Mutual Funds - General Discussion: Why the U.S. Is No Bargain

» SteveT - Why the U.S. Is No Bargain

FEW INVESTORS CAN LAY CLAIM to the record of consistency and quality that de Vaulx has made his hallmark at the funds he manages for Arnhold & S. Bleichroeder. A long-practiced value discipline, combined with an intensive research process, elevates these funds to a level of superiority not easily found among the scrum of investment choices today. The incomparable Jean-Marie Eveillard, who retired last year, established the model, and now de Vaulx, who worked alongside Eveillard for almost 19 years, is proving to be, well, equally incomparable. His flagship, First Eagle Global, is up about 13% this year; since its start in the 'Seventies, the fund has advanced 15.52% annually, on average. The overseas fund has gained 14.42% this year and delivered average annual returns of about 14.16% since its start about 12 years ago. And on it goes. With around $30 billion in assets spread among different funds and accounts, de Vaulx's challenge is clear. We give you his account of how he's meeting the challenge.

Barron's: One of the few sectors that worked for investors this year, including yourself, was energy. What's your outlook on energy stocks?

De Vaulx: Late this summer, I sold some of our energy holdings. I either sold positions entirely, as was the case with Tenaris [ticker: TS], a Luxembourg-based company, though its origins are in Argentina. Tenaris is one of the biggest manufacturers worldwide of the seamless steel tubes used for exploration and production and pipelines for oil and gas. Tenaris was not leveraged financially and the stock was as cheap as $20 in 2003. Yet it reached $140 in late September, and we got out of our position late in the third quarter. It still is a great company, and I would love to buy it back in the future, but it just got too pricey for us. I also sold a lot of our EnCana [ECA], which is largely a natural-gas company, with interests in Canada and to some extent in the U.S.

What changed there for you?

The valuation. When you look at a chart of EnCana, the stock was below $20 a share in 2003, and it reached almost $58 or so in late September. I sold some of the PetroChina [PTR], which we bought at the same time Warren Buffett was buying those same shares three years ago. But I still like the energy sector. In a lot of exploration and production companies what is intriguing is many of them trade at a significant discount to the spot price of oil and gas and also the futures price. That's the case with Burlington Resources [BR], for instance. The stock is trading at $77. At $77, the price of natural gas at only $7 to $7.50 per mcf [thousand cubic feet] is discounted, and is still quite a bit lower than the actual price and the futures price. I think the discount exists because it hasn't been arbitraged away yet. I wouldn't be surprised to see some E&P companies being acquired by private-equity people, who would then go out and hedge forward and lock in the price of the underlying commodity as far out as possible. Yet we have not seen that, so far.

No. Maybe the market is also telling us that the huge increase in production costs in energy will keep rising. The price of oil rigs and so forth has gone through the roof. That's another reason I sold so much EnCana this summer. One of the beauties of Burlington Resources is they have very low production costs. And right now, two of my analysts are doing work on the energy-service side to see if the drillers are able to increase prices further and whether more exploration money is being allocated to the oil-services companies.

When you sold or pared back energy, did you just raise cash levels?

Yes. Except for some names such as Toyota [TM], which we were lucky to buy in May and June, by and large it is becoming more and more difficult for us to find names overseas, even though foreign markets remain cheaper than the U.S. market. Based on a price-to-cash flow basis, Europe and Asia are around 9½ times, versus 12½ times, roughly, U.S. At 12½ times, the U.S. is not cheap by historical measures. We are very much valuation-driven, as opposed to outlook-driven. Not that the outlook seems very rosy, by the way, but it is more because of valuation. Five years ago, the beauty was we had a bifurcated, two-tier market with very expensive growth stocks and tech stocks on the one hand and quite a few cheap small and mid-cap value stocks on the other. That gap has disappeared, so everything looks quite expensive in the U.S.

Anything else worry you about U.S. stocks?

One of the first things I read in Barron's is the column that shows insider transactions. Typically, there are 20 companies listed with the heaviest insider buying and 20 companies with the heaviest insider selling. In the past 12 months, insider selling has dwarfed insider buying at those 20 companies by a ratio of 20-to-1. When I look at the kinds of companies that are doing insider selling, it is pretty much across the board, and that's not encouraging.

Also, the P/Es most people talk about for companies are typically understated. Most companies do not yet expense stock options and have pension liabilities that are grossly understated. Most U.S. corporations assume their pension plans will have a return of 8½%. When you know that typically pension plans are 60% equities and 40% bonds, an assumption of 8½% is criminal.

