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Investing in Equities Amid Increased Volatility
At the end of Q1 earnings estimates were trending downwards. Watch as three experts discuss how investors can approach the equity markets amid uncertainty.
Tom Kolefas, CFA - Portfolio Manager, Equity Investments at TIAA-CREF Asset Management
Randell A. Cain, Jr. CFA - Principal and Portfolio Manager at Herndon Capital Management, LLC
Richard Bregman - Chief Executive Officer at MJB Asset Management
Duration:
00:56:05
Transcript:
Courtney: Tom, we’re just kicking off first quarter earnings, analysts lowered their expectations dramatically for their first quarter. So we’re going to see negative revenues and even maybe negative earnings. So why would I want to put money to work in stocks if I know earnings are going to struggle, or is this a huge buying opportunity?
Tom Kolefas: [00:00:16] Yeah, it sounds terrible, but look where we came from. We were at low double digits in terms of earnings estimates. And now they’ve coalesced the mid single digits. So expectations have come way down, that allows these companies to beat, and they’ve already been buffeted with low oil prices, low interest rates, recharge the banks, a lot of different issues, high dollar hurts a lot of companies. All of that expectation has been taken out. You’ve now gotten down to mid single digits. I think that provides an opportunity.
Courtney: [00:00:46] You think we’re going to surprise the upside maybe, Randy?
Randell A. Cain Jr: [00:00:48] Well, I think that it depends on where you’re looking to invest. When we talk about the market in general it’s easy to get, I think, sometimes blindsided by the collective thoughts about the market in general. Whereas for most of us on active management, so we’re digging into individual sectors, we’re digging individual industries, as well as individual stocks. And I think that’s where the real opportunity happens to lie, because I think with what Tom is saying, what we should take from that basically is that their stocks where that negative pessimism has already been priced in. And so in some case you can find that less worse news and some of the companies that might disappoint actually reflects good opt out opportunities within the individual stocks. It’s not unusual at all to see a company come in and meet expectations and even if they diminish you can see the stock price respond quite nicely, if the market was actually expecting for the company to miss.
Courtney: [00:01:37] That makes sense. So is this a stock pickers market, Richard?
Richard Bregman: [00:01:40] Well, if you’re a good active value manager, yeah, you’re picking stocks. And earnings reports, my experience is good managers are totally aware of the macro environment. But they’re looking at individual names. And the beauty of a good value paradigm is to find a great company that’s trading at a price for whatever the reason, whatever the reason, whether it’s earnings or offer some other issue that brings the price down into a reasonable place or a devalued place, depending on your style, so stock pickers. By the way I think it’s always a stock pickers market, you know, it doesn’t really seem that way, but I think it always is.
Courtney: [00:02:22] Well, with two active managers here I think they’ll agree with you. Randy, you know, guidance is going to come out. We’re going to hear what the CEOs, what the management teams are going to say. How important is that from a value investor’s perspective?
Randell A. Cain Jr: [00:02:34] It’s interesting because I think when we talk about value, we think about it from different flavors and perspectives. From our perspective we’re looking at only buying companies in part, which will actually buying the whole company. And when you’re looking to buying a whole company, what you’re buying in that is seasonalities or the cyclicality. And so that also means if you’re buying with a big enough discount in terms of price, you’re allowing for the company sometimes to have some mis-steps in there and not necessarily cause you to be stopped out or be weak in your positioning in that particular company and stick with it through some of the more challenging times. We have some big issues that are impacting companies right now. In the energy space clearly the decline in oil prices, that’s been an impact. For the multinational corporations, the impact with the strong dollar, we’ve been dealing with that for the past couple of quarters. CEOs are coming out, talking about how they’re trying to fight the good fight in that regard. And in a short one it can look like they’re losing it, but again I think when you look at the whole strategy for a company to manage with the operations as well as not just a financial report. It can help you to basically feel confident and understand that sometimes when these things go against a company in a short run, it’s creating opportunities to step in as a long term manager, and not necessarily be susceptible to the fluctuations that the market may have, say on [unclear] release and the [unclear] that comes thereafter, frequently that can be some of the best opportunities that actually come out.
Courtney: [00:03:56] That’s a really good point.
Richard Bergman: [00:03:58] I would say this is the first time in six years where specific stock picking matters, because up until now it’s been a lot of micro, it’s been quantitative easing, stocks have been correlated with each other. And now you’re starting to see the differential, meaning companies with good balance sheets, good free cash flow generation starting to break away from the pack. The market is starting to focus on those things. And giving, you know, when companies have those things, they have optionality. They have the ability to do good things for shareholders. That’s what we look for and I think now it’s starting to get focused on in the market.
Courtney: [00:04:31] Interesting. And is there any reason to think … and Randy, you talked about these themes, the dollar, oil, you know, these themes that we’ve seen in place, Tom, like oil falling 50% off it’s high, the dollar rising 25% against other major currencies in the last year or so. Do you think these themes will stay in place? Are we going to see a reversal? And even if they do or don’t, what’s the implication there for a value investor?
Tom Kolefas: [00:04:56] I think generally things do revert to the mean, so that the dollar’s run up a lot, but when … since we got that March 18th Fed meeting it seems to have fallen and the euro has come up. So Europe ultimately is going to pick up and when it does the euro will strengthen, the dollar will fall. And sure, you’ll get a reversion to the mean, well, they’ll both kind of you know, converge to one point or another. Again, it’s important that companies have the flexibility to deal with this pain that happened. It’s okay, you take a big hit on the dollar, your revenues get hurt, what you can do on the cost front? What can you do to maybe change your cost structure and maybe produce out of country? So managers take actions that they need to, to deal with these issues. But the key is going back to balance sheets is if you have a good one you could survive that downfall or that difficult issue and get through it, of you don’t, then maybe not, then you’ve got a liquidity problem. You need to issue equity, you need to do other things. Case in point, in the energy patch, these companies have been buffeted with horrific results in terms of the commodity falling, but they also cut CAPEX very quickly, and that preserved their balance sheets and has kind of kept them in the game, which means that they, in my opinion, could be good investments down the road. But they did what they had to do to preserve balance sheets and cash flows.
