Mon, 19 Dec 2011
The market's flat performance amid terrible macro headlines holds an important insight for investors, says Sanibel Captiva Investment Advisers' Pat Dorsey.
Jason Stipp: I'm Jason Stipp for Morningstar.
Investors got socked by a lot of surprises in 2011. But Pat Dorsey, president of Sanibel Captiva Investment Advisers, says there is one surprise that should be on investors' radars and offers an important lesson for them. He's here with me to explain.
Pat, thanks for joining me.
Pat Dorsey: Always happy to be here, Jason.
Stipp: So, there is no shortage of surprise headlines in 2011. As you are looking over all the news that we got. What really occurs to you as the biggest surprise that faced investors this year?
Dorsey: Well, I think, especially for U.S.-based investors, it's that macro didn't really drive the market. I think that because of what happened in 2008 and 2009, recent events in Europe, everybody has become an amateur macroeconomist, right?
But now let's roll the clock back to Jan. 1 of this year, and imagine that you knew with perfect clarity some of the most important headlines of this year: U.S. downgraded from AAA. Italian bond yields, sovereign debt above 7%. Massive earthquake in Japan. U.S. unemployment remains above 8%. You would have been running so far from the equity markets that you couldn't even see them.
Stipp: This isn't what we've seen when you actually take a step back and look at the S&P.
Dorsey: Exactly. So, how is the U.S. equity market down this year? About flat, right?
Dorsey: So, all those awful, negative headlines actually didn't affect the market that much, because corporate earnings held up well, and we started this year at a pretty reasonable valuation. Surprise there is that valuations and earnings really are what ultimately drive the market--not day-to-day headlines.
Stipp: So, I think this is going to be somewhat counterintuitive, though, because when you do look at the market day-to-day, what does seem to be driving daily market activity is the latest headline out of Europe and what the EU summit leaders are saying, and who said what and what the plans are going to be.
Dorsey: No question about it. On a day-to-day basis, if you had a mole in the ECB and you knew exactly what the eurocrats were going to say tomorrow, you could make a killing on a day-to-day basis. If you do know that, let me know, I'd like to know that mole myself.
But again, over a longer-term basis, it's earnings and valuation that drive stocks, because the macro environment is just the context in which you operate; it's not the kind of thing that ultimately drives equity returns.
Stipp: So, if valuation is one of the key things that you should be looking at as an investor, what do the valuation say to you today? Where are we right now, and what might that mean for 2012, 2013?
Dorsey: I would say for U.S. equities in particular, U.S. large cap equity, on an absolute basis, pretty good. And on a relative basis, darn good.
So, relative to bonds, you've got the 10-year Treasury down below 2% now. You flip that on its head, that's essentially 50 times earnings or more. Whereas U.S. equities, 12 or 13 times earnings depending on which metric you want to use, which is pretty reasonable. 12 times, 13 times it's not rock bottom; this is not the '70s right now, but it's pretty good.
And when you think about the fact that your downside risk from that level is not huge, from a 12 times earnings multiple, if you put together a good portfolio of companies, you can get about high 2s, 3% yield that's growing at a midsingle-digit rate, that's a pretty reasonable total return.
Stipp: So, you mentioned downside risk there, and I think investors naturally are thinking about what is the risk to the story. So, even if they're trying to stick with valuations and see what is the potential for companies coming up, I think, they're still worried about what macroeconomic risk might do?
And I'll tell you, Pat, I talk to a lot of fund managers, and when I ask them about what some of the risks are on their radar and what they're expecting for the economy, they say, I'm a bottom-up investor, we don't worry about the economy, we look at company-by-company basis. But, yet, after a year like 2008 where we saw a lot of systemic risk coming through and taking down a lot of companies, I just wonder how can you ignore some of the macroeconomic risks? Certainly, they're going to have an effect on businesses, right, at some level?
Dorsey: Yes, that kind of response is just punting. I mean, everyone has an opinion and the question is whether that opinion drives what you do in your portfolio, in which case you're probably a top-down investor, which is neither bad nor good, it's just different.
But if your bottom-up investor, you are aware of these things, it's just the context in which you operate. Certainly, if the economy is going great guns, you're going to invest differently than if you think things might be in a rough patch for the next couple of years.
At the moment, of course, the biggest tail risk is some kind of breakup of the eurozone, and I think the odds of a couple of the weaker currencies, Greece and Portugal being the most obvious ones, exiting the eurozone at some point in the next couple of years, those odds are pretty good. So that's a disruptive event. It's one that's probably going to cause some rough headlines for a little while. But is it really likely to impact what United Technologies makes over the next two to three years? Probably not a whole heck of a lot.
The much bigger risk would have been, say, a disorderly breakup of the eurozone, and the fact that you are seeing some movement in Europe towards greater fiscal union, ... putting more stringency on what countries can do within their own budget situations, that's a good sign. At the end of the day, one currency, different budgets, it wasn't sustainable long-term, and you're starting to see some baby steps towards greater integration, and that takes that huge tail risk of disorderly euro breakup, if not off the table, at least really, really dials down the probabilities.
Stipp: Given the situation that is in Europe, are there some areas where just on the fundamental basis you really wouldn't advise investing right now, because the risk of some of those unknowns is just is too much to get over. Then on the flipside are there some areas, like we've seen financials really take a hit recently, even in the U.S., is that overdone? Are investors kind of extrapolating that Europe situation and worrying too much about systemic risk there?
Dorsey: Certainly, say, let's take European banks in particular. I think for the non-expert trying to bottom-fish in European banks is a pretty tough thing to do, and it's not something I would even try to do. We don't own European banks in any of our portfolios, simply because the systemic risks are large, but also a lot of it's going to be decided at the table of regulators. Predicting what regulators do or don't do and bureaucrats do and don't do is, I think, a pretty difficult for most investors.
Now for a U.S. bank like, say, like Wells Fargo, to be really dragged down with the situation in Europe, when they have very, very little, if any, European exposure--they don't have any business in Europe. They don't have any European sovereign debt in their portfolio. That, to me, seems a little bit overdone. Even if the environment for U.S. banks, like Wells Fargo, is going to be tougher for the next decade than it was over the past decade.
In terms of bottom-fishing opportunities, what I would encourage investors to look at are well-capitalized institutions that are not dependent upon credit markets, because credit markets are just going to be roiled for a while now. Emerging markets are now down to about 10.5, 11 times earnings. Sovereign balance sheets there are quite good, and so you kind of escape a lot of euro issues to a large extent.
The U.S. as a whole exports about 12% to 18% into Europe. Many U.S. companies, it's a little bit more, a little bit less. Again, they are relying on U.S. credit markets, so you dial down your risk there. Then if you want to go even poking around in Europe, many smaller companies in Europe, you think about well-capitalized companies in the German Mittelstand; they are basically the sort of smaller exporters ... in Germany. Again they tend to be very, very conservatively capitalized, mainly export-oriented businesses. So, ... basically, their home is in a rough neighborhood, but they work somewhere else. So, the valuations are probably getting dragged down by issues that aren't going to affect their businesses terribly much.
Stipp: All right, Pat, some great insights on the market today and also the potential opportunities today. Thanks for helping us take a step back and see the real drivers in the market.
Dorsey: Thanks so much, Jason.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.