«I call what we are currently seeing a nervous rally»: Rajiv Jain
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«This is the Time when Investors Should Focus on Balance Sheet Strength»
In an in-depth interview, Florida-based fund manager Rajiv Jain shares where he finds high-quality investments with sustainable earnings growth and reasonable valuations. Plus: His view on what's wrong with banking.
Rajiv Jain is no man of timid words. The founder and lead portfolio manager of the Florida-based asset management boutique GQG Partners explains why he distrusts the current stock market rally, why he would not count on continued stimulus in China and why he currently sees buying opportunities in the healthcare sector.
Rajiv Jain
Jain loves Swiss companies like Novartis, Nestlé and Sika and warns of the «frothiness» in some segments of the technology sector. In the banking sector, he sees much better investment opportunities in US names like Goldman Sachs and JPMorgan. «European banks are not really cheap, because their growth prospects are non-existent», says Jain.
Mr. Jain, equities have had a great start into the year. What do you make of these markets?
A lot of it is a starting point issue. Markets collapsed in the fourth quarter of 2018 and bottomed a couple of days before the end of the year. So when you just look at the year-to-date returns, they look fantastic, but when you look at it from a 12-month perspective, we are more or less flat. The other part is that this rally is very macro driven, it’s a reaction to the turnaround of the Fed in January.
So the main driver of this rally was monetary policy?
Exactly. I think we ought to be careful not to get too excited after this start into the year. If you look at estimates for corporate earnings in general, they are coming down. We should pay attention to that fact.
What does that mean going forward?
Equity markets anticipate a very strong recovery in the second half of the year. If you look at semiconductors for example, the most cyclical sector within technology, they are the biggest drivers of this rally. They are all anticipating a very strong recovery. I would caution against that. Look at the high inventory levels at Samsung and Micron Technology, for example. Everybody is cutting capex. Texas Instruments reported earnings a few days ago, and they implied that people are being too optimistic about the recovery prospects. Also, I think people are underestimating the dangers of the US-Sino trade war on some of the tech names.
What do you mean by that?
The real issue about the trade war is intellectual property. Sure, you can say the Chinese will buy more soy beans from America, and then Trump and Xi shake hands and all are happy. But the real issue is IP. And that is where I feel there is no resolution at this point. In fact, just a few days ago, Applied Materials was restricted from selling semiconductor equipment to native Chinese companies. That is critical.
Do you see investors being too complacent about the tech sector?
The frothiness is pretty apparent. I can work with the valuations of Google for example, but if you go beyond the very high-quality names, the picture is frothy. The market is back to valuing these new tech companies at sales multiples again, and suddenly you hear things like 15x revenue is an attractive valuation. This is dangerous. A lot of these companies will never make money. Plus, regulatory risk has gone up meaningfully. What's more, the number of new users coming onto the internet is slowing down. I mean in China, on average people are spending almost six hours per day on the internet. Per day! Growth is going to slow, but how much is difficult to judge. The same thing is happening in the US. So, the growth expectations embedded to justify valuations for a lot of tech names are really stretched.
Which tech names would you still buy today?
We still like Google or rather Alphabet or emerging markets names like Tata Consultancy Services: Double digit growth with reasonable valuations.
At the same time, the defensive sectors aren’t really cheap though, right?
That’s the problem, the traditional defensive safe havens are not necessarily cheap. That’s why I call what we are currently seeing a nervous rally: After the big sell-off we saw in late 2018, if we had a true economic recovery, we would see it being led by the cyclical sectors. That’s how it was in 2003 and in 2009. But we are not seeing that this time. Yes, semiconductors are booming, but many segments that would traditionally benefit from a strong economic recovery are not performing well.
Which segments do you mean?
Look at European banks, for example. Look at Japan, Korea, Taiwan. These are reasonable indicators, because their earnings are exposed to global cyclicality. Two thirds of the earnings in the Korean KOSPI index are highly cyclical, very linked to semiconductors, autos, steel, etc. They are not doing so well. So for me, what we saw in the past four months was a nervous rally. This is not on a very strong footing. I just don’t feel like we are in the spot where you would see a meaningful run-up from here simply because the Fed is off.
When I summarize the current macro narrative that seems to be the market consensus: China is accelerating again, commodity prices are going up, the US economy is doing okay. Do you agree with that narrative?