Courtney: [00:06:19] And we’re going to get to oil since it’s such a huge sector, later. But you mentioned what management teams were doing with currency, is it currency hedged ETFs, when you say you’re looking for what managements are doing to buffet?
Tom Kolefas: [00:06:31] If they haven’t hedged already there’s not a lot they could do right now. It’s very expensive for them. They’re almost better off riding out the storm. They need to have had a regular plan that they do, you know, forward every six to nine months. If you weren’t doing anything and all of a sudden the dollar strengthens like this, you’re not going to be able to protect your earnings. You’re just going to have to take the pain.Courtney: [00:07:05] And Tom and Randy are both US value managers. But, Richard, you have the ability to kind of allocate anywhere in the world for your clients? Where are you allocating right now?
Richard Bregman: [00:07:14] Yeah. We’re primarily allocators and we rely on top flight managers to deliver results. So we like the equity market, interest rates are low and we’re okay there. We find value in Europe, developed Europe particularly, quantitative easing going on there. So it looks like they’re our tailwinds to a certain extent, and they’re a little bit behind us. But they seem to be coming out. So we’re comforting allocating a little bit more there than we might have in prior years. Last year it hurt by the way, it hurt a lot in results, this year it’s been helping – it’s been helping.
Courtney: [00:07:50] Anywhere else within equities that you’re reallocating, looking into the second quarter?
Richard Bregman: [00:07:56] Well, we’ve talked about oil, we’re not company specific. But clearly there’s a huge dislocation in that part of the market. So we’ve been playing it with MLPs because we just feel that they got tossed out, babies with the bathwater, long term contracts, they’re not really dependent on the price of oil so much. And we just think they got caught up in the downfall, the downturn. And we’ve been playing that way with the … actually, I hate to say it, with the ETF, [unclear] ETF I suppose for the active managers, although we’ve been looking and talking with a lot of active managers in the MLP space.
Courtney: [00:08:39] So you’re a mix of active and passive, though not within the MLP space specifically, but broadly?
Richard Bregman: [00:08:43] Active and passive, this is my feeling on it, you know, there are just times when active wins and there are times when passive wins. And you know the cost issue that people harp on all the time, certainly passive is less expensive than active. But you’re getting limited set of exposure really. And yes, there are times when a cap weighted index is outperforming, there’s no doubt about that and not much you can do about that. But it doesn’t take away the value of active management. And so we want to have active managers always. But we’re not averse to having some passive exposure where we think it makes sense.
Courtney: [00:09:21] And, Randy, when we look at midcap managers are they able to be insulated from the dollar whilst still enjoying the vibrancy of the US economy now? I know you deal with both mid and large caps?
Randell A. Cain Jr: [00:09:31] I think it really depends on the dispersion of revenue as far as geographic exposure. Last year one of the things we saw as being a bit challenging were some of our companies, especially those that have more of a multinational flavor to them was the impact of the dollar. The market was basically playing defense in a variety of areas, one in the yield orientation, they were past the mark such as utilities, the electric utilities that last year on the Russell 1000 Value were up about 26%. The Russell 1000 Value was up 13%. It’s quite rare when you see utilities giving you double the absolute positive return of a benchmark. And so I think they give you a sense of partially fear, worry and anxiety, but also it was being tied in as a bond surrogate. And [unclear] about 30% last year. Another big thing though was the more domestic focus, which I think for small cap securities and for the midcap securities was very beneficial. But I think as what Tom was saying, these things tend to move in cycles and the pendulum in my opinion, has swung very far in one direction to where what we’ve perceived as being defensive and safe, has actually become quite risky because the valuations associated with it, that the fundamentals really are not being priced appropriately. And some of the areas where there’s been a bit more fear has created some opportunities. But last year it [unclear] untimely to basically be early and say I’m going to be more aggressive in areas the market is more pessimistic to buy right now because of trend. In terms of duration and magnitude, was quite strong.
Tom Kolefas: [00:11:03] I think that whole issue with the yield oriented stocks has to do with the strength of the dollar. A lot of money came offshore to the US looking for yield just as a safe haven to protect it. And that’s why it’s dangerous in that if Europe picks up and there are better investments in the emerging markets, that money will flow back out. And that whole group can correct. So I agree with you, if fundamentals don’t support it, if the US stays very weak they’ll be supportive. But ultimately I think we all to some degree or another, believe the US economy will get better, tempered or not, but will get better. And if it does you really don’t want to be heavily into the bond proxies. And then could have a double effect in that money flowing out to Europe or elsewhere.
Randell A. Cain Jr: [00:11:44] Yeah, absolutely.
Courtney: [00:11:45] And speaking of the economy, Bill Dudley just said we need to be watching for any signs of the economy slowing down, because then maybe The Fed won’t be able to do this string of rate increases, do you agree with that?
Tom Kolefas: [00:11:54] Yeah. Yeah, he’s got to be careful and they do, they can’t just willy nilly take an action. The fact that they’ve been so cautious about it says they don’t see enough evidence, because it’s not just the first increase 25 or 50 basis points. They have to see clarity that they can do several steps after that. And the problem is you’ve got this reflexive effect. Once you raise rates, that probably strengthens the dollars, strengthens makes our yields more attractive. So you have this counter-availing force, you’re breaking the economy by raising rates. And then you’ve got a double effect because the dollar goes up so that breaks it more. So you have to make sure that the power of the economy is strong enough to overcome both of those effects and so you could have clear sailing. And I think that’s the issue that’s taking them so long to get over that hump. But when it happens, it’ll be a really positive message for the economy and ultimately for the stock market, maybe not right away. Maybe you’ll get roiled in terms of a correction, you know, interest rates go up, PEs go down, people are worried, the bond proxy stocks go down, but ultimately it’s wow, earnings should be coming through because the economy’s better and that plays into. You know kind of the old school fundamentalists, we look for earnings, we look for that drives stocks and ultimately performance.
So it happens and in 11 out of 13 times in the last 60 years when you’ve had a Fed rate increase, you’ve had stocks higher within a year, and 10 out of 13 times within six months. It’s a good thing when The Fed raises rates if it’s done for the right reasons and they don’t do it too early, too prematurely, and then it’s, oh Jeeze, we’re back down again and now we have to scale back. That’s why they would rather err on the side of being too late than being too early.
