SAN FRANCISCO -- The panelists at Pensions & Investments' annual Investment Outlook Roundtable generally were positive on the U.S. economy, projecting roughly 4% economic growth and continued low inflation at the 1999. Outside of the domestic market, however, things look different.
The panelists in the Nov. 30 session, an edited transcript of which follows, were:
* Frank J. Husic, managing partner of Husic Capital Management, San Francisco;
* Peggy Woodford Forbes, chairman of Woodford Capital Management LLC, Los Altos, Calif.;
* Gail P. Seneca, managing partner and chief investment officer of Seneca Capital Management LLC, San Francisco;
* David S. Post, director of research at Harris, Bretall, Sullivan & Smith LLC, San Francisco; and
* Robert Gillam, president and chief financial officer of McKinley Capital Management Inc., Anchorage, Alaska.
Mike Clowes, editorial director of P&I, moderated the session.
* * *
P&I: Gail, how do you see the outlook for the U.S. economy next year? Will it continue strong? Will it suffer some weakness?
Ms. Seneca: We will have continued strength going in, probably through the first half of the year. But we think accompanying that strength will be continued pressure coming from the Federal Reserve, and eventually the Federal Reserve's rate increases are going to bite.
So by the second half, we think we're going to start to see some meaningful weakening in the economy. By fourth quarter I wouldn't be surprised to see a (gross domestic product) rate in the 2.5% area. So we'll start strong, probably not as strong as the fourth quarter because we're borrowing a little bit this quarter from next year, but it will be a healthy economy, healthy enough to frighten the Fed further. And so they will continue pressuring us, and, finally, they'll win.
P&I: What about interest rates?
Ms. Seneca: They'll follow precisely that economic pattern. Interest rates will go up in the first half, but by the time we get to the fourth quarter of the year -- if we're right and this scenario pans out -- we'll see 30-year bonds below 6% again, and we'll see the Fed funds rate at a lower level than where it is today. Probably at the peak, long-term rates in the second quarter of the year could get as high as 6.75%. But by the time we get to the fourth quarter, we think the 30-year bond is below 6%, down to maybe 5.5%.
P&I: Inflation?
Ms. Seneca: Inflation's going to be frightening. We expect we'll get a quarter or two of 3%-plus numbers in (the consumer price index), and that's something we have not had in a very long time in this country. But we think for the year CPI comes in probably around 2.4%, 2.5%. So a similar pattern: Inflationary increases in the first half that are frightening to the Fed, followed by much more moderate, much more comforting numbers in the second half.
P&I: Peggy, what are your expectations for the next year?
Ms. Woodford Forbes: Our expectation is that the economy will continue to grow in a fairly robust fashion. We, too, are looking for much more pickup in the first two quarters of next year, and we're looking for GDP growth to be somewhere between 4.5% to 5.5%. We feel there's a lot of spending that will continue to push things forward as we go into the millennium, and we'll see tremendous earnings growth and profit growth, certainly, in the first two quarters.
The Fed will be on watch. They may raise rates again in the second quarter, but we feel the Internet presence is also going to exert somewhat of a deflationary pressure on the picture.
We also feel that in the second half of the year there will be more moderation in the economy. Interest rates will be somewhere between 6.75% to perhaps 5% by the end of the year. So we think it's a fairly good picture.
P&I: Bob, agree or disagree?
Mr. Gillam: I think we're going to see 6.75% before 5%. We see inflationary pressures building. I think we're going to see significant demand pull on wages. I would guess the Fed also will begin to develop new kinds of tools. We really have two economies here: We have the physical-based economy and the knowledge-based economy. The knowledge-based economy, which is the Internet of course, has been growing 14 to 15 times as fast as the physical economy. The tools do not yet exist to measure what productivity gains are coming from the Internet.
In terms of profits, we see double-digit profits in the United States, but selectively so, primarily in the high productivity area. The technology area should see over 40%. The S&P maybe 15% to 18%, which sounds like a wonderful number, but it's going to pale in comparison to other parts of the world in 2000.
Gross domestic product, still on a roll, will continue to grow between 3% and 4%, probably closer to 4% for the year. We share the view that the first half is going to be scary for everybody -- wages especially. So higher bond rates sooner, lower bond rates later, a dampening effect in the economy later in the year, but, nevertheless, a very fine playing field indeed for equities, especially in the technology area.
P&I: Frank?
Mr. Husic: I think 2000 will be one of the best years for global growth that we've had for a while, maybe for 10 years. But I see 2000 as just being another year in a longer-term trend where I believe the real forces in the world are deflationary forces.
I hope we don't make a big mistake in the United States by killing the golden goose, because my view is that in the world today there's only one source of internal economic growth, and that's the United States. Growth in other parts of the world is basically a result of export demand and not good internal growth. And I hope that both Europe and Asia can start to develop growth-oriented policies of their own so they can begin to help the United States pull along the rest of the world, because the emerging markets are only going to grow if industrial economies are growing.
