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Das Non-Plus-Ultra f.d. EW-Leser(Innen):Taste it.......
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Barron's Roundtable Participants
BILL GROSS
Founder and chief investment officer, Pimco, Newport Beach, Calif.
ARCHIE MacALLASTER
Chairman, MacAllaster
Pitfield MacKay, N.Y.
JOHN NEFF
Retired portfolio manager, Vanguard Windsor Fund and Gemini II; managing partner (retired), Wellington Management, Radnor, Pa.
MERYL WITMER
General partner, Eagle Capital Partners, N.Y.
MARIO GABELLI
Chairman, Gabelli
Asset Management,
Rye, N.Y.
ABBY JOSEPH COHEN
Chair, investment policy committee, Goldman
Sachs, N.Y.
OSCAR SCHAFER
Managing partner, O.S.S. Capital Management, N.Y.
FELIX ZULAUF
Founding partner and
president, Zulauf
Asset Management, Zug, Switzerland.
SCOTT BLACK
Founder and president, Delphi Management;
portfolio manager, Delphi Value Fund,
Boston, Mass.
ART SAMBERG
Chairman and CEO, Pequot Capital Management,
Westport, Conn.
MARC FABER
Managing director, Marc Faber Ltd., Hong Kong.
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COMPANIES
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Procter & Gamble Co. (PG)
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U.S. dollars 26.01
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U.S. dollars 58.40
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U.S. dollars 43.05
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* At Market Close
The Long View
Our panel sees a year of growth, and a wall of worries
By LAUREN R. RUBLIN
THEY CAME FROM far and near. Mark Faber from Buenos Aires. Abby Cohen from around the corner. But where they're going -- and more important, where stocks, bonds and the U.S. economy are headed in 2004 -- was all that mattered Jan. 12, when the 36th annual Barron's Roundtable convened in lower Manhattan.
You can learn a lot, as Barron's editors did, when you sequester 11 of the smartest investment pros on the planet for an entire day, plying them with questions and, later, caffeine. We learned that most expect the good times to roll on for the stock market and the economy, at least until Nov. 2, when President Bush most likely secures his next term in office. Later, however, the piper will have to be paid -- for the too-easy money, towering deficits and slap-happy speculation of the past year. Put another way, the chickens will come home to roost, perhaps on the White House lawn (though some might stay at the Greenspans').
This year's Roundtable brought much talk of China, the newest cause of deflation, inflation and all-round fascination. It also brought us a new face -- that of Bill Gross, founder and chief investment officer of Pimco and the world's wisest man on bonds. Bill is not merely a scholar but a gentleman (he laughed at Mario's jokes). He also doesn't mince his words, which are as chilly as a New York winter. In short, he reminds us that when interest rates hit bottom, there's only one direction: up.
In addition to the big themes, this week's Roundtable issue, the first of three, spotlights the investment picks of Archie MacAllaster and Meryl Witmer. There are few undervalued financials that haven't met Archie's charming acquaintance. This year, an energy stock does, too. Meryl's research skills are something special, which may explain her fondness for, yes, special situations. She's got six, on the long and short sides, including a telecom bond.
Barron's: It has been an interesting year -- and a rewarding one, too. What's ahead for 2004? John, let's start with the economy.
Neff: I'd buy a 4% increase in GDP. Corporate profits couldn't have a more ideal scenario. Productivity is remarkable. Even [Federal Reserve Chairman] Alan Greenspan, who is not given to superlatives, called the 8.1% increase in third-quarter productivity astonishing. Wage growth is moderate, unit growth is good and there's a little pickup in pricing here and there.
Q: How come you left out employment? December's payroll report showed 1,000 new jobs, not the 150,000 expected. That was astonishing, too.
Neff: Companies have been very stringent. The corporate guys are trying to come up with a good bottom line. But at some point you have to add people. We are at that point. Anyway, [S&P 500] corporate operating profits will be about $61, up from $54.50 or so.
Q: Bill, do you have a similar view?
Gross: The economy will do fine in the first half. More tax cuts are coming, and we'll have the delayed effects of 1% money. Anyone who bets against this in stocks or bonds is fighting a headwind. Beyond the first half, however, the U.S. and global economy have problems, because we are running out of stimulation.
Q: They haven't dropped money from helicopters yet.
Gross: There's some chance of that down the road, I suppose. There are two primary agendas in the world today. No. 1, the U.S. is trying to reflate its economy, to get out from under the crushing burden of consumer, business and now federal debt. No. 2, China is trying to employ tens of millions of people. Both agendas are dominating in terms of not only 1% interest rates in the U.S., but China's insistence on fixing the renminbi to the dollar. These agendas are calling the shots for lots of currency moves, mini-bubbles in asset markets and potential global volatility.
Q: Scott, what is your take on '04?
Black: Real GDP will grow 4% to 4½%, with modest inflation of 1% to 2%. But there are systemic problems. We are living on borrowed time. A lot of it is politically driven. Mr. Bush wants to get re-elected, so he's going to keep interest rates as low as possible until November. But he has a conundrum: The dollar is in free-fall. The biggest problem is the federal budget deficit -- $450 billion-plus. It is unsustainable over the long term. We also have an enormous trade deficit. The Chinese might want to buy our debt because they are hooked to the dollar, but I don't see Europeans buying if they get a 5% coupon but take a 20% hit on currency. [The dollar fell 16% against the euro in 2003.] We'll do well until the first Tuesday in November, but there are many warning signs for '05.
Q: Archie?
MacAllaster: It's a presidential year. The authorities are throwing out all the money they can. I see 12%-13% growth in corporate earnings and 5% growth in GDP. As for jobs, a 5.7% unemployment rate used to be considered full employment. Canada's is 7.4%. France's is 9%-plus. In general, we're in pretty good shape. But I would be nervous. Somewhere along the way, there will be a real problem with inflation. The Fed will have to raise rates to protect the dollar.
Oscar Schafer (L) and Art Samberg see short-term gain, future pain for the U.S. economy.
Q: Oscar, how do things look to you?
Schafer: The weak dollar helps our manufacturers, and Chinese imports keep inflation down. In the short term, this helps our economy, but there are long-term risks.
Q: Abby?
Cohen: The second half of '03 was extraordinarily robust, and there will be some deceleration. But this year will still be good. GDP growth will be about 4% and corporate profits will grow about 10%, based on S&P 500 operating earnings. But the budget deficit is very large and becomes problematic in '05 if it continues to grow, particularly as a percentage of GDP. Also, politicians sometimes do and say strange things during election campaigns.
Q: We're surprised you said that!
