Ramblings of a Portfolio Manager 10-26-2009

Ramblings of a Portfolio Manager

Nouriel Roubini, perpetual bear a.k.a. Dr. Doom, was on CNBC early this morning doing a fair amount backpedaling and sounding (for him) positively bullish. His thesis: things somehow changed in government policy back in March (huh?) and so the market rally is justified. As he sees it, the market is now at fair value! Sharp-eyed contrarians instantly brought the early Dow futures down 30 basis points. We note that a broken clock is only correct twice a day as long as no-one fiddles with the hands or mechanism. Clearly, the negative feedback loop of rising stock prices fiddled with Dr. Roubini’s inner workings so we no longer trust this clock and decline to take the contrarian bet just now.

Third quarter earnings season is about two-thirds over and the results have been fairly good, despite the market’s apparent lack of interest. Experienced portfolio managers, however, are already looking at 2010 and have been doing so since at least July, which explains much of the market’s rise since then. The media has made much hullabaloo about Dow 10,000 since we crossed that psychological barrier and the “too far too fast” crowd has used the milestone to bolster their case. In their view, the market is expensive and the earnings don’t justify the levels. In our view, they have missed two very important points: First, consolidated Dow Jones constituent earnings are now projected to be 22% higher in 2010 than in 2009, which represents only an 8% decline from 2007 earnings, when the index was 40% higher. Doing the math, assuming we get to the same trailing multiple as we had in 2007 (and remember the housing crisis started in that year) we get, roughly, Dow 12,700 by year-end 2010 (that’s a 27% return!). Secondly, in the same vein, looking at 1999 when the Dow last crossed 10,000 on the way up, actual constituent company earnings were 24% lower than actual 2008 earnings (viewed another way, earnings are 31% higher now!) and 26% lower than 2010 expectations (which represent 36% growth from 1999). So much for the valuation argument!

Of course all of this is a simplistic analysis involving just the Dow Jones index and we remind investors that, back in 1999, we were in a different world—one in which that new-fangled thingy called the internet, coupled with Y2K spending, were going to drive US earnings growth at double digit rates well into the next millennium. Clearly, that bullish outlook on our economy had a big influence on the multiple investors were willing to place on forward-looking earnings at the time. By the same token, however, we now have that not-so-new-fangled thingy called a global economy in which very large (China, India) population centers are growing rapidly in wealth and, thus, consumer demand. If we need to remind you which country is king at developing and delivering products for consumers, first go to your local supermarket and count the varieties of potato chips available, then move up the value-added chain and browse the Apple Store. And that’s just consumer products. Where else does one find the likes of Caterpillar, IBM, Boeing, etc., all of whom produce things growing economies need? Rising global demand for the diversified base of US products, we believe, is a much more robust and sustainable underpinning to future domestic earnings growth than a new distribution and information system. That underpinning will give us higher US company earnings over the next decade and for multiple expansion on those earnings, all we need is for folks like Dr. Roubini to recognize it.

Ramblings of a Portfolio Manager 10-19-2009

Ramblings of a Portfolio Manager or You have to take the bitter with the sweet -Diana Ross

Well the “most crucial earnings season in decades” went into full swing last week, largely following the pattern we predicted. That is, technology, having become part of the whisper number gang, performed like any high expectation, momentum driven group and sold off on earnings reports--even when the reports (and guidance) surpassed expectations. Banks and financials, solidly in the low expectations camp, didn’t disappoint in their ability to disappoint and, so, also sold off on in-line to worse than expected news. Uh-oh? Summarizing earnings season to date, then, we’ve gotten some really good reports that resulted in a sell-off and some so-so reports that also ended up with profit taking. Have stocks truly run too far ahead of fundamentals and are their reactions signaling the end of the bull-run, as so many bears have predicted? We remain unconcerned for now as a little profit-taking is a necessary function of a healthy market. Frankly, we are less concerned with the implications of the reaction to earnings reports than with what the reports themselves are saying.

