Jim Rothenberg, chairman of Capital Group Companies, which manages more than $1.4 trillion of assets, spoke with Jame DiBiasio about investment parameters and portfolio management during a visit to Hong Kong.
Q. Where are corporate earnings in the US?
A. The US economy continues to make progress. The Federal Reserve has indicated as much by saying it is still targeting a rise in interest rates in September. The job numbers continue to suggest progress. But the economy is not going to run away on the upside. Retail sales remain weak, the housing market is soft; mortgage rates just went north of 4%. There are a lot of checks and balances on the economy.
Q. Companies seem more interested in buybacks than investing or hiring. Is that healthy?
A. Corporate North America has done a great many things since 2008 to rationalise business, cut costs, and outsource more. That’s what’s enabled incredibly strong profit margins, which led to dividend increases and share buybacks. It looks as though the Democratic Party’s approach to the 2016 elections involve the notion that Big Business is doing buybacks instead of investing, which explains why the economy isn’t growing so much. But the situation is more nuanced. There are shareholder activists who will pressure any company to better utilise assets if the management just builds up cash reserves. Investment into capital expenditure and running the business is a different challenge. You can’t just throw money at a business if it can’t absorb that money effectively. The best companies I know maintain that discipline.
Q. What explains the lack of investment or expansion opportunities for US companies?
A. The trajectory of economic growth has been slow so there is not a need for companies to grow incremental capacity. Airlines have plenty of capacity, so they extend delivery times for new aircraft. The automotive sector globally has way too much capacity today, so there’s going to be consolidation. We hear rumblings about whether GM should merge with Fiat, for example. There are a number of businesses with excess capacity. In certain areas you’re also short of talented labour. This is true for many construction or engineering companies: they lack skilled workers, and training people in those fields is difficult. Our country’s immigration policies don’t help either. In fact our immigration policies have hurt us a lot.
Q. Let’s talk about valuations. Is the US market expensive or not?
A. Broadly speaking valuations are a little high. Companies in the US are trading at 17 times earnings, 18 times, 19 times. I hear a lot of people in the market say that’s all fine, it’s reasonable. But it’s only reasonable because interest rates are so low. If you hypothesise higher interest rates, those valuations can’t be supported. This is true around the world: no equities market today looks dramatically cheap or inexpensive.
Q. How do you see US interest rates playing out?
A. The Fed has to begin to raise rates sometime. It might as well pick its spot and get started. The Fed can’t dictate most interest rates, because the market does; it can only influence the very short end. It can raise the federal funds rate and hope that, instead of raising the entire yield curve, it changes the curve’s shape and flattens it out. I’d like to hope that eventually rates would rise at the long end of the yield curve if the economy picks up, but the most dramatic increase would be at the short end and you’d end up with an inverted curve. But we’re a long way away from that.
Q. What’s the biggest risk as the Fed considers raising rates?
A. If the Fed raises rates too fast, then the dollar could appreciate too much. You don’t want to see the dollar cause grief for emerging markets. Some dollar strength is fine but too much causes problems.
Q. Valuations are a little stretched, and companies have reasons for not investing much of their cash. But they have been spending on information technology and digital solutions. What impact is this having on productivity?
A. Traditional measures of productivity don’t show a gain – if anything, they suggest productivity has been a disappointment. Technology investment is not unique for this moment in time, but what’s new is whether we can measure its impact. Government statistics for measuring productivity are still biased toward manufacturing and don’t reflect the service economy so well.
Q. So what explains relatively strong equity valuations?
A. M&A is what is lifting stocks. There has been an incredible number of deals and this won’t stop any time soon because of the amount of cash sitting on balance sheets. Just since I’ve been out of the United States on this trip, two healthcare deals have been announced. These deals can be good for the companies involved, but they don’t change a country’s GNP.
