Charles de Vaulx is chief investment Officer at International Value Advisers. I recently sat down with Charles to discuss his changing feelings about banks, Japan and Apple. Part II of our conversation follows in a video and transcript.
(Click here for the first half of my interview with Charles de Vaulx.)
Forbes: Now in a May newsletter, you said, « Markets are being manipulated very heavily these days, » when talking about the global scene. What did you mean by that?
de Vaulx: The policymakers who we believe were, you know, more than responsible for what led to the financial crisis you know, I own no bank stock from ’04 to ’08, which was basically a way for me to say that we were in the middle of a credit bubble of epic proportion, in the US, but in many other places
Forbes: Explain quickly why you stayed away from banks when on paper, including Fannie and Freddie, they looked cheap? You mentioned leverage.
de Vaulx: Well, because the banks themselves became more and more levered, but we also could tell that they were making worse and worse loans. I mean, securitization basically allowed banks to lower their standards in terms of lending, because they knew that once they would originate the loan, they would repackage it and sell it.
There were so many signs of a credit bubble of historical proportion. And also there were some sober minds out there. I mean, anyone who, you know, read your publication or Grant’s Interest Rate Observer, anyway who read the annual reports from the bank for international settlements realized that there was something amazing going on.
Forbes: Do you buy banks today?
de Vaulx: No. I mean, we bought a few after the crisis: UBS, Goldman Sachs, Bangkok Bank in Thailand. Recently, the Brazilian stock market has been weak, along with many other BRICs, so we’ve started buying into Itau Bank. It’s a pretty well-managed bank in Brazil. So, yes, at the right price, we will buy a bank if we think that the underlying culture of the bank is good enough.
I think Warren Buffett several years ago said, « The problem is that there are many more banks than bankers. » It’s a levered business and there are very few people that have the right mind to properly manage those banks, and I think that Buffett was spot-on. He’s still spot-on. So whenever we pick banks, we try to find those that have a pretty good culture, and a pretty good understanding of risk. In the case of UBS, the fact that they are moving more and more into private wealthy management at the expense of lending is something that we’ve been welcoming.
Forbes: Now, you don’t have very much, you mentioned, yet of Brazilian stock, but you stay away from what we call « emerging markets »?
de Vaulx: Yes, because there is a paradox, which is that high economic growth does not always translate to good stock market performance.
Forbes: You see that in China.
de Vaulx: There are many reasons for that within China, but Steve, we have seen this even in the United States. I think of the United States, in the middle to late 19th century, as the ultimate emerging economy. America was so successful that by World War I, it became the leading economic superpower. Yet my history books somehow suggest that stocks did okay but not that great. The big stocks were those big capital intensive businesses.
Forbes: Railroads
de Vaulx: Many of which exist in China, for instance, or Brazil. They were, in the case of America, canals and railroads. For all sorts of reasons, these companies did not do too well – 90% of them went bankrupt. In good American fashion, we made sure that it was mostly the foreigners that owned them, the Brits at the time. And so it’s a paradox that is hard for people to grasp, but it’s a reality.
Forbes: Now do you still fight equities when you feel you’re not getting a good price? Bank for International Settlements was one example where you fought, and you’ve done some other. Do you still do that?
de Vaulx: Absolutely. If we have to, we will be reactive. Now ironically we’ve had three battles in our past. Our first battle, oddly enough, was an American company. People always ask me about the risk of investing outside the US, and I, tongue in cheek, remind them that my first battle was against Kohler, Wisconsin, Herb Kohler. And he runs a wonderful business, by the way, but he had his own personal reasons to want to eliminate non-family members as shareholders, so he did a squeeze-out deal at a price that was not too nice, so we fought and succeeded.
In the case of the Bank for International Settlements, they did a squeeze-out deal, as well, in 2000. The price seemed generous; there was a 100% premium over where the stock was trading. Despite that generous premium, the price was still a 53% discount to liquidation value. In the case of most businesses, one can argue as to what the real value of the company is. In the case of the BIS it was a liquidation value. I mean, it was very easy every day to compute what that number was.
