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“An old rancher in the Texas Hill Country kept two big hogs in a pen at the top of small hill near his house. The animals were nasty – smelled bad – but the breeze higher up kept the smell away from the house. Every day, morning and late afternoon, the old rancher would walk his hogs down to the creek at the bottom of the hill and water them. The rancher’s grown son observed this ritual for years and finally spoke up. ‘Dad,’ he said, ‘If you would drill a water well up near the pen, it would save a lot of time.’ The old rancher looked at his son with an expression that said, ‘You never seem to get it,’ and asked, testily, ‘What the hell is time to a hog?’ There are a number of morals to this story. The moral from Jim’s perspective, I suspect, is ‘This is not the Texas Hill Country and you don’t have all day, so get to your point’.”
... Frederick E. “Shad” Rowe, General Partner of Greenbrier Partners, Ltd.
So said Frederick “Shad” Rowe as he began his address to a packed room at Jim Grant’s London conference last month. Since the 1980s I have read articles by Shad in Forbes, Fortune, Barron’s, etc. and always found them insightful. Moreover, I have often used his sagacious comments in these missives to emphasize those gleanings in an attempt to help investors profit from them. This morning is no exception.
Shad went on to opine why he is a steadfast bull on the American stock market. Said bullishness does not stem from his nature, for a couple of decades ago he enjoyed great success as a “short seller.” Nope, Shad’s bullishness is based on the belief that innovation is thriving in America. He used Google as an example. To wit:
“In the United States, two graduate students have managed to develop a product that led to the creation of the most scalable business model in history. Google is 12 years old and is already the 39th most profitable company in the world. Google’s core product is useful to corporations and consumers both, but has also become the lifeblood of thousands of small and medium-sized businesses. Beyond generating close to $30 billion in revenue this year, Google’s success has created an ecosystem that employs thousands of people around the world and Google alumni populate the upper echelon of the next batch of revolutionary technology companies. Facebook is one of many other examples.”
I would add Groupon as such an example, which was a “startup” three years ago and now employs more than 5,000 people. To be sure, the country is going through what the economist Joseph Schumpeter described as “creative destruction” whereby the dying industries, like the building of McMansions or giant SUVs, fade away but are replaced by new, growth industries. As scribed in Wikipedia:
“Schumpeter identified innovation as the critical dimension of economic change. He argued that economic change revolves around innovation, entrepreneurial activities and market power and sought to prove that innovation-originated market power could provide better results than the invisible hand and price competition.”
Granted, this creative destruction process takes time, and does not occur without “hard spots” along the way, but as Shad notes:
The same factors that have served the U.S. well in the past are the same factors I believe will lead us to future prosperity:
1) The United States is the home of the entrepreneur. 2) The U.S. is the most open/flexible society the world has ever seen. 3) The brightest minds from around the world dream of coming to the U.S. 4) English is the universal language. 5) Americanization remains a powerful and growing – though resented – economic and social trend throughout the world. (To quote the advertising/marketing giant WPP Group’s CEO, Sir Martin Sorrell, “Globalization is a misnomer. The better word is Americanization.”)
I revisit Shad’s cogent comments this morning not just because Greenbrier Partners has produced above market investment returns since its inception in 1985, but because during my Texas speaking tour last week I had the pleasure of spending time with him. Following our strategizing, Shad borrowed a phrase from another acquaintance of mine, Adam Smith (aka Gerry Goodman) author of the classic book The Money Game – “What do we do about it on Monday morning?” Shad goes on to counsel:
“Subscribing as I do to the Charlie Munger dictum that a great business at a fair price is superior to a fair business at a great price, we buy shares in what we believe are ‘Great Companies.’ Since the stock market currently makes little distinction in valuation between fair and great companies, the normal dilemma – Do I pay up for quality? – does not exist. My plan is to proceed as follows:”
“First, I define what makes a company ‘Great.’
1) A great company brings value to its customers, its suppliers, its shareholders, and a culture of fulfillment to its employees. 2) As a customer, you can’t beat it and what the company sells is good for its customers. 3) A great business generates a lot of free cash for reinvestment and is able to reinvest at high rates of return. 4) The chief executive does not ‘alternate between smart and dumb.’ He/She is smart all the time and demonstrates respect for shareholders, first because it is right and second because the CEO is a significant owner. 5) The socio/economic wind is at the back of the company. 6) Ideally, there is a ‘moat’ around the business that Buffett and Munger define as a sustainable competitive advantage. ‘Moats’ are problematic in practice because the world changes so fast that most of them are not sustainable. My concept of a ‘moat’ is superior management with superior brains fixated on adjusting to and capitalizing on rapid change.”
