Thu, 21 Jun 2012
The Fed's attempts to manage risk assets could have severe ramifications, argues the FPA Crescent manager.
Kevin McDevitt: Hi, I'm Kevin McDevitt for Morningstar.
We are here at the Morningstar Conference with Steve Romick from FPA. Steve is the lead manager on FPA Crescent.
Steve, you've written a lot about what's happening right now with Fed monetary policy and also with the increasing indebtedness that we are having as a country, with greater Treasury issuance, greater debt-to GDP ratios, all of those things. What are the implications of all this, and what is the effect that you see on asset classes over next three to five years?
Steve Romick: We are living in a grand experiment. We have never lived through times like this before. We have never executed policy in this fashion, like we are doing now. And how it ends is anybody's guess, but just in simple terms, I think by avoiding the ability to clear prices at a normal low level as historically has happened in the past, the Fed's trying to step in and manage risk assets to too great a degree. I don’t think it's going to end well.
And if you look at quantitative easing--QE, QE2 and now Operation Twist--if you were literally to look at the stock market, the S&P 500 chart, during those periods of time, the S&P 500 is going up every time the Fed's active. And it's been falling off when the Fed isn't active. And so, I don't know what kind of indication that might be to you, but to me, it certainly points to the Fed's managing through this in a way that's going to have some severe ramifications.
At the end of the day, the consumer debt, we got overleveraged. Consumer debt came down, hurt the economy. Government debts replaced that. And we've literally had these huge transfer payments to the consumer to try and keep them spending. And it doesn't make any sense to us. At this point in time, I think 44% of our nation is receiving some form of government subsidy. That’s not good. That doesn't reflect strong internals for an economy.
So, at some point in time, there are ramifications. At some point in time, interest rates are going higher, and mind you, with or without inflation, I would argue. So, if interest rates go higher, then it does a couple of different things. One, it does make a difference to those companies that are more highly levered, who haven't termed out their debt, although a lot of companies have.
But more importantly, let’s look at it from the government level--government interest expense as a percentage of the total budget is about 6% today. And it was as high as 7% back in the early '70s. Well, that's a hell of a lot higher today with rates being a lot lower, making these numbers look a lot more attractive. And as far as that goes, the denominator is higher as well because our budget is growing at a faster rate than inflation.
So if interest rates actually were to rise to a 5% to 6% level, what is a 6% interest expense as a percentage of our budget, will rise to someplace in the midteens. There is going to be a lot of crowding out of other types of spending, and that scares the hell out of us.
McDevitt: So, if you are talking about higher interest rates, what does that potentially mean in terms of inflation, and then how are you trying to protect against that? How are you positioning your portfolio in that context?
Romick: You can live with higher interest rates, I would argue, without higher inflation. That potential exists. For that to happen, you have to, I would argue, have China and other large trading partners have a larger middle class than they have today, higher GDP per capita, where they are less dependent upon the U.S. as an engine of growth. Were that to happen, then you would end up, in my opinion, with a trading hold on the U.S., or a buyers strike if you will, on U.S. Treasury debt, and we would have to buy more and more, and the Fed would have to print more and more money. I don't think that's likely to happen in the short term, but that's our fear in driving those rates higher.
And I also think that as you think about what our U.S. government is doing and some of its ramifications, if you look at our debt, 41% of the public portion of our debt matures inside of two years, and thus Operation Twist, trying to get those maturities extended.
So, I think higher rates--which could bring inflation along with it, but may not--will have a lot of negative ramifications for investors, particularly those investors who have been scared about the risk-on trade, have moved to bonds, and bonds are just one of the worst investments out there: Treasury bonds, 10 years, 20 years, 30 years. We think it’s crazy.
McDevitt: You're also talking about high-yield bonds too. You have really cut back on high yields in your portfolio. What about relative valuations there?
Romick: High-yield bonds are actually trading at average spreads. They are not dirt cheap, and they are not expensive, but the problem is the starting yield is so ridiculously low that we are not willing to engage. So our high-yield bond book which went from 6%-ish prior to fall of 2008, up to 34% in the spring of '09, now it's down to 3%--because, A) spreads aren't unusually attractive; B) the starting yield is so low; and C) a lot of these companies are putting on a lot more debt, not all companies, there is tremendous cash in corporate America. But a lot of companies have gotten increasingly leveraged as a result of this, and so if you look at the last two years, you have issued almost $500 billion of new high-yield bonds, of which 80-some odd billion are CCC non-rated, highest of any two-year point in time in history.