The Bank for International Settlements, which they tried to be, you know, do-gooders. They tried to, you know, preach good corporate governance, transparency and yet they could not resist the idea of fleecing their own shareholders. It was a two-year battle and we prevailed, and there’s a book that came out recently, written by Adam LeBor called The Tower of Basel that talks a little bit about that. But more importantly, it traces back the history of the Bank for International Settlements since its founding in 1930, and it’s quite a sinister history, with Germany and the Nazis and so forth.
Forbes: Bonds. You think they’re a bubble today? You had a brief buying, as you mentioned, in ’08 and ’09. Are they still overpriced today?
de Vaulx: I think they may be overpriced. Bubble, I’m not sure is the right word. I mean, in my mind, for a bubble to be a bubble, it has to be fueled on credit. I think people have been buying bonds out of fear, not out of greed. And I don’t think people have been buying bonds on credit. So, I would not call it a bubble.
But I think the fact that people were willing to buy ten-year treasuries a few month ago when the yield was barely 1.7%, even though inflation expectations for the next ten years are that the CPI will probably rise at least two, two and a half percent over the next ten years, meant that people were willing to hold bonds knowing that they would lose money for the next ten years. The Fed themselves, in some various studies, have acknowledged that interest rates would be one and a half points higher than what they were today, were it not for quantitative easing. Yes, so I think owning bonds today, buying bonds does not make much sense. Having said this, I believe that the biggest risk right now in the world economy is China.
They had a big credit bubble, especially over the past seven or eight years. That bubble is deflating, so I think there’s more downside risk to the world economy than upside risk. Just morning I was reading something about the fact that the government in China is asking for an audit to be done of what is the real size of the national debt.
So I think if there’s a slowdown in China short term that means that there’s room probably for yields to go back down a little bit before eventually they go back up. But our belief though is that whatever policymakers have been doing over the past six, seven years, governments with their fiscal policies, central bankers will lead to inflation at one point. So, we shy away from bonds as much as possible.
Forbes: Which gets to gold. You said in 2011 I think that gold was under-owned, even though it’s $1,800-$1,900 now. It’s had a fallback. What do you see ahead? Is it just a temporary pause, until central banks get back to their bad deeds?
de Vaulx: Probably. Bear in mind that the Chinese and Indians have become big buyers of gold over the past ten years. They have had mostly a good experience with gold. We have around 3.8%, 3.9% in gold. Now we don’t think that anyone should have 10% in gold. It’s probably too much. But because there are still risks out there, uncertainty as to what the final outcome will be of what’s going on, whether it will be some deflation or a lot of inflation down the road, we think it’s prudent to have some gold.
Forbes: As an insurance policy?
de Vaulx: Insurance policy. And as you may have noticed, we have been adamant that one should own physical gold, in lieu of gold-mining shares. You know, gold-mining is an extractive business. It’s a dirty business. It’s very hard. Mother Nature makes it very hard to find gold. It’s very expensive to find gold.There are many countries where gold is being produced where the governments cannot help themselves but ask for higher taxes or higher royalties from those gold-mining companies. So, I think one is better off owning the metal than bother with the gold-mining stock.
Forbes: What’s the marginal cost of an ounce of gold now? Not cash, but the real
de Vaulx: The cash operating costs are around $600 to $700. But if you want to add to that the cash replacement cost, the maintenance CAPEX cash, you’re talking about $1,200. With gold being at $1,330, you don’t have much of a cushion anymore, so it’s very highly levered, highly speculative. Owning gold mining’s a very speculative way of owning gold.
Forbes: What’s been the impact of ETFs on gold and silver, do you think?
de Vaulx: Well, clearly the reason gold went all the way to $1,900 briefly in the summer of 2011 has been investment demand. It’s been easier than before for individuals, pension funds to own gold as an investment. So, it has helped gold, and I think it will keep helping it in the future. You know, you can easily pick up your phone and call Merrill Lynch or UBS and buy yourself some gold ETF along with some IBM shares.
Forbes: You’ve been partial to Japan for years and have been active in that market. We chatted earlier about your ability to get in and out, but you’re bullish now, not because of the recent elections there, but what you see happening on the corporate governance side, at least with some companies. Can you explain?
de Vaulx: Yes. The Japanese market has been in the doldrums for the past 25 years or so. They had a big credit bubble that started to burst in December of ’89. The stock market fell 70%, if not 80%. And so the Japanese market became extraordinarily cheap.
