Investment Strategy by Jeffrey Saut
“Alpha, Beta!”
May 20, 2013
I had a somewhat lengthy conversation with Rich Bernstein last Friday. I have been on TV with Rich over the years, but have never really had a one-on-one talk with him. Recall that Richard Bernstein was the Chief U.S. Strategist at Merrill Lynch for years before becoming the eponymous captain of Richard Bernstein Advisors (RBA). I was speaking with Rich because I have developed an interest in a few of the funds he manages for various entities. Rich began by stating he is extremely bullish, believing we are in one of the biggest “bull markets” ever. He commented that individual investors have “selective memories” and they think things should “feel good” when the stock market is going up. That is clearly not the case now. Things don’t feel very good, which is why investors don’t understand why the equity markets are so buoyant. Rich therefore opines we are likely only in the 4th or 5th inning of this bull market and when things start to feel good, and investors return in droves, the market will be in its 8th or 9th inning. Of course. that is the historic psychological cycle of the market, as can be seen in the chart on page 3.
Turning to emerging markets (EMs), Rich is shunning them, noting that while the U.S. economy is improving, and Europe is bottoming, there are debt, currency, economic, etc. issues in most of the EMs. For example, India has the highest inflation rate of any large economy in the world and yet its Central Bank is lowering interest rates. In China, he observes a banking problem, with non-performing assets (NPAs) rising rapidly. Hence, Rich is very underweight the EMs with only a 1% exposure. He continued, “I am very bullish on U.S. domestic companies with indexes like the S&P SmallCap 600 estimated to grow at more than twice the projected rate of most EMs.” He did say his funds bought Japan last fall, which luckily was right before “quantitative easing” was announced. Like me, Rich is a big believer in the American Industrial Renaissance and noted that to his knowledge he is managing the only “pure” industrial renaissance fund in this country. Also, like me, he is a big believer in energy independence for our country by 2020. We concluded our discussion with Rich stating, “We are Beta managers, and not Alpha managers, because correct asset allocation is the key to outperformance in the markets.”
I revisit Rich Bernstein this morning because I am hosting a “conference call” with him this Thursday at 4:15 p.m. (800.369.1922) where some of the underlying themes we will discuss include: 1) U.S. labor costs are becoming more competitive; 2) Lower Energy costs, both for natural gas and gasoline, making U.S. supply and distribution chains more efficient than those in EMs; 3) The U.S. has greater political stability, including respect for the rule of law; 4) U.S. companies are already gaining market share in many cases; 5) The American Industrial Renaissance (AIR); 6) Why there could be some problems with EMs, and anything else y’all want to talk about. Worthy of mention is that the AIR theme presently comprises about 10% of the Eaton Vance Richard Bernstein Equity Strategy Fund (ERBAX/$12.95) and a commensurate proportion of the equity sleeve of the Eaton Vance Richard Bernstein All Asset Strategy Fund (EARAX/$12.16). Because RBA is a macro- and quantitative-based firm, it has invested in a basket of approximately 50 companies fitting such investment themes. As with all of the firm’s theme-based investing, no one stock dominates a theme in order to help reduce the risk of the theme to the overall fund. I suggest listening to this call because Rich is one of Wall Street’s best.
Last week I hosted another call with my friend Troy Shaver, portfolio manager of the Goldman Sachs Rising Dividend Growth Fund (GSRLX/$17.80). Like Rich and I, Troy noted the low cost of energy is the key to a resurgence of the reshoring of industrial production back to this country. Troy began the discussion with, “Ten years ago we were importing 14 million barrels of oil a day and now it’s down to 7 million. In fact, last year we surpassed Kuwait’s crude oil production.” Referencing the Bakken, Troy mentioned that only 8,000 wells have been drilled so far, but before it’s over 36,000+ wells will be drilled. Moreover, the resource we are currently drilling is only 35 inches thick, but there is another resource under that (the Three Forks Formation) that is 4,000 feet thick and is estimated to have more than 7 billion barrels of oil.