In our humble opinion, this earnings season is already over in terms of economic signaling. Now, consultants and anyone else trained in statistics and nothing else will criticize our sample size, conclusions and extrapolations. Fine--we like it here on the other side--but hear us out. So far this bull-run has demonstrated an almost classic pattern. That is, early cycle stocks like technology, transports and even some financials have led the way off the bottom. We say “almost” because many mid to late cycle stocks such as producer durables and basic materials have also been strong leaders (we wont even touch gold) while some traditional early cycle sectors like consumer cyclicals (principally retailers and many bank and non-bank financials) have been laggards. All this, however, is quite explainable given the weakness in the US dollar. Early cycle technology and late cycle producer durable manufacturers share one common trait—they are, largely, multinational exporters. The weak US dollar has made their products more attractive overseas and sales are expected to follow. Similarly, dollar-denominated commodities like oil, precious and industrial metals (mid-late cycle) have also benefited from the greenback’s weakness and stocks in those sectors have also been market leaders in anticipation of greater global sales. Missing from this entire equation are the early-cycle consumer cyclicals—specifically, retailers and, to a large degree, non-bank and regional-bank financials. To be sure these two sectors have performed well off the bottom but they have lagged the later-cycle groups significantly of late. The reason is simple. These sectors are pegged more to domestic than international growth.

This earnings season, so far, is demonstrating the implications of that narrow dependence. Management at Intel, IBM, Alcoa and Caterpillar, all multinational industrials, had good things to say about the quarter past and those to come. Citibank, BofA and American Express Management were less sanguine. Though they have a good deal of international exposure, their domestic consumer franchises are holding them back--and with 70% of our domestic GDP tied to the consumer and unemployment nearing 10%, that is hardly a surprise. One thing we do agree on with the pundits is that employment is a lagging indicator so expect regional banks and consumer finance companies to say much the same things over the coming weeks. We anticipate more of the same as the reports roll in and so, from our point of view, this earnings season has already said all it needs to about the health and direction of the economy. Regardless of what market reaction we receive during and following this earnings season we are more concerned with a set of data points further down the road…specifically, Black Friday and beyond. That, more than “the most crucial earnings season in decades,” will be a bigger “tell” on whether that lagging indicator will continue to be a drag on earnings and whether we have, in fact, come too far too fast.

Ramblings of a Portfolio Manager 10-12-2009

Ramblings of a Portfolio Manager or Sometimes it pays to be a fish

When at a loss for words, just add superlatives. That’s what CNBC is doing this month. Having already declared last earnings season the “most important ever” it has found itself needing to one-up its own pronouncements for the third quarter. So now we have the “most crucial earnings season in history” before us. To avoid embarrassment to the anchors, they aren’t even allowed to refer to it as such. Instead, “Jay in the booth” makes the announcement during commercial breaks. Lampooning all this is way too much of a lay-up so we’re not going there this week.

Instead, we thought we would take the opportunity to talk about what we are doing amid the media’s Halloween Hysteria. We’ve rambled about analyst expectations and media hype for several months now so a fair question to ask is how we are positioning ourselves. Our philosophy has always been to sell hype, buy pessimism. But before you dub us contrarians, realize that we’ve been in this business for over 25 years now and, perhaps, that means we’ve (hopefully) learned a few things. To use an allegory, we recognize that salmon swimming upstream strengthens the breed and ensures the perpetuation of the species--but we also recognize that only a very small percentage of the fish embarking on the journey actually live to achieve their goal. Remaining at sea, they would all survive the year but would eventually become extinct. John Maynard Keynes said it another way—the market can stay irrational a lot longer than you can stay solvent. No investment discipline (discipline being the operative word), rigorously applied, works in all market environments. So, using a mixed metaphor, even though following the herd too long often leads you off the cliff, there are times when you need to swim with the current. Flexibility is the key to survival in this business.

