Episode 37 – Economic Observation from Portfolio Manager, Charlie Smith, of Fort Pitt Capital Group

Episode: 37
Originally Aired: September 22, 2010
Topic: Economic Observation from Portfolio Manager, Charlie Smith, of Fort Pitt Capital Group

The Lange Money Hour: Where Smart Money Talks
James Lange, CPA/Attorney
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Economic Observation from Portfolio Manager, Charlie Smith, of Fort Pitt Capital Group
James Lange, CPA/Attorney
Guest: Charlie Smith, EVP/CIO of Fort Pitt Capital Group
Episode 37

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TOPICS COVERED:

1. Introduction of Special Guest, Charlie Smith
2. Equity Premium Defined
3. The Art of Diversification
4. The Impact of Marcellus Shale
5. A View on International Investing

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1. Introduction of Special Guest – Charlie Smith

Now I want to tell you about our esteemed guest we have here tonight.  Mr. Charlie Smith, who is live with us in the studio and actually, let me remind you that tonight’s show is live, and we love our live shows because we love hearing from you.  Our lines are open right now, as we speak, and if you have a question or a comment, you can give us a call.  That studio line is 412-333-9385, again that’s 412-333-9385.  Alright, back to Charlie.  Let me introduce Charlie to you.  Charlie is the Executive Vice President, Chief Investment Officer and a founding partner of Fort Pitt Capital Group located right here in Greentree, outside of our city, where he oversees the investment policy and strategy.  In this role, he manages client portfolios of individual securities and provides an economic overview for the firm.  Charlie is a regular for providing information for the financial media.  He’s been in Money Magazine, Barron’s, The Wall Street Journal.  He’s written and lectured on stock selections strategies, macro economics, value style management, securities analysis.  He’s spent his entire career in the investment management business and has extensive experience in both securities analysis and portfolio management.  Charlie, thank you for being here.

Charlie Smith: Well, thank you, Nicole. I appreciate the chance to join you.

Nicole DeMartino: You’re welcome.  Well, I know that you just left your investment policy meeting so I’m sure you are just ready to explode with all this information for us so I’m going to turn it over to Jim.  Jim?  Good evening, Jim.

James Lange: Hi there.  Thank you, Nicole.  One of the things that I will mention is, I’ve been a big Charlie Smith fan for years and years.  Charlie is pretty amazing answering questions.  There would be one argument to say you don’t have to prepare a radio show at all for Charlie because he would be so good with questions.  So I would encourage people to ask questions.  He can not, because of regulatory reasons, answer questions on individual securities, but if there is more of a general question, I think that you could not get a better person to answer them.  I have a couple questions for Charlie that I would start.  I have heard you in the past, Charlie, talk about the equity premium.  And these days, you have a lot of jittery investors, a lot of nervous people, who say hey, you know, is this really the right idea.  In the last 10 years, I really didn’t do so well in the stock market.  Should I just kind of stick it out, or should I really start looking for alternatives for the majority?  And let’s just say, for discussion’s sake, that we’re talking about a long term investor.

Charlie Smith: Let’s define the equity premium first because it is sort of a high-faluting industry where, not a lot of people really understand what it is.

James Lange:  OK.

2. Equity Premium Defined

Charlie Smith: The equity premium is the extra return you get when you take risk.  Basically, the extra return you get when you take ownership risk.  The way we measure it is, what return would we expect to get from the average stock, relative to what we are getting on a Treasury bond.  We want to compare apples to apples here, so we use a long term Treasury bond with a stock.  And a stock has a fancy term for a longevity of the investment, the duration.  A stock is a very high duration the same way a long term bond does.  A typical Treasury bond you can get 10, 15, 20 30 year maturities. The equity premium is the return that you get on the stock portfolio relative to what you would get on a Treasury.  And as you said, over the past decade or so, long term Treasury bonds have actually performed stocks.  So the equity premium has not been there.  And as you just also said, investors are concerned about that.  They’re saying to themselves, look, why take the risk of putting my money into an equity portfolio if I’m not going to be compensated for taking that risk.  And that’s a question we get all the time from our investors.  And the way we answer it is by saying the last decade was a very unusual period for a couple of reasons.  First of all, we started the decade with interest rates at very, very high, historic levels.  We go back to the late 90s, we had interest rates on the long term Treasurys in the 8 ½ percent range.  They’ve since fallen on a 30-year bond down under 4%.  So, the environment in which stocks were competing, so to speak, was one in which we were starting in a very high rate of interest.  So it had a very high hurdle for the average stock to overcome.  Secondly, we had a period where we started the decade of  2000 through 2010 that followed a historically very powerful period for stock prices.  If you remember, in the latter part of the 90s, we had the average as measured by the S&P 500 producing returns in the mid 20% range for most of the decade of the 90s.  So we were coming off of a period where stocks had performed at historically high levels, and we had very high interest rates.  So we were sort of setting ourselves up for under performance, at the time.  Now, it was hard to convince people of that.  In fact, people were clammering to put their money in stocks in 1999 and 2000, as you can remember.  But the point is that the equity premium has only been negative, or disappeared for two periods in the history or the US economy.  One was just the last decade and the other was the decade of the 30s.  So each of those periods was a period where we had weak economic performance, interest rates falling and, at the beginning of that period, very high share prices.  So you want to take today’s environment and say how does that compare with 1999 or 1929 and that will tell you whether you have decent odds for getting positive returns for stocks.  Given what we see today, with historically fairly low interest rates, a multiple on the S&P 500 of only about 14 times earnings, it’s our belief that the equity premium the next 10 years is going to be decidedly positive.

