Air
date: September 10, 2004
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Chanos, Rutledge roundtable
GEOFF COLVIN: John Kerry wins -- will the stock market go down, as some predict? Will your taxes go down, as he promises? George Bush wins -- will the federal deficit go up, as some fear? Will the tax code get simpler, as he favors? This election could mean big changes for you as an investor, a consumer, a taxpayer -- but what, exactly, and what can you do now? John Rutledge is chairman of Rutledge Capital and an advisor to the Bush White House. He was one of the architects of President Reagan's economic plan in the early 80s. Jim Chanos is on the Kerry campaign's finance board, but does not speak for the Campaign. He's president of Kynikos Associates, an investment firm that specializes in short selling, and was one of the very first to spot big trouble at Enron back in 2001.
John, in mid-summer when Kerry's poll numbers were looking very strong, the stock market went down, and some people said it was cause and effect. Do you think it was?
JOHN RUTLEDGE: I think in some part. But you know the people have been frightened this summer by the violence around the world and in the Middle East, and I think it's hard to distinguish between the two. But the one area I think there's a clear connection is that if Bush is re-elected, he's going to make another try for the zero dividend tax, and the zero dividend tax is probably worth about a trillion dollars in the stock market. And so that may be the most clear difference in tax policy regarding the markets.
COLVIN: We want to come back to that. Jim, do you think it was cause and effect this summer when Kerry was up, the market was down?
JIM CHANOS: Well, it's interesting, Geoff, because most studies have actually shown that stock markets do better under Democratic administrations than Republican administrations.
COLVIN: Right, as we have reported in the past.
CHANOS: So that cause and effect, if that indeed was the case, might be a little misplaced. But I think there is a general feeling right now in the marketplace that a Bush victory, if it happens, will be good for lower dividend taxes, as John indicated, and probably a boost to the market over the short term.
COLVIN: John, if lower dividend taxes come, does this influence your investments?
RUTLEDGE: Absolutely. There's about $2 trillion sitting on the sides in money market funds today that I think will come back into the market, regardless of who wins, if anyone wins the election. And the dividend tax cut, it works by lowering the cost of capital for companies by almost a percentage point you could get, and even if it doesn't go up, the clarification of that will allow corporations to restructure. Companies will, the right strategy for a low dividend tax rate is to dump the cash out to the shareholders through a special dividend, increase your payouts, buy back your stock with taxable preferred stock, and file a shelf registration that you use like an ATM machine to do capital spending...
COLVIN: When you need to raise money.
RUTLEDGE: Absolutely. So I think the dividend-bearing stocks, a DVY as an index fund is a way to do that. It's a very good way of making bets on this election on the other side.
COLVIN: You would bet on that if you thought Bush was going to win and if you then thought that he would be able to succeed in getting the dividend tax down.
RUTLEDGE: Absolutely, and I think there's a difference not only, the chances he'll get the tax lower is not 100 percent, but I suspect that you're going to see a press to increase that tax rate back to the ordinary income tax rate with Kerry as President. So as a CEO, I would face 12 months from now a zero or a 40 percent dividend tax rate. I don't know what to do. A lot of people are sitting on their hands in companies waiting to know that before they make a decision on capital spending.
COLVIN: Jim, stepping back from the effect on the markets, looking at the economy overall, John Kerry wins - what would be the biggest effect on the economy overall?
CHANOS: Well, I think the biggest effect on the economy overall would be a change in policy. I think reforming the health care system would certainly create a number of ripples through the economy, as the campaign has indicated it wants to do. But interestingly enough, I don't know that you'd see as many changes in the economic landscape as a lot of people suspect they'd see. I think the policies are going to be, particularly with a Republican Congress, a lot tougher to get through. I think that would be one of the challenges for a Kerry administration.
COLVIN: A divided government in either case could put all these predictions on hold.
CHANOS: Exactly.
COLVIN: The deficit has been a huge issue, record deficits now. John Kerry says he would cut it in half. What do you think would happen with deficits under the two scenarios?
CHANOS: Well, again, I'm not an expert in this area, but I'm not sure that anyone's been able to predict with any kind of great authority what happens prospectively to the deficits and whether or not that was good or bad for the markets.
COLVIN: Right.
CHANOS: And if we had looked at what happened under the Reagan years, John, as you know, with deficits exploding and a boom that ensued, or the Clinton years, where deficits were reduced and a boom ensued. I don't know, the markets are so complex, I don't know a simple cause and effect on…
COLVIN: Deficits were a specialty of yours, the study of them I mean. What do you think?
RUTLEDGE: Sure. Jim is right. As a signal for investing, a deficit number is worthless. The correlation between deficits and interest rates is actually the wrong way over the last 50 years.
