The Key to Profits: Pricing Power
As costs of energy and other commodities soar, investors should be on the hunt for companies with pricing power. So says fund manager Michael Cuggino, who believes that the ability to pass along higher product costs to consumers gives such outfits an edge and, in the long run, boosts returns.
Cuggino is skipper of the Aggressive Growth Portfolio (PAGRX ), a domestic all-cap equity fund, as well as the Permanent Portfolio (PRPFX ), a defensive allocation fund with a mix of gold bullion, silver, Swiss Franc bonds, and stocks (see BW Online, 3/8/05, "Balancing Assets for Lower Risks").
A focus on tax efficiency, along with stellar returns, sets these funds apart from the bunch. The Aggressive Growth Portfolio returned 40.18% after taxes for the last 12 months through Aug. 31, vs. a gain of 12.55% for the Standard & Poor's 500-stock index. For the last three years, the fund rose an average of 21.81% per year after taxes, vs. 12.02% for the S&P 500.
Cuggino recently spoke with BusinessWeek Online's Karyn McCormack about his investing strategy and top holdings. Here are edited excerpts from their conversation:
What's your market outlook?
Several factors are in place that indicate continued growth in the equity markets. There are some risks. But overall, the factors that bode well for an increase in equities outweigh the risks.
No. 1, you've got a growing economy. GDP growth is in the high 3% to low 4% on an annualized basis, and that has been true for the last several quarters.
Earnings from the S&P 500 companies have surprised on the upside in the first and second quarters. Corporations are sitting on a lot of cash, which eventually either will be reinvested in the business or distributed to shareholders via share buybacks and dividends. [This] would put more money in consumers' pockets and continue to drive economic growth on the consumer side.
The tax environment is favorable. Rates are lower than they were several years ago. I think the environment could even be better if Congress legislates into law some additional tax decreases that it has been talking about. Those are the positive factors.
What are the risks?
The negative factors primarily are inflationary threats and the effect on the economy of an extended period of high energy and commodity prices. The question is how long these prices will remain at these levels, and how long it takes for these high prices to work themselves through the production system, and to what extent companies that use these things in their products and services will be able pass on higher prices to consumers.
What about the Fed?
Another favorable factor would be interest rates, although it could be a negative, depending on how you view it. My own view is that rising interest rates are a by-product of a growing economy. The gradual increases that we've seen coming out of the Fed to our current levels are natural in a growing economy and shouldn't be taken as a negative.
I think the key thing with the Fed is: Do they continue [raising rates] at a gradual pace, or suddenly get more aggressive and move by a half a percentage point or three-quarters of a point in one sitting? And at what point do they stop?
I think economic growth in the second quarter and the improved job picture in the last few months have indicated the economy is a lot stronger than people thought. So I don't think the Fed is done yet, although I don't think it will deviate from its measured pace.
How are you positioning your fund?
The Aggressive Growth Portfolio (PAGRX ) is a fully invested domestic all-cap go-anywhere equity fund. It's designed to be invested in anywhere from a dozen to 15 different industry groups at any one time and to beat the broad stock market as measured by the S&P 500. It has done that over its life since 1990.
We start from the top down, and we look for industry groups that we think over a long period of time are going to outperform the broad market. Within those industries, we look for companies that possess what we believe are characteristics of good growth stories. Those characteristics are basically creation of new markets, expansion of existing markets for their products and services, a healthy investment in R&D spending, strong financial condition and operating results, management's background in an industry and their ability to properly execute a business plan and run the business profitably, strong balance sheet, and introduction of new products and services.
Then we'll look to get in at a reasonable or fair price. Most of our holdings are multiyear holdings. We're not interested at all in short-term results, but more the long-term story. We like to buy companies as opposed to trading stocks. For example, if a company misses an earnings target or revenue forecast in a given quarter, if the long-term growth story is intact, we're still going to like the company.
One thing you look for is pricing power. Which companies have it?
Given where we are with energy and raw-materials prices, some industries are going to be hurt more than others. As an investor, you want to be in companies and industries that have the ability to maintain pricing power. You want to see companies that have rising input costs to produce goods be able to pass them on to consumers.
In the energy sector, if you're a refiner, right now you have pricing power. You buy a barrel of oil at, say, $68, and you can manufacture and refine it and sell it at a higher price. That's a good place to be.
Otherwise you want companies that don't use a lot of that stuff. Things that come to mind are some consumer and entertainment companies. We hold Walt Disney (DIS ) and Viacom (VIA.B ). Pharmaceuticals is an area that has low commodity and input costs.
On the other hand, the auto industry is in a tough situation. They're getting squeezed at both ends. Not only are they incurring higher and higher input costs -- whether it be raw materials like steel or energy prices to run the plants -- but also on the demand side, they're selling things at a discount.
GM (GM ) and Ford (F ) had the program this summer with a discount that cleared inventories, but at what price? These companies are competing to lower sales prices with each other to gain volume sales. That's not pricing power. As a result, you see that reflected in their stock prices. They're definitely not a place to be.
What about consumers and retailers?