No. It’s partially correct, but it’s too convenient. That was how the world was operating before. We are all prisoners of our past. The narrative that you mention was valid for years: China will stimulate whenever its growth is too weak, the US is doing fine, and if something goes wrong, the Fed will rescue us all. Check, check, check.
Where is this narrative wrong today? What should we focus on?
For one, I would caution against ever falling in love with a narrative. Yes, the Chinese have stimulated the economy late in 2018, but they are now already talking about stepping on the brakes again. The Chinese authorities worry about leverage, and they are reluctant to stimulate too aggressively. This is not 2016, and it is definitely not 2008/09. Back then, there was a lot of room for them to ease. Today, not anymore. The other thing I think we should focus on is that corporate leverage in the US is very high, and the quality of corporate earnings is not as good as people think.
How so?
Just look at the shenanigans being used in corporate reporting again. WeWork, still unlisted but owned by a lot of large, well-known fund managers, is reporting a thing called community-adjusted EBITDA. What is that? Exclude everything and then say this is our profit? I mean, come on. Even with larger companies, the quality of earnings is not that good. You have to be very careful with corporate balance sheets today. As we know from experience, quality can be bought in two ways: One is quality in the profit and loss statement, the other is balance sheet quality.
And you would stress the importance of balance sheet quality today?
Yes. P&L quality can be misleading because of cyclicality. Earnings can collapse quickly. I feel that this is the time when you want to focus on balance sheet strength. Look at the collapse of AnheuserBusch InBev in Belgium or Kraft in America as an example. A lot of people blindly followed Warren Buffett and owned Kraft.
Let’s take a bottom up perspective. You look for high quality names with sustainable earnings growth. Where do you find them today?
One sector that I like is healthcare. Many companies in that sector have disappointed for a long time. But the pipelines have been improving remarkably. I like Novartis, for example. They reported great numbers, we like the new CEO. He’s not an empire builder, he’s R&D focused. They have a very good pipeline. At 15 times earnings, this is a good place to be.
Which other names within healthcare would you buy today?
We quite like a number of medical technology names like Becton Dickinson. They should grow at low double digit rates and trade at reasonable valuations. Another one: UnitedHealth is a very attractive name at current levels. I believe it will continue to grow at mid-teens with little currency risk. Healthcare in America will change a lot less than people believe and any change has to include UnitedHealth simply because of their scale.
Novartis has spun off Alcon. Do you think they should spin out the Sandoz generics business as well?
Yes, I think they should. In the generics business it’s hard to innovate and thus hard to create sustainable competitive barriers. The pricing pressure is going to be tremendous. That’s different from before. Sandoz does not really belong into Novartis anymore. Just like Alcon, they should stand on their own feet.
Why has the healthcare sector been so weak in the past months?
For one, it was the best-performing sector in the fourth quarter of last year. We saw a reversal in the market. Plus, what is making people nervous is the healthcare policy discussion in the US. Things like «Medicare for All», where everything would go into a government run system. So, on the one hand, you have Republicans wanting to repeal Obamacare, and some of the Democratic presidential contenders talking about «Medicare for All». I think it’s going to be somewhere in the middle.
Where else do you see opportunities?
In Europe, we like the exchanges. Deutsche Börse and LSE. They have a secular growth story, driven by all sorts of derivatives. There is a big regulatory push to force trading from OTC markets to exchanges. And their valuation is still reasonable.
What about European banks? Don’t they offer good value at these depressed prices?
Not really. People talk about Intesa Sanpaolo for example, it being cheap, it being the best Italian bank and so on. Intesa is trading around 0,8 times book, with a mid-single digit return on equity. I’m not recommending Citi per se, but Citigroup is also trading at 0,85 times book, but it earns 11 to 12% return on equity. Citigroup gives you double the return at about the same valuation. European banks are not really cheap, because their growth prospects are non-existent. There is a big difference between European and US banks when it comes to how they dealt with the financial crisis: The American banks were forced to take tough cleaning measures very early. The capital shortfall issue went away instantly. In Europe, it was rather death by a thousand cuts over ten years. And here we are in Europe, with some banks still not having enough capital. I mean, why do we still have to worry about Deutsche Bank ten years after the crisis? It's mind-boggling.
So between European and US banks you would go with the US names?
If we have to buy a bank then definitely we prefer US large banks. They are buying back stocks, they are growing. Goldman has bought back 25% of its outstanding stocks in the past 5-6 years, and you can buy Goldman basically at tangible book value. Full disclosure: We have a partnership with Goldman Sachs. JPMorgan is also buying back stocks. JPM trades at 10 times earnings. That’s an opportunity. The valuation of US banks is pricing in a recession, which I think is too pessimistic.
