Arguably the 30 year US bull market in bonds is at a close. What’s clear is that yields are exceedingly low and real yields are now negative. In effect bondholders are often paying the US government to lend funds when inflation is taken into account. The question is what to do about this if you are a bond manager. Pimco’s Anne Gudefin, who is helping Pimco, the world’s largest bond manager, get into stocks, has some thoughts.
She spoke to Fortune Magazine, outlining her strategy, which they summarized as "Bullish on cognac, yogurt, and gold". For the most part, Gudefin sounds like a typical value investor. Here’s a bit of the discussion:
Q. How do you decide a stock is cheap?
A. I’m really attracted to good business models. We’ve seen over the years that quality pays, and I’m always looking for companies with high barriers to entry and strong free cash flow generation. I also want to see things that aren’t operating perfectly at the moment, so there’s a margin for improvement. I look for there to be a number of catalysts for value to be unlocked…
A large chunk of your portfolio is in consumer staples. Why?
There are very high barriers to entry: The consumer is attached to a brand. It’s also a sector that has low requirements for capital expenditures — generally somewhere between 3% and 5% of sales — and the Ebitda margins can be in the mid double digits, so they have high free cash flow generation that they can use to pay dividends or make acquisitions. And they benefit from growth in emerging markets. We like Pernod Ricard, which is the No. 2 spirits company in the world. The Chinese consumer is crazy about cognac and, to a lesser extent, Scotch…
We also own Danone, which is the only large food company that gets 100% of its sales from healthy products. It does 50% of its sales in emerging markets, but it’s only in about 50 countries, so it can still expand globally. The per capita consumption of yogurt is very small in a number of countries, including the U.S. Americans consume only a quarter of what Europeans consume in yogurt, so the U.S. is like an emerging market.
But Pimco is also dabbling in the precious metals. The largest position in her fund is GOLD. That tells you they think inflation will be a problem. But it doesn’t really have to be a problem in nominal terms. It’s really all about real yields. 10-year Treasuries are now near the negative real yield department as a result of inflation in food and energy. When real yields on ten year paper are below 2%, thinking abut the time value of money and the risk premium for holding long-lived assets, the potential for some serious capital losses are not compensated for by the yield. The risk-reward is poor. That certainly makes gold more attractive.
But, of course, commodities price inflation is held in check by demand destruction, and with core inflation near 1%, there is the potential for yields to go lower in a disinflationary environment. If the economy were to tip into outright deflation as a result of a deleveraging, bankruptcy and overcapacity-ridden recession, then real yields could pop back up quickly. That is why bond market tops take a long time to reverse trend. This makes for a very tricky investing climate in which portfolio rotation is key. For example, Felix Zulauf and Jeremy Grantham have already said this short business cycle may have topped. They recommend rotating into a defensive position. I expect short business cycles and heavy monetary policy activism, but I do not expect another aggressive policy response in this cycle before the real economy rolls over completely. In my view, this is as good as it’s going to get.
As for gold, check out the video below if you want to see what a million dollars in gold coins looks like.