The overall US stock market is not cheap. But it is not so exuberant that long-term investors need to fear losing money is a given in our opinion. Yes, there are pockets of extreme overvaluation and there are seasonal reasons for being cautious, but the future is unknowable. So we rely on common sense.
We live in a world where investment grade corporate bonds yield only 3%. Yet we continue to find companies, even in the US, with free cash flow yields of 5% to 10%. We therefore believe stocks may continue to offer value on a relative basis if one is selective and patient.
Everyone knows stocks are risky but with yields so paltry safe bonds lack appeal. Simple math implies a 4.8% “current dividend return” for the S&P 500 Index (SPX) if you add up both dividends and share buybacks, according to Deutsche Bank. As a point of reference, the 10-year US Treasury bond yields about 2.6% as of June 19 for investors.
In our opinion, the argument for a continuation of the secular bull market is simple. Corporations flush with cash, combined with increased CEO confidence in the economy, means mergers and acquisitions are heating up. Interest rates will probably remain historically low. The psychological zeitgeist is attractive as investors remain shell-shocked from the crashes of 2008-09 and 2000-2002.
We are well-aware that long-term metrics are flashing yellow in the US, but markets can stay expensive for an extended period as confidence rises. During the 8-years starting in 1958, the median annual P/E ratio for US stocks was at or higher than current levels. The thesis making the rounds that this bull will end in a bubble, at much higher prices, is a credible one in our mind.
Investors should be selective and look for growth and high levels of free cash flow and avoid “unimaginative” bets on certain sectors in the US (particularly building materials and homebuilders). Consider quality companies in undervalued markets like Singapore and Hong Kong.
Last month we added a new theme to the Core International Portfolio: alternative assets. As a result, we purchased shares in Carlyle Group (CG) and Oaktree Capital (OAK), both of which are considered to be best-in-class managers.
Alternatives run the gamut from real assets like commodities, farmland, and timber to sophisticated debt structures, derivatives contracts and partnership interests in privately held businesses, referred to as private equity.
Alternatives are increasingly popular with institutional investors and wealthy individuals because their returns are perceived to have a low correlation with those of the stock and bond markets.
Many consultants, chief investment officers and advisors claim alternative investing combines higher returns with lower risk relative to the stock market.
Carlyle and Oaktree have been public for just over two years each. The granddaddy of them all, Blackstone Group (BX), went public in 2007 amid concerns, proven correct, that we were at a peak in valuations and fund raising ability.
We do not think the industry is at a peak in fund raising ability and we believe these companies are currently undervalued. Many of the companies are selling below their net asset values.
Carlyle is trading at a 30% discount to what Credit Suisse estimates is a per unit book value of $47.00. Oaktree owns 22% of DoubleLine, a traditional fixed income investor run by Jeffrey Gundlach, and is valued on its balance sheet at a fraction of its true value.
Both firms pay very high dividend yields that are variable and both managers have heavy insider ownership. Due to the high insider ownership these stocks are less liquid than their market capitalizations imply.
This means their share prices may be volatile but it also buttresses our thesis the shares are undervalued because the relatively small floats have kept ETFs from owning them—for now.
We believe Carlyle and Oaktree represent growth businesses because of their proven ability to successfully raise assets under management. Carlyle’s AUM is approaching $200 billion and Oaktree manages roughly $86 billion. Major pension funds, sovereign wealth funds and other large pools of capital want their money managed by the big global brands because they personify stability, consistency of returns and transparency.
We believe both companies are well positioned to benefit from numerous trends: the reduction in the number of alternative managers used by the ever larger pools of capital, growth in the emerging markets, and an increased allocation to alternatives by every group of investor including a burgeoning demand from mass affluent individuals.
Carlyle and Oaktree should benefit from a prevailing belief that large professional firms with talented managers and economies of scale are best position to add value in managing alternative assets.
DISCLAIMER: The investments discussed are held in client accounts as of May 31, 2013. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable. Past performance is no guarantee of future results.
