- Carl Icahn has been warning us how dangerous low interest rates are as they create bubbles.
- The most important bubble is the earnings bubble.
- Repatriation and inversions are two crucial issues for the U.S.
We are continuing with our series of articles on successful fund managers. You can read more about Ray Dalio here, George Soros here and Peter Lynch here. Looking at what these successful managers are doing gives us a better understanding of the market, its potential and its inherent risks.
In today’s article we are going to look at Carl Icahn’s investing style and look at his current positions through his latest SEC filing.
Carl Icahn – An Introduction
Icahn’s investing style is one that cannot be easily replicated by common investors. Few among us are able to invest enough to get a controlling position which is exactly what Icahn does. This tactic has given him the nickname “corporate raider” and the ultimate “barbarian at the gate,” but the $16.7 billion in wealth he has accumulated in his life makes him a person to listen to.
He has taken substantial or controlling positions in various corporations including RJR Nabisco, TWA, Texaco, Phillips Petroleum, Western Union, Gulf & Western, Viacom, Uniroyal, Dan River, Marshall Field’s, E-II (Culligan and Samsonite), American Can, USX, Marvel Comics, Revlon, Imclone, Federal-Mogul, Fairmont Hotels, Blockbuster, Kerr-McGee, Time Warner, Netflix, Motorola and Herbalife.
His activist actions are well received by shareholders as companies that he takes an interest in usually go through the “Icahn lift,” which is the Wall Street name for the bounce in price.
But more interesting than what he has done is what he thinks of the current market.
Carl Icahn – Current Opinion
His major investing thesis is that corporate management is dysfunctional. Therefore, he looks for broken companies that have management issues that he can influence.
Icahn is worried that politicians in general are focusing too much on the short term. We are going to skip the election related political issues but mention two issues that are very interesting for investors, repatriation and inversion.
Icahn sees a great opportunity for the U.S. if companies were allowed to repatriate foreign profits which currently amount to $2.3 trillion. Companies don’t repatriate that money because of the 35% tax on cash repatriation.
Repatriation leads to another issue, inversions, where companies move their headquarters abroad. As many U.S. companies have more revenues from abroad, it pays to move their headquarters to countries where you pay less in taxes.
Since 2012, 20 companies have made an inversion with the most notable examples being Medtronic, which became Irish, and Burger King, which became Canadian. Pfizer also tried to acquire Allergan and move to Ireland but was stopped by the government.
Figure 1: Inversion deals completed each year. Source: Bloomberg.
Icahn is opposed to low interest rates because it maxes financial engineering. With low interest rates, companies are more encouraged to buy other companies or do buybacks than they are to invest in new equipment and machinery. This phenomenon inflates earnings for the short term but is detrimental in the long term.
On top of the financial engineering issue, Icahn is also frustrated with the fact that companies manipulate earnings by taking various costs out of the picture which distorts the true earnings figure. Management is especially guilty when it comes to earnings guidance.
Figure 2: Earnings guidance is without the following items. Source: Carl Icahn.
This short-term activity can be seen in the current earnings guidance from the S&P 500 companies, 71% of which have issued a negative guidance for Q3 2016.
Figure 3: Earnings guidance by sector. Source: FACTSET.
Low interest rates and financial engineering have managed to consistently increase earnings since 2009, but it hasn’t worked in the last 5 quarters and, according to guidance, it will not improve anytime soon.
Icahn also states that the majority of companies should not be doing buybacks because they are just a short term fix. Companies that should be doing buybacks according to Icahn are Apple, which has a PE ratio of 9, and companies that trade below book value. By doing buybacks at higher valuations or above book value, management weakens the balance sheet which is a disservice to investors in the long run.
Low Interest Rates
Icahn is in favor of immediately raising interest rates because low interest rates cause bubbles in real estate, stocks and even the art market. Low interest rates further push people to search for yields in very risky markets—like junk bonds—where very few people really understand what is going on. The iShares High Yield Corporate Bond ETF (HYG) has a yield of 5.57% and it has outperformed the S&P 500 in the last 10 years as people are desperate for any kind of yield. The S&P 500 is up 40% since 2007 while the high yield bond ETF is up 63% and has a higher yield than the S&P 500 dividends.
Figure 4: iShares high yield bond ETF performance since 2007. Source: iShares.
Icahn warns investors that any problem in the economy will create a rush for the exits and people will want their money, but there will be no market for junk bonds at that moment even if they appear very liquid today. Icahn’s cartoon below reveals this situation better than any words could.
Figure 5: High yielders going towards a cliff. Source: Carl Icahn.
Icahn says that he saw the same pattern evolve in 1969, 1974, 1979, 1987, 2000, and 2007, and warns us that a time is coming that might make all those years look pretty good. His main message is that those who do not learn from history are going to repeat it, and that he is afraid that we are going down that road again.
One of the perks of being above a certain age is that you can say whatever you want, without fear of a lawsuit over what you say, as you will be long dead by the time those lawsuits are resolved. What we can learn from Icahn is something fresh while also getting an opinion from someone that has been around for a long time.
The question is not so much if all the negative things will happen, that scenario will for sure hit us eventually as boom and bust cycles are human nature. We are wired for instant gratification, even if that means less gratification in the future, therefore no one is going to stop the party by raising rates or lowering credit availability. That will happen sometime, but it will be very sudden and people will wonder why they didn’t listen to Icahn.
But, why don’t we listen? Because we don’t know if the negative scenario will present itself today or 10 years from now. If we immediately heed Icahn, sell everything and the bust cycle doesn’t come in the next 5 years, we will look stupid.
The main point is that Icahn is right, but all the folks buying stocks at high PE ratios and high yield junk bonds are also right for the time being, because no one can be right on the most important thing, timing.
If you own high yield ETFs, or stocks that use lots of the cheap leverage to do buybacks and acquisitions, know that there is also a risk of losing a big chunk of your money if credit tightens. Just be aware of the risks you are taking for the higher yield you are getting.