As head of Woodside, Cal.-based Fisher Investments, Ken Fisher manages more than $25 billion in investment assets for institutions and private investors. His investing insights are widely published in popular magazines as well as in academic journals. Recently, Kiplinger's Personal Finance contributing editor David Landis had a cup of coffee with Fisher in New York. Here are excerpts from their conversation:
Kiplinger's: Judging from your recent writings, you seem to be fairly bullish. Why?
Fisher: A medium-sized corporation today in America can borrow money at 6% or less. After tax, it's more like 4%. The average company has a price-to-earnings ratio of 15, and that's an earnings yield [earnings divided by share price] of 6.7%. So if a company can borrow money at 4% after tax and buy back stock with 6.7% earnings yield, it picks up 2.7% as free money, and that makes its earnings per share go up immediately.
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Today, more than two-thirds of the companies on the U.S. stock market are able to buy back their own shares and make their own earnings per share rise in the process by doing just that. Or a company can borrow money and take over its competitor. Say it borrows at 4%, and buys a competitor with an earnings yield of 8% and picks up the 4% spread as free money. Its earnings per share immediately go up.
These two features are behind the stock buyback boom and the takeover boom. When a company buys back its own stock for cash, it is destroying the supply of stock, and it has fewer shares outstanding afterward. When a company buys a competitor for cash, it gets the acquired company's earnings and destroys all the acquired company's shares. My bullishness is predicated on the point that we're destroying equity securities at a very rapid rate, faster than at any time I can measure in history, and that has to be a bullish feature.
Why aren't large-company stocks benefiting from this? A lot of people say that because the past six years have been years in which small-cap stocks led big-cap stocks that it's now time for big-cap stocks to do best. I don't believe that's right. The very biggest-cap stocks are too big to be taken over. If you believe, like I do, that takeovers are a really big thing right now, the stocks that are too big to be taken over aren't going to participate in any of that. To my mind, this is a time where smaller and midsize stocks are better than the very biggest stocks. When we think of the Intels and Mercks and Wal-Marts, they're really pretty darn big and not going to be taken over.
How can investors take advantage? One of the points I'm big on right now is whatever someone wants to do, they ought to want to do it in a way where the stocks would also be takeover targets. Almost regardless of what you think is a good type of stock, like technology versus energy versus consumer products, this is a time where you're seeing a lot of takeovers. You might as well buy companies where you would be content if they weren't taken over, but they might be taken over. It's a way to get paid twice.
Some examples, please? I am of the view that oil prices should remain firm and energy stocks will do okay. But if energy stocks do okay, you don't really get the biggest oomph in the vertically integrated oil companies. The biggest oomph is in drillers and services companies. So when I look at that, I look at companies like Petroleum Geo Services (symbol PGS) from Norway, which is the leading-market-share vendor of undersea seismic mapping for oilfields. As long as the price of oil stays relatively firm, they've got all the work they can do and more. Profits remain excessively strong. It's something where the acquirer can buy it and make its own earnings per share rise by acquisition.
Petroleum Geo Services is an example of a market share play. When you look at retailing, a good example is Tiffany (TIF), a leading retailer of jewelry. It is a growth area, but a low-growth area, but the name Tiffany itself is valuable. How many other retailers have their image associated with multiple movies over your lifetime? And yet it's about a $5.5-billion market cap item and therefore lots of other retailers can acquire it and fit it into their line of chains.
How about another example? Inco (N) is currently the number-two nickel maker in world and is in the process of trying to acquire Falconbridge, which would make the combined company tied for number one. If they can pull that off, or even if they don't pull it off, either way they're a perfectly logical product-line acquisition for one of the bigger diversified mining companies.
The only defense that any of these companies have against a takeover, in my view, is to borrow money and buy back stock to drive up their share price to where it is uneconomic for the acquirer. But either way the shareholder wins, because when you borrow money to buy back your own stock, you make your earnings per share go up.
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