 a share, and are rising by about 10% a year. The growth could accelerate as management uses the balance sheet to reduce the share count.
Has IFF repurchased a lot of stock?
It has bought stock to offset options issuance. Given its healthy balance sheet and good cash-flow characteristics, I don't understand why it hasn't bought more. Things could change when the CEO, Doug Tough, steps down in September.
Deal activity has been rampant in the advertising industry, although Publicis Groupe [PUB.France] and Omnicom Group [OMC] called off their planned merger last month. I like Interpublic Group of Companies [IPG]. Interpublic, an advertising concern based in New York, has 423 million shares. The stock is $19. The company will generate about $1 billion of Ebitda this year. It has been buying back stock, and the balance sheet is improving. Interpublic will have $350 million of net cash at the end of the year if it doesn't buy back shares. Capital spending is minimal.
The company ran into trouble in the past.
It has cleaned up its legacy problems in the past decade. It has net operating-loss carryforwards outside the U.S., which will reduce its tax burden. Michael Roth, the CEO, is doing a good job. [For more on Roth, see page 50.] Globally, advertising is a $500 billion-a-year business; $270 billion is spent in the U.S. Interpublic has scale, and is getting its share of growth, including in digital, social media, and Internet advertising.
Now that Publicis and Omnicom have broken their engagement, will one try to buy Interpublic?
They should. The last big deal in the industry, Dentsu's [4324.Japan] acquisition of Aegis, was done at 14 or 15 times Ebitda. Interpublic could command a sale price of nine or 10 times Ebitda. Put a multiple of nine on the company and the valuation could be close to $25 a share. The stock got a boost when the Publicis/Omnicom deal was called off. If there is no deal, Interpublic's bright fundamentals should bolster the stock.
Let's talk about old friends such as Chemtura [CHMT], which I recommended at the January Roundtable. The stock has come down a little, which is good.
It is?
Chemtura makes specialty chemicals. It is trading for $24.80 and has 96 million shares. It is a late-stage turnaround. The CEO, Craig Rogerson, made money for shareholders when he ran Hercules and sold it to Ashland [ASH]. He has struck a deal to sell Chemtura's agrochemicals business to Platform Specialty Products [PAH] for $1 billion. If it closes in the fall, Chemtura will have net cash of $500 million, most of which will be used to buy back shares. The share count could drop to 70 million to 75 million in the next two, three years. Capital spending also is falling. The remaining businesses could show dramatic improvement. I expect Chemtura to generate $450 million of Ebitda in 2015 and have a private-market value of $40 to $45 a share.
Weatherford International [WFT] is another turnaround, but one that doesn't have a management change associated with it.
The stock is up more than 50% since you recommended it in January.
It went from $14.49 to $23. That is partly because spending on unconventional drilling has accelerated. Secondly, management has decided to sell assets and reduce debt. Weatherford will be left with strong assets and significant market share in artificial lift [an oil-and-gas recovery technology] and well-services completion. The stock could rise another 50% in the next 12 to 18 months.
There is one challenge: The land rigs Weatherford hopes to sell are located primarily in Russia. If it can't do the deal, this will slow its deleveraging, but this is a short-term problem. So, do you want to talk about the Clippers and the Rangers?
Who doesn't these days?
Steve Ballmer, the former CEO of Microsoft [MSFT], plans to buy the Los Angeles Clippers basketball team for $2 billion. My pick is Madison Square Garden [MSG], which owns the New York Knicks and the Rangers. The stock is $55, and the company has 77 million shares. It is controlled by the Dolan family through super-voting shares.
MSG owns MSG Networks, a regional sports TV network. It has about eight million subscribers who each pay $5 a month. That's $480 million a year in subscription and ad revenue, with high profit margins. MSG Networks is worth the entire market capitalization of the company, which means you're getting the rest, including the teams, for free.
MSG has put about $1 billion into renovating Madison Square Garden. It owns or operates other venues, including Radio City Musical Hall. The MSG Entertainment unit hosts concerts and other live entertainment. The company has $77 million in cash.
Given the Dolans' control, how will shareholders realize MSG's value?
This is a long-term holding with many hidden assets. The Dolans created value for shareholders of Cablevision [CVC], another of their properties, by spinning off AMC Networks [AMCX] and MSG. Madison Square Garden is a keeper for James Dolan, the executive chairman; he isn't going to sell it. But if you want to own a piece of a sports franchise, this is a cheap way to do it.
Good point. Thanks, Mario.
BILL GROSS
Barron's: Can you explain the bond market's strength this year?
Gross: Stocks and bonds are artificially priced. We expect them to remain so, given billions of dollars of check-writing by the Federal Reserve and a federal-funds rate of only 25 basis points [0.25%]. The European Central Bank's $500 billion stimulus program will begin in September. The Bank of Japan is writing even more checks than the Fed. This triangle of monetary stimulation is propelling equity and bond markets higher and lowering bond yields. It is a grand party.
At some point, bond yields can fall no further, although the ECB adopted negative rates recently in announcing that it will charge banks 0.1% on overnight assets. We don't expect the party to end with a bang -- the popping of a bubble. More likely, upside momentum will simply fade. We have been talking about what we call the New Neutral -- sluggish but stable global growth and continued low rates.
Can you elaborate?
In prior cycles, and up until Lehman Brothers' collapse in 2008, people expected a nominal fed-funds rate of 3% or 4%. At the beginning of this year, many were expecting rates to return to those levels in the next few years. But a highly levered economy can't withstand historic rates of interest. In order to keep the system functioning and allow the party in the markets to end with a whimper and not with a bang, the Fed and other central banks have to keep policy rates close to historically low levels.
The Fed could start lifting the fed-funds rate in mid-2015. We see rates rising to 2% in 2017, but the market expects 3% or 4%. The Fed and other central banks are all trying to find the magic number. If it is close to 2%, the markets will be supported, which means today's prices and price/earnings are OK.
When do you expect the economy to start showing momentum again?
We don't. The economy has grown by only 2% a year for the past five years, even with all the monetary stimulation, because there is too much debt and structural head winds. These head winds include an aging population, not just in the U.S. but in Europe and Japan, and the technology revolution, which is good for productivity and profits but has displaced many workers. Without the consumer, capitalism can't exist. It is hard to model these head winds, and most policy makers don't recognize them. But they are probable causes of the sluggish growth.
It takes a long time to work out these issues. The way central bankers do it is to cheat savers, bondholders, and investors of historic returns by keeping interest rates close to zero. In some cases, such as Detroit and the General Motors [GM] of five years ago, you default on your debt. If you are Venezuela or Argentina, you get out of a debt trap by devaluing your currency. In every case, investors who hold securities have the short end of the straw. Under the New Neutral, people should expect stocks to return about 5% a year, and bonds 3% to 4%.
