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May 22, 2016 Individual Stocks

Treading Water – May 22, 2016

After a deep dive early in the year, followed by a rebound into the black, stocks have slipped back to near even on the year, with some indices in the black and others now in the red.

The stock market is starting to resemble the economy, in that while it is generally holding on, there is little forward momentum and every step forward seems to be followed by one backwards.  Investors seem to lack conviction and are easily spooked by the Fed, slight changes in earnings outlooks or news from China.

While underlying market fundamentals still seem solid, i.e. valuations, rising dividends, interest rates, inflation and profits, money continues to leave stocks for other waters. For reasons that are not always entirely clear, investors around the world remain very risk averse and prefer cash or bonds to stocks.

We’ve also seen some forced selling by hedge funds as investors pull money out of the big funds that have seen significant losses this year due to concentrated holdings in poorly performing stocks.  Stock in Valeant (VRX) has become the poster child for everything wrong with hedge funds, as many of them adopted overlapping strategies which included holding a large chunk of their investment funds in this one stock.

Valeant seemed to say all the right things, and by reporting what appeared to be strong growth, few questioned the nature of it and the stock become a hedge fund and analyst darling. However, while we were not so prescient to see it’s collapse coming, our analysis of the stock last year and in years past quickly showed the company to be a financial and accounting quagmire, one that was not suitable for investment.  We prefer not to buy on blind faith!

Finally, questions started to be raised about their operating and financial structure last year, and as problems started to leak out, the stock collapsed, down 90% since last August and 75% this year alone.

The collapse of Valeant – a stock with a market value of $100 billion at its peak – is a stark reminder of why we diversify.  While we all wish that the portfolios were highly concentrated in the stocks which turn out to be the best performers (unfortunately we can’t glean this information beforehand!) diversification is critical for avoiding a situation where a disaster in one stock would have a huge impact on our portfolios.  As we have said many times in the past, investing is a marathon, not a sprint, and the long term profits accrue to those of us who can stay in the market for long periods of time, not those who take Vegas like risks hoping to secure a fortune overnight.

As we near the halfway point of 2016, what might cause stocks to break out of their funk?

For one, a modest improvement in the economy could create an uptick in interest rates, and cause some money to leave bonds for greener pastures.

We also think simply that the passage of time relative to the 2008 meltdown should start to leave room for investors to start returning to stocks, as participation in the market is now at relatively low levels.  Only 52% of adults now participate in the stock market, the lowest in at least 20 years.

Fundamentally, we have finally seen some easing in the dollar’s surge, and while the weaker dollar is off its lows it is still down a few % which takes some pain off earnings coming from overseas. And with inflation up and rates flat, monetary policy is somewhat more accommodating.

Within portfolios, we are adding stocks with good and growing dividend yields, and we have been adding a small bit of emerging market exposure as those markets have now lagged for almost ten years.  We are also sticking with our focus on identifying specific companies which have unique and attractive characteristics rather than place bets on specific economic sectors or the direction of the economy as a whole.

We have added, where appropriate, positions in AT&T, Kimberly Clark de Mexico, Independent Alliance Bank, Danaher and Bristol Myers.  All these stocks, with the exception of Danaher, have above average dividend yields and a record of regular increases.  AT&T is seeing its earnings show modest growth from wireless and its satellite TV division, not to mention successfully bundling wireless, TV and phone service.  With a yield of about 5%, we have a hard time imagining how this stock won’t outperform bonds which yield roughly half as much.    Kimberly Clark de Mexico essentially is the Mexican arm of U.S. parent Kimberly Clark, and with Mexican incomes on the rise and household formation much faster than here, we expect demand for their household products should continue to rise at a good pace.

Independent Alliance is a small Indiana bank trading at a big discounted valuation with a 3%+ yield, and a strong balance sheet.  Bristol Myers has one of the fastest growing cancer drugs on the market, and is seeing industry leading sales growth.  And finally, Danaher (DHR) is in process of splitting the company into two parts, one (to remain Danaher) focused on markets such as dental products, water treatment and food safety, while the other (to be named Fortive) will be focused on industrial products and professional tools. At this time we have not determined if we will hold shares in both companies, or concentrate holdings in the surviving Danaher.

In summary, the financial markets are well into their second year in a row of anemic returns, something no investor welcomes.  While investors in diversified portfolios focused on the U.S. markets, such as ourselves, have avoided the big problems associated with some other markets and hedge funds, the big downturn in commodities and the bankruptcies going through the oil patch, that does not entirely compensate for the trading range market we are in. Still, as noted above, we do feel that many stocks represent good value, and there are potential catalysts in place which could improve the market performance, both reasons to remain patient.

