3 European Blue Chips Below 6 Times Earnings. Plus, Free Toys

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Really, the greatest pocket of value today is probably in European equities. But Europe has people scared off because there's a war going on close by and it's slow brewing.

Hello and welcome to the Barron's Streetwise Podcast. I'm Jack Howe, and the voice you just heard, that's David Harrow. He's the longtime manager of the Oakmark International Fund and some other Oakmark funds. He's an expert on finding attractive stocks overseas. I mean, Overseas to me in the US, they might not be overseas to you depending on where you're listening from. You get the idea. We'll hear from him about 3 of his favorite stocks in a moment. We'll also say a few words about toys. Listening in is our audio producer Meta. Hi Meta.

Hi Jack.

My voice is halfway back, 3/4 of the way back to being in form, wouldn't you say? Is it a little froggy still?

Wait, is this Jack or Kermit the Frog?

Kermit doesn't sound like this. Kermit is, um, he's got a higher voice. He's kind of in the Mark Zuckerberg register, I think. Play a clip of both of them.

The way we want to communicate keeps getting richer and more immersive, and our computing platforms keep on getting more natural and ubiquitous.

I know it's a close call, but the one who founded Meta is the one without the banjo. That's the way you tell them apart. Anyhow, the important point here is that I'm on the vocal mend. And in any case, David Harrow is going to do most of the heavy lifting when he talks to us about a few stocks he likes coming right up. Let's say a few words first. On the subject of toys, it being the post-Halloween, pre-Thanksgiving stretch, which is basically pre-pre-Christmas shopping season, right, Meta?

Right. And then maybe at some point we can get you a Banjo. I just want to test something out.

For Christmas. For Christmas. Come on. I was going to mention this last week. It's just an interesting little tidbit from, you know, going through the Wall Street research that I read. This one comes from UBS. And it's about Hasbro, and we have spoken about Hasbro and Mattel on this podcast before. And the title of this report is Getting the Toy Business for No Additional Costs? I suppose I should go up in the end. Getting the Toy Business for No Additional Cost? Here is the case on the stock, and you can decide whether you agree. So Hasbro, At the time this report was about $45 a share, it's $44 and change now. And the analyst writes that it's trading at about 11 times next year's projected earnings, about 10 times the following year's earnings. And that's a significant discount to its historical average of 17, 18, 19 times earnings depending on the timeframe you're using. One concern over Hasbro is that no one's quite sure what consumer product spending is gonna look like this holiday season. It might be weaker than we've seen in recent years. There's also some market share loss. We've spoken in the past about that Disney Princess toy line. It was once controlled by Mattel, and then it was won by Hasbro, and now it's gone back to Mattel. So that's an issue. And we don't know what discounting is going to look like, but if, if sales indeed look weak for consumer products, for toys this holiday season, there's a chance that retailers might have to discount to clear out store shelves to keep inventories where they need to be. So those are all concerns. There's also been some moving parts here that have made Hasbro a bit complicated for investors. This year, the company sold something called E1— that's a TV and film production business— to Lionsgate, and that's 4 years after it had bought that business. So it's becoming a more asset-light company. It's, it's following Mattel in that regard. Okay, so UBS says take a look at what's going on with the wizard and digital business. What is that? If you're a regular listener, do you remember us talking about Magic cards in this podcast? We talked about how when interest rates were near zero, there was a price run-up in just about everything collectible, and that included the cards from this game called Magic: The Gathering. And Magic: The Gathering is a Boy, I don't want to get this terminology wrong because people who love this game are going to email me and say mean things. It's a role-playing game. So it's kind of a Dungeons Dragons style game, except that it includes cards and the cards have— you know what, I don't want to get too into the weeds of this thing. But the important thing is that some of these cards went up to thousands of dollars in value. And then Hasbro issued a bunch of them and there was some concern about whether there was a bubble that was going to pop and so on and so on. But that aside, it's a very popular game with a lot of fans around the world, and it's a business that has grown nicely for Hasbro. Last year in its annual report, Hasbro pointed out that a 30th anniversary celebration for Magic: The Gathering drew more than 10,000 players in Las Vegas. The company says the game has been played by more than 50 million people around the world to date. Okay, so Magic: The Gathering is the main component of a business division for Hasbro called Wizards of the Coast and Digital Gaming. UBS says the current revenue run rate for that business is a little over $1.4 billion a year, and it's growing nicely. You see where this is heading. UBS writes, we believe the digital/Wizards segment can deliver consistent mid-to-high single-digit percentage revenue growth high operating margin, and a digital component to complement a strong analog offering that has a loyal/sticky user base. A business like that ought to be worth a good amount of money. How much? Well, UBS says 14 times EBITDA. That's an adjusted profit measure that works out to an enterprise value of $9 to $10 billion, and that works out to a stock value of $42 to $47 a share. The bank compares this business to video gaming, and it says that that valuation that it's using is below where Activision and Take-Two have traded. UBS writes, at a current stock price of about $45 a share, we think investors are essentially getting the consumer product business, meaning the toy business, for no additional cost. In addition to, as they point out, a 6%+ dividend yield, which they call a compelling risk-reward for the stock. Do you agree or disagree? I'm intrigued, but I'm not sure. By the way, those Hasbro toy brands, in case you're wondering, include My Little Pony, Play-Doh, Mr. Potato Head— well, we just call it Potato Head, man. I mean, there, there is a Mrs. Potato Head. Out there.

