Investor spotlight: Randall Eley
KAREN GIBBS: The stock market is treading water for the year, having been held back by rising oil prices and higher interest rates. And investors have been skittish, thanks to the recent roller coaster ride of big moves up one day and then down the next. But our next guest has a strategy that he says makes sense in a shaky market -- buy large-cap stocks -- those included in the S&P 500. Randall Eley manages the Edgar Lomax Value Fund and joins us in the studio.
Well, Randall, it's interesting to hear you talk about large-cap stocks, those being included in the S&P, when many people always look at the value of the stocks outstanding. Why do you look at just the S&P?
RANDALL ELEY: Well, it's an index in which there's plenty of names from which to choose, but they are roughly the 500 largest companies in the country, so the basic doctrine of too big to fail gives the investor who chooses from that list an advantage in that you have companies that have great stable histories or have been profitable for a long time. And the rest of the economy has too much at stake to just let them fall apart quickly if something goes wrong.
GIBBS: Well, what's your outlook on the market and the economy right now?
ELEY: I think the key factor affecting all of that is rising interest rates, and the Federal Reserve has stated that interest rates will go up and will likely go up higher on a cumulative basis than most observers expect, and I believe that. And so as a result, the stock market's going to have a very difficult time moving very far ahead with interest rates going up over the foreseeable future.
GIBBS: Well, we've had eight moves since last year and it's pretty much in the stock price, don't you think?
ELEY: Yes, but I'm not sure the future rises are in the stock price. And so many people are assuming that the Federal Reserve will stop raising interest rates if the economy weakens, but I don't think the central bank has much choice. The fact is the U.S. dollar has fallen sharply, and they have to stop that decline or at least slow it at some point.
GIBBS: But doesn't that help the stocks of companies that are major exporters, the falling dollar that is, making their goods cheaper overseas?
ELEY: Up to some degree. The fact of life is the U.S. government is the largest governmental borrower in the world. The American people also have large amounts of debt. If we let the U.S. dollar continue to fall at the rate that it has, over the last four years, for example, the U.S. dollar index, which compares the dollar to a basket of major currencies, is down 7.5 percent a year. Now the rest of the world can take some degree of decrease with equanimity, if that's the right word, maybe 3 percent or so. But 7.5 percent a year, at some point interest rates the central bank does not control, and that's the long-term, the 10-year, the 30-year, will rise so sharply we wouldn't be able to borrow, and there would be great shocks to the system.
GIBBS: Talk about a great shock to the system, oil prices.
ELEY: Yes, that's right. And that's a good indicator of I think what we would see across the board. Over the last year, oil prices up about 45 percent, if you look at crude oil. And the fact of life is although it's slowed recently, many people think the Federal Reserve should reduce interest rates because of energy prices having risen. But they have to take into account -- this is the Federal Reserve governance -- that people can buy energy and everything else more easily if they keep using credit cards and paying the interest rates that are available. So they're forcing us all to think about what we really can afford, no matter what it is.
GIBBS: Well, with all the headwinds that you just described, why do you think that large-caps, these companies that are included in the S&P 500, are the way to go?
ELEY: Two reasons. First, they're large, and so most people have not predicted extremely rapid rates of growth, but also over the five-year period through the end of last year, your smaller-cap stocks have outperformed your larger-cap stocks at almost historic rates. Over the last 25 years or so, if you compare the S&P 500 to some smaller-cap index like the Russell 1000, the performance of those two indexes is not that awfully different, but if you look at the last five years, there's a much different performance.
You have stocks of companies that are smaller rising at rates of 20 to 30 percent more than those of larger companies, yet their earnings over the last five or 10 years have not risen at that much higher a rate. Sooner or later there's got to be a balance, so right now your larger-cap companies I think are also undervalued in comparison to smaller-cap ones.
GIBBS: Well, let's talk about your portfolio, your largest holdings.
ELEY: Yes, starting with Altria. Here you have a low P/E stock as well as a high yield, 4.5 percent. This stock everyone knows is under pressure from all of the potential liability, I should say potential, but legal liability as well as potential liability, but it pays out like a bond -- 4.5 percent U.S. government 10-year bond is what, 4.2, 4.15 something like that?
GIBBS: You're talking about the dividend yield right?
ELEY: Oh, yes. So you're getting a dividend yield which is backed by earnings, and here's a company that whatever the legal liabilities, I don't expect to go out of business in the foreseeable future. Then you have Merck, so two companies facing potential legal liabilities, but I think Merck's story is even potentially better than Altria's. One of our largest drug companies, people fear what the Vioxx recall will do to the company. But here we've had an FDA advisory panel say there are good uses for Vioxx, so I don't think the legal liability there will be nearly as large as many fear.
