Galbraith: Visible Hand Is the Biggest Risk for Investors, Equities Are the Best Opportunity
“I’m a stock investor and express my views in individual securities, but I think some things have changed,” Steven Galbraith, managing partner at the hedge fund Herring Creek Capital, said at the 15th Annual Equity Research and Valuation Conference conference in Philadelphia. “You can no longer just look at the micro,” Galbraith said. “The visible hand and policy blunders are the primary risks for investors today.”
Galbraith, a former Morgan Stanley strategist and former partner at Maverick Capital, then took the audience on a quick tour of the world to highlight key macro and micro issues, review past booms and busts, and identify where “reversion to the mean” opportunities could likely occur over the next three, five, or even ten years.
To understand why Europe is different, Galbraith did a word count. “EU regulations on the sale of cabbage is 26,911 words. That is three times the number of words in the US constitution with all 27 amendments,” he said. European regulators already have a heavy hand in the markets and “all politics are local,” so politicians are balancing their own self-interest with the need to bring down massive debt levels and mend the EU economy.
Europe is under stress and affecting global stocks in strange ways, but also it looks very intriguing to an experienced value investor like Galbraith. Galbraith pointed out that the market capitalization of Apple (AAPL) is larger than the market caps of all the banks in Germany, France, Portugal, Italy, Greece, and Spain combined! As a stock picker, “You can either buy Apple or the entire European financial system,” said Galbraith. He recommended that the audience dig deeper in the financial sector in Europe for value situations.
“If I had to outline the biggest tail risk for 2013–2014, it would be China,” continued Galbraith “One thing I’ve learned is that you cannot have excessive confidence in this business and do well. If anyone is telling you they know how China’s going to turn out, they’re lying.”
Instead of relying on the official published data, Galbraith looks at actual output and rolls up the financials of publicly traded and state-owned enterprises to evaluate the aggregate. “This is a heavily industrial economy, so you can look at things like electricity output or railcar volume and see massive deceleration.”
Disturbingly, debt has also been rising dramatically in both government and corporate sectors in China. Total debt-to-GDP went from 130% in 2007 to 180% today, which is by far the highest level in emerging markets, and Galbraith says its source is the unregulated part of the financial system — think structured investment vehicles (SIVs), off-balance-sheet items, and wealth management products. In the corporate sector, debt-to-EBITDA has gone up nearly 50% in the last several years, profit margins have been squeezed, inventories are bloated, and liquidity has dried up. Galbraith showed that 4 out of 10 companies are highly levered, while “reported” nonperforming loans (NPLs) are at an all-time low. Something is wrong! Galbraith believes China is understating the extent of credit risk in its system. “The ‘reversion to the mean’ guy in me is saying maybe we’ve reached the bottom and it couldn’t get any worse,” said Galbraith. “Though I think it’s too early to have a strong point of view and right now the data looks pretty scary.”
The United States
I’m less sanguine on the United States from a “reversion to the mean” point of view. Galbraith noted that on a sectoral basis, earnings on the S&P 500 are at an all-time high and tech earnings are 200% of the prior peak. “Maybe that’s a cause for concern. Maybe it’s time to hedge Apple,” he said.
The corporate sector responded well to the crash of 2008, slashed SG&A, and reigned in spending. “This is why unemployment has been so high and sticky,” Galbraith said. He forecasted that in 2013, when some of the fiscal uncertainty is behind us, corporations will start to invest again. But watch out for M&A peaks like 2000 and 2007. “The corporate sector always tends to blow it with bad M&A,” he said.
One sector in the United States that Galbraith is positive on is the financials. Certainly there is regulatory risk and the balance sheets are difficult to understand, but he’d much rather invest in them today, when they’re better capitalized, than before the bust. “If you value Goldman Sachs as a public utility, you’ve got 50% upside,”Galbraith said.
Here We Go Again
Galbraith ended with a tour of the last 10 year’s ebbs and flows/booms and busts in major asset classes. Galbraith predicted the Nasdaq may get back to its peak of February 2000 in 2018! High-yield-bond spreads, which blew out to 2000 bps in November 2008, are back to more normal levels. Commodities spiked in June 2008 and again in 2012. The BRIC markets that peaked in 2007 and collapsed dramatically in the last few years are now near old highs. The US housing market — which spiked 60% from the early 2000s, peaked in 2005, and then collapsed down 40% through 2008 — is stabilizing. “The last one to go may be the government bond market,” said Galbraith. “Jack Bogle said it can’t be a bubble by definition, but it certainly looks ‘iffy’ to me. I’d rather own Anheuser Inbev than Belgian debt. Free cash flow is higher, and it’s a living breathing entity that can reincorporate if it gets into a penal tax regime.”
What’s most important, according to Gailbraith, is that we look for the kernel of truth in each of these bubbles. “The internet did change everything, and the key was to find the companies that were the champions of the change — like Amazon, Google, and Priceline. I do think we’re in a commodity-restricted environment and there is a case for peak oil. I do think we’ll reach scarcity in housing again. Just look at the institutional investors buying thousands of homes at deep discounts. And I would be more heavily weighted in high-quality equities than almost any fixed-income sector.” (Gailbraith isn’t alone: half of the respondents to this year’s Global Market Sentiment Survey said that they expected equities to provide the highest returns compared to other asset classes.)
Galbraith’s stunning conclusion is that over the next year or so, after more than a decade of underperforming the index, active managers will finally be able to invest again. “That’s why I’m starting my own firm,” Galbraith said. “We’re not that bad. I think we’ve got a shot.”
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