On The Call With Wally Forbes
The Rip Van Winkle Approach: Buy Microsoft, Pepsi And IBM
by Wallace Forbes, 12.16.11, 12:00 PM EST
Forbes.com

Henry Mercer III is president of Mercer Capital Advisers.

Henry Mercer III: These days, investors are being confronted with a tremendous amount of uncertainty and market volatility. The day-to-day action seems like trench warfare, as the bulls and bears battle back and forth over the same territory.

U.S. stock indices have swung abruptly between gains and losses throughout 2011, and the S&P 500 Index is now down about 6% for the year. Everyone knows the problems, but here are two of the most significant: Political brinksmanship in Washington, D.C. is killing confidence here in the U.S., and the European Union’s inability to deal decisively with its sovereign debt crisis is igniting another financial panic.

We could keep going. Governments are toppling in North Africa and the Middle East. China’s economic miracle is encountering turbulence. The list of worries is lengthy. But with all this happening, it’s tough for investors to keep a long-term perspective. However, investors need to recognize that today’s problems say little about what will happen in the future. Our long-term outlook is in fact bullish.

Wallace Forbes: That’s encouraging.

Mercer: Our optimism is due to a couple of factors. One is the depressed sentiment. One constant throughout investment history is the abundance of fear at ideal buying points, and fear can now be seen everywhere. The mood is truly gloomy. You can observe it on the evening news and read it on newspaper front pages.

All this pessimism is influencing investor behavior. Individual investors have been hitting equity mutual funds with redemptions all year long. Pension funds have been de-risking, fleeing stocks and piling into the perceived safety of bonds and other low-volatility alternatives. But all this is positive from a contrary point of view.

The main factor contributing to our bullishness is the appealing value being presented by equities. Shares of many high-quality companies pay dividends well in excess of the meager yields generated by US treasury notes. This is a rare phenomenon. And these dividends are increased on a regular basis, unlike fixed bond interest. So we’re taking advantage of the depressed market environment to make long-term investments in dominant businesses at attractive prices.

Forbes: Well, that’s encouraging indeed.

Mercer: Lately, we’ve been focusing on what we call “the best of the best companies” and adopting what we refer to as a “Rip Van Winkle approach.” Meaning these are investments we’d be happy to own if we fell asleep for the next ten years. Among our favorites is Microsoft, which is just incredibly cheap, trading at less than ten times earnings with a 3.2% dividend yield.

The company has a fortress balance sheet and is generating a ton of cash, which leaves plenty of room for future dividend increases and stock buybacks. Everyone seems to think of the company as a technology dinosaur, but it continues to grow and innovate today and should for many years ahead.

We also like PepsiCo, which coincidentally also has a 3.2% dividend yield. The company has raised this dividend for 39 straight years. At 14 times earnings, PepsiCo is trading at a wide discount to its competitor, Coca-Cola. Beyond its namesake soft drink business, PepsiCo has a dominant position in snack foods with its ownership of Frito-Lay. Yet its shares also sell at a discount to food companies like Heinz and General Mills.

The company has 19 brands with more than $1 billion in annual sales – iconic names such as Gatorade and Tropicana. And there’s been a lot of talk lately that PepsiCo might spin off Frito-Lay in an effort to unlock value in the near term. But we bought it for the long haul and are happy to own it — spin off or not.

Forbes: That sounds very encouraging also.

Mercer: We’re also encouraged by Warren Buffet’s recent purchase of a sizeable stake in IBM, which we feel validates Mercer Capital’s strategy of taking advantage of the current gloom to invest in great businesses. Buffet once said that he had made most of his best purchases when apprehensions about some macro event were at a peak. This is something to keep in mind now, when everyone is so frightened.

Forbes: IBM was once such a solitary idol. It went through a lot, but it’s back in much more promising shape.

Mercer: Buffett acknowledges that IBM is less of a pure technology company today than it was in the past. It’s very big in software and consulting. It’s also interesting that, on the surface, IBM doesn’t appear to be an all-together cheap investment from a value standpoint. But he really believes in the long-term franchise power of the company in the years ahead. Again, in a time of doom and gloom, when everyone is sort of fearful of what the economic future might look like, he still believes in the long-term power of capitalism and business.

And we hope he’s right.

Forbes: Don’t we all? That’s terrific. Any other companies you want to comment on?

Mercer: We have been focusing on what we’d call our best of the best. We’ve been investing in 3M also, for example, which we consider to be a powerhouse industrial company that’s very well managed, with a global scope. It’s very well positioned for the future. 3M is really the bluest of the blue chips that we find attractive these days.

Forbes: That’s a comforting outlook. When you start talking things like 3M, IBM and Pepsi, you’re talking about what were the old blue chips – and they’re back looking blue again. That’s great.

Mercer: The blue chips are priced, as investments, very attractively. That’s not always the case. They normally trade at a premium, but we can buy them at a discount today. And these companies tend to have better balance sheets than governments and are certainly better managed. We take some confidence, given the unpredictable future, in the fact that these businesses have done well for years and years, and we anticipate that they will in the years ahead.

Forbes: Henry, thank you. You’ve made me feel a lot better.

Mercer: Thank you, Wally. Take advantage of doom and gloom. That’s all I know.

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