Bill Gross Photo: Brad Trent for Barron's
What are the broader implications of that?
Many liability structures, including pension funds and insurance companies, have built into their plans expectations of 7% to 8% returns. Let's say their assets are split 50/50 between stocks and bonds. If bonds return only 3%, they need to get 13% or 14% or 15% from stocks, which is hard to imagine. Individuals saving for education expenses or retirement are in the same boat. If households can't get an 8% return on investments, at some point they have to start saving more and that slows economic growth.
Most of your January picks delivered more than 8%. What do you recommend now?
It pays to own some mildly levered closed-end bond funds because they can borrow at 10 or 20 basis points and relend the money at 400 or 500 basis points. That produces a dividend yield of 7% or 8%.
One of my favorites is the BlackRock Build America Bond Trust [BBN]. The federal government subsidizes 35% of the interest paid. The fund typically holds A-rated and AA-rated long-term bonds issued by state and municipal authorities to fund various infrastructure projects. It yields 7.5%, and I have been buying it for my own portfolio.
I am also buying Pimco Dynamic Income fund [PDI], which holds nonagency mortgages. It has an expected yield of between 8% and 10%, and it trades at net asset value.
My final pick is iShares U.S. Preferred Stock [PFF], an exchange-traded fund. It is highly liquid, and its expense ratio is below 50 basis points.
What exactly does it own?
The fund holds primarily bank preferred shares.
Banks are becoming better capitalized, and credit quality is improving. Typical holdings include preferred stocks issued by Wells Fargo [WFC], Bank of America [BAC], and HSBC Holdings [HSBC]. The fund is a short-term investment, as many of these preferreds will be refunded in the next year or two.
What will happen to the fund then?
The dividend will start to fall as shares are reissued at lower yields. In the interim, you can collect a current yield of 5.5%. The fund carries more risk than a money-market fund and has a longer maturity, but it is a good place to park money for the next two years. I am buying a lot for my own account. A 5.5% payout beats 0.01% in a money-market fund.
If you want to go long, buy BBN. If you want to take some risk and make a bet on the housing market, buy PDI. And, if you want a one- or two-year piece of paper, there's PFF.
Thank you, Bill.
SCOTT BLACK
Barron's: Where to now, Scott, for the economy and the market?
Black: I had a spirited debate about the economy in January with Abby. She thought U.S. gross domestic product would grow by 3%-plus this year, and I said we'd be lucky to see 2.5%.
At the moment, you're both losing. First-quarter GDP was revised to minus 1%.
People blamed that on the weather, but personal-consumption expenditures were up 3% in the quarter. On the other hand, private inventory was down. Nonresidential fixed investment and state- and local-government spending were down, year over year. I expect 2.5% growth to be the norm for the rest of year. The economy is sluggish.
There is little growth because the U.S. has no fiscal policy. You can blame the president and an obstructionist Congress. [Federal Reserve Chair] Janet Yellen is maintaining Ben Bernanke's accommodative monetary policy, but the Fed is out of bullets. Some studies show that the last few rounds of quantitative easing had minimal impact on economic growth.
You're painting a grim picture here.
The federal debt is now 102% of GDP. There was no grand bargain to bring down the deficit or reform taxes. Our corporate tax rates are much too high, relative to the rest of the world. We have finally recovered the 8.7 million jobs lost in the recession, but President Obama should have taken a page from Franklin Roosevelt's book and put people to work rebuilding the nation's infrastructure.
I am sticking with my forecast in January for S&P 500 earnings to reach $116 this year. That is about 8% growth, year over year.
That seems inconsistent with a weak economy.
Companies have little revenue growth. That's why merger-and-acquisition activity is on the rise. There is $1.7 trillion in cash and equivalents on nonfinancial-company balance sheets. Companies can borrow at low nominal rates. Driving top-line growth through acquisitions is the only way to get earnings per share to rise at many big companies.
S&P 500 operating profit margins are at an all-time high of 9.75%, up 23 basis points, year over year. Turning to valuation, the Russell 2000 is selling at 22 times this year's estimated earnings, and the Russell 2500 is selling at 21 times. Some individual stocks might be cheap, but small- and mid-cap stocks, as an asset class, are overpriced.
Scott Black Photo: Brad Trent for Barron's
Do you consider the S&P 500 overpriced at 17 times your earnings estimate?
The market's P/E has averaged 16 since the end of World War II. But interest rates are low, and there is little competition for stocks, so you could argue the market is at fair value. The market will continue to rise because it is liquidity-driven. There is little downside risk.
Where will the S&P 500 end the year?
If the market's P/E multiple rose to 17.5, that would take the average up 5% to 2030. Ironically, I have two small-cap stock picks. The first is Super Micro Computer [SMCI]. It is trading for $21.92. There are 48.1 million fully diluted shares, and the market cap is $1.05 billion. There is no dividend. Super Micro is a leading manufacturer of customized high-performance, Intel -based [INTC] servers. Its products serve customers with supercomputing needs.
How long has Super Micro been around?
It was founded about 10 years ago and is based in San Jose [Calif.]. It manufactures in the U.S., in Taiwan, and the Netherlands. Most of its cash is in the U.S. We're expecting sales of $1.43 billion for the year that ends June 30. Sales have been driven by the growth of data centers and demand from original-equipment manufacturers. The revenue mix is 55% U.S.; 22% Europe; 21% Asia; and the rest of the world, 2%.
The biggest portion of the business, OEM and Direct, accounts for 48% of sales. Data centers contribute 16% of sales, and there is also a distribution business.
What do you like best about Super Micro?
Management thinks it can grow the top line by 20%, to $1.72 billion, in 2015. Pencil in operating margins of 7%, and you have operating earnings of $120.4 million. Subtract interest expense of $600,000, and profit before tax is $119.8 million. Tax that at 31%, and you get $82.7 million in after-tax earnings, or $1.72 a share. That equates to a pro-forma return on equity of 16.3%. The company could generate $30 million in free cash.
We believe in deducting stock-based compensation from earnings. If you do that, Super Micro could earn $1.60 a share in fiscal 2015. The company has $1.15 a share of net cash. Subtract that from the stock price and you get a P/E of 13, which is pretty cheap.
What is your second pick?
PDC Energy [PDCE] has a market cap of $2.24 billion. It is a domestic energy producer based in Denver. The stock is $62.75, and there are 35.7 million shares outstanding. There is no dividend. Years ago, the company was a gas producer. Then the management left; PDC sold off some gas properties and began to focus on developing mostly oil and natural-gas liquids, or NGLs.
Where does the company operate?
The Wattenberg Field in Colorado accounts for 80% of production and reserves. Bonanza Creek Energy [BCEI], which I recommended in January, also is in the Wattenberg. PDC has a small operation in the Utica Shale in Ohio, which represents 3% of production and 5% of reserves. It also operates in the Marcellus in West Virginia, which accounts for 17% of production and 15% of reserves.