Randell A. Cain Jr: [00:13:40] But I tell you, Courtney, what Tom is saying, you’re picking up on a positioning that Richard’s mentioned is where he’s going with allocating funds. That focus on Europe, the focus on XUS, I think it’s critical because when we talk about economy and while we’re a domestic manager, a significant portion of our revenues for our companies comes outside of the US. And so was built into the assumptions about the strengthening of the US economy, is that it can’t do it alone. We’re not isolationists. And so if you think about what happened in terms of the global recession, the US let the world down and now it appears not only in terms of the techniques but also in a result, the US appears to be leading the world gradually back out. Quantitative easing has been exported to other parts of the world right now. And so as a result, if we have any type of similarity as far as correlation of results with what’s happening in the States, then we can expect for developed markets in Europe, Japan and other areas also to pick up. China has gotten a lot more creative in trying to find ways to mitigate some of the … not negative growth, but the declines in growth that they experience in their geography, some of the other emerging markets, I think I heard Richard saying, he was getting interested in as well, are really a key part of the equation.
I think that The Fed is probably being a bit more holistic in how it’s looking at things and what we may be seeing from some of the sound bites that are coming out right now. I’ve got to believe a lot of these discussions aren’t just about the US economy and to the extent that the other parts of the world start participating in the growth, even as Tom said, tepid as it may be, I would rather take positive than flatter negative. But to the extent, if these geographies can start to pick up economically, I think it gives actually The Fed room to be more aggressive in raising rates.
Richard Bregman: [00:15:18] I like what you said, that’s another export of American culture. But you know, but they all like it, right, they all like it. I was talking with Courtney yesterday, I have this thought way in the back of my mind, that they’re not raising rates ever, The Fed is never raising them because … because actually from what you were saying which is there are all these counter-availing forces, Tom, right. And is the economy strong enough to take it? I don’t know. So I think what The Fed does is they test it out. And they give a speech here saying, “Okay, maybe there’s a liftoff in June.” And then all of a sudden, you know, the San Francisco Fed Chair said, “Well, it’s ready, you know.” Then Dudley comes out and says, “Well, let’s do it gradually”, and they wait to see. And is it going to be another taper tantrum type of thing, you know, with the liftoff tantrum? We have to give it a name, right, a liftoff Lulu or something. But I don’t think, I think they love, I think the world loves having low rates. And I just think they’re going to stay low for a good long time. I wouldn’t want to be The Fed Chairperson on whose watch we make that mistake that you’re talking about.
Tom Kolefas: [00:16:23] But some people would call that an addiction.
Richard Bregman: [00:16:24] It is. It is, yeah.
Tom Kolefas: [00:16:26] Financial markets are looking for it immediately, and the minute you hear that, well we might raise temper, you know, taper tantrum, yes, that’s what happens, that’s when rates goes up.
Richard Bregman: [00:16:34] So who controls who?
Tom Kolefas: [00:16:36] But the problem is, I mean should these Central Banks … are they managing the world for the financial markets or for the real economies? And one would argue we’ve had quantitative easing for six years, great for the financial markets here in the US, what has it really done for the economy? It’s done some good things, we’re back on the job market, we’re down on world count and capital goods. But it’s not been as explosive as you probably would have expected. So is Europe going to be any better? Maybe, maybe they’re, you know, get situations better and their fiscal spending is better, it might work for them better. But I still think it’s dangerous that we’re this far along and the real economy hasn’t kicked in. And I actually would celebrate if they actually did the raise because they’re so strong in the economy. I think that would be a much healthier signal.
Richard Bregman: [00:17:18] Be a nice signal wouldn’t it?
Tom Kolefas: [00:17:20] As for what’s really going on as opposed to okay, let’s just keep at this [unclear].
Courtney: [00:17:24] Or it could be a one and done, maybe it’ll split the difference between a string of, you know, and zero. But sectors that traditionally do well on a rising rate environment like financials, you know, you might think, okay, that’s improving the net interest margin, but is that too consensus for a value investor? Is that just antithetical to value investing, something that you could read in an economics textbook, okay, rising rates, bullish for financials?
Randell A. Cain Jr: [00:17:48] Sure. Well, Courtney, one of my favorite phrases is a conventional wisdom is an oxymoron.
Courtney: [00:17:54] That’s right, I like that.
Randell A. Cain Jr: [00:17:55] And that is if something is conventional then it’s not wisdom, and if it’s wisdom it’s not something as readily apparent for everybody to embrace and actually try to take in to how they’re thinking about, in the markets in particular, exploring opportunities. And with financials it is becoming quite popular. And I think when you look at, frankly, the valuations of some of the financial to say a rising rate environment is going to be helpful to the financials. In my opinion that’s already been priced into a lot of these securities. The challenge that you have within it and I think it really resonates with the discussion that’s going on right now is a rising rate environment should be consistent with a better economy. One of the things that I do believe we are seeing is that the economy’s improving but there’s been a level of conservatism at the institutional, at the individual level, that’s been somewhat unlike what we’ve seen in past periods of recovery. But I think a key part of that has been because the culprit that took the economy down and took the market down to some degree was the housing market. And if you look back at what was happening in 2007/2008 time period, rate of housing formation was hock on a hockey stick. But that was because it was speculative. Now we still have big inventories, our housing market is gradually improving but we still have a lot to work off. And I don’t think it has really proven to be the catalyst that it has been in previous periods of coming out of a recession or something of that nature.
And so when we think about interest rates being a catalyst for a sector like the financials, with what’s happened from a regulatory standpoint, many of the large institutions have become more plain vanilla, getting closer to blocking and tackling that they were prior to the repeal of the last evil. Now the challenges they’re having is not just whether rates levels happen to be, but the velocity of that in terms of the actual loan growth. One of the things I think that sometimes gets missed when we do the pure math of saying [unclear] interest margin because rates move up, yield curve steepens, therefore you have more profitability per loan, is the velocity of those loans and the credit worthiness of the buyers associated with that. The last time I checked the math out, so if interest rates go up, the amounts you can borrow actually goes down. And so thinking that that will be a key catalyst for the financials on an individual … if we get a plain vanilla loan basis, yes, but how many of those loans actually get lent out, so actually that the banks can actually benefit from that versus them actually just taking capital on their balance sheets and try to invest it for a higher level of return.