What's going on with retail is, energy costs are a regressive cost, almost like a tax -- it's a fixed cost of a household to operate. For lower-income households, a larger percentage of their income is going to go to energy, vs. a higher-income household. Some companies that cater to lower-income households, like Wal-Mart (WMT ) and Costco (COST ), are struggling a little bit more than the higher end, luxury retailers. Costco is a core, broad-based retail holding for us.
We also hold Williams-Sonoma (WSM ). We like the company for the long term and have held it for a while. It fits into the theme of high-end retailer. It's a market leader in its segment -- home furnishings and redoing kitchens and such -- it has a niche. Their products are very much in demand...whether people are buying homes or redoing homes, it's an area where people always spend money. That's an area where energy is not having much of an impact.
What are some of your top holdings?
Frontier Oil (FTO ) is a domestic oil and gas refiner. Their specialty is the refinement of sour or heavy crude. In this environment where everybody is searching for oil, light sweet crude is easier to refine, and sour crude is more difficult to get and more expensive to refine. Frontier is equipped to process this sort of lower-grade, sulfur-heavy sour crude. Their services are in demand.
Energy prices are still high, and I don't see them decreasing anytime soon. The story with commodities right now -- whether it be energy, industrial metals, timber -- is we're in the middle of a multiyear cycle of a structural imbalance of worldwide demand and worldwide supply. Until that imbalance is brought back into equilibrium, and either demand decreases or more supply comes online, we're going to have higher prices. With energy being one of those things, Frontier should continue to outperform.
Why has the fund done so well?
One of our other top holdings is Ryland Group (RYL ). Ryland is a smaller name in the homebuilding sector. We like it because it has a very diversified portfolio of investment properties. It's based in Southern California, but it builds homes all over the country. It's not beholden to any one localized area or the potential bubble in supply in certain areas. The diversification really helps it to maintain its business in an overall uptrend in the housing cycle.
I don't believe the housing industry is going to collapse, providing we maintain a schedule of gradual rate increases consistent with a growing economy and the good communication between the Fed and the marketplace. We might see a cooling off of demand to some degree, but interest rates are still historically low -- low enough for people to continue to buy homes.
Ryland's market position is entry-level to mid-level homes, so they're still very affordable. It might lend them to be interest rate sensitive on one hand, but interest rates are still historically low, and initial home buying and the first upgrade cycle is still within their realm. In addition, prices are less elastic at that lower end than they are at the higher end, in terms of the potential decrease in prices due to interest-rate sensitivity.
Ryland has a strong management team, and they do a good job of share buybacks and dividends to manage shareholder returns properly and to not waste corporate cash. In this environment, when corporations are sitting on a lot of cash generally, one thing you want to see in the stocks you hold is a management team that knows how to manage the cash and not spend it like drunken sailors.
We've already seen big increases in homebuilding. I would continue to opportunistically add to the stock on dips. On the other hand, it's fairly valued, and nothing grows to the sky. But it's definitely one reason we've been up.
Are there any other themes that you're playing?
Another area that we think has room to grow is financial services. Global trends -- growing baby boomers, more wealth being passed down through inheritances, people of all ages turning to financial advisers and such for advice in managing their portfolios and saving for retirement -- are making financial-services firms important over the long term.
One of our holdings in this area is Morgan Stanley (MWD ). The thing I like about Morgan Stanley is it has a tremendous brand name. It has been in turmoil lately. The idea of merging the retail Dean Witter Discover a few years ago with the white-shoe Morgan Stanley -- I don't believe that was all wet as a strategy. There was a certain synergy there, providing the management team could execute the strategy.
The management team under Phillip Purcell didn't execute, and the stock underperformed both the overall market and its peer group pretty much for the life of the combined company. Something needed to be done.
As a result, it's a discounted value right now relative to its peers. I think with the right management team in place and the right tweaking of the business model, that company is poised to grow over the long term. So far, the initial steps by the new management team under John Mack have been in the right direction with respect to shoring up management talent, convincing some talent to come back to the firm, and taking a measured review of the Discover unit before just spinning it off.
I think those are positive steps, but now they've got to tackle rebuilding their banking business. So as long as the management team executes, they should continue to grow.
What else is catching your eye?
The biotech area is another industry that doesn't have large input costs. It's a dynamic industry -- there's a lot of R&D going on, and there's constantly new products in development. A long-term growth investor needs to be in this area.
Amgen (AMGN ) really typifies our stock-selection process. It successfully made the transition from R&D house to selling products on the marketplace. It has a very smart management team that made strategic acquisitions that have contributed to the bottom line.
Amgen initially rose to prominence with their Epogen and Neupogen products. It has since come out with newer, better, faster versions of those that are hitting the marketplace and will soon overtake the older line versions in terms of sales. So it's cannibalizing old products with new, better ones and further increasing sales.
It has an active R&D group. Its management team has been in the business a long time. Financially, it has a strong balance sheet. I think the prognosis for it is very good.... It surprised with earnings recently, and the stock went from $60 to $80 pretty quick -- and I think it has further room to go.
Is it time to be defensive, as we head into a seasonally weak time of year?
I think the overall reasons for a continued rise in stocks are still there. They outweigh some of the risks. The good outweigh the bad.
I don't know about being defensive. If those historical trends remain true this year, which is never a given, it could be a buying opportunity to get into some names at a discounted price.