I mean, I don't— he's just called Potato Head.

The business is called Potato Head, the division, and the tagline is all in the yamily, which I'm, I'm against that. Yeah, clearly Mr. Potato Head is not a yam. There's Nerf, there's Transformers, there's some Marvel and Star Wars toys, Scrabble, and so on. And that is about all I have to say about Hasbro for the moment. I think I've yammered on enough. Oh, don't you dare laugh at that.

You're in a real yam now.

Oh, Meta, what do you say we jump into my conversation with David Harrow, which I think started with his thoughts about how he invests, where he invests, what parts of the world look most attractive to him now. I want to check in with you about overseas markets. I have heard the case that many of them are cheap relative to the US and that US investors ought to diversify more money overseas for that reason. And at the same time, the US markets have outperformed for a long time. So it's hard for people to see, you know, here's Alphabet, here's Apple, here's Amazon, and where are the equivalents overseas and that sort of thing. It's easy for people to say, let me just stick with the US because it's been working so well. So What does the relative value look like overseas? What's the case for putting more money there now?

Well, first, to just remind you what makes a company attractive to us, basically is the value proposition, which is what you pay for what you get. So using conventional valuation multiples, and the one I'm most concerned about is free cash flow yield, we are investing in financial assets. So as such, we have to determine what makes a financial asset valuable. And our first and foremost variable is its cash flow stream, whether it's a stock, a bond, an investment property, or whatever. If you start with that premise and you look at where can you buy financial assets that you pay the lowest amount for the highest cash flow stream, Today, that's basically outside the US, and it's outside the US for two main reasons. The valuations are so low because share prices have underperformed and you've had huge valuation compression in overseas markets over the last about 11 or 12 years. And since 2014, you've had a dollar bull market, thereby making the returns that you would earn owning foreign assets muted. Because remember, total return of a foreign investment is the local market return plus the currency return. Since 2014, so for almost 9 years, over 9 years, that has been a headwind. Now, I would certainly not argue that stocks outside the US should trade at a premium to the US. And the reason why I would not make that argument is because all else equal, US companies earn higher returns than their foreign counterparts. So they should trade at some premium. Right now, the S&P 500 is what, 17, 18 times? It was 19. And let's take the DAX, is that 9 times? And then what's even more interesting, Jack, is if you compare this to the local bond market. So let's just take the earnings yield, which is the inverse of the PE of the S&P 500, is just over 5%, and the US 10-year is 4.6%. So maybe you get a 40 basis point premium of the earnings yield of US stocks over the 10-year. The number for Germany as an example, the German 10-year is 2.65%. And the earnings yield's about 11 or 12%. So you get almost 800 basis points of equity yield over fixed income yield.

In other words, they're not anywhere close to this concern that, hey, what if the bond market, those plump yields, what if that starts to lure people outta the stock market? They're not anywhere close to that in Germany.

No. And the reason why it probably won't get that way is because next year Germany will probably run a balanced budget. And even this year, deficit to GDP is probably under 3%, whereas of course in the US we see 5, 6% as far as the eye can see. And even in France, you have a 10-year of 3.25%. Believe it or not, both Italy and Greece, the 10-year is below the US. In Italy, it's 4.5% versus 4.58%. And in Greece, Greece, it's 3.92 versus 4.58. So I'm not saying that Amazon and Microsoft aren't great companies. What I'm saying is the price you're paying for those cash flow streams is pretty high. And what we as investors, as opposed to traders, are trying to do, let's get back to what we're trying to do, is to buy a cash flow stream at a low price, really the greatest pocket of value today is probably in European equities. But Europe has people scared off because there's a war going on close by and it's slow brewing.

