Where Cash Is Yielding Big Time
Susan Byrne, Chairman and Chief Investment Officer, Westwood Holdings Group
By SANDRA WARD
IN THE MORE THAN 35 YEARS SHE has surveyed the investing scene, Susan Byrne has displayed an uncommon ability to identify emerging themes and pick the stocks that would benefit the most from them. For almost 25 of those years, she has been at the helm of Dallas-based Westwood Holdings Group, which now boasts $7.7 billion in assets and the WHG family of funds. Performance in her flagship large-cap value fund is up about 14% this year, and for the past five years it has delivered 16.3% a year on average. We'll let her explain why she now likes software companies and has been reducing exposure to Big Oil.
Barron's: The themes that you have been sounding the past few years -- big U.S. multinationals benefiting from globalization and the emerging world -- have all come to pass.
Byrne: I keep wanting to find the next new thing because I'm afraid that because we were early on many of these industrials and basic-material companies they are probably very overvalued. Then we look at them and they are not. So I'm kind of in a quandary in that sense. We've got 4½% rates and we are going to be down near 4% in Fed funds and they are at 15-16 times earnings. The larger mega-cap names are trading in line with the overall market, about 16-18 times earnings. Compare that to 1987, when we had about a 10% interest rate and stocks were trading at about 20 times, or 2000, when we had lower rates but P/Es of 25-26. We take our market views and apply various inflation assumptions or interest-rate assumptions and we find we are not in a period of excess.
So the trend continues.
I thought Jim Paulsen [chief investment strategist of Wells Fargo's Wells Capital Management], had a provocative idea in that there could be a renaissance in U.S. manufacturing. People assume that everything we import is sold at Wal-Mart. But a lot of what we import is fabricated manufacturing that is then put together here with more highly skilled workers. It is not so much manufacturing in the traditional sense but the assemblage of different parts that are then shipped from here. What has benefited the market and is still benefiting the market is that these are American-based multinationals that pay taxes, report their earnings and pay their dividends in dollars here, whether their product ever was here or not. And, obviously, the return on invested capital outside the United States is very, very high.
Susan Byrne
From a quality-control standpoint, companies prefer to keep the value-added part of their business here rather than transferring the technology overseas. That affects what might look like a turn-up in manufacturing jobs. Now with the dollar down, it also pays for other companies to be here and be closer to customers and it may also be cheaper for them to make and ship products from here.
You're not concerned about the credit crunch?
There is a lot of debt around. But that debt is not in the major companies. I'm not surprised the market is moving to large-cap growth companies. That is the equity market's way of saying, "We may be in a credit crunch, so I want the companies that can always get the money."
This period of cheap credit went on for so long, let's say five to seven years; there has been a generational bias that credit for everybody is cheap and there has been no penalty for riskier balance sheets. What we are going through right now is an adjustment period and a return to more normal risk perceptions.
In a more normal period where credit counts, the larger, more liquid and more highly ranked companies in the equity market will do better, and the market is rotating that way.
Will the subprime mess lead to a recession?
Right now, we think no, because it appears the policymakers are going to provide for a workout. It could take two years to work out, and the economy could stay slow during that time. But unemployment isn't a particular problem, and for that reason we probably will escape a recession.
What kind of a shape do you see the consumer in?
I don't think they are in such bad shape. Everybody has credit-card bills, but people are working and they are getting raises and they are cautious. There are going to be people who, say, speculated on condos, who will get hurt on an individual basis. But by and large people are working. This is not an environment where the consumer just falls over dead. Taking money out of houses for little extras is over, but that's not a recession, that's a recession in the housing market.
What about the oil price?
We've been involved in the oil trade for a long time, and we are not overweight oil anymore. We are shifting our emphasis to natural-gas companies. Our big overweight now, and I hesitate to say it because everybody else is saying it too, is in technology. The Russell 1000 index only has 3% or 4% in technology, but we have about 15% or 16% in technology.
Why the shift on energy? Prices are higher than you thought they would be, so do you still think they're heading lower?
I don't really know. I feel very humbled by it. The market appears to be out of whack. The price of oil is over $80 a barrel and gasoline is really not moving, and so that means the integrated oil companies, the refiners, must be getting killed.
Something is amiss. I don't understand it. I'm sensing that in the large-cap integrated oil companies, there may be some earnings disappointments, because they are getting upside-down on refining. There is nothing wrong with them fundamentally. It is a good business. It is a great cash-flow business.
We favor the smaller speciality companies, like Murphy Oil [ticker: MUR], which will benefit more from its exploration and production activities. Murphy is just bringing on production in Malaysia that they found about six years ago, and it is a huge field.
Let's move on to technology. Where are you focused?
Finding free-cash-flow yield is a big part of our stock-picking process, and we were finding really low valuations based on that in a number of mostly software companies. Whether it is Oracle [ORCL], or Cisco Systems [CSCO], even Microsoft [MSFT] and Accenture [ACN], they are all selling with nice cash margins. That is not that unusual for software companies that are doing well. But what is intriguing is that their free-cash-flow yields were very high, and it meant the market was not valuing very highly their ability to generate this cash.