Cohen: I didn't say which party. Any comments about trade protectionism could be of concern. There has been enormous erosion in our trade situation because of weak economic conditions in Europe over the past three years. China is not our most important trade partner outside North America -- Europe is. Europeans buy more sophisticated things -- value-added goods and services. We have a $100 billion trade deficit because the European economy remains lackluster. But if Europe starts to improve, the companies in the S&P 500, which tend to be multinational, could do well.
The inflection point has been passed. Continental Europe shows signs of life. But the weakness in the dollar relative to the euro has led many European companies to complain that they are losing competitively to U.S. concerns. Europe will get better, but it's trickier to forecast.
Q: Mario, do you have any thoughts?
Gabelli: Never. Fiscal and monetary stimulation continues to work. The consumer gets another round of tax cuts. The business community is starting to show life after Sarbanes-Oxley [a 2002 securities-reform act, which many executives deem too restrictive]. Companies have gotten past corporate-governance issues to thinking about taking on risk again. You'll start seeing the benefits of more capital spending and inventory rebuilding. As for the consumer, the wealth effect will lead to more discretionary spending on things like travel. Pent-up demand in housing and autos is not there. Après the election, like everyone else, we're concerned with how to pay for this.
Schafer: Après le deluge.
Q: Gee, a bunch of linguists.
Gabelli: Oil is an issue, though for Europe it's a stimulant [oil is priced in dollars]. European economies will be good in the second half. Japan shows more signs of vitality. The rest of the world is reflating, in part because 130 million Japanese and 500 million Europeans are buying oil at a discount to last year's price. The rest of the world starts to look better as we go into '05-'06.
Q: Felix, what do you see?
Zulauf: A convergence of high-cost, highly saturated industrialized economies with low-cost, unsaturated emerging economies. A breakdown in industrialized economies, such as the one in the U.S. in 2001 and '02, calls for huge financial stimulus. The Chinese don't want to rock the boat, so they will continue to buy Treasuries. When will China change its policy, and what other factors in Asia could change? If Japan begins to invest again, that would redirect Asian savings to Asia instead of the U.S.
But it's an election year, and everyone is happy with the way things are rolling. We'll continue to have stimulative policies in the U.S. GDP growth could average 3%. The European Central Bank will have to stimulate European economies. Japan has seen structural improvements. The emerging economies continue to boom. This means higher commodity prices, however, and the risk that oil will break to the upside.
Q: Meryl, your turn.
Witmer: The consumer will spend more. I went to Disney World over the holidays.
Q: Is that how you spent your stock-market winnings?
Witmer: They closed the Magic Kingdom because it reached full capacity. Also, I noticed a lot of Europeans. The euro buys a lot, and they are spending it here. On the corporate side, the government has accelerated the depreciation schedule for capital goods. A truck that had a 12-year useful life may now be retired by a company at 10 years, because of the depreciation incentives. This encourages spending on the capital-goods side of the economy. The law runs through 2004, and they're talking about extending it.
Zulauf: Actually, you're borrowing from 2005.
Gabelli: Sections 168 and 179 of the tax code have been extraordinarily helpful. Purchases of heavy-duty trucks were up 50% in December. Dentists bought equipment because their accountants told them to do it.
MacAllaster: It hasn't shown up yet in the economic data.
Witmer: Companies are starting to buy more equipment. You need earnings to use the write-off. While it's true that we're stealing from the future somewhat, shortening the useful life of a truck from 12 to 10 years increases capital spending 16% over those 12 years.
Q: None of you has a negative view of '04. That's very bearish.
Samberg: If you're a stockpicker today, you've got to be optimistic. There is nothing negative. When you talk to companies, they are going to spend.
Q:"Nothing negative." That should be emblazoned on something. Wait a minute, $30-$35 oil is not a negative?
Samberg: It's going to $40 a barrel. That is a negative, but it's not as big as all the positives. All year long, anyone who followed the standard prediction was budgeting for $22 to $25 oil. Yet oil stayed high, and earnings are coming through.
Q: If heating oil and gasoline rise by more than $2, that's going to be a serious drag. Also, consumers have a lot of debt.
Samberg: Until interest rates rise, that won't be a problem. Consumer spending has exceeded disposable income by 2.3 percentage points for 11 years. Someday, this will change, but in the short term, if you can find a company that's going to blow away its numbers, you're going to get rewarded.
Amused or confused? Only Bill Gross (l.), Mario Gabelli (c.) and John Neff know for sure.
As for the growth of China, it's a two-way street. It is helping commodity prices and giving companies pricing power. Japan is coming around. Europe is starting to waken. Brazil is turning around.
Q: China is overheating.
Zulauf: But it doesn't have an inflation problem yet, thanks to productivity gains. The only problem that could slow China is bottlenecks and shortages. Electric power is being rationed. Other Asian economies are doing well. The world economy is doing well. Later in the year, you could have a problem if U.S. consumer spending moderates. You need much stronger employment and wage growth.
In Europe, the consumer will spend more this year than last. The employment situation has stabilized, as the big firings are over. There are small but important tax reforms coming in Germany. And the European Central Bank will get more stimulative to cut the rise of the euro.
Cohen: The euro's strength versus the dollar is a problem for the Euro-zone, not the U.S. The euro has gone up significantly, but the dollar on a trade-weighted basis has gone down much less.
Gross: This simply means the price of the currency relative to the dollar is being fixed. Price-fixing can't work in the long term. Expect the dollar to go down a lot more once it becomes impossible to continue to support it.
Zulauf: Any other country with America's external imbalances, deficits and policies would have seen her currency collapse. The bond market, stock market and economy would have collapsed, and the IMF [International Monetary Fund] would be coming in. This is not happening because Asia, in its own interest, is willing to remain a creditor of the U.S. Therefore, the endgame is postponed.
Gabelli: Three years ago, we talked about three bubbles. One was the Nasdaq and the bubble in wealth. As of last night, the wealth in equities was over $31 trillion, up $9 trillion last year alone. We're within 20% of 2000's peak of $35 trillion. The wealth in fixed income has grown to almost $7 trillion in the past three years. Second, we talked about the bubble in capital spending. Other than telecom spending, which became irrational, capex [capital expenditures] is picking up. The third bubble was the dollar. We knew it was going to break. It's breaking. There shouldn't be any surprise.
Table: A Last Look Back
Q: There seems to be a sanguine consensus for '04, but no visibility beyond that. When does this start to hurt the economy?
Gabelli: When [Democratic presidential aspirant] Howard Dean makes a strong showing in the polls in March or April. Then people will start to worry about '05.
Abby Cohen:"I'm bullish, but not as bullish as I was last spring."