Right now only the U.S. is growing, and I'm optimistic that Japan's going to do the right things, and I'm optimistic that Europe will do the right things. I worry a little bit that there could be a real run on the euro, because if people lose confidence in the fiscal policies that are being generated in Europe, it could really start to unwind the kind of current equilibrium we have.
However I have a different point of view about the fixed-income market. There's a tremendous consensus that the Fed has to raise rates. I don't see it in gold; I don't see in it oil; I don't see it in commodity prices. And as far as wages are concerned, I really believe there's excess labor around the world. It's just a matter of producing growth to employ these people. I don't see inflation in any way, shape or form, and I think interest rates are closer to a peak rather than moving the other way.
P&I: David?
Mr. Post: Our feeling is that domestic GDP growth could be as strong next year as it is this year, which would be around 4%. If you look at GDP forecasts at the beginning of the year each of the last three years, the expectation was strong first half, weak second half. And each of the last three years it was strong first half, strong second half.
Continuing trend
So we're thinking that we're going to see the same kind of trends -- strong first half, strong second half -- driven partly by inventories. We've had relatively limited inventory growth domestically this year. That's been a little bit of a drag on GDP growth this year, a fraction of a percentage point, but the trade deficit should probably reduce the GDP this year by between 1.5% and 2%.
I may have a little more confidence than does Frank in Europe in the next year. If Europe accelerates a little bit -- something like 3% GDP growth in Europe next year in the euro countries vs. 2% this -- if Japan accelerates a little bit, the $300 billion annual pace of the trade deficit might be cut a little bit, so we think GDP growth could be somewhat stronger.
One more comment on GDP growth. The last three years, 4% GDP growth has been the best three-year period of GDP growth in about 20 years. Combine that with the last three years of CPI growth in the 2% range. You adjust for the decline because of oil prices and the increase because of oil prices. We're looking at the best three-year period for CPI in about 20 years. So strong growth, low inflation, we don't think that's an anomaly; we think that's going to continue. The drivers behind it -- technology, the Internet, globalization -- are going to continue.
P&I: What is the major threat to the U.S. economic well-being next year?
Mr. Post: Maybe a decline in the stock market. The margin debt as a percentage of consumer disposable income is around 2.5% right now, and that compares with a 30-year average between 0.5% and 1%. So there's a lot of margin debt out there on behalf of consumers.
On the other hand, equity portfolios of consumers are worth a lot more. The driver of consumer spending is substantially the equity markets. So we think that if the equity markets have a bad time -- we don't think that's going to happen, but if they do -- that's probably the biggest threat as far as we see to well-being for the U.S.
P&I: Frank, what's your biggest threat?
Mr. Husic: An unintelligent Federal Reserve that looks too much in the rearview mirror, thinks it has to fight the boogeyman of inflation, raises rates, changes policy, tightens, forces the U.S. into a slowdown, house of cards falls around the world and then we have really big problems.
P&I: Repeat of 1929-1933?
Mr. Husic: Yeah. Play our own version of the '30s.
P&I: Bob?
Mr. Gillam: I have more confidence in the Fed than Frank. We don't think that's as much of a threat as it might seem, although it's certainly a possibility, the Fed getting too far ahead.
It seems like the shocks in the market and to our economy have been external in the last half-dozen years, and in Asia an unexpected shock. And we would guess the largest threat to the U.S. economy today is external, not internal, and that external threat could come from Russia. We know we have presidential elections there in a few months. It could come from the WTO not including China, which is, at the moment, a foregone conclusion with respect to the markets. There are a number of possible events around the world. There's a proliferation of arms about that could get used accidentally.
So we think the major threat to the economy is probably external.
Ms. Woodford Forbes: We, too, believe the foreign shock could be the one that derails this rosy picture. Asia is a big concern, Russia's a big concern, and possibly even Latin America. So there could be some kind of currency manipulation that could be very negative and other kinds of political situations that we're not totally aware of that could help to derail the process. The second would be a big backup in the interest rates.
P&I: Gail?
Ms. Seneca: The Fed is also my concern, because I do think the Fed will act again, and I don't think there's ever any precision when the Fed acts. The Fed doesn't know which rate hike is going to cause problems, particularly in this economy, which the Fed doesn't fully understand, as we don't fully understand it.
This economy's highly levered. Since the '80s we've been building debt in the U.S. at an enormous clip; now private debt to GDP is something like 130%. So for every dollar of GDP, we have $1.30 of private debt, not government debt. So when the Fed starts to move, you really have the possibility of real accidents. The good news is this is a very deliberate and very gradualist Fed, so the probability of this accident is not high.
P&I: Bob, let's start with you and ask you what is your expected return for U.S. equities in 2000 and why?