While these are not Shad’s selections, some companies from the Raymond James research universe that appear to “foot” with Shad’s metrics, all of which are rated Strong Buy, are: IESI-BFC Ltd. (BIN/$25.81); Pão de Açúcar (CBD/$43.12); IBERIABANK Corporation (IBKC/$60.39); and Kansas City Southern (KSU/$54.47), to name just a few.
The call for this week: Last week we saw an improvement in private sector payrolls, the ISM manufacturing report was solid, pending home sales were better, and corporate layoff intentions fell. The result left all the indices we follow higher on the week. The star, however, was the D-J Transportation Average (TRAN/5370.47), which leaped 3.13% and in the process traded above its February 17, 2011 high (5298.10) to a new reaction high. Unfortunately, the D-J Industrial (INDU/12376.72) has not confirmed the Trannies with a like move above its February reaction high of 12391.25. If the Industrials do confirm on the upside it would be the third Dow Theory “buy signal” in the past 10 months. Potentially telegraphing a move higher are the S&P SmallCap 600, and the S&P MidCap 400, indices that have now recorded new all-time highs; and, the Russell 2000 is close to doing the same. To us, the S&P 500 (SPX/1332.41) is poised to go higher. The only question is will we get a one- to two-week pullback/consolidation to alleviate the overbought condition (see chart on next page) before we head higher?
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“Here’s the paradox: the odds are overwhelming I will end up richer by aiming for a good return rather than a brilliant return – and sleep better en route. Folks who seek a killing usually get killed. Gunslingers get shot, and often in the foot, with their own guns. While there is always some guy around on a red-hot streak, his main function is to tempt the rest of us into becoming fools and paupers. A return of 15% to 20% annually is a lot more than most folks realize, or need. If a 30-year old with $10,000 in an IRA gets 15% annually, he’ll be a millionaire before normal retirement. That’s the power of compound interest. If that same 30-year old were to sock away another $2,000 per year at 15%, he would end up as a 65-year old $3 million fat cat. At 20%, it’s an incredible $13 million. That’s a lot, but it’s not too much to ask. The two most definitive studies ever on long-term returns, the Ibbotson/Sinquefield and Fisher/Lorie studies, both point to average annual returns for stocks of 9% plus per year going back to the mid-1920s. So 15% to 20% per year is really 66% to 100% better than the market as a whole. That’s tough but doable. Consistency is the key. It is close to impossible to get a good, long-term, rate of return if you suffer serious negative numbers en route. It’s the math. A single year that is down 30% means you have to get 30% per year positive returns for the next four years to get back on track for a 15% annual average. Or, if you score 20% annually for four years, and then suffer a 30% decline, your five-year average return is only 7%.”
... Ken Fisher, Forbes, 1989
I have often republished Ken Fisher’s sage quote ever since first reading it in 1989 because it speaks to the centerpiece of my investment philosophy. To wit, “Here’s the paradox: the odds are overwhelming I will end up richer by aiming for a good return rather than a brilliant return – and sleep better en route.” Or as Benjamin Graham wrote, “The essence of investment management is the management of RISKS, not the management of RETURNS. Well-managed portfolios start with this precept.” Indeed, if you manage the downside the upside will take care of itself. Avoiding the big loss is the key to investment success. And, that’s why when I think the odds are not decidedly tipped in my favor I tend to be more cautious in my investment approach.
The most recent example of this style was coming into 2011 when I became more cautious. That was a pretty good “call” on developing markets (emerging and frontier), but was not such a good “call” on developed markets; that is until February 18 when the S&P 500 (SPX/1313.80) peaked at 1344. From there the SPX slid into its March 16 intra-day low (1249), a 7% pullback. For the last few months I have commented that any decline would likely be contained in the 7% - 10% range. Quite frankly, however, I really didn’t think the low recorded on March 16 was THE low, yet it increasingly looks like it was. Nevertheless, we did recommend buying select stocks the week of March 13 because a number of them had declined to levels where the risk/reward ratio was tipped in our favor.
