This is a continuation of the transcript. For part one, click here.
If there was sort of a funnel effect for a great number of capital markets around the world, so that in Asian slowdowns, the overall sluggish European equity scene just pumped a lot of money into the U.S., we assumed that that had to reach a certain extremity and the tide has to turn another way.
Do you have any ideas on where it would go if we just consider moving back as a pendulum and not just this money disappearing? Because a lot of people are saying that. A lot of the capital markets around the world have been sort of running up with the
. The continental equities have been having a pretty good time of it,
is over 20,000 again, despite two quarters that looked pretty messy as far as GDP goes.
Whether you look at Japan or Europe, you'll see it's sort of their equivalent of the Nasdaq that's driving things. It isn't very broad. It's a handful of stocks that are moving Europe, and they're all either tech, telecom or media.
If in fact, you really do get a turnaround in the Japanese economy, you could see the Japanese equity market really broaden out, and that could receive lots of capital. But I think more important is the real economy. There is net outflow of capital from Germany; there is net outflow of capital from Japan. It shows up in the
International Monetary Fund
data as foreign-directed investment, all this M&A activity. But to me, it isn't unthinkable that some of it could reverse.
I mean, I think one of the reasons
didn't use pooling
accounting is because they want to buy some more companies. Where are they going to go shopping? If it's outside the U.S., capital starts going the other way.
If a lot of the U.S. tech companies really want to grow abroad, how are they going to do it? I think it implies they start buying some companies out there. And again, that would start pushing these black bars down. Maybe not in a violent way, but so it looked more like it did earlier in the decade. So I wouldn't just focus on financial markets. What we've really seen in the past 24 months is U.S. buying of non-U.S. fixed assets slow violently, and foreign buying of our fixed assets accelerating, equally violently.
Maybe this is sustained this year, maybe next year, but the only thing I'm trying to highlight is I don't know how you can time this. It sure seems to me like these bars are outliers, not that we should grow accustomed to importing $130 billion a year, painlessly. But if we can't, then we're probably going to see the dollar go down. It's the only way we can be running our current account deficit that's 4% of the GDP and the dollar's going up. We'll probably see interest rates go higher than most people want to contemplate.
The old-fashioned way of attracting capital might have to reassert itself.
Doug, how much in all of this analysis do you factor in usually in terms of the amount of money that's in the equity markets?
I think you almost have to assume that you can make more money investing in Europe or Japan than in the U.S. in the financial markets, because when you look at equity as a share of household assets in Japan, you'd come up with a number somewhere not too far from 5%. Same exercise in Europe, you'd probably come up with a number like 7%. The number in the U.S. is somewhere between 60% to 65%. And so who's got room to increase, in an asset allocation sense, their equity ratings?
Of course, some of the Japanese money will come here and some of the European money will come here, but I think it would be heroic to assume that most of it didn't stay at home. It makes sense to stay at home. I mean, you start talking about things like currency risk and other risk removals when you invest offshore.
How much do you think of this global M&A stuff is due to mega deals? There's been a bunch of foreign buyouts of U.S. companies. Are those things going to continue? Could there be a reversal of that with U.S. companies buying overseas?
The only thing I feel confident about is that our whole macro setting has become dependent upon those flows. And since they are big, lumpy transactions, it isn't a smooth, continuous thing. It's a high-risk bet to assume that they'd continue. They could. One rumor -- or the reported potential transaction might be the best way to put it -- is that
is shopping for telecom service providers in the U.S.
That would be a huge transaction in and of itself and could equal at least a few months' worth of mutual fund inflows. So that could keep things going for the next six months.
The point isn't that it won't keep happening, it's that at our currency levels, our interest-rate levels, we need that to keep happening, which, from an investment standpoint or a risk-return standpoint, I don't think is a good sign. It would be great if it came. That was sort of the story of 1998. We didn't really need it that badly, but as we got further into 1998, we started to need it. And in 1999, we definitely needed it, given what's happened to the trade account.
And where we sit right now, we are absolutely addicted to it.
If you were in that old college debate environment, how would you argue the other side of this?
Great question. I don't know how, and I wish I did. Obviously, a lot of what I'm saying, by definition, is going to be wrong (laughter). It's the nature of the beast.
But you've been around this to know enough. If some of the denizens of the Silicon Valley were sitting here, they would say you don't get it. You've heard those arguments. What would your rebuttals be?
What they would be is that it's a New Economy, and I would argue that it is the media responsible for this divergence in attitudes. New is good, old is bad. But that's getting back to the point where I think anyone thinking that a lot of these technology companies today are going to have a sustainable, competitive advantage and hedge super-normal profitability, they are making an enormous leap of faith because there is virtually no historical precedent for it.
But if they don't need to get to that point because they will be acquiring -- sort of what is happening in a Darwinian fashion in technology -- and people are getting their money out of those acquisitions, isn't that part of the new dynamic?
Oh, that's not a new dynamic. The greater fool theory has been around for a long, long time.