Mr. Gillam: We think U.S. equities are going to be on a very good playing field this year, because our survey . . . shows 77% of U.S. companies expect higher earnings in 2000 with only about 5.7% of the companies estimating to be lower.
So with interest rates being relatively flat, maybe peaking at 6.75% (and) backing off later in the year, but earnings on a roll, we would expect the technology sector to post considerably higher numbers in the next 12 months, perhaps as much as 20%, whereas
perhaps value stocks or, say, the S&P 500, (will be) more in the 10% to 15% range. It's going to be clearly a two-tiered market, maybe three-tiered, large- and small-cap. But it should be a fairly good year for equities, provided the Fed doesn't get out of hand.
P&I: Frank, you're next.
Mr. Husic: I think the S&P 500 will go up, but it will be a subpar year, about zero to 5% rate of return total. The Nasdaq would be something better than that, perhaps 15%. But the most important characteristic is it will be a stock-pickers' market.
IPO blizzard
One of the phenomena of this cycle is there have been private pools of capital. I think it's created a competitive thing for us in money management, because it has meant clients have an alternative, which is all of these pools of private capital. That's what the IPO market is all about. There's a blizzard of IPOs coming. There is a small subset of them that are going to be spectacular winners. And so people who buy those are probably going to be able to do a lot better than people who buy traditional indexes.
P&I: David?
Mr. Post: We think 15% or so for the S&P. Our focus is on earnings. We don't think you're going to see multiple expansion, so what's going to happen to earnings? Going into this year the top-down consensus was we were going to see zero to 5% earnings growth. So far after three quarters we've seen 10% in Q1; Q2 was 14% or 15%; Q3 is about 16% or 17%. Q4 might be a slowdown. But the whole year will come in probably 16% or 17%. The consensus for next year, bottom up is 17%, top down is 10%. We think it will surprise on the upside, so a 12% or 13% number.
P&I: Gail?
Ms. Seneca: I'm a bit less optimistic on earnings growth for the S&P next year, and that drives the expectation for where the S&P's going to go. We're looking more for a 7% to 10% kind of market, which makes it a normal year, I guess, but it's not very normal coming after four years of 20%-plus growth. So it's still going to be a pretty good run for this market next year. I would echo the comment that there's no multiple expansion possible. And I do think earnings are going to be quite a stretch. Part of the reason earnings will look a little bit lower next year -- and I'm more in the 10% kind of earnings growth camp -- is the comparisons with '99 are going to be tough.
The '99 numbers were enormous, and they were enormous because '98 was weak. So the comparisons are going to be tough.
Secondly, there really is going to be a bit of wage pressure, which is going to show up in profit margins, and that's not going to be good for earnings. Now, 7% to 10% earnings growth number is nothing to be worried about; that's a decent year. But it's certainly not going to provide the kind of fireworks we saw this year.
I'm speaking specifically about the S&P 500. I think other parts of the market offer a lot more potential next year. And the market we think will broaden out next year, and it's begun to do so, in fact, already here in the fourth quarter. I think that's where the real excitement is going to be.
P&I: Peggy?
Ms. Woodford Forbes: We're looking at an S&P of somewhere between 12% and 15% next year, and we're looking at a Nasdaq somewhere between 25% and 30%. We think, again, we're going to see a two-tiered market. I also agree very much that we're going to see a lot of good companies coming out of other places.
`Stock-picker's market'
It will be a stock-picker's market next year, and it's going to tilt toward the side of the technology companies and the high growth that we're going to see there. As large-cap managers, we really do feel that we want to be in the technology sectors, and those are going to broaden out. Not just the large-cap, but the midcap sector will be increasing. And we do feel there are going to be some surprises in terms of good returns in the markets. It's going to be in the Nasdaq again. So we think there's going to be somewhat of a repetition of this year.
P&I: Is there any particular kind of technology stocks that you think will prosper?
Ms. Woodford Forbes: I think many of the leaders that we're seeing now are going to continue to prosper, those stocks that you have to own because they are the backbone of the Internet economy; Stocks like Sun Microsystems, EMC, Cisco. The names that are there, they may suffer some pullbacks because there will be some amount of profit-taking and disbelief in the valuations they're hitting. A lot of these stocks will hit tremendous valuations. But I think they will continue to be leaders.
We also like some biotech companies and many of the telecom companies, because we see the whole communications picture coalescing. And we think stocks like QualComm will continue to have a certain amount of dominance; some of the other telecom companies such as PCS and Nextel will continue to grow very well. So we would be tilting toward technology and communications areas.
P&I: Bob, what you do you think about that?
Mr. Gillam: I think telecommunications is really a global phenomenon. Last week telecom companies in Germany, France, Italy and U.K. all made new all-time highs in prices.
