Bonds are expensive and investors are fleeing stocks, so where should you invest? Global bond manager, David Rolley, co-head of the Global Fixed Income at Loomis Sayles and global stock investor, Rupal Bhansali, CIO, International Equities, from Ariel Investments discuss where they are finding the best opportunities.
David Rolley's "One Investment"
DECENT YIELD
Emerging market corporate debt and actively managed domestic bank loan portfolios
“I think that the two fixed income ideas that probably will not break your heart over the next year would be emerging market corporate debt… which I’ve talked about and, to go domestically, bank loan portfolios but that are actively managed. Again, now you’re at the top of the capital structure, and you have a decent yield. We’re talking about a flow income of over four percent, so that’s... in a dangerous fixed income landscape, that’s a relatively safe place to be.”
-David Rolley
Rupal Bhansali's "One Investment"
“CONTROVERSIAL” IDEA
Japanese multinational companies
“This will prove to be a very contrarian, possibly controversial idea for people, but that’s exactly what we at Ariel do. We try to pick the best investment ideas before the market discovers it, so here I go. I would say that the biggest mistake people are making in their portfolios today is not owning Japanese multinational companies. You know, everybody wants to own emerging markets. Japan is viewed as a submerging market. I think that’s where you go, because some of these Japanese multinationals- Toyota, Nintendo, Canon, and I can give you a string of names like that. I don’t mean Japan, the domestic stocks, but I mean the multinationals. I think they have extremely good products. They’re very competitive, and they have the global marketplace as their opportunity. So no matter what happens to Japan, they will sell their wares in overseas markets.
And they’re very undervalued. You get four to five percent dividend yields in a stock like Canon. I mean, this is unheard of in Japanese markets. They’ve corrected 75% from the peak while the U.S. market of the same period, about the last 25 years, is up 500%. Japan is down 75%. Enough is enough. All good things will come to an end. All bad things will come to an end.”
- Rupal Bhansali
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Full Transcript:
CONSUELO MACK: This week on WealthTrack, the hunt for big investment gains in out of the way places. Two global money managers- Ariel Investments’ stock star, Rupal Bhansali and a Loomis Sayles bond leader, David Rolley- travel off the beaten path to find hidden winners next on Consuelo Mack WealthTrack.
Hello and welcome to this edition of WealthTrack, I’m Consuelo Mack. How do you feel about your portfolio this year? If you are similar to the vast majority of investors, you are probably leery of stocks, resigned to bonds, and grateful for anything yielding more than the 2.5% or less offered on ten-year treasury notes.
In fact the trend away from stocks and into bonds has grown more pronounced since the 2008 financial crisis. As this chart from innovative research firm Strategas shows, net inflows into bond mutual funds have accelerated in recent years, whereas stock mutual funds have seen quickening outflows. It is a stunning divergence.
Do these gigantic shifts still make sense? Well, stocks have had a remarkably good year- the S&P 500 is up double digits as is the NASDAQ and major European and emerging market indices. Meanwhile, there is huge divergence in bond performance. Ten year treasuries have lagged significantly, but high yield bonds have delivered equity like returns as have emerging market issues.
So where in the world should you look for opportunities in 2013? Two global investors are joining us this week, both with excellent track records, one in stocks and one in bonds, and both are new to WealthTrack. Rupal Bhansali is a star global stock manager who is now the Chief Investment Officer of International Equities at Ariel Investments and portfolio manager of Ariel International Equity and Ariel Global Equity funds. Bhansali spent a decade at Mackay Shields where she ran a top decile, five star rated international equity fund. David Rolley is co-head of the global fixed income group at Loomis Sayles and co-portfolio manager of the Loomis Sayles Global Bond Fund, Loomis Sayles International Bond, and Global Equity and Income funds. Over the years, Dave and his team have been recognized as best in their categories by Morningstar and Lipper. I began the interview by asking them what surprised them the most in the markets in 2012.
RUPAL BHANSALI: The markets always surprise, but I think the surprise for everybody in 2012 was that developed markets, equity markets in Europe and the U.S. outperformed by a mile emerging markets. You know, the inflows into mutual funds have all been into EM, and to think that DM would shoot the lights out compared to EM I think was the biggest surprise.