Gross: There's little visibility after '04 because the U.S., and the globe to some extent, is a finance-based economy. We now have 1% short interest rates, multi-hundreds of billions of dollars of deficits. You can reignite animal spirits -- Mario talked about that -- but you do that at the expense of the future. Japanese rates fell to zero and have been there for a long time. But once you get there, what's next? The logical direction of interest rates is not down, it's up. The logical direction of budget deficits may be up, but there are limits because of political constraints. If you have a finance-based economy that is predicated on low rates, low yields, a strong dollar and increasing budget deficits, then '05 and '06 and '07 are wanting for lack of further stimulation. It's just that simple.
Black: I want to address the consumer. The mortgage-refinancing punchbowl has been going for 2½-3 years. We've refinanced over $3 trillion worth of mortgages. Backing out incremental amounts of money has spurred consumption.
But re-fi activity will fall if interest rates back up sharply. Real disposable income is up if you back out payroll taxes. But add in co-pays like health care -- people have seen enormous increases in health-care costs, passed along by employers -- and disposable income is down. Also, there has been a bifurcation in incomes, which started in the Reagan-Bush years. It narrowed a little bit, and now it's widening again. People at the top, who own securities, have been doing well. But many people have been left behind in this recovery.
Gabelli: Scott, over 100 million people own securities.
Black: That doesn't mean their disposable income and their mental health about their wealth has improved.
Gross: Once you reach rock-bottom on the savings rate, which we did 12 months ago, and which we're close to again, there is only one way to go, and that's up. That means additional savings and less consumption ahead. It might not happen in '04, but it's out there.
Archie MacAllaster's Picks
Company Ticker Price 1/9
El Paso EP $8.29
Fidelity Natl Finl FNF 38.46
FBL Financial Group FFG 26.21
Cigna CI 57.26
Bank of America BAC 78.35
National City NCC 32.89
Wachovia WB 47.15
UnumProvident UNM 15.66
Q: Here comes Marc, just in time [his plane had been delayed]. We desperately need a negative view.
Faber: I just came from Argentina. It was one of the richest countries at the beginning of the 20th century. I have a book written by an Argentine professor in 1950 called Argentina: World Power. When you see the total decline of the Argentine economy over the past 50 to 100 years, you wonder whether it can also happen elsewhere.
Q: Where?
Faber: Specifically, in the U.S. Argentina's agricultural sector has recovered because of strong soybean exports to China. But the unemployment rate is 25% or so. Argentines spent beyond their means. The high inflation rates of the 1970s and 1980s led to growing wealth inequality. The rich people moved their funds overseas. The average person had pesos, which lost more and more of their value. With Alan Greenspan and [Federal Reserve Gov. Ben Bernanke] running monetary policy here, you will have domestic asset inflation and a depreciating currency. In the long run, that is not a desirable state of affairs. It creates tremendous wealth inequality and an absolute decline in living standards.
Felix Zulauf (l.) and Scott Black await their 15 minutes.
The Dow Jones Industrials were up 25% in dollars last year, but only 5% in euros. The euro has climbed from a low of 82 cents in 2000 to $1.27. Asset inflation is necessary to keep up living standards. But in euro terms, or relative to a basket of commodities or gold and silver, the U.S. already is deflating.
Q: What will happen to the economy this year?
Faber: You can have a deflationary boom, such as the U.S. had for the entire 19th century or China has today. In the U.S., however, this kind of deflation is unacceptable to policymakers because the debt-to-GDP ratio is excessive. Between 1950 and 1980, debt and gross domestic product were growing at about the same rate, and the ratio was about 120%. Today, it is more than 300%. Mr. Greenspan was one of the principal architects of this debt explosion over the past 20 years. But I pray he lives as long as possible and is replaced by Mr. Bernanke, because the business of everybody in this room has thrived on account of their policies. We must be grateful to Mr. Greenspan. Every time there is a shock to the system, more money is printed and our businesses can continue to flourish.
Q: We get the picture.
Faber: The housing boom has come to an end. Refinancings are down about 70%. Real-estate loans have started to contract and home sales have weakened in the past few months. Once this asset inflation ends, consumption will slow or contract. It may start this year, as the impact of tax cuts ends. I doubt interest rates will fall significantly. But let's distinguish between real and fictitious growth. In China, there is tremendous investment in plant and equipment and infrastructure, which is real economic growth. On the other hand, it has now become fashionable, especially in the U.S., for men to have cosmetic surgery. As a result, let's say more hospitals are built. More doctors have to be hired and employment goes up. But to what extent does that create economic growth? A lot of economic growth in the U.S. is artificial, essentially transferring money from Peter's pocket to Paul's.
Samberg: That's a dangerous slope to go down, because it means quality-of-life expenditures have no economic role.
Gross: It's all well and good to have plastic surgery, or buy or sell a certain service. But we can't sell our plastic surgery to the rest of the world. To the extent we can sell our paper, or could sell our automobiles in the past, that was good. But if growth now is predicated on services that are not tradable and that the rest of the world doesn't want, it's a negative in terms of the trade deficit, the dollar and ultimately a our standard of living.
Witmer: If the dollar is low enough, the world can get its plastic surgery here.
Gabelli: Take New York City. One of its largest employers is hospitals. Not only is the population aging, but people from around the world come here to get medical treatment. American universities are still the schools of choice. Agriculture is our largest export. Movies are our second largest export. So let's cut it out about cars. We haven't sold many cars outside the U.S. But we sell lots of corn and wheat and soybeans. And software.
Gross: You're optimistic on the U.S. economy because of our agricultural exports?
Gabelli: The Iowa corn farmer is the most productive individual in the world.
Q: He is also subsidized.
Gabelli: You've got $100 billion of livestock and $100 billion of commodities. There is only $20 billion of transfer payments.
Gross: You can't knock the American farmer. But in order to sell agricultural goods to the rest of the world, you need a depreciating dollar. That might be good for the farmer, but ultimately it lowers the standard of living for all Americans. That's the point most Americans don't seem to realize. As the dollar declines, it costs more to import goods.
Schafer: Imports are a small part of our GDP. Why does a weak dollar hurt?
Gross: Two or three years ago, the mantra was that because of the strong dollar, foreign investors wanted to hold our stocks and bonds. If we have a weak dollar, foreign investors won't want to hold our bonds and, believe it or not, our stocks. That ultimately affects Americans' wealth.
Q: Let's move on to the interest-rate outlook. Bill, you know something about rates.
Gross: Interest rates are commonsensical when you think about it. What you see is what you get. If you see 1% rates on short-term bills, or a 4% U.S. Treasury note for a 10-year period of time, by golly, that is what you are going to get over that period of time. It is only the fluctuations that confuse people in terms of capital losses and gains. Interest rates are at historic lows, and you can make the same case around the world. Adjusted for inflation, we are at negative yields. This means the only direction is up. The question is, when and by how much?