PDC had reserves at the end of last year of 266 million barrels of oil equivalent, up 38% from the prior year. Daily production climbed about 35% in 2013 to 20,400 barrels of oil-equivalent. The company figures conservatively that it will grow production at the drill bit between 28% and 35% this year. In the first quarter, its production mix was 43% crude oil, 41% gas, and 16% NGLs.
Is the stock trading at a discount?
It isn't cheap based on price to discretionary cash flow. But it is cheap based on breakup value. PDC had proved oil reserves of 93.8 million barrels at the end of last year, with an estimated net present value of $18 per barrel, or $1.688 billion. It had 740 billion cubic feet of gas, which we value at $1.85 billion, and 48.7 million barrels of NGLs, with an estimated value of $365 million. The total is $3.9 billion. Add a gas-gathering pipeline that's worth $118 million, and gross value is $4.02 billion. Subtract net debt at year end of $580 million, and deferred taxes, and PDC is worth $3.44 billion, or $96 a share. At some point, this is a layup for a takeover.
What would be a logical buyer?
A medium-size independent producer could buy it. Everyone knows that the Wattenberg field is a home run with the bases loaded. We own several companies producing there.
Here are the numbers on PDC. Net income could total $46 million to $49 million this year, which means earnings per share will be between $1.30 and $1.37. Adding back noncash charges yields discretionary cash flow of between $250 million and $275 million, or $7 and $7.70 a share.
The company plans to spend aggressively this year to grow, and probably will have negative free cash of $375 million. But the balance sheet supports this. Net debt to equity was 0.4% at the end of last year and will be 0.85%, pro forma, at the end of this year. The coverage ratio is excellent, however. Annual Ebitda is 5.9 times interest expense.
Does PDC hedge any of its production?
It hedges roughly 20% of its crude and NGL production, and 26% of its gas production. It has a ceiling of $94 a barrel on its oil hedges, so it will lose a little money with oil at $104. The gas is hedged around $4.05 per thousand cubic feet, and gas is north of $4.50 now.
Thank you, Scott.
BRIAN ROGERS
Barron's: How's your year going, Brian?
Rogers: It has been a sluggish year for stocks, as I expected, with the market up about 5%. One thing I've been wrong on is the strong performance of long Treasury bonds. I never would have expected, in the context of a continually improving global economy and generally stronger U.S. corporate earnings, that the 30-year Treasury would rally sharply -- or the 10-year, for that matter.
What accounts for the rally?
The bond market acts like it knows more about the pace of the global economy than the rest of us do. It is signaling that the pace isn't that strong. If the Treasury market doesn't reverse somewhat in the second half of the year, it might be a tough time for equities.
In Europe, countries such as Greece, Spain, and Italy are borrowing money on attractive terms. Some parts of the global fixed-income market are saying that the crisis is over and things are getting better. There are also technical factors at play: Treasury supply has been reduced, and defined-benefit plans have immunized their liabilities by buying long-maturity fixed-income securities. But low yields at the long end of the Treasury market suggest that growth will be moderate, at best.
The Federal Reserve is scheduled to end its third round of quantitative easing later this year. Will that have an impact on the stock market?
If it is communicated to the market, as the Fed has done, it shouldn't be a big deal. Then, there is the question of when the Fed will start to raise rates. The Fed has indicated it is concerned about ultralow interest rates, or "free" money, at this stage of an economic recovery. Looking back on economic history, you would expect short-term yields to be 1% or 2% by now. I suspect we will find, at some point, that the Fed has been a bit behind the curve in raising rates. People are still frightened about what happened in 2008-09. The fear is apparent in the amount of cash on corporate balance sheets. Everybody is focused on fighting the last war.
How does an equity investor make money in this environment?
You have to be really selective. Now is not the time to jack up beta. In a moderate-return environment, it is easy for stockpickers to find interesting opportunities without making heroic bets. The market turned rocky for a few weeks in April and is bound to have another rocky period in late summer or early fall. But the bar is low for equity investors; it is set at 2.5% -- the 10-year Treasury yield. Long term, equity-return patterns should exceed that easily.
I still like five of the six ideas I recommended in January. Applied Materials [AMAT] had a good first half. Its focus is on closing the merger with Tokyo Electron [8035.Japan] in the second half. The company will start buying back stock upon the deal's close. The stock is up about 25%, but it isn't extended. The company's prospects continue to be good.
Consol Energy [CNX] has done well, too.
Brian Rogers Photo: Brad Trent for Barron's
Consol is up 30%, to $47. Everything is going well. The company sold the bulk of its coal business about six months ago. It is a shale-gas play in the Marcellus, and gas production has been strong. Earnings and cash-flow growth have been outstanding. The stock reflects some of this, but isn't too expensive, based on asset value, which is probably north of $50 a share. Consol had a well-thought-out management change. It cleaned up the balance sheet a bit with proceeds from the coal sale. I haven't sold any shares.
Cablevision Systems, another pick, is up 4%. It has reported two good quarters since we met. Cash flow has been strong, and the company has had small subscriber additions. The stock yields 4%. I am not selling now, but the longer-term question is: With all the deal activity in the cable business -- Comcast [CMCSA] buying Time Warner Cable [TWC], divesting subscribers to Charter Communications [CHTR], spinning out a new cable company, and so forth -- will Cablevision be isolated? But the stock isn't expensive, the company is doing well, and there is some distant optionality here.
What options are you referring to?
Many investors are critical of the Dolan family, which controls Cablevision and Madison Square Garden, another of my holdings. I am not. Under the Dolans, Cablevision spun off MSG and AMC Networks. Somewhat ironically, MSG has become the crown jewel now that Steve Ballmer has agreed to pay $2 billion for the Los Angeles Clippers. There is probably someone out there who would pay $3 billion for the New York Knicks. The team is owned by MSG.
Moving on, I am closing out my recommendation of Entergy [ETR]. In my experience, whenever a utility stock goes up 20%-plus in five or six months, it is good to take some money off the table. The company's fundamentals are better than in January, and the energy market is stronger. The value of Entergy's merchant-power fleet arguably has risen, based on some of the contracts posted in the merchant-power market. Everything is going well, but the stock reflects it.
Case closed.
Newmont Mining [NEM] shares are down slightly since the January Roundtable. The price of gold is relatively flat. There had been some buzz about a merger with Barrick Gold [ABX], and some debate about which company walked away from a deal. When a deal makes sense, however, sooner or later something happens. A Newmont/Barrick combination would make a lot of sense because both companies have huge properties in Nevada and an opportunity for big operating synergies.
My final pick in January was the T. Rowe Price Emerging Markets Stock fund [PRMSX], which is up about 8%. Emerging markets have done better this year than expected. Money flows have started to perk up. Investors are intrigued by valuations. Emerging markets could be a good play for a couple of years.