The broadening out of the marketplace is going to be a global phenomena in 2000. Asia's back. We see an incredible acceleration in earnings in a number of companies there. We've got double-digit GDP growth in those countries now. We see an enormous earnings gain in Japan. Matter of fact, our bottom-up estimate is 50%.
But, really, for the first time maybe in three years there will be extraordinarily large opportunities in the non-U.S. markets. The themes of the marketplace, we think, in the United States are going to be broadband development, clearly; outsourcing; the Internet, especially the infrastructure; semiconductors. We think this is going to be one of the longest up cycles of all time, and of course consolidation, especially in the media area.
There're enormous opportunities around the world. It will no longer be just the United States. Technology is spreading. Imagine, 100 million people on the Internet in America today. What's it going to be like in five years when there's 300 million Chinese on the Internet? So the backbone, the ability to build the Internet and build around the world is going to be perhaps the most exciting thing for the next half decade anywhere in the world.
P&I: Frank, what kinds of stocks do you favor for next year?
Mr. Husic: I would say that I share some of Bob's point of view. On the whole I focus on the area of high-speed broadband access to the home. There're three major combatants: the telephone companies deploying digital subscriber line technology; the direct broadcast satellite; and the cable TV people doing fiberoptics. And I think this is going to be a war that's going to accelerate big time in 2000, and I think there are some companies that you can find that win no matter which of those people win. People like Gemstar, that has the lock on the patents for electronic interactive TV guides, or somebody like Tevo that has a way of recording devices onto a hard disk instead of videotape.
I like the video game industry, because we're going to have a real important move in change of platforms. We're moving now to Sega Dreamcast. The big event of next year will be Sony Playstation 2, which is going to be an incredible device, I believe. And then after that Nintendo will come with their next line. So I think people like Electronic Arts, a little company called 3DO, and people who provide software should be in a real interesting environment over that period.
Finally, if we're going to get to 300 million Chinese, we're not going to do it with wired systems, because no other country in the world will ever wire up a reliable economic telephone system. So it's got to be done wireless, through other devices than PCs. So I think this is going to be an unbelievable growth area, especially now with WAP technology -- wireless application protocol -- becoming standard. We're really going to see an explosion of companies and opportunities in the whole wireless area.
And then I would reinforce Bob's perspective on the semiconductor industry, which might be the mother of all cycles this time, because the nature of the cycle has shifted. All through the '90s the tail that wagged the dog for the semiconductor industry was the PC business. Now I believe that the marginal demand is coming instead from telecommunications, Internet infrastructure and media applications, which are very different. And that's why you see, for example, the phenomenon in this cycle of Intel not leading the charge, but instead Texas Instruments, because Texas Instruments a while ago restructured itself and organized itself around mixed-signal processors, which, it turns out, is the magic device, because you want to take analog motion and convert it to digital bits and then reconvert it back to analog after you send it down some pipeline. So I think the cycle's going to be a real different one.
P&I: David?
Mr. Post: Echo the technology, then also health care and some select financials. We're going to go from, you know, 140 million global Internet users in the last year to 500 million in 2003. That's globally. It will be faster outside the U.S.; slower in the U.S. We went to 25% Internet penetration after seven years of consumer availability for the Internet. That compares to something like 13 years or 14 years for the cell phone. The rapidity with which the Internet has been adopted by consumers is a record, and what that results in is an accelerated spending cycle for those companies that want to provide the service, either telecom companies or the companies that are going to manufacture the devices. So the accelerated cycle here in North America is going to transfer itself into Europe and into Asia, the rest of the world, so it's going to be a fairly long-legged cycle.
Lots of countries in Asia, lots of countries in Europe, need to make the investment. So we're favorable on companies like Lucent, Cisco, Applied Materials and EMC.
On the health care side, I guess really the big pharma-companies have been a rotten place to be this year, despite the fact the companies delivered the same kind of earnings growth that they deliver, traditionally 14% or so. That's because S&P earnings growth went from 0% to 16% or 17%. They lost the earnings advantage. They're also interest-rate sensitive companies, so as interest rates moved up from lows of October of last year, people sold the big pharma-companies.
Rates are going to probably go up a little bit, but not very much. So the relative earnings headwind will be gone. And it's proven to be a bad time to sell the big pharma-companies when there's a concern about the pipeline or the sustainability of earnings growth, because they're always able to do deals and mergers. So we think that is probably going to be a good place to be next year, unlike this year.
`Net beneficiaries'
Finally, financials. We think there's some companies that are Net beneficiaries. In the big area we think Schwab's a Net beneficiary. They're posting record operating profit margins in the history of the company, 26%. And that's driven, not entirely but substantially, by the Net. And as they get more of their transactions done over the Net, that will improve their margin. Sixty-five percent of the customer service done at Schwab is done over the Net. That's a low-cost model.
