PATIENCE AND POTHOLE AVOIDANCE ARE the secrets of the $14.5 billion Julius Baer International Equity Fund. That, at least, is in the humble opinion of Riad, who manages a total of $27 billion in international equities, with colleague Richard Pell. The two celebrated their 10th anniversary as an investment team in April, at which time the fund was deemed best in class by Lipper Analytical Services during that span. We would venture that some measure of smarts and savvy stock selection, not to mention a dose of contrarianism, might also have something to do with the stellar performance. Though closed to new investors, the fund (ticker: BJBIX) is up 14.2% annually in the 10-year period ending July, 4.82% for the five years, 20.17% in the three years and 6.61% this year, through Wednesday. Riad's latest thinking follows.
Barron's: What's your take on the economy and your outlook for investing? Younes: Two years ago, we were concerned about global imbalances and at the time we were in the minority and now it's the consensus. The difficult question is what will happen next.
But is the economy holding up more strongly than you thought it would? Definitely. We are still in a virtuous cycle. House prices are up even more this year, despite Federal Reserve Chairman Alan Greenspan's concern about froth. The froth is getting frothier. The current-account deficit is at a record level and getting worse. We are making new lows on long bond yields. To borrow an expression from the Fed, we are entering another hard patch. Look at reported earnings. Third-quarter reported earnings in the U.S., with about 75% of companies reporting as of July 29, were up almost 27%, annualized year-over-year. That is huge, and from a very high level. Before the third quarter, earnings were 50% above mid-cycle earnings. The government is still trying to lower taxes. We are still providing stimulus. It is very difficult to tell how big the bubble will get and when it will burst. When you have very easy monetary policies, the bubble will appear in different places, depending where the money is. Now it seems to be in house prices.
What will happen to the bubbles when the Fed starts to raise rates further also depends on the long bond. The real puzzle for the economy is not the fed-funds rate, but the 10- and 30-year bonds, mostly the 10-year, because the Fed is pressing on the brakes by raising short-term rates, yet the market is pressing on the accelerator by lowering 10-year yields. In the U.K. and Australia, real estate has stabilized at a very high level, but that's created a weakness in the economy and now there are talks about the Bank of England having to cut rates very soon. [The U.K. central bank lowered its short-term target rate to 4.5% from 4.75% Thursday.] But home prices haven't collapsed because the long bond hasn't collapsed. The U.K. and Australia represent smaller economies. The world's two major economies, the U.S. and China, are basically running on all cylinders. The question is: When do the big economies slow down?
What are your thoughts on China? All the overinvestment is going to lead to deflation in that economy.
What about the revaluation of the renminbi? It was 2%. It was a small step, a small gesture. On a non-news day, the yen and the euro move 2%. So it is nothing. Given the wage gap that exists between the U.S. and China, it is nothing. From a debt perspective, it is detrimental to the Chinese economy because suddenly every corporation in China that is highly leveraged will suddenly see their debt go up 30%-40% if their currency goes up 30%-40%. But more and more of the adjustment will fall upon us, because China is too powerful a force. We can't go to war with them. We can try global protectionism, but that will hurt us. That's why we're seeing a fight break out between Greenspan and the market.
The market? In the past six months, Greenspan has been jawboning the market to raise the long-bond rate higher and yet the market hasn't budged. That means he has to raise short-term rates higher. The Fed will be forced to fight the market, realizing how dangerous the situation is, and very likely short rates will go higher than the fed-fund futures are predicting.
Then we end up with an inverted yield curve? It is likely. And the likely outcome is that we will have to resort to a devaluation of our currency. And that's what we've been doing every time we get into a problem. The dollar is a problem because no one's getting paid for owning the dollar. People are going after real assets. The CRB [Commodities Research Bureau] Index is up about 10% this year, and that reflects the flight from the dollar. This high home-price inflation is a flight from dollars. But if the Fed raises the interest rate closer to nominal GDP (gross domestic product growth), people will suddenly respect the dollar. The problem is getting bigger as the cycle gets longer because the global economy has doubled. Before it was Western Europe, the U.S. and Japan. Now the global economy includes Eastern Europe, Russia, China, India and parts of the Middle East. The global economy is bigger; therefore, it is taking longer and longer for things to adjust. Plus capital is moving more freely, and it is taking longer to see the consequences of our actions.