March 18, 2016 Individual Stocks, Mutual Funds

The Disconnect Between Main Street and Wall Street – March 18, 2016

2016 has started off on two separate paths.  Economically, things seem to be still moving forward at a moderate pace – we’ve now had a record 72 straight months of employment gains – and all signs point to continued growth.  Consumer confidence remains elevated, job growth is consistent, corporate profits outside the troubled energy sector are solid, interest rates remain low and consumers are spending on their homes, helped by a huge drop in gasoline prices.  In fact, the estimated global savings from the drop in oil is estimated to be $1.5 trillion.

On Wall Street, however, manic behavior continues to rule the day.  The year started out a very negative note and stocks sank, only to reverse trend when investors realized ala Chicken Little it was a pine cone not the sky that was falling.

This is not to say there aren’t any important issues for the markets to contend with, but rather that they seem focused in certain areas, not the market as a whole.

For instance:

  • Many speculative biotech and internet stocks seemed to be rising on nothing but hot air last year, but when faced with a few doses of reality have come crashing down to earth, with many showing losses of 50% just this year.

  • Oil prices seemed immune to soaring production, until suddenly they were not, which sent prices crumbling until recently stabilizing as wells are shut down.

  • Dozens of privately held companies with little or so in sales were valued at over $1 billion – called Unicorns – until suddenly investors have realized it was a bit of the greater fool theory, which has sent the values of many private companies sinking back to earth.

  • Investors have ignored the negative impact of excessive issuance of stocks options (discussed in our last July letter on Watered Stock) for years, only to suddenly realize they are a factor to contend with, as witnessed by LinkedIn’s recent one day decline of roughly 50% and questions about Twitter’s excessive use of options contributing to its 50% drop over the past several months.

  • Rising losses in the oil patch were certain to cause big losses for banks lending to many speculative oil companies, but it wasn’t until early this year that banks and investors suddenly paid attention, sending many of the related stocks sinking.

Within portfolios we are focused on sticking with disciplines and on identifying opportunities to buy (or sell) during the market’s manic up and down moves that often bear little if any relation to the underlying fundamentals.

Generally speaking, we continue to believe that stocks look attractive both on their own and relative to the record low interest rates now being paid on bonds.   Over the past 15 years, despite solid earnings and dividend growth, stocks have returned on average less than 5% per year, as valuations shrank by a third or more from their very inflated 1999/2000 levels.  Now that valuations are closer to historical averages, we believe stock returns over the subsequent decade are more likely to match the projected growth in earnings of 5-7% plus 2%-3% dividends, leading to a total return which looks much higher than bonds.

In summary, 2016 is starting off as yet another year when the market acts much more manic than the underlying economic fundamentals would suggest.  This is further evidence that the day to day market action is fairly meaningless for long term investors, especially when the positive outlook for economic growth is taken into consideration.

January 18, 2016 Individual Stocks

Market & Portfolio Update – January 18, 2016

The market correction to start 2016 is certainly a severe one, but it is not uncommon for the market to suffer setbacks of this magnitude in a short time period.  Over the past ten years there have been at least 12 one month drops greater than 5%, indicating an average of over one per year.

As we have often discussed, there are two types of market downdrafts.  The first type is clearly related to specific economic conditions changing quickly for the worse, such as in 2000 or 2008.

The other type of correction is when stocks get hit for reasons that are more psychological in nature, in that investors adopt a negative view towards the markets based upon at least partially misplaced fears about some extraneous event.  In recent years we’ve seen big but temporary drops related to Greece, government shutdowns, Fed actions, hedge fund collapses, war news, etc.

So what seems to be going on this year?  We think this correction reflects a bit of both types of correction.  On the economic front we have a bit of a mixed situation.  On one hand economic news here in the U.S. and in Europe is generally okay and stable, with employment growth at a good pace and consumer spending growing, albeit at a very modest pace especially given the drop in gasoline prices.  On the other hand there is no question that the big drop in oil and gas prices is playing havoc on an economic sector that was previously creating jobs, and also leading to a severe drop in coal demand, which is also pressuring many industries and causing some job losses.

On the psychological front, investors seem overly caught up in the daily market action of the relatively modest sized Chinese stock market and changes in oil prices.  In addition, hedge funds had a weak 2015 and may be selling to raise cash for redemptions.  And finally, with Fed policy having now reversed, investors may be repositioning investments in light of the changes.

From a money flow perspective, selling begets selling and thus investors are liquidating their stock funds and that adds pressure to the market, and thus not surprisingly investor sentiment – often a contrarian indicator – has reached levels of negativity not seen since 2009.

