Tag: episode-1112


September 12, 2014

With the stock market trading near record highs should investors adjust their portfolios? David Darst and Jay Kaplan say yes! Darst is an independent investment consultant and Senior Advisor and member of the Global Investment Committee at Morgan Stanley. He is also the author of 11 books, including two on mastering the art of asset allocation. Kaplan is portfolio manager of several funds run by small cap pioneer, The Royce Funds, which is known for its value orientation and high quality company focus. We’ll get their personal perspectives on market valuations.

This week on WealthTrack, what do high altitude markets mean for portfolio selection? Asset allocation master David Darst and small cap fund champion Jay Kaplan discuss the routes they are taking to stay at peak performance in pricey markets. They are next on Consuelo Mack WealthTrack. Hello and welcome to this edition of WealthTrack, I’m Consuelo Mack.

We don’t pay too much attention to daily, weekly or even monthly moves in the markets on WealthTrack. As JP Morgan once quipped “the market will fluctuate!” And so it does and will. We do however look at longer term data to determine how expensive or cheap stock prices are and one of the best guages that we have seen is the creation of Nobel Prize winning economist Robert Shiller and a colleague, John Campbell. As WealthTrack viewers know, Shiller, a frequent WealthTrack guest is a professor of economics at Yale, while Campbell teaches at Harvard. More than 25 years ago they collaborated and created what they called the “Cyclically Adjusted Price- Earnings Ratio, or CAPE Ratio. What the CAPE Ratio does is divide the current price of the market by inflation adjusted corporate earnings averaged over the prior 10 years instead of the traditional P/E where the denominator is current earnings. According to Shiller the ten year history helps “minimize effects of business-cycle fluctuations” and is “helpful in comparing valuations over long horizons. “ Over a year ago Shiller warned that the CAPE Ratio stood at around 23, far above its 20th century average of 15.21.

In a column in The New York Times last month Shiller noted that the cape was above 25, “a level that has been surpassed since 1881 in only three previous periods: the years clustered around 1929, 1999 and 2007. Major market drops followed those peaks.”

As Shiller was quick to point out the CAPE was never intended to indicate exactly when to buy and sell. It’s been a very imprecise timing indicator and in fact has been relatively high, above 20 for almost all of the last 20 years. But here’s the Shiller kicker, over the last century the CAPE has consistently reverted to its historical mean of around 15.

It fell as low as 13.2 in the midst of the financial crisis.

This week’s guests are more than aware of how expensive the markets have been and are adjusting accordingly.

David Darst is an independent investment consultant and senior advisor and member of the global investment committee at Morgan Stanley. For 17 years he was the Chief Investment Strategist of Morgan Stanley Wealth Management. He is also the author of 11 books including two on mastering the art of asset allocation. Jay Kaplan is a Portfolio Manager at small cap pioneer, The Royce Funds which is known for its value orientation and high quality company focus.

Kaplan manages several Royce funds including Royce Value, and he is a Portfolio Manager for Royce Total Return and Royce Dividend Value funds with small cap legend Chuck Royce as Lead Portfolio Manager.

I began the interview by asking Darst about his personal perspective on market valuations.

DAVID DARST: I think we’re relatively late in this party, this bull market phase. You’ve got several indicators of valuation which would tell me that this is not the … If a party goes from six o’clock until midnight, this is not seven or eight o’clock. This is more 10 o’clock-ish or even after that. You’ve got four big, long-term valuation indicators. One is you’ve talked about many times the Cyclically Adjusted Price Earnings Ratio which is the Professor Shiller ratio, it’s 50 percent higher than the normal, than the long-term average. Secondly, you have the market capitalization to GDP ratio. It is double the GDP of the United States right now. It has never been this high except three times before 1929, before 2000, the big crash then and in 2007 before the crash then. Price to sales is 1.67 times sales. The long-term average is half that. It is double the long-term average, price to sales. You can’t mess around with sales like you can with earnings and, finally, what’s it called? The Tobin ratio, the Q ratio which is price to replacement cost. It too is very elevated. So on a long- term basis, people talk about price the next 12 months, earnings. That’s fine. It’s in the zone, 15, 16 times earnings, but on a long-term basis, Consuelo, but the drivers of asset prices for thousands of years are fundamentals, valuation and psychology, and the time to really leave the party is when the psychology gets too ebullient and too optimistic. We’re not there yet. This valuation abnormality, this valuation anomaly can continue until people all get pulled into the party. Then it’s time to leave the party.

CONSUELO MACK: So you’re not seeing that yet.