In the meantime, over the past 20 years, companies have had the time to repair the balance sheet, so much so that the problem with most Japanese companies today is that their balance sheets are way too strong. Many Japanese companies sit on mountains of cash. Very little of it will be ever needed by the business.
So we have felt for a while now that the key to Japan was to see one day, hopefully, corporations realize that they have too much cash, and hopefully they would start to give some of that cash back to shareholders, either via higher dividends or increasingly start buy-backs
Then the next step hopefully will be more corporate activity. Friendly takeovers, hostile takeovers. One interesting test right now is Sony. We’ve had, in the past, when American activists I can think of even T. Boone Pickens back in the late ’80s. When American activists have tried to do something in Japan, they were sent back to the US. And I’m not suggesting that Sony has embraced Dan Loeb from Third Point, but they’ve more than welcomed him.
In fact, I believe they’ve hired an investment bank, Sony has, to consider the merits of some of his proposals. And they may decide to take public one or two of their subsidiaries. So, yes, we do believe that there’s a huge change going on in corporate Japan, and that is the key for that market to go up a lot more than it has. Despite the recent rally, the Japanese market only trades at 1.1 times tangible book.
Forbes: Now you, unlike others who invest in Japan, you like what you might call « internal companies. » You know, not the traditional big exporters.
de Vaulx: There’s nothing wrong with the export companies. It’s just that the domestic ones, the smaller ones tend to be a lot cheaper in the stock market. Nothing wrong with Canon or Shimano at all. We’ve owned some of those. Or Makita, for that matter, which competes against Black & Decker.
But the smaller ones, the more domestic ones are far cheaper, and so that’s where we have put a lot of our emphasis. Some of these stocks have done very well. Yahoo Japan, that’s a strictly domestic business. The stock has more than doubled over the past two or three months. Temp Holdings is a temporary staffing business, like a Kelly Service or Manpower. That stock has more than tripled over the past nine month.
Forbes: You like a pharmaceutical company there, too?
de Vaulx: Our biggest lot holding is Astellas Pharma. It’s a pharma company, global. More than half their earnings come from outside Japan, and they’ve been unusual un-Japanese, in the good sense of for many years, they’ve been willing to pay high dividends, roughly half their free cash that they’re willing to pay in the form of dividends.
Over the past eight years, they’ve been willing to buy back over 20% of their shares. That is un-Japanese. It’s very impressive. Whenever they’ve made acquisitions, they’ve been very careful not to overpay. And even though the stock has done well, we feel that the local investors don’t fully understand the company. They don’t understand the IBIT as reported, is a lot less than the real IBIT.
Forbes: You talk about, especially with Japanese companies, a lot of companies, cash-laden, and therefore you have to adjust the real returns
de Vaulx: Well, yes. Oftentimes a Japanese company will show low-return equity. But if you strip out the cash, you’ll realize that the business itself does have a very high return on capital employed. So, there are many fine Japanese companies where the attractiveness of the business, the profitability of the business is hidden by the fact that next to the business, you have a pile of cash that dilutes the return on equity.
Likewise, from a valuation standpoint, if you look at Japanese stocks just from a pure and simplistic price-to-earnings basis, as opposed to an inter-price value where just the market cap and the cash, this is how you’ll notice how cheap some of these stocks are.
Forbes: Now, let’s go quickly to some individual stocks. One that you have not bought, which you owned years ago, talking about having a lot of cash but it doesn’t meet your criteria now apparently is Apple?
de Vaulx: No, because we acknowledged that the stock looks cheap. We just questioned the sustainability of those margins. I remember two years ago hearing people talk about, you know, all these applications, you know, providing some sort of moat. Not sure there’s much of a moat, frankly.
But recently, we’ve sold some puts that mature in early 2015. Strike price $430 and $440. We got paid $60 and $70 premiums. We’ve tried to create an entry price into Apple at $360 per share. But it’s a small position. Our level of conviction, frankly, is low. We think competition will heat up, and we think their margins will come down significantly.
