February 7, 2012
Neel mentioned currency and hedging expertise. How is that manifesting itself in your portfolio today?
AG: Our risk management is focused on thorough fundamental research on a company-by-company basis and disciplined buy and sell strategies based on discounts to our estimates of intrinsic value. But we also believe that in the current environment it has become more and more important to hedge, particularly with respect to currencies and to tail risks.
CL: Being value investors we’re finding a lot to do in Europe, but we are not comfortable with un-hedged exposure to the euro. One thing we’ve learned at PIMCO is that when a crisis hits and correlations go to one and betas go to two or three, currency options actually don’t have the basis risk you might think. They can be quite effective as equity hedges and are much cheaper than equity options. So our first primary hedge today is in dollar/euro puts.
We’re also using broad equity-index puts – struck at about 10% out of the money or a bit more – to hedge against things going very wrong in Europe, where as Anne mentioned we have roughly 45% of the portfolio. We’re seeing a brief respite in the European crisis based on what the European Central Bank has done to backstop funding, but it doesn’t really solve the underlying solvency issues we’re seeing in many of these peripheral countries. Those issues pose a pretty clear risk to equity markets.
Is your large gold ETF holding a complementary hedge?
CL: Yes. When macroeconomic and political risk is high – especially given the potential for adverse outcomes on fiat currencies – we’re quite comfortable owning gold as insurance against extreme outcomes. Gold would be a natural habitat if things deteriorated, making it a good hedge. That said, I would add that we’re very constructive on the supply/demand characteristics of gold as well and at today’s prices consider it a good independent value.
Are there any over-arching themes evident in what you’re finding attractive today?
CL: One would be a focus on quality multinationals, both in the U.S. and Europe. These are companies with strong market positions, pricing power, and high growth potential in emerging markets. We find it difficult to imagine you’ll go wrong over the next five years holding stocks in technology like Intel [INTC] and Microsoft [MSFT], in tobacco like Imperial Tobacco [IMT:LN] and British American Tobacco [BATS:LN], or in consumer products like Danone [BN:FP]. In the case of Danone, its stock trades 30% short of the multiple it had three to four years ago, while its growth opportunities in products like yogurt and bottled water are still very strong.
In many of these companies we’re seeing a quasi-arbitrage between developed and emerging-markets profit streams. BAT is a good example. The company gets a substantial proportion of its earnings before interest and taxes from emerging markets, where tobacco consumption is rapidly growing. It has a publicly traded Indian subsidiary that sells for 25x earnings, but you can buy that as part of BAT, which today has a 7%-plus free cash flow yield and a 4.5% dividend yield. Sometimes when you buy emerging-market businesses within developed-market companies, you’re setting up the developed-market piece at a steep discount.
Your overall exposure to financials is relatively high. Where’s that coming from?
CL: We’re absent from large money-center banks in the U.S. and continental Europe, but we have established positions in Barclays [BCS] and Lloyds [LYG] in the U.K. We believe they are high-quality franchises with fewer macro risks, but they currently trade at roughly 60% of tangible book value while banks on the Continent are at closer to 80% of tangible book value. As they restructure themselves, we expect both Barclays and Lloyds to generate at least low-double-digit returns on equity. Banks with that kind of ROE capacity should not be trading at 60% of book.
Much of our financials exposure is in insurance, both in intelligent capital allocators like White Mountains Insurance [WTM], and in specialty insurers with unique underwriting skills, like Lancashire Holdings [LRE:LN].
Walk through your investment case for Lancashire.
CL: This is a London-listed, Bermuda-based specialty insurer that was born along with many others in 2005 to capitalize on the hard pricing markets expected after hurricanes Katrina, Rita and Wilma and the losses left in their wake. It operates in four key markets – property, energy, marine and aviation – and its policies typically cover high-severity, low-frequency events.
The company distinguishes itself in a few key ways. It is selective in moving in and out of markets depending on the opportunity. Pricing of late has been strong in energy markets and in Asia, for example, so it has stepped up activity in both areas. It has also been very skilled in underwriting risk. Many insurers struggle to hit a 100% combined ratio [meaning their underwriting losses and expenses match their premium revenue], but Lancashire typically books combined ratios of 40-70%. All that has allowed it to produce 20% returns on equity and to grow tangible book value per share by 23% per year over the past five years.
All the excess capital generated gets returned to shareholders in the form of dividends and buybacks, consistent with CEO Richard Brindle’s philosophy in building the company that total shareholder return is the only thing that matters. He’s not an empire builder, which is a pretty rare attribute, not just in insurance but broadly among CEOs. The dividend yield last year was close to 10%, consistent with past payouts.
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