Q: When and by how much?
Gross: The Fed probably acts toward the end of the year. Much depends upon how strong the economy is. Typically, over the past century, we had 0.5% to 1% real short-term rates. In today's inflationary terms, that means 2% to 3%. The Fed can't afford to do that now because consumers and businesses are in hock too much to put up with a 200-basis-point [two percentage point] rise in the federal- funds rate. But by the end of the year, we might see the Fed at 2%, as opposed to 1%. And that is probably only the beginning if inflation continues.
The Fed controls short rates. Intermediate and long rates are determined by institutions, individuals and foreign central banks, such as China's, which have been massive buyers of Treasuries. Yields are too low and ultimately will have to move higher. Ten-year Treasuries are yielding 4% right now, and will rise to 5% by the end of the year. We could see higher rates in the next few years.
Q: Scott?
Black: Congress is planning to raise the federal debt ceiling to more than $7 trillion. Otherwise, they are going to need a budget resolution to keep the country going. If you put a"normalized" interest rate on $7.5 trillion of debt and say the average at some point will be 5.75% to 6%, you're looking at $450 billion of interest payments a year. That is bigger than the defense budget of the U.S. This is untenable. The deficit will be monetized. Because it's an election year the Fed is going to try to put the fix in as long as possible to keep interest rates low. There will be some creep in the mid-term range; the 10-year could back up to 4.50%-4.75%. Fed policy is not going to change much for the first six months of the year. But I am more concerned about next year and beyond.
Q: Won't the markets start to worry, too?
Black: Yes. Price-earnings multiples on stocks move inversely to rates. And bond investors, at the margin, are going to demand higher rates. Also, there could be a"crowding out" in a few years, when the government tries to borrow so much money, it competes with the private sector. Ultimately, inflation rates could return to 3%. Bonds historically have yielded 2.5 to three percentage points over inflation rates. The 10-year at some point could back up to 5.50% or 6%, unless we rectify our budgetary problems. I am not sure there will be the willpower to do so.
Gross: My 4.75%-5% prediction, by the way, is a total-return figure, meaning income plus price -- in this case, depreciation. It would equate to the 1% short-term rate that Greenspan is targeting at the moment. Bonds sometimes are amazingly efficient in discounting our yield forecasts. This yield basically subjects the American bondholder to the same negative return that Alan Greenspan is offering with a 1% federal-funds rate.
Q: What happened to the bond-market vigilantes?
Gross: When interest rates reach lows, you are backed into a corner. That's true in the stock market, too. If you want to be defensive, you are stuck with a 1% yield. And if you want to get aggressive by extending your maturity, you might suffer a price loss as reflation takes hold.
Q: It a mystery why people still have money in money-market funds, which really aren't paying any interest at all.
MacAllaster: Negative interest, actually.
Gross: Money-market holders are willing to accept a very low interest rates relative to what they can get by extending out on the yield curve. The Chinese are willing to subsidize the U.S. bond market at low interest rates. You don't want to invest in money markets, nor do you want to invest in U.S. fixed-income markets in the conventional sense.
Cohen: The Japanese purchased four times as many Treasury securities in 2003 as the Chinese. In the first three quarters the Chinese acquired about $20 billion of Treasuries, the Japanese about $80 billion.
Zulauf: That's because the Chinese are buying commodities, which the Japanese don't need.
Cohen: It might be more useful to watch foreign direct investment. When the dollar goes down, foreign companies can acquire operating assets in the U.S. at attractive prices.
Q: Money-market funds became popular when interest rates were high. The 1980s were their golden era. But many people never switched out. Is there a point when this money will leave?
Cohen: We are already there. There was enormous, almost exponential, growth in money-market funds under management until a few months ago. In the past few months, money-fund assets have stabilized.
Q: That's because institutions have put their money in the stock market.
Gross: There is a permanent money-market constituency. Mom and Pop. Retired people who will stay in such funds, no matter what. The only way to beat it is to take additional risk.
Faber: We should reward people who save money. They are the ones who make capital available for investments. A saver should not be penalized by artificially low rates or negative real interest rates.
Q: That's an old-fashioned concept.
Faber: I may be old-fashioned, but economies that became prosperous were economies with high savings rates and strong capital formation, not over-consumption. Artificially low or negative real rates drive people to move safe funds into risky assets. The longer these rates last, the more people will be driven into an asset class that is appreciating rapidly. Eventually, you get a bubble. The public then buys an asset class nearest its peak and loses a ton of money once again. Very low interest rates create the basis for the next big bubble.
Cohen: It would be more disturbing if the yield curve itself was not so steep. But yields on intermediate and long-term debt are well within historic norms.
Faber: So the poor individual -- let's say, the elderly gentleman who depends on some income -- 10 years ago earned 6% to 7% on his money-market fund. Now he's down to 1%. He decides to switch to 30-year bonds. Well, tough luck, because rates have been declining since Sept. 29, 1981, and probably bottomed in June 2003. From here on, you'll have rising rates for the next 20 to 30 years. Rates in the U.S. eventually could be 20%, 30% per annum. In the next three months, the bond market might rally. But it's starting to smell that the economic statistics have been grossly exaggerated on the positive side, and the economy is very soft.
Archie MacAllaster
Gabelli: Not only are people being pushed into riskier investments, but brokers are selling leveraged fixed-income funds. They borrow short and lend long, to get that extra yield enhancement. That's a time bomb. It will blow up. On the other hand, we have created the best incentive for investors in 50 years: a 15% tax rate on dividends and capital gains. It's not as good as in Hong Kong, but it's terrific. What is the tax rate in Hong Kong?
Faber: I don't pay any tax anywhere, so I wouldn't know.
Gross: Tell us how you do that later.
Q: Mario, given our deficits, are those low tax rates sustainable?
Gabelli: Dividends already are taxed once at the corporate level. Why should they be doubly taxed? Even at 15%, they are doubly taxed.
Q: The government needs the money.
Faber: The government cut the tax rate after a 20-year bull market just to keep it up.
Gabelli: I disagree. The tax cuts were pushed to promote a degree of fairness and to reinstill investors' confidence.
Gross: They are coming at the end of a 20-year political cycle that began with Margaret Thatcher in the U.K. and Ronald Reagan in the U.S. To believe that capital-gains taxes or nominal taxes can go any lower is fool's play. The only direction they can go is higher.
Q: Oscar, what do you think of interest rates, if you think of them at all?
Schafer: I don't think they will rise this year.
Q: John?
Neff: Long governments will go to 5.50%-5.75% before the year is out.
Q: Abby?
