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EARLY DECEMBER 2010 NEWLETTER
In my many years of observing economic trends, I’ve never seen such a large differential between
corporate performance and the U.S. economy. In a nutshell, private sector companies are able to grow
their bottom-line through nimble market access, continuous cost reductions, and innovation. It’s
becoming clear that these primary drivers for corporate performance are increasingly independent of
U.S. government policy or even the American customer.
Corporate performance, particularly for those companies that have re-defined themselves during this
downturn, is seemingly strong. However, in dramatic contrast, the U.S. economy, continues to limp
along despite spectacular, unprecedented Federal Reserve to reduce interest rates and inject massive
liquidity, and the government’s action to continue to “stimulate” the economy. The November job
report highlights that the recovery may have a pulse – but is nowhere close to reaching “economic
escape velocity”. When will we see the day where the economy is self-sufficient without needing
massive capital injections or stimulus? Sadly, it’s easier to see how all this liquidity and over
government spending will end in Economic Armageddon instead of Economic Prosperity. For a long
time now, politicians have been more worried about the splitting of the U.S. economic pie rather than
growing it – leaving our great nation mired in high government debt without building commensurate
capabilities for Americans to succeed.
While I am deeply concerned about how the U.S. will fare, I am bullish on stocks – for now. No, I am
not totally psycho. My view is that many companies can overcome a weak American consumer,
increasing U.S. regulation, and higher potential taxation. Here's an example: The BP incident resulted
in a government induced shutdown on Gulf of Mexico drilling. The oil and gas industry took no more
than a matter of days to redeploy their assets and people elsewhere. These flexible, global business
models are not only reflected in the energy sector, but across many sectors including industrial, retail,
technology, entertainment, and restaurant sectors. Leading companies have re-invented themselves
to opportunistically access global markets, leverage global supply chains, and maintain lean cost
structures to propel earnings to new heights – in many cases, well above pre-financial crisis levels.
So as an investor, I am bullish. I continue to select best-in-class companies that I am truly proud to own.
I love specific companies in the sectors I mentioned above – and even more excited by companies that I
run across nearly daily that are truly innovating. For example, there are a whole slew of new innovative
companies that will soon IPO – just take a look at Sharespost.com to get an idea of pre-IPO companies.
American private sector innovation is still alive!
Back to Washington -- You’ve got a big problem. You continue to prime the U.S. economic pump, but
each new “trick” you pull out has even less impact than the previous one. Meanwhile, you ignore the
big structural issues while you argue about how to split our comparative shrinking economic pie. Where
is a comprehensive energy policy? Where are we investing in innovation so that we can compete
against new titans of innovation (Singapore, China, India – just to name a few)? How are we preparing
our workforce for truly globally competitive, even playing field?
I mentioned the possibility of U.S. economic disaster. I pray it never happens….But we need to be
prepared.
APRIL 2010 Newsletter
What a terrific first quarter 2010 with U.S. market indices up 5-8%. Since the bottoming of this market
March 2009, many best-in-class companies that were once left for dead are up over 2 to 6 times their
valuation since bottoming. Here is a brief sampling of stocks discussed previously and the approximate
relative gain to their bottom (excluding dividends):
Financials:
Goldman Sachs 280%
Bank of America 410%
Morgan Stanley 350%
GE
165%
Technology:
Ciena
200%
Apple
200%
IBM
85%
Research in Motion 105%
Amazon 300%
HP
100%
Industrials:
Boeing
85%
Caterpillar 195%
Dow Chem 450%
Monsanto
9% (Whoops)
Retail:
Nordstrom 540%
Walmart
17%
Energy:
LINE
140% (plus 30%+ dividend on top)
Permian Basin Trust 150% (plus 10%+ dividend on top)
Travel:
Continental Airlines 260%
Yet, these sectors and stocks weren’t necessarily the absolute best. Autos (Ford = 800% return) and Car
rental (Avis = 1400% return) smashed all the above. Clearly the panic in late 2008/early 2009 which
incorporated some degree of bankruptcy risk led to an incredible buying opportunity.
