The Year Ahead from Joe Battipaglia
02/28/2003 12:00 am EST
Joe Battipaglia, chief investment officer for Ryan, Beck & Co., is among the most popular fundamental analysts anywhere. His physical stature - he stands at an imposing 6' 7" - is equally matched by his international renown as a financial expert. While cognizant of the market's risks, he also sees a silver lining in the current outlook. Here's his bullish assessment for the year ahead and his current favorite stocks.
"What I’d like to talk about tonight is the outlook for the rest of the year in terms of US equity markets and the bond market and talk about what conditions have to be present for the economy and the markets to have a positive return – something we haven’t seen in a quite a while. And the best way to do that is to talk about what’s in position now to help stimulate the economy that there can be no argument about.
"First, monetary policy in this country clearly is greatly relaxed; it is designed to stimulate and will stay that way for the foreseeable future. Why? Because the Federal Reserve, through Alan Greenspan, will make it so. It’s quite possible that the Fed could cut interest rates again, before this cycle of cuts is over. And we know that the monetary aggregates are growing at a double digit rate and the last time we had seen that was in 1999, when the Fed was literally pumping money into the economy to help with the Y2K conversion. So in terms of monetary policy, the stimulation is coming on fast and furious. And it obviously has been very helpful to the housing market and the consumer market. Housing sales have stayed high, new builds have hit record levels, and auto sales have stayed at a steady pace.
"On fiscal policy, where are we today? We’re in an unusual position to have a Republican president talking about tax cuts, but also proposing fairly massive spending increases in a variety of areas. So as entitlement programs grow – Medicaid, Medicare, Social Security, defense spending, the newly created Homeland Security – which will in turn put us back in a deficit position on the budget. So the spending from the government sector – which represents about a third of the economy – will clearly be stimulative this year.
"Third, we must consider tax cuts. I don't want to get into a debate about tax policy. There are many opinions about that. But a couple of proposals that are on the table, are readily compromisable and could be put into place fairly quickly. For example, cuts in the marginal tax rate, scheduled for 2004 and 2006, should be made effective today. Make permanent the tax plan that was enacted a year ago. Provide more write-offs to small business for investment spending. These steps are easily compromised by both Democrats and Republicans to get something done and would have an immediate effect on the economy today. And, conceptually, both houses of Congress believe this is something the economy should have. So tax policy should be stimulative. Whether or not we get dividend relief, an expanded saving program, they’ll be fights about those.
"Another part of the stimulation that is already in place, that is undeniable, is the fall in the value of the dollar. The US dollar has fallen sufficiently to encourage greater exportation, which helps American business. A falling dollar, in the manner in which it has fallen, has prompted overseas corporations to make direct investments in the United States. Now why are they doing this? It sounds counter-intuitive, because if the value of the currency is falling, why would you make a direct investment here? You would do it for the following reasons: First, the US is the world’s biggest consumer market. Number two, for many global corporations, Toyota for example, it is the source of about 75% of profitability. So you are going to fight hard for your market share in the US, you’re going to open plants, and put in distribution to maintain and grow that share. That’s why we recently saw Toyota commit to an $800 million investment in Texas, to manufacture more cars and SUVs for this market. A falling dollar also modestly raises the cost of imports, which knocks away inflation expectations. By and large, while our leadership will not talk about the dollar in any other terms but strong, they are happy to see it back off the way it has, in an orderly manner.
"These are undeniable facts that are already in place. And that, of course, is the ongoing war on terrorism, the threat posed by Iraq and North Korea, and the uneasiness that the economy feels about these circumstances. So clearly, we need some catalyst here to help us along. And I submit to you, when it comes to the global issues, we must make a decision, vis a vis Iraq, and execute a successful strategy one way or another – and do it very quickly. That has to happen. In addition, we have to have continued success in the war on terrorism.