Wells Fargo is another example. At the pace they're going, they're doubling the rate of increase in online banking every year -- 120,000 new online customers per month. By the time you get to 2002, that will mean half of the customers of Wells Fargo are banking online. Online customers have higher balances, higher revenues, higher margins, so there could be some fairly substantial upside earnings opportunities for people that buy Wells Fargo.
And then, finally, global M&A is in maybe the second or third inning. European M&A this year will probably be six times what it was in '97, or triple last year, which was double the year before. And the deals are still coming. And there's a long way to go to restructure because of the euro. It's really amazing, Mannesmann/Vodafone, the biggest, by far, hostile deal in the history of the world is being done in Europe. It's not being done here. And who are the leaders in that? Goldman Sachs and Morgan Stanley. They're the guys that are leading teams for both companies. So we think that global M&A is going to spread into Asia. Should be good for guys like Morgan Stanley and Goldman Sachs.
Ms. Seneca: The market's going to broaden, and it's going to broaden, we think, into smaller-capitalization companies.
Specifically, where we see a lot of juice is in midcap companies. And, in fact, in our own shop we've been able to exceed the S&P midcap for the last few years. We think that sector is really not only attractive from the point of view of earnings growth, but it's downright cheap, which you can't say about almost any of these large-cap stocks, even the ones we love, and there are lots of them. Sector-wise, in terms of industries and so on, no disagreement about the semiconductor cycle. It's extraordinary.
There are lots of ways to play it, but a very simple way to play it is to play the quality control companies like KLA-Tencor, which is still a cheap company from the point of view of the earnings growth. It hasn't been superexploited. And then, of course, to play all the specialty chip makers that work in the area of wireless and broadband, everybody from RF Micro Devices to AMCC. There's a host of these companies. They're all smaller companies, midcap companies. Most of them are not household names and all of that's a benefit. There's lots and lots of price appreciation to come in these companies.
Retail plays
I think the other simple notion to play here, which is related to the technology revolution we're undergoing, is simply to play this via retail. Tandy, in particular, is a tremendous play on all of this, and it's one that shouldn't be neglected. It's gone up a lot, but I think there's a lot more to go as the consumer needs, in fact, to installall of these devices or all this conductivity to his home.
And, lastly, there's a sector that hasn't been mentioned here, and that's oil services. I think oil services will have a good year -- not necessarily big oil, but oil services -- simply catching up to the fact that oil prices have more than doubled at this point. We're not going to see oil prices down below $10 or $15 a barrel that they threatened to go to during the crisis of '98, and all of that is going to be very helpful for oil service companies.
P&I: David, what stocks would you definitely stay away?
Mr. Post: Despite my comment about M&A globally, and also in the U.S., we would stay away from companies that are relatively new to the business of acquiring. Investment bankers are great salespeople. They sell vision, and sometimes company managers can get blinded. Look at Mattel and The Learning Co. They didn't know what they were getting into. Companies that have made a living in the past of making acquisitions, we think, can do fine.
Mr. Husic: I think I would sort out people who are getting hurt by the Internet phenomenon. Supermarkets is a good place to look. Another good place to look is Pitney Bowes. Another good place to look is insurance companies. People who are in financial services, generally.
I also would be pretty negative about the health care sector, in general. I think that next year it's going to be the main whipping boy of the political campaign. We face in the health care system an impossible situation: enormous demand for services and no real will to allow prices to rise where they need to go to allocate that demand. So we are in an environment in the United States where there's excess demand for health care services because the prices aren't free to rise.
And, at the same time, health care systems being disintermediated through Dr. Koop and Planet RX and all of the other Internet devices. I think that all comes together poorly in 2000 for political elections where President Clinton has just sent some committee out to investigate raping the public with prices on drugs. I think it's just the beginning of the rhetoric that will be around for a while.
And then finally I think the tobacco industry continues to be a great place to be negative, because social points of view concerning that have changed dramatically as the population has aged, and I think that this is a long-tail liability from which people are not likely to escape for some time.
P&I: Bob, stocks you would avoid?
Mr. Gillam: Not popular, but I'd say the e-tailers. Our survey of the Internet shows that except for two companies, the advertising dollars spent per customer presently exceed the revenues per customer. There's going to be an enormous fallout, we believe, on e-tailers on the Internet. The large portals, the AOLs, the Yahoos!, will, of course, do well.
I think there's going to be a big expense and many, many of the e-tailers won't be here next year that are here this year after they run out of IPO money, which they've spent, which incidentally is on the opposite side. The e-tailers have spent an enormous amount of money with established media companies, which have been doing quite, quite well.