Do you have any new recommendations?
Are you sitting down? I like Avon Products [AVP]. The stock has fallen 40% in the past 12 months, to $14. The market cap is $6 billion. The story has gotten better, while the stock price has gotten worse. CEO Sherilyn McCoy, who came to Avon from Johnson & Johnson [JNJ], continues to build out the management team. The company has agreed to settle its Foreign Corrupt Practices Act case. Insiders have been buying shares. Avon has been cleaning up its balance sheet. I keep in the back of my mind that Coty offered to buy Avon two years ago in the $20s.
If you like to buy when sentiment is bad, and you don't mind making some heroic assumptions about earnings power, Avon could be a good investment. Put a 15 to 18 multiple on $1.25 to $1.50 a share in earnings and it looks pretty good, compared to many other potential investments. The company seems capable of developing new products and marketing them more effectively than in the past. Avon would also do well if emerging markets do well.
Do you anticipate another takeover bid?
Nothing would surprise me. At this price, you're not paying for the possibility, but historically, where there is smoke, there is fire.
Going back to the market, I'd love it to be up 15% to 20% this year, but the individual investor is reluctant to be heroic. The only thing that will lift stock prices in a big way is continued good economic news. I don't think a market "melt-up" will happen, but I have built up cash in my funds to be able to buy.
How big is your cash position?
About 8% of assets. That's more than I've had in years, and is a function primarily of finding more positions to trim than stocks to buy. But I would feel stupid if we had another 2013, with the market up 30%, and I couldn't put cash to work.
Wouldn't we all! Thanks, Brian.
FELIX ZULAUF
Barron's: Give us your update, Felix.
Zulauf: I said in January that U.S. economic growth would be the best this year among developed economies. I also predicted disappointing growth worldwide. China is in a growth slump that could worsen next year. That will dampen economic growth throughout the emerging markets.
We have never seen so much money added to the global credit system as in the past five years. Yet, this has been the weakest economic recovery by far.
What went wrong?
The transmission mechanism that moves liquidity into the real economy is broken. The industrialized world is plagued by aging populations. Globalization has dampened the income of the middle class and moved some of it to the emerging world. Middle- and lower-income households in developed economies don't have the means to leverage their balance sheets and spend.
Central bankers will continue to throw money at the system, and some economies will respond better than others. It's unlikely the U.S. will achieve 3% GDP growth this year, but 2% is probable. Growth in the euro zone will stay below 1%. Everyone thought Germany should inflate and peripheral economies should deflate to reduce the imbalances within the European Monetary Union, but it hasn't happened. German investors are seeking higher yields outside Germany. They are buying stocks and bonds of peripheral countries.
Felix Zulauf Photo: Brad Trent for Barron's
Is that why Spanish government bonds now yield less than U.S. Treasuries?
It is one reason why. It is ridiculous. The world is yield-hungry, but there is less and less yield, so people are going after riskier investments. They don't realize that the fundamentals that would support such investments aren't there.
I said in January that the market could have a double-digit correction at some point. I would target late summer. The market has gone sideways for many months, and stocks recently made new highs in the U.S. and some markets in Europe. Sentiment has shifted from fear of a correction to fear of missing a further rally. Professional investors are under pressure to perform. I am looking for a correction of more than 10%. If it happens, Treasury yields will fall again, to the low-2% range. The world is too optimistic about growth and inflation.
What would trigger the correction?
Every cycle has a major excess. In the previous cycle, it was housing. Before that, it was overheated tech stocks. The imbalances today are largest in the emerging world, China in particular. Historically, in an economy with excesses such as China's, a correction occurs that is deep and can last five years. GDP can decline by 5% to 15%. I am not saying this will happen, but if it did, China would lose 50 million jobs. China has lost its competitiveness in many ways because wages for low-cost labor have risen 20% a year in the past five years. And the currency has strengthened, which has hurt China's export capabilities and competitiveness.
Let's ignore the short term. What is the best way to make money in the next 10 years?
In 10 years, the emerging world will have gone through a transformation. It will have implemented reforms and digested the excesses created in the past few years. It will have the best demographic profile. It will still be lower-cost than the developed world, and will outperform industrialized economies.
I don't know whether the euro will exist in 10 years. The world will have one more serious crisis in the next decade. Governments are going deeper and deeper into debt, and that has to end. Some of the currencies may disappear. Around the world, everyone is trying to gain a competitive advantage, but the pie doesn't grow. Countries are cheapening their currencies to gain an advantage. Today, to weaken your currency, you have to create more of it, which adds liquidity to the system. We will continue to swim in a sea of liquidity, but at some point investors will wake up and say: 'The emperor has no clothes.'
That implies something much worse than a 10% correction.
There will be a bigger decline. If the Chinese economy weakens much more than the market is assuming, China will devalue its currency. That could lead to another systemic crisis. The best way to fix our economic problems is to let those who can't compete go out of business. This means we need to adjust our prosperity downward.
Do you have any investment recommendations for the second half?
No. I'm pretty much in bonds. I will buy whatever performs well during the coming decline and has decent fundamentals.
A quick update on Japan: I said in January that the Nikkei would surprise on the downside and the yen would strengthen, an anti-consensus call. That's happening. The Bank of Japan is hardly expanding its balance sheet any more. Later this year or early next, the BoJ will have to cheapen the currency again and print money, and the Nikkei will rally.
Thanks for the update, Felix.
MERYL WITMER
Barron's: How does the market look to you?
Witmer: We like to own good companies that are growing and generating free cash flow, and we like to buy them relatively cheaply. We don't concentrate on the macro backdrop. Stocks aren't inexpensive, and we don't see tons of opportunities. It is hard to see a reason for the market to move one way or another through year end.
Meryl Witmer's Picks
Company/Ticker 6/11/14 Price
Ingredion/INGR $76.33
Tate & Lyle/TATE.United Kingdom 690 pence
Source: Bloomberg
That seems to be the consensus.
Then it's likely to be wrong. I have two picks, Ingredion [INGR] and Tate & Lyle [TATE.UK] They both produce ingredients, mainly sweeteners and starch, used in the food, beverage, and brewing industries. They also sell to the paper, personal-care, pharmaceutical, textile, and animal-feed industries.
Their products are derived from corn and other starch-based materials such as tapioca, rice, and potatoes. Ingredion and Tate wet-mill corn, which separates the kernel from its constituent parts. The protein and oil are sold with some further processing, leaving behind a starch slurry, an amazing and flexible raw material.
What is the slurry used for?
It can be dried and sold as cornstarch, or processed to make core and specialty ingredients. Core products not only sweeten but add body, control crystallization, and act as binders in processed foods. They are also used in drug tablets. In paper production, starch is used to improve the strength of recycled paper. It is also used in water-filtration, oil-and-gas drilling, fabric softeners, and insulation production.