Case in point, for months one of our favorite ideas has been Williams Company (WMB/$31.13/Outperform) based on the belief the new CEO (Alan Armstrong) would split the company into two parts. In mid-February he announced just that. Obviously Wall Street liked the idea given that day’s leap in WMB’s share price from $27.76 to $30.95. Subsequently, on March 16 WMB’s share price had pulled back to $28.70 despite the fact the fundamentals had gotten better. Accordingly, we thought much of the price risk had been removed from the shares, and with the pending split acting as the carrot in front of the proverbial horse, we reiterated WMB as one of our favorite ideas.
Another one of our favorite ideas, following the management team’s excellent presentation at Raymond James’ 32nd Annual Institutional Conference (March 7), is 6.7%-yielding LINN Energy (LINE/$39.26/Strong Buy). As stated, LINN Energy is an independent oil and gas producer with outstanding prospects. It has a 20-year resource reserve, a 100% return on investment on its drilling program, should grow organically by 30% per year (plus acquisitions), is 95% hedged on its production, and has a cost of capital of ~7%. Similarly, we find EV Energy Partners (EVEP/$51.09/Outperform) attractive. Hereto, 5.9%-yielding EVEP is a master limited partnership focused on acquiring, developing, and producing oil and gas. What is intriguing about EVEP is its 280,000 acres in the Utica Shale reservoir, which is not being given much value. The reason is that there is little data on how prolific Utica will be. Recently, however, as our fundamental analyst Darren Horowitz writes:
“While the Barnett Shale is currently the company’s growth engine, the Utica Shale has the potential to play a huge role in the company’s future. EV Energy Partners is sitting on 150,000 net acres and an overriding royalty interest in an additional 80,000 net acres in this emerging shale play. No doubt it is very early in the play with very few public drilling results; however, the Point Pleasant portion of the Utica Shale, found primarily in Ohio, is attracting a lot of attention. As a reminder, the Utica Shale, perhaps the geographically largest shale formations in the U.S., sits below the Marcellus formation in the Appalachia. The Point Pleasant formation is the organically rich lower member of the Utica Shale, which is thought to have decent liquids content. Assuming EV Energy Partners’ Utica acreage, from which the company currently has zero production, could achieve a market valuation of $2,000 per acre, in-line valuation with other undeveloped shale play acreage, then the company likely has roughly $460 million in value that is largely not reflected in its stock price.”
From our perspective what EVEP represents is an attractive situation without the Utica Shale resource. Yet, if Utica turns out to be anything like the Barnett Shale, it would be a huge “win” for the company.
Turning to another name where we think much of the price risk has been removed, one of our fundamental bank analysts (Anthony Polini) had this to say last Friday:
“We reiterate our Strong Buy rating on 4.9%-yielding Peoples United Financial (PBCT/$12.64). This out-of-favor stock could benefit from several factors over the next few months, including: an inexpensive valuation, a better-than-average net interest margin outlook, significant organic commercial loan growth opportunities, the closing of the Danvers acquisition in 2Q11, more aggressive share buybacks, and the market factoring in an eventual Fed tightening policy. The shares are inexpensive, having closed just above their 52-week low of $12.17 and are down 13% YTD compared to a 2% decline for the KBW Bank Index (BKX/51.82). The shares now trade at 16.9x 2012E EPS, 82% of book, and 131% of tangible book. (Moreover), People's is one of the best positioned banks for rising interest rates. A 100 bp increase in rates would increase PBCT's net interest income 6% compared to the peer median of 2%. A 200 bp increase in rates would increase PBCT's net interest income over 13% compared to 4% for peers. In other words, every 100 bp increase in rates adds $0.08 to EPS. Our $20.00 target price assumes PBCT shares trade at about 137% of 4Q11E book value ($14.65E), a discount to the 15-year industry average of 150%.”
The call for this week: I am in Texas all week speaking at seminars/conferences and seeing institutional accounts, so these will be the only strategy comments for the week. That said, as stated last week, whether the March 16 “low” gets retested is now doubtful in my opinion. Still, a partial pullback to 1275 – 1300 on the S&P 500 cannot be ruled out because the recent rally has occurred due to more of a decline in Selling Pressure rather than enthusiastic buying. Indeed, the decline from February 18 into the March 16 “low” was accompanied by two 90% Downside Days, where 90% of the points and volume traded came on the downside. As well, there were two additional nearly 90% Downside Days (~89.5%) during the decline. Typically it takes at least one 90% Upside Day to conclude that a correction is over and so far we have not seen that. Still, I think a lot of the price risk has been removed from select stocks and therefore I am not afraid to gradually accumulate favored names.