GIBBS: SBC Communications, you still holding on to that?
ELEY: Oh, yes. Yes, a very low P/E stock. I don't expect earnings to grow, but the management there has shown themselves to be survivors, so I expect that they will continue to make changes and be flexible in whatever they have to do to continue having a profitable business.
GIBBS: You had General Electric last time we talked. Still holding on to that?
ELEY: No, and when I say no, we have a small position left. We sold most of it. Nothing wrong with the company we can see. This is a case of the stock having done well, and as a result we were able to find more undervalued options.
GIBBS: And CIGNA Insurance, why CIGNA?
ELEY: CIGNA is one of the lowest dividend payers we have. In fact, it barely pays a dividend at all, but very low P/E ratio, something in the neighborhood of -- in fact, I looked at that just before coming in because -- in the neighborhood of about 8. So anything that's under 10 percent, over the next five to 10 years you could actually make 10 to 12 percent per annum in this stock.
GIBBS: Okay, so you're looking at companies with low P/E ratios, at least lower than the S&P. How about their balance sheets?
ELEY: That's right. We think having a strong balance sheet is important because with interest rates rising, the ability to maintain earnings - not grow them, because I don't think that's the main concern right now - the ability to maintain earnings has a lot to do with managements having taken steps not to have factors in the balance sheet that will detract from earnings in the future.
GIBBS: Are there any other stocks that meet the criteria that you have not mentioned?
ELEY: Yes. We talked about Merck of course, and secondly Chevron Texaco. Here's an energy company. In fact it's in an area where we've had a difficult time finding value recently, but again trading at a current P/E ratio of 8 again, and a good dividend yield, about 4.5 percent. So even if their earnings decline, I don't think there's any question about people buying their product, so you have a good return instrument over the next five to 10 years in a market that can be shaky.
GIBBS: Are there any of these large-cap stocks that are household names that you would say maybe stay away from?
ELEY: Oh, well frankly other than those we're selecting, I think you're going to have to be careful. I expect over the next one and a half to two years at some point a general acceptance that we will have been in a bear market. In fact I think the old secular bear market that began back in 2000…
GIBBS: Meaning that longer-term bear market.
ELEY: That's right, I think it's still in place. Remember the Dow Jones Industrial Average and the S&P 500, they have not hit new highs, and I'm not one of those people projecting they're going to fall extremely sharply, but the S&P's P/E ratio -- I'm sorry, price-to-book ratio -- is somewhere in the neighborhood of between 3 and 3.2 to 1 right now. Long-term normal is somewhere about 1.75 to 1 if you look at the last hundred years or so of history. So we could have prices coming down toward normal before in fact we see a good general buying opportunity for all stocks across the board.
GIBBS: Well, in that type of a scenario with these prices very volatile, what words of reassurance can you give investors, a Dramamine of sorts?
ELEY: Well, again, as long as you remember that investing should be a profession, it should be a serious undertaking, not a speculation or a game, I think you will be safe. Even though our specialty at the Edgar Lomax Company is picking stocks, people should remember, have a good asset allocation plan. If you don't know how to do anything else, make sure you keep your money split between fixed income instruments -- in this market I would say for most people money market funds or Treasury bills, 50 percent perhaps -- and then select stocks with the other 50 percent, but taking time to buy those with strong balance sheets and a history of long-term earnings.
GIBBS: Randall Eley, it's a pleasure. Thanks for joining us.
ELEY: It's always a pleasure, Karen.
Estate tax discussion
GEOFF COLVIN: It's amazing how passionate so many people get over a tax that affects so few. It's the estate tax, at least if you're for it, the death tax or the grave-robber tax if you're against it -- and under a bizarre provision of the tax law, it's getting a little bit lighter every year until 2010, when it disappears entirely, and then returns with a vengeance in 2011. The House of Representatives recently voted to repeal the tax permanently, the Senate will take up the matter soon, and the debate is getting heated. Michael Graetz favors the tax. He was a top tax official in the first Bush administration and is now a professor at Yale Law School; he joins us from New Haven. William Beach opposes the tax. He's a senior fellow at the Heritage Foundation in Washington.
Bill, we've had an estate tax for 89 years. It affects only two percent of the population. It will bring the federal government 18 billion badly needed dollars this year. Why would we want to get rid of it?
WILLIAM BEACH: There's an economic argument, there's a moral argument.
It affects a good deal more people than the 2 percent who end up paying it.
We think, and so do a number of analysts, that the presence of the tax has retarded or slowed down job growth because it increases the cost of capital, which means that you have less capital for investment. That affects hundreds of thousands of people each year who aren't able to find work or aren't able to find the kind of work that pays the kind of wage that they want.
