What's ahead for 2008
Four top investment experts look at what will move markets and shape the economy in the coming year.
NEW YORK (Fortune Magazine) -- These times are more than usually trying for investors, what with home prices, corporate profits, and consumer confidence all dropping - plus the subprime mess.
For guidance we convened four star performers in the Grand Ballroom of the Manhattan Center Studios in New York City: Bob Rodriguez of First Pacific Advisors, who manages the FPA Capital and New Income funds; Susan Byrne, who heads Westwood Holdings Group; Sarah Ketterer, CEO of Causeway Capital Management, who pilots its International Value fund; and John Eade, who helms Argus Research. Fortune's Geoff Colvin led the discussion. Edited excerpts follow.
Fortune: People are wondering how bad the economy is going to get. Will we see a recession in 2008?
John Eade, president and director of research, Argus Research: We say no. We're hinging that call on the strength of the consumer sector. For 63 quarters now, through previous recessions, through terrorist attacks, through weather disasters, the American consumer has continued to spend, and we expect to see that in 2008. Will growth be as robust as we had in 2007? Probably not. But we're not looking for a recession.
Sarah, what do you think?
Sarah Ketterer, CEO, Causeway Capital Management: Although we don't expect a recession, we do think it will feel like one in this country in 2008. That's largely to do with the decline in house prices. We haven't seen anything like it. The long-term average on house prices is an appreciation of 0.7% since 1940, and the decline thus far, albeit measured loosely, is about 7% nationwide and could drop as low as 25%.
Clearly there will be some type of consumption pullback, and the implications for other parts of the world, particularly emerging markets, are quite significant. The U.S. consumer is extremely important, and has been, in Chinese growth. We're all in this together.
Bob, where do you put the odds of a recession?
Bob Rodriguez, CEO, First Pacific Advisors: I put it at north of 70%. The consumer is getting hammered unmercifully with interest rates and food, energy, and medical costs. We're looking for employment numbers to finally get hit in '08.
The severity of the credit crunch has been totally misunderstood and underestimated by the vast majority of equity investors. Economists will be debating whether it's technically a recession, but from the standpoint of economic profits and stock market profits, it will be a recession.
And you didn't even mention housing. John, how is the consumer going to withstand a big price decline?
Eade: The key is going to be employment. We are at historically low levels of unemployment right now. Our economist is looking for unemployment to tick back a little bit higher, but nothing terribly alarming. We think that's going to be strong enough to keep the consumer spending, probably not at the 5% economic growth rate we saw in the third quarter, but still enough to keep the consumer's head above water.
Susan Byrne, chairman and chief investment officer, Westwood Holdings Group: I live in Dallas, and I would include the Southwest and the Sunbelt in saying that we are bringing in new jobs and new people and that our home prices have not gone down. They haven't gone up, either. But housing in our areas is very affordable relative to the coasts. We worry more about the fact that we can't come to any agreement on immigration.
What does the subprime mortgage mess mean for the supply of credit and capital in the economy?
Rodriguez: If you look at this economy since 2000, it has been driven by structured finance. That game is over. Until something changes that, we have a major credit crunch, the likes of which we have not seen before, and I have no idea where it is leading.
There's opacity that's in the securities, there's pricing that is less than accurate - there are 50% differentials in prices for these structured products right now. If you use current or accurate pricing it would wipe out the capital of some of our major financial institutions. This credit cycle has a long way to go, and we have to have a reorganization of the whole structured-finance area and the rating agencies. There's blood on their hands.
Eade: The Federal Reserve had a somewhat surprising 50-basis-point cut earlier this fall, and markets shot back to record highs. Our bank analyst said, "This doesn't make any sense at all." These capital problems aren't solved in a week.
We've calculated that $500 billion of equity value has been wiped out in the U.S. financial sector alone. The scary thing that people can't get their arms around is, How low can the valuation of some of these securities go? There just isn't that information.
Byrne: Don't you think that's part of the problem? You're dealing with absolutely no transparency, no ability for price discovery, so what you end up with are ghost stories around the campfire. Not every person in the U.S. is going to walk away from his mortgage.
Rodriguez: But, Susan, I've never seen a corporate bond go from AAA to BB-- in four months. In the structured-finance area, we have. From the borrower to the lender, you needed a telescope to see the interested parties. It's a fundamental breakdown in the entire credit system.
Let's talk about stocks. As we sit here today, the markets are down 10% from their all-time highs. Bob, what's your sense of overall market valuation?
Rodriguez: Still too high for us. By my measure, at least 50% of S&P 500 earnings are at risk for 2008. When I total up the financial services companies, energy companies, and consumer-related companies, I don't believe the earnings guesstimates for 2008 are anywhere close to accurate. We're sitting here waiting.
Byrne: We're not so concerned with the overall market valuation. We look for stocks that have a high probability of continuing their growth and cash flow, and the stocks can be cheap or dear.
One that looks cheap is Freeport-McMoRan (FCX, Fortune 500), which is the world's biggest publicly traded copper company. But we like some stocks that appear very expensive, like MasterCard (MA). We're looking at the growth of plastic, either in debit or credit form, and the more people go ka-ching, ka-ching around the world, the more MasterCard gets paid. They take no credit risk whatsoever. They're a toll collector. I like that because I can understand it as a consumer. So we're able to find individual companies for the portfolio that we like because of either valuation or growth outlook, regardless of the overall market valuation.
John, what themes do you like for 2008?
Eade: International growth will be important, and exposure to international markets is going to help offset domestic issues. Efficiency is going to be important. We've seen corporate margins, during this recent period of 20% annual earnings growth, go from about 5.5% to almost 10%. Now they're going to start to come down. Companies that can help other companies become more efficient will be key.