COLVIN: High deficits are supposed to lead to high interest rates, but they haven't.
RUTLEDGE: That's right. And the reason they don't is because the economy we talk about -- GDP, how much we produce -- is $11 trillion, but in the U.S. we have $130 trillion worth of assets. This is a huge balance sheet. If you're talking about $100 billion either way of the deficit, it's chump change in that game. And in the world today, Japan's deficit is twice the size of the U.S., and the U.S. and France and Germany and the U.K. are all within about a tenth of a percent of GDP. It's just not an interesting issue.
I'd be much more interested in tax rates or in credit availability, as has come back in Japan now, very, very interesting, and China. I think it's a growth world, and the theme is competing for capital.
COLVIN: When you look at the market overall, do you think it's cheap or expensive?
RUTLEDGE: I think the market is cheap. There's so much cash on the sidelines, that when it comes in after the election, the markets should rebound very nicely. So I'm a believer, as Jim said, I'm a believer that no one is going to control health care costs. And as a baby boomer, I use a lot of pills, and plan to use more. So I think that's, my largest single investment is in a company that manages pain, and so I think it's a growth industry. I own a position in Endo which is a maker of pain management medicine, that I own through a private equity deal that is now public. Very attractive company, great management. Aging baby boomers with sore knees are going to need a lot of pain management, and I think this is a great company long term.
COLVIN: Jim, when you look at the overall market, does it look cheap or expensive to you?
CHANOS: Well, as a short seller, I think I'm also familiar with pain, so as a segue there, we're finding lots of companies that look quite expensive to us relative to their prospects. As to the overall market, I suspect that there are pockets of opportunity both on the long and short side.
But we think earnings generally are still somewhat overstated. By the way, we look at corporate accounting. And Sarbanes-Oxley has changed behavior somewhat, but it has not gone to the root of the accounting problem that we saw post-Enron.
COLVIN: When you look at big picture trends that guide you in choosing the companies you are going to short, what do you see?
CHANOS: Well, other than very specific, company specific problems that will lead us to a short sell candidate, one of the areas that we've found fruitful in the past five years or six years has been the ongoing migration of the world from analog to digital, and that has just disrupted all kinds of businesses. It led to great growth in a number of areas. Obviously we saw that in the late '90s, and we see it today in the Internet and related phenomena.
COLVIN: So who has suffered?
CHANOS: Well, there's been a series of people who did not foresee the change and got caught, and really it's people who distributed product that went from analog to digital. For example, we started music retailing in the late '90s which was devastated for a couple of years, a lot of Chapter 11 results in that area. Ongoing to the video rental world, which finally...
COLVIN: You were short Blockbuster for a long time.
CHANOS: We were and still are to a small extent. Photography, which has gone from an analog world to a digital world.
COLVIN: Eastman Kodak.
CHANOS: Eastman Kodak. And then more recently we think there's going to be another battle between content and distribution in television, cable TV, satellites, versus the content providers.
COLVIN: And so you are short who in cable and satellite?
CHANOS: Well, we're short the major satellite provider pure play, which is EchoStar.
COLVIN: EchoStar.
CHANOS: And one or two of the cable companies, the more leveraged cable companies. And we're looking at the content companies right now to go long in our long short...
COLVIN: Content meaning what? Disney?
CHANOS: Well, Disney would be a possibility, Fox would be a possibility, although some of the major players have both distribution and content, like Time Warner.
COLVIN: Most of the big ones do.
CHANOS: But you see a bidding war perhaps right now for MGM, which is pure content. And Comcast's bid for Disney I think was an important event in this idea that we're talking about. I think Brian Roberts saw...
COLVIN: The Comcast CEO.
CHANOS: ... the writing on the wall, yes, the Comcast CEO, and made an attempt to swap his stock for content.
COLVIN: John, I know that you have observed in the past that there are certain sectors that you think are topping out, industrials, steel, timber, things like that. What's the big picture? What's going on there?
RUTLEDGE: Well, to choose a sector you need to first have a view of where the tectonic plates are shifting. When there's a policy change, it raises or lowers the return on a category of assets relative to another one. This shift that Jim is talking about is being augmented by a change in telecom policy that's underway right now. Telecom policy is going to change in a way that's going to spur an enormous amount of capital spending in network assets, distribution assets, which means the margins in distribution will dissipate. And unless you have content in a very broad distribution platform, you won't be able to make money, and so that's changing. Overpriced sectors to me are the winners of last year, materials, you know, steel prices, copper prices, oil prices. The commodity prices jumped last year.
COLVIN: They jumped a lot, but some people said this is a 10-year trend, that it's going to go on for a long time.