It is somewhat surprising that the market continues to broadly rise with modest levels of volatility. First,
I had expected people to take gains, particularly when the awesome gains since market bottom shifted
from short-term to long-term, but this hasn’t happened. (Note: this may happen towards year-end as
long-term cap gains tax rate is slated to increase from15 to 20%)
Second, in stark contrast to the equity market, the Washington DC volatility index boiled over several
times during the quarter. The surprising republican win in Massachusetts led many to believe health
care “reform” was dead. Oh well, it wasn’t quite dead – through political mumbo-jumbo, a health care
package was passed amidst high strung drama that led C-SPAN to have its highest ratings ever. I believe
that Webster needs to add a new definition to the word “reconciliation”.
However, nothing really changed upon the passage. As Obama so eloquently stated shortly after health
care passage, “contrary to Republican fear-mongering, no one pulled the plug on granny”. So granny
lives and apparently so does the stock market rally. The only real change so far, and trust me, it impacts
me in no way whatsoever, was a new tax for artificial sun bathers.
So, I suppose one can conclude that all the banter in Washington is doing little to stem the continued
calming and confidence building of stock investors. Either investors embrace Washington policy as
supportive of corporate profits, or they discount its impact. I believe it a combination of both.
First off, not all Washington-led programs are turning out to be disasters. For example, TARP will turn
out to be a money maker. Latest figures show that TARP will only be down $100 billion (made back
over $600 billion so far), but that estimate is well understated and doesn’t reflect large profits expected
from the government sales of its stake in Citibank, as an example.
Also, the government take-over of GM, while painful in thinking through the full ramifications of it, will
likely be a money-maker.
However, the $787 billion stimulus effort continues to be a joke. The latest figures show $300 billion
paid out and 600K jobs created for a total of $500K per job created. It’s incredibly inefficient and
continues to throw good money after bad. In fact, I would argue that portions of the stimulus program
should be terminated immediately.
Investor sentiment continues to improve for good reason. The year-end 2009 earnings were fairly
strong, particularly for best in class companies that continue to cut costs amidst improving revenue
growth. The financial infrastructure continues to heal and is coming closer to being fully functioning.
Overseas, the BRICs are continuing their economic growth trajectories with minimal impact from the
financial crisis aftermath. Indeed, Greece, Portugal, and perhaps Spain are dealing with overheated
debt issues, but ironically this has helped the U.S. position, with a strengthening dollar versus the Euro.
Also, these economies represent a fraction of the global picture. Finally, I believe that there is a stock –
friendly cycle playing out – good companies will continue to cut costs while growing, resulting in sluggish
employment growth, thereby locking in the Fed to extend a low interest rate environment. This cycle
will eventually break – and with unfavorable consequences, but in the meanwhile, the coast is clear.
In summary, the conditions I identified last fall as indicators of our economy continue to
improve/accelerate:
• Employment:
Finally, the decline in employment is slowing (March)
• Dollar stabilization: Stabilized/strengthening
• Health Care status: health care light passed, not clear if it will have lasting effect
• M&A: Strong in several sectors, robust IPO market
• Market leadership by 2 or more sectors : leadership across the board – rally has broadened to most
sectors
So, I continue to be confident in the overall landscape.
That being said, I am growing increasingly sensitive to two important aspects of this market. First, we
are headed into 1st quarter earnings season, with expectations ratcheted up for many companies – and
if reality doesn’t exceed expectations, stocks will correct. Expectations are high for technology stocks –
any mention of softness, or margin compression, or lack of product line expansion potential will tank a
tech stock. Good example: RIMM reported a couple weeks ago – everything strong except for slightly
light margin expectations – and the stock dropped 10%.
Stocks did drop fairly quickly in late Jan/Feb on the heels of earnings, and that could happen this time
around. Three strategies that are worth condistering to protect gains while still participating in the
market:
• Consider selling stock outright, pulling a percentage of the profits back into “stock replacement
strategy”. For example, if you sell Apple with a 20K gain, put 10K back into a bullish option stock spread
– this way you share in the upside if the stock continues to progress, but get to keep half your robust
profits in case you are wrong.
• Low volatility translates into low option prices, so therefore buying put protection is cheap. Consider
protecting yourself by buying a put spread.