Specialty starch products have many food applications. They serve as fat replacements and stabilizers; they add texture and mouth feel, and can add nutritional elements such as fiber. They are usually much less expensive than thickeners like gums.
Are Ingredion and Tate & Lyle the biggest producers in the industry?
There are four players: Archer Daniels Midland [ADM] and ConAgra Foods [CAG] are the other two. Ingredion and Tate focus more on specialty applications, which we like. The use of specialty ingredients in processed foods is growing with the development of new formulations to capitalize on health, wellness, and convenience trends, and population growth and emerging markets. It is prohibitive to enter the industry; it costs more than $1 billion to set up a wet-milling plant.
Meryl Witmer Photo: Brad Trent for Barron's
Ingredion and Tate are consistently transitioning a higher percentage of their starch slurry into higher-value-added products that give food a desirable taste, texture, functionality, or label, such as "good source of fiber" or "gluten-free." Food companies are reluctant to change formulations, so once an ingredient is qualified into a product, it is an annuity stream. There is a long lead time to reformulate products, and it can be difficult and expensive, so there aren't many new entrants. We like the structure of the industry.
What is the growth outlook for Ingredion and Tate?
Ingredion is based in the U.S. and led by Ilene Gordon, who made a savvy purchase of National Starch in 2010. That catapulted the company into specialty-food ingredients. Ingredion has relatively steady earnings in its bulk business, because it hedges its corn purchases. Over time, it can pass on raw-material price changes to customers.
Recently Ingredion had some difficulties in its Argentina unit, which resulted in a hit to earnings. That will normalize at some point. Assuming no contribution from Argentina, the company could earn $5.37 a share in 2015. Depreciation and amortization exceed maintenance capital spending by more than 90 cents a share, which leads to after-tax free cash flow of $6.30 a share. We put a 14 multiple on this, and add the free cash flow they will earn in the next year, to get a value of $91 a share. Normalizing the Argentina business would add another 50 cents a share of free cash flow, or about $6 per share to the valuation. We have a one-year price target of $95 to $100.
Is the balance sheet healthy?
Yes. Ingredion has $7 a share of gross cash and interest coverage of more than 10 times.
Tate & Lyle is based in the U.K. Its business and portfolio are similar to Ingredion's, but Tate also produces Splenda Sucralose, a zero-calorie sweetener. Splenda historically was highly profitable, but recently there has been aggressive price competition from Chinese generics. Tate has been forced to lower its Splenda prices, which has hurt earnings and obscured the underlying growth in the rest of the business.
How fast is the business growing?
Historically, Splenda Sucralose volume grew by mid- to high-single digits annually. Lower pricing seems to be adding to the growth rate, as it is now affordable to add the sweetener to more foods. A few years ago Tate restarted a Sucralose-manufacturing plant. As volume grows, the plant will generate significant incremental free cash flow.
Tate could earn 56 pence per share (94 cents) of free cash flow in the year ending March 2015, including about five pence of excess depreciation and amortization. In fiscal 2016, free cash flow could rise to 59 pence. A multiple of 14 times, plus the free cash flow they will earn in the interim, gets us a target price of 880 pence, with upside from Splenda getting back on track. Like Ingredion, Tate has a solid management team and a conservative balance sheet. Plus, you get paid to wait with a 4% dividend yield.
That's sweet. Thanks.
FRED HICKEY
Barron's: What's the view from New Hampshire, Fred?
Hickey: The economy doesn't look good. I never expected the Fed's quantitative-easing program to rejuvenate the economy, and after 5½ years of near-zero interest rates, we've had the worst recovery in modern history. The current recovery is based mostly on asset-price inflation. QE has created extreme wealth among some, but the middle class isn't participating. Wages are stagnant or falling in inflation-adjusted terms. Fed policies also have led to a loss of business confidence. The Fed's failure will become apparent as the central bank continues to taper its asset-buying.
The stock market has seemed pretty happy with the way things are going.
The averages are up, but the market isn't healthy internally. There are many divergences. Big-caps are rising, small-caps are falling. Breadth is terrible. The bullish sentiment of professional investors, as measured by Investors Intelligence, is near record highs, which signals trouble. Sentiment among individual investors is much worse. Put another way, there is a dangerous level of complacency or exuberance among the people paid to play.
Momentum stocks such as Twitter [TWTR] and shares of 3-D printing companies have broken down. The same thing happened in 2000. Tech and Internet stocks were killed first, and after a lag, the rest of the market broke down. I expect the broad market to get killed. As I said in January, I expect a dislocation in stocks as the Fed continues to taper. The market tumbled when QE1 and QE2 ended. Why would you expect something else when QE3 ends? There is big trouble ahead.
How low will stocks go?
Not too low, because the next round of QE will start. If stocks fall hard, the wealth effect diminishes. Most big-box retailers saw weak sales this spring. Business capital spending is suffering, too. IDC just cut its forecast for global IT spending. Sales are off in the computer-server and storage industries. Chinese smartphone sales fell 9%, year over year, in the first quarter. The CEO of Samsung Electronics [005930.Korea] said last month that the big cellphone markets are saturated. Growth in tablet sales has fallen. IDC says users are holding on to their tablets longer. IBM [IBM], Cisco Systems [CSCO)], and Hewlett-Packard [HPQ] have all seen lower revenue growth. Hewlett-Packard has laid off 50,000 people.
If money-printing doesn't work, what will?
A free-market approach would work eventually. You can't avoid the pain forever, which is what we've tried to do. As for interest rates, there is no possible chance of Fed-controlled rates going up. Someday, when people lose faith in the Fed, long rates will go up, but the timing is hard to predict.
Fred Hickey Photo: Brad Trent for Barron's
If you are expecting a big decline in the market, you want to have a lot of cash to buy on the downturn before the Fed steps back in. The other way to protect yourself is to own gold and silver. Gold is in a secular bull market. It was down in 2013, but is up this year, and it could be up a lot by the end of the year. India has always been a big buyer of gold. Last year, the ruling Congress Party raised the import tax on gold to 10% from 4%, and imports plunged. Now a new government has come to power and will probably lift most of the restrictions on gold-buying, which could create huge demand. At the same time, supply is low. Gold miners haven't made many investments in new projects recently.
How high could the gold price go?
It could reach $1,600 by the end of the year, up from $1,250 now. Within a year, it could be back at $2,000. Gold sales are slow in the early summer until the Indian harvest, but late summer is a seasonally strong period. I have been buying gold and silver in various forms. The silver price topped in early 2011, before the top in gold. Silver has been in a cyclical bear market for a longer period, and is even more hated than gold. I'm seeing big short positions in silver futures.
Why are many investors bearish on gold?
