Scott Schermerhorn discusses Granite Investment Advisors with The Wall Street Transcript. Mr. Schermerhorn selects stocks using a value discipline. He looks for high-quality companies selling at a discount. His goal is to make investments for the long term. Mr. Schermerhorn says that value has underperformed the S&P since the financial crisis and has created opportunities. He advises investors to be concerned with some of the excess valuations in the market.
Companies discussed: Amazon.com (NASDAQ:AMZN); FedEx Corporation (NYSE:FDX); United Parcel Service (NYSE:UPS); Walmart (NYSE:WMT); Walgreens Boots Alliance (NASDAQ:WBA); CVS Health Corp. (NYSE:CVS); AT&T (NYSE:T); Royal Dutch Shell plc (ADR) (NYSE:RDS.A); Berkshire Hathaway (NYSE:BRK.A); Tesla (NASDAQ:TSLA) and Ford Motor Company (NYSE:F)
Scott Schermerhorn is Managing Partner and Chief Investment Officer at Granite Investment Advisors. He has over 30 years’ experience in the sector. He has been interviewed by CNBC’s Squawkbox, CBS News, Fox Business News, The Wall Street Journal, Investment News, Barron’s, Bloomberg, Yahoo Finance, The Fiscal Times and The Business Times. He is also an adjunct business professor at Boston University, from which he received a bachelor’s degree. He also holds an MBA from Seton Hall University.
Sector — General Investing
TWST: Could you tell me a little bit about the firm?
Mr. Schermerhorn: We manage over $700 million for both high net worth individuals and small institutions. We choose individual stocks and bonds. The majority of our stock selection is a value discipline, although we do have a smaller growth product at the same time.
TWST: And is there a unique investment philosophy that you follow?
Mr. Schermerhorn: The majority of the equity assets are in a value discipline. And we’re looking for high-quality companies selling at discounts to their intrinsic values. And we try to invest for the long term; we’re not traders. We make long-term investments and hold these companies.
TWST: Did you want to talk about the situation for value stocks and highlight a company that you find interesting now?
Mr. Schermerhorn: Here is where we are right now. We are in a cycle, since the financial crisis, where value has underperformed the overall S&P and the broader market for the longest period of time on record. This includes the period in the late 1990s just before the tech bubble burst. This has been the longest period of underperformance for value that we’ve ever seen. In many cases, what that’s done is to create incredible opportunities.
Why it’s happening is hard to say. Part of it might be the slow growth environment we’ve been in since the financial crisis. The other part is probably the whole move to passive investing. If you think about it, passive investing really doesn’t care about valuation; it simply cares about what percent a particular company is in an index and it automatically buys it.
However, if you look at value stocks as an aggregate right now, they are at the widest valuation discounts they’ve ever been as to growth stocks. Add to this that their balance sheets are actually in the best shape they’ve ever been in relative to growth stocks. Strangely, the beta of the group is higher than the overall market, which is unusual given how inexpensive they are and what great shape their balance sheets are in. If you look at cash flows and dividends and earnings again, they’re at the lowest valuation they’ve ever seen. We believe this is a unique opportunity for investors.
The market is assuming the traditional companies are going to have their businesses disrupted by some of the new technology that’s out there, whether it’s retailing versus Amazon (NASDAQ:AMZN) or a whole host of other things. Often, something may happen, but it may not be in the time frame the market expects.
As a simple example, the shift to electric cars that many see as coming, we’re going to get there, but they’re not going to be here in a year or two for a variety of reasons. When this cycle reverses itself, which it has always done in the past, some of these quality companies that are very inexpensive, which I’m going to talk about, should dramatically outperform.
Let’s start with FedEx Corporation (NYSE:FDX). As you know, FedEx is dominant in its industry. It’s really between UPS (NYSE:UPS) and the United States Postal Service, at least in this country. This has set up an oligopoly within this industry, which historically has been good for investors. The company has built out a logistics and transportation network that is very hard to replicate. This industry has high barriers to entry.
That said, the market has been very concerned that Amazon is going to start competing with them. However, I think what the market ismissing are two things. One, Amazon’s business with FedEx is only about 1.5% of revenues. Amazon is not important to FedEx. The other is that e-commerce is going to continue to grow and grow dramatically. Some of the traditional retailers, whether it’s a Walmart (NYSE:WMT) or a host of other ones, should have higher growth in e-commerce than Amazon will simply because they’re just beginning, where Amazon is already established.
