From BARRON'S
By Sandra Ward
Interview with David Richards
Private Investor
Of all the people we interview, David Richards strikes the deepest chord with readers. His interviews seem to be the ones that get tacked to walls or saved in a desk drawer, treasures of insight and wisdom. People who have benefited from his calls on gold (2002) and energy (2004) or just plain enjoy hearing a smart man put the global economy in perspective ring us asking whether we plan to talk to him again. His time running public money at two respected firms, PrimecapManagement and Capital Research & Management, may be over, but he still puts in long days of research and travel, particularly as a member of the Rand Corporation's Center for Middle East Public Policy advisory board. During a conversation in his Maine barn looking out to the Deer Isle Thorofare near Penobscot Bay and beyond, we found him most bullish, excited by the cheap valuations on many big-cap U.S. stocks with extensive international operations.
Barron's: What was your impression of the recent market rout?
Richards: It was a mini-panic. But I don't think it is anything very serious, and we can expect several of these over the next couple of years because so much leverage and credit has been so available, and some people are overextended. The spreads have gone from being ridiculous at 2 1/2% on high-yield debt to maybe 4 1/2% or 5%, and those are more normal spreads. What was screwy was the narrowness.
Q: Why don't you treat the selloff as something more serious?
A: My position has changed enormously from what it was last summer. For the first time since I first talked to you back in 2000, I have no shorts. I believe the growth potential of the international economy and the potential for higher rates of inflation are not fully appreciated in the current valuations of stocks and bonds. I am attracted especially to the big international stocks that have pristine balance sheets and generate cash, that are buying back their own stocks and will benefit from the global boom.
Q: The global boom has been in place for some time, so what's changed your mind?
A: But the attitude toward the boom has been -- and it gets repeated over and over -- that we are in a bubble economy, we are in a bubble in commodities, we are in a bubble in real estate. What gets overlooked are two major developments that have occurred in the last 10 to 15 years, but really got going in the last five or six years: One, the whole world has adopted the notion that market- and economy-oriented policies are correct. In other words, there is a theology of capitalism that is sweeping the world, to borrow a phrase from British historian Eric Hobsbawm. There are 3.5 billion people from Eastern Europe to the Pacific and from the Indian Ocean to the Arctic that were living under socialism or communism, where it was not possible to trade and not possible for entrepreneurs to get rich -- and they have been transformed.
This has to be thought of in terms of the kind of 20-, 30-, 40-year growth we saw during the Industrial Revolution in the 19th century, when peasant societies would become industrial societies within 50 years. Urbanization is happening all over the world, and there is no way to stop it, unless people lose faith in this new theology of capitalism.
Q: And the other development?
A: There has been a total collapse in the cost of communication and computation. Time and distance in communication have been eliminated through the Internet and fiberoptics. Communication is instantaneous and virtually costless, and, as a result, you can run businesses all over the world from a headquarters positioned anywhere in the globe.
This, together with the first point, means the whole global economy has to be transformed. There are huge incentives to do it, but there is also a necessity to do it. This gives huge advantage to big international companies or even small ones that have an international point of view. These big developments are happening totally outside the financial markets. They have nothing to do with derivatives, nothing to do with home-equity loans and nothing to do with private equity or hedge funds.
Q: Yet the financial markets have been reeling from concerns about derivatives and hedge-fund failures related to the U.S. mortgage market.
A: The logic says subprime goes down so consumer spending goes down; house prices aren't going to go up and so you can't borrow more against your house, therefore consumption in the U.S. is going to go down or slow down, and it is going to affect the rest of the world. That's wrong. The U.S. at most is 25% of the global economy. The housing area at the peak was about 6% of U.S. gross domestic product. It can drop by half. It is insignificant in terms of the global growth of the economy.
It doesn't mean that some guys aren't going to go broke in the financial markets. The subprime lenders that gave these no-doc, no-money-down loans were stupid, and they are getting clocked and they will continue to.