RUTLEDGE: Well, since the day I was born, commodities have been in a bear market, and I suspect the day I die they will be in a bear market, too. This is a world of electrons and digital information flow, not steel and copper. The thing that drove the prices up was China's growth. China has been restricting credit now for some months, and they have no ability to know how it's going to play out. They've shrunk mortgages, increased down payments. After the Fed meets this month, they will likely increase interest rates. You've already had spot steel prices come off. So materials, industrials, cyclicals, look to me very dangerous, because you're all betting on the same thing, the growth rate in China. Under-priced looks to me like telecom, in certain pockets, and branded consumer goods whose margins have been squeezed by slow GDP growth, but will fatten up on the way back up again.
COLVIN: Jim, one of the companies you have shorted is Weight Watchers. Now it has taken a lot of punishment as the Atkins diet has been so popular, but you think it still has further to fall?
CHANOS: Well, it actually has held up, actually, we think rather well, given the fact that it's missed its earnings projections for the last few quarters. It's not really the Atkins diet. It is a myriad of different diets that Americans are now putting themselves on, whether it's Atkins or any of the other diets that are popular, on the bestseller list or over the Internet. And I think it's also realization longer term that as genetic engineering brings forth more and more targeted drug therapies, we already are seeing some very promising anti-obesity drugs being developed out of Europe, and I think longer term selling in effect self help through directed meetings and programs I think is going to come under increasing assault in the marketplace.
COLVIN: Thank you very much John Rutledge and Jim Chanos.
RUTLEDGE: It's a pleasure.
CHANOS: Thank you.
Dow interview
KAREN GIBBS: Phil Dow, Director of Equity Strategy for RBC Dain Rauscher and author of "The Citizen Investor: the Power of Ownership" says no matter what your age, you should consider owning stocks for life.
Well, Phil, why should we consider stocks coming off of a bruising bear market and looking at a kind of sideways market where stocks are making two steps forward and then two steps back?
PHIL DOW: It's the confidence I get from talking to people. I do maybe 70 or 100 client meetings a year, and a lot of them you'll see seniors come. They're in their 70s or 80s. They've owned stocks through a number of business cycles, and they're sold. Basically they've made huge amounts of money profitably on the stocks, and the dividend income keeps them coming back. So over time they've owned the businesses, and the power of ownership helps them manage the risk they see in the market.
GIBBS: Where do fear and greed, those two emotions that are said to drive the stock market, fall in?
DOW: They do on a short-term basis, and I think most folks treat stocks like they're certificates that you trade, when in reality owning a living, breathing organism is what a stock certificate demonstrates. And I think if people can begin to look at owning a business over long periods they begin to gain confidence. And the book is unique I think in that it points out how rare these good companies are, and they're normally the dominant, big companies we all kind of know.
GIBBS: Is there a difference between having an owner mentality versus just being a shareholder?
DOW: Absolutely. I think you learn how to tolerate the inevitable ups and downs of the market as an owner. You know that your franchise is worth more than maybe Wall Street's votes today. And oftentimes the leader in an industry, we call them bulldogs, they're number one or number two in an industry, tend to have the 10-year (tenure?) size and scale that they can deliver solid financial results for years. So what I find is a lot of really successful investors own companies for three, five, 10 years.
GIBBS: Give me this bulldog example. Explain it. What is a bulldog?
DOW: A bulldog is a company that tends to dominate an industry, and the best way to think of it is a company that is likely to endure over long periods of time. And for me, the main thing I focus on is above average compound revenue and earnings growth. I look for these dominant companies to continue to grow over time. I'm not looking for the next company that's going to get FDA approval for a new drug. I'm looking for the company that can continually grow at above 10 percent, 12 percent over the long term. If you look at healthcare companies, they typically can do that. Some technology companies during their cycle, some financials can do that. And I look for those unique companies to own over long periods of time. And it takes timing out of the question. I don't worry when to buy and sell per se. If a company continues to deliver good financial results, I'll own it.
GIBBS: Isn't there a little bit more risk entailed with being a bulldog investor than a value?
DOW: Yeah, you look like an idiot from time to time. I mean there are times when your stock isn't doing well and you have to wait it out, but what I find over long periods is you begin to feel confident in your ownership position.
GIBBS: We've got a shift in demographics going on in this country. How does demographics change an investor to an owner?
DOW: When people retire, they need to recognize that on average their retirement period is going to be 20 years. So this belief that you retire and don't have investment risk anymore is just that. It's kind of a fairy tale. Most of us are probably going to have to own stocks well into retirement years to deliver the returns we need.
GIBBS: With the fear of Social Security not being there for many of us, what's an investor to do?