McDevitt: So, because the default rate is really low at this point, a relatively low at this point, is that more just a reflection of companies' ability to refinance more than the health of their underlying businesses?
Romick: No, I think the health of businesses, relatively speaking, is pretty good. I mean margins are at all time highs, I think somewhat suspect of certain industries, and you also have a lot of companies who cut a lot of fat, a lot of people they have let go, and they didn’t get the bad press that usually goes along with it, because everybody understood why those people were being let go.
McDevitt: Sure. How about in terms of higher margins--again, people see corporate margins at historical highs. Do those margins have to revert to the mean, do you see that happening, and what are the risk factors for corporate margins?
Romick: There is a lot of reversion to mean theories out there in looking at the operating margins. I would argue, when looking at U.S. operating margins, that the mean over the last 23 years is not as relevant. And it's not as relevant because there has been a structural change in the makeup of corporate America. We've moved our manufacturing offshore. Manufacturing historically has been a lower-margin business. So, we've taken our lower-margin business out and moved it to another country, and ... we've become more of a services-based economy, that are higher margin in many of these different businesses. Plus that which we do produce certainly has higher margins, you know a lot of these businesses, like Oracle or Google and others.
So, I think there is a structurally higher normal for operating margins today. That does not mean that operating margins can't go down. I think there's a very high probability that they will fall off of their peaks. I think that a lot of these companies, when there is more inflation, will not have the pricing power to offset their input costs, and those companies without the moats are going to be challenged as a result.
McDevitt: You talked before about consumption in China, and you also have quite a bit of your equity portfolio in Europe. Are some of those positions an indirect play in any way on increasing consumption in China or other emerging markets?
Romick: I think your question has more or less been asked from the position of domicile--countries where the companies are domiciled--and I want to be careful just to make sure we are clear in our discussion, because the country of domicile is not relevant. It's really the revenue stream, where the revenues are coming from. We have four companies in our portfolio that four years ago were U.S. companies. Today they are European, because there's better tax hedges, advantages.
McDevitt: In terms of domicile?
Romick: Yes, country of domicile. And these companies, Covidien, Aon, Rowan and Ensco, are now all in Ireland and the UK, and they are paying less in taxes. So, these companies, like Ensco, for example, has 80%-plus of their businesses outside the U.S. anyway.
So, ... as we think about revenues, and where the revenues are domiciled, I think our businesses like WPP Group, which has 30% of their revenues coming from emerging markets, they were in the BRIC nations before the term was ever coined, and they are number one in all those nations, and yet they still have 25% in Continental Europe and 12% of sales in the United Kingdom and then the balance is in North America. And this is a business that has headwinds in these slowing markets.
Danone sells less yogurt in Spain and to the extent that one of WPP's companies is doing business with Danone, it's probably going to hurt their business. I don't know if they actually are doing business with them, but just as an example. But you'll end up normalizing at some point in time, but that is a headwind today, but it's offset by strength in emerging markets, which have much greater tailwinds.
McDevitt: In terms of what you are paying for those revenues that are coming from emerging markets, do you feel like you're getting decent or at least good prices in Europe, if they are listed in Europe?
Romick: Right. We think that they are showing up in a lot of these companies to be discounted. If you look at the WPP Group, a company that's grown sales organically 6% over the last almost two decades, a company that is growing earnings in the midteens over the last decade or two, this is a very good business. It's a business with high margins, double-digit margins, double-digit returns on equity, a good balance sheet--but it's cyclical, there's a cyclicality to that business. Consumer spending drops, their business is getting hurt, economies weaken, their marketing spending goes down.
That being said, I am very confident that five years and 10 years from now, they'll be a bigger business than they are today. I don't know what that means over the next couple of years. So, we are comfortable making an investment in a company like WPP at 9 times the earnings, which is where we were able to buy it last year.
McDevitt: Excellent. Steve, thank you for your time.
Romick: You're welcome. Thank you.