Investors have reaped the benefited from QE infinity on asset prices. Bill Priest, CEO & Co-Chief Investment Officer, Epoch Investment Partners, talks with Kim Parlee about whether earnings will be strong enough to push stock prices higher when stimulus programs come to an end.
Hello, and welcome to the show. It is great to have you with us tonight.
Let's start things off by taking a look at the five-year chart of the S&P 500. You're going to see pretty clearly here that this index has nearly doubled over the time frame. We've got it on the screen.
But market watchers will tell you that much of the rise was from things like multiple expansion, which of course has been driven by the central banks around the world, their massive quantitative easing.
But the end of global QE is fast approaching, and interest rates, many people are positing, will rise. So what's it going to take to take the markets higher once that's gone? Joining me is Bill Priest. He's CEO and co-chief investment officer of New York-based investment management firm Epoch Investment Partners. So good to have you here.
A pleasure to be back. Thank you.
In person, I have to say, because sometimes we get you from New York, which is great. But it's nice to have you sitting down. We've got you for the full half hour.
And we kind of want to go through a number of things in terms of how you're seeing the markets right now. And I'll just let people know that we are going to talk about-- we'll get a few kind of sectors and names that I think are interesting a little later on in the show.
We want to start off with what I just mentioned, the levels of the market right now. Take us through your thinking in terms of how the markets got to where they are, because they just keep on going up, and what's driving it.
Well, I think the first thing to do is perhaps show our viewers a chart, which basically will walk you through what happened in the last five years.
Now, when you look at any index, there are only three things that determine the outcome of a stock or an index. It's the change in earnings plus the dividend yield plus the change in valuation, which people generally measure as PE ratios.
So as you were saying earlier, if you look at the S&P 500, for the five years ending December 31, 2016, the S&P is up 98%. But if we broke that into its three components, what you'll find, multiple expansion, as you indicate, is 2/3 of that expansion. In other words, 68 percentage points of the 98 came from multiple expansion.
Now, if you look at the global market, and that would be looking at the MSCI index, for example.
Which I'll let people know is the middle, if they are keeping track here.
The middle of that page, correct. It also had quite a rise, 87%. But there was no earnings gains. Now, if someone had told me in January of 2012, good news, Bill, the MSCI will be up 87%, and by the way, there will be no earnings gains, I would have said that could not happen.
The only reason that can happen is because the discount rate for dividends or earnings or cash flow-- whatever metric you want to use-- was pulled down artificially by quantitative easing. The way to think about the MSCI, imagine the MSCI was a company.
And the MSCI, if it were a company, it had a higher valuation in 2016 than it did in 2012, despite a decline in earnings. That is highly unusual. And it's set the stage.
And false. It almost just seems false.
It does seem false. But it did set the stage for an acceleration of the active-passive debate, which I'm sure we'll get into at some point.
The third pie chart there showed the history of the S&P for 90 years.
Yeah, let's just bring that chart back up, if we could.
So if you look at the 90-year chart, this one covers 90 years, from 1926 through 2016 for the S&P. What's interesting is that earnings provided 5% of that 9.9%, dividends were 4%, and the PE ratios were only 80 basis points. They didn't matter in the long run. It was all earnings, dividends, and real economic growth.
But for the last five years, that wasn't true. And it created a very difficult environment for active managers.
OK, so let's then say if you are of the belief that quantitative easing, which we're seeing right now is starting to taper off, and rates, we keep getting hints that they're going to start going up in a meaningful way. And I think that's an important qualifier, to say meaningful. What does that mean for the markets?
Well, the way I would look at it is we've had this five-year period where interest rates were essentially flat to falling. And the corresponding outlook for PE ratios would be they would be flat to rising.
The inverse will start to take place, but it will be slow. If you think inflation is going to be modest, then I think interest rate rises will be modest. But interest rates are likely to rise slightly. So if interest rates are flat to rising, I think you can expect PEs to be flat to falling, other things equal.