I want to come back to that in just a moment. Talk to me a little bit about how you invest. Do you start with looking at regions you find attractive? Do you just start with companies you find attractive? And you mentioned about free free cash flow yield being so important to you, can I assume that there are cases where you see a company where you say, well, the free cash flow isn't there now, but we can envision it being there in a couple of few years down the road because the company's growing so nicely?

Yes. Looking at free cash flow yield, this is a flow concept. So think of a river, not a lake. If you were to judge a river, you wouldn't just take one point of the river. I mean, I like to use the analogy, there's a place in the Twin Cities that you could jump across the Mississippi River. Well, compare that to down in Louisiana where it empties into the ocean. So what you have to do is through analysis is determine what the normalized cash flow level is, not through boom, not through bust, a normal cash flow, and then use that to compare to the enterprise value of the business.

And in terms of targeting countries or regions versus just looking for the right kinds of companies, just looking for companies.

Our view is eventually our client's money ends up invested in a business. So we spend all our analytical efforts on pricing and valuing the businesses which we may or may not invest our clients' money into.

Okay. And after you select all these companies and then you sort of look at the map of them, I suppose you have more in some places than in others. If you had to restrict your investing to one particular region in the world right now, what would be your favorite in terms of the relative value right now?

Well, this is today. Now this does change through time. In '98, '99, During the Asian financial crisis, we were way overweight in Asia. In 2012, 2011, post the earthquake and tsunami in Japan, we were way overweight in Japan, which by the way, was the only time in my 38-year career, been doing this since 1986, that I was overweight in Japan was 2011 to about 2013 or '14. Today, we would be overweight Europe because people are making the mistake of judging European companies by the European continent. I mean, look at these big European companies, Mercedes-Benz, Bayer, Kering, CNH, they do business all over the world. Yes, their postal code is in Europe, but most of them, the majority of their revenues don't even come from here.

Let me try to anticipate some pushback from people who are worried about Europe. You know, the war in Ukraine and the fact that Russia has historically controlled so much of the energy that Europe relies on. Doesn't that make Europe sort of uniquely vulnerable or more vulnerable certainly than the US? Isn't that part of what contributes to the discount there?

That is a negative, but depending on which country in Europe, pre-war they were 30 to 50% dependent on Russian gas, some a lot less. Germany got into the 40s depending on at any point in time. So what happened last summer, very, very instructive. By the way, it's just a perfect example of capitalism and free markets work. So the price of gas spiked way up tenfold. And remember, everyone was worried in Europe that it's going to throw them into a recession because the consumers are going to have to pay higher prices, companies are going to go bankrupt, blah, blah, blah, blah, blah. So what happened? Step 1, the governments came in and they said, Okay, we got to soften this blow. Above a certain level, we're going to subsidize consumers' and companies' energy bills. They said that both in the UK and in continental Europe. Then they said, okay, we got to find other forms of energy and really fast because winter is coming. And so what did they do? Some people won't like this, but they kept some of the nuclear plants going longer because Germany wants to shut down all their new plants. They decided to keep some of them going. Number 2, all these natural gas-fired power plants that, you know, depended on Russian gas, they substituted those with— this is what some people really won't like, but they did it— coal-fired plants. So all around Europe, they refired up these coal-fired plants. Italy, Germany, you name it, all over Europe. They restarted coal-fired plants. Number 3, they found other sources of gas, either from other suppliers to tap into going in through existing pipelines, or there was a great story in your sister publication last December in the Wall Street Journal, how in 1 year Germany got up and running a liquefaction plant. 1 year, which normally takes 3. And they knew this was coming and they just put the pedal to the metal. And now they got all these abilities, whether it be permanent or by ships to buy liquefied natural gas, which they did not have a couple of years ago. Number 4, some of the Russian gas did sneak in through Turkey. And number 5, conservation in a warm winter. Since all that happened, now we see the price of natural gas in Europe is actually below it was before the war started.