What has this meant for your investing? It is always about dogmatism versus pragmatism. We are convinced the imbalances put us in dangerous territory.
Only when you see the imbalances being addressed, which means you will see house prices stabilize or the current-account deficit decrease a bit, will you start to see cracks in the economy and it will pay to be dogmatic. But as long as we are in the midst of this virtuous cycle, it is prudent to be patient. We are trying to avoid the areas that have benefited the most from these imbalances, the Anglo-Saxon economies and the highly cyclical sectors in Asia. We are looking at markets that have faced very bad economic conditions, such as Italy or France, or even Scandinavia, plus we are looking at special situations such as the emergence of central Europe and Turkey.
What are you investing in these days? Much of our success in the 10 years we've been operating has more to do with avoiding potholes than finding the next Microsoft. Right now, we don't like the Anglo-Saxon economies because these are the ones that have the most imbalances. When it is time to pay, these are the ones that will pay the highest price.
That would include which countries exactly? The U.K., the U.S. and Australia are the main culprits.
But Australia is a commodities producer and you like commodities. Yes, but the Australian consumer has been overindulging like crazy. There is a reason why they are doing well, but there is also an overextension in that economy as well. Don't forget, if the U.S. slows down, although we like commodities, we may get a cyclical downturn in commodities within a structural bull market. We also don't like technology.
Why? There are three reasons: valuation, valuation and valuation. The catalyst for me is expensing stock options. If it were to pass by the end of this year I would be much more courageous to be very severely underweight the sector. But there is now a bit of danger that the stock- option law will be extremely diluted thanks to Cisco Systems [CSCO] and some Wall Street firms aiming to put one over on the Securities and Exchange Commission. They are arguing that stock options shouldn't be valued as they would in the open market because there are restrictions on the receiver that decrease the value. They are switching the debate from the cost of the gift to the donor to the value of the gift to the receiver.
Also, technology companies are cyclical companies and the technology firms that are growing are in Asia as opposed to here. This is another problem with the U.S. business model. The way U.S. technology companies have been growing is by using other countries' savings and other countries' children. Bill Gates appears before Congress and says only 4% of U.S. children study math and physics and therefore we cannot support technology unless we get more people from abroad. It will be more and more difficult to attract foreign workers as they will be able to find jobs in their own countries which are becoming more and more developed.
What do you like? Sectors that are not threatened by global trade, which is going to be in a deflationary environment. Sectors that are service based or local.
Local? Banking. Hospitals. And we are looking at parts of the world that haven't participated in the imbalances. That includes many parts of Europe because Europe has gone through a big economic malaise in the past 10 years. Then there are regions going through a once-in-a-life time shift. Eastern and central Europe are in the first inning of a convergence. There is the potential of Russia and Turkey. Countries like Italy and Germany have been in a recession and in malaise for many, many years. These are the regions that when the imbalances unfold will pay the least price because they have consumed the least.
We are very bullish on commodities, but we are not overly leveraged. We are slightly overweight because we are concerned about the number of hedge funds and hot money leveraged in the commodity sector. Also, when the imbalances of the world get adjusted we are going to see a correction in that sector. But our longer view is commodities are in another big cycle. The one commodity we are most interested in is oil. In the next 12 months either we could reach peak oil production or that oil production increases less than demand increases. If we see a flattening or a decline in production we are in big trouble.
What's an example of something you like? We have a lot of oil and gas companies in our portfolio from all different regions. One of the most interesting stories would be Gazprom. For fun, we put the same multiple of enterprise value to barrel-of-oil equivalent on Gazprom as we have on the average major oil company. We got a value of almost $1.4 trillion. Of course, there are a lot of reasons to justify a much lower valuation. But still it shows the potential upside, purely from an asset-base perspective.
How about some more picks? I have what I call "The revenge of the French." Three French stocks I'd recommend are Lafarge, a cement company; Pernod-Ricard, because we love the spirits industry; and the other is Generale de Sante, a private hospital in France.