• Sell your stock, and take a lower risk strategy (lower profit) by selling puts with a strike price below
current price.
Further, I am concerned about two major sectors of our economy – health care and financials -- that are
at risk of increased governmental influence.
• Health care. It has always been my principal philosophy to keep away from anything health care
related. It’s too hard to figure out what’s what in this convoluted industry sector from an investor
standpoint – and now it has become more confusing with passage of the health care bill. Also, I think
major pharma companies are struggling to innovate and extend their product pipeline. With Obamacare, I still see no compelling reason to jump into health care stocks.
• Financials: There is stuff heating up in Washington about financial reform. Of course, Goldman
Sachs (which I think is the best financial institution), is in the rhetoric crossfire . However, if Washington
proves to be too onerous, Goldman will simply go private – so I believe the downside risk is relatively
small. As often the case, Washington’s bark is bigger than its bite, and I think this is the case with
financial reform. I’m still a buyer of Goldman.
That being said, there are other places to look in financials – for example, I like Greenhill – particularly as
the M&A market heats up. Greenhill is insulated from the brunt of reform and has a pure-play model
on M&A and not trading.
I also like the increasing value in regional banks – Huntington Bank (HBAN) and Sterling Bank are
breaking out.
I am also trolling for value plays to minimize downside in a potential near-term correction.
I continue to leverage Walmart in combination with selling covered calls as a cash replacement strategy.
For 18 months in a row, I have made 0.5 – 1.25% per month using this low risk strategy – much better
than interest rates on short-term cash.
Other value plays abound – including select Majors. I believe XOM, BP and Chevron are good values
(for a short term window). I believe AT&T and Verizon are stocks that are safe bets with strong
dividend yields. Finally, natural gas and refining are on my radar screen, waiting for a turnaround.
As equities complete their transition from the depths of hell to being valued on some sort of normalcy, it
is important to sharpen the pencil and look for good, solid companies with great operating models and
exposed to key mega-trends. Here are a few mega-trends on my mind:
• Continued mobile computing, connectivity, entertainment, and productivity enhancements – this is
just the beginning. Apple is the clear leader. I think Apple is still cheap, at 25x 2010 earnings, and less
than 20x 2011 earnings. And earnings are likely to be revised upward. Their products are gaining
traction, everyone (software companies, networkers, phone companies, content providers) are trying to
weave themselves into the Apple web. RIMM is the runner-up. Lots of companies in the midst of this,
including Ciena, Qualcomm, Electronic Arts, Google, American Tower, Best Buy, and Amazon.
• Entertainment and travel revolution: Movie makers have never seen so many blockbusters. Airlines
are increasing fares and getting away with it (note: March saw biggest increase in year-over-year RASM
ever). Speaking of airlines, mergers are on the horizon, with CAL-United the best possibility. People
are coming out of their caves after two years of isolation and ready to go! Also like hotels and casinos,
although already have run up significantly.
• De-manning of the workplace: Companies have learned to produce more with fewer people. Plus
the cost of people is unclear. Translates to higher profits for those that are on the de-manning
forefront, including car companies, airlines, chemical companies, refiners, etc. Also, technology
companies that enable automation and de-manning – IBM, Cisco, and Juniper Systems.
• Local to National expansion of Best in Class Retailers: Nothing beats buying into companies that are
expanding nationally with great success. Nordstroms is the top of my list here. Speculative pick:
Build a Bear Workshop, and Hot Topic. Also on my list are a couple of local restaurant/entertainment
formats that are expanding nationally.
• Emerging market growth continues unabated – ideas here are Yum Brands, Walmart, and yes, Apple.
• Energy security and greening trends: Eventually natural gas will kick-up. Also, like rig companies,
Transocean (cheap). Not sure about the green stuff – best bet in mind mind are engineering
companies, Flour, McDermott.
• Financial oligopolies: Bank combinations leading to mega-bank oligopolies – BOA and JPM continue
to track higher
• Housing overhand looms, commercial real estate recovers faster. Meaning regional banks strengthen.
Stay away from housing stocks.
Good luck with this earnings season – comments welcome!