DOW: Well, I think we all have to learn how to tolerate risk better. I mean it's kind of up to us. I don't know whether the government's going to be there for all of us for the entire period. There are some pretty scary demographic arguments. My experience with demographic arguments is that they can make a lot of sense, but sometimes they paint a really bleak picture when the reality has been better. I mean our country has been faced with a lot of problems and we've always come up with solutions. So I'm not saying you shouldn't worry about it, but I think understanding that being an investor is learning to tolerate risk that's always there is absolutely critical and that it's your responsibility and that it's not rocket science.
GIBBS: Well, we asked you to put together portfolios for two different groups. First you've got the mid-50s or so, looking at what they should be investing in. Talk about that. How would you divide their assets?
DOW: Well, right now our asset allocation model at the firm is about 30 percent bonds, 70 percent stocks. It could be 65/35, but on the bond side, and I went to our bond department, they view the attractive part of the yield curve and the taxable side as the 5 to 8 year period.
GIBBS: Why do they see that as attractive?
DOW: Risk/reward. I mean basically they think that in a rising interest rate environment, if you do a bond ladder, invest in each of those years, and then as they mature, reinvest. It's probably the best part. You can capture the sweet spot or the best yields on the yield curve and then reinvest over time. In the taxable, in the non-taxable market, they think that number is in the 15 to 20 year side of things, and they would buy short-term maturities and then long-term maturities, a barbell strategy, for the 30 percent.
GIBBS: Those are for the tax exempt.
DOW: In any asset allocation model, bonds will help you manage risk over the long term. With the 70 percent in stocks, I would recommend that people put about 35 percent total into bulldogs or companies that can dominate their industry over time with a real eye now on dividends and dividend growth. I think that's going to be a powerful trend for the next 10 or 15 years. About 15 percent in mid-cap stocks, 10 percent in small-cap stocks. Those could be mutual funds. I would prefer that people consider individual ownership in that big 35 category. And then the final part would be international. You don't know what the dollar is going to do. One way, prudent way I think Americans can hedge the dollar is to own international equity funds.
GIBBS: And show some diversity and diversification going on there. But now I need some specific stocks that you would put it with.
DOW: For dividend growth, I would say the great names are Citigroup, Pfizer, GE would be names, Wells Fargo would be great names. Johnson & Johnson would fit that category, as would Medtronic. These are companies that have relatively low dividends, so it's kind of counterintuitive. But Pfizer, for example, only has a 1.71.8 yield, but the dividend doubled, more than doubled over the last five years. So what I'm saying is five years from now you'll probably have a 4 or 5 percent yield in Pfizer based on today's price. Who knows 10 years from now. So it's dividend growth. Then with regard to other special situations, I think healthcare is a big industry, and I think that you will see opportunity in names like Pfizer, Medtronic, Johnson & Johnson as I mentioned. I think we need to pay some attention to inflation now, and I think energy is the most attractive place to go. So a company like ChevronTexaco would also fit the dividend theme. Burlington Resources in natural gas. We're not going to have anymore reserves until LNG comes in, liquefied natural gas, '08 or '09. So I think most people want, should have a natural gas position. And then other unique opportunities as they come up.
GIBBS: Conventional wisdom says that once you retire, you should scale back on your stock holdings and rely on fixed income or income. What's your take on that?
DOW: Well, I run into these people in their 70s and 80s, the citizen investor, it's who I wrote the book about, and predominately they own stocks, and it normally represents half their portfolio or more. I'd say for the typical person in their later years, 70, you ought to consider owning some individual stocks. And for current, high current yield, REITs, master limited partnerships, selected, there's just a few good electric utilities, makes some sense. And then I'd recommend with a portion of the money considering these very dominant companies that can grow the dividend over time.
GIBBS: Is it the same 70/30 equity/bond ratio?
DOW: Well, it's the exact opposite. It would be 70 percent bonds, 30 percent stocks for most people in their 70s I would say, particularly those that have never owned stocks or view it as a casino. I think it's a real leap to expect them to buy stocks. But if you look at REITs and MLPs, master limited partnerships….
GIBBS: Describe for us some of the characteristics we should be looking for in REITs.
DOW: Our firm's got a big research commitment to REITs, but basically it's quality again, and these operations own real estate properties, and they're typically either warehouses or office complexes or residential. And they share the benefits, the cash flow with the owner, with the shareholder. It's flowed through straight to the shareholder, and so it's kind of a combination ownership of the real estate and cash distribution benefits. It's a pretty good way to own real estate over time. My sense is the big attractiveness of the group is pretty stable, above average yields. I use them with people who are in their 70s who want the security of a real estate investment because they can own it, see it, feel it, and then the cash flow as well.
GIBBS: Phil Dow, great book, great interview. Thanks for joining us.
DOW: Thanks very much, Karen. My pleasure.
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