Switching gears, he stated that over the past 40 years the leading space for stock performance has come from “dividend growth” stocks, with “dividend payers” being the second best performing group. Currently, he stated the “growth dividend payers” are more cheaply valued than the “dividend payers” and noted, “McDonalds (MCD/$101.54/Market Perform) has a 10-year average dividend growth record of 29% per year.” Another name he owns from Raymond James’ research universe is EOG (EOG/$135.25/Outperform). Troy considers EOG the best integrated energy company in the world. In Troy’s view, EOG is the most efficient E&P company on the plant, it has consistently increased reserves, possesses a huge ROI, owns its own sand/water/trucks/rigs/rail cars/ hoppers/etc., and has increased its dividend for 10 years by 10%+ per year. Another name mentioned was Polaris (PII/$91.46/Strong Buy), which is the leader in all of its seven categories. Troy went on to say he currently has no Utilities or bank stocks in his fund, but does have a 20% position in master limited partnerships (MLPs), which I actually like. His “sell discipline” is if a company “cuts” its dividend, if the 10-year dividend growth rate falls below 10% per year, or if there is a fundamental change in the company’s strategic direction. His fund has a low turnover ratio of 20%, a three-year Beta of 0.7, and an upside capture ratio of 0.9%.
Speaking to the stock market, last week‘s action was no surprise, even though we are now at session 97 in the longest “buying stampede” I have ever seen. As noted, this stampede is legend, eclipsing the now second longest stampede of 53 sessions by nearly twice. Last week’s “win” lifted the S&P 500 (SPX/1667.47) by 2.07%, but the real star was the economically sensitive D-J Transportation Average (TRAN/6549.16), which gained 2.72%. Unsurprisingly, such strength left all the macro sectors higher for the week with Financials being the strongest (+3.32%). Also unsurprising, currently all of those macro sectors are way overbought. Of course in “bull moves” markets can stay overbought for a lot longer than most think. And, that’s what I believe is going to happen as I expect the SPX to trade to 1700 into the end of the quarter before a polarity flip occurs sometime in the July/August timeframe, leaving stocks susceptible to a low double-digit decline.
The call for this week: The negative nabobs that continue to call this rally just a “tactical rally” in an ongoing “secular bear” market, as they have for more than four years, should consider this. The equally weighted S&P 500 (SPXEW/2590.60) made a new all-time high in April 2011; and made another new all-time high in March of last year, and has been pointing the way higher ever since (see chart on page 3). I, like Rich Bernstein, think this “bull” has a lot further to run. I do, however, think the equity market will become vulnerable to a decent pullback in the July/August timeframe.
“Who is Henry Singleton?”
May 13, 2013
“‘So Jeff, in your November Strategy Report you said, I recommend the gradual accumulation of stocks because they are trading at below known values. What are your top three stock picks?’ My response was Teledyne, Teledyne and Teledyne!”
... Jeffrey Saut, E.F. Hutton (11/20/1974)
The year was 1974 and Teledyne (TDY/$77.56/Outperform), on a split-adjusted basis, was trading at about $0.05 per share. By 1986 it was changing hands around $75 per share. Unfortunately, back in 1974 I didn’t have enough money to buy more than 10 shares, having lived through the devastating bear market of 1973 – 1974 where the D-J Industrial Average (INDU/15118.49) lost 47% of its value. At the time Warren Buffett was stating he felt like, “A kid in a candy store” because companies were selling at below net/net working capital and the INDU was changing hands at 6x earnings, below book value and with a dividend yield of 6%+. I was reminded of Teledyne last week by the excellent article written by Andrew Ross Sorkin co-anchor of CNBC’s Opening Bell. Andrew was a gifted writer for the New York Times before joining my friends at CNBC and regrettably he now writes more sparingly for the Times. However, his article in the Times last week, titled “For Buffet, the Past Isn’t Always Prologue,” was, by my pencil, the best article of the week!