So that gets you back to dividends and earnings, and it gets you back to more active investing than passive.
The one thing I think has been fascinating is, of course, that passive has done so much, and the rise of passive has been nothing short of monumental in the past little while, but on the back of rising markets. So do you really think you're going to see a shift? I mean, obviously, this is where active managers, like yourself, will gain what you do. Because in this new environment with not all markets rising, it's going to make a difference.
I think what will happen is both are going to exist. And you have to think about how one came into play. It was the middle of the 1960s when the first S&P 500 index fund came about. It was actually Wells Fargo who introduced it for Samsonite, a client of theirs.
The perfect time to launch a passive fund is when the world is all active, because in the active world, essentially, there's lots of arbitrage going on. There's lots of price discovery. And in effect, the first passive index fund gets pretty much a free ride on the benefit of the arbitrage and the research done by the actives.
By the same token, if the world goes all passive, it's the perfect time to launch an active fund, because at that point, when you buy an index fund, you own the good stuff and you own the bad stuff. The reality is we'll sort ourselves out in the middle somewhere. And it will be one where the active managers, there will be fewer of them in five years than there are today, but they'll all be good.
It's a little bit like playing poker. You and I might be the best poker players in the building right now, but we might not be the best in Toronto. We might not be the best in Canada. And then we come to North America, and you really want to get to the championship game in Las Vegas, not that I'm comparing investing to that.
But the whole idea is that the competition gets keener and keener and keener. And at the end of the day, the people who are left will be very, very good active managers.
Let me ask you-- and we'll get into this in the next two segments-- but given that, with the environment changing, what are the kinds of things you're listening for from companies to determine they have your interest?
I think the key to understanding a company is do they generate cash. Now, this may sound simple, but the value of any company is a function of, first, its ability to generate cash flow. Are they profitable? It's not earnings. It's cash.
The one thing accountants cannot hide is cash. So if you can observe how cash is generated in a business, you can start to understand how the business works. But that's only part one.
The second part of being a good manager is the allocation of that cash. And there are only five things management can do with cash. They can pay a cash dividend. They can buy back stock. They can make an acquisition. They can reinvest in the business. And they can pay down debt. That's it.
So you can look at management and say, do you have a good business? Do they generate cash each and every year? Are they good capital allocators? And you can look back, and say-- look at their history of how well they've done. Only then, can you really start to say I think this is an interesting business.
The problem is, what price do you pay for it? And companies don't control that. That's controlled by the markets, particularly interest rates. So you can have a good company and watch it go down in price because interest rates double, for example.
By the same token, you can have a bad company, and if interest rates fall, it could go up in price. And that's pretty much what happened to a lot of companies in the last five years.
Bad ones went up with the good ones.
One other, I know, thesis that you've talked about and that I've heard is that technology is the new macro-- very catchy-- so what does that mean? And why do we care?
Well, we'll see it in the allocation of capital. But let's take one step back. And I would recommend to the listeners a book called The Second Machine Age.
It's written by two guys at MIT, and they basically tell the story of how-- why now? Why is technology such a big deal today?
And it goes all the way back to Moore's law. Gordon Moore was the founder of Intel. And Moore's law basically says the power of a computer chip will double every 18 to 24 months. Well, since he said that, you've had about 30 doubles. So all of a sudden, we're not used to exponential growth.
So all of this data has been digitized. It all exists in the cloud. And because you've had this mass amount of data in the cloud, you can create all kinds of algorithms and replications of data. And it's having a powerful effect on running any business.
So for example, the best way to see that-- and there's an equation, which you'll show on the chart.
It's called the DuPont return on equity equation. Those of you that had a little bit of finance probably ran into it ages ago. But essentially, return on equity is a function of three things. What's your profit margin? What's the scale of your business in terms of assets and sales? And how much leverage do you have in the business?