Cohen: I don't do the interest-rate forecast for Goldman Sachs. In my work, I assume the market is correct in presuming the Fed could raise rates 0.50 to 0.75 of a percentage point. Because I'm trying to build some valuation headwinds into my equity model, I add another 0.25 to 0.50 of a point to do a sensitivity analysis. And I try to use a higher discount rate in my dividend-discount and discount-to-cash-flow models. So much of this increase already is reflected in the equity market that if rates move up as people here expect, it should not create undue problems for stocks.
Q: Art, do you agree?
Samberg: Rates will go up, but not by a heck of a lot.
Witmer: I agree.
Gabelli: I see 2% short-term rates and 5% 10-year yields. The implication is inflation is picking up, but it is not a negative if I own companies that are conduits for inflation.
Q: It has implications for housing.
Neff: If long mortgages go up 0.50 to 0.75 of a percentage point, housing is still a steal.
Meryl Witmer
Schafer: Rent is 40% of the CPI. Since everybody is buying houses, rents are very low. That is keeping the CPI down. If the housing market slows down, and people start renting, that will have a lot to do with the increase in inflation.
Faber: How do you define inflation in the United States? You can have CPI inflation, which is mainly goods and services. I don't see much inflation in goods as long as China continues to produce. In the service sector, tradable services will come down, because of outsourcing to India and other countries continues. But you might have commodities inflation. Oil prices will rise significantly in the next 12 to 18 months.
Cohen: Do energy prices go up because of the dollar going down, or do you expect energy to rise around the world?
Faber: The energy market is tight. It takes a long time to bring on new capacity in natural resources. If you have a semiconductor shortage, you can double capacity in 18 months. Not so in resources. If demand goes up, there is tremendous pressure on prices. And oil is very cheap, cheaper than a bottle of Perrier.
MacAllaster: The federal-funds rate is going up sooner rather than later, in the second quarter, perhaps. Ten-year bonds are going to 5.50%-5.75% by the end of the year, unless Europe finds a way to halt or bring down the euro. Also, Greenspan is getting near the end of his tenure. He will not be as affected by the presidential election as you think.
Q: Well, you're wrong. Felix, what say you?
Zulauf: The Fed has indicated many times that the Japanese tightened too early. Therefore, it will err on the side of staying too easy for too long. Short rates will stay low for most of the year, but the long end eventually goes up, perhaps from 4.10% to 5.50%.
Q: What will force the Fed's hand?
Zulauf: After the election the Fed is freed to move. But the long end will move ahead of the Fed, and it will follow. The Fed will not set rates to break inflation. There is no CPI inflation risk. The currency usually forces the hand of central banks. The Europeans start cutting rates in the first half, which leads to a temporary rally in the dollar. Sometime in the second half, the U.S. bond market's problems start. The dollar could rise 10% or more within three months, wiping out speculators. It could be brutal.
MacAllaster: I think that will happen.
Zulauf: Once the technical positions are cleaned out, fundamentals return. The dollar has not reached a low, nor the euro a high. If the euro were to shoot straight to $1.50, it would cut off a lot of marginal European exporters.
Gabelli: Felix, German exports to China have helped the entire export sector, even with the current exchange rate.
Zulauf: China helps, because it is looking for capital goods. But the euro-dollar rate is still important for the European economy.
Gross: And for inflation. To the extent the euro goes to $1.30 or $1.35, prices fall in Europe and rise in the U.S., tilting the table in favor of European bonds.
Q: Doesn't a weak dollar automatically spark inflation in the U.S.?
Gross: It depends on your definition of"spark." A lower dollar means higher inflation relative to what would have been. But does it precipitate a significant increase in inflation? I don't think so. The wild card is whether OPEC responds in the form of tighter supply constraints and a higher price for oil. If it fights back in the form of higher prices, that's bad for inflation in the U.S.
Zulauf: That has already happened. OPEC had a policy of oil priced at $22 to $28 a barrel. Once it's above $28, they should increase production. But do they have much capacity left? This begs the question: Should oil be priced in another currency?
Faber: A radical change like that is unrealistic. I'd like to make another point concerning currencies. The U.S. has a large and growing trade and current-account deficit. The problem is not with Europe but Asian countries whose currencies largely are pegged to the dollar. No matter how low the dollar goes, it doesn't change the imbalance. But once the Asian countries start to trade freely with each other, they can let their currencies appreciate against the dollar without hurting their competitive positions. With stronger currencies, they could buy resources at lower prices. The only solution is a significant decline in U.S. consumption. In other words, a crisis.
Cohen: What happens to economic growth among our suppliers?
Faber: The Asian economic block is far larger than generally perceived. The region is big enough to grow within itself.
Q: Much of the investment in Asia has come from the U.S.
Faber: But U.S. investments in Asia are not that significant in comparison to worldwide investments in Asia. The argument is always that China, and Asia, need the U.S. market. In fact, the U.S. needs Asian suppliers or inflation in this country will go through the roof. Interest rates will shoot up, and the whole system will collapse.
Gabelli: Marc, you are just echoing what Adam Smith said 200 years ago. With free trade the whole world is better off. So, thank you Marc...Adam.
Q: Let's talk about the market. Art?
Samberg: The parts of the market that are overvalued continue to get overvalued. We never broke the mentality of the last market cycle. There will be a day of reckoning, but I don't see it right now. We're a third to halfway through the current move, which is a bear-market rally.
Corporate profits will grow approximately 8% to 10% this year. The year will be front-end weighted, but the market will be up another 10%. A lot of companies have earnings leverage. And a lot are going nowhere.
Q: Which sectors are interesting?
Samberg: Property and casualty pricing looks like it will remain strong for the next two-three years. Anything that has to do with capital spending on infrastructure in areas that were underfunded for the past 10 to 15 years looks really, really good. I am not that keen on technology, even though there is a lot of money flowing into it. People are betting on replacement cycles. A lot of money is being spent on consumer electronics. But it's not like 10 years ago, when there was a paradigm shift in industrial computing revolving around client-server models. This is a cyclical upturn. There's a lot of good stuff ahead, but it will be later. Health care remains interesting.
Q: What infrastructure?
Samberg: There will be a lot of spending to support the growth of energy and natural resources. The Chinese now account for 25% of iron-ore consumption in the world, and 25% of steel, and they are building like mad. This will cause infrastructure spending across the world.
Q: Abby, where are you on the market?
Cohen: I am bullish, but not as bullish as I was in the spring. My fair-value estimate for the S&P 500 is 1250, which is equivalent to about 11,800 on the Dow. If these numbers are correct, we'll see gains of 12% to 15%, about half of last year's, but still above normal. The key is fundamentals -- corporate profits and cash generation, which is important not just for corporate bonds, but dividends. Quite a few companies in the S&P 500 will be announcing increases in dividends. Everyone likes companies to announce their dividend changes in time for annual meetings. The news flow is going to be interesting in March and April.