I’m not sure that that’s what investors are looking for out of these lending institutions. I think they really want to see them start lending, but that conservative nature, with corporations that need capital they focus right now on repairing their balance sheets. They’ve built huge hordes of cash, they’re not investing any capital, they’re not investing in property. They’re not investing in people right now. That’s something else was missing in the economy right now, the lending institutions, they’ve done pretty much the same thing, they’ve been basically almost like money market fund managers internally, trying to find ways to beef up their bottom line returns in growth. And so I think that, you know, financials, again from a conventional standpoint that argument makes sense. But when you dig a bit deeper in that in terms of current valuations and what are the real opportunities that’s available to the financials [unclear] with the larger more diversifiables, I think it’s a bit more limited than what traditional conventional wisdom will lead you to believe.
Courtney: [00:21:03] And I want to pull out something interesting you said about corporations sitting on more cash on their balance sheets. I think that’s translating also with individuals, you know, we’re seeing … we should be seeing this big surplus because of people saving a lot of money at the gas pump. But you know, traditionally also in a rising rate environment we should see consumer discretionary going up. They should be splurging on these items, you know, are we seeing that?
Tom Kolefas: [00:21:26] Maybe not splurging but improving. The consumer cyclical sector led, was one of the leading groups in my benchmark in the first quarter. So I think you’re seeing signs of life, the weather didn’t help. But low interest rates, low gas prices, they’re starting to play themselves into these names and in these earnings. So we like the retail group, we think they’re showing better comps. I’m not so sure about housing. I think housing is improving, hopefully is picking up speed. The other parts, media seems to have kind of gone sideways. So I really think it’s going to come down to retail. And then autos, auto sales have kind of reached a high level and seem to have plateaued. So I don’t know if the rate of changes in autos is going to add anything to the economy.
Courtney: [00:22:14] And what about healthcare, healthcare is another thing that people are having to spend a lot more per person on, you know, than they used to in the past, do you like healthcare right now?
Tom Kolefas: [00:22:23] We do, we like healthcare a lot. I mean it’s been a little bit of a momentum group, it’s outperformed the market for two plus years. But even, you can still find value in healthcare. There are still mid teen multiple names, a lot have been the specialty pharma space as you see in the paper today. There is a lot of M&A in that group. But the multiples aren’t crazy, they are mid teens multiples for mid teens earnings growth. There’s a lot of value accretion when these companies merge with each other. One of our favorite names has been Actavis, so they’ve been on the forefront. They’re rolling up companies and still trade in a mid teens multiple and huge free cash flow yield. So we like that space. We also like the HMOs, the hospitals, they’re all benefitting from the Affordable Care Act, much more volume, many more people, more devices being sold. I think that’s the underpinning. And they’re not that expensive relative to their own history. They are kind of middle of the road. So I still think there’s more upside on the healthcare group.
Courtney: [00:23:22] And most of these that you like are midcaps?
Tom Kolefas: [00:23:24] They are, but Actavis isn’t but there are others that we do. [Unclear] Care’s another name we really like, it’s a distribution company that serves nursing homes and skilled nursing facilities, and a specialty pharma distribution channel, which I think, one, it’s a well run company, it generates a lot of cash flow. But I also think it’s an attractive M&A target down the road.
Courtney: [00:23:46] Interesting. And we’re going to get to energy, but before we do sectors, is there anything you don’t really like right now, Randy as far as financials?
Randell A. Cain Jr: [00:23:52] It’s interesting, you know, Tom, again values comes in different flavors, so does portfolio management. With healthcare we’re actually underweight that sector. But it’s not … and we try to be very, I would say, agnostic in terms of sectors. And what I mean by that is we will overweight/underweight sectors according to where we see the value. From a fundamental standpoint, everything Tom said is spot on. I just think that after the two year run that we’ve had in some of these securities, that it is slimmer pickings in healthcare and aggregate. But if you notice one of the areas he didn’t talk about which is a huge part of the market cap in healthcare was large cap pharma. And we’re not seeing any value right now in that particular space. We are seeing some opportunities in specialty pharma as what Tom’s identifying. But also even within biotech and that’s been the area that has had a very nice run in with the exception of one particular name, Gilead Sciences which we have on our portfolio that we’ve done quite well in. Another one of the names has been Mylan that we’ve done well and they announced was making an acquisition yesterday in a stock, had a pretty significant move in the portfolio. But across the board right now we’re just not finding a significant amount of opportunity in the healthcare, in spite of the fundamentals that again, I cannot disagree with anything that Tom said in that regard. So that’s one area where we’re not that enthusiastic right now, on the basis of valuation.
The other areas I mentioned before was financials. We are seeing opportunities in some of the asset management companies, they are some of the more market related companies, some of the consumer finance companies. But as far as the banks go and the diversifier financials we’re seeing nothing that really draws our interest in here right now. We just think that the valuations have discounted a future that’s going to be pretty hard for those institutions to actually realize. The other areas where we don’t have quite as much exposure, also [unclear] areas such as utilities and telecom, these are parts of the market that have the defensive attributes. They have the yield orientation, that was very highly priced over the past couple of years. But again it’s been discounted in my opinion in these particular securities. When you look at utilities, they’re trading at a premium to the market multiple. That happens on occasion, but every time that it’s happened, when they’ve spiked at these premium levels versus the market, they’ve come back down. It doesn’t mean they have to go down aggressively but they shouldn’t participate if the market continues to rise. And now so far this year, although utilities was the second best performing area in our benchmark at Russell 1000 Value last year, it has been the worst performing sector so far this year, actually generating a negative return.