For the record, Henry Singleton was the Warren Buffet of that era. Singleton was the co-founder of Teledyne in 1960 and built it into one of the most profitable companies ever. He was the pioneer of company share repurchases, as well as the instigator of the purchase of deeply undervalued companies. He had an uncanny ability to resist fads, as well as criticism. His focus was on 1) defining his investment framework by following a strict discipline; and, 2) always doing his own work. Those focuses generated extraordinary results from ordinary businesses whereby Teledyne enjoyed 30%+ returns on equity, and EPS growth of greater than 1200% in a 10-year period. Teledyne’s businesses were diverse, but with exceptional returns on capital that included companies like offshore drilling units, auto parts, machine tools, electronic components, engines, Water Pik, etc. Singleton often stated, “After we acquire a business, we reflect on all aspects of that business. Our conclusion was that the key was cash flow.” He went on to note that investors should NOT focus on accounting profits, but free cash flow that can be redeployed in the business at a high rate of return to shareholders.
Moreover, like Buffett, Singleton concentrated his investments with Litton, at one point making up 25% of his investment portfolio. He also tried to stay within his “circle of competence” by buying companies that paralleled Teledyne’s strengths. Further, Singleton liked to buy companies at 6x earnings (price/earnings), with an earnings yield of 17% (earnings/price), because such metrics provide a large margin of safety on the downside. After spending decades creating one of the world’s largest conglomerates, Singleton stepped down as CEO in 1986, but remained as Chairman, and decided to break the company into three pieces, believing it had become too big for a single manager to oversee.
I revisit the Henry Singleton’s Teledyne story this morning because my friend Doug Kass, of Seabreeze Partners fame, peppered Warren Buffet with questions at last week’s Berkshire Hathaway annual event in Omaha. One of his more prickly questions was, “Should Berkshire be broken up into various pieces, like Henry Singleton did with Teledyne, to maximize shareholder value?” After a long pause a scowling Warren Buffet responded, “Breaking them up into several companies I’m convinced would create a poorer result.” Charlie Munger, Buffet’s partner, added, “I don’t think you should get into your head, just because he is a genius, [that] he did it better than us.”
I read Sorkin’s article a few times and got the sense that Warren Buffet, and Charlie Munger, have been merely copying the traits of Henry Singleton’s investment style. I also have to question, after the transition to new leadership, if Berkshire can compound money as well as it has under the current dynamic duo? For example, it is doubtful that new management will be able to command the kind of special convertible preferreds, with very high dividend yields, that Buffet was able to garner from companies like Goldman Sachs and General Electric among others, which have clearly helped Berkshire’s performance.
Dougie concluded by asking Buffet if his son Howard would be installed as the nonexecutive chairman of Berkshire by asking, “How, beyond the accident of birth, is your son qualified to be nonexecutive chairman?” Buffet responded, “He has no illusions at all of running the business.” Charlie Munger chimed in with, “I want to say to the many Mungers in the audience: Don’t be stupid and sell these shares.” And, last week that advice proved correct as Berkshire shares traded to new all-time highs.
Similarly, the equity markets traded to new all-time highs last week led by the strongest sectors – Industrials (+2.28%), Consumer Services (+1.88%), and Basic Materials (+1.88%). Interestingly, there was a rotation out of the defensive sectors as seen in the large 2.42% decline of the Utilities. I have previously warned that the Utilities, and Consumer Goods, sectors were about as expensively valued as they ever get and advised trimming back on those positions in favor of the other eight macro sectors. The Utilities have also come under pressure the past few weeks as interest rates have spiked, with the 30-year Treasury bond’s yield rising from 2.81% to 3.13% in just seven sessions. That move also caused the T’bond to travel above its 50-day moving average (DMA), which gives a negative look to its chart pattern (see chart on page 3). Moreover, the long bond is now up from what I have termed the “yield yelp” low of 2.45% last July for a total rate-ratchet of roughly 28%. Buoyed by higher interest rates, the U.S. Dollar Index has likewise climbed above its 50-DMA (read: bullishly). While the strength in the greenback has surprised me, it does give foreign investors a “double kick” when combined with a rising U.S. stock market. The reciprocal, going back to last October, would be Japan’s Nikkei 225 Index, which is up 71% when measured in yen, but is up by 32% when measured in U.S. dollars. Speaking to the waning earnings season, as of Friday 57.6% of reporting companies have beaten their earnings estimates with 51.6% beating revenue estimates. Accordingly, so much for the negative nabobs that have told us for seven quarters that earnings were going to fall out of bed. This week the economic calendar is much more robust than last week with the more import reports of Retail Sales (-0.3e), Industrial Production (-0.1e), Capacity Utilization (78.3e), Housing Starts (980e), Philly Fed (2.5e), and Leading Indicators (0.2e) on tap.