James Lange: Alright, that actually is very good and the other thing that I always love that you like to say is when you’re talking about equities, you’re not really talking about a dartboard, you’re actually talking about real ownership of real companies that get up every day, just like we all do and go to work and try to make some money.

Charlie Smith: The [inaudible] for our economy is for people to add value to the various enterprises.  The phrase I like to use is, there’s nobody on the Forbes 400 who made their nut by lending money to somebody.  You get rich, you build value, you compound equity in our economy by taking risks. That’s really the only way to build wealth.  So if you are going to build a diverse portfolio, of well run businesses, purchased at a reasonable price, and hold to them over time, you will earn a premium return, relative to the bond market.

James Lange: Alright, would you see a role of money manager to help keep you in the market or, I have heard criticisms well, why didn’t you know that the market was going down.  And I’ve heard you say, well, I’m a little bit better at predicting what’s going to happen in the next 3 years, than the next 3 days or the next 3 months.

Charlie Smith: Most certainly.  To answer your first question, we really earn our keep, more so than anything else, by helping people stick to their plan.  There were a whole lot of people that, as I like to put it, went off the reservation, in the latter part of 08 and early 09 when it looked like things were flying apart at certain points along the way there.  And the idea that we, to a certain extent, get paid to disagree with our customers.  If our clients are going to pay us a fee, they expect us to do something not only different than what they might do, but also better.  So in a sense, if you are going to pay an advisor to run your stock portfolio, you should expect results and documented results, but you should also let them do their job.  So in some ways, we get paid to protect investors from themselves.

James Lange: I was reading Jonathan Clements book and what he said that was pretty interesting is that, when people get in trouble, it is not necessarily because they have a bad asset allocation investment strategy to start, it’s because they vary it at the wrong times, and they would have been better off just kind of sticking to their discipline.

Charlie Smith: Exactly.  My old boss used to have a saying that investing is like a bar of soap, that if you play with it too much, it’s going to disappear.  And I think there is a certain amount of truth from the idea that you build a portfolio that’s appropriate for your risk tolerance and then you let it work.  And the idea, if you have the fortitude to be contrary, go ahead and exercise it, but most people don’t.  People are social animals.  They want to do what their neighbors and their friends are doing.  And when their friends and neighbors have gotten off the reservation, they want to follow because it feels more comfortable.  As Warren Buffet has said millions of times, investing is not about comfort, it’s about doing what the numbers tell you to do.  And as an investment advisor, I get paid more for my ability to follow the numbers and do what the numbers tell me to do than anything else.  No, the ability to keep your head when the crowd around you is either euphoric over a market condition or down in the dumps about a market condition.  The ability to objectively look through that and let the valuations tell you what you should do is where value gets added.

James Lange: Well, it’s interesting you say that because I sometimes have clients and they come in and I’ll see and, I, of course, learned this from you, I see them have too high a percentage of their portfolio in any one stock, no matter how wonderful they think it is and you have always preached, no, you don’t want to have and maybe you can comment on what percentage for what stocks, but they’ll say something like, well, my dad left this to me.  Or, the other thing is, I think by nature, people don’t like to lose money and if they buy something for $100 and they sell it for $75, that means they can never recover on that particular investment where maybe you might say, well, hey, $75 is a good price for this stock right now, let’s just get out and let’s get into something else.

3. The Art of Diversification

Charlie Smith: There are a couple of questions there.  First of all, diversification.  Academic research has shown that once you get beyond about 17 to 20 stocks in your portfolio, you’ve removed the risk that any one stock is going to wreck your results over time.  Academics will tell you once you have 20 stocks in your portfolio, you are pretty much diversified.  Now, there are lots of managers out there who will put 80, 100, 150 stocks in a portfolio, and we don’t understand that.  At that point, you’re making all the effort of finding all these individual businesses you want to invest in and your results are going to look like the market because you’ve got just too many names in there.  So diversification, we believe that the average position size anywhere between 3% and 5% of your portfolio, 5% to the up side, 3% to the down side is a reasonable portfolio.  So you’ve got between 25 and 35 names in a portfolio for full diversification.

James Lange: When you say diversification, I assume that you are not necessarily not going to take every stock that is the same sector, whether it be large cap value or large cap growth.  And then do you also diversify across industries?

Charlie Smith: Most certainly.  That’s the most important aspect of the diversification function is, making sure that you’ve got a mix of industries in there.  Now,

James Lange: That’s even more important than the size?  Like large cap vs. small cap?