And so we’re starting to see some of the … if we want to call sector bubble type evaluations starting to be looked at a bit differently, I think that’s happening. Again, you know, Tom talked about overriding characteristics that allow you to look at a company in a multiplicity of ways, and coupling that with valuation, I think brings you to an assessment to say there is a reversion to the mean in terms of where value can be found. And some of these sectors it’s been exploited to where it’s gotten egregiously expensive in our opinion. But then there are other areas I’m sure we’ll get to where there is a bit more opportunity.
Courtney: [00:26:49] Yeah. And with utilities do you think it’s because people, you know, they’re chasing yield, are they using it as a fixed income proxy and that’s what baked in the overvaluation there or…
Randell A. Cain Jr: [00:27:00] I really believe that’s been a big part of it. And it’s something … it is rational if you are looking for a certain characteristic in your investment portfolio and you’re seeing a lack of opportunity where you should traditionally get it in the fixed income part of your portfolio, so where can I get that yield? You have investors with portfolio, they need a certain amount of income to continue to live. And so they look for where they can find it and utilities thought of as being the traditional widow and orphan stocks, almost like bond surrogates, they play that role. The problem that you have within that though, I think comes down to math, the bond math suggested long duration assets are a lot more volatile than shorter duration assets. When you get to equities the duration on those is considered to be close to positive infinity. We had a [unclear] 30% last year, we had utilities that basically followed suit where when it starts to unwind and go the other way, if the math works against those stocks, the same way it works against the bonds, I think investors may be pretty disappointed, what happens in their portfolio. And the competing issue you have to deal with is also if rates do start to rise then a traditional asset class where they’re supposed to get that yield starts to come back into favor which also robs a natural buyer of utilities and has them shift back over to where they should have been in fixed income.
Courtney: [00:28:17] Right, I see you’re agreeing.
Richard Bergman: [00:28:18] Just there’s a huge liquidity issue out there, right, which is exactly what will happen whenever it is that rates do go up or alternative income areas start to … it’s just going to come flowing out. And that’s a disaster and it’s a shame, you know, there are many people who are saving, you know, counted on getting 5% in their bonds in retirement social security. And they’re not getting that 5% so they have been compelled to go into utilities, to the MLPs, to the REITs, to areas that are offering yield right now. And that’s a potential disaster. I’m curious, I wanted to ask you a question Randy, because that Mylan deal, right, in healthcare, right. So did the stock price go up when they announced? I didn’t…
Randell A. Cain Jr: [00:29:02] They did actually, yes, they did.
Richard Bergman: [00:29:04] Right. So, right, so on the conventional wisdom oxymoron typically on a merger, the acquirer drops the price because presumably they’re paying too much a premium. So does it say anything in that sector if we’re seeing stock prices go up when the acquisitions are announced, does that suggest anything or it’s just this particular deal is so accretive that it’s well worth it?
Randell A. Cain Jr: [00:29:26] Well, from the math that, again, and Tom, please help me out. But from the mathematical standpoint, Mylan has indicated this will be accretive. And so … and contrasted deals that are done, strategic reasons and then [unclear] on the front end, their strategic [unclear] going to be coming in the future. This is one that appears to make sense in a couple vantage points, one, from a strategic standpoint. It gives Mylan access to drugs and distribution channels to broaden their network, also taking their drugs from [unclear], the company that they’re making an acquisition bid for and pushing that through Mylan’s distribution network as well. But also from a financial standpoint it should be accretive right now. That is something where I think you may have challenges with companies that do have the bigger balance sheets and can do deals perhaps in cash and the like. But the issue you deal with that is from a pure return standpoint, right now cash is giving you basically zero. So even doing a deal that on face value may not look great from a financial standpoint, when you do the accounting it can look as if it’s beneficial to the company. Now, from a strategic standpoint may or may not work out. But you can have the stocks that will respond quite nicely.
Richard Bergman: [00:30:34] I’m just interested, I mean if I’m a target and the acquirer price goes up and they bid for me, I’m saying, “You’re not bidding enough”, right.
Tom Kolefas: [00:30:44] But a lot of those deals are being done kind of half cash, half stock. So the seller participates in that upside that’s created by the synergies. And I think that’s what you’re seeing, one company could be for argument’s sake, is trading at 10 times EBITDA, buys another one that’s the same multiple, uses some cash, merge your synergies, [unclear] both, to both, the buyer goes up, the seller goes up and it’s kind of a happy story. And it’s been happening in this specialty pharma [unclear] pharma space. And again you can borrow money at 5/6%.
Richard Bergman: [00:31:13] Right, it’s crazy, yeah.
Tom Kolefas: [00:31:13] [Unclear] it’s crazy. So very cheap bonds, very cheap equity and they’re able to … and a lot of synergy, and that’s why the job picture isn’t growing as fast as it could.
Richard Bergman: [00:31:26] And you’re right, I mean that merges the [unclear] essentially.
Courtney: [00:31:29] Interesting. And I want to pivot a little bit to what you said, to energy. We’ve all kind of touched on it. According to S&P Capital IQ, earnings are down 63%, revenue down 30%, I think this means they’re going to cut CAPEX, they’re going to cut jobs. But is this the catalyst to buy?
Tom Kolefas: [00:31:44] Somebody said the solution to low prices is low prices. So the faster we go down the faster you’re going to get to a point where you have to cut supply, you have to cut off your supply [unclear] and the capital spending you’re doing in these companies in the US have been very flexible in doing that. It’s amazing, I think the Saudis looked at it and are amazed that how quickly did the US industry kind of adjust to this. We thought these guys would be going bankrupt, there’d be issues and we’d have a lot of supply problems. And yes, you have supply coming down to the point that by the fourth quarter we will have evened up. But we’re doing a lot better than some other high class places. So we think the industry has really corrected itself. So supply has taken care of itself because price is low and people are cutting rates and not drawing, bad for the service companies. Demand is coming back, all the refineries are telling you, you know, volumes are up 2-3% year to date. Globally it’s getting better, so … I mean I don’t know when that point happens, but a lot of … we’re bullish, we think that happens sooner rather than later and probably by the end of this year. And yes, the stocks have moved up sort of in anticipation of that, but then they’ll probably trade off with this Iranian nuclear deal, when more supply comes on the market. But we think there’s sustainability to it. Tepid economy globally even with that, its own supply demand characteristics I think are going to carry the day.