Then, within the S&P 500, up to 40% -- if not more -- of its earnings comes from the financial-services sector: banking, insurance, brokerage firms and so forth. Those earnings may very well be peak earnings, because we have had 23 years of declining interest rates helping that sector. The outlook for earnings from the financial-services sector is not a good one. A big chunk of the S&P's earnings may be peaking, and even if 15 times was the real market multiple -- which we think it is not, but is closer to 20 times if earnings were properly accounted for -- then we probably are talking about many sectors that are experiencing peak earnings. Also, up to now, foreigners have been willing to finance America's household consumption by buying U.S. dollar assets: stocks, bonds and Treasury bonds. Other worries would include huge budget deficits and a record-high trade deficit. If the housing bubble is not sustainable, there will be a major correction in real-estate prices over the next three to five years, and, as a result, consumption by Americans will be cut back significantly and hurt the U.S. economy along with some of the export-oriented countries such as China. That's why we are not sanguine about U.S. stocks in particular.

What about certain sectors?

We see more and more sectors -- I'm thinking of big pharma, for instance, and the media and telephony sectors -- that are in such a state of flux that it is hard to assess who will be the ultimate winner five to 10 to 15 years down the road. If anything, there are many sectors where it seems that the profitability level could be less in 10 years than what it is now because of rising competition. That said, we timidly bought a few media-related companies this year.

Brave of you.

We are doing it in a very modest way because we are aware the landscape is changing. Newspaper publishing ain't what it used to be. We don't believe these properties are worth the 12 to 14 times Ebitda [earnings before interest, taxes, depreciation and amortization] they were worth many years ago. It will be very interesting to see who buys Knight Ridder [KRI] and what multiple is paid.

We bought a tiny amount of Dow Jones [DJ] a few months ago. Considering the franchise it has, its low margin of profitability, intuitively, does not make sense. If you compare its margins with all other newspaper companies, it is like night and day. I cannot put my finger on exactly what is wrong with Dow Jones, but something tells me it would be better managed in different hands. One problem with Dow Jones is that it is financial-services related, and so if there were to be a bear market in stocks or bonds in the next three to five years, that would not help. Typically, we are not among those value investors that insist on a catalyst, but in this case we believe that, at some point, some members of the family that controls Dow Jones will lose their patience.

Why did you buy Clear Channel?

It is a small position for us. We are not betting the farm. We are aware that satellite radio is gaining market share, but in the case of Clear Channel [CCU] we believe their outdoor-advertising business is very valuable. That was highlighted a few weeks ago, when the outdoor division was offered to the public. They sold 10% to the public, and it trades at the same multiple we had used to value the division. In the radio business, we applaud the initiatives of a year ago to reduce significantly the amount of advertising per hour, to make the experience of listening to radio more pleasant. This year's earnings are taking a hit because there is so much less advertising because of its "less is more" campaign. We think margins and earnings should start to stabilize. Using a pretty modest multiple for the radio business and adding the value of the outdoor division, we come up with a value for Clear Channel in the high 30s. It is not the bargain of the century. The media name we are the keenest on is Liberty Media [L], and we have been adding to our holdings recently.

You've owned it quite a while.

We have. People have had the impression the stock has done nothing over the past two to three years. Looking at the numbers since the middle of 2002, if you factor in the spin-out of the Liberty Global and Discovery holdings, the stock has gone up more than 30%. It has not been as bad as people think it has. More to the point, the bulk of the value within Liberty Media lies with QVC. And QVC we view, first and foremost, not as a media asset, but as a retailer. It is much bigger than its No. 2 competitor, Home Shopping Network. As a result of being so much bigger, it is a company that has much higher margins than its competitors. If we apply a very modest multiple to QVC, we come up with an intrinsic value for Liberty Media of about $11.50, and the stock is at 7.80. Whatever is happening on the media landscape should not affect QVC as a business. Now some people find Liberty's John Malone to be too creative. You know, recently he announced a deal to create a tracking stock for QVC.

Tracking stocks? I thought they were a thing of the past.

Yes, but he, for tax reasons, has to structure it as a tracking stock. Once the tax issues are resolved, John Malone has made it clear it will be spun out as a regular common stock.

Anything else you can recommend?

