By Lauren R. Rublin, Barron's | 16 June 2008
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Midyear 2008 Roundtable Report Card
You can't trust anything these days. Take the innocent-looking tomato— delicious, nutritious and now a weapon of mass digestive destruction. Or inflation, still soothingly low, so long as you don't eat or drive. Then there's Wall Street, where humongous earnings these past few years have fed similarly humongous bonuses. Sorry, wrong numbers. Just ask Lehman Brothers, which announced last week that it will report a loss of nearly $3 billion for the second quarter, wiping out numerous periods of supposed gains. [[Wonder if that was bad for bonuses?: normxxx]]
The Barron's roundtable represents a notable exception to the current bull market in duplicity and false impressions. Year in and year out, we can trust its members— 11 of Wall Street's most insightful investment experts— to give us the straight skinny on the economy, the financial markets and dozens of individual stocks and funds, even if the truth is sometimes painful, as it has been this year.
Brad Trent: When the Roundtable last met Jan. 7 with the editors of Barron's, our distinguished panelists minced no words: This year would be difficult to dismal for the economy and stocks, as the bubbles in housing and credit unwind. So far, so good (er, bad). Most still feel that way about '08, and even '09, though a handful see the skies clearing at last, even for decimated financial and home-building shares. [[dream on! : normxxx]].
In the pages ahead, we've distilled the latest views of the Roundtable crew. We hope you're enlightened, amused and provoked by them to discover your own truths about markets. And, should you disagree with any of the opinions expressed herein, please, no tomatoes.
Bill Gross
Barron's: What a year it's been for investors— and it's only June. How do things look to you, Bill?
Gross: The economy has fooled us. Pimco expected at least a quarter of negative GDP [gross domestic product] growth, but we haven't seen it yet. We don't expect a return to normalized growth rates in the next six months, however. There still are weaknesses in housing, and housing deflation affects employment and consumption. Also, the states, which had been reluctant savers, will have to cut back because they are over budget. Growth will stay positive, but very, very low.
How will the markets deal with this?
Relatively high inflation combined with meager economic growth sends a mixed message to the bond market. With the economy down, the Federal Reserve can't raise rates to tame inflation. Yet, higher inflation means it should, or at least should be thinking about it.
What advice would you give the Fed?
The U.S. should simply stand pat. About a month ago the Fed sent a clear signal that 2% was it on the downside for rates, and that further stimulation would come from policy changes such as its liquidity provisions for Wall Street and heavy lifting from the Treasury and Congress to ease the mortgage crisis. But it's difficult to raise interest rates in the face of a housing market that is falling by double digits.
Bill Gross's Picks
Company Ticker 6/11/08 Price
FairPoint Communications FRP $7.79
Countrywide Financial CFC 4.58
6/11/08 Yield
JPMorgan Chase 7.9%, due April 2049 8.30%
Source: Bloomberg
The good news for stocks is that economic growth hasn't turned negative[!?!] and that corporate profits haven't declined[!?!] A substantial portion of profits comes from outside the U.S., either through currency adjustments or greater growth in foreign markets. That said, financials play a dominant role in the market. That means lower profit margins, and lower profits. It's a tale of two stock markets.
Nonfinancial companies are doing better, you mean.
Finance companies are stinking up the joint, but the industrial economy is benefiting from a lower dollar and more exports. The railroads are doing well. The stock market might not have much upside, although foreign reserves have to go somewhere, and with oil prices at records, we're talking about an additional $500 billion of reserves generated in the past six months. That money will come to the U.S., and its owners don't want bonds. Almost by default— if you'll pardon the term— stocks are benefiting. They are the least bad choice. But be cautious: This is not a new bull market.
Your January picks— auto bonds and some closed-end funds— did well, especially relative to the market. How about a few new ideas?
Fairpoint Communications, a land-line phone company, acquired substantial properties from Verizon Communications [ticker: VZ]. Related to the deal, the dividend will fall to $1.03 from $1.59, for a yield of 11% for the next year. JPMorgan Chase has a 7.9% preferred stock due April 29, 2049. This is the crème de la crème of banks today; the Fed loves [CEO] Jamie Dimon. Why shouldn't you? This preferred can be bought for 96 cents on the dollar, for a yield of 8%-plus. Lastly, Countrywide Financial trades at a 10% discount to the price that Bank of America, its future parent, has agreed to pay in an all-stock deal. The deal will close in a few months, and Countrywide yields 10% while you wait.
Sounds like it's worth waiting. Thanks, Bill.
Oscar Schafer
Barron's: What is your second-half forecast, Oscar?
Schafer: We are in the 6th or 7th inning of losses taken on subprime and other financial instruments. But we are in the third or fourth inning of deleveraging the economy after four or five years of borrowing. Growth will remain slow as we reverse the trend of having spent more than we earned. And we haven't yet seen all the problems of the regional banks, which, although they hold less of the risky financial instruments, will have problems with customers defaulting on credit-card debt and auto loans.
Consumers will continue to be under pressure as house prices fall, mortgage-equity withdrawals decline and gas is at $4 a gallon. That's why companies like Wal-Mart Stores [WMT] are doing better than expected. The U.S. has $20 trillion in household wealth. House prices have come down 13% or 14%, so that's $2.6 trillion in wealth destruction.
Compare that to tax cuts, which have been all of $150 billion. The continuing erosion in household wealth will make consumers spend less. And the banks, with big write-offs, are constrained in lending money, even if the Fed lowers rates. The growth of the past few years was credit-driven, and credit is drying up.