The other thing, it's fundamentally a tax on virtue, economic virtues of thrift, of savings, of investment are actually sort of punished in a way. So we're telling wealthy people, successful people, people who have done the right sort of things in life that, look, spend it now and don't invest it, and that really does retard the economy. About 70 percent of the people, when they're asked is this the kind of tax we should have, argue or say no, it's not.
COLVIN: Will say no. Professor Graetz, let's start with that, public opinion, because you would think that a tax affecting only the wealthiest Americans would have very broad popular appeal, but in fact, as Bill Beach says, public opinion polls consistently show that about 70 percent of the public is opposed to it. Now why do you think so many people are opposed to your position on this?
MICHAEL GRAETZ: Well, I think there are two reasons. One is that the proponents of repeal have been very effective in convincing a lot of people that it's going to apply to them when it won't, and also they were tremendously sanguine in polling this tax as a stand-alone question. That is the 70 percent numbers that you see are in response to a question, would you like to repeal the death tax or the estate tax? Either way, you get about that same number.
They didn't ask, you know, whether you want to put in other taxes instead or whether you want to borrow from the Chinese to finance it or where you think the money is coming from. So they polled it as a stand-alone issue. When you poll it with other questions, those numbers go way down. But it is a tribute to the optimism of the American public that 40 percent of them think that they'll be in the top one percent or so when they die.
COLVIN: Well, that certainly is a phenomenon that we've seen in many other places as well. People are very optimistic about their own fate, or at least they think there's a chance. But let's get to the next point or one of the other points that Bill Beach raised, which is the incentive effect of the estate tax. In other words, his point is that having an estate tax incentivizes people to spend it now, live it up, don't save and invest because it's only going to be taken away from you if you still have it when you die.
GRAETZ: Well, one of the really interesting things about this debate was how unimportant the economic arguments were. There are economists on both sides. Some claim it will affect some jobs. Others claim it has very little effect on jobs. But the economists on Mr. Bush's economic team didn't think it was terribly important.
This issue really became important because of the momentum on the side of virtue that Bill Beach speaks of, that is the entire focus of the campaign to repeal the tax was on small businessmen, farmers, people who had built up wealth over their life. Nobody ever stood up and said, "Look, this is not a tax on Conrad Hilton. It's a tax on Paris Hilton."
Conrad Hilton could not take the money with him after he died, and there's an equally important principle in American life, which is that we're not an aristocracy, that we're not a futile nation, and that we believe strongly in equality of opportunity. And so the question on the other side is, why should the heirs of very wealthy people pay no taxes just because they receive money from someone who was enormously successful?
COLVIN: Bill, it sounds to me like that line of argument might cut some ice with the American people.
BEACH: Let me go to that point, because I think it's a commonly misunderstood point, and in Mr. Graetz's book I don't think it's any better understood. The critics of this tax have argued all along that if you want to have a progressive system of taxation, where you basically are looking at the income distribution and from that the distribution of political power and social influence, that you have a perfectly good tax system in place to do it, and that is the progressive income tax. In point of fact, the estate tax undermines the income tax, because it undermines investment and it stimulates consumption.
And if you look at the testimony, if you look at what the senators and the members of the House, those people who took an active role in this, in both parties the virtue argument was very important, and it went like this: It is wrong for us to have a tax in place that says work hard, invest your money, save it, do the kinds of things which constitute an A-plus on the American dream scorecard; and then we have a tax, that used to be a 55 percent tax, (that) would basically take that away.
It wasn't that we said we shouldn't have a tax on wealthy people. That was never the point. The point was this tax on wealthy people is un-American, it is not moral and it is a tax on economic virtue. I know many people, including Carol Moseley Braun, who believe that this is not the kind of tax we ought to have, that in point of fact we ought to put more focus on the progressive income tax.
COLVIN: Professor Graetz, that's a fairly powerful point that has to be argued one way or the other. Aside from the pragmatic economic effects, is it morally okay to tax estates at a high rate as we have been doing?
GRAETZ: Well, I think it's nice to hear the Heritage Foundation and Bill Beach supporting highly progressive income tax rates. This is an unusual event. We ought to at least mark it before we answer the question.
But the key point is that this is our only tax on wealth. The top one percent of Americans own 25 percent of the wealth, and for constitutional reasons there is no other tax in the United States on wealth. Joe Sixpack, he pays tax when he works. He pays his payroll tax, he also pays his income tax. He goes out and buys cigarettes or gasoline or alcohol or goes and buys anything in a retail store and pays sales tax. So Joe Sixpack is taxed four or five or six times, but somehow the argument from the richest people in America is that it's immoral to tax their accumulations of wealth. It just doesn't make any sense.