The BRIC countries, Brazil, Russia, India and China, are somewhere between 17% and 20% of global GDP. There is a bunch of smaller countries -- Estonia, Turkey and Bulgaria and many, many more -- growing 5%, 6%, 7% a year. All the headlines are about China growing at 10% and India at 8% or 9%, but the rest of the developing world is growing at somewhere between 6% and 8% a year and might be 40% of the global GDP. There's 2 1/2% growth in the global economy coming from these areas and another 2% or 3% from the developed world for a global economy growing at 4 1/2% to 5 1/2% the last several years. Compound that 4 1/2% to 5 1/2%, and you have got a hell of a strain on all resources, whether it's energy or metals. That's why the prices of these commodities are going up, and it is a real boom.
Until this market breakdown recently, the big oil companies, and the BHP Billitons [ticker: BHP] and the Caterpillars [CAT] of the world -- all beneficiaries of the capital-spending boom that is under-way -- saw their stocks begin to go up again. This is signaling the beginning of a really rapid expansion of capital spending all over the world, a really big boom, whether it is for energy, roads or infrastructure, and that is only possible when people have confidence that the prices of these commodities that have gone up so much are not bubbles.
Q: How are you playing this global boom?
A: General Electric [GE] is now my second largest holding after Microsoft [MSFT]. I bought it in February when I decided to diversify my holdings from just oil and gold and Microsoft and Berkshire Hathaway [BRKA]. GE was selling at $34-$35 a share. It is a question of valuation and it is a question of international exposure and it is a question of a strong financial balance sheet. It is also a question of Immelt [CEO Jeffrey Immelt]. I like Immelt. He has had about five years to clean up what he inherited. If he is not there, he is almost there. The earnings for '08 are going to be around $2.50 a share, and I bought the stock at 14 times earnings with a 3% yield. It now trades at 16 times. Given my outlook for the global economy, for a company of that quality with its participation in aircraft and locomotives and power plants and international finance, what is the risk at 16 times earnings?
I also like Coca-Cola [KO], PepsiCo [PEP], Johnson & Johnson [JNJ] and Eli Lilly [LLY]. The natural buyers of these big companies, the big pension funds, have abandoned them in favor of hedge funds, private equity, international investment and bond arbitrage. These companies are selling at 15 times earnings when they used to sell at 25-30 times earnings.
With Coca-Cola, the amount of its earnings that are coming out of the U.S. are between 25% and 30% and its unit case volume growth around the world is often in double digits. Bottled drinks in many parts of the world are growing rapidly and are considered luxury items. If you are worried about clean water in the world, Coke and Pepsi deliver clean water and their business is getting bigger. They probably can grow at 10% or 11%, maybe even 12%, in earnings. You can buy these companies at P/Es that you haven't seen for years and at prices that probably existed back in 1998-'99. At these levels, they make very good long-term investments. They are not going to make you rich, but they are going to go up and they are going to go up more than the returns you can get anywhere else.
Q: What will make people rich?
A: The markets are not so cheap that you can expect big, big gains.
Q: Are you concerned about inflation?
A: I'm still concerned about inflation. Interest rates are not high enough. The inflation is coming from the big commodities boom, and it is coming because the Chinese are experiencing some inflation and the pressure is on them to revalue. The yuan has been going up at 4 1/2%-5% annually. I think the rate of revaluation will go to 7% or 8% annually. Prices of goods out of China are going to go up, and so China is not going to be a source of deflation as it has been in the world economy. It will modestly add to inflation. You will see rising consumption out of China.
Q: How is rising inflation beneficial?
A: American consumers are going to be under pressure in real terms to keep their spending up. I don't want to be in domestic retailers, for example, or something connected with housing or most all of the financial companies because they have been lending money to the American consumer one way or another, be it for mortgages or car loans. But for Caterpillar or Boeing [BA] or Coca Cola, big companies with international exposure, it is a plus. The growth rates of the portions of their business that are international are not fully appreciated.