Q. You mentioned that technology upgrades are nothing new but the scale and scope of big data analytics must be.
A. Big data and data analytics come with pros and cons. The con is that while we can analyse lots of different things, there is a tendency to create correlations that don’t really exist. But companies are using data to understand what a customer wants to buy.
I think the effectiveness will vary. It should be impressive in the medical field, where you can draw from data across patient populations, use it to understand best practices and use data from the human genome to see how individuals respond to a treatment. I don’t know if the same benefits apply to making automobiles, unless you’re talking about the self-driven car, which in other words is not the car you drive today – that’s a 10- to 15-year proposition.
The challenge for companies is still about coming up with something that is unique and different. Uber recently hired the entire robotics facility from Carnegie Mellon University to help it develop self-driving cars. On the other hand, California’s courts have just told Uber that one of its drivers must be considered an employee, not just a contractor, which implies they’ll need to pay benefits and the minimum wage.
Q. So welcome to the real world Silicon Valley?
A. Welcome to the real battle.
Q. How actively do you invest in the tech story? At what point along the spectrum?
A. We try to invest at all levels. Over the past decade the marketplace for technology has developed to allow you to go in and buy an interest before the company goes public.
Q. Some mutual fund companies have set up private equity funds to access pre-IPO stories – has Capital?
A. We don’t have a specific fund but we have flexibility. In theory across different portfolios we could invest up to $40 billion in pre-public opportunities. We don’t have anything near that but we have positions in smaller-sized companies, where there could be some exits. Sometimes the companies are bought by a strategic acquirer.
Q. Is this a healthy development for capital markets? Companies raising pre-IPO money and then selling to a strategic buyer denies the public the chance to invest, and doesn’t enable the market cap to expand.
A. It’s probably positive for smaller companies. In many cases we may continue to own the shares even after a sale. But when we make an investment and the company sells to a strategic buyer, I wouldn’t say it’s ‘bad’ but it’s not as productive as going public.
Q. Is modern portfolio theory broken? There have been so many criticisms of Markowitz’s capital asset pricing model since the 2008 crisis, and multiple periods in which bonds have outperformed equities.
A. We’ve had two difficult periods in a short space of time, 2000 to 2002 and 2008 to 2009, when bonds have outperformed equities on the back of very large and unexpected drops in interest rates. I don’t worry about the model being broken. I’m an equities guy, so I’m biased, but I don’t own long-term bonds. You don’t get paid enough and you’re not getting enough of a yield spread for the risk you take if you move down the risk curve. It makes far more sense to expect growth in the equities world. This is my personal view, not the firm’s, but I bet that in 10 years from now equities will have turned out a good place to be.
Q. We’ve seen incredibly dramatic rallies in the China and Hong Kong stock markets in the past six months. What do you make of it?
A. China presents an interesting problem. If it continues to open its capital market, the quoted market value of China will become the second largest in the world, and in the not too distant future it will challenge the US to become the biggest. Given that, it’s strange to think China should be classified as an emerging market.
Q. The recent conversation has been all about inclusion into MSCI’s emerging markets index.
A. I think you should pull China out of the EM bucket. What does that leave you? The US, China, the rest of the developed world, and emerging markets. I think that’s how people will think about asset allocation. The China issue is size, how it is construed in an index. Professional investors have to make an explicit decision about China.
Q. Meaning?
A. Meaning do you invest in it or not.
Another emerging notion is that you might get it wrong if you focus on a company’s domicile. A big US company might today get 50% of its revenues from emerging markets. We look through portfolio companies’ revenues to take a view about where a company sits. But this flies in the face of indexes and style boxes, and it will take time to change. But it’s a better way to think.
Q. We’re seeing China’s domestic markets heavily influence the market in Hong Kong. How long before China begins to influence global markets?
A. It will continue to influence flows. People will distinguish less between the mainland and Hong Kong, and just call it “China”. More money will flow into the region. Some other countries will get additional allocations once China is no longer viewed as an emerging market.