CONSUELO MACK: Jay Kaplan, from your vantage point as a portfolio manager of small cap stocks, how do small cap valuations look?

JAY KAPLAN: Small cap markets? Pretty high. It’s gone almost straight up since the financial crisis of 2008, 2009. That’s a little bit dangerous, so when we think about …

CONSUELO MACK: A little bit dangerous.

JAY KAPLAN: Just a little bit dangerous. We think about the Russell 2000 and what constitutes that. There are close to 25 percent of the companies that don’t earn any money, and that makes the valuation look really extreme. So when people think about that market, there’s a lot of danger lurking within, things like biotech stocks and internet stocks and social media stocks. So I think care is warranted, and at Royce we think about how can we buy good companies and try and minimize any damage from a potential correction, but interest rates are zero, still close to zero, and earnings are growing. The economy is growing slowly. So as long as rates stay close to zero and the economy doesn’t go into a recession, the market can keep going up, but rates will start to go up one of these days as the economy gets better, and then we have to be kind of careful.

CONSUELO MACK: So, careful. So what does that mean as far as your investment strategy is concerned at Royce? What do you do in a situation where overall the market looks pretty pricey?

JAY KAPLAN: It does look pretty pricey, so we focus on what we think are quality companies with really strong financials, companies that earn great returns on capital, and we try to buy them cheap. The problem today is there’s not that much that’s cheap, so as a portfolio manager what we’ve done is focused on the highest quality companies and maybe we hold onto them a little longer than we might otherwise, and we’ll hold them at higher valuations than we might otherwise because the stocks that look really cheap today are really not great quality, and they deserve to be cheap. In a normal market, there are always bargains, companies that are mis-priced. The mis-pricings really aren’t there right now. So instead of digging down to buy cheap stuff that’s not of really good quality again, we will hold things and take valuation risk instead of taking business risk.

CONSUELO MACK: Right, and so valuation risk means that they might be expensive.

JAY KAPLAN: They might be.

CONSUELO MACK: You wouldn’t buy them at current levels, but you’re not willing to sell them.

JAY KAPLAN: Because if I sell them, what I would replace them with is probably of much lesser quality, and I’d rather hold on to businesses that are really good that I like.

CONSUELO MACK: Okay, so what do we do with our asset allocation? How do we adjust in a period where you’re seeing pretty high valuations?

DAVID DARST: Well, Consuelo, as Jay just mentioned this is a very low yield world, and so you want to basically be very selective in terms of the industry sectors you get exposed to. Master Limited Partnerships give you a yield right now of 5.15 percent. Okay? The telecom area is 4.3 percent yield. So even though some of these slow-growing telephone giants in the U.S. and in Canada will give you a nice yield, Europe, 3.8 percent yield.

CONSUELO MACK: So the European market, the MSCI or whatever Europe.

DAVID DARST: That’s right. The MSCI Europe. Then you’ve got the utility index and, again, you want to be selective as Jay was highlighting. You want to be selective. Get good quality utilities. You have the real estate …

CONSUELO MACK: You’re talking about looking for a deal.

DAVID DARST: This is within equity. This is getting yield within equity now, Consuelo. Finally, real estate investment trusts are giving you three and a half percent, and then listen to this. MSCI China index, and I like china. China is one of the premier emerging markets, very cheap valuation. Nobody likes China right now. China and then finally the utilities. You want to get some exposure there. So to me you have many opportunities within equities to get some yield. Now equities versus bonds versus cash, my thought would be to basically be very careful with the bonds, have short- maturity bonds. In high-yield area, have higher quality short-maturity bonds.

CONSUELO MACK: So higher quality in high-yield which are called junk.

DAVID DARST: B or double B or better on the rating but not C and D and some of the more speculative.

CONSUELO MACK: Why not? Why wouldn’t you go with…?

DAVID DARST: They are at all-time record high. It’s as if the Dow Jones which is somewhere in the neighborhood of 17,000 were above 25,000. The relative valuation compared to history of high- yield or junk bonds. High-yield is a euphemism for junk bonds, but they are not high-yield. They’re about 5.3 percent right now and the spread over Treasuries. John D. Rockefeller who lived for 99 years, he said that more money has been lost by people inappropriately stretching and looking for yield in the wrong places than in all the bank robberies in human recorded history.

CONSUELO MACK: (laughs) So I’m thinking, Jay, of what you just said, too, about the quality aspects of this, and so you would probably agree if you put a credit rating on stocks, you would agree don’t go for the lower-quality stocks because as you and Janet Yellon have said, they look pricey.