The other angle to these big companies is that the pension funds that abandoned them for alternative investments are likely to be disappointed. The private-equity players such as Blackstone Group [BX] and KKR are now very, very big. They have become conglomerates. They are operating companies and in a sense they are like General Electric. But there are a couple of important differences. One is they are run by financial types who like to manage money and not people. Second, they are owned by people who are now extraordinarily rich and who have to hire managers to run these companies. They have to poach people out of General Electric, for example, and they have to incentivize them. The costs of doing that are high. The cost of credit going up is going to limit their growth, but the operational side of it is going to be increasingly a problem and then later on they have got to sell the stuff they've bought. I don't think the returns are going to be that attractive.
If you look at them as big conglomerates leveraged, say, three or four or five to one, you could buy a General Electric on margin and get a similar kind of a conglomerate without the same risk and a hell of a lot more liquidity. Pension funds say it's too risky to buy stuff on margin, yet they'll give money to KKR and Blackstone and those guys will leverage it to the moon.
Q: Do high oil prices throw off global growth?
A: No. Remember, oil is still under the $100 a barrel that you saw 25-odd years ago. The economy is much bigger and oil as a percent of the economy is much smaller.
Q: What oil companies do you like at this point?
A: The two biggest are ConocoPhillips [COP] and BP. BP is attractive because it has lagged so much. ExxonMobil [XOM] and Chevron [CVX] are up 50% to 60% in the last few years and BP [BP] is up 5% or 10%. It used to sell along with the rest of them.
Q: What about the meltdown in the subprime-mortgage market? Can that derail global markets?
A: The argument that credit risk is dispersed is true. The troubles that you will see and have seen in the papers with Bear Stearns and Sowood Capital Management, the hedge fund whose credit portfolio was taken over by Citadel Investment after the fund suffered heavy losses, are severe for those entities. They were very highly leveraged and got caught when credit spreads widened. There is no serious vulnerability to underlying asset prices yet. It is not as if there's been a total collapse. This is not a depression. To have a systemic problem there has to be a collapse in the price structure of the economy, yet oil is $77 a barrel, copper is $3.50 a pound, corn is $3.40 a bushel and last summer it was $2.50. The list goes on.
Q: Thanks, David.
---
For Barron's subscription information call 1-888-BARRONS ext. 685 or inquire online at http://www.barronsmag.com/subscription/subscription.html.
Of all the people we interview, David Richards strikes the deepest chord with readers. His interviews seem to be the ones that get tacked to walls or saved in a desk drawer, treasures of insight and wisdom. People who have benefited from his calls on gold (2002) and energy (2004) or just plain enjoy hearing a smart man put the global economy in perspective ring us asking whether we plan to talk to him again. His time running public money at two respected firms, PrimecapManagement and Capital Research & Management, may be over, but he still puts in long days of research and travel, particularly as a member of the Rand Corporation's Center for Middle East Public Policy advisory board. During a conversation in his Maine barn looking out to the Deer Isle Thorofare near Penobscot Bay and beyond, we found him most bullish, excited by the cheap valuations on many big-cap U.S. stocks with extensive international operations.
Barron's: What was your impression of the recent market rout?
Richards: It was a mini-panic. But I don't think it is anything very serious, and we can expect several of these over the next couple of years because so much leverage and credit has been so available, and some people are overextended. The spreads have gone from being ridiculous at 2 1/2% on high-yield debt to maybe 4 1/2% or 5%, and those are more normal spreads. What was screwy was the narrowness.
Q: Why don't you treat the selloff as something more serious?
A: My position has changed enormously from what it was last summer. For the first time since I first talked to you back in 2000, I have no shorts. I believe the growth potential of the international economy and the potential for higher rates of inflation are not fully appreciated in the current valuations of stocks and bonds. I am attracted especially to the big international stocks that have pristine balance sheets and generate cash, that are buying back their own stocks and will benefit from the global boom.
Q: The global boom has been in place for some time, so what's changed your mind?
A: But the attitude toward the boom has been -- and it gets repeated over and over -- that we are in a bubble economy, we are in a bubble in commodities, we are in a bubble in real estate. What gets overlooked are two major developments that have occurred in the last 10 to 15 years, but really got going in the last five or six years: One, the whole world has adopted the notion that market- and economy-oriented policies are correct. In other words, there is a theology of capitalism that is sweeping the world, to borrow a phrase from British historian Eric Hobsbawm. There are 3.5 billion people from Eastern Europe to the Pacific and from the Indian Ocean to the Arctic that were living under socialism or communism, where it was not possible to trade and not possible for entrepreneurs to get rich -- and they have been transformed.