Charlie Smith: Most certainly.  Yes.  We would actually be agnostic when it comes to market cap.  Market cap, I think has been way overrated as an investment metric.  We believe that market cap is something that Wall Street is able to measure tick by tick, second by second with their computer power.  It doesn’t really tell you a whole lot.  Market cap, diversification by market cap is really not diversification.  Diversification by industry and by company most certainly.  Market cap, we will move towards a cheaper group.  If small cap stocks are priced more attractively than large cap, we may have more small cap, but otherwise, market cap is really overrated as a measure of diversification.  It doesn’t do anything for you as far as diversification is concerned.

James Lange: Alright, so in other words, if you have two companies at the same industry and one happens to be a billion dollar company and the other one is a hundred billion dollar company…

Charlie Smith: They are going to perform, they are going to behave the same, if they’re in the same industry.  The industry, the factor that comes from the industry therein is going to be a much greater factor in the performance than anything else.

James Lange: Alright, so then when you see some of these charts that have so much percent large cap, so much percent small cap, etc., you’re saying that it might be more appropriate to say, so much percent technology, so much percent financial, so much percent healthcare, etc.

Charlie Smith: Yes, exactly.  I think to a certain extent, Wall Street focuses on market cap because it is so easy to measure.

James Lange: OK.  And then what do you do with all these companies that, maybe, I don’t know if the trend is sports conglomerates, or if it’s actually going away from that, but many companies, even thinking locally, Westinghouse, that you like of, or at least used to think of an engineering company and then they acquired all these, CBS and all these other things.

Charlie Smith: You have to dig below the level of the corporate name and what business they say they are in.  Now the conglomerates were a very popular form of corporate structure back in the late 60s and early 70s and that came from the idea that you could have a portfolio of businesses within one company and when one business was down, another one would be outperforming it which would level out your performance over time.  That was sort of, has been debunked…. GE was a great example of a conglomerate that didn’t add any value.  It didn’t add value for years and years.  The point being that, deciding what industries and understanding what industries the companies that you own are in, and how those industries interact with one another will determine whether you are diversified or not.  There are, I think, eight or ten different sectors within the S&P 500 and maybe 15 or 20 industries one layer lower, but your portfolio performance is going to be determined by how diverse you are relative to industry.  Even more important in terms of performance, and this is something we tell our customers, almost we preach it really, the only way you are going to outperform the S&P 500, and if you hire a money manager, their job is to add value relative to the index.  You can go out and buy an index fund, pay almost nothing, Vanguard can sell you an index fund for 10 basis.  If you hire a money manager, you should expect them to outperform the index over time, and the only way a manager is going to do that is if their portfolio looks different from the index.  If you have a portfolio that looks just like the S&P 500 and you charge a fee, your results are going to be the S&P 500 minus your fee.  So a manager has to make a bet, so to speak.  A manager has to have the fortitude and the courage of their convictions to go and build a portfolio of companies that he or she thinks is going to outperform.  And where that comes out in our portfolios is a mix of industries that tend to be either overweighted or underweighted.  So, for example, in our portfolios today, Telecomm Companies, you know Verizon, AT&T, Sprint are about 3 to 4% of the S&P 500.  Our portfolios are made up of about 12% telecomm companies.  So we have about a quadruple weighting relative to the S&P and Telecomm.  That’s a pretty sizable bet.  We’re perfectly comfortable making that bet because we know that, over time, if we are going to add value, that’s where it’s going to come from.  We have to be different to be better.

James Lange: OK, but you don’t necessarily come to that conclusion just to be different, you’re actually saying well, this is what I really think is going to be the right thing and it just happens to be different than the S&P.

Charlie Smith: Certainly, that’s the way it falls out, in a sense.  We will, we come through thousands of businesses every week, every month.  The companies that we believe represent good value, well run companies at reasonable prices and then if they happen to fall out a certain way, that’s the way they fall out.  Now, we are not going to go to extremes.  We’re not going to put, as I said before, we are not going to put all, an entire portfolio is not going to made up of companies within one single industry, but we will consciously over or underweight.  We will underweight the industries where we think the valuation’s not attractive or the secular or long term trends are not attractive and we’ll overweight the ones we think are the opposite.  Where we think we see good value, we think we see a portfolio, or a set of businesses that either have the wind at their back in terms of secular economic trends or are simply undervalued or underloved by the street so that we can build a portfolio that does look different from the S&P.

James Lange: And how do you decide… So that sounds like it’s really more of an issue of what percentage of different types of companies in your equity portfolio.  How do you also decide what is the appropriate percentage of equities and what is the appropriate percentage of fixed income, and of course that would be, I guess to some extent, on a case-by- case basis?

Charlie Smith: It is, to a certain extent.  We have sort of a generic portfolio that we would recommend for investors in general.  Let me describe that.  We calculate, every single week, what the equity premium is, how much extra we would expect to earn by owning the average stock.  And we compare the prospective return from the average stock for the next two or three years relative to a Treasury bond.  And we come up with, hopefully, a positive number.  Once we see that number, we say, OK, we, depending on what that number comes out, right now, it’s about as high as it’s been in the last 12 to 15 years.  We’re in the mid fours, we’re at an equity premium of about 4.8% or 4.9% on our calculations today.  It’s about a 15 year high.  So that tells us that we want to be fairly well invested in the stock market.  Now, we will customize for individuals that can’t stomach the volatility that comes with a portfolio that comes with 100% stocks, but what we will tell people is, we will give you our very best advice as to how much of your portfolio we think you should have in equities and then you can decide, given your willingness or ability to bear volatility, how much you want to buy into that.