"To determine the outlook for the markets, we've got to take a good look at the balance sheets of the American consumer and American business. So let’s do that together. Among the many things the Federal Reserve board does is that it accumulates a great amount of data, as well as information on wealth in this country. And they have found some interesting statistics. At the boom point for the stock market, the first quarter of the year 2000, the net worth of the American household was $45 trillion. The American household in the aggregate was carrying on the order of $8 trillion in debt, principally mortgages. So the total assets were approximately $53 trillion. That number was double the level of wealth in 1990. So in effect, over a decade of fast-paced economic excitement, a tremendous amount of wealth was created. Now I’m sure that many people think that the decline in stock values since then has obliterated a lot of that gain. If you look at the composition of America’s wealth, you find something interesting. You find first that we do not rely exclusively on stocks to create wealth. Americans have 25% of their assets in equities. At the same time, about 28% of their assets are in real estate, predominantly their personal homes. On top of that, they also own approximately 29% in fixed income investments, such as CDs, money funds, and bonds. Lastly, the other source of wealth which is tremendously under-appreciated and under-measured is private businesses. The cleaners on the corner, the fruit stand down the street, the small manufacturing company with 25 employees in the middle of Ohio. That’s the private direct investment piece.
"When you string these pieces together, you suddenly realize something. That while the years since 2000 have been very bad for stocks so far, they have been very, very good for bonds, and very, very good for real estate. In other words, we may have lost $7 trillion in equities, but we picked up $4 trillion on the side of bond values and real estate values. So that at the end of the day, the American household has only dropped $4 trillion from its record high. The meaning of that is quite evident: we have the financial wherewithal to participate in the next investment opportunity in any one of these categories. So if you cut taxes, you then make private investment in business more lucrative, because the business owner will keep more of his returns. If bond rates are moving up in response to a stronger economy, and the above mentioned issues with Iraq and terrorism play out, then stocks become much more attractive again. And money gravitates from the bond market into equities. I can’t imagine a situation in which the public will be comfortable earning less than 1% on idle balances when other markets are providing a positive return. We’ve seen that play in real estate in the last 12 months, and you’ve seen it in the gold market, you’ve even seen it play in the oil market. Wherever the opportunity is, that’s where the money will go.
"After rampant over investment in the second half of the 1990s, I believe that American industry is now under-invested in technology, productivity drivers, and the big capital projects that make their businesses hum. In fact, for the last 12 months, the depreciation rate in the United States, measured in dollars, is greater than the investment rates. And it’s rare that you see a period like that. I submit to you that the technology platform that exists is now ready for an upgrade. Business investment has been held back for the obvious reasons, but that as soon as some of these things line themselves up, that investment will start. Companies have the capital, they have restructured to keep lean during this tough time, and we also now have very low interest rates. So companies are positioning themselves to make future investments. In particular, the Internet is growing and utilization rates are rising. All that requires investment. And slowly but surely, that is coming.
"So, we’ve talked about the government sector and their spending requirements. We have businesses poised to spend more. And we know the state of the consumer now. We've also helped our export position by lowering the value of the dollar. And that’s additive to the calculation of GDP. In other words, at the end of the day, you get a much better profile for growth for the economy this year and again next year, and the year after that. And what you have to see happen, beyond the geopolitical issues, is to see the jobless claims rate stay below 400,000 and move lower. You have to see new job creation on a more frequent basis, and when you start to see that, you get confirmation that what we are saying about the economy has validity.
"My suspicion is that the expectations for corporate performance will start to radically improve. And unlike the last 12 months, and the 12 months before that, and the 12 months before that, where the expectations for earnings continued to be reduced, expectations should start to rise again. If that’s true, stock prices will move with them. Now, it’s not all stocks, and it’s not all groups. But the point to be made here, is that in general, stocks become much more attractive again. So what do we do in this environment? We have an opportunity as investors to take a deep breath and go into our investments and into our portfolios, with a very good understanding of what we want to accomplish, the risks we want to take, and exercise some discipline. The investment time horizon is indeed measured in years. So if there are near term events that you must prepare for, then I suggest you do that. Secondly, there’s no one right answer on risk. The risks that Berkshire Hathaway might take may be quite different than those taken by Bill Gates, and very different from the risks that you are willing to take. There is no one right answer. You have to come to grips with volatility in your portfolio. If you’re risk averse, don’t be ashamed. Just maximize your opportunities while limiting your risk to a level you are comfortable with.