JAY KAPLAN: Oh, 100 percent absolutely. So for us in our dividend-focused portfolios like Royce Total Return and Royce Dividend Value, we’re not exactly looking for yield. We’re really looking for total return with a dividend. So …

CONSUELO MACK: And what’s the difference?

JAY KAPLAN: Oh, the difference is, well, we don’t do a lot of Master Limited Partnerships, and we don’t do a lot of REITs, and we don’t do a lot of utilities because those companies run with a lot of debt and heavily leveraged balance sheets in order to pay out their capital. MLPs pay out all of their income so they need the capital markets to grow, and when markets go down and capital markets seize up, they don’t do very well. They’re known as the bond proxies, a lot of those stocks, and if interest rates go up and the bond market takes a little bit of a hit, those stocks won’t do that well. So for us, we’re looking for the great businesses that generate free cash flow, can grow their earnings and compound wealth over time, run by people who are good capital allocators and are willing to return some of that capital to shareholders, some of that in the form of dividends. So we don’t really need a big dividend, but we’re looking for a dividend along with capital appreciation and wealth compounding.

CONSUELO MACK: Now one of the issues in this market since the 2009 bottom has that risk actually has really paid off, and so investors, David, have benefited by being in the below double B and below the single B ratings in junk. I mean, the high-yield risky assets have paid off as have a lot of in jay’s space as well, the lower quality companies, and so that’s been a real conundrum. We can say go for the higher quality but, in fact, you’ve lagged if you’ve gone for the higher quality in many cases.

DAVID DARST: We have had a repeal of the laws of Isaac Newton who lived in the 1700s. By that I mean we’ve learned as a catechism that risk is related to return. Right now there is extremely low-return things that are of extremely high risk, and we say to you and your viewers, be very, very careful and selective. If there’s one word that would maybe encapsulate both what Jay and I are saying, it is selectivity right now. This is not a time when you can work with a broad brush. You have to pay attention, and this is a time to drive with both hands on the steering wheel. This is not cruise control type investing.

CONSUELO MACK: So to my original question to you, David Darst, from an asset allocation point of view, not from an income point of view, from an asset allocation point of view, what do we do in a late-stage market like this? So is it that you just look for the yield vehicles that you were talking about?

DAVID DARST: That was only …

CONSUELO MACK: Or do you raise cash?

DAVID DARST: Great, great, Consuelo. Great.

CONSUELO MACK: What do I do in my stock portion of my portfolio? What do I do in my bond portion of my portfolio? What do I do in my alternative investment portion in a late cycle market like we’ve got across the board? Because all the markets are in late cycles.

DAVID DARST: I love coming on your show because it makes me feel like I’m being chased by a rottweiler, and I have a sausage in my pocket. Okay? And what I mean by that is I love the way you don’t let go, but that’s only within the equity piece. Cash? Don’t be afraid of having some cash. Warren Buffett has said many times that cash is like a call option on assets at lower prices. So don’t be so fearful. So many investors come and say, “I have 10 percent. I have 12 percent. I have 20 percent cash.” Stay with what you have and use that prices do correct when they do come off a little bit. That’s one. So don’t be …

CONSUELO MACK: So wouldn’t you raise more cash?

DAVID DARST: Don’t be an enemy of cash? I would not be raising cash here right now.

CONSUELO MACK: Really. Taking profits in some of these risk assets that we just talked about?

DAVID DARST: Rottweilers chasing me right now.

CONSUELO MACK: Right, exactly. Well, so?

DAVID DARST: Okay, now listen, listen. Okay, listen. The cash and the short-maturity bonds are there to basically deploy into good assets.

CONSUELO MACK: Okay, so those are the cash equivalents.

DAVID DARST: Now the raising of cash, I would not be doing that right now. I would basically use this time to reposition the portfolio from a quality standpoint. What you want to do from an asset allocation standpoint? Do have some bonds. Have some bonds. Keep them short maturity. Keep them high quality. You might want to have some high-yield bonds. Okay.

CONSUELO MACK: But again, you said the higher-quality high-yield bonds.

DAVID DARST: Higher-quality high-yield bonds. In alternatives, real estate investment trusts, you could have a little exposure to gold mining stocks that would be maybe a three or four percent position there. You want to have some Master Limited Partnerships, again, three, four percent, three, four percent in Real Estate Investment Trusts, and you might have some hedge strategies that do well when things go down. It’s not for all of your viewers. Within the stock space, you want to be also diversified geographically. You need some Japan exposure. They had a phenomenal year back in 2013, up 58 percent. So far in 2014 as of mid-September they’re about down eight, nine percent. They’re not doing anything, but they had such a big run, and we think we’re getting ready for another wave of structural reform that Shinzo Abe is driving.