James Lange: Well, that sounds like a pretty positive outlook.  I’ve avoided the question up until now, but maybe I can’t put it off any longer and I suspect that everybody wants to ask you what is going to happen in the next three months, which I know is much tougher, does this mean that with the highest equity index that you have seen in 15 years that you are bullish and you are thinking that this is a good time to be in the stock market?

Charlie Smith: What it means is, the pieces, the chess pieces are aligned where if we get some catalysts, and I think the political catalysts will be key here in the next 6 months.  If the catalysts work in the way that we think they could, we could have a pretty decent equity market, equity environment the next 3 to 5 years.  We don’t know how the short term pieces are going to fall out, but the valuations, as I said a minute ago, the PE multiple and the S&P 500 is about 14 times  next year’s earnings, historically it’s average is in the 16 range.  Now that number is skewed upward by the large multiples that we had in the mid to late 90s, but still, I think it is still valid because we’ve got inflation very low, so we’ve got reasonable valuation, profitability in terms of profit margins in the S&P, just as our best example, are at all time highs, and we don’t see any reason why they have to decline . In fact, we think, given the continued ability to substitute software and systems for people in corporate structures, profit margins actually have some room to continue to move up.  Now that doesn’t do good things for the employment rate at all, but we’re talking about the business environment in terms of profitability right now and not employment.  So profitability, we think, could remain at what it is, historically high levels, multiples are reasonable, and if we get a settling down in the political environment, we could see the willingness on the part of corporate managements to go out and spend some of this capital that they, basically, have been hoarding over the past years so we could see some improvement.

Nicole DeMartino: Alrighty, Charlie, we are going to take a quick break.  We’re here with Charlie Smith, Chief Investment Officer of Fort Pitt Capital Group and Jim Lange.  We’ll be right back with The Lange Money Hour:  Where Smart Money Talks.

Nicole DeMartino:  Welcome back to The Lange Money Hour:  Where Smart Money Talks.  We’re here with Charlie Smith, Chief Investment Officer of Fort Pitt Capital Group and Jim Lange and I know everybody…Actually, before we even get to what you want to talk about for a second, Jim, we are live and I just want to give you that number again, 412-333-9385.  Go ahead and give us a call.  Jim, before we get back to Charlie, I know you wanted to mention something about the new law that was just passed since last week.

4. The Impact of Marcellus Shale

James Lange: Yes, we actually had a whole show on the new law, and we thought it was going to happen, within a day of having that show and it didn’t, but then it was finally passed last week by the Senate.  It’s really considered, at this point, a formality that the House is going to approve it and the President is expected to sign it, either later this month or early October.  And it’s really important for a lot of people who have retirement plans at work.  So let’s say that you are an employee of a company and you have money in your 401(k) plan.  Let’s take the extreme.  Let’s even assume you don’t have an IRA or you don’t have a significant IRA and you’re interested in making a Roth IRA conversion.  Under the old law, or really still as today, you’re not allowed to make a Roth IRA conversion of your 401(k) plan.  But the new law says if your company has a Roth 401(k) plan and offers that to you, and if you are an employer, I would really urge you to implement a Roth 401(k) option, assuming you have a 401(k) plan at work, but if you are an employee who has access to a Roth 401(k) plan, under the new law, you’re now allowed to make a Roth conversion and the money will be transferred from your 401(k), where the money is growing tax-free, to your Roth 401(k), by the way, it would be the same for the university folks or the hospital folks in the non-profit world, from a 403(b) to a Roth 403(b).  And this is really a big opportunity for people who want to be in the Roth world in a big way, but right now are limited.  We are going to include that in our workshop coming up and that is big, big news and it’s new and, frankly, I wouldn’t mind talking about that for the whole time, but we already had a show on that and we have Charlie Smith and I’m very anxious to ask Charlie about something that, perhaps, would interest both investors and people interested in the local economy.  And Charlie, with the Marcellus Shale, I have heard, actually from executives from the gas company that says this is going to be like U.S. Steel for Western PA.  This thing is just going to be huge, there’s going to be so much money in it, the employment is going to shoot through the roof, the stocks are going to do wonderfully, we are going to increase our national security, we are going to reduce our dependence on foreign oil and this is just going to be a wonderful thing and then, of course, you know the side, the environmentalist are terribly concerned.  Are we going to ruin our water table, are we going to drill right in the middle of Yellowstone?  But perhaps, since there is such a huge track in Pennsylvania, specifically, Western Pennsylvania, I was wondering if you could maybe make some comments in general about the economy, and is this an opportunity and are you guys, as money managers, looking at investing in natural gas companies, or even companies that provide services to natural gas companies, perhaps, trucking companies or drilling companies, etc.?