COLVIN: But the argument on the other side of that is why should the federal government be taking away an estate or a large chunk of the money that someone has gone out and earned? And of course the evidence is that the vast majority of millionaires earned it on their own, 80 percent of them or so. If all that happens is that the person dies -- there isn't any new income being earned or anything -- why should the federal government be taking that away, especially if the person only wants to pass it on to their own kids?
GRAETZ: Well, Geoff, there are only four things that you can tax and get any money for the government to run. That's wages, spending in the form of consumption income, and wealth. And as I say, because of the constitutional structure of the United States, the federal government cannot tax wealth except when it is transferred, and so it taxes it when it's given away to heirs or when a person dies and passes it on at their estate. And in those cases we impose a wealth tax.
It's the most progressive tax in the system, and it is a tax which suggests that the people who did not earn it, the people who are the children or the grandchildren -- or now we have gotten rid in many states of rules against perpetuity, so it's many, many generations -- are wealthy because of the success of one individual, while the other people in the country who are just earning wages are going to be taxed two and three and four times.
COLVIN: Bill, there's another angle on this, those who oppose repealing the tax have said as a practical effect it will greatly reduce charitable giving, some people have said by as much as $15 billion a year, because people do give a lot of money to charity as a way of evading, or avoiding I should say, some of that tax.
BEACH: This is a much-studied critique of the repeal argument. And what I say in response to that is this. Charitable giving goes up as income rises. So if we have a booming economy, a growing economy, we will have more charitable giving. Americans are very generous and they give about 2.5 percent of their income, whether or not the country's at war or whether the country's at peace. And I think that charities should earn their charitable giving. And I'm sort of opposed to a tax provision which allows the Vanderbilts, just to pick a name, to give money to a university and to name the performing arts center after their family. It's a form of monument building which just doesn't seem American. So I think what we need to do is repeal this tax -- this is a tax on virtue. It's got a solid moral argument against it - put our focus on economic growth.
COLVIN: Professor Graetz, one of the main arguments against the tax in favor of repealing the tax is that it falls very heavily, very harmfully on owners of small businesses and family farms. To what extent do you give weight to that?
GRAETZ: Well, I'm a person who has argued that you could exempt family farms and small businesses from the tax as long as they stay in the family and exempt them completely from the tax and eliminate that problem. Small businesses account for a very tiny percentage of the revenue that's raised from this tax.
The money that comes in, comes in due to portfolio holdings of large supplies of liquid assets by very wealthy people, and (yet) the small businesses and the farmers have been the people who the argument has focused on. The repeal forces want you to think about the small business owner and not to think about the coupon clipper.
But the small business piece of this, while very important to those businesses that it hits, and I have great sympathy for people who have not planned and don't have insurance to pay the tax and have problems in liquidating their businesses. Bill Beach has collected a number of stories of these people. I think they should be exempted from this tax.
COLVIN: So bottom line, Professor Graetz, if the repeal is successful, and let's say that the estate tax is repealed permanently, or as permanently as anything happens in Washington, as of 2010 what's the effect on the U.S. economy?
GRAETZ: Well, I think there's a trivial effect on the U.S. economy. All we'll do is increase our deficits unless we find a way to replace the revenues or to reduce spending, which we have not been very successful in doing. We've got huge deficits, we've got an aging population. We're going to need more money, and the question is where is it going to come from?
COLVIN: In the immediate future - you've been in Washington for a while - what do you expect to happen on this? Is there some kind of a compromise that's going to come out?
BEACH: Yes, I think what will happen now, the House, as you have said earlier, has permanently repealed it, given a sort of a phase-out period. The Senate will come back with a very different approach. They will do what Professor Graetz has recommended, and my guess is have a generous exemption with complicated rules for small businesses and farmers that nobody is going to understand. And then in conference we will cobble together something that looks like permanent repeal with maybe some changes in the income tax that will pay for all of this.
COLVIN: Professor Graetz, does that sound right to you? You were a Treasury official working on tax.
GRAETZ: Well, I think it's very hard to predict a compromise. The forces that have been for repeal here, the grasstops constituents of members of Congress who have convinced them to repeal this tax, are not ready to compromise. So I'm less optimistic about a compromise of any sort, unless it leads to permanent repeal, which is what Bill Beach has suggested which doesn't sound like a compromise to me. It sounds like a miracle or a victory.
COLVIN: Well, in any case, we should find the results for real pretty soon. Professor Michael Graetz, Bill Beach, thank you.
BEACH: You're welcome.
GRAETZ: Thank you.
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