Bob, you're looking for incredible bargains. What have you found?
Rodriguez: In the energy area we've been mostly in oil services. Patterson-UTI (PTEN) is selling around $19 at very depressed levels of P/E and cash flows. There are worries that there's going to be excess in the land-drilling area, but the only way we're going to find anything more in this country is to punch holes.
We're putting our toes back into the water in the consumer sector. Circuit City (CC, Fortune 500) is a high-risk stock because you're betting that it will survive - its market cap is equal to only 8% of revenues. They have about $2 in cash on the balance sheet. If they execute their working-capital management plans, that could generate another $3 of cash, so here's the stock at $6, down from $30.
We've been expanding our position in Foot Locker (FL, Fortune 500). The stock is at $12 with $2 of net cash per share, generating free cash flow despite depressed earnings that could recover next year and provide a 10% after-tax free-cash-flow yield at the current price. We're also looking at some industrial companies, but it's still early. One that we've reduced and we're keeping an eye on is Trinity Industries (TRN).
Sarah, where are you seeing value today?
Ketterer: Geographically, everywhere. There are financials that have been tainted with this huge credit problem in the U.S., which has created a liquidity problem for non-U.S. financials, or the perception of one. Sony finally listed its financial services business, Sony Financial Holdings [which trades in Tokyo, with the ticker 8729] at a very low multiple - and life insurance is a good business in Japan, particularly when it comes to people saving for retirement.
The U.S. government-sponsored enterprises, Fannie Mae (FNM) and Freddie Mac (FRE, Fortune 500), have been pummeled. Our stress-test analysis indicates those stocks are at bargain-basement prices. The businesses were designed to provide liquidity in the mortgage market, and ultimately there must be some type of government capitulation to allow them to step in with lower capital requirements to alleviate this huge problem in terms of mortgage loans and securitization.
Health care is another interesting area. Pharmaceuticals have been dead in the water for three years, but they're in the fortunate position of having surplus capital for investment in the pipeline. They can also pay it out to shareholders, and they will finally be able to make some acquisitions and add value. You're not paying for pipeline in companies like the Swiss giant Novartis (NVS). And they have quite a good one. Maybe none of these R&D projects will come to fruition, but historical probability indicates something will, and in effect you're getting it for free.
Susan, some other stocks you like?
Byrne: We look at free-cash-flow payout - not just the payout of earnings, but what percentage of their free cash flow is paid out in dividend. One area that looks awfully cheap to us is big technology.
Before, why would you want to be in a technology company when buyers didn't respect your patents? But last year the President of China came and met Bill Gates, and I guess China's going to protect the patents. Those companies now have end markets to grow. They always had great balance sheets, and they generate tons of cash. Now they're paying dividends, they have very low payout ratios on their free cash flow, and they're starting to grow.
Names I would call people's attention to are Accenture (ACN), which has an 11% free-cash-flow yield; Automatic Data Processing (ADP, Fortune 500); Microsoft (MSFT, Fortune 500); IBM (IBM, Fortune 500), which has been growing its dividend at 20% a year; Cisco (CSCO, Fortune 500); and Oracle (ORCL, Fortune 500). I'm a large-cap value manager, and these would be my unexpected safe spots.
Eade: I asked our team about where we are going to have the best earnings power. We also like Accenture. Our consumer staples analyst sees a lot of earnings strength at a small-cap organic-products company, Hain Celestial (HAIN). They have about 25% of their business overseas, and their products get 15% to 20% premiums. They have a clean balance sheet and a history of being able to acquire companies and focus on the cash flow. In the industrial sector, Danaher (DHR, Fortune 500) has grown its earnings by 15% yearly for the past five years, and free cash flow has grown at 20%.
Is there more fun to be had investing in China and India?
Ketterer: Long term, definitely. Short term, I expect a pullback in the frothier developing markets. China is a perfect example. It has a tremendous amount of surplus savings that has to go somewhere. In anticipation of Chinese investment in foreign stock exchanges, investors sent the Hong Kong market up some 45% in a couple of months in the third and fourth quarters. These companies aren't worth 45% more - they just got re-rated in anticipation of a surge of incoming liquidity. That gives you some idea of the speculative element in this part of Asia. Also, in the past three to five years the valuation discount for political risk in developing markets has dwindled to negligible levels.
What's the most important thing for individual investors to focus on in 2008?
Rodriguez: Preservation of capital. You never know the value of liquidity until you need it and don't have it. In our own portfolios we've taken that to heart. I'm sitting on close to 47% cash.
Ketterer: I would argue against timing markets or tactical allocation. I believe investors should employ a dollar-cost-averaging approach, regardless of peaks or valleys. They should be disciplined about how they invest and put an incremental amount of money into a very diversified portfolio to ensure they don't have their eggs all in one basket.
Byrne: Think in terms of being willing to lose opportunity instead of capital. Losing opportunity can be embarrassing, but losing capital is permanent.
Eade: Early in 2007, when we saw a declining trend in earnings, we lowered our asset allocation for stocks to 55%. I've never seen it that low in the 18 years I've been at the firm.
But we do think investors should be in the market, and we think they should be diversified. Also, there are opportunities in the imbalances. I'll just give you a real simple example: the price of natural gas with the price of oil. The normal ratio is eight or ten to one, but with oil prices up at around $100, that ratio is now 13 to one.
Our energy analyst is selling off some of his pure oil stocks but looking to reinvest in a more undervalued area, like natural gas. With an unclear path for the markets over the next year, you might have an opportunity to take advantage of those imbalances.