Spring 2014 – Newsletter

Last month I went to Las Vegas with three guys I grew up with in New York to maintain bonds built 35 years ago on stickball games and good pizza. It was an odd destination because I don’t gamble, but after doing some research on the plane I realized that Craps gives players the best odds in the house, allowing them to hedge their bets and limit the bleeding.My friends got slaughtered at the Black Jack table; I paid for dinner.

If you’ve seen the movie Wolf of Wall Street, I can testify to the environment in lower Manhattan during the early 1990’s, having sold stocks over the phone across the street from the World Trade Center. When a prospect said “I don’t like the stock market”, we’d reply “I don’t buy the market, I buy stocks” and then ask for the order.

This makes sense in theory, but not always in practice. On April 10th, the Premier of China made clear in a speech that despite the decline of imports, he would not implement a new stimulus plan. In other words, China has no intention of mimicking the antics of the Federal Reserve and its funny money to satisfy lobbyists, poll numbers and Chinese banks in need of capital.

Please note, however, that if the Chinese banking system lacks liquidity, they’re likely to dump U.S stocks as they did in June 2013 and January 2014 to free up cash when we experienced a pullback. What’s the point? The S&P 500 and NASDAQ dropped by 2% and 3% respectively just hours after these latest comments were made.

So while it is a true statement that I buy stocks and not the market, macro-economic conditions impact good companies, even if it is often temporary. Natural gas is half as expensive in the U.S. as compared to Europe (and one-third of the price in Asia), they’re widening the Panama Canal so natural gas barges can pass through for exports and the U.S. is currently the largest natural gas manufacturer in the world (not Russia).

graph3Moreover, 70 percent of crude oil from North Dakota is transported by rail, which is more expensive and dangerous than a pipeline. As one might imagine, there are companies that store and transport oil and natural gas (and I would name them if my compliance department didn’t prohibit me from doing so), but they also took a hit when the broader market was under pressure.

diagram2Stock buybacks are another macro-economic phenomenon that has pushed the markets higher. Since the beginning of 2005, companies have bought back $4.21 trillion of their own stock, which is nearly one-fifth of the total value of all U.S. stocks today. Here’s the catch, the money they spent on buybacks could have been invested in research and development.

Stock buybacks sound good until they don’t. There are 6 billion cell phone users in the world and 80 percent of Chinese consumers use the antiquated 2G network. I don’t mean to put words in the mouths of investors, but they’re probably satisfied if they own a company that spent money building the 3G, 4G and LTE networks, as opposed to buying back shares of the firm, especially since the ensuing royalties from these platforms generate a significant amount of revenue.

I remember my mother telling me to get off the phone because she was expecting a phone call (call waiting had yet to be invented). Nowadays, Walmart executes 1 million customer transactions every hour and that data is the equivalent of 167 times all of the books in the Library of Congress.

If you’ve ever been on a web site and seen an advertisement from a company you just patronized, it’s because data is being mined to predict outcomes and forecast events. Companies who develop these and other technologies may ultimately prosper in a world that has more cell phones than toilets. Nevertheless, they recently stumbled along with many of their high tech brethren.

Naturally, there are numerous industries with attractive participants. Despite the uproar behind the Affordable Care Act, over 8 million people have purchased private health insurance since October and 80-90 percent have paid their first premium. Well, somebody had to sell them that policy.

graph4I’m not allowed to buy my own clothes any more, Carole claims I’ve lost my touch, but I still go to the department stores and ask what’s selling and why. The next time you meet somebody in a particular line of work, ask them about a related company in your portfolio and gage their reaction. As the economy recovers, some enterprises will inevitably do better than others, and identifying those opportunities is no small feat.
At the same time, the obligations of the United States have continued to increase at a rate that will be unsustainable. Should interest rates rise faster than forecasted, interest payments on our debt, which now represent six percent of the national budget, would require cuts to entitlement programs, military spending and generous tax benefits Americans take for granted.

To compound the problem, many of the technologies mentioned earlier puts low skilled labor out of work, which in turn reduces tax revenue, slows the economy and demands more social services from strained local budgets. While the unemployment rate has declined, the number of people who are no longer counted once they stopped receiving benefits brings the true number closer to 13 percent.

Fortunately, the jobs lost to antiquated responsibilities may be replaced by the need for skilled workers. For instance, the number of U.S. energy-related jobs is expected to nearly double to 3 million by 2020. And why not, the Interstate Natural Gas Association of America said North America’s shale revolution will require a cumulative $30-billion-a-yearin investment through 2035.

Young workers who borrowed six-figures to major in sociology might not capitalize, but one-third of manufacturing workers are between 55 and 64 years old and starting to look toward retirement. And these aren’t low paying jobs – the American Welding Society estimates that by 2020 there will be a shortage of 290,000 professionals, including inspectors, engineers, and teachers.

graph5We could be the midst of creative destruction, an economic concept that describes old industries being replaced by newer business models. Yesterday’s buggy whip maker might be today’s lap top manufacturer. It’s a painful transition for workers, but a process that will likely be repeated with greater frequency.

Environmental concerns notwithstanding, this is the silver lining of it all. We may very well have an exportable asset the rest of the world needs which will create well-paying jobs, wealthier consumers, more revenue for Uncle Sam and industries that don’t currently exist. Crazier things have happened – the internet comes to mind.
So with all that said, now that China’s turning an increasingly blind eye to money backed by nothing of value, the stock buyback gravy train losing steam (buybacks in the first quarter of 2014 fell to their lowest in five quarters) and the Federal Reserve reducing Quantitative Easing by $10 billion a month, what’s one to do? After all, nobody doubts that the ride will be bumpy.

My crystal ball was confiscated in 2008, later returned to me and then confiscated once again. It’s a long story. What I do believe is that owning forward thinking companies with strong financials over a long period of time (with reasonable valuations) is better than owning something that mirrors the market, and that coupled with appropriate hedging strategies, should go a long way in helping investors reach their milestones.

At least that’s my theory.

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1 China says no major stimulus planned; March trade weak; Reuters; 4/10/14
2 Key Trends Impacting Natural Gas Prices In The U.S.; Forbes; 1/2/14
3 Panama Canal Expansion Can Help US LNG Producers In Exporting To Asian Markets: Federal Maritime
Commission; International Business Times; 9/20/13
4 Move over, Russia: U.S. is now the world’s biggest oil and gas producer; Market Watch; 10/14/13 5 Investors flock to energy partnerships in new shale play; CNBC; 4/3/14
6 Will Stock Buybacks Bite Back?; Wall Street Journal; 3/21/14
7 More People Have Cell Phones Than Toilets, U.N. Study Shows; Time Magazine; 3/25/13
8 Obamacare Enrollment Hits 8 Million; Time Magazine; 4/17/14
9 Insurers: Most new enrollees have paid health premiums; USA Today; 5/7/14 10 Chart of the Day: The real unemployment rate?; CNBC; 1/10/14
11 Energy companies lament skills gap as ‘crisis’ festers; CNBC; 5/8/14
12 Investors flock to energy partnerships in new shale play; CNBC; 4/3/14
13 The coming brain drain in U.S. manufacturing; Fortune; 11/5/2013
14 Welders, America Needs You; Bloomberg; 3/20/14
15 Fall in buybacks could signal S&P pause; CNBC; 3/31/14