February 2015

“If you can't beat 'em, join 'em”

- Bugs Bunny. Bunker Hill Bunny (1949). Directed by Friz Freleng

We all know how important it is to look at history as an element of accessing what might happen in the future.  But a big piece of “the art of the game” in investing is seeing something that may materially affect share value, and preserve or build equity value with that unique insight.

So here we sit as this month’s blog rolls out.  Flat markets YTD.  Very low interest rates, now worldwide.  U.S. markets are at all-time highs (unadjusted for inflation), and the typical assortment of potential worldwide threats and uncertainties are certainly out there.  Oil prices have fallen by 50% and remain very volatile on a daily basis, with speculation building on both sides with some betting on another leg down and some predicting a rise to “normalized” levels—whatever normalized means.   Overall the S&P 500 is trading at about 16x forward earnings, slightly higher than the historical “average.”  So the term “market value” rolls on as the discussion de jour day-to-day.

So which way will the markets move next?  We do not know…

…But here is what we do know.  Over 75% of the S&P 500 companies have met or exceeded their earnings estimated in the current quarter.  Overall, earnings are slightly up over previous quarters.  Job growth has picked up.  Wages are going positive, and there is effectively a “tax break” that every single family has received by virtue of lower gas and oil costs.  The tail winds from this are just beginning to leak into the worldwide economy (as opposed to the domestic economic tailwinds the United States has enjoyed in the last couple years).

But even with all this, we are told that valuations on large-cap multinational companies are high from a historical perspective and ready for a market correction.  They may be; however, we believe they are not ready for a “value” correction within their balance sheets.  In fact, we believe some of these companies are getting stronger, mostly because of one predominant element, never before present in history to the extent it is today: large scale central bank intervention.

Central banks—the country specific monetary authorities who manage a state’s currency, money supply and interest rates— have made it a central point of their strategy to discourage saving and encourage (almost force) borrowing and equity investing. Why?  It has historically been seen as a way of boosting equity markets and investor confidence in times of economic downturns and uncertainty.  Some countries now offer a negative rate of return (yes you pay them to hold your money if you buy their bonds.)

Japan and the U.S. have historically low rates.  By extension, central banks have allowed the largest, most credit-worthy multi-nationals to sell bonds at astoundingly low yields.  In fact, some of Nestlé’s bonds (Switzerland based) were yielding negative rates in early February.  Within the last couple weeks, Apple issued Swiss-denominated 10-year bonds at 28 basis points (yes, 28% of 1% per year). Microsoft raised over $7 billion at less than their dividend yield on common stock, with up to 40 year paper included.   BP borrowed over $2 billion at less than 2%.  These are just a few examples.  The bottom line is that in a worldwide effort to stimulate economies, the largest balance sheets in the world are benefiting more than any of the beneficiaries of this low-rate market.  When in history has a company been able to borrow for 10 years at 1/8th the cost of their dividend and buy back shares which ends up being accretive to earnings.  This is happening in many large-caps as we speak.  Inevitably, when (not if) rates rise back to at least historic averages, the debt on the mega balance sheets will remain very well positioned for years.  It is not too different from refinancing a home in a low rate environment, and enjoying the benefits for years or even decades.

We understand that there are a lot more variables to solid financial progress than low-interest rates and central bank action.  But, we also believe this one element lowers our risk to “value loss” (not market fluctuation loss) within the large cap sector.  Their liabilities will re-price much slower than their product prices will rise, and the increased assets that result.

Finally, while we believe wholeheartedly in broad diversification in the market, we are still strong believers that risk/reward is still weighted toward US based multi-nationals, with at least modest growth and strong balance sheets.  We are also beginning to see the QE and central bank effect in large-cap multinational foreign-based companies in places like Canada, Germany and a few other strong economies outside the U.S.; the strong U.S. dollar makes them start to look interesting.  We note that these companies are selling bonds, not buying bonds, and we side with them as long as the central banks keep the extremely favorable environment for financing and restructuring balance sheets of the most credit worthy companies.  After all, as a wise old rabbit named Bugs Bunny said over 65 years ago in a heavy Brooklyn accent, “if you can’t beat ‘em, join ‘em.”

Happy investing!


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