Amid the almost daily chaos in the markets, it’s easy to miss the forest for the trees. We spoke with William Muggia, manager of Touchstone Mid Cap Growth (TEGAX), for a broad overview of the global economy. Muggia believes that a growing global middle class will drive demand for all manner of commodities. Although he sees potential for a correction in the U.S. equity markets, he’s bullish on U.S. stock.
What is your outlook for the year?
I’m optimistic about the U.S. market’s long-term growth prospects and believe the U.S. has a good chance of out performing the emerging markets this year. Corporate earnings look phenomenal, particularly for industrials, cyclical industries and transportation, all of which have posted blowout earnings. The economy is faring well and the employment situation is improving.
However, I’m focused on the U.S. dollar’s disorderly decline. The greenback is down about 13 percent over the past year, and Federal Reserve Chairman Ben Bernanke couldn’t care less about the currency’s value; he’s only concerned about the economy and employment. That’s fine until it isn’t.
The U.S. dollar is a great safe-haven currency. But zero percent interest rates can’t be sustained for much longer with a slowing economy and rising inflation – at some point the Fed will have to raise rates. The weak dollar has helped push stocks higher thus far, but a further 10 percent drop in the dollar’s value is a disaster scenario that would destabilize the market.
I’m cautious in the near-term because I see signs of overly ebullient sentiment such as hot initial public offerings, heavy public flows into domestic equities and action on heavily shorted names. Short-term interest rates may rise later in the year, increasing the likelihood of market corrections. At these levels, many stocks also appear overextended.
Why are mid-cap names more attractive compared to large-cap stocks?
In terms of their valuations, large-caps are cheaper than mid-caps and small-caps. U.S.-based mega-cap dividend-paying stocks look really cheap. But I love the higher growth rates you find in mid-cap stocks.
Our sweet spot is the $2 billion to $15 billion market capitalization range. These companies have new product cycles, yet their small size and large addressable markets allow them to grow at outsized rates for several years. These companies can also supplement organic growth with accretive acquisitions. The merger and acquisition (M&A) environment right now is in a frenzy and it’s harder for bigger companies to move the needle. But a mid-cap company that’s growing nicely can find good strategic acquisitions.
Is the M&A environment overheated?
Cash on corporate balance sheets is near an all-time high and free cash flow generation is phenomenal. But I think every CEO remains concerned that growth could slow, particularly as the economic stimulus fades and interest rates rise. Companies always look to supplement growth. The question for many is whether to build or buy. They’re all doing their best to build their businesses, but they’re also eager to make acquisitions.
I expect an uptick in cross-boarder M&A, particularly from Asia. Asian currencies and the Australian dollar are strong right now. We may see a string of deals where companies with stronger domestic currencies essentially buy cheap U.S. dollars. Concomitantly, private-equity funds have raised huge amounts of capital that they need to put to work. There’s a fair amount of competition for deals.
Thus far I haven’t seen any egregious overpricing for deals. In the health care industry, for example, we’ve seen acquisitions of some loser companies. Sanofi-Aventis (SNY) isn’t a stellar company, so it bought Genzyme — which also has some challenges — as a defensive move. Valeant Pharmaceuticals (VRX) tried to buy Cephalon (CEPH), a deal with no real value, save an opportunity to cut costs. Many of the health care companies that have been acquired aren’t good businesses, but the acquirers can cut costs to drive earnings. Eventually we’ll see acquisitions of some stronger names. Right now, companies in the sector are focused on buying inexpensive under-performers that have the potential to be turned around and contribute to the acquirer’s earnings.
Are there any themes you’re particularly bullish on?
The food and agriculture cycle over the next 10 years will be absolutely enormous because of the burgeoning middle class in the emerging markets. I spent some time in China and Africa last June. The people in the regions once lived in poverty, eating grains and rice, but now they have jobs and a higher standard of living. This means they now want to eat more protein. One of my biggest concerns is that food prices will continue to soar, leading to shortages and riots. Yields can be increased with fertilizer and technology, but the middle class is becoming so large that food-related businesses will have to tailwind for the foreseeable future. Unfortunately, it’s not that easy for investors to play that theme; you can’t just buy fertilizer stocks because pricing can fluctuate.
China’s profit cycle is also shifting. The China economic miracle was based on exports and a cheap currency. The country is now moving up the value chain, China makes not only textiles and toys but also planes and automobiles. The country will also continue to build out its infrastructure. The domestic consumption story will be huge, and will require vast amounts of virtually every commodity.
That being said, commodity prices that have doubled and tripled this year won’t do so again in 2012. Nonetheless, we’re in a period of sustained high prices; it’s hard to imagine why the price of oil would fall back to $75 a barrel unless there’s a worldwide economic slowdown.
Ralcorp (RAH) is the largest provider of private-label cereals in the US. The firm bought Post in 2008 and American International Pasta last year. Ralcorp struggled in 2010 as agricultural commodity prices skyrocketed. But input prices shouldn’t double or triple again. However, Ralcorp and most of its peers have already raised prices. They’ve raised prices, but costs are beginning to stabilize. This means that margins could expand significantly.
Additionally, gasoline costs about $4 a gallon across most of the country, which puts pressure on consumers’ spending power. Consumers will begin to trade down to private-label brands to save 20 to 30 percent on their grocery bill. Ralcorp has already experienced input cost inflation, has pricing power and deal accretion from both of its acquisitions. The stock also trades at only 12 times earnings. That’s a substantial discount to its competitors. That gap in multiples will likely narrow as Ralcorp begins to post earnings that beat analysts’ estimates. This stock provides growth without much risk.
The health care segment has underperformed during the last two years, but the space will surprise investors in 2011. Thirty million new health care consumers will be added to the rolls if President Obama’s health care reform isn’t struck down by Congress or the courts. People were clamoring for a repeal of the bill last year, but I haven’t read a single health care-related article this year. It seems to be off the table until 2012.
We’ve owned a lot of the managed-care stocks that have performed well, but this year we’re looking to utilization plays. We like the health care services segment because we expect a strengthening labor market to drive a recovery in procedures. When the unemployed go back to work, the first thing they do is visit a doctor for a physical or another procedure they put off while they were uninsured.
One name I like that isn’t widely followed is CareFusion (CFN), which was spun off from Cardinal Health (CAH) in 2009. I love these spinoffs because the management team is much more focused when the company goes out on its own. In CareFusion’s case, a series of acquisitions produced a lot of operational redundancies. The company has underperformed its earnings potential. CareFusion specializes in medication dispensing systems and infusion pumps. The company is also a major player in the infection prevention. The company’s products help reduce costs in the system–that’s all that matters now.
The company’s operating margins are currently at 12 percent, but they should be in the high teens. CareFusion will generate 10 to 15 percent earnings growth over the next several years as they trim legacy assets. It’s not a sexy story, but a recovery in procedures and a new focused management team should drive earnings.