Oddly enough, in the Global Fund, I've been able to add to a few U.S. holdings. This summer, I added to Berkshire Hathaway [BRK.A, BRK.B]. I was adding to Costco [COST] as long as the stock traded below $43. I don't want to chase it here. Buying Microsoft [MSFT] at 25 to 26 and having a 1% or 2% position is something we are comfortable with. One angle that intrigues us with Microsoft is they spend billions in research and development, more than 15% of sales. Yet one of the mysteries of disclosure requirements in the U.S. is that the company is under no obligation to explain how the money is spent and on what projects. People always talk about how bad disclosure is overseas. Well, if Microsoft doesn't have to tell much about the 15% of sales it spends on R&D, I'm not sure that is good disclosure, either. Anyway, our sense is that, in the past 10 years, Microsoft has not come up with much in the way of products after spending so much money. We think either they will start coming up with something or, if not, we would not be surprised if half of the R&D budget were cut. That still wouldn't impair Microsoft's current business. Ebidta margins would be quite a bit higher than their current levels. At the current share price, we are paying roughly 13 times Ebitda for the company, and if R&D could be cut or, preferably, if R&D could yield better results, we are paying just slightly over 10 times for the parent business, which is generating more than a billion dollars per month in free cash flow. In the meantime, the company is working for us by using free cash flow to buy back its own shares.

What are your thoughts on gold?

By and large, gold stocks are expensive. And many so-called gold companies aren't pure plays on gold, but have interests in other base metals. In the 'Thirties, the Depression era, gold and gold-mining stocks did well, but base metals did not do well. If there's some sort of major recession in the U.S. and China, or some sort of systemic financial crisis, I am not sure I want to hold gold-mining companies, which have a fair amount of revenue coming from byproducts such as copper, lead and zinc. For our big funds, we have about a 5½% exposure related to gold and gold-related securities, but more than 50% of that exposure is to gold itself or gold-linked notes, which provide leverage to gold. We have gold notes, custom-made notes we bought through HSBC and UBS, that are 1½-to-2 leveraged to the price of gold. We try to be agnostic, and we view gold as insurance and as a hedge against extreme outcomes. In other words, if the sky stays blue, we will not make money, and, in fact, we will lose money with our 5½% position in gold.

What is your favorite investment now?

There is nothing. When I look at the top 10 holdings of the fund, there are pretty good companies, businesses with a scope for some intrinsic value to grow over time, companies that have superb balance sheets so they are not about to go bankrupt, but there is nothing dirt-cheap that we are totally excited about.

We have been buying Johnson & Johnson [JNJ] in the past few months in the U.S. Is it your typical value stock? No. But the stock trades at roughly 12 times operating income for next year and yet it is a company with a superb balance sheet. The medical-devices business is as big, or slightly bigger, than the pharmaceutical business. On the pharmaceutical side, we've tried to look at other names such as Pfizer [PFE] and so forth, but we've found the pipelines were not very inspiring. A lot of these companies' drugs were going off patent in the next few years. In the case of Johnson & Johnson, the pipeline doesn't look that great, but it looks OK. For Johnson & Johnson, we are factoring in the fact that next year the sales and earnings on the pharmaceutical side will be down from this year, but by and large they have fewer drugs going off patent next year. The company has been so much better- managed than so many of the other pharmaceutical companies.

Going forward, the medical-devices part of the company will surpass the pharmaceutical business. On the consumer side, they have wonderful brands. So we aren't talking about a typical value stock trading at eight times operating income. We are talking about 12 times next year's operating income, with a great balance sheet and top-notch management. It's a cautious way to have exposure to the health-care industry.

What's your view on McDonald's and the pressure it faces from hedge-fund manager Bill Ackman, the subject of our cover story last week, to sell its real estate?

Bill Ackman is helping the company and the investing public understand that McDonald's [MCD] is not a restaurant company. It is first and foremost a very powerful brand. They are also landlords of significant real estate. Having said this, we don't believe the plan he suggested to the company makes sense. We think it is financial engineering. The real-estate value Ackman assumes is inflated, we think, because a lot of the rents McDonald's collects from franchisees are in fact royalties or franchise fees in disguise. It is a superior company and deserves to trade at a much higher multiple than the other companies in the sector. What got McDonald's into trouble a few years ago was that the quality of its food and service deteriorated. And that's what the company should focus on, not financial engineering.

Thanks, Charles.

E-mail comments to editors@barrons.com
URL for this article:
http://online.barrons.com/article/SB1134...

-- posted by SteveT