Thank you, David. I asked David if we can generalize about how European companies are acting toward their investors right now. And he said, we can— there's a heck of a lot of buybacks going on in Europe, stock buybacks, which reduce, uh, the outstanding share count and theoretically make remaining shares more valuable. That's one of the ways companies return cash to investors. David says that they're actually doing more buybacks in Europe than the U.S. right now. He says that company managers in Europe are taking a shareholder-friendly attitude. That's also happening in Japan, but more slowly. And that brings us to, well, let's take a break here for a moment and we'll come back with some stocks that David likes. That's next after this quick break.

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Welcome back. We're speaking with David Harrow. He's the manager of the Oakmark International Fund. And I asked David for a few of his favorite stocks right now, and he gave me 3, beginning with Lloyds Banking Group that trades in London. And there's an American Depository Receipt, trades in New York. The ticker there is LYG.

Lloyd's Bank is not a universal bank. You know what I mean by universal bank? It's an investment bank, trading operation, retail bank. That's called a universal bank. Lloyd's Bank is basically a retail bank in the United Kingdom that banks businesses, small businesses, high net worth individuals, and It has a great franchise. It probably has close to 20% of the market's deposits because it's viewed as solid and safe. Uh, it doesn't have to get in these deposit wars. It consistently makes good net interest margins. Even when rates were low, they were still in the mid-2s. Now they're in the low 3s. Credit quality is good. And this is a company that in the next 5 years should give back the equivalent of its market cap to the shareholders in the form of dividends and stock buybacks.

That's a neat trick. 5 years, you basically pay for yourself.

Yeah. Yeah. So its P/E ratio is below its dividend yield. Its price-to-book is 65%, and they should continue. There are a number of micro factors as well as macro factors of spinning this free cash because once these banks become fully capitalized, Don't forget that from 2010 to about today, banks had to build capital. Core equity tier 1 around the world for banks was 4 to 6%. Now it's 12 to 15%. And while they were building that, that was money we didn't really get or they couldn't use to grow. Now that they're at their level of required capital, which one could argue is even overcapitalized, everything they generate, they could give back. And this is exactly what the Lloyds management pledged to us, is to basically keep giving back either via buybacks and dividends as well as extra money to grow their business.

Why is the bank so cheap? You know, something is cheap, you say that looks good, it gets— it's cheaper, you say that looks even better. It gets to a certain point, you say, wait a second, what's going on here? Is this just people are down on the UK economy or what's happening here?

I would say there's a couple of factors why it's cheap. Number one, European financials still, I think people are living in the history of negative rates, not negative real rates like we had. Remember in Europe, they had negative rates for the better part of a decade and they still don't have their arms wrapped around this whole notion of this funny money, modern monetary theory. This is over. We're not doing this anymore. We're now to normalization. And I think perhaps in the US, if you look at the big high-quality banks in the US, they trade at 1.4 to 1.6 book. In Europe, BNP, Lloyds, they trade at 60, 70% of book, half, half what the US banks trade, number one, because they had to live with negative rates for so long. Number two, there was compliance charges that went back, I think, to the mid to late '90s that literally cost Lloyds Bank $22 £20 billion. These were called principal protection insurance, which all banks sold, and they lost this case and they had this settlement that the banks had to refund this insurance that these clients paid over a 10-year period. Lloyd's probably spent £20 billion. Today, their market cap, £26 billion. Pounds. So that's stunted their growth in the past, but that's been behind them now for a couple of years. And the third reason is every now and then when a UK bank reports good earnings, there's kind of noise about should we do some kind of tax. Now they already have a profits tax that's greater than a typical industrial business, but this summer in particular, there was some noise around all this. Now that seems to have died down, A couple weeks ago, HSBC reported and said they're going to do a $1 or $2 billion buyback. But I think some of these things have acted to hurt UK bank valuations. But we think, A, the valuations in the sector are too low, and this is the quality of the sector beyond a doubt.

Okay, that's Lloyds. And the next company is Bayer, as David says it, and as I think they say in Germany. Although for the aspirin brand here in the US, we say Bayer. So maybe I've been mispronouncing the whole company my entire life. In any event, they do over-the-counter consumer products like aspirin. They also have a pharma business and they have an agricultural business focused on seeds and genetic traits.