At the risk of sounding like a kook, I began writing about the weird weather in September of last year. The text read like this:
“I revisit the coal theme this morning because the La Niña weather pattern, combined with numerous volcanic eruptions that put large amounts of ash into the atmosphere, has allowed the Tropic of Cancer and the Tropic of Capricorn to expand. The result has brought increased hurricane activity, soaring temperatures, Asian floods, droughts (Russia has lost 30% of its wheat crop), and the list goes on. While the current focus is on the unusually warm weather, don’t expect this to continue as the Northern Hemisphere faces an upcoming VERY cold/wet winter due to massive amounts of volcanic ash in the atmosphere. Energy stocks, therefore, should be over-weighted in portfolios with the biggest ‘bang’ going to the Exploration & Production stocks (E&P), as well as coal stocks.”
Again, at the risk of sounding like a kook, this morning I offer another topical view from Jim Berkland, a geologist that has a decent record of targeting potential timeframes of increased earthquake activity. Know that Mr. Berkland correctly forecast San Francisco’s Loma Prieta earthquake (aka, “The World Series” earthquake) that occurred on October 17, 1989 right before the third game of the World Series. He did so by using a combination of tidal tables, lunar/gravitational phases, animal behavior, beached whales, and a keen sense of the “Pacific Ring of Fire.” That prediction caused a suspension from his job as County Geologist for Santa Clara, California on fears that future predictions might cause mass hysteria. Also know that many of his predictions never came to pass and consequently he too is considered a kook by some.
That said, his interview with Neil Cavuto begins (see it here: http://www.youtube.com/watch?v=xQXDt4VdS0E) with Jim stating that the months of October, March, and April are the most dangerous for earthquakes in the San Francisco Bay area. He further opines that March 19th’s full moon, where the moon made its closest approach to Earth until 2016, coincides with the equinoctial tide. While some folks are familiar with ocean tides, most are unfamiliar with Earth tides (caused by the Sun and Moon’s gravitation), as well as groundwater tides. Accordingly, all three tides will be at their zenith during what Jim terms the “seismic window” between March 19 and March 26. He continues by citing the recent million dead fish in Redondo Beach and the “beaching” of whales. His claim is that the Earth’s magnetic fields change dramatically right before earthquakes; since most fish/animals have magnetite in them to navigate those magnetic fields, said fish/animals become confused by the change. As a sidebar, magnetite (or lodestone) is the most magnetic of all naturally occurring minerals on the planet. Jim cites such events happening shortly before the 1989 World Series quake, the 2004 Indian Ocean earthquake, the 1964 Alaska earthquake, etc. He concludes with the fact that the Alaska’s 9.2 Richter scale quake occurred with a full moon.
While I certainly don’t want to ride into history as the Joe Granville of my era, I do find it unsettling that Chile’s 8.8 earthquake has been followed by New Zealand’s 6.2 quake and now Japan’s 9.0 tragedy in what appears to be a series of events occurring in a clockwise rotation around the Pacific Ring of Fire. If so, the next target should be either Alaska (the Aleutian Trench), or our west coast (the Juan de Fuca Subduction Zone, see chart). Joe Granville, by the way, hit the peak of his stock market career with his faulty prediction in April 1981 that a major earthquake, “would make Phoenix waterfront property during the week of April 10, 1981.”
Yet it is not really the threat of earthquakes that keeps me cautious on the stock market. Despite the fact that we still have not had more than three consecutive down days since September 1, 2010, and therefore the Buying Stampede remains intact, I can’t shake the feeling it actually ended on February 18. If that subsequently proves correct, we are at session 20 of a Selling Stampede. Recall, stampedes (both up and down) typically last 17 – 25 sessions before they exhaust themselves. A few have extended for 25 – 30 sessions, but it is rare to have one last for more than 30 sessions. Indeed, previously the longest stampede chronicled in my notes was a 52-session upside skein, of course that is until the September 2010 to February 2011 affair, which if ended on February 18 was legend at 117 sessions. If not, today is session 137 in the upside stampede.