And if you look at FedEx right now, it’s selling at the lowest valuation of multiple it’s ever been at, 10 times earnings. It’s got a 1.6% dividend yield, which should grow over time. We believe this is a great opportunity for investors in this company. Its balance sheet is wonderful; management is good.
Yes, they stumbled with the TNT acquisition in Europe, but I think 10 times earnings makes no sense given the market multiplies roughly 19 times earnings. So this is literally selling at really half of where the market is. Investors are assuming this is dramatically inferior to the average company in the S&P 500. We just simply don’t believe it
TWST: And do you think something new is on the horizon for them that might be of interest to
Mr. Schermerhorn: The big issue where investors have really taken pause with FedEx was when they purchased TNT, which is a transportation company over in Europe. The company was troubled when they bought it, and they’ve been trying to turn it around. However, in the middle of doing so, TNT systems got hacked, which dramatically disrupted the business over there. What investors are waiting to see is, can FedEx turn around TNT and get it to where they need to be? We expect they can, and you’re going to start to see evidence of that in the next coming quarters.
“This growth is driven by the aging of the Baby Boomers. Studies have shown that the elderly basically consume almost 80% of the prescription drugs out there. So as the Baby Boomers age, the demand for prescription drugs is going to increase.”
TWST: Is there a certain approach they may take to get that company turned around?
Mr. Schermerhorn: They’ve already begun. They’ve changed management over there and enhanced and improved their systems. Chances are there it won’t be hacked again. What you’re eventually going to see is TNT will be more absorbed into FedEx and less of a standalone unit. When that happens, you’re going to start to see earnings and cash flow improved even more than where they are now.
TWST: Did you want to mention another company?
Mr. Schermerhorn: Sure. The other thing I will talk about, similar to FedEx, is Walgreens (NASDAQ:WBA). I say similar in that drug retailing in this country is a duopoly. It’s Walgreens, CVS (NYSE:CVS), and then there’s a whole host of other small players. The concern investors have is Amazon getting into the prescription drug business. The way we are looking at it: Is the overall prescription drug business growing fast enough that another entrant into that business shouldn’t materially affect the growth rates?
This growth is driven by the aging of the Baby Boomers. Studies have shown that the elderly basically consume almost 80% of the prescription drugs out there. So as the Baby Boomers age, the demand for prescription drugs is going to increase. What people are concerned about is Amazon bought PillPack, and they’re going to have some kind of a disruptive way to get drugs to the people that need it.
However, here’s where we take a little pause. I’ll give you a good example. My mother is 84 years old. She is never going to buy drugs on Amazon. She just isn’t that computer savvy, and she likes the traditional drugstore. She likes going there. She knows the pharmacist, and she’s comfortable with that. I don’t think my mother is all that unusual for Baby Boomers. I just don’t see them adopting an e-commerce method of getting their drugs any time soon. Having said this, even if they do, both Walgreens and CVS
have the ability to ship your drugs to your house.
So I’m not viewing the threat as big as some people believe. I think the bigger issue that the drugstores have is the front of the store. I’m less concerned about the back of the store, meaning the pharmacy, but really the front of the store where they are selling candy bars, toilet paper or whatever. Part of the reason that’s under pressure, we don’t believe is because of Amazon but rather other competitors.
Just look at what’s happened with gas stations in this country. They no longer just sell gas. In fact, their margins on selling just gas is close to zero. They really are small convenience stores that happen to sell gas at the same time. This is where the pressure is coming from.
Walgreens and CVS have already begun repurposing the front of their stores from convenience stores to more of health care offerings. They’re going to have instant medical clinics in there, will offer eye exams, hearing tests and so forth. It’s going to become more of a health care offering versus a retail store.
As you see this build out, investors are going to start rewarding them. Similar to FedEx, Walgreens — it is selling at 9 times earnings, which is the lowest valuation it’s ever sold at. You get a 3.4% yield. It’s a very stable business. And it’s part of the oligopoly. Investors are overlooking the ability this company has to reinvent itself — and the prospects it has.
“Yes, they are open over the weekends, early mornings and late at night. These clinics are making health care more accessible, which is what people want. They want convenience and accessibility. We’re in an environment where we are used to getting almost instant gratification, whether it’s shopping, watching television or ordering takeout.”
TWST: And why do these mini clinics make sense for places like Walgreens and CVS? Because it’s one-stop shopping where you can get seen by a health professional and get your medication right there?