CONSUELO MACK: That is a big surprise when you look back. Dave, from your perspective as a global bond fund manager.
DAVID ROLLEY: I think one of the reasons why that might have happened is my surprise which was how little volatility we had. I mean, after August and September of 2011, a lot of people went into 2012 prepared for essentially more bad news from Europe and, in fact, Europe really was not the big problem for investors. It was a low volatility year, and a low volatility year is not what people were looking for.
CONSUELO MACK: So that risk on, risk off trade that we all kept reading about and talking about and everything else, you know, refresh my memory. That didn’t really happen this year?
DAVID ROLLEY: It was really muted. I’d say we certainly had risk on. In January and February, all markets rallied, particularly, you know, importantly risk markets with the liquidity from the European central bank that began about this time a year ago, and they did more of it in February. The only thing we had that really looked much like a sell-off was a bit of a pullback in May, and it was not nearly as bad as the previous year.
CONSUELO MACK: Except right after the election, but then since then it’s been fine. So what about 2013? We’ve just got a little bit of time left in this year, so what are you planning for, Rupal, in 2013?
RUPAL BHANSALI: I think that the markets in general have gone up a lot, and so next year and many years going forward, I think it’s going to be about choosing and selecting alpha rather than relying on beta to get your performance. So stock picking...
CONSUELO MACK: And explain for our viewers the difference between alpha and beta.
RUPAL BHANSALI: Oh, sure. Beta is something where the asset class itself, you know, just by being long the asset class, you can get your returns, because it’s just undervalued across the spectrum.
CONSUELO MACK: So the markets go up.
RUPAL BHANSALI: That’s right. The whole market goes up, and you just go up with the tide. I think that given the valuations of the market, I think stock picking, so cherry picking your exposures, being in particular parts of the market rather than the entire market is what’s going to serve you well in 2013, and that’s how we are positioning. We are looking specifically for those portions of the market where you can get the best combination of growth and value, because both are very important to improve the risk/reward of an investment proposition which is kind of our mantra. We don’t look just for return management. We look for good risk management.
CONSUELO MACK: And what about in the bond market? And I’m thinking the bond market which, of course, everyone has been saying for years that bonds are really expensive and especially sell Treasuries. They’re the most risky investment you can possibly buy. So what are you expecting for 2013?
DAVID ROLLEY: Well, I’m hoping that we have a sideways market in 2013, but I’d have to agree with your comment, and this is embarrassing. If I just say, well, gee, interest rates are really low now, I’m thinking, wow, that’s an expert remark, isn’t it? I mean, you get nothing if you hold cash, and you don’t get very much if you hold two-year or five-year Treasuries. You get 1.6%, something like that, if you hold 10-year Treasuries, but it’s not just the United States. The U.S. Treasury market is expensive, meaning yields are really low, but so is sterling, so is the northern half of the Euro Zone. So is Japan, and that’s 85% of my benchmark. So what I’m hoping to do in 2013 first is protect capital and then, after that, do exactly what Rupal said and replace market risk with specific risk. So in this yield desert, what we’re going to be looking for is little oases of positive return, and there are going to be lots of different little things, so no one big theme, lots of small themes.
CONSUELO MACK: So talk to me about some of your big themes, the big investment themes that you have.
RUPAL BHANSALI: I think a lesson and a principle that all investors would be well advised to pay attention to is the following: All good things come to an end. The corollary of that is all bad things come to an end and, in investing, a lot of people tend to own the good things that have happened to them, which is fixed income, for example, and they tend to over own it. They over own the portions of the market that have performed very well, like the fixed income proxies, utilities, real estate, the REITs, energy stocks, and so on. We think that that good trade has come to an end, and we think some of the bad things that are coming to an end provide an excellent investment opportunity.