Western investors hate gold and silver. Many see stronger prices as a reflection of the Fed's failure, and they want the Fed to succeed. Naysayers complain, by the way, that gold and silver don't have a yield. Well, cash doesn't yield anything in Europe anymore. The European Central bank just announced it will charge banks 0.1% for parking cash overnight. That gold and silver now yield more than cash could be a spectacularly bullish propellant for the metals.
Are you still buying gold stocks, too?
Agnico Eagle Mines [AEM] remains my favorite gold stock. Its mines are in Canada, Mexico, and Finland, where there is little risk of government expropriation. It is one of the best-performing big-cap gold stock this year. The shares are up 16%, to $31, even though gold has been weak. If the gold price rises, as I expect, there will be huge leverage on the company's bottom line. Agnico had record gold production in the first quarter, up 55% year over year. Cash costs fell from $740 an ounce to $537.
How much is the company earning?
In the third quarter, Agnico was supposed to earn eight cents a share. It earned 35 cents. In the fourth, the estimate was 19 cents, and it did 25 cents. In the first quarter, Wall Street was looking for 23 cents. Earnings came in at 61 cents. Plus, Agnico and Yamana Gold [AUY] just teamed up to buy Osisko Mining [OSK.Canada]. The deal will be accretive to earnings.
Given your bearish market outlook, are there stocks you're shorting?
I've often said I wouldn't short stocks in a market where the Fed is printing money. But I changed my mind in February. I used put options to short a long list of crazily valued stocks, including Yelp [YELP] and Facebook [FB].
Maybe that whetted my appetite, because now I'm short IBM. The company missed revenue estimates in the first quarter and posted the lowest revenue since the first quarter of 2009. Revenue has declined for eight consecutive quarters. The hardware, software, and services businesses all came in below expectations. Business was down by double-digits in China, and that was before China told its banks a few weeks ago not to use IBM servers anymore. It was a political move aimed at retaliating against the Obama administration.
IBM's revenue has shrunk in part because the company has exited certain businesses.
IBM is the poster child for financial engineering. It is piling up debt like there's no tomorrow. Debt has risen to $44 billion, up $10.6 billion in one year. The company is borrowing to buy back shares because its cash flow is imploding. It has been declining since at least 2009. IBM front-loaded stock repurchases in the first quarter to make earnings. It also benefited from a lower tax rate. Total shareholder equity is $16.7 billion, and that's all goodwill. The company has negative tangible assets.
For all that, Fred, the stock seems to be doing fine. What would take it down?
When the Fed ends the taper, the market is going to decline. IBM could fall to $150 or so from a current $186. It will fall until the next round of quantitative easing.
When might the company grow again?
If IBM focused on developing new businesses or products instead of financial engineering, it might grow. Its roadmap to achieving the $20 a share in earnings that it promised Wall Street is killing it. If you pile up that much debt, you won't have any money to invest in capital projects or research and development. You'll be fending off debt-ratings downgrades from S&P and Moody's. Many companies are buying back stock to boost earnings. When earnings go up, executives get bigger bonuses. This is dangerous for the country, long-term.
Are there any tech stocks you like?
The only positive thing happening in tech is a big inventory build in front of the rollout of Apple's [AAPL] iPhone 6. Shares of Apple suppliers have been soaring. Apple is just 10% away from exceeding its old high. There is no growth in any of the company's core markets. Yet the stock could top its old high because there is nothing else to buy in tech.
Thank you, Fred.
OSCAR SCHAFER
Barron's: How does the world look to you?
Schafer: We are stockpickers. We don't ignore the big picture, but most people who focus on it got it wrong this year. They were long U.S., European, and Japanese equities, short emerging markets, long the dollar against the yen, short fixed income. The economy is getting a little better, although probably not as quickly as people had thought. The stock-market averages will continue to do little this year, but there have been and will be opportunities on both the long and short side.
Are most hedge funds making money?
My read is that most funds are up in the single digits. We have made money by going long and short. One stock we like is Maple Leaf Foods [MFI.Canada]. The company, which is based in Canada, has a 2.5 billion Canadian-dollar market cap ($2.3 billion) and is at the tail end of a five-year transformation. It controls the No. 1 and No. 2 retail meat brands in Canada, with a combined market share of nearly 50%. It produces branded ham, hot dogs, sausages, and poultry for supermarket customers, and has a small hog-raising business.
Hogs are hot, as seen by a rash of takeovers in the industry. Could Maple Leaf become a takeover target?
We didn't buy it for that reason, but it potentially could become one. In the past few years, Maple Leaf has undertaken a complete overhaul of its meat plants and distribution facilities. This transformation will be complete by the end of 2014. The CEO personally owns 35% of the shares, and an activist investor and current board member owns another 10%. The stock trades for C$18.66 and we see upside in the next 12 months of 50% to 100%.
Maple Leaf's origins date back to 1836 as a small meat producer and flour mill in St. Catharines, Ontario. Over time, it grew to become Canada's largest meat processor and ran its largest wholesale bakery. The McCain family, of McCain Foods, and the Ontario Teachers Pension Plan acquired a controlling stake in 1995, and Michael McCain became CEO. An activist investor, West Face Capital, bought the pension plan's stake. A representative joined the board and began the review process that would transform the company.
Why did Maple Leaf need an overhaul?
Its distribution and information-technology systems had never been modernized, and synergies between the bakery and protein businesses had never been realized. Despite strong revenue and a dominant market share, profit margins languished below U.S. peers'. Ebitda margins in the meat business generally were 3% to 4%, versus 10% at Hormel Foods [HRL], ConAgra, and Hillshire Brands [HSH].
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 implementation of SAP [SAP] software, and consolidation of nine manufacturing plants and 19 distribution centers into four new plants and two state-of-the-art distribution facilities. When the transition is complete, the company will save approximately C$110 million in operating expenses and increase its revenue through more efficient distribution.
Does Maple Leaf focus only on meat?
It's been transforming its portfolio. Last year, it sold Rothsay to Darling International for C$645 million. It sold its pasta business, Olivieri, for C$120 million. Recently it sold its bakery business to Grupo Bimbo [BIMBOA.Mexico] for C$1.8 billion. By the end of this year it will be a pure-play Canadian meat producer with a pristine balance sheet.
Oscar Schafer Photo: Brad Trent for Barron's
Maple Leaf has a tremendous opportunity in 2015 and beyond. This year will be difficult due to peak investments in new facilities and the cost of operating two supply chains. The company also faces cyclical swings in commodity prices driven by the PED virus in pigs. Next year, however, investment spending will decline, and operating costs will fall dramatically. Just by adding cost savings to prior Ebitda levels and assuming a more normal commodity market, we get Ebitda of C$280 million to C$300 million. We are buying Maple Leaf for between five and 6.5 times Ebitda, whereas branded peers trade for nine to 11 times. Tyson Foods [TSN] is buying Hillshire for 16.5 times. With or without consolidation, Maple Leaf's valuation will expand significantly in the next 18 months.
