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Might Makes Right

The market has rarely discounted large, strong companies this cheaply, argue Steven Romick of FPA and Ben Inker of GMO.

Ryan Leggio, 10/19/2010

Jeremy Grantham has been pounding the table for high-quality stocks since at least 2006. That was the year when his firm, Grantham, Mayo, Van Otterloo & Co., estimated that large-cap companies such as Coca-Cola KO and Johnson & Johnson JNJ would beat the S&P 500 by more than 3% per year during the next seven years.

No one paid much attention, as high-quality stocks (defined by GMO as companies that have low debt and stable, above-average returns on capital) lagged over the next two years. But investors took notice when 2008's results were tallied: The S&P 500 dropped 37% while GMO Quality GQETX, a fully invested mutual fund stocked with high-quality firms, lost 24% and the Morningstar Wide Moat Index, a market-cap-weighted index of high-quality companies, lost 30%.

Grantham and GMO still think the future is bright for these strong businesses. According to GMO's research, mega-cap high-quality stocks trade at their biggest discount to the S&P 500 in recent history--a 10% discount today compared with a 40% premium in the mid-1970s (otherwise known as the Nifty-Fifty era).

Unlike GMO, other go-anywhere managers had not made much of a fuss about high-quality names. That changed when Steven Romick, manager of the Los Angeles-based FPA Crescent Fund FPACX, announced during his second-quarter conference call that he and his team had been spending "an inordinate amount of time studying high-quality companies." This was big news because Romick, one of the five finalists for Morningstar's Manager of the Decade award, has a history of buying primarily small- and mid-cap companies.

When we see managers such as Romick and those at GMO get on the same page in regard to an investment theme, we want to learn more. We invited Romick and Ben Inker, GMO's head of asset allocation and manager of GMO Global Balanced Asset Allocation Fund GMWAX, to discuss this subset of the equity market. Our conversation took place Aug. 24 and has been edited for clarity and length.

Defining High Quality
Ryan Leggio: Both of you have been talking a lot recently about high-quality stocks. Steve, what's your definition of a high-quality company?

Steven Romick: Are we talking about high-quality stocks or high-quality companies?

Leggio: Both.

Romick: Because what we were really talking about in our conference call was the nature of what we view as a compounder. A compounder is a company in which we're very confident that the business 10 years from now will be in a very good place and will give us a good compounded rate of return. The business won't disappear; its competitive moat will not have deteriorated over that time frame. The question is not, "Will you get a rate of return?" but, "What will the rate of return be?"

Lots of high-quality businesses are far more cyclical in nature. We wouldn't put these into our compounder bucket, because at the end of the 10-year period, margins may not be where they are today. I'm not suggesting that one shouldn't own these businesses; we just put them in a different bucket.

What we talked about in the call was that for the first time in our history we're able to see companies--compounders--that have high returns on capital, generate tremendous cash flow, are doing good things with that cash flow, have businesses that have a defensible position, and that we think will be in a better place 10 years out than where they are today.PAGEBREAK

Leggio: Do you know these compounders when you see them, or do you use some sort of quantitative measures to find them?

Romick: There isn't a long list of companies that make this cut. There are certain firms that you know just from having followed companies for so many years. But admittedly, we look at quantitative measures--unlevered return on capital above X and the incremental return on invested capital of Y. Those kinds of things.

Balance sheet is something that is an overlay, because one presumably has the ability to create a balance sheet that would be optimized. We see a lot of managers use balance sheets and cash flow poorly. Some managers simply default to repurchasing their own stock. It's almost like buying stock willy-nilly. It doesn't matter what price. Well, it's got to meet a hurdle rate for it to really make sense. So we spend a lot of time thinking about what incremental return on capital a company achieves for their reinvested cash flow.

Leggio: Ben, your firm has a quantitative process for identifying high-quality firms.

Ben Inker: We've got three major characteristics that we're looking for. We want companies that have shown they can earn an above- average return on capital, that return on capital has been stable over at least an economic cycle, and that they have low debt.

I don't think that is a tremendously different definition than almost anyone else's. From our perspective, it is not necessarily the case that these are companies that you expect to outperform. They are high-quality companies. They may or may not be high-quality investments. If they're overvalued, they're going to lose.

What has struck us in recent years is that the market just doesn't seem to much care about these characteristics. For the first time ever that we can see, we can get these characteristics at a discount to the overall market--which is what has caused us to be interested in making them a big part of our portfolio.

Leggio: One group of companies that isn't in either of your portfolios is financials-- even household names like Wells Fargo WFC and American Express AXP. Why don't you consider these high-quality companies?