Forbes: What about Microsoft? There’s a stock that’s done nothing for a long time?
de Vaulx: It’s done nothing. A few years ago, we were able to buy it in the mid-$20s. It may be helped by the activist Jeff Ubben from ValueAct. The stock was at $34, $35 a few weeks ago, before the recent pullback. We’ve trimmed our position nicely. We have mixed feelings about it. The outlook for their business is murky. We’re not big fans of top management.
Conversely, we were able last year to buy Google very cheaply, even below $600. Now the stock has done well. It’s almost priced as a growth stock today. But we think that the moat of the Google business is very strong and hopefully they’ll have nice tailwinds. In the technology arena, the stock that we’ve been able to add quite a bit recently has been Oracle.
Forbes: Now everyone says the cloud will do them in, but you don’t believe it?
de Vaulx: We don’t believe that. I hope we’re not missing something. From a valuation standpoint, it’s much cheaper than even Microsoft. Enterprise value to IBIT is 7.2 times. They’ve been wonderful capital allocators over time. They’ve not diversified.
They’ve not tried all these things Microsoft has tried to do, typically unsuccessfully. Microsoft, that is. And yes, we think those concerns regarding the cloud are overblown. What they offer, they work mostly with Fortune 500 companies, many governments. They offer very complex software solutions, and we think that their services will be needed by their clients, going forward.
Forbes: A company most Americans don’t know, Wendel?
de Vaulx: Well, Wendel, don’t blame them for not knowing, is a French holding company controlled by a family. Even though I preach the virtues of eating their own cooking, they, during the bubble a few years ago, couldn’t help themselves but they made a mistake. They used some leverage and bought a wrong asset.
So, the company got levered. We were able to buy some high-yield bonds in ’08, ’09, during the crisis, when those bonds were yielding 18%. These bonds are maturing in 2015, ’16, ’17. Now these bonds have done well, but they still offer a yield of 4.5%, 5%, 5.5%, which is still 300, 400 basis points over French government bonds. So we’re happy to hold onto these bonds.
Forbes: Expediters International?
de Vaulx: For many years, we owned a competitor of theirs, called Kuehner + Nagel, which is a Swiss-based yet global freight forwarding company. Kuehner/ Nagel, maybe because the float was limited, always treaded a big discounted to Expediters. Today it’s the other way around. Expediters is cheaper than Kuehner/Nagel. That stock used to be held by growth investors that liked the fact that word trade grew a lot faster than world GDP.
That growth has reduced significantly, but the multiple at which the stock trades has contracted significantly. So we think it will not grow as much as in the past, but it’s still a fantastic business. They don’t own the ships. They don’t own the airplanes. It’s a service business. It’s not capital-intensive. They generate significant free cash flow. And they’ve been wonderful allocators of capital in the past. A few months ago, top management noticed that the stocks were undervalued. They took advantage of it by doing a pretty sizeable stock buy-back, and we would expect more of that going forward, should the stock keep languishing.
Forbes: Berkshire Hathaway, an old favorite?
de Vaulx: Berkshire is a strange stock. A year ago, the market seemed to hate them because they did not pay a dividend. They still don’t pay a dividend, but a year ago the discount at which that stock traded was huge. We bought a lot more of it at the time. But I think since then, Mr. Buffett has been willing to up the price at which they would consider buying back their own shares. Now they’re willing to pay up to 120% of reported book value.
Also they’ve shown, including recently with the Heinz deal, an ability to still do small deals. And the stock has been rewarded and now trades much closer to its intrinsic value estimate. Now we still think that they can still compound wealth over time. We think intrinsic value can still grow over time, but the discount has narrowed so we have trimmed our position over the past few months.
Forbes: Are there stocks that excited you now?
de Vaulx: Well, Nestle is a very boring stock. It’s a food company. But it’s an extremely well-managed food company. Very global—40% of their earnings come from emerging markets, which is typically good. Now, it’s not good when the underlying currencies of these markets go down. Recently, the Indian rupee has come down. Recently, the Brazilian real has come down. But still, they have exposure to these vast, fast-growing economies. And the stock trades at a very modest multiple. So, it’s a very boring stock, but we’re very comfortable holding onto it.
Forbes: Charles, thank you very much.
de Vaulx: You’re welcome, Steve. I enjoyed it.
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Steve Forbes is the co-author of Freedom Manifesto: Why Free Markets Are Moral And Big Government Isn’t.