Courtney: [00:33:11] Yeah. Randy, what’s your sense right now of the supply and demand dynamic in the energy complex?
Randell A. Cain Jr: [00:33:15] Well, it’s interesting because if you go back and look at the charts it would indicate that there was a point within 2014 where demand was actually at a higher level than supply. But when that crossed, we started seeing oil prices stall out and gradually started to come down. It wasn’t just OPEC giving us the Thanksgiving turkey of turkeys, while not cutting production. On November 27th, that caused the oil market to fall. It had already fallen off prior to that, that was a catalyst for another significant leg down. But it was pure economics. The thing about it though is … and I know all of us here have had our compliance people, we all have the compliance people at our firms talk to us about superlatives and things. I hear a lot in the media published as well as on television, radio and the like, the word ‘glut’, that there’s a huge supply glut. Well, when I see between a 1-2% differential between supply and demand that to me is not a glut, especially when you’re dealing with a commodity from the supply standpoint that can be kind of volatile, especially when a good source of that commodity is coming out of the Middle East, where we can speak of peace in the Middle East, we’ve never had it, at least for any sustainable periods of time. And so there’s always disruptions that will come about, that can help to correct the supply demand imbalances.
But the other issue that I think, you know, that Tom did bring up was there’s been a corrective factor in the States, especially in the shale region where the response has been very quick. I think the difference that we have here within the States is that we don’t have national oil companies, where a significant portion of our revenues are tied to a company to produce a commodity that’s being traded on a global basis, if you look at some of the non-OPEC countries, because OPEC prior to their meeting tried to get some of the larger non-OPEC countries to come together.
Courtney: [00:34:54] Like a Brazil?
Randell A. Cain Jr: [00:34:54] Exactly, Brazil, Venezuela and Russia to have a coordinated cut. They said no, and Saudi Arabia and we can say OPEC, but really it’s Saudi Arabia, they say, “Well you know what, we’re tired of you balancing your buddies off our backs. And so we’re going to allow you to feel some pain because our cost production is next to nothing and so we can just try and make this lower price a lot better than you can especially with the reserves that we have in place.” And so what you’ve seen happen is, is that the US with independent companies that don’t have to satisfy that type of need. They’re focused more so on a long term growth, a long term capital and the returns in their capital within their companies, they’re making decisions in the best interest for the long haul. And I think it’s been a very prudent response in contrast to hearing that oil prices are going to go down, it didn’t, actually in some cases they kind of started ramping up production to get as much as what they can. And so that’s been very, very helpful to the companies. And so in a short run when you hear these negative pieces of information it can sound as if things are really bad, but actually when you think about the long term, [unclear] oil price is still in the stage for a decent rebound. Because even as Tom was mentioning with Iran, with the potential lifting of the sanctions depending on how that’s done, that there will be additional oil that will come on the market.
They’ve been storing oil and so that oil that’s been stored is going to come back on the market but it’s almost like within … like in with math, where you have a phase change where things move up. But they can’t sustain that level of production where it moves to, so gradually, once that oil goes to market and has basically been bought and put away then it will come back down. But I think there was an international agency that came out and was speculating that prices of West Texas Intermediate might be in the 70s next year. And so then we’re all forecasting…
Courtney: [00:36:32] Right. And [unclear] said that too.
Randell A. Cain Jr: [00:36:33] That the impact from Iranian oil might be $5-15, well if it’s $15 and West Texas Intermediate is at 70, and that drops to 55, well, I look at that and say, “Okay, that’s almost 10% higher than we are right now if that’s the worst case scenario.” I don’t see that as a bad outcome. And so when you look at it on a short term basis and look at the news from the headlines, again I think some opportunities are being created here in the energy complex. But again, it’s not, all things are not created equal, the companies that will benefit the most from that will be like the ones that are more volatile, hard beta names, the drillers, the service companies and the E&P companies. Right now they’re suffering and it causes the pain that they’re experiencing. But if you get a supply demand imbalance come back then the market starts … it’s going to discount that. And that’s the one thing about commodities, you can’t wait for all the fundamentals to clear, when the smoke clears then likely it’s too late. And basically you’re going to be, I will say, getting stuff sold to you rather than as an investor actually buying things. To me this is the time when you should be buying.
Courtney: [00:37:35] And if you look in [unclear] count when you look at the supply demand dynamic?
Tom Kolefas: [00:37:39] Sure, it’s a key metric as to what your production will be six to nine months down the road. And the fact that rigs have been cut 45-50% from the high tells you that you’re not going to be producing at a very good rate by the fourth quarter, by the exit rate of this year, such that you’ll probably end the year flat versus prior year fourth quarter. So then it’s, well, what do they do for 2016. If it continues where they’re at, 2016 drilling will be flat. And it’ll be tough to have up product, so you’ll have flat production in all likelihood. Marry that with, you know, Russia, Mexico, Venezuela, Brazil, offshore generally very expensive. You’ve got that fall and you’ve got the US flat, you’ve got Saudis saying that we have an incremental million barrels a day of excess capacity, they haven’t proven that they have. So that really tightens up the market. So I’m in agreement with Randy.
Courtney: [00:38:36] Yeah. And I also want to look at L&G, we just saw a huge deal, Royal Dutch Shell bought BG for 70 billion dollars, Exxon thinks they were going to global trade and L&G will triple by 2040, that’s a huge trend. What are you guys seeing there?
Tom Kolefas: [00:38:55] I’m not an L&G expert but it seems like they paid a big multiple, not a lot of accretion, very little actually and not a lot of synergies, at least that they’ve reported. Yes, will L&G traffic be greater down the road? But these are long capital intensive projects that will earn single digit returns on, that’s what Chevron’s earning on this project. So it’s steady, so you’ll get risk adjusted, it’s not bad but it’s not dynamic.
Courtney: [00:39:24] Do you think they’ll be more… Go ahead, sorry.
Tom Kolefas: [00:39:27] I’m saying, companies that don’t have great prospects will settle for L&G, the ones that do drill for oil.
Courtney: [00:39:33] Interesting. Got it. Ooh, a good sound bite. But what about just in general, more M&A in that space, do you think that’s going to have any impact on the oil companies, you know, the Exxons, the Chevrons?