Top-line growth
We don't like companies that don't have top-line growth, which goes back to the hospital companies. That's clearly a political football. We're not big on the PC manufacturers. Big reason: Y2K spending peaked in the last part of 1998. Almost every company has new PCs on every desk. We think that the spending for boxes is going to decline substantially and that 2000 will be the year of the proliferation of the handheld, take-it-with-you devices. The Internet is now much, much too important to leave at home. So PCs, I think they do not have pricing power, and I think the demand is going to be slack for the next two to three quarters.
Another area that I think that is extraordinarily, I won't say overpriced but certainly volatile, is the small online brokers. Sixty-five days with a down market and many of these small online brokers will lose 30%, 40%, 50%, 60% of their market cap. I think it's going to be the large, established firms, perhaps the Charlie Schwabs, that ultimately will do well. But many, many of the second-tier online brokers will not ultimately make it.
Mr. Post: I don't know whether WebVan is worth $9 billion or some of these other e-tailers' models are economic, but the stock market is allowing them to exist and to spend this kind of money, and that's the threat to the traditional guys. Even if the model for e*Trade and WebVan and others is not economic, they're able to build war chests and spend money and build distribution facilities.
The traditional business model companies have to understand the true threat and have to be willing to adjust their business models to counter that threat. And it's a big focus for us to understand the extent to which the traditional business model companies do understand that threat. We had a meeting with the CEO of a top-five retailer in the country less than a month ago, and we were shocked at his lack of fear of these well-financed competitors, by his (lack of) willingness to take action.
Mr. Gillam: Our research shows that up to 20% of all retailing activity will take place on the Web by 2003. The question is how many wrecks along the way will there be. Our model doesn't allow us to buy companies that don't have forward earnings. There are plenty of companies on the Web and the Internet development that do have forward earnings. And to buy companies whose models are not yet proven, wherein the entire distribution channel of the American retailing system is under stress, strikes us as perhaps more risk than necessary.
New creations
There is another thing that's coming out of all of this, and that is that there's companies that are created in entirely new, separate businesses. AOL, MCI WorldCom, and Yahoo!, as an example. They do not manage their own Web sites. Companies like Exis (EXDS) are stepping in as a third-party outsource. These companies have visible earnings that are making money today, whereas many of the e-tailers, if not most of them, the business models are not proven. And when the IPO money runs out, I think there's going to be a host of bankruptcies and consolidations.
P&I: Peggy, which stocks would you stay away from?
Ms. Woodford Forbes: As growth managers we have fairly non-existent positions in basic materials companies, utilities. We are underweight in the health care area. We do believe the political picture is a negative right now for the big pharmas, but we do like some of the more robust biotech companies, the larger biotech companies. We feel many of them are developing terrific products and have some larger pipelines, but also are potential takeover candidates, so we don't buy them for that reason. We do believe that in order for the pharmas to branch out and have the newest technologies, they're going to have to buy some of the biotech companies that have fairly small products. And so we like that, although we're underweighting health care.
We also agree with the comments made on tobacco. We don't really own tobacco companies. We do feel the social picture has changed. The round of litigation is going to continue. There is pretty much a negative, and so we don't believe they have the kind of earnings that we want to see in the portfolio. We are concerned about companies that really don't have much pricing power. So we're really going to look more toward the financials and technology and telecommunications.
P&I: Which non-U.S. stock markets look best next year, and which ones would you underweight?
Mr. Post: Europe looks pretty good. Again, our belief is that GDP will accelerate. The 11 euro countries should go from a 2% or so level to 3% next year, so that should be good. We also think that restructuring, M&A activity should drive earnings. And also it's our opinion that the euro should no longer, relative to the dollar, have the kind of decline it did this year. Therefore, the people that were hesitant about investing in Europe because of what was going on with the euro will be more willing to do so. So Europe is attractive.
You've had Asian markets just absolutely go through the roof in the last year, rightly so for some very good reasons. Japan has had a good year. We think they'll probably be OK, but not anywhere close to the kind of returns that they earned this year.
Ms. Seneca: I'm not very optimistic about Europe, actually. The problems in Europe, as we see them, are really just a reflection, a mirror image of the problems in the United States in the following sense: In the U.S. we're frightened the Fed may act and raise rates. In Europe, the same threat is there. In fact, the Europeans already have started raising rates, and they started raising rates in an economy that is far more feeble than our own, far less established, and that has huge structural problems.
So it seems to us the European economic recovery is still a projection rather than reality. Yet you have increases in interest rates happening there, which cannot be good for the recovery. So it's undoubtedly true that M&A there is huge at the moment, but that's about all that I think those markets have going for them. And if you look at how those markets have performed this year, indeed they haven't provided any benefit over U.S. markets. I think the same will be true next year, but in much bigger fashion, that Europe will be a real disappointer.
Homogenous Europe
The other reality about Europe is that it no longer provides the kind of benefit for diversification that it once did. I mean, it was once possible for a German investor to get diversification by going to France. Clearly that's over because it's all now Euroland. So Europe doesn't seem particularly interesting to me.