Inker: One of the exciting things about a high-quality company is that to understand it you need to understand the income statement and the statement of cash flows. You don't need to spend much time worrying about the balance sheet of Microsoft MSFT. The big problem for us with financials is that because they are so levered, you need to understand an awful lot about what is on their balance sheet. We are incapable of getting enough transparency into what is on their balance sheet to be confident that Wells Fargo is a high-quality company. It may be a cheap company, and it may be a perfectly well-run bank, but there don't have to be very big errors in the way you are valuing your assets when you are levered 12-to-1 for it to be disastrous.

Romick: I agree with that. We were happy to own financials at points in time. But again, we make a distinction between a high-quality company and a compounder. I'm not going to speak to Wells Fargo or American Express specifically, given that we're not following them closely, but I think that these businesses certainly can be very high-quality businesses. But can I say that I'm confident that they're going to be in a better place 10 years from now than they are today? I don't see that I can make that statement for the reasons that Ben mentioned.

The Right Side of Fair Value
Leggio: Ben, as of your July asset-class forecast, you think high-quality companies are only marginally cheap on an absolute basis. What goes into your forecast?

Inker: When we look at asset classes, we come up with a forecast that has one basic assumption: At the end of seven years, we think everything will look normal. What we're saying is that at the end of seven years, if high-quality stocks are trading at a normal P/E, they have normal profit margins, and their prospects look normal, what kind of returns are we going to get in the interim? What kind of income are we going to get? What kind of revaluation?

At the end of July, high-quality companies looked a little bit cheap. We thought that the overall U.S. market was noticeably expensive, but these guys were at least mildly cheap in absolute terms. Quite frankly, that is the best thing that we can say about any of the asset classes we look at right now. Unfortunately, mildly cheap is about as good as it gets.

But to us, there is really something to be said for being on the right side of fair value. You've got something cheap, and it may get cheaper. It may get a lot cheaper. But that's OK. If cheap assets get cheaper, you get to compound out your returns quite nicely. When expensive assets go down, that money is lost forever. But if you're getting a good free-cash-flow yield, and it goes up because the price goes down, good things can happen. The company can pay out a higher dividend yield. It can buy back more of its own stock.

So for us, there is something really different about an asset that is cheap in absolute terms versus one that may be relatively cheap in an overvalued market but still is trading at higher-than-normal valuations.

Now, if high-quality are "growth-y," and certainly not all of these guys are, we're prepared to pay up for them in terms of a high P/E. One of the reasons why people get burned in growth stocks--well, one of them is that growth is hard to predict--but the other is that not all growth is created equal. If you are growing without a really good return on invested capital, you're not giving your shareholders any real benefit.

What we like to see are companies that have good growth prospects, that have a high return on capital--those are the ones where we can say, "Yeah, it makes sense to pay 20 times earnings for a Google GOOG." They have a nice high return on capital. If they can grow their business, great. It doesn't make sense to pay a high P/E for somebody who's going to grow just because they're going to invest a ton of money at fairly pedestrian returns on capital.

So this is a group that we expect to pay a slightly above-market P/E for, and today, in general, it looks like we can get them for a slight discount on P/E. That is different than we have ever seen before. Historically, it's always been a question of how big a premium do these guys trade at. Today, they are not trading at a premium. They are trading at a small discount.

Blue Chips Are In
Romick: This conversation is focusing on high quality, but I would also like to center it on large caps, because I believe that right now large caps are cheaper than small caps. In the late 1990s at First Pacific Advisors, we didn't play the Internet game because we are value investors and the valuations didn't make sense. Our fund was heavily tilted toward smaller-cap, high-quality companies because they were cheap. But it didn't matter how great these businesses were. These companies were at 20% discount to large-cap stocks in 1997, which was historically wide. They went to a 30% discount in 1998, which was an all-time high, and then they went to 40% in 1999-2000, a new all-time high, and they stayed there for two years. Our short-term performance suffered, and many of our investors redeemed, at precisely the wrong time.

It was not a lot of fun. My partner, Bob Rodriguez, and I used to joke about just opening up a restaurant. With me being Jewish and Bob being Mexican, we thought we'd just call it Casa Hadassah, home of the gefilte fish taco. You really had to consider your other alternatives at that point in time.

Now, we're at the opposite point in time in the cycle, and large-cap stocks are cheap by comparison--much cheaper than they've ever been versus small caps. Let's leave quality out of the equation for a moment. Let's just start with large-cap stocks are much cheaper than small-cap stocks, as a relative statement. I agree with Ben that growth is very difficult to predict. I mean, it's impossible to predict.