The call for this week: As stated in Friday’s verbal strategy comments, there is a small window for a mild pullback this week with my daily internal energy indicator out of energy. However, there is minor support for the S&P 500 (SPX/1633.70) at 1614, and major support between 1590 and 1600, so I think any selling should be contained by one of those support levels with no damage to the uptrend. More importantly, last week the Buying Power Index crossed above the Selling Pressure Index (see chart on page 3), confirming the strength of the primary uptrend. Accordingly, I don’t think the bears can prevent a move to 1700 into the end of the quarter (July 1st) unless there is some kind of “black swan” event.
“That Was the Week That Was”
May 6, 2013
Informally the TV show, “That Was The Week That Was,” is referred to as TW3 and was a satirical comedy program first aired in the early 1960s. The program was considered a lampooning of the establishment. At the time it was considered a radical departure from legitimate television, but it set the stage for many more such radical departures. I revisit TW3 this morning because I have had so many requests for a formal repartee of a number of last week’s Morning Tacks woven into a more formal strategy letter.
I began last week with Monday’s comments that read:
Clearly, this performance pressure is currently playing on the ‘street of dreams’ as the D-J Industrials and the D-J Transports have tagged new all-time ‘highs’ over the past few months (yet another Dow Theory ‘buy signal’). Accordingly, I revisit Ralph Wanger’s ‘Zebra’ story this morning having returned from the RJFS National Conference where I interfaced with a number of portfolio managers (PMs) that are currently experiencing the same ‘performance pressures’ that many investors are feeling having missed the recent rally. Yet one of the most frustrating comments came from a PM that was almost fully invested, but is still woefully underperforming. His problem is he is fully invested in U.S. companies that generate more than half of their revenues outside the United States (Internationals). Surprisingly, companies generating more than 50% of their revenues inside the U.S. (Domestics) are outperforming the Internationals by a wide margin, as can be seen in the nearby chart (page 3) from the sagacious Bespoke organization. Indeed, the Domestics are better by 21.3% over the last 12 months while the Internationals are up only 8%.
On Tuesday I began the Morning Tack with a quote from my friend David Kotok, of Cumberland Advisors, where he noted the anger from the American public over the sequestration-induced TSA slowdown had caused the public to coalesce and demand a quick solution, which happened. I subsequently wrote:
Recall that I have said similar things about an angered electorate, and their collective need to change the status quo, since the mid-term elections of 2010. Indeed, I think the ‘sea change’ that occurred with those mid-term elections has ushered in a new assembly made up not of professional politicians, but rather having a business orientation. That sea change, I think, will evoke the election of smarter policy makers, and therefore smarter policies, with attendant more practical solutions to our nation’s problems. And, evidently the stock market feels the same way as the Dow Industrials continue to trade to new all-time highs. Still, most investors do not trust the current rally, which has been a detriment to the performance in their respective portfolios! As repeatedly stated in these missives, ‘I think there is a decent chance that a new secular bull market is afoot,’ and has given investors multiple ways to leverage their way into that potential ‘bull move’ over the past five months.