Unlike what has been said so far here, Japan, I think, is also kind of a show-me story. Clearly something is happening in Japan. You can see what's gone on in the markets there and you can see what's gone on in the GDP. The question we would raise about Japan is how much of that GDP growth is purely a function of fiscal stimulus and how much is coming from genuine organic demand in the economy.
And if you look at what's happening in bank loan growth there, you don't get the impression that there's very much organic demand happening in the economy. Nor if you look at the distribution system, which is still paralytic, nor if you look at the bank regulation system, do you get any kind of sense there's a free market operating there that has the kind of the healthy entrepreneurial animal spirits the U.S. markets have exhibited now for years.
So neither Japan nor Europe, which are the two large alternatives really to the U.S., look particularly appealing to us. So we think the U.S., almost by default, will be the market of choice.
The emerging markets, on the other hand, are too small for this to matter enormously. But I do think in the emerging markets, specifically in Latin America -- unbelievably, Latin American countries have demonstrated that they can handle major currency devaluations. We've seen Mexico, we've seen Brazil go through major devals and survive in very good shape. Argentina had a mini-crisis this year without a deval, but did very well. So I think the emerging markets, both Latin America and Southeast Asia, are likely to benefit from what looks to be a real internal demand, real organic growth within those economies. And, of course, if China does make it to the WTO, that can be nothing but a positive for the Southeast Asian markets.
But for major developed countries, the U.S. looks to us to be the place to be for 2000.
Mr. Husic: Gail's sort of re-echoing what I mentioned at the beginning, which is my major concern, and that is that the U.S. is the only organic source of growth in the world. And it bothers me to death when (German Chancellor Gerhard) Schroeder gets involved and says (Philipp) Holzmann can't get out of business, because it's an old way of thinking that hasn't died.
Running out of gas
Japan, I hope -- all of my stuff is premised on "I hope" -- these places are turning, because if they don't turn, eventually we're going to run out of gas here and not be able to lead the world. Because I'm fairly optimistic that we'll have a rebound of growth in those places in 2000, I think Asia will be a terrific place to be because the Asians are incredibly productive. They took such a hit. The recovery of whatever percentages is nothing from where they fell from.
And I'm always bullish on Mexico when things are OK, because Mexico has the greatest advantage in the world: It has this fabulous borderline with the United States. And as long as the elections don't screw things up too much, I think it could be a very good year for stocks in Mexico.
But I really worry that both Europe and Japan just don't get it and that we're going to be disappointed in the end. But my vote at this point will be that it's going to be better than it's been.
P&I: Peggy?
Ms. Woodford Forbes: I think it's going to be a two-tier market with the U.S. predominance. East European countries, I don't know how one could even really look there. Japan, I think the growth there will be fairly slow, echoing what Gail's saying on the banking side and also demographics in Japan. I don't think they really support a really robust recovery. China, Asia, may be very productive and may come on extreme, but I still think that will be slow. Europe I think will be slow. I think there is a bit of fire in Latin America, possibly in Brazil.
So, again, I really feel that the U.S. is the place to be. And I think it is scary if the U.S. is the only place to be, because we do need to have that export power, and hopefully we'll get some of it. But we really concentrate more on the U.S.-based stocks.
Mr. Husic: As long as we have the only adult currency in the world, we're OK, because people will live with our trade deficits. So we've got to hope that stays the case.
P&I: Bob?
Mr. Gillam: For perhaps 100 or 200 years or more, investing in Japan has been relationship investing. This is the families, the directors, the managers of companies invest in one another because during times of stress they tend to support one another. This has been the structural barrier in some ways that has led to the malaise in the Japanese economies.
Earnings explosion
A survey that we did recently in Tokyo, however, showed this: Five years ago we could not find a single company in Japan where the management was rewarded on any basis other than longevity. We now find that between 30% and one-third of all Japanese companies' management is now rewarded based upon one of two things or both, the first of which is return on stock equity, the second of which is the performance of the stock price.
Now, this is an enormous structural change. And for that reason, the earnings growth rates in select Japanese companies, especially telecoms, are accelerating in an explosive way. Companies such as SoftBank, which is not a bank --it's in fact the largest Internet company in Japan, they're having traditional U.S.-type earnings revisions, dramatically higher one week, one month, three months, six months. Another company is NTT DoCoMo. They have 2 million subscribers in what Mr. Husic was talking about earlier, and that is the wireless Internet. They have 2 million subscribers already on that system, fastest growing, we believe, in the world. So there is an explosion in earnings growth rates selectively in Japan, and it's coming from that 30% of the marketplace where the management has been restructured on Western standards.