Another thing that keeps me cautious is that the U.S. is going to find it increasingly difficult to finance its enormous debt given that our primary lenders are going need more of their capital at home. Think about it, the Chinese are now running a trade deficit, the Japanese are going to have a huge “call” on their capital, Europe is facing larger and larger bailouts for the PIGs, the petro-dollar nations (Middle East) are trying to buy-off dissidents, and the Federal Reserve is slated to stop QE2 in June. Unless the Martians start lending us money it is difficult to see how our cost of capital is not going to rise.
As for Japan, it is a strange feeling to attempt considering how investors should position themselves in light of this tragedy. As stated, I have thought Japanese stocks were cheap for quite some time. They obviously got cheaper last week given the Nikkei 225’s 20% decline from its March 9 high into last Wednesday’s intra-day low before firming late week. Plainly, this weakness caused a concurrent drop in the two investment vehicles I have been using since May 2009, namely Japan Smaller Capitalization Fund (JOF/$8.70) and WisdomTree SmallCap Dividend Index (DFJ/$41.55). These funds are now back to the levels I originally recommended them. Those wanting to invest in Japan should consider said vehicles using last week’s intra-day low as a failsafe point. I also think Japan will use more liquefied natural gas (LNG) and consequently I have recommended 6%-yielding Teekay LNG Partners (TGP/$39.98/Strong Buy) for investment accounts. Obviously, the nuclear nightmare had an equally deleterious impact on nuclear stocks. Hereto, a buying opportunity may be at hand. Accordingly, investors should consider the Global X Uranium ETF (URA/$14.85), which is a fund that holds a basket of more than 20 uranium stocks. I would use last week’s intra-day low of $13.25 as an “uncle point.”
While I remain cautious on stocks in the short-term, I am steadfast in my two-year belief that the equity markets are in an “up” phase for reasons often scribed in these reports. Last Friday the insightful folks at Minyanville gave me yet another reason to be constructive. To wit:
“The current myth is that it is ‘all one market.’ This was true from ~2005 to 2009 (according to the DeMark Indicator) in what people called the ‘grand reflation’ or ‘reflation trade’ and subsequently went bust. All stocks, virtually all risk assets really, had identical DeMark counts. If you covered up the name and price of the stock, and nearly all commodities, it was impossible to tell what you were looking at. They all looked alike, which in my universe is the same as saying correlations went to 1.0, which is what happens during bear markets. At the onset of bull markets the correlations break down and things begin to diverge once again. That has been happening for over a year now. It is not apparent in indexes due to their capitalization weighting, but in individual stocks it is. People now treat every company as if it were AIG or Lehman Brothers. But some companies actually have good business models and are making money despite the ongoing housing collapse and economic stress.”
The call for this week: Minyanville’s insightful CEO (Todd Harrison) had this to say on Minyanville’s must have “Buzz and Banter,” late last Friday, “A confluence of elements have come together today, including a potential ‘blink’ in Libya, relative calm in the Mid East and optimism regarding the nuclear situation in Japan. One other item bears mentioning and that’s the news the Fed says some banks can resume dividends after the stress test. That news has poked the ‘piggies’ back through the $52 level for the KBW Banking Index (BKX/$52.09) and lent a ‘bid’ to the (overall) tape.” Recall, after avoiding banks for ~10 years, I turned constructive on them last November when the bank index began outperforming the S&P 500 (SPX/1279.20). While I have not recommended the money center banks, I continue to embrace many of the regional banks often mentioned in these letters. I also remain an energy bull and offer 6.8%-yielding LINN Energy (LINE/$38.80/Strong Buy) for your consideration. LINN has a 20-year reserve life, a 100% ROI on drilling, 30% organic growth, a 7% cost of capital, is 95% hedged, and has a 50/50 mix of oil to natural gas. As for the stock market, for weeks I have suggested that any correction should be contained in the 7% - 10% range. On cue, the SPX declined 7.06% from its intra-day high of 1344 to last week’s intra-day low (1249), begging the question, “Is that it?” While I would like to think so, I just don’t believe it since we have had two 90% Downside days and two nearly 90% Downside since the February 18 high. However, that opinion could change if the SPX can hold above 1280 combined with a 90% Upside Day.
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Source: Granny Geek.
Sites for monitoring earthquakes: http://earthquake.usgs.gov/earthquakes/recenteqsww/Quakes/quakes_all.php http://www.msnbc.msn.com/id/42037498/ns/world_news-asia-pacific/
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