Why the cement company? Global growth? There is consolidation. There is disciplined pricing. Only four or five players control the whole market. There is cost-cutting. Very nice returns. Global infrastructure spending, especially in the emerging markets. This is a company that uses excess cash flow to invest more and more in emerging markets.
And Pernod? There are very few spirits players, say three or four in the world. With the recent merger of Pernod with Allied Domecq, we're heading toward a duopoly. Pernod-Ricard will be No. 1 or 2 in any region of the world. There are high barriers to entry because of the expense of building a distribution network and high marketing expenses. It is benefiting from demographics because as people age, they switch from beer to hard liquor. Hard liquor also has luxury-goods appeal, and sales growth is booming in Asia and the emerging markets. Pernod has the highest percentage of its sales in emerging markets. It is one of the fastest-growing stocks in the sector. The deal with Allied Domecq will be very accretive, and the synergies will be high. It trades at a P/E of about 15.5 times conservative estimates, and it is growing earnings by 20%.
And Generale de Sante? The private hospital sector is benefiting because the government is privatizing more and more and outsourcing hospital care. The private sector is usually more efficient than the public sector. And you have a very fragmented sector -- private hospitals' share is very small, and so there are a lot of opportunities to grow organically and gain market share through acquisitions of government- sponsored companies. There will be growth in pricing. Private hospitals' government reimbursement is almost 30%-40% less on many treatments than the public sector. The government plans to converge prices by 2012. As Generale de Sante made a lot of acquisitions to get to a 12% market share, it has been a bit negligent on the cost side. It recently initiated a cost-cutting program.
Finally, France enacted a tax law that creates a window for the company to sell its real-estate property and lease it back and avoid a lot of capital gains tax. It can then use those proceeds to releverage the balance sheet and acquire even more companies. We think the company could easily increase its sales by 50% from those proceeds. It is valued at about a 25%-to-30% discount to its competitors in the region. It has a P/E of 15 times earnings and an enterprise value [equity plus net debt] to sales ratio of 0.8. It trades at 6 times enterprise value to Ebitda [earnings before income, taxes, depreciation and amortization] and has a dividend yield of about 3½%. In two-to-three years, this stock could double easily if they do well, especially on the cost side.
What else do you like? Italian banks. There is a low penetration of credit in Italy. Consumer credit as a percentage of GDP based on 2003 data was 2.5% in Italy, versus, say, 11% in the U.K. Residential mortgages is about 11% of GDP in Italy versus 55% in the U.K. In time, there is much more growth potential in Italy than in some of the Anglo-Saxon economies. Cyclically, Italy has been in a very tough economy and there is a lot of pent-up demand. Nobody has been borrowing. Once there is improvement, we will see some cyclical pickup.
There is also cost-cutting potential as the cost of operating as a percentage of assets in Italy is very high, relative to other European banking markets. There is also a very strong possibility of increased consolidation in the market because the central bank governor is in trouble and might be forced to resign and he has been the most vocal opponent of Western banks to acquire Italian targets.
How about a couple of names? Our two favorites are Capitalia and Banca Popolare di Milano. Both are trading at about 1.4 times book and almost 13 times P/E.
Anything else? In the emerging markets, we like PKO Bank Polski. It is Polish. It was privatized at the end of last year. It is the No. 1 bank in Poland and the only one with a nationwide presence and one of the two remaining independent banks in the region. It has a monopoly on savings deposits and so it is very dominant in retail banking, which is the more interesting and profitable part of banking today. They have a 23% market share in deposits and almost a 15% market share in branches. The bank has very low funding costs, with almost 80% of its funding from deposits. It has the highest return equity among Polish banks. It has a very strong franchise and can leverage off its huge customer base by going into mortgages and consumer credit.
The weakness that could be turned into strength is its very high cost-to-income ratio because it is still majority owned by the government. But it also has one of the highest return-on-equity ratios in the business. That tells you the potential for profitability is really high at this bank. The valuation is not dirt cheap, but it is attractive, given the growth potential. It is trading at about three times book, its P/E is about 16.5 times earnings and its dividend yield is around 5%. The government still owns about 62.3% of the company. So, if Poland gets more confidence in itself and allows foreign banks to take a stake in the bank, it could do even better.
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