Patent cliffs in the pharmaceutical sector. You know, we all talk about patent cliffs and generics threat. Well, that sort of played out over the last decade, but the pharma stocks are extremely cheap now and, frankly, some of the pharmaceutical companies that invest in R&D which takes 10 to 12 years to fructify, well, the payday is now around the horizon. Take GlaxoSmithKline. They have a lot of drugs in the pipeline that are in phase III, and you can look forward to both a single-digit to double-digit earnings growth, cash flow growth, and a low valuation of 10 times with a five, six percent dividend yield. So contrary to what you have in the fixed income markets where you have extremely low yield, there are portions of the equity markets where you have very high yield. So I would say that that’s where the opportunity is. That’s the big theme. All good things coming to an end, all bad things coming to an end, so it’s time to reposition the portfolio.
CONSUELO MACK: Would you agree that basically that all good things come to an end and, therefore, the good place to be has been in the bond market overall for like the last 30 years? And that, in fact, the best things in the bond market, the best performance in the bond market, are behind us now? And that there is going to be some sort of a reversion to the mean which people have been talking about now for five years?
DAVID ROLLEY: That’s a really deep question.
CONSUELO MACK: I’m not sure about that, but ...
DAVID ROLLEY: It may be the deepest question in fixed income, and let me explain why it’s really fairly profound. I believe in reversion of the mean and so do most investors, but what you have no consensus on is whose mean are we going to revert to? And what I’m really talking about is the difference between traditional American valuation metrics and traditional American levels of interest rates and Japan. If you think about Japan, you had very low interest rates not for a year or two years, but for...
CONSUELO MACK: Twenty years.
DAVID ROLLEY: ...20 years, 20 years, and the question is, are we all becoming Japanese? The United States, I think, will not become Japanese, and I think the reason is that there are no votes in that. I think that the policymakers, particularly the Federal Reserve, is targeting nominal GDP growth. When they talk about what they do, they talk about a dual mandate- unemployment rate on one side, inflation on the other side. You put them together, you’re talking about how the economy overall is doing. If you were going to use one number to do that, you’d look at how the whole economy is growing not in real terms- that’s how it’s usually discussed by us and by others- but in nominal terms. That used to be five to six percent per year. We’re growing at about four percent a year and struggling.
CONSUELO MACK: In nominal terms.
DAVID ROLLEY: In nominal terms.
CONSUELO MACK: That’s the GDP growth, what, of two percent and inflation of two percent?
DAVID ROLLEY: Yeah, GDP growth of two percent on a good quarter and inflation of about two, and you add those together. You get that four percent number, and we’re throwing everything but the kitchen sink in monetary policy to hold that number up. Well, the problem is, the way the Fed throws liquidity to try to push up nominal GDP... the other name for nominal GDP is our tax base. You see why they want it up. You want a tax base up if you’re worried about tradeoffs between cutting back government transfer payments and government expenditures on the one side and raising taxes on the other side. The higher the tax base goes up, the easier that tradeoff becomes, but the way you do it with quantitative ease is also called yield suppression. So the government policy from central banks, and not just ours but the United Kingdom and others, is to push yields down to try and get nominal GDP up. Well, nominal GDP is my value metric. You know, for 30 years if I ask, “What’s fair value for a bond yield?” I’ll look at nominal GDP trend growth. So if they want it higher, that means that at some point out there, there is a pretty ugly bond bear market. So ultimately I’m saying we mean revert to something that looks more American in terms of GDP history and less Japanese...
CONSUELO MACK: Globally more American.
DAVID ROLLEY: Globally, because if we don’t I think the fiscal conversations are just going to be very, very unpleasant.
CONSUELO MACK: So you think bonds are really expensive, too. Correct?
RUPAL BHANSALI: Absolutely. Yes, I think that investors have pushed the envelope on this good thing and, again, it’s a rearview mirror. Because they perform so well, there’s a lot of money chasing this asset class, and I think what investors are forgetting is they are so afraid of the volatility risk in equities because equities bounce around in double digits too often in ’08. In 2001, 2002, sort of really put the fear of volatility risk. I think people are forgetting that by owning fixed income, you may have less volatility risk, but you have swapped for another form of risk which is valuation risk which is the biggest risk of all. You know, real estate didn’t have too much volatility until it fell 30, 40%. It’s a one-way move down.