"The next point after you’ve done the risk assessment, is to then build a balanced portfolio of the assets you need to generate income and growth, and gain diversification. In the fixed income world, we’re at an important point in time. We have record low interest rates. And record low inflation. Do we believe that these rates are going to stay this way for an extended period of time? I don’t think so. In which case, the Fed – at some point - will have to start to raise interest rates. Remember, just a few years ago, the Fed Funds rate was 61/2%. Rates are likely to return to some level between there and where we are today. What does this mean to the bond investor? Well it means that their bonds become less and less attractive as those rates return to more normal levels. So maybe this is the time, to take on a little more credit risk, and sacrifice some rate risk. In other words, the safe haven of Treasuries, and AAA municipals that are long-term in nature, might well be candidates for sale now, where you can shorten those maturities, or go into another fixed income category. Specifically, corporate bonds are attractive, because they have stayed at a fairly wide spread against Treasuries. This spread is due to investor concern over corporate troubles and perceived risks in various sectors. But with the passage of time, those risks diminish, and the spreads narrow. So corporate bonds can give you attractive yields, even in the face of the Fed raising rates. Corporate preferred stocks trade like bonds, and offer yields in the area of 6 ½% to 8%. These are another choice for the fixed income buyer.
"Also, consider real estate investment trusts. The real estate market is acting very rationally. In those cities where there is a high vacancy rate, the rates for rents are going down and the values are moving sideways, if not lower. The residential marketplace has a bunch of factors going for it that explain why there is such vitality in real estate prices. First is demographics. The baby boom generation is now coming into prime home ownership. Second a personal residence is an illiquid asset. Private residential real estate is not necessarily easy to get into or out of. So it holds its value very well. Thirdly is that local real estate markets determine value as opposed to the national market. In the case of REITs, you can look very hard at their portfolio composition, their geographic reach, the businesses that are part of their lease-up list, the history of these companies through recessions and scares, and you can find REIT yields anywhere from 5% to 8%, as a range, with ongoing growth potential. So REITs have a place for fixed income investors looking to make changes in this environment.
"Let me talk about equities. This is a big, big category. All we’ve been through in the last two-and-a-half years is a precursor to what we are going to go through for the next five. And that is to say that the economy’s excesses have been worked through and ultimately the bad guys will go to jail, we will deal with terrorism, and Iraq. Meanwhile, the value of equities has fallen sufficiently to erase what people call the bubble premium. Today, the S&P 500 trades at 16 times expected earnings, down from the mid-20s. If I’m right about earnings expectations rising, that gives stocks a lot of room to move. A very interesting way to look at stocks is to take that p/e ratio and turn it on its head. Look at the earnings yield for the S&P 500. For a dollar invested in stocks, what would I expect as my earnings yield? Not the dividend yield. But what can those companies earn for me as a stockholder? And what you find is that the current yield on the S&P 500 is 6.5%. Now, what do I do with that information? Well, I can look at the history of that yield and I can compare it to bonds. Now, I’m looking at a 6½% earnings yield on equities and a 4% yield on ten-year Treasuries, which happens to be something that the Federal Reserve looks at. And I find now that stocks are at a disadvantage by 250 basis points. The last time that discrepancy was this big was in 1982. So roll the tape back to 1982. What was going on then? High interest rates and an economic funk. And you know what happened on the heels of that. Now, I’m not promising you another rose garden, so to speak, but I am saying that the conditions are quite similar, because we have wiped out some of the speculative excess. We have put proper valuations back into the marketplace. We have put money on the sidelines, ready to make incremental investments. And, we’re at a position when many things can change simultaneously.
"What's the best case scenario? Action is taken against Iraq, and the war on terrorism continues. Venezuela increases oil production and the price of oil goes back down into the $20s. The President, on the heels of that victory, rams through a stimulative package on the economy, cutting taxes for all Americans, and all of a sudden economic activity reaccelerates. By the end of the year, the S&P earnings are rising faster than the expectations. By the way, for the last three quarters, S&P earnings have been rising faster than expectations. Then you suddenly get better performance in the equity markets.