Procter & Gamble
There were a lot of people who were bullish on
Procter & Gamble
and didn't see the railroad coming. I know that your analyst was bullish on Procter & Gamble and, in fact, in this report you mention that.
As one of the names that we've got on our stock list. That's right.
I'm still learning what happened with P&G, to be very honest. I'm not trying to avoid it, because we got blindsided, completely blindsided by what they said things looked like because what they've been saying things looked like not too long ago seemed very different.
Well that was kind of slightly disingenuous to say, well, we only saw these problems this week.
But I wonder why people on Wall Street didn't see it. If you look at pulp and paper in the Producer Price Index, it's up 6% above last year. It was kind of there to see.
I think you use whatever sources of information you have. I wouldn't pretend to know how you can do it well, and how you cannot do it well. What I feel real comfortable talking about is why we think staples are a good investment right now.
Earnings are usually slowing in the broad market, and consumer staples companies' revenues and earnings are holding up better than the broader market.
Most importantly, look at consensus EPS growth. It was -3% in 1999, the guess is 13%, 12.7%, for this year. There aren't many groups in the U.S. marketplace that show that kind of incremental improvement. And I guess that was the message from Procter. The numbers were too high. But if you'd have looked throughout the economy -- who's going to get hurt by higher oil prices, and who's going to get hurt by higher forest products prices -- I wouldn't put consumer staples high on the list. I'd put transports high on the list. They were down 5% Tuesday. I'd put a lot of hard-copy publishing high on the list. I'd put homebuilders and
high on the list of who's going to be inflicted by pain.
Consumer cyclicals are far more at risk to higher energy prices than consumer staples, because it's gotta matter that instead of it costing 30 bucks to fill up the tank in your Suburban, now it costs 50 bucks. And if you live in California, 60 bucks.
Is that going to make you buy less toilet paper, or is it going to make you buy less something discretionary?
The Next Best Thing
I'd like to think we have our eyes open. We don't think we're going back to an '80s type environment where foods, beverages, household products were going to give you 15%, 16%, 17% EPS growth year in and year out. We don't think that at all. But we're hesitant to recommend 100% of our portfolio should be in energy stocks, and as you go down the tier, it seems to us, staples are the next best thing, after energy.
Everywhere else we look -- whether earnings look good but what you have to pay for it
the stock is outrageous, like a lot of the tech segments, or the earnings trends look a lot worse than they will look for P&G -- we're finding it very, very hard to come up with a 100% equity portfolio in the U.S.
We've got a recommended stock list with 30 names. P&G was on it and it hurt us, but I think that's why you have a portfolio and you don't own just one or two stocks. Do we wish we figured this out ahead of time? Absolutely. But in a sense, what we're trying to do is by following these kinds of indicators we look at, and by looking at what's going on with consensus earnings estimates, what direction are they moving in. We're trying to minimize the number of occurrences like this, knowing that you're never going to bring that down to zero.
Investing Right Now
It's very, very rare now that we encounter investors who are excited about any individual equity security that they're buying. Anyone. An investor out in the Midwest yesterday phrased it best: You could basically categorize the stocks that are working in America right now are not based on any kind of fundamentals, but do they fit the category, "Wow! That could be big." That's the driver, and that's an ephemeral concept. I don't think it's something that we're going to be able to hold onto for a very long period of time, but it's sure worked wonderfully since Oct. 15.
So you're saying that the
kind of investment companies are mostly just looking at sectors?
I think so. I guess that's what makes me very nervous, and again, I wouldn't pretend to have a comprehensive knowledge of market history globally, but I think if you're buying an equity security, the only justification I can think of for buying an equity security, if you're really an investor and not just living off the greater fool theory, is that you are buying a stream of income. And you think you're getting that stream of income at an attractive price.
Honestly, if you're not doing that, I don't know what you're doing. I think the only other thing you could be doing is again, taking a leap of faith that you'll be able to sell this to someone at a higher price. That has been a wonderful trading strategy, but I think it would be a profound mistake to confuse that with an investment strategy.
What about, people saying that you're buying a stream of income that is sort of postponed, that these companies will eventually grow up and grow into these valuations?
I think, in theory, yes. But to me that's where heart and head really smash. Because looking back in time at any sort of meaningful time frame, what I think you'll see is that tech sector earnings per share growth tends to be among the slowest in the marketplace, not among the fastest. And it's because of a very simple economic thing that economists have been writing about for centuries: that new technologies destroy old technologies, and with it they destroy the profitability of old technologies.
I think, in that sense, there is a brutal or vicious logic under way in the marketplace right now. But it makes a lot more sense that there's dramatic, relative performance differences within tech, and that tech is doing well and everything else isn't. Again, I think it's very simplistic, but if all this stuff doesn't raise a lot of companies' productivity growth rates in earnings, then everyone's going to stop buying this stuff. I know it's simple and it might be wrong, but it's always been that way. In some way, it makes a lot more sense that we'll only pay for those handful of tech companies that are very good at making consumer products than those companies that are making capital goods.