Consumer spending is going to decelerate this year. We'll get less bang for the buck from tax reduction. Dramatic spending on housing and autos already has occurred and will slow, especially if rates start to move up. Even if the Fed doesn't act, rates already have moved up. That has a dampening effect on rate-sensitive sectors.
Q: Do you agree with Art that this is a bear-market rally?
Cohen: It is a bull market.
Q: Did we ever have a bear market?
Cohen: Yes. Even I noticed it. But this is a real bull market. The economy is doing well. A lot of problems have been repaired.
Q: Do you have a forecast for Nasdaq?
Cohen: We stopped forecasting the Nasdaq in 1998.
Q: That was clever.
Cohen: Our models relate to earnings and cash flow, and work best for seasoned companies. There were too many companies in the Nasdaq that didn't fit the bill. I look at P/E ratios. There's a lot of controversy about what the right P/E is for the S&P or the Dow. People should adjust for low inflation and low interest rates. Other things being equal, P/Es are higher when inflation and rates are low. Also, P/Es often look overextended, not because the P is high but because the E is low. Typically, I look at the median P/E, for the 250th company in the S&P, which removes outliers. The market is selling for 17-17.5 times 2004 earnings, which is reasonable under a low-inflation scenario. The market is modestly undervalued and will move higher as earnings improve.
The pace of economic activity will be critically important. The S&P is much more multinational than the overall economy, and a good chunk of that is related to technology and capital goods. If growth is better, tech will pick up. I agree with Art, though, that tech is not as attractive as it was last year, when we were hugely overweight in the sector. Now we're just modestly overweight. This is a year of rotation -- away from the consumer and toward the industrial side of the economy, away from dependence on domestic activity and toward activity from outside the U.S.
Q: Will the bull market end this year?
Cohen: No. The Fed wants to wait as long as possible before raising interest rates, and it will be given that opportunity. Inflation is low, and until the Fed is convinced the labor market is getting better, it will be wary. Also, the global economy still needs support from the U.S. That said, there will be a seasonal ebbing and flowing. We've already talked about the election. As for mutual-fund flows, December saw phenomenal inflows, continuing into this year, which reflects in part the investment of year-end incentive compensation. We might get another spike as April 15 approaches, and again in the fall, as individual investors feel better about '05.
Q: Scott?
Black: We're using an S&P earnings estimate of $54 to $55, which implies a 20.8 multiple for '04. That compares with earnings of $45 to $46 last year. The market is selling at three times book, with a yield of 1.8%. By historic benchmarks it's expensive. But in light of very low nominal interest rates, it's slightly undervalued, even for a dyed-in-the-wool value investor like me. It's approximately 8.5% to 9% undervalued. There's an ebullience factor here, because rates are so low. The S&P will be up between 8% and 15% this year.
Q: What about you, Bill?
Neff: Is he allowed to talk about equities?
Gross: Yes. Thanks for the question. I know I am primarily here for bonds, but I deserve to be treated with respect because of my Dow 5000 forecast. I am Mr. Dow 5000. [Gross wrote in the fall of 2002 that stocks probably would be priced appropriately somewhere around Dow 5000.]
There are two aspects to this game. The first is to determine whether or not stocks are appropriately valued, and the second is to determine if animal spirits are at play. That's been the most difficult part. Most of us agree as to what the P/E ratios are, and whether or not they're properly valued. Trying to determine whether Mr. and Mrs. America will continue to buy stocks and move out of money-market funds is the more difficult task. At the moment they are still bullish and probably will continue to buy until signaled otherwise by some cataclysmic event or dramatic increase in rates. But we are in a low-return world. Stock prices only increase over a longer period at about the same pace as nominal GDP, or a little less, because nominal GDP is comprised of lots of small growth companies that are not listed on any stock exchange. Nominal GDP will be 4% to 5% this year, absent significant disruptions. Base your estimated return upon that number. Let's talk about the happy days when we had a happy year. I mean
2003. We might have another one in 2004, so long as people continue to believe like Peter Pan.
MacAllaster: What do you think of the market today? Is it too high? Too low?
Gross: It's relatively high. One of my favorite measures is the Q ratio [of stock-market value to replacement costs]. The Q ratio suggests stocks are significantly overvalued relative to plant and equipment.
Meryl Witmer's Picks...
Company Ticker Price 1/9
Rinker Group ADR RIN $49.94
HHG Group HHG LN 43 pence
HHG AU AU$1.05
Medco Health Sol MHS $32.94
...& Pans
Mattel MAT $18.86
Investors Finl Svcs IFIN $37.91
Bond Yield
Verizon New York 6.375%
73/8, due 2032
Q: Archie, what do you think?
MacAllaster: The market is relatively high. There's a lot of new investment in January, which will push prices up, but by the end of the year the market will be at about the same level. Yet, a lot of stocks are not expensive -- stocks that raise dividends and have good yields. They are far cheaper than 18 times earnings.
Q: Meryl?
Witmer: I disagree with everyone, except maybe Archie. The market is very high. It's difficult to find good values. Only one of my long picks today is a U.S.-based company. Maybe the market runs a little more. I don't see the catalysts to knock it down. I call for a roughly flat market.
Q: What do you call for, Mario?
Gabelli: Earnings for many companies will benefit from the translation of euros into dollars. Noncyclical companies like Procter & Gamble already are starting to benefit from currency trends. Overall, the Dow rises to 11,500. There will be basic structural reform, including new policies regarding energy, utilities, the telecom industry and then, tort reform. All help to create jobs, because the president wants to get reelected. Tort reform is tough, but if you believe the Senate will have more Republicans in November, you might want to queue up now and take advantage of what has long been a drain on American industry.
Q: Sounds like you lost a lawsuit.
Gabelli: I won two. We both get sued and sue. We're very active in business. You want to sell to China. So agriculture in all its forms will do well. Health care is a play on old age, and old age -- in cars, planes and people -- always attracts me.
In the market, I'm looking for a strong first half. Around the middle of August, we start to see what happens after the election. How do we pay the piper and address some structural long-term issues? I see an uninspiring second half and a year that is slightly up. On a five- to 10-year basis, I see 6%, 7% returns.
Q: And you, Felix?
Zulauf: We are in a secular bear market in the U.S., and a cyclical bull market that will make a top sometime this year. Financials, homebuilders, technology and consumer nondurables probably peak in the first part of the year. Energy, agriculture, natural resources -- the deeper cyclicals -- will break to new highs in the second half. There is a chance the Dow makes a marginal new high. That would probably be the kiss of death for the stock market. In '05, I see the next bear biting.