Well, profit margins are profits divided by sales. If you can substitute technology for labor, and your revenues are not harmed, your profit margins go up. And you can see this particularly in retail today. There's an enormous substitution of technology for bricks and mortar and employees in many retail establishments.
You can also see it in asset utilization. Then that is measured by sales per dollar of assets. You don't need to have bricks and mortar today that generate a sale. So therefore, you can shut down some of those assets. They're redundant, and you don't need them.
So if you're getting better margins and higher asset turnover, your return assets are going up.
You also usually have some leverage in the business. And the way you measure leverage is assets per dollar of stockholders' equity. Well, if you don't need the assets, you don't need the stockholders' equity, or at least as much. And what that means is dividends are going up. You're going to see a substantial rise in dividend payout ratios.
So this is like Moore's law for capital returns, almost.
In a sense, it is. It's technology, and it's going to go through the allocation of capital in every single business you can imagine. There will be no business untouched by this.
Who does this hit first, I guess? I mean, this is part of, I guess, the role, again, of active manager. You're looking around, and going, OK, we're seeing this happen everywhere.
Well, we're seeing it happen. Some of these businesses have remarkably high valuations. Amazon, for example, comes to mind.
It's a gigantic firm. It's been amazingly successful.
It generates virtually no free cash flow. That said, they have disrupted so many businesses. And nothing is going to stop them, because capital has been incredibly cheap for them.
When capital is free, dreams come true. And you pretty much have had that in this declining interest rate environment. Now, when rates start to rise, that may be less so.
A better example might be Google. So if you look at Google, they are the dominant source of search, by a long shot, in the internet. And they are remarkably profitable. They have a lot of cash on the balance sheet, and they continue to grow free cash flow in mid double digits. It's a remarkable firm.
There's also firms that make things that enable this digitization to take place, and Applied Materials would be an example of that. They make the equipment that basically makes the chips.
And all three of these entities are in significant growth phases.
I guess the question I would have is-- and this is maybe just a timing thing. But they are all in significant growth phases. They're doing all these things you said. But the valuations have been pushed up so much from what's happening in the market. How do you, like you know--
That's a problem. That is a problem. Amazon is an entity. We do not own Amazon, because we have a hard time justifying the valuation.
But we do own Google in our portfolios, and we do own Applied Materials. And you can see enough of the future there to indicate that the price per dollar of future cash flow growth still looks somewhat reasonable to us.
It's exciting times. I mean, this is revolutionary, this stuff that's going on.
It is revolutionary, and it's not going to stop. It's just going to accelerate.
I want to bring up this chart, Bill. And maybe you could take us through this. You've brought here a chart showing manufacturing margins. We're looking at the line chart on the upper left here.
And basically, you've seen a huge move up in the margins of manufacturers. In this, I believe, is in the United States. And I want to talk a bit about, what does President Trump have to do with this?
Well, the good news is I don't think this margin expansion is going to go away, unless protectionism sets in in a big way.
But what's important about the slope of this, it's all been fairly sudden. It's been the last 15 or 20 years that you've seen this explosion of margins in manufacturing, in particular, but in the S&P 500, in general. And it has largely been driven by the technology points that we discussed earlier.
But if you look at the margin expansion over the last 15 years, there were four factors that really drove this. First of all, you did have the labor arbitrage, which is the wage savings, which you can see in the upper right of the pie chart. You also saw wage savings from more efficient domestic plants. That's essentially the substitution of technology for assets that we talked about.
There's also been a decline in the effective tax rate. Sometimes, you'll see that the US has the highest tax rate in the world. It's not true. The effective tax rate is in the mid 20s.
And then we have the decline in interest rates. So the cost of capital has declined over this period of time, as well.
Well, if you start to put in mechanisms that increase protectionism, you're not going to get the labor savings. You're probably going to get a downturn in final consumption.
What most people don't fully realize is the law of comparative advantage essentially says it pays to trade. It truly is a win-win.
Right. You do what you're good at. I do what I'm good at.