Mr. Schermerhorn: I think you hit the nail on the head. It really is about convenience. I’m sure most readers understand this. Let’s say you have a common cold, and you simply need a prescription decongestant or an antibiotic. If you call your doctor’s office, they might be able to see you in a week, maybe longer than that. Because of the way traditional doctors are compensated, these visits are not priorities for them, so they’re putting these visits out further and further.
If I have a cold right now and I need an antibiotic, I can simply go to one of their clinics to get diagnosed and get a prescription and have it filled under one roof. I get my antibiotic, I can take it, and I can get back to work. It’s just much more convenient.
TWST: And the same thing may be true even for things like routine physicals or shots?
Mr. Schermerhorn: Absolutely. For whatever reason, doctors just de-emphasized this, so the drugstores have become a more convenient solution. If you have a real issue or they believe you’re very sick, they might be able to squeeze you in, but it’s just inconvenient. You have to try to get to your doctor in a week or two, but you’re sick right now and want some relief.
With traditional doctors, you have to wait a week or two and then once you see the doctor, then you have to take the prescription to a pharmacy to get it filled. It’s just much easier to walk into a pharmacy and get it all done under one roof. Given that most couples are dual income earners, they just don’t have the time to run around to the doctor anymore. They’re busy. It makes things just more convenient for everyone.
TWST: And a lot of these clinics are open over the weekends too, where the doctor’s office may not be.
Mr. Schermerhorn: Yes, they are open over the weekends, early mornings and late at night. These clinics are making health care more accessible, which is what people want. They want convenience and accessibility. We’re in an environment where we are used to getting almost instant gratification, whether it’s shopping, watching television or ordering takeout. You want things right now. This is just going to continue. It’s a better system for the consumer. And I think at the end of the day, what’s more convenient for the consumer wins.
TWST: Do you want to mention another company?
Mr. Schermerhorn: Another company along the same line right now is AT&T (NYSE:T). Here’s a company selling at 9 times earnings, which is the cheapest valuation it’s ever been at. It’s got a 6.3% yield. They went from landlines to cellphones, and now what they’re really becoming is an entertainment company. Between their DirecTV and Time Warner businesses, they have transformed themselves from a telecommunication utility into an entertainment, internet and telecommunications powerhouse.
And what’s going to happen is very interesting going forward. If 5G can do what it claims it will do — meaning they’ll deliver wirelessly internet speeds that are as fast, if not faster, than your cable modem — I think they’re going to take market share from some of the cable companies over time simply because it’s more convenient. They should be able to deliver better, more reliable broadband to their customers at a lower cost. Not necessarily lower cost to the customer but lower cost to AT&T, as they will not have to maintain the wire networks running along telephone poles like the cable industry does. Sending out trucks at all hours of the night is a very costly proposition.
Over time, investors will realize the potential of this, and they should start rewarding it with a more favorable multiple. Like the other companies I have mentioned, this is a very inexpensive company at 9 times earnings. Once they demonstrate the capabilities of 5G and that they’ve properly integrated HBO, we think investors will start to realize how valuable this company is. And in the meantime, you get a 6.3% yield to be patient, which compared to fixed income is a great opportunity.
TWST: Is there anything coming out before 5G becomes widely available, or is there anything that’s on the horizon that might be interesting for investors, something they’re working on now?
Mr. Schermerhorn: A couple of things. One, investors are concerned with the leverage they took on to do the Time Warner acquisition. I believe investors are looking for the company to pay down debt to improve the balance sheet. AT&T is fully onboard with this, and we think you’re going to see them surprised to the upside — meaning, we believe they’re going to retire more debt than investors have given them credit for going forward.
The other thing they’re doing is a whole bundling offer. If you are an AT&T cellphone customer now, you’re going to get HBO and some other content bundled in your service, which will make things very appealing. What it really does is lock the consumer into AT&T going forward. Not only will they be your cellphone operator, they will be your broadband provider because it’s going to go over 5G, and they’re going to be the content provider through HBO and all of their properties.
I think what you’re going to find is investors, right now, are concerned about subscription losses at the old DirecTV business. We think you’re going to find that they will continue for a bit, but then you should see subscribers pick up. They should increase over time as customers understand the value proposition of their 5G network and content.
“The whole notion of increasing renewable energy is good, and it’s good for the environment. But that’s going to take years to really build out. Part of the reason for our longer-term view is the lack of battery technology. Renewable energy needs an ability to store power, as it only works when Mother Nature allows it to.”
TWST: Did you want to mention one final company?
Mr. Schermerhorn: Yes. Royal Dutch Shell (NYSE:RDS.A). This one is kind of interesting in the sense that obviously what investors currently believe is demand for oil is going to peak at some point and then start to decline. At some point, this will happen, but not any time soon.