Oscar Schafer's Picks
Company Ticker 6/11/08 Price
Tyco International TYC $42.91
CommScope CTV 52.14
Source: Bloomberg
How long will the deleveraging take?
It could last another 12 to 18 months. We look for companies that are somewhat immune to these problems. The further you get from housing and consumer spending, the less the impact is likely to be. If the rest of the world— China, India, Brazil— doesn't collapse, the industrial part of our economy will keep going.
Are you expecting them to collapse?
It's the $64 question. If it happens, all bets are off for the rest of the world. The stock market probably won't do much this year. There is a yin and yang between the financial sector and everything else. We'll have a standoff. As long as there aren't significant layoffs, the economy— and the stock market— will muddle along.
What stocks do well in this sort of market?
I've got two special situations. Tyco International sells for 43 a share and has a $21 billion market cap. After spinning off its health-care business into Covidien [COV] and electronics manufacturing into Tyco Electronics [TEL], the remaining Tyco is a diversified manufacturing and service company operating in several business segments. These include ADT, the nation's largest electronic-security provider; Flow Control, the largest manufacturer of flow-control products, and fire-protection, safety-products and electrical and metal-products businesses.
Tyco is significantly undervalued. The company has big opportunities to improve margins across various business segments and reduce corporate overhead. In particular, ADT's European business has operating margins less than half those in the U.S. The company is in the early stages of an operational turnaround. Also, the flow-control business is underappreciated, as its end markets— particularly oil and gas, power, waste and water— have excellent growth prospects, and it is 75% international. The growth in these end markets could continue for several years.
What do Tyco's financials look like?
The company is underlevered, with current net debt equal to EBITDA [earnings before interest, taxes, depreciation and amortization]. Tyco's businesses generate significant cash flow due to high recurring revenue, a strong service-revenue component and relatively modest capital-expenditure requirements. The company is making tuck-in acquisitions and is in the process of divesting its engineering and construction business, the proceeds of which will be reinvested and used to repurchase stock. Tyco has a great management team led by CEO Ed Breen, who can focus on the core businesses following last year's spinoffs.
Did Tyco retain a piece of the spinoffs?
No, though all the pieces are interesting. The company isn't economically sensitive; management is in control of its destiny. The stock is selling for about 6.5 times next year's estimated EBITDA, and about 11 times 2009 estimated cash earnings of just under $4 a share. Tyco could be worth in the mid-60s. If it doesn't get credit for hidden gems such as Flow Control, it could spin those off, too.
CommScope is a producer of antennas and cabling for wireless towers, data transport and cable companies. It is a leading producer in all its segments, domestically and internationally. The key to the story is the superb execution capabilities of the CommScope management team. The CEO, chief financial officer and chief operating officer have been running this company together for more than 30 years.
As an example, after acquiring Avaya's enterprise-cabling business in 2004 and doubling the revenue base, CommScope proceeded to grow its earnings per share by more than 400% from 2004 until 2007, on revenue growth of only 65%. Increased purchasing scale, manufacturing efficiencies and rationalization enabled significant operating leverage. At the end of 2007, CommScope's management embarked on its next large acquisition, buying Andrew Corp.
This is another doubling-of-revenue acquisition. Similarly, there are significant opportunities for cost synergy, including plant rationalizations, purchasing scale and the conversion of copper products to aluminum. CommScope's wireless antenna and cabling business should benefit from the rapid increase in wireless-data demand.
Where is the stock?
While the stock has run up 30% to $53 - $54 since the company reported its first quarter in April, there is at least 25% upside from current levels. Wall Street's estimate for this year is $3.36 a share. For next year, it's $4.10, and there is upside to both years' estimates. CommScope trades for 13 times '09 earnings. The market cap is $3.7 billion.
With both Tyco and CommScope, we are betting on the management, not the economy. You have to focus on management that can execute despite headwinds.
Good advice. Thanks, Oscar.
Archie Macallaster
Barron's: How's the year treating you, Archie?
MacAllaster: I have been neutral on the market for a year and a half. I've survived and my customers have survived. But these are brutal markets and you have to be careful. You wish everybody was off margin, because this is not a time to be speculating with borrowed money.
Tell that to Wall Street.
Lehman Brothers has reduced its leverage from 32 times equity to about 25 times in one quarter, which is good. But they have a long way to go. They raised $6 billion of equity and they are probably going to lose that $6 billion.
Archie MacAllaster's Picks
Company Ticker 6/11/08 Price
JPMorgan Chase JPM $37.13
Wells Fargo WFC 25.55
Bank of America BAC 28.85
Source: Bloomberg
The economy has performed well if you get away from housing and the financials. Companies with foreign operations have done well. McDonald's [MCD] reported good earnings and its stock is up. I'm an optimist. The economy hasn't had a negative quarter yet, and if it does, the downturn won't be deep. I have three bank stocks to recommend.
Surely, you're joking.
If nobody loves banks, at the least they're fairly priced[!?!] The five largest banks in America have 44% - 45% of the total assets of the banking system. They have increased that percentage year after year, and it won't be long before they own more than 50%. Two [Citigroup and Wachovia] have cut their dividends, but the other three are a good investment in the next 12 to 18 months. One is conservative, one a growth company and one speculative.