And then we work out a trade where you wind up getting a greater proportion of the two-- if you made butter and I made guns, and we did a swap, you would have more butter and guns than you had before you started, and so would I.
And how is this possible? It has to do with the relative cost of producing these things. And you produce the one that you are relatively better at than me, and I do likewise.
There are a small segment of the population that will be harmed by this. And in America, we've done a very poor job of providing supplemental income or training. In fact, it's much worse than Europe. And that is something that Trump and his supporters have leaned on.
I think it's easier to fix the help part than just to have target import quotas or things of that nature.
But having said that, that doesn't look like it's the path that America is on right now. It looks like they want their guns and butter made in America, and they will sell them to Canada, for example, in our new NAFTA agreement, or what have you. So how does that affect the investment thesis?
Well, let's see how that plays out. I think business has started to put this-- business sees that its trade is valuable. We'll see how much of the protectionism does get in place.
I would say that I do not share Donald Trump's enthusiasm for protectionism. I think there are things that have been wrong with regard to supplementing income and training for people in the United States. But that's a much easier fix than saying one down, all down.
If win-win in trade is good for everybody, then protectionism is lose-lose. Everyone will lose. It's just not a good outcome.
What about upcoming tax changes we can see also in the United States? I mean, what kind of-- I mean, a lot of that's been the Trump bump when it first came, and you saw that. If those just turn into a tax cut one time just to get something done to help the midterm elections that are coming, too. I mean, how is that all going to play out?
Well, the tax thing is really quite interesting. The border tax issue that was raised, it looks like that's dead.
It looks like that's not going to happen. The way they account for the tax to accelerate growth, you can do that, but you do have to pay for it somehow down the road.
And they have something called dynamic scoring, which basically says if I spend $1 today, it will generate more value added next year and the following year. So when that lower tax rate is taxed on a higher income down the road, it'll all work its way out. Dynamic scoring is-- let's just say it's imaginative. It's more imagination than reality.
It's unclear to me, given the state of where we are in our government right now, that you're going to see a lot done. They are going to go after the tax thing. But I'm not sure. You've got to pay for this tax cut. I don't know how they're going to pay for it.
I was wondering, I guess, seeing it from the people I've spoken with, if you're going to see, maybe, the Republicans feel as though it's more important to get re-elected than to pay for a tax cut. So that's would they cut-- would they pass something to make sure that they get to be around for the next election?
Well, they might. And I do think there is-- tax reform is necessary, and it is a good thing.
We haven't had tax reform in the United States of any consequence since the Reagan years. And when that happened in the mid 80s, that was a good thing.
What you have to be careful of, you can accelerate growth through just borrowing money. And you can accelerate growth in the US by significantly expanding the fiscal deficit. But somebody down the road is going to have to pay for this. And that's unclear. And there will-- you'll have to have some kind of a mechanism by which that takes place.
Let me ask you, last question-- I've only got about 45 seconds left-- but if you and I are sitting at this table again one year from now, which I hope that we do, what do you think are we going to talk about? I mean, what's happened in the markets? I mean, you talk about some of the trends, but is a year enough for these things to be kicking in, or are we talking a little longer term?
I think the future is unknowable. And I think we will always be surprised. Something will happen between now and then that we didn't talk about yet.
And I have no idea what that might be. We clearly have some concerns about the consistency of the current administration. But there are some significant individuals there that I think have the greater good in mind.
We'll have to see.
The exogenous variables that matter would be things like North Korea. The Mideast is a mess. Everybody knows that. But it's unclear to me what might happen.
You would hope that the US would come to its senses and be a leader in the world. The world will not do well if power-- if there's a vacuum of power.
Well, there's certainly not a vacuum of smart things being said here tonight. Bill, thanks so much.
Bill Priest, he is the chief executive officer and co-chief investment officer at Epoch Investment Partners.
I'm Kim Parlee. There's a look at his book, Winning at Active Management, Bill Priest, Steven Bleiberg, Michael Welhoelter, and John Keefe.