Mixed Signals

Why would that guy on eBay want to sell his ashtray from the old Las Vegas Sands hotel? I don't know, but I bought it. All markets, from eBay to Wall Street, are characterized by participants who want to sell and those who desire to buy, coming together to navigate and negotiate a bid/ask proposition to arrive at a transaction. That is always, by definition, true, but sometimes the differing perspectives of buyer and seller turn out to be downright conundrums. Sometimes the larger economic environment that informs such perspectives is so fraught with conflicting signals that it is almost impossible to discern where the true weight of the evidence lies.

The noted economist Milton Friedman emphasized that "Inflation is always and everywhere a monetary phenomenon..."--another version of this thought being that inflation is caused by too much money chasing too few goods, or money growth that outpaces output growth. Friedman died in 2006, so we can only speculate as to his thoughts about the Federal Reserve's unprecedented monetary stimulus over the past several years. I imagine he would have endorsed it only as a laboratory experiment.So far the results of that experiment have not yielded the expected inflationary outcome, as inflation remains quite low even with all the money sloshing around to chase prices higher.

The yield on the 30-year U.S. Treasury Bond now hovers around record low levels just shy of 2.4%. When the federal government borrows money to finance budget deficits, its activity in the credit markets is said, according to economic theory, to "crowd out" some private borrowing as upward pressure is put on interest rates. That's one reason to raise an eyebrow at the bond market, as interest rates have fallen even as the government continues to borrow. The other eyebrow might go up because record-low long-term interest rates are not what we would expect to see when the economy is expanding.

One explanation for these seeming contradictions is the increasingly global nature of the economy and capital markets. Our government's borrowing doesn't cause interest rates to skyrocket because other governments are more than willing to buy our Treasury bonds. Inflation doesn't tick up because there are plenty of places around the globe where the costs of labor and manufacturing are cheap. And these realities were in place before the price of oil went through the floor. Add to that the fact that yields are even lower around the world, and that the main concern is becoming deflation, not inflation. When central banks used to talk about hitting inflation targets, that usually meant managing monetary policy to bring inflation down--now they are targeting higher inflation, concerned that economies might slip into the deflationary pit.

When Wall Street opened on Tuesday, it appeared that the blizzard that hit New York City had kept all the buyers stranded at home while the sellers had no trouble making their way to Lower Manhattan. The real culprit, though, was an unexpected reported decline in Durable Goods orders, which were expected to be up slightly in December but were actually down 3.4%. Then Caterpillar (CAT, $79.85) chimed in with disappointing earnings and weak outlook, citing its exposure to the energy sector. The strength in the U.S. Dollar is also doing its part to inflict some pain on the multinationals. This serves as a reminder that the energy boom in the U.S. has been a strong driver of economic growth and a source of strength for companies in the manufacturing/industrial sector--and that the downturn will not be limited to those companies strictly classified as belonging to the energy sector.

So, with the Dow Jones Industrial Average down almost 400 points Tuesday morning, was there anything that wasn't collapsing? The shares of Ulta Salon, Cosmetics, and Fragrance (ULTA, $135.84) were managing to eke out a fractional gain amid all the selling in the morning before closing the day down 24 cents. ULTA is a retailer of, as the name suggests, a variety of beauty products across a range of price points--and a company with no international exposure. Did ULTA escape the selling because people in the oil business don't care about looking good and smelling good? I can't speak to that, but what I can say is that ULTA is a growth stock, and its stores offer salon services in addition to the beauty products it sells. It is sort of a luxury spa for the masses--and by that I mean the mass market. The business model is familiar, as Starbucks (SBUX, $88.34) has found success in bringing gourmet coffee to the mass market, and Nike (NKE, $94.50) and Under Armour (UA, $71.96) have grown by bringing performance athletic wear to the masses. This might just be a place where consumers decide to spend the extra cash in their pockets that they saved at the gas pump. Never heard of ULTA? Consider that a plus, or at least an indicator that it has not yet saturated the market.