JPMorgan Chase has the most conservative balance sheet and the fewest problems. The stock sells at about $37. The high for the past year was $51, the low $36. The dividend is $1.52 a share and the stock yields 4%. JPMorgan earned $4.37 a share in 2007. The estimate for '08 is $2.50. If they pay out $1.52 a share, they will earn well in excess of the dividend. There is no reason it should be cut. You don't have to hurry to buy these things because they could go down in the next month or two. But in 12 to 18 months, the stock ought to be somewhere in the neighborhood of $46 to $48.
Which is the growth company?
Wells Fargo. It has a major problem in home-equity loans, but has reserved well. The stock is about $25, and the range is $38 to $24.38. Wells has had the best growth of all the large banks for many years, and it still will. It is well run. It does three or four different kinds of business with its customers. The market has knocked its shares down too far. Wells Fargo earned $2.41 a share last year, and the estimate this year is $2 to $2.10. This, too, is well in excess of its dividend, which is $1.24 a share. The stock yields almost 5%. My earnings estimate for 2009 is $3.10 a share.
Your speculative bet must be Bank of America.
Yes, because they may cut the dividend. Bank of America offers the greatest potential. It's trading around $29, the low for the year. The high was $53. The dividend is $2.56 a share, and it yields about 8.6%. They don't have to cut the dividend, but with the yield over 8%, the market is saying they will. Bank of America's pending acquisition of Countrywide Financial has been criticized; people are worried about the size of the reserves they'll have to take against Countrywide's loans. Long term, the deal will be a positive, though it's going to take 18 months to two years.
Bank of America also owns about 20 billion shares of China Construction Bank [939.Hong Kong]. It accounts for about $15 billion of the bank's market value. The first piece they purchased becomes marketable in October. They'll sell part of it. When they do, they'll have a big profit. That will allow them to offset some of the losses, and perhaps preserve the dividend. The bank earned $3.32 a share in 2007, and that's after taking big write-offs in the fourth quarter. My estimate for this year is $2.50 to $2.60, which is about equal to the $2.56 dividend. My 18-month target is $50 to $52.
Thank you, Archie.
Scott Black
Barron's: Some of your January picks did well, including Devon Energy, Ensco and Ross Stores.
Black: You didn't have to be a genius to do well in oil stocks, given oil is $134 a barrel and gas is $12.67 per million British thermal units— well above levels earlier this year. It's like having a big wind to your back as you're sailing off Newport to Block Island. Devon Energy [DVN] also is great with the drill bit. I originally thought earnings would be around $7.50 a share. Now they could top $11. It's a good company, but the price is a lot higher now.
Ensco International [ESV] also is doing well. They still have 45 rigs— 44 jack-ups and one semi-submersible— and six semi-submersibles on the way. The upside lies in the semi-submersibles; the first will be delivered next spring. The company is almost debt-free. Earnings estimates have been ratcheting up, and the stock still sells at nine times this year's estimates.
Scott Black's Picks
Company Ticker 6/11/08 Price
Bolt Technology BOLT $19.68
Belden BDC 36.05
Source: Bloomberg
As for Ross Stores [ROST], women like to shop. They like to buy name brands at a bargain. Ross sells name-brand merchandise at 25% to 40% off department-store prices. Comp-store sales [sales at stores open a year or more] were up 7% in May, versus estimates of 4%. I thought they would earn $2.10 to $2.12 a share. The estimates are now $2.25. But the stock— at 37, or 16 times this year's earnings— is too expensive to initiate a position.
Thanks for the update. What's ahead?
Analysts estimate the S&P 500 will earn $89.27 this year. Strategists say $79.25. If we use $84.25, which is in the middle, the P/E is 16. The market is fully valued. On a dividend-discount model, as well, it is efficient. In January and February we had the greatest opportunity to buy name-brand technology stocks since the Long Term Capital debacle in 1998. We bought Oracle [ORCL] at 12 times earnings, Texas Instruments [TXN], KLA-Tencor [KLAC], Xilinx [XLNX].
And now?
There are no more pockets of opportunity. We're ignoring consumer-discretionary stocks. Everyone is recommending financials. We aren't. We have the lowest weighting in financials since I started Delphi. The only major brokerage we own is Goldman Sachs [GS], because they seem to have weathered the storm. Elsewhere in the industry, the bloodletting continues. The meltdown in housing also is ongoing. The stock market won't get out of its own way until the banking system regains transparency. This also overhangs S&P earnings.
The unwinding of the housing bubble is killing the economy. Household net worth is dropping for the first time in five or six years. The average family income in America is $48,600. For Main Street, this is a recession. Real GDP growth in 2008 and '09 is going to be weak, at 1% to 1.5%.
That's robust compared with some estimates.
Everybody knocks [Federal Reserve Chairman] Ben Bernanke, but I give him kudos. He could have kept interest rates high and defended the dollar, and risked a massive recession. He did the right thing by cutting rates. Opening the discount window to the investment banks was smart. So was bailing out Bear Stearns. We could have had a banking crisis like 1928 and '29 if Bear had failed.
If the market thinks S&P 500 earnings can get up to $100 in 2009, as some predict, stocks will take off later this year. But if S&P earnings come in around $84-$87 this year, it is going to be a stockpicker's market. Treasuries are a fool's bet. With headline inflation at almost 4%, parking money in two-, five— or 10-year Treasuries yields a negative real return.
Where are you parking money for Delphi's clients?
