When The Cloud Disappears, Look Out Above!

Feb 14 2014, 10:16am CST | by

When The Cloud Disappears, Look Out Above!

Rudolph-Riad Younes, Co-Founder and Head of International Equities, R Squared Capital Management and Co-Portfolio Manager of the RSQ Funds

Rudolph-Riad Younes: Before we invest in the international equity markets, we look at the global picture. Currently, there are eight key pieces to the global puzzle that we are attentive to as we make our stock selections.

The first point is that we have profit margins that are at double the historic average in the United States. Our analysis attributes it mainly to government deficit spending, ironically its unintended consequence is corporate welfare. Whenever fiscal deficit spending disappears, so will half of corporate profit margins, in our opinion.

Second, we expect global growth to remain subpar for the foreseeable future. Sovereign Debt-to-GDP in the developed world remains alarmingly high at above 110%. No meaningful de-leveraging has occurred in this down cycle. The debt mainly shifted from the private to the public sector.

Third, commodities are at the beginning of a multi-year downward correction. Most major commodities appreciated about five-fold or more since China’s entry into the World Trade Organization (WTO) in 2001-2002. This demand shock from China generated a belated supply response. A combination of decreasing demand today from China and increasing supply will force a severe retracement in these commodities prices. For example, if we look at the long-term forward contract for the West Texas Intermediate Oil, we find that the market is at $75 versus today’s price of $97. And we expect a similar deflation in other commodities prices.

Fourth, China’s failure to wean off its addiction to fixed asset investments has been blatantly apparent in the last two years. Despite its acknowledgment that fixed asset investments are too high and consumption is too low as a percentage of GDP, the Chinese government failed to steer these ratios in the right direction. As a matter of fact, these ratios have gone ballistic in the wrong direction — an omen that the adjustment and the balancing of the economy are not likely to occur smoothly.

Fifth, given this outlook, we are bearish on most emerging countries or those developed countries that are rich in commodities like Australia and Canada. Over many years, these countries have benefited from rising commodities prices and foreign capital flow seeking growth and yield. Now as the prices of commodities have started to correct downward and foreign capital has started to exit, we expect many emerging markets to enter a long and harsh winter. That is the usual correction needed to redress a long binge of excesses and misplaced confidence.

Sixth, Europe is the brightest spot in our investment universe, especially the financial sector, which was decimated mainly due to fears regarding the fault lines in the Europe project. We believe great strides have been finally made to correct them, and many more will be needed and will be taken in the coming years. European banks, especially those in the Euro area, still trade at or below tangible book. We believe they represent a unique opportunity of substantial appreciation in a world of 0% interest rates and over-valued assets.

Seventh, Japan’s efforts to create an inflation of 2% and to revitalize its economic growth, if successful, will make the recent rally very sustainable. Japan surely needs to address its mushrooming public debt, which means that they need to have GDP growth that is much higher than the coupon on the Japanese government bond in order to facilitate the decline of the government debt-to-GDP ratio without the need for draconian fiscal austerity measures.

Finally, while in the recent past, global players with high emerging market exposure have been handsomely rewarded, today we expect companies whose activities are concentrated in the developed world, especially Europe and the U.S., will outperform their global counterparts.

Wally Forbes: Did you say that Japan is one of the vulnerable areas?

Younes: Not really. It’s more like we are cautiously optimistic because Japan has a very high debt-to-GDP ratio — especially the government debt. In Japan, you have 0% interest rate, and you have 0% economic growth, so there is no room to have the debt decline without resorting to austerity measures.

But if Japan were to have 3% to 4% nominal GDP growth while the average coupon on its debt is like 0.5% to 1%, then debt relative to GDP can decline by 2 to 3% per year. Hence, over ten years that will make the ratio decline by almost 30% to 40% while having just a primary balanced budget–without any need for a primary surplus.

Forbes: So, it’s cautiously optimistic as you say rather than as positive as both the U.S. and Europe are at this moment?

Younes: Correct, because we don’t know if it’s going to work. If we look at Lloyds Banking Group (NYSE: LYG) and Bank of Ireland (NYSE: IRE), they both have kind of a similar story. The crisis has been a boon to the surviving banks because the sector has dramatically consolidated. Let’s start with Lloyds. In the U.K., Lloyds has a market share of 25% in the deposit market. It’s a huge, dominant position. The industry has become very oligopolistic. And Lloyds is the strongest bank today. It’s the bank that has cleaned its balance sheet the earliest and we expect the government to be out as a shareholder in the near to medium term. We also expect them to start paying a dividend over the next couple of quarters.

So with a combination of government exit and the start of dividends, we expect the stock to rise from today’s low valuation. Also, given the oligopolistic nature, we believe over the full economic cycle, this is a bank that can easily have an ROE in the high teens. Therefore we expect it to trade north of two times book versus today barely trading around 1.4 times tangible book.

Forbes: That sounds very powerful.

Younes: Yes. The second bank is Bank of Ireland. We all know about the problems we had in Ireland. That’s why, after the crisis, opportunities usually occur. And in Ireland, the banking sector is even more concentrated than in the U.K.

Bank of Ireland has a deposit market share of about 40%, and the second largest one, Allied Irish Bank, has about a 35% market share. Ulster Bank, which is owned by Royal Bank of Scotland, has a market share of about 15%. So three banks own about 90% of the market.

This is crazy. And if you look at Bank of Ireland, it’s only trading today at 1.1 tangible book. Again, this is a stock that when the cloud disappears, like Lloyds, should easily make an ROE (return on tangible equity) in the high teens. Again, this is a bank that should easily be trading at 2 times tangible book or more. Today it’s at only 1.1 times. And, within a year, we expect also this bank to start paying a dividend.