Here's David. They got to be the biggest by buying Monsanto. And when they bought Monsanto, you know, they bought Roundup, which is an $8 to $10 billion liability, which everyone knows about. It's all accounted for because they lost some cases. There was one study out of 800 that said it might cause cancer. And so they had to pay these settlements, especially since they lost the first couple of trials. Now they are winning them all. So that settlement amount is probably going to continue to drop. There's a couple other things happening within this business. Number one, the pharmaceutical business, which seemed to have a short new compound pipeline, seems to be having some success at stretching it out. Number two, the consumer health business used to be subprofitable. Now it earns at or above what the industry earns. And number 3, you know about agriculture and the need. Arable land is shrinking and the population of the world keeps going up. And so the only way, of course, to increase yield is through science and companies like Bayer's egg business is the leading one in the world. Corteva's a distant second.

People are going to think you're saying the egg business, you're saying ag as in agriculture. You're giving it a Chicago pronunciation just for anyone out there who thinks Bayer's into eggs. Go ahead.

Or maybe Milwaukee.

Oh, okay.

Okay. So one of the issues with this company besides the Roundup litigation has been it's been sleepily managed. I mean, they just layers of people, too much bureaucracy. You know, you have 3 businesses that really don't belong with each other, frankly. And so There was a bit of a shareholder uprising about a year or so ago, and the CEO got fired more or less, and they replaced them with an American who was at Genentech, then Roche, and I believe he will be a major change agent for this company. He's been there not quite a year. His name is Bill Anderson, and I think he's just what the doctor ordered. To fully recognize the value that's inherent within these 3 businesses.

Okay, that's Bayer. And the third company is CNH, and they make farm equipment, tractors. David shared with me the company's origins. There was a massive industrial conglomerate in Italy called Fiat, controlled by a family called the Agnellis. And we know about Fiat cars. The company also had a hand in newspapers, trucks, a lot more. And so the patriarch of the family that controlled that conglomerate died, and remaining members of the family split up the business into a number of different parts. And one of those parts is CNH, which stands for Case New Holland, because Case and New Holland are both tractor brands, and they're from Well, not Italy. One's from Wisconsin, the other's from Pennsylvania. Fiat decades ago bought an interest in one of them. It's complicated. Anyhow, here's David on what he likes about the stock.

So why we're so excited about CNH. First of all, you know, there's a long-term tailwind for automated farm equipment. I think you understand what they're doing with all this precision farming and all this stuff. Deere is number one. CNH is rapidly becoming number two, and they did it through making acquisitions over the last 5 years, which they brought this technology in-house. Very important to have this in-house. Then what they did was 2 years, not quite 2 years ago, they spun off the truck business of ECO, and that really didn't belong in there, and it kind of was a distraction to the agriculture equipment. I won't say ag. So today now you have a near pure agriculture equipment company with an off-road case. You see the construction machinery. This is a company that trades at not much more than 5 or 6 times earnings. Now, we're going through a little cycle right now, little downturn in the egg cycle, but there's so much self-help available here. Even as they said on the call today, if revenues go down 10%, they believe they can hold their margins. And once revenues start growing, they can keep growing their margins. There's a great chart in their presentation that shows how they've already lifted their margins. So this should be a mid to long-term growth business at 5 or 6 times earnings, a competitive number 2 to Deere. And they just announced with all their excess capital, a billion-dollar stock buyback And because they don't feel that the people in Europe understand this and dears in the US and cats in the US, starting January 2nd, this company's going to domicile in the United States where it should get a higher multiple. So we think that this is a very, very, very strong long-term, medium-term investment story. You have a structural tailwind, you have a competitive business, You have more self-help, you're going to get more visibility, you have the company buying back stock. I frankly have no clue why this thing trades at 5.5 times.

And that is CNH. Did I give everyone the tickers on these? I know I gave it to you for Lloyd's. For Bayer, I'll give you the American Depository Receipts, that's B-A-Y-R-Y. There are also, of of course, ordinary shares that trade in Germany. And for CNH Industrial, that's a New York listing, CNHI. I'd like to thank, let's see, David most of all, but also Kermit and Mark Zuckerberg and the whole Potato Head family. And thank all of you for listening. Meta Lutzoft is our producer. You can subscribe to the podcast. There's got to be a button somewhere for that. If you listen on Apple, you can write us a review. You can send us a question, tape it, voice memo thing, email it, jack.hough@barons.com. Thank you and see you next week.

Data is everywhere, but is it ready for consumption? Morningstar developed the language of global investment data so you have the right ingredients to help you shine. Morningstar, where data speaks.