Charlie Smith: Jim, you’ve captured a lot in the intro there.  It is a gigantic opportunity.  The geologists tell us that the Marcellus formation could be the second or third largest gas field in the world.  Several trillion cubic feet of natural gas in Marcellus layer, which, I think, is 5 to 8 thousand feet down.  There’s been an improvement in technology, just over the past decade or so with regard to horizontal drilling and fracking.  And fracking is simply high pressure, pumping fluids into the shale formation to release the gas.  Those are the two transformative, technological advancements that have happened in the past decade or so that have allowed this field, this formation.  We’ve known about it for a long, long time, but these two technologies have combined to allow us to get access to the gas that we never had before.  And it really does represent, as you mentioned, the potentially transforming technology in terms of our national security, but we lack the infrastructure to use natural gas as a transportation fuel that we would need to remove our dependence from foreign oil.  And you asked about investing.  We are exploring, right now, several companies which are really [inaudible] the infrastructure to allow the use of natural gas as a transportation fuel.

James Lange: So you’re talking about, in effect, a special pump or a special gas station.

Charlie Smith: Well, that’s part of it.  At retail, the first big volume uses will be in place and we’ve seen, T Bone Pickens has been marching around the country for the last couple of years telling us that we need to get going on building the infrastructure for natural for over the road trucks and large fleets.  I believe that we are going to see that.  I think it’s mostly due to the fact that the energy value of natural gas versus the energy value of oil, at today’s prices, is so compelling.  That is the multiple of the price of gas that oil is selling at is at historic highs.  So the amount of energy that you can get out of the equivalent dollar amount of these two energy sources is at a huge disparity.  Natural gas is ridiculously cheap.  And given oil at $75 or $80 a barrel, and natural gas at $3.60 an mcf, the energy equivalent is just not there.  Gas is ridiculously cheap, relative to oil.  So the economics are compelling.  We’re beginning to see some of the politics becoming compelling.  There will be, before the election, we expect Congress to move forward with some incentive for using natural gas in over the road vehicles, much bigger incentives than exist today, so that we believe there’s a big opportunity for investing in companies that will build the infrastructure that allow us to use natural gas as a transportation fuel in very, very large volumes.  The environmental question is a real one, obviously, but the key, sort of technical piece of information, that I think that people need to recognize is that the big concern is the water table and are we going to be compromising the quality of our water by drilling for natural gas in the Marcellus formation?  The answer to the question is, if the drillers are properly regulated, there is absolutely no technical barrier, or technical problem in drilling through the water table, which is typically, 100 to 150 feet below the surface.  Two, the Marcellus formation is, as I said, a mile down and if you do the well properly, case it properly and you monitor the production properly, there is no risk to the water table.  The key is, we are going to be able to tax it and the state is debating right now, a severance tax on natural gas, and I believe the tax will pass.  It will probably be in the 5% to 6% level, and then we’ll be able to build a regulatory infrastructure to monitor the drillers, and then we’ll be on our way to building an industry that could parallel what we had in the steel industry in this country for the first half of the 20th century.

James Lange: It’s very interesting.  I, almost, without even asking you, I kind of almost knew that you weren’t going to say, hey, we’re looking at all the natural gas companies and all the different companies that are actually going to sell the gas, but we are looking at companies that support the infrastructure.

Charlie Smith: That’s where the leverage is.  That’s where we really don’t have a group of mature businesses to take advantage of this incredible disparity in energy value of gas versus oil.  Therefore, we don’t have those businesses so there’s an opportunity for growth.  There is a huge disparity in the cost of oil versus natural gas, and if we just take advantage of closing that disparity by using a whole lot more natural gas as a transportation fuel, there’s an opportunity for huge growth in these companies that make the infrastructure.

James Lange: Do you think that this is something that is going to come one way or another and it’s just a matter of time, or do you think that this is a flash in the pan and maybe we’ll see some activity and then it will kind of die again?

Charlie Smith: No, I think it is something permanent because the implications for national security are so profound.  If we can, basically, become self-sufficient in transportation fuel, and we’re not importing millions of barrels of foreign crude oil every single day, then we sort of become masters of our fate again at that point.  And that’s very, very important.  I don’t know how any national leader could argue against that.  It’s going to happen, I believe.

James Lange: Well, without getting political, I really like the idea of, if not completely, at least substantially reducing our dependence on foreign oil and particularly, some of the players we are buying from right now.

Charlie Smith: Well, particularly relative to all the “green technologies” out there, natural gas, when you burn natural gas, it only produces half the carbon of coal.  So, not only is it ridiculously cheap because of these wonderful new supplies we’ve found, but it’s cleaner.  So there are opportunities for burning natural gas in electricity generation, and that’s beginning to happen.  We’re seeing many of the large electric utilities around the country are mothballing, or retiring their coal-fired plants, particularly their older plants, that generate a lot of noxious NO2 and sulfur dioxide and cadmium and all these heavy metals in their waste stream, shutting down those plants and turning the burners over to run on natural gas.