But we believe that the larger-cap companies, on a relative basis, have better growth opportunities available to them than they have in the past, relative to small-cap companies, because we think that there's more growth overseas than there is in the United States. Larger-cap companies, on average, have more overseas exposure. I believe that this begins to speak to the quality of larger-cap companies. I'm generalizing. There are many small-cap companies that do a lot of business overseas. But there are large-cap companies out there that get half their sales internationally. You're less likely to find a lot of that in smaller companies.

Inker: We agree with an awful lot of that. I'm not going to talk about the potential for large caps versus small caps to take advantage of growth outside of the United States, but as we see it, large caps look cheap relative to small all around the world. And when we look at quality, high quality looks cheap, but big high quality looks cheap relative to small high quality. And big value looks cheap relative to small value. And big growth looks cheap relative to small growth. That's true not just in the United States, but globally. We have spent a lot of time overweight small caps. We loved them from the late 1990s to the early to middle part of this decade, but now they're expensive, and the big dopey blue chips are a lot cheaper.

Two Caveats: Margins and Interest Rates
Romick: The caveat, and I think this is problematic, is the question, what is the normal margin? Margins are still above average. A lot of these big companies have had a nice margin benefit from cost-savings programs, including firing people. Companies aren't getting pilloried for it, because everybody knows how bad the economy is and that jobs are being lost right and left. There's been a lot of fat cut out. So we question, what is the normal margin in these cases? Will Johnson & Johnson's margin be as good as it's been? They've optimized to a great degree. What is the sustainability of that margin? We're an owner of Johnson & Johnson in a small way, but these are the questions that we're asking ourselves, and it does raise some concerns.

The other caveat with these large-cap companies--and this goes for stocks in general, for that matter--is that we look at some of these companies as infinite- duration bonds with rising coupons; they're companies that we believe are going to be here a decade from now with higher earnings. When you think of it in those terms, you realize they're going to be affected by a rise in interest rates. We think that a rise in interest rates is probable in the future. We do not know when, and we do not know how high. We would first need to know what kind of inflation we'll have. Will rates increase with inflation or will there be relatively benign inflation but other exogenous variables that cause interest rates to increase? We would argue that rates are going to go up with or without inflation for a host of different reasons.

If you get the higher interest rates without the kind of inflation that you can pass through in price increases, where your ability to get price is not keeping up with the rise in your input costs, then that's going to negatively affect margins, so cash flow would also be negatively affected. We do raise the question that higher interest rates, in many cases, could create a lower P/E for companies. If you're buying a company that historically looks cheap and it's at 11 or 12 times earnings, that sounds great right now with interest rates where they are. But if the 10-year is at 7%, that might not look so great, unless otherwise justified by earnings growth.

Leggio: You pointedly said on your conference call that cash may be an even better investment than some of these high-quality firms in a rising-interest-rate environment.

Romick: If you're smart enough to figure out when interest rates are rising and how much, then yeah. The question comes back to, what causes interest rates to rise? Is it inflation? If so, how much? And how is that company affected by it? We believe that some companies, like Aon Corp. AON, will benefit from rising inflation. Aon is in the insurance business but without the underwriting risk. They are just brokers. So if a building costs more to replace in 10 years, they benefit--annually. They've basically got a tithing. It's a tax on economic activity. They also have a couple billion dollars sitting around on the balance sheet. If interest rates go up, then they're going to get a higher return on that. But we can think of other companies where it's not going to be as easy as that.

Leggio: Ben, I assume you think that margin levels are sustainable for high-quality firms.

Inker: Yes. One of the things that scares us a little bit is that the past 12 to 15 years have been a pretty good time to be a company from a margin perspective, whether you're looking at return on sales or ROE, or what have you. We have been in a pretty good place. But it has affected the high-quality guys less than the rest of the market. So today, we think that their margins are probably just about normal.

I do want to say one thing with regard to stocks versus bonds. The thing about bonds is that they're nominal instruments. So they hate inflation and they love deflation. The way we think about it is that stocks are real instruments, but there's a strong behavioral aspect to valuations. Investors in stocks do not like "flation"--they don't like inflation, they don't like deflation. So right now, we have bond yields that look to us as being consistent with mild deflation. As near as we can tell, stock-market investors are happy with nice, stable inflation of around 2%, or maybe 2.5%. As you get further away from that, either up or down, they get increasingly less happy.

If we got rising interest rates because people stopped being quite so scared about a double dip and thought that deflation was off the table, and we got bond yields going back up into the fours and maybe as high as five, it's not clear to us that stocks would care that much. Now, if we get deflation on its way to inflation, that would probably be a bad thing for stock valuations, because stocks around the world generally tend to trade at lower P/Es when we've got high inflation, just as they tend to trade at lower P/Es when we've got deflation.