The whole notion of increasing renewable energy is good, and it’s good for the environment. But that’s going to take years to really build out. Part of the reason for our longer-term view is the lack of battery technology. Renewable energy needs an ability to store power, as it only works when Mother Nature allows it to. We will figure out a storage option someday, but we are simply not there yet.
On top of this, you’ve got emerging economies becoming more mature. When economies lift more people from poverty to middle-class levels, energy demand increases. Now, the interesting part with Royal Dutch is how disciplined they are. We had the energy bust of 2015, which caused the price of oil to collapse. This scared investors away from energy as a whole. They just want nothing to do with it.
That said, what is interesting right now is Royal Dutch is 11 times earnings. You got almost 6% dividend yield. But what’s fascinating, if you look at the free cash flow of Royal Dutch right now, it is greater than where it was when oil was north of $100 a barrel. We believe investors are simply looking at the fact that energy prices are down from the peak, so they don’t want to own energy stocks. However, here’s a company that’s done such a good job of reducing costs and matching their capital expenditures to what they believe is proper that there’s more free cash flow in this company now than there’s been in years. Investors seem to be just ignoring this.
Clearly, Royal Dutch is a high-quality company within the troubled space or at least a questionable space in investors’ minds. However, over time, I think what you’ll find is energy demand, meaning oil, is going to continue to grow. And yes, we’re going to have electric cars. Yes, we’re going to have more renewable energy. But still, demand for traditional oil is going to continue to grow. When investors realize this and realize the profitability of this company coupled with how inexpensive the company is, they’re going to be rewarded. Here again, you’re getting a 5.8% yield to be patient and wait, and compared to fixed income, that’s a very attractive opportunity.
TWST: And did you want to highlight some of the better- known brands within Royal Dutch?
Mr. Schermerhorn: You’ve got Shell gas stations, you got Shell Oil, a large LNG division, petrochemicals and a growing renewable energy business. It really is a global company that’s positioned very well going forward. A good portion of their business is in some of the emerging economies. And that’s really where you’re going to see demand for traditional gasoline and oil increase, whereas you’re probably going to see it flatten out in the United States.
TWST: Changing direction, when you talk with clients, what are some of their concerns as they look at the rest of this year and into next year?
Mr. Schermerhorn: I would say two. One, as I mentioned before, this has been the longest cycle of value underperformance. And while many customers and investors believe in value as a style, they appreciate the quality companies they own, it’s underperformed for a long time. The fact that it’s underperformed for so long has really given them pause. They wonder if they’re missing something or the whole investment landscape is turning.
And this sounds very similar to what happened in the late 1990s. I remember in the late 1990s there were articles written saying that value investing as a style was no longer valid. It was going to go the way of the dinosaur. If you recall, back then there were a few publications that had Warren Buffett on the cover, basically saying that he’s lost it, he no longer is a good investor. You are having the same thing happen now. I’ve seen numerous publications reporting how the Berkshire (NYSE:BRK.A) portfolio is done. And that it has underperformed and that Warren has lost his magic, for lack of a better phrase. This is what you typically see as a setup at the bottom of the cycle, this tremendous pessimism.
The other thing investors are concerned about is the length of the economic recovery we’ve had. It’s been a long time coming now and value has underperformed throughout it. The economy is another concern as we maybe reach toward the end of the expansion and perhaps we’re going to go into another recession. The fear: The next recession will be similar to 2008.
Yes, we will go into another recession at some point in time; when this happens, no one knows. However, we don’t believe it’s going to be anywhere near as severe as the financial crisis. The financial crisis was much worse than a typical recession. It ended up being a global depression, which is very, very, different. Recessions are normal in business cycles; depressions are not. Many investors are expecting a repeat of 2008, which we don’t see in the cards because simply we are not seeing the wild speculation that you saw before the financial crisis.
In addition, they are concerned that the ability to pick stocks by any active manager is gone — simply buy an index. So why would I use an active manager when I can buy an index product? These are all things that are weighing on them.
“One, yes, it’s been one of the longest ones, but it’s also been one of the most muted ones. So if you look at economic growth from the trough of 2008 to where it is now, the economy hasn’t grown that fast. In fact, it has grown less than a typical recovery, but it’s been muted and drawn out.”
TWST: In terms of government policy and Federal Reserve policy, what would help the market the most in terms of what they do?