What other bargains have you found?
RealD [RLD] licenses 3-D technology to movie exhibitors.
After the 2009 release of Avatar, Hollywood rushed to produce 3-D movies. The director James Cameron famously said that 100% of movies would be 3-D in a few years. Since then, 3-D box-office numbers have disappointed. The studios have figured out that not everything works in 3-D, and that it makes sense to shoot only a few films a year in 3-D instead of converting two-dimensional films to 3-D. The 3-D technology accounts for 15% of box-office receipts, and RealD is the dominant player, with a 75% market share in the U.S. and 40% abroad. Its business model is attractive.
In what way?
The company signs contracts with individual exhibitors to deploy its XL systems to a certain number of screens. It costs RealD $10,000 to install a system, and it receives 50 cents for each 3-D ticket sold. RealD provides the theaters with recyclable 3-D glasses, paid for by the movie studios. Once a system is deployed, there are virtually no ongoing expenses associated with it.
In the past few years, RealD overspent and overexpanded. It deployed too many screens in the U.S., and spent on consumer technology that generated no revenue. It has stopped deploying its XL system to more screens in the U.S., and has committed to commercializing its consumer technology next year. Two activists have recently taken large stakes in the company, and management is eager to show the Street that it can operate a lean company while harvesting some of its investments.
What does the future hold?
China now represents 18% of revenue, and Russia and Brazil, less than 10%. These markets are benefiting from the emergence of strong local-language film industries. RealD will open 1,600 screens in these countries next year, which should offer a nice runway for growth. At $13 a share, we are buying RealD for about 10 times recurring free cash flow, including $20 million of R&D for products that haven't yet been commercialized. And the company has no debt.
Given the nature of RealD's high-fixed-cost licensing model, earnings will be volatile. But we see good things in 2015 and 2016, as the release slate is loaded with sequels to hot movies like Avatar, Jurassic Park, The Avengers, and many others.
Do you have another recommendation?
My final pick is Albany Molecular Research [AMRI]. In January, I recommended ANI Pharmaceuticals [ANIP], which benefited from large pharma companies shedding smaller products. When I invest in this industry, I look for change, and managements that anticipate and benefit from change.
Two important trends in the pharmaceutical business are consolidation and outsourcing. Pharmaceutical companies increasingly are focusing on core competencies in research, sales, and marketing, and outsourcing much of the rest. As they consolidate, they need larger vendors for their outsourced needs.
Albany Molecular is building a one-stop shop for drug companies, from idea to final product. Rarely have I seen a management give five-year forecasts, but CEO Bill Marth and his team, who built Teva Pharmaceutical Industries ' [TEVA] U.S. business to $10.5 billion from $350 million, have done so. If Marth succeeds in achieving his goals in the next three or four years, Albany will have sales of $1.3 billion, up from $250 million, and earnings of between $3 and $4 a share. The stock is $17.
Thanks, Oscar.
ABBY JOSEPH COHEN
Barron's: How does the world look to you, Abby?
Cohen: The global economy is getting better, but it's a mixed picture. The U.S. is leading the world in the re-acceleration of growth, which might sound odd, given that first-quarter GDP growth recently was revised downward to minus 1%. The decline was a statistical fluke, related largely to weather, inventory levels, and so on. Looking at other metrics, including industrial production, retail sales, and developments in the labor market, we conclude that real [inflation-adjusted] gross domestic product could grow by 3% for the remainder of the year.
Most companies we follow say that things are looking better. The consumer is more confident. Wages have risen. Business fixed investment is up.
What is your take on the rest of the world?
The big picture is more disturbing, with Europe at the top of the list. It is pulling ever so slowly out of its recession. The ECB's recent steps to lower interest rates and spur growth indicate it is concerned. Among European central bankers, there is much more discussion about deflation than in the U.S. Labor productivity has been sagging, and this is the fourth year of downward revisions in corporate earnings. Even so, we are forecasting 1% GDP growth in Europe for this year, and 1.5% for 2015.
What do you see in Asia?
In Japan, there has been a fiscal-policy push to try to stimulate the economy, which has been stuck for a long time. Our team in Tokyo forecasts that real GDP growth will be 1.3% this year and 1.2% next.
On China, we have been more optimistic than many other observers. We see the deceleration of the economy and the strains in housing and other areas, but the new government has made a conscious decision to sacrifice current and intermediate-term growth to make necessary structural adjustments. China's leaders want to get its financial markets, banking system, and housing in better order. They are also serious about dealing with environmental degradation.
Assuming a U.S. recovery is under way, when will the Fed raise interest rates?
Recent public commentary by members of the Fed's policy-making committee suggest the Fed could start raising rates even before it has finished tapering, or winding down, the latest round of quantitative easing. There is enormous pressure on any central bank when real interest rates are zero. It is nearly out of monetary tools. Market rates likely will move higher. We expect the 10-year Treasury yield to rise to 3.25% by year end.
Has Goldman's stock-market forecast changed much this year?
At the beginning of the year, David Kostin, our chief U.S. equity strategist, put forth an S&P 500 target of 1900. We are now looking for the S&P 500 to reach 2100 next year. Reasonable valuations, low volatility, and evidence of economic growth all could encourage investors to become less risk-averse. We hear mixed views from portfolio managers. Some are taking on more risk and investing in growth companies, while others continue to look for companies with strong balance sheets that return capital via dividends and share buybacks.
Abby Joseph Cohen Photo: Brad Trent for Barron's
Let's talk about some companies you like.
I'm picking stocks recommended by our analysts that reflect themes I like. I've got five, starting with Six Flags Entertainment [SIX]. If the economy, consumer confidence, and employment are improving, that is good news for discretionary spending. Six Flags and other theme parks are seeing stronger pricing. Six Flags reported that pricing was up 9% in the first quarter. Many visitors are buying season passes, which are lucrative. Profit margins could expand to 16% from 14%. Six Flags has high recurring revenue and generates a lot of cash. The stock yields 4.5%. The business has high barriers to entry.
Is Six Flags a master limited partnership?
No, but there is a possibility that it could convert to one.
Health care has been one of the best-performing sectors this year, but Bristol-Myers Squibb [BMY] shares have been flat. Investors have been concerned about the company's new-drug pipeline.
Bristol-Myers is best-positioned in immuno-oncology, an exciting area. Within the drug industry, it has the broadest immuno-oncology portfolio, because of its own research and partnerships with other drug companies.
Being the first mover will be essential. The company is working on treatments primarily for lung cancer, and also renal cancer and melanoma. It has shown that some of its therapies work well in combination with other, existing therapies.
Why is the stock ailing?