Randell A. Cain Jr: [00:39:45] Well, I think it probably comes down to a couple of things. It’s going to be what’s available to be purchased and then the access to capital and then the price that you have to pay. As we’ve talked about the low interest rate environment right now, it’s creating a great environment for companies to be aggressive in making acquisitions, especially if they do have the cap on their balance sheet, as Tom was saying, not to do completely stock deals, that’d be potentially, you know, dilutive. But also to mobilize the cash that they have on their balance sheets or do you get additional cash through debt financing on very low rates. And so there’s an opportunity to diversify portfolios in the areas, but it’s interesting, doing it now, it may not look as if it’s going to be very accretive. But we look at it longer term. This may be a very good buying opportunity.
I think about Exxon and Mobil Fuels bought one of my favorite engine companies, XTO Energy, that was doing quite well. Well, they bought it and it was closer to the highs of natural gas prices. And so they have resource, they have access to natural gas, but natural gas prices are significantly lower than where they were at the time of purchase. But they’re looking at natural gas as far as being a part of a very diversified energy portfolio. And so that is where when you think about corporate management, I think that as investors we have to determine are we willing to buy again, parts of the company as if we buy the whole and believe in the long term strategic vision of the management team that’s in place. Because maybe these comes in a resource area especially, they’re not making deals for a quarter or even for a year. They’re making deals for decades. And so even from a scarcity value standpoint to the extent that L&G is going to be a decent part of an energy company’s portfolio, then it can make sense for more deals to actually be done because again when a big player is taken off the market. Then everything else actually becomes that much more at least interesting to the other investors who are thinking about those areas.
Courtney: [00:41:43] That’s a really interesting point. What other sectors do you like, Tom?
Tom Kolefas: [00:41:46] I was just going to add, sorry.
Courtney: [00:41:48] Go ahead.
Tom Kolefas: [00:41:48] Just a little point that it seems that there’s this frenzy in the Permian, like that seems to be the best basin that everybody thinks has the best economics because it has multiple layers, multiple pay that for one well or a couple of horizontal wells. So denominator’s a certain number but you can get a big numerator in terms of the cash flows you can get out. And some people have better acreage than others, Midland basins versus Delaware and so forth. I think there’s going to be a lot of consolidation in that space. Some companies have higher multiples, they could use their stock to buy smaller companies, something’s got to give. And then you have the big players, Chevron, Exxon, Occidental who all have an interest in that area. I don’t know if they do or don’t do anything. Exxon’s a smart company. They’ve been great stewards of capital for 100 years. So I never want to second guess them, although they did get some criticism on the XTO, it took a while to play out, but long term it was the right move for them and they got all this capability. I think something happens in the Permian and I think it’s a very interesting area and we’re positioned with a lot of different names there.
Courtney: [00:42:49] Interesting. So that’s…
Tom Kolefas: [00:42:50] Sorry for that backlash.
Courtney: [00:42:51] No, that’s alright. That’s a really good point. But I do want to talk about, besides energy, what other sectors you guys are looking at right now. So, Randy, what else do you like?
Randell A. Cain Jr: [00:43:00] Well, we’re overweight in our portfolios in materials. And so from a commodity orientation expectation that the demand environment likely gets better, you know, we have exposure there primarily in chemicals as well as fertilizer. We’re also overweight technology, but we’re overweight on Oat Tech, we’re overweight some other companies that were around when we had the blow up after YO2K as far as Apple being one … it is the largest holding in our large cap portfolio. We also have Microsoft in the portfolio, Western Digital and Western Union. And then we’re overweight consumer staples. And it can seem like an odd eclectic mix in that we have some of the pro cyclical companies as far as energy, materials, and technology. And then we have this typically thought of as a defensive oriented area but our exposure in consumer staples is actually multinational companies predominantly. We only have four companies in that part of our portfolio, only one is purely domestic based, is Altria, the others are [unclear] International which is, you know, about 99.9% non-US.
And then we also own Colgate and Campbell Soup, companies that are trying to grow the non-US portions of their portfolio. So these are ones that unlike some consumer staple companies, are more domestic based, they did well last year such as supermarkets and the drug stores, these companies got hit because of the currency issues we were addressing earlier. We see opportunity within that, when a company is investing outside of the US in a currency, their dominant home currency gets stronger, yes, from the accounting standpoint quarter to quarter there’s a hit. And everyone gets all agitated and excited about it, but what gets missed within that is that all the capital that a company is deploying and investing does not get basically repatriated back into the domicile at end of every quarter. I mean one of the issues you’ve had with Apple is they have these, you know, billions and billions of dollars of capital outside of the US and they’re trying to figure out ways, the US really wants them to bring it back so they can tax it. And they’re saying, “We don’t want to bring it back because you want to tax it.” And that’s not a situation that’s dissimilar for other companies. And so they keep their capital overseas but then they also utilize it overseas. And so where things are weaker right now we think it helps to set a platform for astute management teams to making investments for better return opportunities in the future. And again for us as investors, we’re not … we pay attention what happens quarter to quarter but we’re really trying to buy companies, not just flip pieces of paper. So we try to, again, buy when assets are trading at a significant discount to what the fundamentals would actually justify. We think in those areas we’re seeing that.
Courtney: [00:45:36] And I think that’s interesting that you said that because, you know, you mentioned too, tobacco stocks, that’s a huge too, a superlative secular trend that people are smoking less but you can still find value there in spite of that.
Randell A. Cain Jr: [00:45:47] Right. Well, it’s amazing, I mean, you know.
Richard Bregman: [0:45:48.7] It’s a nice business model.
Randell A. Cain Jr: [0:45:53.0] Well, it’s a regulated business for a reason, I mean it’s a drug, that’s what it is, I mean with tobacco, it’s addictive.
Courtney: [0:45:58.6] Nicotine, yeah.