We like Bolt Technology, based in Norwalk, Conn. It trades for 20, and has a market cap of $172 million. The high last year was 39.57, the low 14.67. We've been buying the stock at $18 - $19. Bolt makes a compressed-air gun for offshore seismology and has an 80% market share worldwide. It also makes underwater electrical connectors and cables, but the gun accounts for roughly 60% of sales. The company benefits from offshore seismology, and is in the sweet spot right now. Big customers include Schlumberger [SLB] and SeaBird Exploration [SBX.Norway].
For the year ending June 30, Bolt could do close to $67 million in revenue and earn about $1.65 a share. There isn't much Street guidance on '09, so I do my own. Conservatively, we have revenues going up 12%, to $75 million. Cost of sales is about 55%, and SG&A [selling, general and administrative expenses] is up 5%, to $9.6 million. Research and development spending is about $200,000. They have more than $2 a share in cash, no debt. There is about $300,000 in interest income. After taxes at 33%, you get $16.3 million in net income. Divide by 8.58 million fully diluted shares, and Bolt will earn $1.90 a share on the low end.
And on the high end?
Revenues will grow 16%, to $78 million, and they'll earn $2 a share, versus $1.65 this year. That's 20% growth and a 10 price/earnings multiple. They have a steady book of business. Schlumberger is a great company, but at a 20 P/E it is not a great value. Bolt, nobody ever heard of.
Belden, in St. Louis, isn't well known, either. It manufactures electrical cable and wire. It trades for $36 a share and there are 47 million fully diluted shares, for a $1.7 billion market cap. The high on the year was $60; the low, $30.28. I like industrial companies that have a big presence outside the U.S. Only 41% of Belden's revenue is U.S.-based. The company made acquisitions at the end of 2006, one in Germany and another in Hong Kong. Revenue guidance for '08 is around $2.25 billion. Operating margins are 12%. That gets you to about $270 million in operating income. They have $31 million in interest expense and $4 million in interest income, so before a recent acquisition, they would have made $243 million, taxed at 32%. I had them earning $3.51 on the low side and $3.68 after economies of scale. The acquisition will dilute '08 earnings by 30 cents a share. Belden is a mundane manufacturer in the right markets.
Thank you, Scott.
Marc Faber
Barron's: What do you make of '08, so far?
Faber: Measured in euros, the U.S. is down around 13%. But it has outperformed many other markets. The U.S. has many problems. One is the slowdown in credit growth. Another is recession. The statistics don't indicate the economy is in a recession, but we question the statistics.
The Federal Reserve's aggressive interest-rate cuts— to 2% from 5.25% last September— make equities relatively attractive compared to cash yields. But in the second half and the first half of 2009 it will become evident that '09 earnings for the S&P 500 won't meet consensus estimates of $110 per S&P share. Earnings instead are coming down and will stay down, and this will weigh on stocks. The recession won't be deep but it could be long. And it could be deep for corporate profits.
How much further will the market fall?
The situation is similar to 1973-74. It's water torture. We may have a rally here or there, but once investors notice that Mr. Obama has a good chance of winning the presidential election, this will be another negative for stocks. He's not going to be good for the market.
Also, the bond market's not acting well. Bond yields are higher than when the Fed cut rates between December and January. The bond market looks as though it could weaken considerably. Once interest rates go up again, that will be another strong headwind for stocks.
Marc Faber's Picks
Investment Ticker 6/11/08 Price
Japan
iShares MSCI
Japan Small Cap SCJ $47.85
Sumitomo Trust & Banking 8403.Japan ¥840
Mitsubishi UFJ MTU $ 9.49
Mizuho Financial 8411.Japan ¥549k
Currencies
Buy the U.S. Dollar/Sell the Euro 1 euro=$1.56
Airlines
AMR AMR $ 6.09
Lufthansa DLAKY $24.30
Singapore Airlines SIA.Singapore S$15.12
Japan Airlines 9205.Japan ¥235
Short
US Steel X $172.46
Source: Bloomberg
The U.S. is down just 8% this year in dollars. India is down 30%; China, 40%; Vietnam, down 60%. Are those markets buys at current levels?
Among emerging markets, only Mexico and Brazil have been strong. I'd get out of them. There is no hurry to buy anything in Asia, though stocks aren't expensive. Thailand, down 7%, could fall another 5% or even 10%.
Japan is the exception. The Japanese market has performed badly in the past 18 months, and stocks are low compared to cash yields. Some corporations have increased their dividends. Steel Partners' ouster of the management of Aderans Holdings [8170.Japan], a Japanese wig maker, was an important event. Pension funds and foreign investors are starting to have more power over Japanese management.
Do you still like the iShares MSCI Japan Small Cap exchange-traded fund, which you recommended in January?
Buy that, and some Japanese banks: Sumitomo Trust, Mitsubishi UFJ and Mizuho Financial. I would still go long the dollar against the euro, which is overvalued. The tightening of global liquidity and the contracting U.S. trade and current-account deficits are likely to be dollar-supportive. Mr. Bernanke does not understand anything about international economics; it's not a weak currency that leads via import prices to inflation, as he suggested, but inflated money and credit growth that leads to a weak currency.
Where is oil headed, now that it trades in the $130s?
Prices should ease a bit. It wouldn't surprise me to see oil dropping to around $80 a barrel. If you're bearish about oil in the next three months— though long-term, commodities will go higher— it's best to own Japanese stocks or airlines. A drop in oil might not help the airlines much, but sentiment toward airlines will improve considerably. Buy AMR, Lufthansa, Singapore Airlines and Japan Airlines.