It rose earlier in the year, but is down about 15% in the past three months. Many biotech stocks have sold off recently, as investors see no short-term boost to revenue and earnings. Bristol-Myers is a long-term investment in an exciting category.
Water-purification is also exciting. As I mentioned in January, the water in several provinces of China is too dirty for human consumption. The new government has passed some laws aimed at environmental improvement, and is making water cleanliness a public issue. I see two investment opportunities in China: Beijing Originwater Technology [300070.China] and Beijing Water Business Doctor [300055.China]. Both companies are involved in waste-water treatment. They focus on coal, chemicals, and the utility industry.
How can U.S. investors buy them?
They can buy the A shares through a broker who has a QFII [Qualified Foreign Institutional Investor] quota. Water Business Doctor, which has a market cap of about $1 billion, has been growing organically and through acquisitions. It has been buying more infrastructure. The company went public in 2010. Originwater Technology, with a market cap of $4.8 billion, has been doing joint ventures in different parts of the country.
Are these companies profitable?
Yes. Growth could be staggering, albeit from a small base. Our analysts are forecasting revenue growth of 40% in 2015 for Originwater Technology, and earnings growth of 37%. At Water Business Doctor, revenue could rise 49%, and earnings, 42%.
My last idea is economically sensitive and benefits from exposure to the U.K., which is doing better than much of the rest of Europe. It is easyJet [EZJ.UK], a low-cost airline. The company is based in London, and its market share continues to grow. The stock trades for 13 times this year's expected earnings and 11 times next year's earnings. It yields 2.5%. What could go wrong here? A rise in fuel prices or an increase in intra-European capacity, but we aren't expecting either. Continued weakness in Europe could also impede results.
Thanks, Abby.
MARC FABER
Barron's: The sky hasn't fallen yet, Marc. Maybe this year?
Faber: Most economists are optimistic about the U.S. I take a different view. If the economy and inflation were measured properly, there would be hardly any growth. Yes, money printing leads to rising asset markets, which lead to incremental economic activity. If my stock portfolio goes up, I might go out to dinner, spend a lot, and tip the waiters well, and the waiters would then spend money. But aside from that, if the economy were strong, median wages wouldn't be down for the past 10 years. I don't believe that the weak growth in first-quarter GDP was all weather-related.
Asset buying by central banks has led to artificially low interest rates. Still, it is remarkable that with everybody talking about stronger economic growth, the bond market has performed so well. I recommended 10-year Treasury notes at the January Roundtable. I wouldn't buy them now, but I haven't sold mine either. If the stock market trades down in the second half of the year, there could be one more rally in Treasury securities.
Marc Faber's Picks & Pans
Investment/Ticker 6/11/14 Price
LONG
Market Vectors Junior Gold Miners ETF/GDXJ $37.46
Gold (spot, per ounce) 1261.07
Platinum (spot, per ounce) 1482.38
China Life Insurance/2628.Hong Kong HK$21.65
TRUE Telecommunications Growth THB10.50
Infrastructure Fund/TRUEIF.Thailand
BTS Rail Mass Transit Growth 9.8
Infrastructure Fund /BTSGIF.Thailand
SHORT
South African rand $1=10.76 ZAR
PAIR TRADE
Long: Market Vectors India Small-Cap ETF/SCIF $51.44
Short: iShares Russell 2000 ETF/IWM 116.1
Source: Bloomberg
Do you expect a market correction?
The Standard & Poor's 500 is up only 5% this year. Without massive stock buybacks, corporate earnings in the U.S. would be down. There is little growth in the world, and valuations in the U.S. are high compared to those in Europe and the emerging markets. The U.S. market hasn't had a significant correction since the fall of 2011. That suggests it will keep rising, but then go down sharply.
The outlook in Europe has improved somewhat, and if the euro weakens, corporate profits will do well there. The Italian market is up 17%. Spain is up 11%. India's Sensex index is up 20%, in dollar terms.
What will spur genuine economic growth?
The U.S. needs a painful readjustment that will send people back to do real work. There is a lack of skilled technical people and a surplus of MBAs. Thousands of people would like to work for NGOs [non-governmental organizations], but they are of little use because they don't even know how to hit a nail into a wall properly.
Ouch, that's harsh.
There is also an entitlement mentality in the U.S. and Europe. People are happy to take from the government, but don't realize that someone else has to pay for it. U.S. government spending equals 42% of gross domestic product. Government expenditures need to be reduced to a maximum of 20% to 25% of economic output. The larger the government, the less economic growth there will be. And the U.S. in many ways is better off than other countries.
How do you invest in the near term?
I recommended the Market Vectors Junior Gold Miners ETF [GDXJ] in January. It had a big move up and then retreated. It could drift a bit, but I would use this weakness as a buying opportunity. I would buy physical gold, especially if it corrects to around $1,180 per ounce. Platinum is even more attractive at current prices.
I am not optimistic about the Chinese economy, but there is a lot of money floating around Asian stock markets. Some money could move into Chinese stocks, especially if the government succumbs to the temptation of monetary easing. Under that scenario, Chinese stocks could rise, even if the economy performs poorly.
Chinese insurance stocks are cheap. I like China Life Insurance [2628.Hong Kong]. I am not optimistic about Thailand's economy either, but the stock market isn't expensive.
The country has had a military coup.
The market actually strengthened because the general in charge has a good reputation. I own a lot of Thai stocks, but have been accumulating two in the past six months: TRUE Telecommunications Growth Infrastructure fund [TRUEIF.Thailand] and BTS Rail Mass Transit Growth Infrastructure fund [BTSGIF.Thailand]. Both should yield more than 8%, although overseas investors must pay a 10% withholding tax on dividends.
Marc Faber Photo: Brad Trent for Barron's
Among currencies, I would short the South African rand. It has strengthened in the past three months and become overvalued. South Africa's economy is overly indebted and doing poorly. At some point, the central bank will ease, and the currency will fall.
In January I recommended Vietnam Dairy Products [VNM.Vietnam]. I have closed my position. The fundamentals are OK, but the uptrend in the shares has broken.
Any other recommendations?
I recommended in January shorting a basket of momentum stocks, and I am maintaining that position. Now I have a pair trade: Go long the Market Vectors India Small-Cap fund [SCIF], and short the iShares Russell 2000 ETF [IWM]. Small caps in India aren't expensive, whereas the U.S. small-cap index is very expensive.
Are you bullish on India generally?
You can't be too bullish, given the country's bureaucracy, but Narendra Modi was just elected prime minister with a mandate. Maybe he will finally be able to implement badly needed reforms.
Going back to China, there was a massive credit bubble. There is concrete evidence now of a slowdown in the growth of Macau. Some markets have seen a diminished number of Chinese travelers. The property market has been weakening. If the central bank eases, however, the stock market will go ballistic. It could rise by 10% or 15%.