CONSUELO MACK: Right, until it did.
RUPAL BHANSALI: Exactly, and I think that’s sort of what is lulling people into thinking that fixed income is safe because it doesn’t fall as much, and it doesn’t have that much volatility, and I think that’s the biggest misnomer in the markets. I’m not such a believer of mean reversion as much as I am of, you know, we have to think for ourselves. So independent thinking is what categorizes Ariel and some of these investment propositions that I’m giving to you, and I think in that construct of independent thinking, looking at portions of the equity market, not the ones that are crowded trades which everybody wants to flock to, that tends to take the valuations to very unattractive levels.
You know, emerging markets is a classic example where everybody over the last decade has gone into it. It’s exactly what happened when people went to technology stocks, you know, TNT, in the late ‘90s, and they couldn’t have enough of it and then, of course, look at the reaction on the other side of the fence. Today I would argue after 10, 11, 12 years, the technology stocks in the U.S. are some of the cheapest out there, and yet nobody wants to own them. So there is opportunity. There is tremendous opportunity, because the good thing with equities is you can truly pick your spots. You don’t even have to have beta. You can have pure alpha, and I have many examples if your viewers care, but...
CONSUELO MACK: I think we do care, and so one of the things that you had told me is that as far as the “all good things must come to an end”, that Apple is an example of all good things must come to an end and all bad things must come to an end. That Microsoft is... I mean, so that’s a classic example in the technology sector. You would sell Apple stock and buy Microsoft? Is that essentially a trade that you would make?
RUPAL BHANSALI: When we make any investment decision, we weigh- and I suggest all investors do this- not just the reward or the return they expect from the investment opportunity but the risk they take, so the down side that you can expose yourself to with that investment as well. When I look at Apple, when the stock is in the 500s, you know, give or take, because it’s been up and down now, and it’s got a market cap of close to half a trillion dollars, for me to think that I’m going to get 30, 35% upside in Apple, means the market cap has to go to $800 billion. Never happened in the history of the world, by the way, so now you’re expecting something that is excruciatingly challenging, you know, even against the odds, right? On the other hand, can I think that Apple could go down 25, 30 percent from here? Absolutely, because there are lots of things that it can have a challenge in succeeding in.
Then you take Microsoft, a stock that’s already derated so much to the point of being on six times X cash, nine times with the cash, excluding the cash earnings. This is a company that generates billions and billions and billions of free cash flows here and now, and that’s the multiple you have to pay. It’s like a 15% free cash flow yield. You can easily see the stock going up 35, 40%, and it’s extremely hard to see why it will go down 10%. So here you’ve got the odds risk/reward, you know, three to one, four to one, and this is a mainstream blue chip company you can have in your portfolio and clip a coupon of three and a half percent, well above the 10-year bond rates of most markets out there.
CONSUELO MACK: All right, and, David, speaking of independent thinking, Loomis Sayles is also known for being an independent thinker, and one of the things that you told me is like first do no harm. So where are kind of the niches, the special places that you’re looking at Loomis Sayles, especially considering that there could be tremendous harm if... and I don’t know when... but if the bond market does implode?
DAVID ROLLEY: Well, as we look at the fixed income landscape right now, we’re driven to certain strategies through almost a process of elimination. Now, if we hold very short maturity securities in good companies, we get paid relatively little as approximating nothing, and so cash-type substitutes do not appeal. It’s a liquidity reserve. It’s not an investment return idea, but at the same time, given that I think that the overall level of interest rates has been artificially suppressed by policy and some day will adjust, I don’t want to own 30-year paper because those will be where you have your biggest capital losses. At least I don’t want to own 30-year paper unless I’m getting paid seven or eight percent to do it. You could find some of those.
CONSUELO MACK: Really.