And sell oil stocks?
Interestingly, they haven't done well relative to crude. One problem is declining reserves. Also, I would rather own physical commodities than commodity-related equities because resource nationalism is on the upswing. That's also true of gold, which has fallen to $870 an ounce from $1,000. The price could go down to $780 to $800 an ounce. If you have no exposure to gold, start buying it here. People are blaming speculators for the recent run-up in commodities, but they are a symptom rather than a cause of the problem. The cause lies in excess liquidity, and the Fed is responsible for that.
My last suggestion concerns steel. If world economies decelerate, the pace of building in places like China will slow, hurting demand for steel. Steel stocks have been among this year's best performers. Short U.S. Steel.
Thank you, Marc.
Mario Gabelli
Barron's: How does the big picture look to you, Mario?
Gabelli: The consumer, as we discussed in January, ran out of money and went off a cliff. Food and fuel costs have been a bigger negative than we expected. Rebate checks are hitting people's pocketbooks now, and we need another round of fiscal stimulation, focused on productivity. As for inflation, as Karl Otto Pöhl, a former president of the German Bundesbank, said, "It's like toothpaste. Once it gets out of the tube, it's very hard to put back." Inflation expectations have been accelerating. That will remain a challenge.
There will be less stress in the financial system in the second half of '08, but continuing uncertainty with regard to the underpinnings of that stress: the housing market. Likewise, the auto market needs help. A lot of auto loans are underwater because of the declining value of the cars they financed. In 2009, however, we'll be further along in correcting the housing balances, and we'll have an OK economy.
And an OK stock market?
Originally I thought the market would be flat to up 5%. It will probably close up. If the Democrats control Congress and the White House, they'll raise taxes. If you own a company, you may want to sell it and pay long-term capital gains this year. Companies may issue more special dividends over the balance of the year.
Mario Gabelli's Picks
Company Ticker 6/11/08 Price
Tyco International TYC $42.91
Telephone & Data Systems TDS $47.14
Tootsie Roll Industries TR 25.67
Tredegar TG 14.19
Herley Industries HRLY 15.54
Diebold DBD 39.16
Source: Bloomberg
There is no question the amount of money earmarked by pension funds, endowments and others toward commodities is having an impact on prices, well beyond Chinese or Indian demand. This speculative bubble should be nipped in the bud. Margin requirements on commodities accounts must be increased or we'll have another bust.
Where do you see value these days?
We like companies with an environmental focus. Going green is good for business. We also like companies with pricing power, and we like takeovers. Strategic buyers are at center stage.
Telephone & Data Systems has a takeover angle. There are 117 million shares outstanding, the stock is $45, and the company has two businesses: wireless, through U.S. Cellular [USM], and telephone companies in rural America. TDS has about $350 million in net cash. EBITDA is $300 million. Valued at six times, that's $2 billion. With every TDS share, you get 0.61 of a share of U.S. Cellular, which trades at about $62 but is worth $100 to $120 a share. In all, you're getting $5 billion of value for free when you buy TDS at $45. Alltel or Verizon might buy U.S. Cellular, and there is speculation that TDS received a bid in the $90-a-share range. It is a potential takeover target.
Next, Tootsie Roll Industries. It has about 55 million shares. Chairman and CEO Melvin Gordon— he's 88— and his wife, Ellen, the chief operating officer— she's 76— control the voting shares, which have 10 votes each. Tootsie Roll has $120 million in cash. Revenues are flattish around $500 million, growing about 3% or 4% a year. Earnings are about a buck a share, going to $1.20. A takeout in the low $30s per share is likely. The stock sells for $26.
Who are the logical buyers?
There are many. With capital-gains taxes at 15% and likely to rise, it may be time for the Gordons to look at alternatives.
Tredegar, located in Richmond, Va., makes diaper components. The number of children 4 years old and under is going to stay flat at about 600 million for the next 30 years, but the use of diapers for incontinence is rising dramatically with the elderly population. Third-party pay is increasing. Tredegar also makes a fiber shield for flat-screen devices, and has an aluminum-products business. The company has 34.5 million shares and has been buying in its stock, which trades for 14.50.
What is the market cap?
It's $500 million. A transaction is likely here, too. Management could take the company private, or continue to shrink its capitalization. Tredegar will earn about 70 cents this year, but earnings could rise 50% in the next few years.
Herley Industries, a maker of defense electronics, also may be taken over. The stock is $15 - $16. There are 13.5 million shares outstanding. Revenues for the year ending July 31 will be about $150 million, and profits will be break-even to a small loss. Herley could earn a dollar a share in the next 12 months.
Any other ideas?
Diebold, which makes automatic-teller machines, sells for $39.50. United Technologies [UTX] bid $40 a share for Diebold, which rejected the offer. Diebold could earn about $2.35 this year, $2.85 in '09 and $3.50 in 2010. The balance sheet is in good shape. They should announce a large capitalization shrink. Self-service at banks is going to be highly sought after in Europe and Asia, and Diebold knows how to work with the banks. NCR [NCR] has terrific management and we're buying it, as well, but Diebold is our official pick.
Thanks, Mario.
Art Samberg
Barron's: What gives with this market, Art?