James Lange: Well, let me ask you this.  Since this is such a PA, or course it’s a national thing and actually international, but since there is so much in PA, do you tend to favor local companies that you might know more about?

Charlie Smith: Sure, when we can sit down and talk to management, or run into them on the golf course on the weekend, certainly, we can get a better feel for, not only what the business opportunity is, but the integrity of the people that are running the company.  No, we are always going to favor a business where we can have a chance to talk with management.  Now, the argument that you need to meet with management or you need to meet with the CEO or CFO repeatedly, to fully understand a business, we don’t necessarily buy into.  But given the chance to own a local company, all else equal, we’ll take a company that’s in our own backyard every time.

James Lange:  I have another question.  It’s more of a global question.  I get this a lot from my clients who are very concerned.  They say, you know I kind of give some of the standard discussion about long term investments, and I don’t necessarily talk about the equity premium, but I do take out the Ibbottson chart showing the long term performance of stocks versus bonds over time and they say, oh, no, but now everything’s completely different.  We have the massive deficits, everything’s a completely new ballgame.  Whatever has happened over the last 70 years in this country, and for that matter, if you read Stocks for the Long Run, by Jeremy Segal, he will argue that there has been this, I don’t know if he uses the word equity premium, but he would say the same basic thought, and his analysis goes back to 1800 for the United States and he compares it will all types of markets, all over the world.  Again, the name of his book is Stocks for the Long Run.  Is this true?  Is this really a brand new ballgame or is every generation, like I’m just picturing, I obviously didn’t live through WWII, but I would imagine, if I had, I would have thought, this is a completely different ballgame, we’ve never had anything like this, you know we might be taken over and be speaking German next year, is this a new ballgame, or is this a variation of the same game?

Charlie Smith: Let’s frame it in the terms of WWII, the analogy you just gave.  If we would have lost the war, it would have been, obviously, a whole new ballgame.  My point there being, if we continue on the path, if we continued on the path that we were in in late 41 and early 42, basically before the battle of Midway swung the war in our direction, if we continue on that path today, in terms of allowing the deficits to continue to rise, unless we make a change, yes, this is a permanent game-changer.  A 1.3 to 1.5 trillion dollar deficit, each in the next 3 to 5 years, by 2015, 2018, we’re out of business.  We, literally, cannot afford the trend that we’ve seen the past two years.  We can’t afford to continue it, but, again, if we change our path, if we take action, if we win the battle of Midway, so to speak, we can turn the process around.  I remember in 99 and early 2000, when we were talking about surpluses, and the people at the Congressional Budget Office would come out and say, you know, we’ve got these surpluses, and given what we are doing now, we can see surpluses as far as the eye can see.  Well, that was eleven years ago.  Think about how much the world has changed since then because of our behavior.  Well, we have the power to make the future right again and it’s going to involve ratcheting these 1.3 trillion dollar deficits back into the 800 billion, 500 billion, 300 billion.  A path, a path made up of political choices, which we are going to make over the next 3 to 5 years that will get us back where we need to be.  And the political choices are maybe not as stark as the ones we made when we decided to retaliate against the Japanese in early 1942 and really getting into the war whole hog, but the outcome could be just as severe if we lose the budgetary war, so to speak.

James Lange: Alright, but I take it, the fact that you still have, that you are still a believer in the equity premium and I believe…

Charlie Smith: I think we are going to win that battle, that’s the best way to phrase it.  I’m an optimistic person.  I believe that the inherent common sense of the American citizen is going to win out here.  We can see it in the stirrings of the activism that we are seeing right now in this country.  People recognizing that the wall we face if we continue this form of behavior is going to be insurmountable.

James Lange: Alright, would you see, not necessarily for your own political convictions, but just say, for the good of the market, if you were.  Do you see a big difference if the Republicans take control of the Senate and/or House and do you have any other long term opinions about, different, a change in the administration, say in another two years, or is it more, going to be, not which administration, but what the administration does?

Charlie Smith: Well, it’s going to be what the administration does.  Barack Obama is a politician.  He wants to be re-elected.  I believe he will follow the template that Bill Clinton has provided him.  If you remember what happened in the 1994 election, the early years of the first Clinton administration were repudiated by Newt Gingrich and the contract with America and Clinton tacked to the right.  And he basically got on board with some of the Republican ideas about, not only taxes, but also welfare reform and he was re-elected, resounding.  I think that’s what Barack Obama wants.  Any politician wants to have a legacy of two terms, any president, wants to have a two-term legacy, and I believe he’s a practical person.  I do not believe he’s the absolute idealog that he’s being painted as here recently.  And so, I think he’s going to behave in a very practical way.  He will tack to the right.  We will see him adjusting, not only his policy, but his cabinet and we will see a different president.  If he doesn’t, it’s going to be a very, very, difficult, politically, a very difficult and painful final two years of his term.

James Lange: And what about the November elections coming up?  That’s going to make much difference either way?