Wednesday’s missive was about the power of dividends. To wit:
As many investors know, the impact of dividends, and the growth of a company’s dividend over time, has a very large impact on the total return of any investment portfolio. The numbers go something like this. Since 1926 the total return on stocks in the aggregate has been ~10.4% per year. Roughly 5% of that return came from price appreciation and 0.9% from price-to-earnings (P/E) multiple expansions. However, the remaining 4.5% of that total return has come from dividends and the compounding of those dividends over time. That means ~43% of total returns have come from dividends, which is why I always harp on them. Recently, however, the ubiquitous question has become, ‘Hasn’t the theme of buying dividend-paying stocks become a very crowded trade?’ To answer that question, I hark back to the last era of financial repression that occurred after World War II. Indeed, post 1945 saw massive defaults on debts leaving the populace short of income. The CEOs of corporate America realized this and began increasing the payout of dividends on their company’s stock. This trend continued into the early 1960s, at which time the dividend-issuers in the S&P 500 were paying out some 70% of their earnings in the form of dividends and the SPX was trading at a P/E ratio of ~23x earnings. Now fast forward, the dividend-issuers in the SPX are currently averaging a dividend payout of ~32% of earnings and the SPX is trading at a P/E ratio of somewhere between 14 – 15x earnings. So no, I don’t think this is a crowded trade.
Because I was out of town speaking Wednesday night, our economist Dr. Scott Brown wrote Thursday’s Tack and noted:
While there is clearly a lot of political noise surrounding fiscal policy in Washington, the biggest factor behind the large deficit of the last few years is that we had a severe recession. Recession-related spending, such as unemployment insurance benefit payments, has been trending lower. Revenues have improved as the economy recovers (but remain far below where they would be if the economy were nearer its potential). It’s estimated that if the economy were near full employment, this year’s budget deficit would be about 2.5% of GDP – not especially large. The problem with the deficit is the longer-term outlook. Lawmakers have focused on trimming the near-term deficit (which is not a problem), but have largely ignored the long-term problem. As the FOMC noted in its policy statement, tighter fiscal policy is currently restraining the recovery.
I closed out the week with this quip:
I was sitting in front of the camera yesterday listening to the program while waiting to be interviewed when one Wall Street strategist was regaling the anchor of the program about why he thought the U.S. equity markets were overpriced. He stated that the S&P 500 is trading at 2.5x book value versus the rest of the world’s major equity markets being valued at 1.5x book. While he conceded the U.S. was likely ‘the best house in a bad neighborhood,’ he questioned if that was worth a 66% premium to the rest of the world. After screaming at my friend the anchor, who obviously could not hear me, I emailed her with this: I have often discussed such issues on your show. Firstly, the depreciation schedule in this country has a tendency to depreciate plant/equipment at a much faster rate than what the true useful life of such assets actually is. This means the stock market’s book value is probably understated by a substantial amount, implying the 2.5x book is an overstatement. Secondly, our accounting system fails to properly account for the accumulation of ‘intangible capital. In my client presentations I talk about intangible capital using the example of Apple (AAPL/$449.98/Outperform). AAPL spent a lot of money developing and perfecting iTunes. To be sure, AAPL can write off the research/development costs of that project. However, now that iTunes is perfected, what is it worth? The answer – it’s worth a lot, but AAPL cannot carry it on its balance sheet as an asset. When such intangible assets are accounted for, the view of our economy, and subsequent ‘book value,’ changes -- and it changes profoundly for the better. It shows we are saving and investing more, which is the defining feature of a modern economy. QED, our price to book value is not too high.
That leaves the call for this week: The April payroll figure was better than expected, but more importantly, not as bad as feared. Moreover, the +114,000 net revision to the two previous months suggests that the labor market is stronger than we thought. And on that news the S&P 500 (SPX/1614.42) leaped above the 1600 level as we have anticipated. I actually thought it would take three or four attempts to surmount 1600 like it has taken at past century marks (the ideal pattern can be seen in the chart on page 3). This week what we have to be vigilant for is a sudden decline that would potentially represent a false upside breakout. However, I am not expecting that since the equity markets have a full charge of internal energy.
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