Forbes: For how long do you anticipate to hold these stocks?

Younes: It’s going to be a gradual appreciation. The time to sell these banks is when everybody’s excited and you’re starting to hit two to three times tangible book.

Forbes: Do you anticipate this could take a year to three years as an objective to recognize some of these goals?

Younes: You need a combination of stabilization of the economy, better clarity on the loan quality, and some kind of modest loan growth. Some may rally faster than others, but again, these are blue chips. They are the dominant banks in the developed countries with great rules of law and the property law and good corporate governance. So, there is no rush to exit. You’re buying after a crisis, so it’s a multi-year rally.

Forbes: Sounds good.

Younes: Another company is Bayer AG (OTC: BAYRY). About ten years ago it used to be merely 80% chemical and 20% healthcare and agrochemical. But now product mixture has dramatically shifted. Now, it’s almost the inverse: roughly 80% today is healthcare and agrochemicals — which are a good business with the highest margins — and only 20% is commodity chemicals.

We expect that ratio and disbursal to continue in the right direction. In all of its businesses, the company holds either the number one or number two position. Moreover, the healthcare, agrochemical and even chemical segments they participate in are oligopolistic in nature with typically 3 or 4 players. This is very good because it means the company can have very high margins as it has a dominant position in consolidated businesses.

If we look at the valuation of healthcare companies in the U.S. they trade around 15 to 17 times earnings. If you look at agrochemical companies, they trade around 17 to 20 times. Today, Bayer trades around 13 times 2015 projections. We expect the company’s P/E-multiples over the next three years to be around 15 times. And at the same time we expect about 15% compound annual growth rate in earnings as they have many promising product launches lined up for its healthcare and agrochemicals businesses. Combined with a nearly 3% dividend yield, that gives us an appreciation potential of 50% over the next three years.

Forbes: Sounds encouraging.

Younes: A fourth company is Deutsche Telekom AG (OTC: DTEGF). We believe improvements both on the regulatory front in Europe and in its US operations will be key catalysts for the stock’s outperformance.

Telecom Operators in the European Union have been subjected to a very tough regulatory environment compared to that in the U.S and that has substantially affected their profitability. In response to their poor profitability, European operators have badly lagged their Northern American counter-parts in investment in capital expenditure and high-tech infrastructure, which has finally gotten the attention of the regulators. If you’re killing the golden goose, you will cease having golden eggs. They are realizing that Europe cannot compete in the 21st century if they have a second-class internet and high-tech infrastructure.

So, there is a wind of change now in Europe to let players consolidate and a realization that four players in each country are too many. Also, if you look at average revenue-per-user (or ARPU as it’s known in the industry jargon), for example, in the U.S. the wireless ARPU is about $69; in Europe it’s about $38. It’s almost half and this competition is killing the earnings and the revenues of these companies. Therefore, they don’t have enough money to reinvest — or at least no incentives to reinvest.

So, Deutsche Telecom is exposed to this change. Friendlier regulation could lead to potential consolidation in Germany by having the number three and number four players merge. Having one less player to compete could improve margins significantly.

In the U.S., its subsidiary T-Mobile has been a poor performer in the past hampered by having non-standard handsets due to its inferior spectrum position. But with the transition to 4G (the fourth generation of mobile phone communication) in the U.S., this weakness has been eliminated and T-Mobile has been taking market share away from competitors. On top of that, there is a potential of Sprint trying to acquire T-Mobile. Either continued market share gains by T-Mobile in the U.S. or an acquisition by Sprint should provide further upside for Deutsche Telekom. Those are the two key pillars for this stock.

Forbes: Okay. So, you do have one last one that you like?

Younes: Accor (OTC: ACRFY) is a worldwide leading operator of hotels present in 92 countries with over 3,500 hotels. It is present in every hotel segment, from luxury to economy, and has many brands, like Sofitel, Pullman, and Ibis. The thesis basically is three-pronged. The first prong is portfolio transformation. The company is undergoing a strategic transformation to reduce the capital intensity of the hotel portfolio that it has, as well as reduce the cash flow volatility. The program is to unlock the value of property assets and structurally improve margins.

Forbes: Does “unlock” mean to sell some of their properties?

Younes: Yes, or at least report their real estate holdings under a separate structure for eventual sale. Basically, the hotel business has two models. Either you are both an owner and a brand operator or you are just a brand operator. The advantage of being a brand operator is that you are asset-light, which means much less fixed cost and higher margins.

Accor is being transformed into a brand operator by restructuring many of their properties. That will allow it to return capital to shareholders and also improve return on capital employed. Secondly, 75% of its operations are in Europe, and we know that Europe has been in a mess the last four or five years. Any improvement in the European economy will significantly impact its earnings since it is highly leveraged to that economic environment.

And finally, the company is pursuing organic growth. They plan to open about 30,000 rooms per year and about 70% of those rooms will be in emerging markets via an asset light manner. The emerging market environment is not something very exciting at the moment, but we know every region will go through a cycle anyway. This is a company with a lot of potential for growth and they see a lot of demand in emerging markets.

Forbes: Sounds like another interesting opportunity. Over what kind of a holding period do you anticipate to be able to reach of these goals?

Younes: We expect Accor’s transformation to take place over the next 3 years.

Forbes: Well, Riad, this has been very interesting. And as you say all of these are available either through U.S. exchanges or as ADRs?

Younes: Correct. We have additional favored stocks, but they are not available for direct purchase in the U.S.

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Source: Forbes Business

 
 

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