So we're not worried that if the 10-year goes from 2.5% to 3.5% stocks would fall. We think it's as likely under those circumstances that stocks might rise, because it might be a sign that people are a bit less worried about deflation than they are now. But certainly, if we're going to wind up with bond yields of 8% or 9%, associated with a real inflation scare, we would have to think stocks may well trade cheaply under those circumstances.

Now, because we think that most stocks are real assets, that would provide a nice buying opportunity, and it looks like investors tend to demand a higher rate of return when there's inflation, or don't quite understand the positive impact that inflation will have on corporate cash flow. So, if we're buying assets at fair value or better and we're worried a little bit about inflation, it's not that big a deal. The more confident we are that inflation is going to get out of hand, the more we would want to wait for a really good buying opportunity-- not something trading at fair value, but something trading at a 25% or 35% discount to fair value. Today, we don't see anything that is trading at a 25% to 35% discount to fair value, with the possible exception of dividend swaps in Europe, which is a pretty esoteric asset class.

Leggio: GMO's long-term inflation assumption is still 2.5%, which is where it's been for a number of years now.

Inker: Yes. Honestly, we don't think we're good at predicting inflation, which is probably why our inflation forecast has stuck around 2.5% for a long time. We don't think the market is particularly good at predicting inflation either. So we're not too impressed by how low bond yields are. We don't think that means that the bond market knows that we are headed for a Japan-style event.

Thriving or Just Surviving?
Leggio: You have a few stocks in common. Steve, you mentioned Johnson & Johnson, but there's also Kraft KFT, Wal-Mart WMT, and Anheuser-Busch InBev BUD. To your concern about rising rates, and maybe even the worst case--1970s stagflation--are you confident that these can be compounders over the next 10 years in such an environment?

Romick: It depends on the company. In some cases, you have more comfort level than in others.

Johnson & Johnson's margins are at an all-time high, and its P/E is at an all-time low. But its operating margin is about 60% higher than it was two decades ago. I do not currently have conviction that margins will not contract some. It's a business that has been fairly well optimized. I think there is more risk there.

But Kraft's operating margin reflects the inverse. We've seen a decline in margins from two decades ago--running well below where they had peaked. So it could be a different case for Kraft. Certainly, they have more room to improve their business, I would argue, than Johnson & Johnson has.

I'm less worried about a Wal-Mart, because Wal-Mart is not one of those companies that is a margin-taker. A margin-taker is a company that keeps cost savings for themselves through expanded margins, rather than passing on the savings to their customers. Wal-Mart has been unusually consistent in their margin over time by taking savings and returning those savings to their customers in the form of lower prices, so that they continue to attract people to their stores. There was an analyst report not too long ago about Wal-Mart and what they're proposing to do with their suppliers. They've gone to their largest vendors and said, "We think that we can manage your supply chain logistics better than you." This analyst came out with a report and made a bullish call on Wal-Mart because it would benefit Wal-Mart's margins. Well, it's the right bullish call but for the wrong reasons. I would argue that whatever cost savings they'll capture won't flow through Wal-Mart's margins; it'll be recycled in the form of lower prices. If they can do this successfully, it will just mean continued low prices relative to the competition for Wal-Mart customers, which will benefit them over the longer term with respect to cash flow. It could also increase transportation costs for their competitors.

With Budweiser, I think that there's a lot more moving parts in terms of commodity exposure-- agricultural products, barley, wheat, etc. But they're pretty well hedged for the next couple of years, so there's less risk now, but higher risk down the road. Beer sales have tracked closely to what's happening at the pump. If gas prices increase a lot, sales of six packs of these low-price beers decline. So a weaker economy will have an impact, as would higher commodity prices. In such a scenario, both sales and margins could get squeezed.

Inker: You've got to be careful asking about a repeat of the 1970s. In the 1970s and early 1980s, the Kelloggs of this world saw declining margins because they didn't react to higher input costs by raising their prices. It's not entirely clear why they chose not to. They could have done it. They seemed to think that it was beneath them. They don't think that way anymore. When agricultural prices increased in 2007 and 2008, food companies responded quickly.

Again, we believe that high-quality companies should be in a decent position to defend their margins in the event of inflation. They can't necessarily do it perfectly, but there's no particular reason to believe that these guys are hurt worse than others. There are some reasons to believe they may be able to hold on to their margins.

Ryan Leggio is a mutual fund analyst with Morningstar.

Ryan Leggio, Esq., is a fund analyst with Morningstar.
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