Samberg: The commodities market has a lot of unfinished business. The bubble isn't going to burst; it's going to continue to expand. We haven't reached the animal-spirits stage yet. This run-up is economically justified. [[Even if we have a recession?: normxxx]]
As for the stock market, a narrower and narrower list of stocks will work. We played some tech and materials names when both groups had major corrections a few months ago. But the stocks have come back, and I'm not as interested any more. The lack of serious innovation is a huge problem for the country, and it gets manifested in technology stocks. The number of interesting IPOs [initial public offerings] is tiny, and the backlog is getting even smaller.
Because there are fewer compelling technologies, or because a choppy market is inhospitable to new stocks?
The venture-capital world is moving from a focus on information technology to green investing. There aren't a lot of new, green-oriented ideas that will be significant in the short term. Health care usually is a good feeder of IPOs, but the macros there are dismal. Much of what's new in tech focuses on consumers. Those stocks are boring.
At the beginning of the year financial institutions were way overlevered. They've brought leverage down quickly, and the rate of return on capital industrywide is falling. When the unwinding ends, financials will sell at book value, not multiples of book.
So they're boring, too?
They could be boring for another two, three or four years. The market will be down this year, and next year won't be much better. It could be worse. There will be bigger problems with consumer credit and trouble in commercial lending. Before it's over, every financial institution will be embarrassed in some way. This is the mother of all credit cycles, at least in my lifetime, and that's the way they end.
Will things improve by 2010?
I'm optimistic about 2010. The U.S. will look good relative to other markets. For now, the only thing left to invest in is inflating assets— copper, natural gas, coal. I recommended Ultra Petroleum in January. We still love it. Natural gas now trades above $12 per million British thermal units, up from $7 in January. Southwestern Energy is another natural-gas play. In the first quarter a lot of commodities rallied, but the related equities didn't. You're starting to get an equity catch-up play. Because gas is rising, there's a double play.
We're big owners of Freeport McMoRan Copper & Gold. Copper used to be obtained through surface mining, but the ore grade has deteriorated and now you have go underground. There isn't enough electricity in places like Chile, and there are water-scarcity problems near many mines. Nationalization is also an issue.
We also like Xstrata, the Anglo-Swiss copper miner. They have a lot of South African coal. Eskom, the South African electric company, can't produce enough electricity, so it's hard to get this stuff out of the ground. Prices will escalate until the infrastructure is built to accommodate the market, and the rate of return improves significantly.
Art Samberg's Picks
Company Ticker 6/11/08 Price
Ultra Petroleum UPL $ 94.96
Southwestern Energy SWN 48.33
Freeport McMoRan Copper&Gold FCX 120.09
Xstrata XTA.UK 4035 pence
CVRD RIO $ 34.44
Halliburton HAL 49.37
Source: Bloomberg
You've been a big fan of Companhia Vale do Rio Doce, or CVRD, the Brazilian commodity giant. Do you like it still?
It's super-cheap. I'm still recommending it. Nothing has changed. My last pick is Halliburton, which makes equipment for oil and gas exploration. The bad press surrounding Halliburton has gone away. [The company, which has close ties to Vice President Dick Cheney, was accused of profiting from government favoritism in Iraq.] I could mention almost any commodities producer: The story is the same. I'm either dead right on commodities, or dead wrong.
Here's hoping you're dead right. Thanks, Art.
Fred Hickey
Barron's: Do things still look bleak to you, Fred?
Hickey: A witch's brew is hitting the economy, including the biggest housing-market collapse in U.S. history. Home prices are declining by 14%, year over year. Oil is $135 a barrel, up almost 40% since January. Food prices are soaring, unemployment is rising and wages are stagnant. Lending standards are tightening. Auto sales are plunging. States have a budget crisis. This combination of problems is unprecedented unless you go back to 1929.
Which we're not. Are we?
Well, they haven't taken protectionist steps yet. But they're talking about it. The U.S. is in a recession. The only people who don't believe that are on Wall Street. The stock market has had a classic bear-market rally, triggered by the Federal Reserve saving the world again. Supposedly. Previously, significant declines in interest rates would lead to corresponding drops in mortgage rates. Not any more. Lending standards are tighter, and consumers have record debt and no savings. Who would want to lend to them?
Good point. How will these problems get solved?
They have to play out. Housing prices have to fall to the point where homes become affordable to the general population. So far, stocks aren't even down 20%. The market will get killed when companies admit the second-half rebound isn't going to happen.
I'm still buying gold and selling "horsemen," the most popular tech stocks. Gold hit $1,000 an ounce within a few weeks of the January Roundtable, which I expected. I slashed my position by 75%, and in March I got out of all my puts on stocks. I've been on the sidelines, though I bought tech stocks such as Microsoft [MSFT], Oracle [ORCL], EMC [EMC], Hewlett-Packard [HPQ] and Apple [AAPL]. Recently I sold them— my intention was to rent them— and re-entered my put positions.
What, specifically, are you shorting through puts?
The SOX, or Philadelphia Semiconductor Index. The severe downturn in the economy has led to lower sales of technology products. Inventories are building at wholesalers. SG Cowen recently calculated that inventories are at a five-year high. Cellphone sales have fallen 16% in Western Europe. A classic inventory correction is coming within a recession. Yet the SOX is up 20% from its lows! The SOX could correct at least to its March lows, and probably more. But don't short, except through put options.
Fred Hickey's Picks
Company Ticker 6/11/08 Price
Short (via Put options only)
Phila Semiconductor Index SOX $381.68
Long
Golden Star Resources GSS 3.00
StreetTracks Gold Shares GLD 87.02
Source: Bloomberg
Any longs these days?