Charlie Smith: We will definitely see a Republican majority in the House.  Senate’s, obviously, with the events in Delaware over the past 10 days or so, that has clouded things a little bit in the Senate, but my guess is that the House will be probably a Republican majority, of at least 20 names.  And at that point, Obama will recognize that he must tack to the center, to the right, in this case.  And he will begin to do some things with regard to policy, whether it be extending the Bush-era tax cuts, whether it be pushing cap and trade issues out into the future, whether it be repealing some of the more erroneous aspects of the healthcare plan.  He will begin to recognize that it’s going to be about producing economic growth and employment growth for the citizens that gets him re-elected.  He’ll figure that out.

Nicole DeMartino: We’re going to take a quick break.  We’ll be right back with The Lange Money Hour:  Where Smart Money Talks.

Nicole DeMartino: Welcome back to The Lange Money Hour:  Where Smart Money Talks.  We’re here, this evening, with Charlie Smith, Chief Investment Officer and portfolio manager of Fort Pitt Capital Group.  Before Jim goes on, I want to mention to you, when Jim was talking about the new law that was passed, I’m going to, tomorrow, we have a press release that we had sent out all over the country, I’m going to post that on our Facebook page and I would encourage you to go to Facebook and type in James Lange and become a fan of our page.  There we post cutting edge information.  We post the audio of the shows that we do here, a lot of great information.  You can write into us and we comment back, so head on over to Facebook and join our page.

James Lange: Before my next question for Charlie, I should say, in fairness as full disclosure, if you will, that I do work closely with Fort Pitt Capital Group, which is Charlie’s company, and we do have an arrangement where I provide advice, such as Roth IRA conversions, estate planning, what I would call, maybe, big picture and  I’m not talking about portfolio because I stay out of portfolios, I stay out of money management completely, but I should say that, in terms of full disclosure.  Charlie, you mentioned several times what is going on in the world and that we can’t just look at this in our own little limited vision.  Could you tell me a little bit about what your view is on international investing?  A lot of times people think, oh, international investing, that’s rolling the dice on some crazy company in Africa, or whether that is just really a sound thing that most of should have in our portfolios?

5. A View on International Investing

Charlie Smith: Well, Jim, 10 years ago, I probably wouldn’t have answered this question this way, but I think it goes back to the discussion we just had about the U.S. eventually getting things right and changing the path that we’ve been on and getting on the right path.  I think you can view overseas investing, investing away from the U.S., as a hedge against a bad outcome on that first question.  That is, if we don’t get our political act together and our fiscal act together, you don’t necessarily want to have all of your assets here invested in the U.S. because we are not going to be a happy place to be invested.  So, I think it really behooves anybody who wants to grow their money to think about where the growth is in the world today.  And it’s decidedly not in the U.S., although as I said before, we have the chance to return to better levels of growth if we play our cards right, but you want to invest where things are happening today in the world.  And the so called emerging economies, which have now emerged, I mean China’s economy is just passed Japan, I believe, as the second largest economy in the world.  Japan, I’m sorry, China, Brazil and India are pretty much the poster children, Russia had been thrown in there, but they’ve got their own problems.  But the point is that, if you’re an investor, the sort of critical structures necessary to make capitalism function had been put in place in many, many rapidly growing and emerging countries around the world where you need to be investing.

James Lange: I actually remember Jeremy Segal said we want to see these companies do well so they will buy our stuff, buy our services.

Charlie Smith: Well sure, most certainly.  And up to this point, the Chinese have sort of been the worst example of mercantilism, that is, they’ve really built their economy on exports and they’ve held their currency artificially cheap for years and years to try to continue to grow their exports.  And they’re finally recognizing that they put themselves in a bit of a box and they need to let their consumers, who’ve been working their tails off for 15 years, to try to build the wealth within the economy.  They need to let their consumers begin to reap the rewards of all the work they’ve put in.  We think the Chinese consumer is going to be the story of the next 10 years of worldwide investing.

James Lange: So you want to go sell some air conditioners in China?

Charlie Smith: Well, that’s a great comment.  It’s a fantastic comment.  We own a company called Ingersoll Rand, which is one of the biggest manufacturers in the world of compressors.  In general, infrastructure to sell into these rapidly growing emerging markets, whether it be Boeing Aircraft, United Technologies Escalators and Elevators, High Capacity Pumps, compressors, GE Locomotives.  There’s a sort of myth going around this country that we don’t make anything any more.  Well, Boeing is the biggest manufacturer of commercial aircraft in the world, and we do it better than anybody else and they’re, actually the largest single component of our exports is Boeing aircrafts.  So, if you can put together a portfolio of companies, or as part of your portfolio, businesses that sell these high value capital goods to these developing markets around the world, we think you can do pretty well.

James Lange: Now do you think China understands this as well as you do, or do you think that they’re just going to continue to be obstinate and then the U.S. retaliates with its own tariffs and it just gets worse and worse?