Mr. Schermerhorn: You bring up a good point that I forgot to mention. The other concern investors have right now is what is going on with global trade policies. Any type of certainty for investors will help in that area. We continue to be of the belief that we will not end up in a total trade war with China and some of our other partners. What we are now seeing are trade negotiations. They look kind of unpleasant and concerning, but we think ultimately it will be resolved.
Why do we have confidence it will be resolved? Because what we’re asking for is fair and is reasonable. By the way, it’s in no one’s best interest to enter a trade war. This rhetoric is something that’s weighing on investors’ minds. Once some of these are resolved and certainty is cleared up, I think you’ll see them come back in the market, have a little more confidence.
The only other concern I would add is how long the economic cycle has been. And I would say two things. One, yes, it’s been one of the longest ones, but it’s also been one of the most muted ones. So if you look at economic growth from the trough of 2008 to where it is now, the economy hasn’t grown that fast. In fact, it has grown less than a typical recovery, but it’s been muted and drawn out. We haven’t seen a quarter of 4% or 5% GDP growth. It’s just been more of the slow growth kind of grinding along.
The final thing that weighs on investors’ minds is the length of the current bull market. You will often hear from the media that this is the longest uninterrupted bull market that we’ve ever experienced. That’s actually not true. A traditional bear market is considered a decline of more than 20%, peak to trough. In fact, if you look at last year, from the peak of the market last year to the trough of the market, it declined more than 20%. If you go back to 2010 and 2011, from peak to trough, we saw another 21% decline.
So I’d argue we’ve had two bear markets since the financial crisis that no one seems to really talk about. Now, they haven’t been long, drawn-out bear markets; they’ve been kind of short and with dramatic recovery. However, we’ve already had two bear markets within this bull market, so the argument that it’s been uninterrupted is simply not true. As such, we don’t buy the argument that we must be looking at a bear market simply because we’ve been in the bull market so long. The fact is, we haven’t.
We also don’t buy the arguments that the economy has to roll over simply because it’s been so long, for one simple reason: This expansion has been much more muted and drawn out. Granted, it’s long in the tooth. But it is by no means the most dramatic recovery we’ve seen since the recession.
TWST: Is there anything else you want to bring up that we haven’t talked about, either about the firm or about some trends out there?
Mr. Schermerhorn: The other thing I would say is that we’re in an environment where valuation simply doesn’t matter. If investors think companies have great growth prospects, they’ll build them up to values that in our opinion don’t make a lot of sense. Conversely, if companies’ prospects are perceived to be questionable, they will be bid down — valuations that make no sense. At the end of the day, my experience, over 30 years, is valuation always matters. It may not matter for short periods of time, but ultimately, in the long run, it does.
This market is buying into good stories without going into too much detail. How many times has Tesla (NASDAQ:TSLA) made promises that it failed to deliver on? Yet investors still get rewarded with a very rich multiple far greater than profitable auto companies. Eventually, investors are going to tire of that. They are going to start valuing for what it really is, a challenged automotive company that’s burning cash. There are other stories like that out there.
Investors are very comfortable in assuming where a company will be 10 years from now if it’s growing rapidly. Studies I’ve seen show people have the ability to forecast out for about a year or so with a reasonable amount of accuracy. After a year, your ability to forecast is just not all that great. If you are looking at a company and assuming where it will be five years from now, chances are you’ll be wrong. We think when some of these optimistic forecasts prove wrong, you will see revaluation and rotation in the market.
We think it’s a good time for investors to be looking at quality companies selling at reasonable valuations. I wouldn’t be afraid of doing that at all. I would be a little concerned with some of the excess valuations out there. In many cases, investors should just take some profits in richly valued companies and put them into more reasonable alternatives.
TWST: Would there be one sector that you think some of those excess valuations are more commonly found?
Mr. Schermerhorn: It’s fair to say we have a lot of companies in the technology space right now that are selling at astronomical valuations. Investors are betting they are going to disrupt the established business models. They may disrupt them a little on the margin. However, it’s unlikely that they’re going to disrupt them to the degree that investors believe is going to happen. Telsa’s lofty valuation makes no sense to me. Its market capitalization is close to Ford’s (NYSE:F) and Tesla is burning cash while the Ford is making a profit. Will Tesla soon sell more cars than Ford or be more profitable? Unlikely.
TWST: Thank you. (ES)
Past performance is no guarantee of future results. There can be no assurance that any of the securities referred to herein were produced for or remain in portfolios managed by Granite Investment Advisors. A complete list of all Granite Investment Advisors’ recommendations within the preceding year is available upon request. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities described herein.