CONSUELO MACK: Right, so it sounds like it’s very well-diversified but higher quality.

DAVID DARST: Well-diversified, higher quality, some equities, some bonds, some alternatives and some cash, those four.

CONSUELO MACK: So, but Jay Kaplan is small caps, and so you’re investing … I mean, one of the things at Royce is that you’re investing in businesses, and again you said it’s high-quality businesses and in your case as well that generate dividends. So give us some examples of the kinds of companies that you look for at Royce that fit that particular category.

JAY KAPLAN: One example would be Helmerich & Payne.


JAY KAPLAN: A driller, drilling rigs, the best rigs in the business. They have taken market share from their competitors for more than a decade now.

CONSUELO MACK: And that’s small-cap or mid-cap?

JAY KAPLAN: Well, we’ve owned it for a very long time, and we haven’t gotten rid of it. We still own it, so it started life very small. It’s about 10 billion now, so we could argue where that is, but it’s in the context of those businesses that we want to own for a very long period of time, very well managed, like I said, taking market share, generating cash. They’ve been raising their dividend the last couple of years as they’ve generated more and more cash as they’ve gotten more mature. So that’s one example of something we can own for a very long time and like to own. Another company would be a company in Canada of all places. I occasionally go north of the border, Genworth of Canada. They ensure mortgages in Canada. In the United States that was an absolutely terrible business, and those companies were dreadful. In Canada the rules are different. You’re personally liable for a mortgage in Canada. You can’t give the keys back. You can’t borrow as much as you can in the U.S., mortgages are of shorter term, and the company’s loss performance is very, very low. They generate lots of excess cash. They buy back stock. They have a bid yield. So those are examples of businesses that we can own for a long time, forgetting about the noise of Wall Street and stock markets, business owners.

CONSUELO MACK: A lot of people now in the search for income are looking for like the Dividend Aristocrats, for instance, and they’re looking for companies that have paid dividends for 10 or 20 some-odd years. Does that matter to you?

JAY KAPLAN: We don’t exactly look for that long-term pattern of dividends. We’re more interested in making sure that the company’s earn their dividends and are not at risk in cutting their dividends. So in small-caps a lot of the companies are cyclical, so the dividends can’t always go up every year because business conditions change, but we do want to make sure that the financially strong companies can pay their dividends. When we talk to managements a lot, I talk about dividends versus stock buybacks, and I talk about dividends like marriage and stock buybacks like dating. So a stock buyback you could turn on. You can turn off. You can date somebody else, but a dividend, it’s very hard to cut. It’s very hard to divorce yourself from dividends. So dividends are more like a marriage.

CONSUELO MACK: And David, where does small cap fit into your asset allocation mix?

DAVID DARST: Well, I think of U.S. equity, we favor right now, I favor large cap growth, then large cap value. We have a moderate allocation to mid-cap growth and mid-cap value as well as to small-cap growth and small-cap value. We are equal weight versus a long-term strategic weight. This translates into …

CONSUELO MACK: And you’re talking about Morgan Stanley’s asset allocation.

DAVID DARST: That’s right. Morgan Stanley’s asset allocation frameworks that I’m involved in helping to form and to craft.

CONSUELO MACK: Well, what about you personally?

DAVID DARST: I think you want to have good quality companies, this Helmerich & Payne idea that they bought when it was small and they’ve stayed with it. They know it. Buy great companies. Buffett said he’d much rather have a buffoon running a great company than a genius running Bethlehem steel. Okay? That’s been very hard with the global competition and all. I think you need to keep in mind, Consuelo; you need to keep in mind technology, globalization, and markets. What markets are they looking at? And I think that the small- and mid-cap companies, if they have and can create a global mindset, because this is where the middle class is going to emerge in these BRIC countries, Brazil, South Africa, Russia, Southeast Asia, Indonesia, Thailand, Malaysia. Myanmar’s got 60 million people. It’s amazing. Vietnam, Philippines has got more people than Germany does.

CONSUELO MACK: And so there are dividend producers, right, overseas.

JAY KAPLAN: In a lot of respects they’re bigger dividend producers because there’s a lot more family ownership and family control, and the families like to get a paycheck, so they pay dividends as well. So that’s a big part of our Dividend Value Fund.

