Interview: Newport Value Partners' Charles Ortel Says 'Get Out of Most Stocks'

Includes: DVN, GE, XOM
by: Harlan Levy

Charles Ortel is a managing director of research firm Newport Value Partners. Previously he was a managing director of Dillon Read, followed by stints at The Bridgeford Group and The Chart Group.
Harlan Levy: What do you think of the U.S. economy?

Charles Ortel: You have to go back and divide the period 1945 to the present into different segments. You can’t say, as Warren Buffett does, or you shouldn’t say that just because the United States has been growing from 1945 on that that’s our future. We think that just after we won the Cold War, arguably after 1991, we began to lose the economic peace.
What has happened is we didn’t think through the unintended consequences of our victory. One unintended consequence is that the supply of accessible labor suddenly increased, not by 10 percent or 20 percent, but by multiples. That placed enormous downward pressure on incomes in places like the U.S., Europe, and Japan. So we’re in this zone where companies like GE can very easily lower their costs by either not hiring in the U.S. or, worse, by shifting employment to other places. This structural imbalance is not going away any time soon.
On top of which, in the public sector we have blithely allowed the many government entities inside the U.S. to continue on a path of economic destruction by borrowing way more than they should borrow to spend money in ways that are completely unaccountable to the voter. So we have a structural trade deficit and a structural government deficit. And since 1999 and thereabouts, we have run up an enormous debt, because not only has the government chosen to borrow a lot of money, but up and down the food chain in our economy, in households, in businesses, in banks, the amount of leverage in our system is just way too high.
Economically, we have these major pressure points, and unfortunately, the folks with their hands on the levers of power down in Washington, D.C., are not economically literate, and they are pushing on a course that’s very dangerous. Standard & Poor’s, hardly a firm to note problems well before they occur, is on record that the U.S. is on a dangerous course. They lowered their outlook, and I think they’re not conservative enough.
Inside the U.S. we’ve sort of been in an economic civil war. We have one broad camp of people that embraces the private sector and the opportunity to build businesses and hatch wealth and is flourishing. Then we have a second group that is engaged primarily in the public sector. The public sector of economic activity in the U.S. has risen to towering heights. These two sectors are in conflict. And that’s an internal lack of consensus that is a brewing fight playing out this summer.
Externally, what I see now is a military that is stretched thin in at least three major theaters. I see a rising Russia and see that we have been assuming a peace dividend in our long-simmering contest with the former Soviet Union, and I wonder if the militant part of Russia has just been biding its time. In the wider Islamic world there’s turmoil everywhere and less focus on just one simple melting pot. We see Iran as a very potent threat and a determined adversary and the threat posed by Al Qaeda and rogue players.
When you look at all this and realize there will not be any meaningful lasting solution to our fiscal and monetary problems until at the earliest 2013, you go back to my investor's bible -- Ben Graham's "The Intelligent Investor." There he talks appropriately 63 years ago about the importance of a margin of safety.

H.L.: Are we looking at another recession?

I think we’re in one already. Unfortunately, neither businesses nor government are forced currently to produce timely reports to allow people who are not prepared to wade through massive detail to get to the bottom of what’s really going on.
We started, like many other analysts, just looking at Gross Domestic Product and accepting it at a good proxy for economic activity. Then a nagging set of questions forced us to go back and look at the actual calculation of GDP, and we believe that GDP overstates productive economic activity in 2009 by more than 50 percent. It’s not really painting the right picture. We think a much better way of looking at it is to track the progress of private-sector income in relation to the total debt on an economy.

When you do that you have to look at private-sector income per household, you see an American economy that has levered itself way past a prudent level. And you see some real danger.
When you take the government’s definition of “private sector” and then take out incomes generated by healthcare, education, and legal services, and you look at that residual, over time what you see is that those incomes per household are not growing quite fast enough. And from information on private-sector incomes from around the world you see from 1999 to 2009-2010, there’s been significant increases in income from outside the U.S., while in the U.S., in other countries like the U.S., in Europe, and in Japan, etc., you don’t see the same level of growth, which is a very disturbing, vexing, structural problem. When you look at private-sector income per household, you see an American economy that has levered itself way past a prudent level, and you see some real danger.

H.L.: What might happen?

We could wake up tomorrow morning with an unanticipated problem, just the way Japan faced the tsunami. It would not take much for one of our government auctions to fail. What would happen is that the government would go and try to raise money in one of its auctions and discover that there simply wasn’t the kind of appetite that was needed, or worse, that people were selling Treasuries, so interest rates would start climbing.
We’re seeing the canary in the coal mine with gold. Since Dec. 31, 1999, it’s been steadily increasing. That tells me that there’s a crisis in confidence, and there’s a growing awareness of it. If you look at the portion of our total local, state, and federal spending, how much is interest? We’ve been able to get away for a long time with interest rates that are too low, unfairly low. And (stock) markets are not kindly animals that will retreat a little bit here or there. We tend to overcorrect. When there’s a boom period, prices go way higher than they should be. When there’s a bump they go way lower than they should be.
H.L.: Do you think the Federal Reserve will raise interest rates soon?

C.O.: I don’t think we’re going to have much latitude. How much has gold moved this year? If you go back to the day QE 2 was announced, I said the actions of the Fed bordered on the criminal, and I stick with that.
H.L.: What will happen in June after the Fed finishes QE 2, spending the $600 billion buying Treasuries?
C.O.: I don’t think they can continue it. Going back to our GDP point, when the modern age was in its infancy, you could say that by increasing production you’re theoretically increasing economic value. But there comes a point where you start having a stack of wealth, as we do now. The Federal Reserve says households today have an aggregate $56 trillion of wealth. You have to start deciding if you’re going down a path of protecting and building that wealth, or are you destroying it.
If you look at what’s happened in gold terms to our household wealth since 1999, we’ve destroyed an unconscionably high amount of wealth by having a lax monetary policy and fiscally unsustainable spending, which has resulted in a loss of confidence in the dollar and a diminution of its value relative to key precious metals and commodities. Unfortunately, wealth in the U.S. is concentrated.
H.L.: Would you own stocks?

C.O.: Now is the time to get out of most stocks. Many investors have made a lot of money in equities, so they reflexively think that they should put some money into equities, particularly because bond yields are so low. We just simply do not think that most equities are fairly priced at this point in time.
When you think through what you really get as a shareholder, you get to eat after management has successfully gotten customers to pay them. After management pays themselves a lot of money, and after the government takes its share, if the company is generous enough to give you a dividend, which Warren Buffett doesn’t believe in doing, you get a dividend if you’re lucky. To me, in view of all of the risks that I see, and perhaps I’m excessively cautious, but I don’t understand buying into equities to be so far down the food chain at these valuation levels.
There’s one exception, and that’s in the area of energy companies. I think it’s as plain as the noses on our faces that there is an imbalance in the supply and demand for energy. And if you believe that India and China and a number of other nations are going to continue to advance, you’ve got to believe that there will be support for the price of important energy sources. Therefore, in that area there are potentially some companies worth thinking about. But beyond that, a company that is opaque and leveraged, like General Electric, is the last place I’d be putting my money.
H.L.: What energy companies would you recommend?
C.O.: One company that we’ve liked in the past is Devon Energy (NYSE:DVN) and also Exxon (NYSE:XOM). You can look at what’s happened in gold and the relative instability around the world, and you look at the fact that most have a small percentage of their portfolios allocated to physical gold. That’s an area where we’re much more comfortable, even at these high prices, thinking about adding physical gold than we would think of adding positions in most equities.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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