In the last 10 months the market has gone from extreme pessimism, to moderate doubt, to mild optimism. We responded, using the animal analogy, by starting off as salmon (not an easy thing to do, especially when at least one client called on March 6th to lambaste us for having ANY exposure to equities). This strategy unintentionally evolved us into herd animals as the market caught up to where we already were. Now, however, we are intentionally devolving ourselves back to the fish. In investment terms, early this year we recognized the extreme pessimism and bought the out of favor, low expectation cyclical stocks while everyone else favored the defensive and higher expectation growth names. As this strategy began to pay off we stuck with it, knowingly swimming with the current, as we believed that the levels of pessimism, although abating, were still quite high meaning our strategy had room to go. Now that we have returned to whisper numbers and analysts expecting companies to “beat expectations,” we are concentrating again on low expectation stocks. This doesn’t mean we have gone defensive—we believe that those stocks themselves have high expectations –but rather are lessening our exposure to technology and soft-cyclicals that have appreciated significantly over the past several months. We still think cyclical and commodity stocks, despite their recent run, still have very low expectations and will be given a “pass” on their earnings reports and so remain there. Technology, on the other hand, is fully within the whisper number realm and we are treating them with caution.

And for those who think China is a fraud (we get those calls too), we have increased our exposure to that part of the world, especially as their market has pulled back. Just remember that there are 3 times more Chinese than there are of us. So even if they were to eat, drive or yap on the cell phone 1/3rd as much as we do they would be, as a consumer group, equal to us. And their aspiration is to emulate us. Think about the potential growth ahead.

Ramblings of a Portfolio Manager 10-2-2009

Ramblings of a Portfolio Manager or Blame it on Rio.

The American Heartland was dealt a psychological blow last week when the IOC eliminated Chicago in the first round for consideration for the 2016 Summer Olympics. The winner, Rio de Janeiro, will become the first country in South America to host an Olympiad.

While the IOC ostensibly chose a Latin American country due to the dearth of Olympic games held in that part of the Southern Hemisphere, it strikes us as a little more than coincidental that each Summer Olympic venue chosen over the last several decades has tended to be where the economic action was occurring (2004 excepted, with Athens being a nostalgic choice). Sydney in 2000 in many ways signaled the passing of the economic growth torch from the US to Asia. Likewise, Beijing 2008 symbolized the rise of China in international economic status. So now we have Rio. Is Brazil where the economic now action lies? Well, the Bovespa is up 63% year-to-date versus, a paltry 8.1% for the Dow Jones (last year they were down similarly at 39% and 32% respectively). There is a not-so-subtle irony in Chicago’s loss to Rio. Barely three decades ago, Latin America was known as the deadbeat of the world. Over leveraged and unable to repay the mountains of debt piled up during their industrial and infrastructure growth phases, Brazil, Argentina, Mexico, Chile and other commodity-dependent South American countries threatened to topple the world’s (particularly US) banks. Lending was cut off and their economies sunk into recession. Any of this sound familiar?

Fast-forward 25 years and Latin America looks to be the hot place to invest (and play Olympic beach volleyball). How did this happen? A combination of sovereign debt forgiveness, currency devaluation and strong (commodity-based) economic growth, which helped the region catch up to their debt payment burden. A resumption of lending by international banks contributed to that strong economic growth. So now that the US is piling on huge amounts of debt is there a potential historical parallel? Perhaps. But it is important to remember that in the early 80’s the Latin American “deadbeats” were (and still are) emerging economies with much of their economic potential still ahead of them, leaving them headroom to outgrow their troubles. The US in 2009, by contrast, is a very mature economy with a population growth near zero. While productivity gains and technological innovation may yet contribute to positive GDP gains here, it’s going to take some significant growth to catch up to the obligations we are now incurring. As Speedy Gonzales would say, Arriba! Andale!