As the Euro Crisis Express trundles down the track to the cliff, for those of us old enough to have been trading during the October 1987 Crash, it’s all starting to seem eerily familiar. As was once said, history doesn’t repeat but it rhymes. This time is different in many ways, but what is the same is the feedback loop of lower confidence driving European sovereign yields higher which further hurts confidence. The evidence of real economic damage is beginning to show through. Steven Odell, Ford of Europe’s CEO, noted that “Contagion is already here” as he announced layoffs at a plant in Valencia, Spain due to slowing demand. Every step policymakers take is deemed to little, too late. There is a growing possibility of a real disaster – and yet there remain some compelling investment opportunities. Here’s the approach investors should take:
1) Don’t borrow any money. Leverage is inconsistent with long-term investing – it’s really for people in a hurry, looking for tomorrow’s returns today as well as today’s. If you have no leverage you always have the luxury of waiting for security prices to bounce back.
2) Don’t invest in companies that borrow excessive amounts of money. For corporations owning profitable assets, some modest leverage is acceptable assuming the returns they can earn from their invested assets are comfortable above the cost of debt. We don’t invest in highly leveraged companies, and typically look for debt:equity ratios of not much greater than 1:1. In this way, even if business turns down it’s unlikely the bondholders will wind up owning the company at the expense of the equity holders.
3) Don’t lend any money. Seriously. What you don’t have in equities, keep in short dated treasury securities. Lending to the U.S. treasury is not going to make you any money but it remains the safest place to park cash. France may be rated higher than the U.S. for now, but that simply reveals the absurdity of the rating agencies and no insight on their part. Short dated high-grade corporate bonds (excluding government agencies) may be an acceptable alternative to treasury bills.
Excessive debt caused today’s problems, and is being used to try and get us out. In the long run it may be inflationary – since more voters are borrowers than lenders, over time we do think the risks are for a quiescent Federal Reserve to accept creeping inflation as a way to devalue the real value of debt to the benefit of the debtors. But in the near term, even German debt carries some risks, in that the much discussed issue of Eurobonds (probably the only solution left) will likely pressure their finances. And the other problem is that if you buy German bonds you can’t even be sure what currency they’ll repay you in.
But equities are attractively priced for the long run. The challenge is finding a way to take advantage of that opportunity. We believe the answer is to modify the traditional approach to portfolio construction of equities, fixed income and cash to one of modestly more equities, sharply less fixed income and more cash. A barbell approach of stocks and cash with no borrowed money and not much lent money.
Consequently, we like companies include: Kraft (KFT), $23BN of long-term debt and showing the benefits of their 2010 Cadbury’s acquisition, maintaining operating margins of greater than 13% and with 2012 consensus EPS of $2.50 following double digits earnings growth offering an earnings yield of 7.4% (P/E 13.5). KFT also provides many different points of exposure to emerging economies. Microsoft (MSFT), perennially disliked but still growing earnings at 10%+. Net of cash (after deducting long-term debt) on balance sheet trades at less than eight times current year’s earnings. Aspen Reinsurance (AHL), likely to benefit from the reduction in reinsurance capacity following a series of catastrophe payouts (Japanese and New Zealand earthquakes, U.S. weather) and trading at 55% of book value.
It’s important to own companies whose long-term prospects are diverse and unlikely to change overnight. We own no banks – in fact we never invest in banks. They operate with too much leverage. In so many ways, debt is becoming a four letter word.
Disclosure: Author is Long KFT, MSFT, AHL