This has to be thought of in terms of the kind of 20-, 30-, 40-year growth we saw during the Industrial Revolution in the 19th century, when peasant societies would become industrial societies within 50 years. Urbanization is happening all over the world, and there is no way to stop it, unless people lose faith in this new theology of capitalism.
Q: And the other development?
A: There has been a total collapse in the cost of communication and computation. Time and distance in communication have been eliminated through the Internet and fiberoptics. Communication is instantaneous and virtually costless, and, as a result, you can run businesses all over the world from a headquarters positioned anywhere in the globe.
This, together with the first point, means the whole global economy has to be transformed. There are huge incentives to do it, but there is also a necessity to do it. This gives huge advantage to big international companies or even small ones that have an international point of view. These big developments are happening totally outside the financial markets. They have nothing to do with derivatives, nothing to do with home-equity loans and nothing to do with private equity or hedge funds.
Q: Yet the financial markets have been reeling from concerns about derivatives and hedge-fund failures related to the U.S. mortgage market.
A: The logic says subprime goes down so consumer spending goes down; house prices aren't going to go up and so you can't borrow more against your house, therefore consumption in the U.S. is going to go down or slow down, and it is going to affect the rest of the world. That's wrong. The U.S. at most is 25% of the global economy. The housing area at the peak was about 6% of U.S. gross domestic product. It can drop by half. It is insignificant in terms of the global growth of the economy.
It doesn't mean that some guys aren't going to go broke in the financial markets. The subprime lenders that gave these no-doc, no-money-down loans were stupid, and they are getting clocked and they will continue to.
The BRIC countries, Brazil, Russia, India and China, are somewhere between 17% and 20% of global GDP. There is a bunch of smaller countries -- Estonia, Turkey and Bulgaria and many, many more -- growing 5%, 6%, 7% a year. All the headlines are about China growing at 10% and India at 8% or 9%, but the rest of the developing world is growing at somewhere between 6% and 8% a year and might be 40% of the global GDP. There's 2 1/2% growth in the global economy coming from these areas and another 2% or 3% from the developed world for a global economy growing at 4 1/2% to 5 1/2% the last several years. Compound that 4 1/2% to 5 1/2%, and you have got a hell of a strain on all resources, whether it's energy or metals. That's why the prices of these commodities are going up, and it is a real boom.
Until this market breakdown recently, the big oil companies, and the BHP Billitons [ticker: BHP] and the Caterpillars [CAT] of the world -- all beneficiaries of the capital-spending boom that is under-way -- saw their stocks begin to go up again. This is signaling the beginning of a really rapid expansion of capital spending all over the world, a really big boom, whether it is for energy, roads or infrastructure, and that is only possible when people have confidence that the prices of these commodities that have gone up so much are not bubbles.
Q: How are you playing this global boom?
A: General Electric [GE] is now my second largest holding after Microsoft [MSFT]. I bought it in February when I decided to diversify my holdings from just oil and gold and Microsoft and Berkshire Hathaway [BRKA]. GE was selling at $34-$35 a share. It is a question of valuation and it is a question of international exposure and it is a question of a strong financial balance sheet. It is also a question of Immelt [CEO Jeffrey Immelt]. I like Immelt. He has had about five years to clean up what he inherited. If he is not there, he is almost there. The earnings for '08 are going to be around $2.50 a share, and I bought the stock at 14 times earnings with a 3% yield. It now trades at 16 times. Given my outlook for the global economy, for a company of that quality with its participation in aircraft and locomotives and power plants and international finance, what is the risk at 16 times earnings?
I also like Coca-Cola [KO], PepsiCo [PEP], Johnson & Johnson [JNJ] and Eli Lilly [LLY]. The natural buyers of these big companies, the big pension funds, have abandoned them in favor of hedge funds, private equity, international investment and bond arbitrage. These companies are selling at 15 times earnings when they used to sell at 25-30 times earnings.