Gold stocks have been hammered. Junior mining shares have been destroyed. Golden Star Resources isn't a junior. It has real mines, in Ghana. Yet its price is destroyed. A new CEO came on late last year from Newmont Mining [NEM], which also has big operations in Ghana. Recently he brought in a new chief operating officer, also from Newmont. Golden Star could become a takeover target, with Newmont a likely buyer.
Gold production in Ghana is expected to rise 60% this year. But it is dependent on technology. Golden Star was bringing on a new processing plant last year and ran into problems. If it can get this plant working properly, production will increase. The stock is at 3, and the market cap is $700 million. The shares could easily double. My biggest positions are in bullion. As fear returns to the market, gold will rise again. I'm buying mostly through GLD, or StreetTracks Gold Shares, an exchange-traded fund.
The horsemen continue to gallop. Research In Motion is up almost 30% since you recommended shorting it through puts in January. Are you skeptical still?
RIM has a market valuation of $75 billion, but just 1% of the cellphone market worldwide. Nokia [NOK] has a market cap of $100 billion, and a 40% market share. What kind of upside is there at this valuation?
Thanks, Fred.
Felix Zulauf
Barron's: You predicted this would be a rough year for investors, and so far, you're right. What now, Felix?
Zulauf: This bear market doesn't look like 2000-02. It is a much more drawn-out affair, but a high-risk environment. There are enough reflation efforts under way in the U.S. and enough economic momentum in other parts of the world to prevent a global recession now. The economic expansion could run another two years or more. The market will remain choppy, with a downward bias lasting three to four years, as macro liquidity deteriorates. Investors' risk appetite is lower. There isn't enough liquidity to push stocks to new highs, but there is still enough to support the dominant themes in the market.
It's a split market. Financials and consumer stocks will remain weak, and energy and agriculture-related issues will keep rising, with occasional corrections. Aside from the European Central Bank, nobody is tightening monetary policy to the point that it becomes restrictive. Therefore the business cycle will continue. Demand for energy will continue. China still has subsidized energy prices and accounts for 80% to 90% of incremental demand. In the short run, the oil complex could correct, but it's not the end of the trend.
Felix Zulauf's Picks
Investment Ticker 6/11/08 Yield
Short
10-year Treasury* 4.08%
Japanese Government Bonds 1.84
Long 6/11/08 Price
CME Nikkei Futures (Jun '08) ¥13900
Nikkei 500 Banks Index 1895.40
PowerShares DB Comm. Idx.Track Fd. DBC $ 43.89
*Enter short when yield declines below 4%.
Source: Bloomberg
Do you see any glimmers of a turnaround for financials?
Some of the value guys are beating the drums for bargains here and there, but I don't believe it. Restructuring bank balance sheets also will be a drawn-out affair. The markets could make an interim low this summer, marked by another selling climax in financials. Stocks then will attempt another rally. Financials could jump 50% or so on short covering. After the elections, stocks will go down.
What are you buying— or selling?
We're at the doorstep of the next inflationary period. You won't see greater inflation in the next one or two years, but prices will be much higher in 10 years. Bond yields will rise as inflationary pressures mount. The yield on 10-year Treasuries, now 4%, could hit 5.5% in 12 to 18 months. The U.S. Treasury bond is a short, though you'll probably get a better entry point below 4% in the next few weeks.
Another short is Japanese government bonds, or JGBs. They yield 1.8%. Inflation is returning to Japan, which may be a good thing for Japanese companies. JGB yields could go to 3% in the next 12 to 18 months. What correlates best inversely with these bond yields? The Japanese stock market. It was in a bear market for 17 or 18 years due to the deflationary environment. Inflation would mean profit margins are normalized. I like the Nikkei for the next 12 months.
How should you buy the Nikkei?
Buy the futures. Japanese banks have restructured their balance sheets. They are sound. As interest rates rise they could charge better spreads. You can buy the banks through the Nikkei 500 Banks Index.
Investors should also be long commodities, through the DBC, the PowerShares DB Commodity Index Tracking Fund. This is a trading market. Based on real-estate cycles in other countries, the U.S. housing market will decline for another two years, bottoming in 2010. The consumer will be in such a precarious position that the government will have to step in to increase spending and support the economy. The Federal Reserve, despite rising inflation rates, has no choice but to leave short-term rates low. That means the dollar won't strengthen much either.
And on that happy note...Thanks.
Abby Cohen
Barron's: How does the market look to you?
Cohen: The housing market peaked in the fourth quarter of 2005. Coming into this year, many people were concerned about what continued weakness in housing would mean for consumer spending and employment. On top of that, the financial markets, and financial intermediaries, ran into trouble starting last summer.
There are signs the U.S. economy may be stabilizing. The likelihood of a deep recession has lessened dramatically. Exports are strong. Business fixed-investment is ongoing. Some people say this will be the worst recession since the 1930s, but we never thought so. Not that things are wonderful, but the abyss? A saucer-shaped recovery is more likely.
Many financial companies have fallen into the abyss.
There were questions earlier this year not just about the price of capital, but whether capital was available at all. Now there are signs things are moving in the right direction, as some financial institutions show a willingness to sell assets below par. There's an important contrast here with Japan, where an illusion of health was kept up for years. Assets were kept on the books at purchase price. It wasn't until those assets began to move off the balance sheets of financial companies, albeit at lower prices, that the Japanese financial system was able to recover.