"Now, when you’re looking for stocks to buy in these categories, what criteria should you use for stock selection? If you’re talking about big cap stocks, you need to be very careful, because many of these stocks have been investor favorites. They have been bid up to strong valuations. Even on these reduced prices, they are still a little rich. So what you’ve got to do is pick those companies that are low cost producers with leading market shares that as the economy re-expands, they will get their share. I like Intel (INTC NASDAQ) on the one hand, and Alcoa Aluminum (AA NYSE) at the other. Both of them are sensitive to how the economy performs, both of them have maintained their market share during the downdraft, and both of them are low cost producers. These are the kind of companies that when you are coming out of a recession, will give you some oomph.
"But I think the real excitement is going to be in the small caps and mid caps – the S&P 400 and the S&P 600. Why? Those stocks are trading at anywhere from 16% to 25% discounts to the S&P 500 in terms of their multiple to growth rate. What I am doing is taking the price-to-earnings ratio and I’m comparing it to the earnings growth expected for these companies for the next three years. And what I find is that while there is some opportunity to be had in the big caps, the small caps and mid caps are even cheaper. Right now. And that makes perfectly good sense. In the depths of a bear market, what is sacrificed on the alter? The stocks we have the biggest questions about. And those are usually the stocks which we perceive to be the relatively smaller and less well known issues. So those stocks are sold off the most. So small and mid caps should offer a level of outperformance that can be quite impressive. In fact, as history points out, coming out of recession, those stocks can perform 30% better than large caps. And that’s what I see coming for this group of stocks.
"Now let me give you some names to consider for your portfolio. I like two banks for exposure to financial services: North Fork Bank (NFB NYSE) and Provident Financial Services (PFS NYSE). In healthcare, I suggest Amgen (AMGN NASDAQ) and Millennium Pharmaceuticals (MLNM NASDAQ). In technology, along with Intel, I also like Autodesk (ADSK NASDAQ) and Dell (DELL NASDAQ), a big market share company, and a low cost producer, which is positioned well. Among consumer product companies, two names that I’d focus in on are Conagra (CAG NYSE), with a fairly health dividend, and Comcast (CMCSA NASDAQ). Among industrial companies, in addition to Alcoa, I like Minnesota Mining (MMM NYSE).
"Let me also give you a REIT that makes sense, Weingarten Realty (WRI NYSE). The yield is approximately 6% and has had a consistent growth record, conservatively managed out of Texas. It’s essentially in strip retail malls. Lastly, on a similar front, consider Kinder Morgan Partners (KMP NYSE). The yield is about 8½%. This is an oil and oil products distribution company. It’s not about finding oil. It’s about distributing it. It’s an oil partnership, so you’ve got the issue of taxes to be wary of, but the yield and the growth potential is there. This will also give you representation in energy.
"Finally, let me share a story about the perfect husband, as an analogy about the difficulty in defining a perfect economy. A man is sitting at the country club and the cell phone rings. He picks it up and there is a woman at the other end. She says, 'Hello darling. I just want you to know that I was at the jewelers and that beautiful necklace that I’ve admired, well they just cut the price to $5,000. You know how much I like it.’ And he says, ‘Well, a necklace on a woman is a beautiful thing. Go ahead and buy it.’ She says, "You know I love you. You’re the best.’ Then she tells him that she got a call from the Mercedes dealer, and that a beautiful sports coupe came in, and for $65,000 she could drive it away. So he said, ‘There’s nothing like that car with the necklace. Go ahead.’ So she says, ‘You’re the perfect husband. And by the way, I drove by that house that I’ve always admired, and there was a for sale sign on it. They want a million and its worth a million, two.’ And he says, ‘Well if you’re really serious about it darling, bid $900,000 to show you’re interested.’ She says, ‘You’re the greatest. You’re the perfect husband.’ And she hangs up. With that the guy hangs up the phone and says, ‘Whose phone is this?’ So just like there is no perfect husband, there is probably no perfect economy."