With Coca-Cola, the amount of its earnings that are coming out of the U.S. are between 25% and 30% and its unit case volume growth around the world is often in double digits. Bottled drinks in many parts of the world are growing rapidly and are considered luxury items. If you are worried about clean water in the world, Coke and Pepsi deliver clean water and their business is getting bigger. They probably can grow at 10% or 11%, maybe even 12%, in earnings. You can buy these companies at P/Es that you haven't seen for years and at prices that probably existed back in 1998-'99. At these levels, they make very good long-term investments. They are not going to make you rich, but they are going to go up and they are going to go up more than the returns you can get anywhere else.
Q: What will make people rich?
A: The markets are not so cheap that you can expect big, big gains.
Q: Are you concerned about inflation?
A: I'm still concerned about inflation. Interest rates are not high enough. The inflation is coming from the big commodities boom, and it is coming because the Chinese are experiencing some inflation and the pressure is on them to revalue. The yuan has been going up at 4 1/2%-5% annually. I think the rate of revaluation will go to 7% or 8% annually. Prices of goods out of China are going to go up, and so China is not going to be a source of deflation as it has been in the world economy. It will modestly add to inflation. You will see rising consumption out of China.
Q: How is rising inflation beneficial?
A: American consumers are going to be under pressure in real terms to keep their spending up. I don't want to be in domestic retailers, for example, or something connected with housing or most all of the financial companies because they have been lending money to the American consumer one way or another, be it for mortgages or car loans. But for Caterpillar or Boeing [BA] or Coca Cola, big companies with international exposure, it is a plus. The growth rates of the portions of their business that are international are not fully appreciated.
The other angle to these big companies is that the pension funds that abandoned them for alternative investments are likely to be disappointed. The private-equity players such as Blackstone Group [BX] and KKR are now very, very big. They have become conglomerates. They are operating companies and in a sense they are like General Electric. But there are a couple of important differences. One is they are run by financial types who like to manage money and not people. Second, they are owned by people who are now extraordinarily rich and who have to hire managers to run these companies. They have to poach people out of General Electric, for example, and they have to incentivize them. The costs of doing that are high. The cost of credit going up is going to limit their growth, but the operational side of it is going to be increasingly a problem and then later on they have got to sell the stuff they've bought. I don't think the returns are going to be that attractive.
If you look at them as big conglomerates leveraged, say, three or four or five to one, you could buy a General Electric on margin and get a similar kind of a conglomerate without the same risk and a hell of a lot more liquidity. Pension funds say it's too risky to buy stuff on margin, yet they'll give money to KKR and Blackstone and those guys will leverage it to the moon.
Q: Do high oil prices throw off global growth?
A: No. Remember, oil is still under the $100 a barrel that you saw 25-odd years ago. The economy is much bigger and oil as a percent of the economy is much smaller.
Q: What oil companies do you like at this point?
A: The two biggest are ConocoPhillips [COP] and BP. BP is attractive because it has lagged so much. ExxonMobil [XOM] and Chevron [CVX] are up 50% to 60% in the last few years and BP [BP] is up 5% or 10%. It used to sell along with the rest of them.
Q: What about the meltdown in the subprime-mortgage market? Can that derail global markets?
A: The argument that credit risk is dispersed is true. The troubles that you will see and have seen in the papers with Bear Stearns and Sowood Capital Management, the hedge fund whose credit portfolio was taken over by Citadel Investment after the fund suffered heavy losses, are severe for those entities. They were very highly leveraged and got caught when credit spreads widened. There is no serious vulnerability to underlying asset prices yet. It is not as if there's been a total collapse. This is not a depression. To have a systemic problem there has to be a collapse in the price structure of the economy, yet oil is $77 a barrel, copper is $3.50 a pound, corn is $3.40 a bushel and last summer it was $2.50. The list goes on.
Q: Thanks, David.
---
For Barron's subscription information call 1-888-BARRONS ext. 685 or inquire online at http://www.barronsmag.com/subscription/subscription.html.
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