Why have oil prices skyrocketed this year?
There is the long-term structural move in energy, and a short-term, cyclical move. Long-term there is an imbalance in the market: Global demand is growing faster than supply. In the past two decades producers haven't invested much in additional sources or refining capacity. That's coming home to roost. Short term, people are talking about the impact of a lower dollar, the activities of oil investors as opposed to users of energy, and geopolitical concerns. Also, some producing nations aren't able to distribute out what they're producing. The general direction of oil prices is correct. On a trading basis, oil can move back toward the bottom end of its recent trading range. But on a long-term basis, the trend is up.
Financial dislocations and higher oil prices have helped sink the stock market this year. What is your S&P forecast?
The markets are in a tenacious trading range: 1325 to 1425 on the S&P 500. But by the end of the year, investors may become more comfortable with the outlook for 2009. We estimate fair value for the S&P will be 1500 at year end. In '09, growth will be OK, not great. If companies begin to feel more comfortable about the future and create more jobs, 2009 could turn out to be better than the consensus forecast.
Abby Joseph Cohen's Picks
Company Ticker 6/11/08 Price
Bank of New York Mellon BK $40.28
D.R. Horton DHI 11.19
SanDisk SNDK 24.48
Eli Lilly LLY 47.43
AT&T T 36.14
Source: Bloomberg
What sorts of stocks will do well in this environment?
Given that we don't see a deep recession, and that the Federal Reserve has done an outstanding job in trying to restore proper functioning to the markets, my first pick is in financial services. Bank of New York Mellon is a custodial company. It is a low-beta business, and the stock hasn't done much this year. It yields 2.3%. Bank of New York merged with Mellon, so we expect some enhancements to earnings from economies of scale. Also, a large trust bank benefits from global growth.
In honor of John Neff [the retired money manager and Roundtable member], my next pick is D.R. Horton.
John will be happy to read about one of his favorite companies, but why recommend a home builder now?
Horton is down 50%, to $11 and change. In housing, some regions of the country are closer to stabilizing than others. Goldman Sachs analysts think 2008 will be the last year of losses for Horton, and there's a chance profits re-emerge next year. We're talking about the most cyclical of industries moving into a healthier phase. The rating agencies recently downgraded many housing stocks, which wasn't unexpected. To be able to buy one of the better-managed companies in the industry, with historically strong cash generation, interests us.
How about another contrarian name?
SanDisk, which makes flash-memory cards, hasn't had a good year. The stock is down about 40%, to $24.48. Earnings have disappointed because sales of products that use flash memory are weak. However, our analysts believe the company has done a good job over the years in identifying new uses and products for flash memory. The company has been pretty clever about marketing itself. It has a brand name, captive market share, and leadership in technology.
We also like Eli Lilly; it's down 16%, to $47. There is always concern about pharmaceutical companies during election years, but the stock is yielding 3.9%, and that would seem to cover a lot of potential aggravation. Also, our analyst thinks Lilly's pipeline looks good. My last name is a golden oldie: AT&T. It's a play on the rapid growth of wireless technology, which accounts for about 40% of revenue. The stock is $36. We don't see tremendous earnings growth, but the dividend yield is 4.3%.
Sweet. Thank you, Abby.
Meryl Witmer
Barron's: What's your second-half forecast?
Witmer: We see what everyone sees. Things are slow, particularly in retail. The consumer is squeezed, although some businesses are benefiting from exports. Over time, inventory will clear in the housing market. Oil potentially comes down if this is indeed a bubble, and things pick up. But in the near term, it's slow. Yet, we see opportunities. Generally, we're still holding the stocks we recommended in January, and finding others. They're coming our way. The market could move up 10% to 15% from current levels. A lot of stocks are washed out.
You're the rare optimist.
Hopefully, the contrarian often makes the money. One stock we like a lot is Interface. The company makes carpet tile, square pieces of carpet with a flexible backing. Carpet tile is in the sweet spot of the flooring industry. Interface's product is made largely of recycled materials. Because it is "green" and easy to install, it is growing nicely.
The original market for carpet tile was office flooring, where its penetration is about 60%. Growth areas include the education market and the hospitality industry, including public spaces and hotel rooms. About half of Interface's sales are in the office market, 10% for new construction. The Americas account for about 60% of revenue.
Meryl Witmer's Pick
Company Ticker 6/11/08 Price
Interface IFSIA $12.87
Source: Bloomberg
Is it breaking into the consumer market?
It is trying, with modest success. The consumer business is losing money, but it is an opportunity. The stock has fallen to 13 from 20 last July, because of slowing growth in Western Europe. The company earned $1.02 a share in 2007. It has a legacy cost of high-coupon debt, which it should be able to retire and refinance in a couple of years.
If you add back the loss in the consumer business and adjust interest expense to a more normalized 7%, the company earned $1.18 a share last year. The stock trades for 11 times adjusted earnings. Assuming modest growth this year of about 5%, and adjusting the earnings the same way, we get earnings per share of $1.30 for 2008. Given Interface's roughly 35% market share, a strong management team and the fact that more than 85% of a tile is made from recycled materials, Interface deserves a higher valuation. Our target is 20 in a year or two. If growth reaccelerates or the product gains more popularity with the consumer market, the return could be even higher.
Sounds goods. Thank you, Meryl.
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Normxxx
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