Randell A. Cain Jr: [0:45:59.5] Yeah, absolutely. And so what you have happening is the companies continue to raise the prices and people continue to buy. And so while their revenues may fluctuate, you know, they may go up or down for the most part the low single digit, the profit margins on these companies and the returns are astronomical. The dividends that they pay, they’re stable, they’re consistent. Many of our state governments are dependent on tobacco bonds helping for them to help balance their budgets. And so I think what you see within this space is it is not a social responsible industry, but it’s an insanely profitable one. And so for us while we have our own social influences one way or the other when it comes to making money, we are capitalist and we see tobacco as being an area where there’s still a good opportunity to do so.
Courtney: [0:46:51.6] Makes sense.
Tom Kolefas: [0:46:51.0] Such state attorney generals and the tobacco industry, strange bedfellows.
Randell A. Cain Jr: [0:46:55.7] Very strange bedfellows, there you go.
Courtney: [0:46:58.6] And, Tom, what sectors do you like?
Tom Kolefas: [0:47:00.4] I’ve mentioned now healthcare and energy, I guess the next best for us would be consumer cyclicals in technology. I think technology can win, if the US economy comes back, if Europe comes back or they both come back, I mean it’s a competitive advantage for the US. We have the best technology companies whether it’s Apple, whether it’s … maybe Hewlett Packard’s not cutting edge, but Oracle, Microsoft, Intel, not right now with PCs. And then of course the social media stocks which are very expensive and are names we don’t usually deal with.
Courtney: [0:47:29.7] Very growthy.
Tom Kolefas: [0:47:30.7] Very growthy, high multiple, but high growth. But technology, you know, we like some of the semiconductor plays and XPI made a very good acquisition of Freescale here, and that was another one, both stocks went up on the deal, used a little stock end cash, sell to the industrial market, sell to the mobility market. TEL, the old Telco Electronics, connector stocks, the intranet of things, comparing all kinds of, you know, putting together all kinds of devices, they’re very well positioned, great company, grows at mid teens, great cash flow, 17% margins and getting better. So we like technology. We think you could win both ways with it. And it’s cheap, they are cheap relative to their history and they have pristine balance sheets. They just … and now they’re starting to pay back the shareholders. Up until now they kind of hoarded cash, very cyclical, very, you know, something changed in the industry, had a difficult time. Now they’re giving it back to shareholders and that’s a good thing.
Courtney: [0:48:30.6] Interesting. And very quickly we have a viewer question, it’s from Rob Acampora, he just has a quick question for you all and then we’re going to wrap it up.
Rob Acampora: [0:48:40.7] Gentlemen, I know everyone has their eye on The Fed, but I think a bigger question right now is what will the US dollar do. Do you believe that the dollar over the next 6-12 months will be strong, what are the reactions to that strong dollar? And conversely, if you think the dollar will be weaker over the next 6-12 months, what will be the reaction of a weak dollar rate?
Courtney: [0:49:05.5] Very quickly, I want to get everybody’s take on that, go ahead.
Richard Bregman: [0:49:13.7] I have no ability to predict the direction of the dollar, you know, currencies are a frightening area for me because there’s politics involved and I don’t fully understand how those markets work. So I’m just happy if companies hedge their exposure to currencies to protect their revenue streams. And I don’t know what, you know, the conventional wisdom applies for when the dollar gets strong in terms of exports and imports. But beyond that, I just want to see hedging to take that out of play.
Courtney: [0:49:42.5] Hedging, okay, Randy.
Randell A. Cain Jr: [0:49:43.8] I think that while the question was the next six months, that’s not a vantage point that I’m very helpful in. But when I think about the conditions that are being set up right now, the dollar was very strong last year because people were fearful of what was happening outside of the US, to the extent that that fear has started to subside. We’ve seen the dollar already weakening as other currencies. Does that mean that we go back to the levels where we were previously? Probably not. But do I think that as the other economies start to do better, does the dollar weaken against those to some degree and give some of that strength back? I think likely, that’s probably more so, it’s a healthier trend I think to actually occur within the markets. And in that case where that actually begins to occur, I think that the non-US market has actually become a bit more attractive. From what Richard is looking at and how he has positioned his portfolios, I believe, and he’s recognizing that. And I would concur with that, we also have international investing within our shop. And we see from a valuation standpoint that the fear associated with the currency as well as the economies has created some very unique opportunities. And so with the dollar, I think potentially weakening in the face of that because another component isn’t just looking at it from an economic standpoint, from country to country or purchasing power parity. I think it becomes a matter of demand for certain assets, and to the extent that demand for non-US assets starts to rise then I think those currencies naturally should rise right along with that.
Courtney: [0:51:10.4] That makes sense.
Randell A. Cain Jr: [0:51:10.4] And the appeal of non-US markets compared with how well the US has done versus other markets, again along with the dollar I think is making for an interesting opportunity, should the currency weaken then it will necessarily mean demise or lack of return to the other markets, I think is probably going to confirm that those are some good places to be.
Courtney: [0:51:27.1] Interesting, Tom.
Tom Kolefas: [0:51:28.4] Great to hear, Rob Acampora’s voice, [unclear] late 1980s when he was at Prudential. So I’m just going to answer the question academically, if the dollar … because I’m not a predictor of currencies, if the dollar goes up and stays strong and goes back to its old levels, then purchasers of items, buyers are going to benefit. The strong dollar buys more things. So if you’re a retailer or if you’re any kind of manufacturer that buys things, raw materials, oil, whatever, from the outside, your costs go down, you should be able to hold price to some degree and your margins should go up. Part of that would be chemicals, plastics and the like, in terms of oil being cheaper. Also some of these yield plays that we talked about probably would hold up better, the REITs and the utilities and the like. And by the way, when we talk about REITs and utilities, they’re bifurcated groups, I mean there are parts of them that would do okay, some of the gas infrastructure stocks and the like and pipeline companies. And if the dollar is weak then it helps the export industries, the gas prices, I mean it helps oil, it helps material stocks, anything that’s an export, export oriented or cyclically oriented, we mentioned technology before, that would pick up, industrials generally. So all the cyclical sectors would pick up if Europe were to do better and Europe would probably be doing better if the dollar was weakening.
Courtney: [0:52:53.5] Makes sense, okay, 30 second final takeaways, Richard.
Richard Bregman: [0:52:57.0] Equities, if we’re talking about equiti