Q: Marc?
Faber: Eighteen months ago, investor expectations were extremely low. People were afraid deflation would engulf the system and interest rates would collapse. Then came 2003, and everything went up except the U.S. dollar. Emerging-market debt had a huge rally. Emerging markets like Venezuela are up almost 100% in dollar terms. Thailand was up 138%. In 2004, everything will not go up. There will be a decoupling. You can have a rise in commodity prices or bonds, but not every asset class can go up at the same time. You cannot have a weak dollar and continuously strong equity markets around the world. Something will give.
Q: We can't imagine what.
Faber: Look at the recent collapse in the money supply. It's still up year to year, but on a three-month basis all measures of money supply have collapsed. In '87, it happened and we had a stock-market crash. In '94, it happened and we had a bond-market crash. I am also concerned about China overheating. Growth could become more pronounced in the next six to nine months, but one day there will be slowdown. Industrial production cannot grow by 20% a year, year in and year out. Geopolitically, I see a lot of clouds. When commodity prices have a secular uptrend, the war cycle picks up and there are tensions in the world. The Americans don't want the Chinese to have access to oil. The Russians and Chinese don't want Americans to control the oil in the Middle East.
The U.S. stock market is very close to a major high and will go down from here. A 20% decline in the S&P 500 would be a minor excursion on the downside in the context of the longer term. The emerging markets are relatively inexpensive compared to the U.S., but there is a lot of speculation. A big supply of securities is coming into the markets, so we could have a meaningful correction. There is also the potential for a big correction in commodities. A year ago, the risk was relatively low, and the potential reward substantial. Today, the risks are high and the rewards limited.
Gabelli: On a secular basis, do you see shortage of things the Chinese will need over a long period?
Faber: We live in one of the most exciting phases of economic history. Following the breakdowns of communism and socialism and policies of isolation, three billion people are joining the capitalist system, the market economy. At first, they deflated the price of goods. Now they have certain needs, particularly for commodities, but also machine tools, Park Avenue apartments, Picasso paintings and Mayfair properties. Trophies have value because there is a whole new group of multimillionaires. There are 200,000 millionaires in China.
Q: John, your turn.
Neff: The market's come up at a fast pace. A 40% advance from the March lows is pretty heady wine. We futz around in the first half, maybe until August. Make no progress, maybe a little on the down side. Then, as 2005 starts to present itself -- not unlike 2004, with solid fundamentals and another good advance in earnings -- we might see a good second half, and end the year up 5% to 7%.
Q: It's been a long time since we futzed around, as you say.
Neff: Two things to watch for: Commodity prices have to come down sharply, because $600 billion of hedge-fund money is betting on them. China is building inventories, and at some point you get to the last guy and it goes the other way. I'd look for a pretty good decline. Crude oil is exposed, too. Gold I can't analyze. That's an emotional experience. Also, mutual-fund cash flow was an awfully good engine in the recent move. So far, the retreat from the Putnams and Alliances and Januses and Strongs has been tippy-toeing right over to the Vanguards and Fidelities and Capitals. There has been $15 billion-$16 billion a month of net positive equity cash flow. That is not going to hold up forever.
Cohen: There's a strong seasonal element to fund flows. We won't have a good sense of normalized flows until February or early March.
Neff: The economy grows by 4%. Corporate earnings are rising by 12%. If 2005 unfolds like 2004, maybe the market trades for 18 times earnings and moves up 10% to 12% a year.
Q: Nice of you to say that, but let's get through this year. Oscar, are you sleeping?
Schafer: Nope. The market will be up 5% to 10% this year, fueled by a weak dollar helping the manufacturing sector and low interest rates continuing to lure money into stocks. It may be a rally in a bear market. If so, the bear market will be an '05 event, for all the reasons Bill mentioned. In that, I disagree with John.
Archie MacAllaster
Q: Fair enough. Archie, you had some good stock picks last year. Let's have some more.
MacAllaster: I love to pick stocks, but I want to warn your readers that they'd better be careful this year.
Q: Duly warned. Now tell them what they should buy.
MacAllaster: El Paso trades for 8.25. There are 625 million shares outstanding. Book value is about $11.50 a share. The stock sold for more than 60 in 2001, with a dividend of 85 cents. It now pays 16 cents a year and yields just under 2%. The company is a mirror of Williams Cos., which I recommended a year ago, only a year behind. It is reducing debt, which peaked at $24 billion, and is selling everything but its exploration and production company and its pipeline system, which is the largest in the U.S. El Paso lowered its debt to $21 billion. It sold a refinery and some other properties in the past month. The company is a buy in two ways. One, it sells below book. Two, it still stands by earnings of $1 to $1.10 a share in 2006. If it is able to stay on schedule and cut its debt to $15 billion, it can easily achieve that.
Q: What will the debt-to-equity ratio look like at that point?
MacAllaster: They have about $7 billion of equity, but El Paso's pipeline systems are very stable. Analysts value their natural gas at about $5 per share. Right now gas is about $7 per mcf., but it swings. It will average more than $5. If the company starts earning at the rate of $1-$1.10 by the last quarter of '05, I expect it to start raising the dividend again. El Paso has earned money every year. They will do about 45 cents in '03 and 65 cents in '04.
Q: What is your price outlook?
MacAllaster: It's a $12 to $14 stock.
Neff: Are they going to sell a Caribbean refinery?
MacAllaster: The point is to sell everything, except their two main businesses, and go back to the past, when they were a stable earner with a good dividend.
Samberg: For a while, they didn't have enough money to explore.
MacAllaster: That's right.
Faber: I own the bonds.
MacAllaster: There are a lot of bonds. Some of the longer ones, the 8% or 9% bonds, got down to the 50s, and now they're in the 90s. They've had substantial rallies, which is another indication the company is doing better. The easy money was made first in the bonds.
My next stock is Fidelity National Financial, the largest title insurer in America. It has about 30% of the business. For '03, they'll earn about $6-$6.25 a share. The stock is 38.46 with a book value of about $25 share. There are 150 million shares outstanding. The dividend is 72 cents and they raised it last year. The title-insurance business is very cyclical, and they're not going to make as much money this year. They bought another company, now called Fidelity Information Services, which handles the mortgage-related paperwork for many other financial firms. This company is growing rapidly and now amounts to about 30% of the business, though it could grow to 50% in the next few years. Fidelity National earned about $6 a share for '03 and will earn $4 to $4.25 in '04. It is selling for less than ten times earnings.
Q: But there's the earnings risk.