Charlie Smith: Well, that is a great question because, I think it was this afternoon, I think it was the House, a bill was introduced to sanction the Chinese for their obstinance on the currency.  So, it’s going to be a terrific political hot potato over the next five  or six weeks because it’s always easy to bash the foreigners for the politicians.  But I think the Chinese are getting the message they said in June that would allow their currency to begin to revalue upward.  It’s only moved about 1% since, but this is the first they’ve made in that direction in several years.  And I think they are getting the message that their consumers are getting a little bit impatient with not being able to reap the rewards of all the exporting that they’ve done over the past few years.  We’re starting to see wages rise in China, and that’s a key driver of consumer spending.  And when the currency begins to rise as well, the Chinese consumer, the Chinese household is going to reap wonderful benefits from all the efforts they put in the last 10 or 15 years.  And we need to be positioned in our portfolios to benefit from that.  I think investors in general need to understand that over time, financial market returns correlate with GEP growth.  All else equal, an economy that’s going at 10% is going to produce better market returns than one that is growing at 3%.  The profit number of the PE equation, the profit number is rising faster in a faster growing economy.  So therefore, all else equal, your share prices should rise at a faster rate.  You want to be invested overseas.  It depends on your risk tolerance, but anybody under the age of 50, from our prospective at Fort Pitt Capital, anybody under the age of 50 needs to have 15% to 20% of their portfolio based outside of the U.S. at a minimum.

James Lange: And what about some of the older listeners who might be in their 60s or 70s?  Would you say…

Charlie Smith: We would say, you need to be invested there.  We’re talking maybe 10%, even 15%. Think about it.  The U.S. market is no longer the king.  It’s still the largest equity market, but we are no longer more than half of the total world equity markets.  We’re less than half now.  You want to be where the growth is.  We, historically, as U.S. investors, really didn’t get involved overseas until the early to mid 80s.  It wasn’t until about 1984 or 1985 that you really began to hear about investing outside U.S.  It really took off in the latter part of the 90s and now, to be an investor, you need to have a significant slug of your portfolio, 25%, 30%, overseas.

James Lange: Alright, you talked about corporate earnings and apparently, with your equity index premium, you sound somewhat bullish.  How would that result in terms of what you would think would be possible?  Corporate earnings, let’s say even measured by the S&P, and what kind of result would that be, in terms of stock prices?  Let’s even say in the short run, although I know that you prefer the long run?

Charlie Smith: Well, six to twelve months is a fairly short run horizon, but that’s really, as an analyst to put together a reasonable estimate, you really can’t look beyond six or twelve months.  S&P earnings estimates for the year 2010 are in the $80 range.  This is S&P as an aggregate.  So you put a 14 multiple.  Yes, let’s put a 15 multiple in that, that puts you at a 1200 in the S&P.  The S&P closed today, I believe, in the 1130, 1140 range.  So, you know we’re not too far below fair value on the S&P for 2010 estimates.  The market’s already looking at 2011.  Stock prices are a forward looking beast. They’re going to be looking out six to nine months, at a minimum.  So let’s say we get only 5% to 7% earnings growth for the S&P in total for next year.  So we are looking at say $85, $86 dollars in earnings for the S&P for next year.  We put a 14, 15 multiple on that number, and we’re looking at 1400 on the S&P 500.  So that’s a good 1400 versus 1150.  I can’t do the math quite quickly enough in my head, but we’re talking north of 20%, in terms of total return, out over the next 15 to 16 months.

James Lange: And usually, when I do projections for people, it’s always an interesting thing because I remember back in the early 2000s, and I would want to use 8% and everybody would be screaming 8%, that’s so conservative.  Use 12%, use 14%.  Now, if I use 8%, they’re screaming, what are you talking about 8%, use 6%, use 4%, use 2%, use nothing.

Charlie Smith: Right.  Well, the entire structure of interest rates has been ratcheted down over the past, actually three decades, since the early 80s.  Remember when we had 17% Treasury bill rates in 1980 and 1981 and we had 14% long bond rates?  Well, now we’ve knocked 10 percentage points off of the long bonds, and we’ve knocked now 17 points off the T bill.  The point is that the entire structure of financial market returns has been ratcheted down and a 7% number, annualized over the next 3 to 5 years, in terms of appreciation, plus maybe another 1 ½ to 2 in dividend yield, gets you to 8%.

James Lange: So 8% is not a pie in the sky?

Charlie Smith: No, it’s not a crazy number at all.

Nicole DeMartino: I think we’re at end of our hour and, Charlie, thank you so much for joining us.  Tell everybody, if you want to learn more about Fort Pitt Capital, your website?

Charlie Smith: Fortpittcapital.com, all one word.  We keep it pretty simple.

Nicole DeMartino:  Alright, Fortpittcapital.com.  And just as a reminder, come on our and see us.  We are going to be at the Crowne Plaza Pittsburgh South on Saturday.  We have two sessions, 9:30 am and we do it again at 1:00 pm.  You’re going to get a complimentary copy of Jim’s bestselling book, Retire Secure, and you’re going to get a certificate that will allow you to meet with Jim for a one time, complimentary strategy review.  You really should take advantage of it.  You can call our reservation line, 1-800-748-1571, again, that’s 1-800-748-1571 or you can always give our office a call and make your reservations.  We hope to see you there.  Thanks for joining us this evening. You’ve been listening to The Lange Money Hour:  Where Smart Money Talks.

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