Staying Positive on Financials

Opportunities remain globally

BILL EHRMAN, MANAGING PARTNER and CIO, PAIX ET PROSPERITÉ FUNDS

Global investing is a science and an art. Don’t let people fool you, it is much more complicated today as you have to take in far more information, analyze it, reflect upon it and finally invest. I start by reviewing global liquidity trends, move on to economic trends, then to interest rates, currencies and finish with a view toward corporate profits.

Let’s take a look at the landscape for investing, concluding with regional, industry and company selection.

1. It is clear that the United States is doing better economically than the rest of the world. In fact, real growth in the second quarter 2014 was at the fastest pace in more than 30 months. The current financial environment is almost the opposite of 2008 when the financial collapse occurred worldwide. US household wealth recently hit a new high, total debt for households and non-profit organizations equaled 77% of GDP versus 96% in 2009 and total debt for the financial sector was down to 81% of GDP versus 119% in 2009. Less leverage combined with ever-increasing capital ratios at financial institutions means less systemic risk. All good on one hand, but a deterrent to growth on the other hand. While monetary policy tries to stimulate growth both here and abroad, financial and regulatory policies are getting more restrictive as exampled by Graham Dodd in the States and Basel III in Europe. Each is offsetting the other, impeding growth.

The US economy is in good shape and will continue to growth at least through 2015. Interest rates will stay low, influenced by prospects for low inflation, lower rates abroad and a strong dollar. Competitively the US is in great shape globally for a host of reasons, led by a major change in energy economics, which puts downward pressure on prices and a lower trade deficit. The positive surprise here is the continued strength in corporate earnings, cash flow and free flow. Managements are doing a better job.

2. Prospects in the Eurozone are grim. Even with exceptionally low interest rates, even below those in the US, the economies continue to languish along the bottom. There need to be significant structural changes country by country to enhance Europe’s competitive position in the world. As in the US, regulatory changes are forcing higher capital ratios at financial institutions, while countries are being forced to reduce their deficits… both bad for growth. Sanctions against Russia have been a tremendous penalty to growth too. No wonder interest rates are so low here and the euro so weak. Unless governments take aggressive actions, to stimulate demand and jobs, the fear of deflation in the Eurozone won’t abate no matter what the ECB does on monetary policy.

3. Growth in China remains disappointing and it is clear that the country won’t achieve its targets of 7.5% growth this year and next. The country is in transition, shifting its emphasis from exports to domestic consumption. The government is now discussing possibly replacing its PBOC chief who has championed more rapid market changes, including liberalizing interest rates. The central bank recently injected $81 billion into its largest banks but we doubt that it will have a meaningful near-term impact on growth. Just look at the price weakness of industrial commodities. Not good for Australia too.

4. Economic activity in Japan has materially suffered since the April hike in the retail tax to help lower the country’s huge deficit. Even with a decline of the yen now to above 110 to the dollar, trade numbers have not improved. Also, there will be another planned hikein the retail sales tax next spring unless the government votes to stop it this November. Here again, monetary ease and weakness in the currency have not been enough to offset other domestic pressures. The outlook for Japan remains weak.

5. India offers great promise. Major changes in economic policy are underway after the most recent election of Narendra Modi as Prime Minister. India offers great promise in the future as it becomes a free market-based economy.

So where does this lead us to invest profitably? Global liquidity provided by the monetary authorities far outstrips the need by the economies for reasons mentioned above. Excess credit creation is good for financial assets. Interest rates are low and will remain so, reflecting slow growth virtually everywhere, and an absence of inflationary pressures. Invest in companies with stable demand for its products, good earnings prospects and with yields well above bond yields with dividends growing 8% to 10% per year. The prospects for economic growth and profits are better in the US than elsewhere. I expect global capital flows into the US markets to benefit from a strong dollar and better economic prospects. For equity-only US-based funds, investing abroad might represent a currency risk.

In addition to investing for yield and dividend growth, change is in the air at corporations around the world. Managements and boards recognize that cost-cutting goes only so far in boosting and sustaining profit growth, so they have engaged in a new strategy. That strategy includes reinvesting in its high-growth, higher-margin businesses, making strategic acquisitions which are additive to earnings and cash flow almost from day one due to the low cost of money, and finally unloading either by selling or spinning off its low-growth, more capital-intensive businesses. Corporations are acting as if under attack by the activists and pre-empting them. Just look at Dow, DuPont, EBay, GE, Phillips, and Bayer to name a few. These companies, due in part to these actions, will have increasing growth in earnings, cash flow, free cash flow, dividends and finally multiples. Companies going through positive change represent the best opportunities. Companies not changing to the new global landscape will languish.

Finally, I would like to comment on CalPERS’s announcement that it would exit in entirety its $4 billion investment in hedge funds. Reading between the lines, hedge funds have grossly underperformed the averages as a group over the last five years while charging high fees. Hedge funds have forgotten that their mandate is to protect money in falling markets and perform near the averages in an up market, therefore outperforming over the cycle. This has not happened, with hedge funds as a group underperforming by 50% over the last five years. Not all managers are equal, and many hedge fund managers deserve their fees by outperforming the market averages over a cycle.

To sum up, I remain positive toward financial assets. Controlling risk at all times by maintaining ample liquidity and through good stock selection on the long and short sides of the market is extremely important. I expect interest rates to remain low and the dollar to remain strong, as well as corporate profits. Companies going through positive change, with strong earnings, cash flow and free cash flow and also with dividends above 2.5% and growing, remain the strongest opportunities. Risk can be controlled by maintaining ample liquidity at all times, through good asset allocation and, most importantly, through good stock selection on both the long and short side.

Bill Ehrman is managing partner and CIO, Paix et Prosperité Funds. He has served as head of the investment committee at Century Capital Associates, and head of investments for worldwide equities and private equities at the Quantum Fund, where he ran merchant banking activities, including acquisitions, bankruptcies, and work-outs. He was George Soros’s first partner, and wasthe founding partner, CEO and head of the investment committee at EGS. Ehrman was a partner at Merlin Partners in Palm Beach, Florida, later becoming a partner at Santana Associates in New York City. He joined True North Resources in 2011 as a financial consultant, and recently launched Paix et Prosperité Funds.