This is the sort of structural change that has now occurred, also, in Korea, and for that same reason, you're seeing some explosive growth rates. Many of these companies used to be small, small divisions of the big, big trading companies, and now have been spun off with Western-style management. So with what perhaps is upwards of a third of our assets invested in non-U.S. marketplaces, we tend to look at these sorts of things. We think that based upon the likelihood of interest rate rises, the extended devaluations in the United States, and earnings growth rates around the world, that the U.S. market could be the middle of the pack, not the leader of the pack.
P&I: What kinds of return do you expect from fixed-income portfolios next year, and what kind of duration exposure do you expect?
Mr. Gillam: We expect a general world upward drift in rates, and that would be in the four areas we discussed: Asia; Europe; Japan; and U.S. And, therefore, we think that at least for the first half of the year, the bear market in bonds is likely to continue. If, as pointed out here, the economy in the U.S. does slow down, we see a long bond coming down to around 5%, 5.25%. But in the short run, self-serving of course, we are underweight bonds.
Mr. Husic: I'm more bullish about bonds, so I think it's a pretty good time to be lengthening maturities now. And I think the spread will widen between governments and corporates.
Mr. Post: If you see a 50-basis-point move up in the long bond across all U.S. fixed-income markets, durations about 4.5. That would tell you about maybe 2.5% price decline. And then add the yield, and probably add up to about 4% or so total return on fixed income vs. 15% or so on equities. We like equities.
Ms. Seneca: Of the $10 billion or so we manage, about half is fixed income so we really do track this part of the market very closely. I said earlier that I think the return from the S&P 500 next year is probably going to be between 7% and 10%. I think the bond return could be almost as good, 6% to 9%, coming from the decline in interest rates that we expect toward the end of the year, and also coming from the fact that the technicals in the spread markets -- and the spread markets are defined as everything which is non-Treasury, so agencies, corporates, high-yields, mortgages -- are improving rapidly as we speak.
And so it's possible to make much more than the coupon that you can earn on the Treasury or on the price return you can earn on the Treasury, if you venture into those other markets selectively. And so we're quite long spread, and we're also looking to get longer duration. It's too early at the moment.
Private investments
P&I: Let's move on to the last question, which is about private investments. Most of you are in the public markets, but your competition is the private markets these days. Is it possible to get significantly better returns in private markets these days, better results than public markets?
Ms. Woodford Forbes: I think it's possible if you're investing with some of the more astute managers, investors, and if you're in some of the really fabulous new technologies. And I think as a diversification technique, it makes a lot of sense to be in the private markets, having that exposure with venture capital markets and so forth. Because with the kind of innovation we're experiencing in the United States, it's hard to not have at least 10% in your portfolio.
P&I: What do you think about the returns of private equity; can they beat public markets by enough to offset the risk?
Mr. Gillam: I think the returns are only part of the equation. The other part, of course, is liquidity. Liquidity to us is key. If it's not liquid, we don't own it. We would guess there's more money chasing deals than there are potentially deals. As a result of that, we'd be pretty careful. We think the public markets worldwide offer incredibly good opportunities, and we would not sacrifice liquidity for perhaps the declining store of terrific opportunities.
P&I: Frank, what do you think?
Mr. Husic: I'm just stunned with what people are doing. I think it will end up very badly. I think most returns will be negative over the next three to five years. I think that if I was going to do private equity now, the best place to do it would be to go abroad with some of these companies, Europe potentially, because in a place like Europe, the capital-raising function is a lot weaker, a lot more feeble and a lot less efficient than it is in the United States. I think that probably there you could find some real opportunities with a lot less competition. That's not to say some of the well-known names won't continue to put up some good returns, but you can only get so much money into those and I think it has spawned a second and third tier of people. The problem in the private marketplace is all deal flow, and the best deals get picked off by those who are on the inside.
P&I: David?
Mr. Post: It's hard to see when the flow of new money into private equity slows. It's really focused most substantially on the Internet, the dotcoms. It certainly is competition for us and others. We actually -- maybe inadvertently -- have a play in our portfolio, because the investment banks, certainly Goldman and Morgan Stanley, have gotten very aggressive at taking pieces of the deals within companies that they're bringing public much earlier on. They don't disclose it. They only disclose their positions in public companies, which is pretty limited right now. But our sense is that unrealized gains are substantial for those kinds of companies.
P&I: Gail, you have the final word.
Ms. Seneca: The final word on this topic would be that private investments do not equal venture capital. I mean, there is venture capital as a subset of private investments. And, indeed, some of the comments that have been made here are reasons to be concerned. But there are other private investments.
Specifically, I would direct plan sponsor attention to entities like buyout funds, which have not posted tremendous returns but have a tremendous set of opportunities now given that there are defaults in the markets, public markets, and there is absolutely a real need for financing.
So I think there is a whole other class of private equity, which, indeed, will outperform public markets over time, but it's not in the most glamorous names, names we all know, the names you can't get into.
P&I: Thank you all very much.