Our viewpoint at this time is that investors should hold tight and in those situations where new funds are being allocated to stocks we are comfortable buying on weakness….  Long term investors have the opportunity to add to stocks at levels which appear very attractive.

It is also worth reminding ourselves of one of the key reasons to buy and hold stocks.  In the long run we know that stocks significantly outperform other financial assets such as bonds, in dramatic fashion.  But in the short term, even as short as five years, stocks can be rocky and volatile.  Yet, over shorter time periods there is one benefit to stocks that is not related to the ups and downs of prices; that is the income they generate.

Just over the past few years, since 2010, the income generated by the typical Tower View stock portfolio has grown about 50%.  In contrast, the income generated by a 5-year bond has been falling and has been lower than stock yields for some time.  Today, a buyer of a diversified portfolio of dividend stocks will earn a yield at least as high as the 10-year Treasury, and could see income double over the next ten years, while the bond portfolio will generate flat income.  The cumulative difference is at least 40% higher income over the decade from stocks, not to mention the fact that stock dividends are taxed at a lower rate than interest income.

Thus, while we all of course would prefer a stock market that only went up, the reality is of course much different.  But, over time, the steady growth in the income stream from a stock portfolio is what will eventually play a key component in funding our future retirement, and in many cases is just as important if not more important than the short to intermediate term performance of stocks.

One of the ways we work to generate this rising income stream is by buying financially strong companies with a long record of dividend increases.  In fact, we can recall only one stock we have held over the entire history of Tower View which cut its dividend.  The norm is steady increases.  By avoiding overly cyclical or financially stretched companies we avoid troubling dividend cuts.

Moreover, at the moment, not only are we continuing to see good dividend news at our holdings but valuations are now increasingly attractive.  Gilead, Southwest, CBS, Apple, Anthem and Union Pacific are all about 12x earnings or less.  The dividend yields are also getting more attractive, in part of course due to lower prices but also because of the aforementioned dividend hikes.  Pepsi, General Mills, Union Pacific, Nestle, Kimberly, United Technologies and Amgen are all yielding about 3%, which is 50% or more than the current 10-year Treasury bond.

In summary, while the correction is rough going, we can take comfort that we don’t own positions in heavily indebted companies – especially in the cyclical and commodity areas – that might never come back, so we don’t want to panic.  At the end of the day… Will the world’s economies keep moving forward albeit at a modest pace? Will American companies remain innovative? Are valuations reasonable? Will stocks i.e. equity be a good place for your money longer term?  Our answers remain Yes to all those questions.

January 10, 2016 Individual Stocks

Rocky Start To The Year- January 10, 2016

We’ve barely had time to  turn the calendar to 2016 and already investors have been confronted with the worst start to year in the stock market in history, with the market down over 5% in the first week.

While certain factors are being pointed to as the cause – China’s economic and market woes, the Korean nuclear test, a further decline in oil prices – none really well explain a decline of this magnitude.  Stocks couldn’t even regain their footing after Friday’s better than expected job growth figures were released.

As we’ve often stated in the past, predicting or understanding short term market moves is essentially impossible, and in this case we don’t want to read too much into the market drop.  As we work through the rest of January we will get our first read on the outlook for the 2016’s corporate profits, and this might help the market find direction.

With the market selling off, we have used the weakness as an opportunity to add to our holdings at these attractive prices.

We have added to positions in small and mid-cap funds, as well as Apple, Disney, Southwest Air and CBS, where appropriate and where there was available cash.

We also started new positions in Berkshire Hathaway (BRKB, $129) and Modelez (MDLZ, $43).

Berkshire is of course the diversified company founded by Warren Buffett in the 1960s. The stock has recently come down in price, and now trades at a level we believe undervalues both the assets and earnings power of the company.  While Buffett’s age is always on investor’s minds, we believe BRK has many talented individuals on board which can keep the company moving forward well after he retires.  BRK is a well diversified company with significant earnings in the rail, utility, financial and consumer markets and a future share repurchase program and/or a dividend is a possibility.

Mondelez is part of the old Kraft Foods, and is focused on snack food (Oreos, Cadbury, Trident, Halls, etc) sales around the world.  MDLZ has a strong presence in emerging markets and Europe, and is in the midst of a multi year cost savings program to boost margins following Kraft’s break-up.  We believe MDLZ has potential both as an independent company and as perhaps a merger partner for another food company at some future date.

We also sold positions in Newell (NWL) for a modest profit after they announced intentions to merge with Jarden, another consumer products company.  We felt the merger would greatly change the complexion of the company, making it riskier and harder to analyze, and therefore we wanted to sell now rather than own shares in the new combination.