You don’t like Swiss banks either?
Look at the Swiss private banks, like Julius Bär or Vontobel. They are trading at 1,7x to 2x book value. But you can buy Goldman Sachs at around book. Who has the better longer-term prospects? I feel Goldman just has access to a much deeper talent pool and their business model has much more headroom. Also, IT spending is becoming a real issue for a lot of smaller banks. The Swiss banks had a unique position because of the highly profitable offshore banking model. But that’s dead. Frankly, while it is a good thing for the world that the whole Swiss offshore banking model has blown up, it’s not good from a shareholder profitability perspective.
So the Swiss banks are not unique anymore?
Exactly. They're not. They are now competing with everybody else with pretty bloated cost structures.
What about the big Swiss banks like UBS?
I like UBS from a structural perspective, in terms of what they have done in the past eight years. But the execution has been weak. Then we have the issue with the huge fine in France. I don’t understand why they didn’t settle that out of court quickly. At the end of the day, the issue with UBS is weak execution. They haven’t been as radical in cleaning up their house, they have been sloppy in managing their costs. Plus, I think the Asian franchise of UBS is not as strong as it was a few years ago.
There are rumours that UBS could merge its asset management business with Deutsche Bank's DWS. Would that create value?
Tell me one large merger in asset management that has worked.
I can’t think of one.
There is not one. The costs usually have gone up, not down. There is no evidence except BlackRock that size makes an asset manager more efficient. The idea of benefits of size is a mirage. Why? Because there is always a fat layer of middle managers. They don’t add any value, they just sit there, creating corporate bureaucracy. Janus Henderson is a great example, or Aberdeen Standard Life: Good portfolio managers are leaving, revenues are going down faster than costs. The fundamental problem of the entire banking industry is there is too much focus on keeping things as they are, nice and cozy for the senior management but not great for clients.
Any views on Credit Suisse?
It's still early, but I like the CEO, Tidjane Thiam. I think he has the right focus and in Swiss banking – or any struggling institution for that matter – you need an outsider to clean up the cozy, clubby environment. So, the fact that he makes people uncomfortable is exactly what is needed. Just like Axel Weber was critical for UBS to help clean up. Having said that, we now need to see delivery.
What other names do you like in Switzerland?
I really like Sika. It’s a phenomenal execution story, continuing under the new CEO. The whole Saint-Gobain story was a mess, the Burkard family could have behaved better, to put it mildly. It turned out well in the end. Another one: Nestlé under CEO Mark Schneider is gaining a lot of traction, he’s executing very well. A lot of managers talk great strategy the whole day, but execution is what really counts.
Any more?
Next to Novartis, Roche is very interesting longer term – but not so now. Their longer term pipeline is good, but in the short term they struggle a bit. It’s a phenomenally good company. Switzerland hosts some incredibly good companies. Well managed, well positioned, very global. Names like Geberit, and so on. In fact, if you had to buy two developed markets and then own and forget about them for the next 20 years, in my view it would be the S&P 500 and the Swiss index.
Overall, what are the biggest bets you are taking right now?
In the global portfolio, it’s still technology, mainly software. Second, healthcare. And in a much smaller way US financials. Not so much in industrials. In emerging markets, it’s India and in a smaller way China and Hong Kong. If you had to own one index in emerging markets and keep it for 20 years, it would be India.
More so than China?
Yes. It’s very hard to make a case for the broad Chinese stock market for the longer run, you have to pick spots. The regulatory changes can be incredibly rapid. It’s hard to get a truly long-term view there for the broad index. We have some holdings in Hong Kong, and I also like Indonesia and Thailand. In China, we like some names in insurance and banking.
What are the value traps that investors should avoid today?
I think some of the cyclicals might be traps. They look cheap, but that’s on top-of-the-cycle earnings. If there is a recession, they could suffer an earnings collapse. Investors always lose most of their money by buying cheap-looking cyclicals at the peak of the cycle. So you have to be careful. European automotive names for example could be at risk.
I remember you were quite fond of tobacco a few years back. Not anymore?
We’re not fans of tobacco exposure anymore, because we see secular headwinds. Much tougher regulation, e-cigarettes, the whole model is changing. Those businesses could deteriorate a lot more, and we see the overall headwinds for the industry sustaining or growing over time.