DAVID ROLLEY: So if I’m not going to be taking a lot of market risk, it comes back to specific risks. There are things we don’t like, and many of them may be the same companies that Rupal does like. Let’s take, say, GlaxoSmithKline. Now, if their dividend is between five and six percent, that’s an interesting equity dividend, but if Glaxo came to the bond market and wanted to borrow a billion dollars, they wouldn’t pay investors anything like five or six percent. It would probably be more like two something. So two percent in the bond, five percent in the stock. If you think in five years’ time Glaxo’s a bigger and more successful company, you prefer the equity. Having said that...
CONSUELO MACK: Right, you go with Rupal.
DAVID ROLLEY: Yeah, but having said that, you can find parts of the bond market that can return that 35%. Let me give you an example. In Europe, you can find good quality companies that have really been beaten down. Some of them are big large-cap utilities. So if we’re talking about...
CONSUELO MACK: So are you talking about stocks that have been beaten down or the bonds?
DAVID ROLLEY: We’re talking about the bonds.
CONSUELO MACK: The bonds.
DAVID ROLLEY: The bonds have been beaten, but the stocks have been beaten down, too, in certain cases, but in many cases the bonds have been beaten down. So you can look at big companies, and we’re talking about like the phone companies and the power companies, so places like Italy, Spain, Portugal, France. Veolia was one of the best performing things in my portfolio. Why? A lot of the people were worried about the euro stuff. They drove their long bonds down to 86. The other day they were 118. Well, you know, 86 to 118 on par is a pretty good return, and so it’s still possible to find securities in the fixed income markets that can return 30 to 40%. It doesn’t seem like that would be possible, but if you can buy them at 85 and sell them at 118, that’s a good day.
CONSUELO MACK: So that’s another issue. So are you finding... when I’m hearing that kind of appreciation, is it time to sell these issues? I mean, are there a lot of your portfolio that looks overvalued that you’ve really got to, you know, got to start thinking of putting somewhere else?
DAVID ROLLEY: Where we find bonds that have had tremendous performance and now trading at a substantial premium to par, we’re more likely to be sellers than buyers. We are buying more new issues coming at close to 100 than might be normal for us. Our preference is to buy good quality companies at a discount to par in the secondary market. Yields are so low that there’s not that many discounts around right now, so we are using more new issues, but we’re still finding islands of opportunity.
One of the places we’re finding it, and here I’m going to go maybe in a different direction from what Rupal said about emerging markets, is in emerging market corporates. Many of them are coming to market for the first time of the bond markets. They have never been issuers before, and so to access global capital, they’re prepared to pay a new issuer premium, sort of just we’ll pay you a little extra compared to our rating and compared to our cash flows so that you will look at us and consider us. Many of them are emerging markets banks. They’ve never had to access the bond market before. They could get cheaper funding from other banks in the developed world, but if you think about the stress that American banks have gone through, that European banks are continuing to go through, well the price of a term loan from a French bank is different from what it used to be in 2007, and they now look at the bond market and say, “Well, you know, five-year dollar pay paper. Maybe we should do some of this.” So you’ve seen a lot of emerging market banks. We’re talking about folks that in that country’s market are blue chip.
CONSUELO MACK: …are the blue chips.
DAVID ROLLEY: You know, top two, top three banks in their local neighborhoods. So the people there think this is a terrific bank, but the people that don’t live there may not know them so well. You can find actually very interesting yields with that kind of an opportunity or other companies in other industries that are looking to grow out of their local footprint and become true multinationals and just need the funding.
RUPAL BHANSALI: It’s interesting. Every security-specific portions of the market he referenced that he’s finding value and opportunity in the bond markets, which is the utilities and telecoms in Europe and the banking sector in emerging markets, et cetera, are exactly the portions of the market that I would not own in the equity markets, and we think that those sectors have significant challenges, and actually the equities are quite overvalued despite the correction. So I think that what it boils down to for any investor is to have a combination of what he can do for the portfolios and what I can do for the portfolios, and the fact of the matter, it sounds like we’d be pretty diversified, because we’re not making the same bets.
DAVID ROLLEY: Let’s talk about that equity. What might be bad for Rupal’s returns if she buys a stock in emerging market might be good for me. I’m a bond investor in that I am senior to that equity. The bigger the market cap of that firm, the more cushion of value there is underneath me, and the more that has to be eliminated before I don’t get paid, before I don’t receive my coupon on my principal back. So an overvalued stock market is not necessarily bad news for a bond investor.