While recent market action is of course very disconcerting, the long term solid fundamentals of the companies we are invested in has not changed, and with valuations reasonable, inflation and interest rates low and cash levels at mutual funds and pensions at above average levels, the positive case for stocks is unchanged.

November 21, 2015 Individual Stocks

The Three H’s – November 21, 2015

As 2015 comes to a close, all too soon, someone looking at just where we sit today – modest single digit percentage gains – would not have a good sense of just how much volatility has happened below the surface the past eleven months.  2015 has been one of those years when many stocks have made rather extreme movements, both up and down, and earnings related volatility has been on the rise.  Some of this is related to the lack of a clear direction on the economy, looming Fed rate hikes, terrorist attacks, very weak performance at hedge funds and just a general sense of pre-election unease.

Despite all of the above, our portfolios have kept their heads above water despite corrections throughout the year.  Both the consumer and business investment sectors are giving economists and investors headaches, as consumer trends are all over the place and business investment has taken a marked turn downward this year.  The two are related, as businesses are cautious to invest when the end market demand – often related to consumer spending – is so unpredictable.  Moreover, emerging market demand is even weaker for capital goods, putting pressure on many multinationals.

From the consumer side of things, we think have identified a way to explain some of the confusion surrounding how consumers are spending their money.  I’m calling it the “Three H’s:” Health, Homes and Happiness.

Despite anemic new home sales, spending on homes is rising nicely, whether it is for remodeling, upgrades or furnishings.  Health is a broad brush and includes both health care as well as things like yoga classes, fitbits, Apple watches, Nike shoes and healthier food.  And finally, happiness.  For instance, while home sales are soft (who wants to deal with the hassle of moving?), airlines are full of vacationers.  People aren’t buying Harley motorcycles but they are buying boats.  Soda sales keep shrinking, but Starbucks is seeing robust demand around the world.  Apple’s phones are as popular as ever, but apparel sales are soft.  Corona beer is flying off the shelves but Frosted Flakes are going stale.  Consumers love spending time watching Netflix and YouTube, visiting Disney parks and watching NFL games, but they are cutting back on paying $100 a month to cable companies for 100s of channels.

Happiness also includes improving the family finances and financial futures, and we are seeing steady improvement in the savings rate which comes at the expense of excessive consumption.  Historically savings rates were 8-10%, but got as low as 2% in 2005.  The decades long decline in the savings rate has finally reversed and the rate is now holding steady around 5%.

We are doing our best to incorporate the three H’s in to our investments.  Apple, Blackrock, Starbucks, Google, Visa, Constellation (Corona) have been some of our best performers, while stocks related to the capital investment cycle have underperformed.

Analyzing the consumer is often difficult but at this time we think these three H’s offer a helpful insight into how both traditional and the new generation of consumers are spending their money.  These insights can help guide future investment choices.

Within portfolios, we have made some changes over the past month as we look to realize losses before year end and make adjustments we think better position portfolios in light of the increased volatility and global uncertainty we are seeing.

We took some profits in some of our biggest winners, cutting back the positions modestly to reflect their higher valuations.  This includes, where appropriate, AO Smith, Blackrock, Celgene and Starbucks.   Also where appropriate we added to our positions in Wells Fargo warrants, Kroger and CVS, as those stocks look relatively undervalued at this time.

We sold out of small positions in Ambarella, Del Taco and Allergan.  AMBA has seen a key customer’s sales fall off sharply, raising concerns and so we exited the stock at breakeven.  Allergan was sold as the rising chorus of a negative drumbeat against pharmaceutical pricing heading into the election led us to want to reduce our pharma/biotech exposure modestly.  Del was sold as a stop loss discipline.  We also sold what turned out to be an ill timed purchase of Nordstrom.  After a long history of consistent growth, JWN surprised us with a very weak and difficult to explain quarter, and following the stock’s rebound from its post earnings low we sold as there is no longer the conviction needed to build up the small position.  These types of unpleasant situations are fortunately few and far between.  Nevertheless, I believe it is important to stick to disciplines that have worked well over the past few decades, even when faced with a quick about face.

The one new purchase made was Elbit Systems (ESLT, $86).  Elbit is based out of Israel and is a leading provider of high technology products to the defense industry and homeland security forces around the world.  They provide advanced avionics, intelligence, unmanned aircraft and cyber security to governments that are in growing demand as countries around the world deal with the rising and difficult to combat terrorist threats.  ESLT is valued below its American counterparts yet has a strong balance sheet, is seeing solid growth in sales and backlog and has an attractive dividend yield.  We would look to add to positions further on any weakness.