When we got involved with these companies, we were looking at free-cash-flow yields of 7%-8%, which is very, very attractive.
Are you confident they can show top-line growth?
Growth on the top line is modest. But with these companies, any small growth translates immediately into an increase in free cash flow. Cisco is selling at maybe 18 times earnings and is growing earnings in excess of 25% and has said they don't see any problem in continuing to do that. They are selling at a nearly 6% free-cash-flow yield with a free-cash-flow margin of 25%. So if 25 cents of every dollar is going to cash, that's an extremely profitable cash margin, which they will use and have used to very aggressively buy in stock and be in a position to grow their business as opposed to having to borrow money to expand.
How about Oracle?
Oracle is cheaper. But there will probably always be a P/E difference between Cisco and Oracle because of the personality trade-off between Cisco CEO John Chambers and Oracle's Larry Ellison.
Oracle is selling at 16 times '08 earnings on expected earnings growth of 15% to 18%, and has a free-cash-flow yield of over 7%, which is pretty amazing, and a free-cash-flow margin of almost 40%. That's very cheap. It is also pretty weird that you can buy Microsoft for 16 times earnings and get a free-cash-flow yield of almost 7% and a free-cash-flow margin of 30%.
Who cares when you can own Apple and Google?
We owned Apple [AAPL] at about a split-adjusted $9 a share in 2001. We sold after it went up about four times. Now, it is up about 20 times and it is too good of a story for us to own. In our trust company, after we sold Apple, our growth manager bought it so our customers on the trust side haven't missed out.
The market is all about these growth names now. They are not our names, whether it is Research In Motion [RIMM] or Google [GOOG] or Apple, but we have been able to stay ahead of the market by picking good stocks that appear to be undervalued.
Are you dabbling in the housing stocks?
Oh no. I definitely have to see the whites of their eyes. As one mentor of mine, Charlie O'Hay, told me early on, it is easier to pick the anvil up off the ground than it is to catch it in mid air. I can afford to wait and see what happens.
Nothing else appeals to you besides technology?
Not right now.
No new place to put your money ?
The problem is that the valuations of the companies we own are much too cheap to sell. They are generating so much cash. So if we are going into a period of time where access to cash and pristine balance sheets and generation of cash flow and all those things are important, you wouldn't sell these. It is very difficult to imagine that the safest stocks to own in a U.S. slowdown are the international stocks.
Were you surprised by Caterpillar's results and its remarks about a possible U.S. recession?
No. We don't own Caterpillar [CAT], but Caterpillar, unlike a lot of big industrial companies that are more diversified, has more exposure domestically. And they have a history of having had some execution problems with their costs. Companies like Lockheed Martin [LMT] and United Technologies [UTX] and Textron [TXT] and ITT [ITT] are companies with a number of different divisions that are critical to some of the fastest-growing areas, whether it's helicopters for offshore oil platforms or water-treatment systems, and the growth in them will offset any slowdown here.
Have you done your annual portfolio reviews and come up with a 2008 outlook?
Yes. We just finished it. Our operative scenario is that there is a 55% probability that the reflating of global rates serves as a catalyst for lower liquidity, slower growth, and an increase in risk premiums. U.S. growth slows from 2007's pace and continues below its potential through 2008, thereby elevating pressure on resource utilization rates and allowing inflation to continue to recede. Housing remains a headwind for the domestic economy but does not cause a recession, and excess inventory is slowly reduced. Unemployment drifts higher as firms focus on reducing costs. Capex [capital expenditures] remains a source of strength. The Fed cuts rates to 4½%. In that scenario, we get a market that is 15%-18% undervalued.
We don't do this exercise to be right; we do it to assess risk. There is a 25% probability, we call it our gloom-and-doom scenario, that losses from housing and real estate accelerate, putting additional pressure on the U.S. economy and the global financial system. The U.S. enters a recession as job losses surge, resulting in massive credit losses in all consumer-related areas. All lending is sharply curtailed as financial institutions struggle with impaired balance sheets. The global economy slows sharply as exports to the U.S. fall and foreign investors realize significant losses on U.S. investments.
In this scenario, the Fed aggressively cuts rates to 1½% on the Fed-funds rate and 3% on the 30-year. There is a collapse in commodity prices. In that environment, our highest investment return would obviously be in long bonds, where we would see a 30%-plus return in contrast to a negative 18%-to-22% one-year return in the equity market.
Any other scenarios in between?
There is a 15% probability -- and two weeks ago it was the prevailing notion -- that despite domestic troubles, demand would remain the same outside and exports would be strong. A weaker dollar results in significantly higher import prices, which along with persistently high commodity prices pushes inflation higher. So we have high interest rates, Fed funds are high, inflation is high, but materials still continue to do well.
What's the best-case scenario?
We have a 5% probability that everything is just wonderful. Somebody always has to remind us this is a possibility. But in that scenario, interest rates move up very sharply and Fed funds have to be moved up to 7%, because we never slowed down, and the return on stocks is zero to 5% because we assume a contraction in the P/E because of interest rates and inflation.
Some kind of wonderful. Thanks, Susan.
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