CONSUELO MACK: So it’s time for the one investment for a long-term diversified portfolio. So Jay Kaplan, what would you have us all own in a long-term diversified portfolio?

JAY KAPLAN: I’ve got a favorite stock today. It’s called The Buckle. It’s a …

CONSUELO MACK: Which I’ve never heard of.

JAY KAPLAN: Right, because there’s no stores here in the New York metro area or in a lot of the cities on the coast. So you have to go into the Midwest. They’re headquartered in Kearney, Nebraska. They’re in malls. They sell $80 jeans in the mall whereas their competitors sell $29.99 jeans. The margins are very high. The customer service is wonderful, and it’s very closely held and well-run by a terrific team.

CONSUELO MACK: The Buckle, and Royce has owned it for a long time.

JAY KAPLAN: For a very long time. We’re a pretty large owner of The Buckle.

CONSUELO MACK: All right, so this is one of those businesses that you bought, you own at Royce.

JAY KAPLAN: You bet.

CONSUELO MACK: David Darst, what would your one investment for a long-term diversified portfolio?

DAVID DARST: Consuelo, I think everyone should have in their portfolios over the long term some exposure to energy, to the global energy. We’re now basically drilling in increasingly remote and increasingly deep underwater places. Schlumberger, who bought Smith International as you know back in 2010 for $11 billion, now has …

CONSUELO MACK: Who’s a blue chip driller.

DAVID DARST: Schlumberger is a blue chip. It’s the third largest energy company. I think it’s the 14th or 15th largest market cap company in the United States. That having been said, they have now with this soup-to-nuts approach, they have the ability … Angola, other countries that are drilling off the waters of other parts of Africa, Mexico. They cannot touch their oil without Schlumberger, okay, giving them ideas. Now Schlumberger has $47 billion in revenue. They’ve got 110,000 employees. Paal Kibsgaard is the new CEO there. He’s done a phenomenal job, and what I love about Schlumberger, pulling this together in terms of … The free cash flow of that company is going from about 55 percent of its earnings that they’ve got discretion on what they can do with it … 55 percent of its earnings going up to 75 percent of its earnings. The next five years, compound growth rate, Wall Street consensus is 16 percent per year each year for the next five years.

CONSUELO MACK: Do they pay a dividend, Schlumberger?

DAVID DARST: They pay a dividend. Right now it’s about 1.9 percent, but this dividend can grow because we think they’re going to return cash and capital to shareholders through stock buybacks and both through dating and through marriage. They’re going to be buying. They’re going to be increasing that dividend as they continue to get this immense amount of free cash flow. This is a stock you want to own for a long period of time.

CONSUELO MACK: A long period of time, and it’s been around for a long time. Thank you both so much for joining us. This was really fun. Jay Kaplan from The Royce Funds and with a specific focus on some Dividend and Total Return Funds, and David Darst, Morgan Stanley and an independent investment consultant as well.

DAVID DARST: Thank you so much.

CONSUELO MACK: It’s really a treat to have you both here.

DAVID DARST: Nice to see you.

JAY KAPLAN: Thank you, consuelo.

CONSUELO MACK: Regular WealthTrack viewers know that we are always looking for sources of investment income for ourselves and our viewers. We recently found a new one thanks to the work of one of our favorite financial journalists and a frequent WealthTrack guest. The Wall Street Journal’s Jason Zweig covered it in his Intelligent Investor column earlier this year. Titled “Floating A Few Cents To Investors” it discusses what Zweig describes as “the first major innovation in U.S. debt since inflation-protected securities were introduced in 1997.” So this week’s action point is: take a look at the U.S. Treasury’s floating rate notes, or FRNs. As Zweig points out, these FRNs, enable you to earn a little more cash than you would on treasury bills. They have a maturity of 2 years but the interest rates on them are divided into two parts, one that floats and is reset every week with the three month T-bill auction and the other that is fixed when the frn is issued, at a rate that is a smidgen higher than that on the T-bill. If interest rates rise part of the income on the note will rise as well. You can buy them commission free directly from the Treasury Department at treasurydirect.com. Next week we are going to explore one of the fastest growing sectors in the mutual fund world: alternative investments with Robert Jenkins, Global Head of Research at Lipper and Lara Magnusen, Chartered Alternative Investment Analyst and Director Altegris Advisors. What are these non- traditional investments? Do they belong in your portfolio? We’ll find out. In our EXTRA feature on our website this week David Darst will tell us about his new personal frontier and Jay Kaplan will explain why his early years as a bond guy gives him an edge in small cap stocks.

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