MacAllaster: The reason the stock is near its highs is because people are starting to figure out the company won't earn $1.50 or $2. The minimum is $4. Also, the company paid a stock dividend last year. It treats shareholders well. It earned $900 million last year. And profit margins on title insurance are very high.
Q: OK, what's next?
MacAllaster: FBL Financial Group. FBL used to stand for"Farm Bureau." It sells both life and property and casualty insurance in the Midwest and some Mountain states. The stock is 26, book is $26 a share, and the company will report about $2.10 a share for '03. So it's selling for 11-12 times earnings. In '01, the earnings were $1.32. Revenues were $475 million. In '02 the earnings were $1.68 and revenue was $541 million. Last year revenues were $640 million. It pays a dividend of 40 cents and has raised the dividend every year except last year.
FBL has a very stable market. Through farm bureaus, it sells insurance in various states. These bureaus own more than 50% of the stock. There's a separate sales organization in the cities, where they sell only life insurance. The company is not well-followed on Wall Street, though it's starting to show real growth.
Q: Where is the stock going?
MacAllaster: It's probably worth 35 a share. We're not going to get triples this year. I've got a few big companies, starting with Cigna. It's got about $85 billion of assets and a book value of $30.50, and sells for 57. The stock was over $130 in '01. It will report $5.40 to $5.50 for '03, and about $5.80 to $6 for '04. It pays a dividend of $1.32, and yields 2.3%. Cigna reduced its capitalization from more than 200 million shares in '98 to 141 million today. It has about $4.5 billion of equity and $1.5 billion of debt. The company is selling its management business to Prudential for $2.1 billion, and a portion of that will be used to buy back more stock. The stock is selling for less than 10 times earnings. Cigna expects to see premium increases of 12% to 14% this year, about 2% more than the increase in their expenses.
Q: What else have you?
MacAllaster: Last year I recommended FleetBoston Financial. This year I'm recommending Bank of America. [In October Bank of America announced plans to buy FleetBoston for $44 billion.] B of A sells for 78, and has about 1.5 billion shares. Last year it earned $7.10 a share and for this year perhaps $7.40. The company has raised its dividend for more than 25 straight years and currently pays $3.20 a share, yielding 4%. It's going to lift the dividend again. This is an enormous company, with 130,000 employees. It will have more than $60 billion of capital when it takes in Fleet.
Q: Do you think it overpaid for Fleet?
MacAllaster: I own Fleet, so I agree. But I don't think it overpaid by much. Other companies were looking at Fleet. Kenneth Lewis, who runs B of A, has done a good job. The company is in the right place.
Q: What multiple should B of A have?
MacAllaster: Twelve times earnings, and that's a 90 stock. Now I've got three"one-liners." National City of Cleveland is 33 a share. It sells for 10 times earnings, pays $1.28 and yields 3.8%. It's very well run. It's a cheap stock. Wachovia is at 47. This year it should earn $3.70 to $3.75, so it's trading for 12 times earnings. The yield's 3%. And I still like UnumProvident at 15.66, or eight times this year's earnings, with a 30-cent dividend and 2% yield. It sells for well under book.
Q: What would a rise in interest rates do to bank stocks?
MacAllaster: These banks have worked to diversify their businesses in terms of fees and other things. I don't think it will hurt them. Also, you're not paying 18 or 20 times for the stocks. things. You're paying 11 or 12, and they pay, too. They're yielding 4% or so. The banks learned their lesson in the early 1990s. Most are over-reserved.
Meryl Witmer
Q: Meryl, your picks were fine, too.
Witmer: Thank you. This year I'll start with Rinker Group, our largest position. Its shares trade mostly in Australia, but the company earns 80% of its income in the U.S. It was spun out of CSR, an Australian company in the sugar and aluminum industries, and is headquartered in West Palm Beach. Its American depositary receipts trade on the New York Stock Exchange. Rinker is in the aggregates and construction-materials business, a longtime favorite of mine. The permits needed to open a quarry are a nice barrier to entry. Once a company opens a quarry, it's a license to make money for the next 50 years. Although the business is sensitive to local economies, it has strong pricing power, even in deflationary periods. Rinker is in terrific markets, with a presence in nine of the 10 fastest-growing states. Florida accounts for 40% of revenue. There is not a lot of quality rock in Florida, but a lot of sand.
Q: Quality sand.
Witmer: The only good rock is outside of Miami, which is where Rinker has its major quarry. There's about 30 years' supply left. The quarry is contiguous to the Florida East Coast rail line, so it can ship rock to Jacksonville or Orlando economically, versus a typical quarry's range of only 40 miles. Rinker was built by acquisition, going back to 1988. In Australia, the company also has a nice business, in a market that's on the upswing from both a currency and pricing perspective. Its Australian real-estate assets are worth a few dollars per ADR. Income overall is about 38% from aggregates, 24% each from cement and concrete block and 15% from ready-mix concrete. Return on capital in each of its businesses is about 20%. Rinker can grow 5% to 7% a year organically, with acquisitions ramping that up. The CEO, David Clarke, is a fantastic manager, who is hard-wired to make money.
Q: How sensitive is the company to the housing boom in Florida?
Witmer: There's some sensitivity, but even when things are slow, they can raise prices. The Florida market is concentrated among big players. And the state does tend to grow. It gets 800 net new people a day.
Neff: What are Rinker's numbers?
Witmer: Rinker could have revenue of $3.7 billion in the year ending March '05 and Ebitda [earnings before interest, taxes, depreciation and amortization] of $755 million.
Schafer: It is a good business, in the aggregate.
All: (Groan.)
Witmer: Earnings per ADR will be $3.40. One ADR equals 10 Australian shares. Add back $75 million of excess depreciation, or 80 cents a share, and you get $4.20 per ADR in after-tax free cash flow. The ADRs now trade at 49.50. The company has a market value of $4.7 billion, and net debt stands at about $700 million.
Schafer: How can Rinker compete for acquisitions if competitors like Vulcan and Martin Marietta Materials trade for higher multiples?
Witmer: I don't expect them to use stock. They have a lot of borrowing capacity. The business deserves to sell at about 16 times trailing cash earnings. My target a year from now is $67 for the ADRs.
My second pick is another Australian spinoff, HHG, which was spun out of AMP Group, a diversified financial firm. It trades in the U.K. and Australia, but U.S. investors can only buy the Australian shares until Jan. 27. The company has 2.4 billion shares. It trades for about 41 pence, and A$1.03. It has three divisions. The first, Henderson Global Investments, is a leading investment manager centered in London and operating throughout Europe. The second is a closed-book life insurance business, and the third is the servicing company for the life business. Henderson had £69 billion under management as of June 30. I believe about 70% of its funds beat their benchmarks. The prospects for growth in managed assets are terrific. I estimate the Henderson division
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