CONSUELO MACK: For a bond investor. So I need to switch gears here, because we’re almost running out of time. I can’t believe that we are. This is so much fun. So Rupal, the One Investment for long-term diversified portfolio, what should we own some of in a diversified long-term portfolio?
RUPAL BHANSALI: This will prove to be a very contrarian, possibly controversial idea for people, but that’s exactly what we at Ariel do. We try to pick the best investment ideas before the market discovers it, so here I go.
CONSUELO MACK: So we could be early, right.
RUPAL BHANSALI: I would say that the biggest mistake people are making in their portfolios today is not owning Japanese multinational companies. You know, everybody wants to own emerging markets. Japan is viewed as a submerging market. I think that’s where you go, because some of these Japanese multinationals- Toyota, Nintendo, Canon, and I can give you a string of names like that. I don’t mean Japan, the domestic stocks, but I mean the multinationals. I think they have extremely good products. They’re very competitive, and they have the global marketplace as their opportunity. So no matter what happens to Japan, they will sell their wares in overseas markets.
CONSUELO MACK: And they’re undervalued right now.
RUPAL BHANSALI: And they’re very undervalued. You get four to five percent dividend yields in a stock like Canon. I mean, this is unheard of in Japanese markets. They’ve corrected 75% from the peak while the U.S. market of the same period, about the last 25 years, is up 500%. Japan is down 75%. Enough is enough. All good things will come to an end. All bad things will come to an end.
CONSUELO MACK: Very intriguing idea. Dave, what would your recommendation be?
DAVID ROLLEY: I think that the two fixed income ideas that probably will not break your heart over the next year would be emerging market corporate debt...
CONSUELO MACK: Which you just talked about.
DAVID ROLLEY: ...which I’ve talked about and, to go domestically, bank loan portfolios but that are actively managed. Again, now you’re at the top of the capital structure, and you have a decent yield. We’re talking about a flow income of over four percent, so that’s... in a dangerous fixed income landscape, that’s a relatively safe place to be.
CONSUELO MACK: Well, thank you both very much. You know, as we kind of close the year and we’re heading into Christmas and the holiday season, I think you both have given us some terrific investment gifts. So I really appreciate your being here on WealthTrack. Rupal Bhansali, it’s great to meet you here finally and have you on WealthTrack and, Dave Rolley, I’ve seen you in many conferences. I’m glad to finally have you on WealthTrack as well. Thanks for joining us.
RUPAL BHANSALI: Likewise.
CONSUELO MACK: And Happy Holidays.
RUPAL BHANSALI: Same to you.
DAVID ROLLEY: Thank you very much.
CONSUELO MACK: As we close out this edition of WealthTrack, we want to share some holiday gift suggestions with you as well. There have been several excellent business/investment books published this year that our Financial Thought Leaders and others have recommended. They might be worth putting under your tree. I know I want them under mine- hint, hint!
One is Walter Isaacson’s biography,Steve Jobs. Everyone I know who has read it has been mesmerized. And as Mae West used to say, goodness had nothing to do with it. Another much mentioned favorite among investment pros isThe Signal and the Noise by Nate Silver, a now famous political analyst who tackles the art of prediction and his thoughtful approach to it in a wide range of areas from economics to terrorism to weather, baseball and the markets. Finally, behavioral economics is making more and more sense. Who better than Nobel Laureate Daniel Kahneman and his new bookThinking, Fast and Slow to help us understand how we think, react and make decisions in all phases of life including investing. I am looking forward to reading all three.
And of course check out our WealthTrack bookshelf with books we and our guests have already read and in some cases authored, on our website, wealthtrack.com. Speaking of which, in the next couple of weeks we will be upgrading our website and adding more content and features from our exceptional guests and sources. We look forward to your comments and suggestions as we roll it out. And that concludes this edition of WealthTrack. Thank you so much for watching. Have a Merry Christmas and make the week ahead a joyous, profitable and productive one.
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