Analysts like to describe the current U.S. economy as being "the best house in a rotten neighborhood." One has to wonder, though, how long this can last before the world's economic weakness spills onto our shores. Deflation is the scourge of economies and markets, and we should be watching for signs that might indicate whether our own Federal Reserve is starting to worry about contagion. If the Fed ends up NOT raising interest rates this year, that stance could actually be the proverbial canary in the coal mine.

Life is short. Get busy.

Jim

Disclosure/Disclaimer: My family members and/or I own shares of ULTA, SBUX, NKE, and UA. Individual stocks are mentioned here for the sole purpose of illustrating investment concepts, and nothing stated here should be construed as the advice to buy or sell any security. Stock prices are as of the close of regular trading on January 27th, 2015.

The Perpetual Beauty Contest

Most investors understand that investing in stocks is, fundamentally, an instance of ownership. Just as with the ownership of any enterprise, the owner puts his or her capital at risk in return for a claim on the profits. Your investment, whether it is as the sole proprietor of a small shop or as one of many shareholders in a multinational corporation, could turn out to be the next Microsoft (MSFT, $47) or the next Radio Shack (RSH, $0.33)--the potential is theoretically unlimited to the upside, but you could also lose every penny of your capital. Of course, being one of millions of shareholders is different from owning a small business. Just try buying some shares of Tesla (TSLA, $201), and then walking into the corporate headquarters and demanding an audience with Elon Musk. Your persistence might land you in a jail cell. The other difference, though, arises when your shares are publicly traded on a stock exchange, a feature that was captured by famed economist John Maynard Keynes with a brilliant metaphor in his classic work, The General Theory of Employment, Interest, and Money (1936). 

Keynes postulated an imaginary beauty contest, sponsored by a newspaper that published the photographs of 100 women. The paper's readers were then challenged to pick the six most beautiful. The twist here is that those eligible to win the contest are not the pretty ladies in the newspaper--instead, the actual "contestants" are the members of the general public, who are vying against one another to guess which six ladies will garner the most votes. If you were serious about winning this contest, you would have to put aside your own preferences and tastes in beauty and think about what the public at large would find beautiful. You might think that the brunette with the angular facial features was the most striking woman you had ever seen, but if you think that the general public is inclined to favor blondes, you would focus your choices on the ones with the golden hair. The best strategy, Keynes noted, isn’t to pick the faces that are your personal favorites. It is to select those that you think others will think prettiest. Better yet, he said, move to the “third degree” and pick the faces you think that others think that still others think are prettiest. Similarly in speculative markets, he said, you win not by picking the soundest investment, but by picking the investment that others, who are playing the same game, will soon bid up higher.

What is helpful about this analogy is that it reminds us of a basic truth of publicly-traded stocks--they go up only because other people buy them, other people who are big investors and traders thoughtful enough to do their buying after we've done ours. Most investors think that stocks appreciate in value because they have great sales and earnings growth, or at least the potential for such growth. That would seem to be true, but the missing link in that chain of causation is the necessary buying pressure from that big, nebulous population of investors and traders that we'll just refer to as "Wall Street."

Here's an old Wall Street joke that is apropos here. A broker persuades his client to buy 1,000 shares of stock in a promising company, at $5.00 per share. About a week later the stock has risen to $6.00, and the broker calls his client to tell him the good news. The client instructs the broker to buy another 1,000 shares. Then another week goes by and the stock is at $7.00; the client buys another 1,000 shares. The stock keeps going up, and the client keeps buying more shares. Some weeks later the broker calls the client to tell him that his stock has hit $12.00. The client tells the broker to sell all of his shares. The broker replies, "To whom?"

If we think about that bit of humor and the fictional beauty contest too much and for too long, we might never buy another share of stock again. That's because these scenarios remind us that when we buy stock in a publicly-traded company, we are, in essence, placing our financial fate in the hands of other people--Wall Street, that is. But before you become a complete cynic, consider the positive side of all this. Unlike perceptions of physical beauty, which tend to be highly subjective, the financial metrics of companies are much more objective. Those factors such as strong sales, margins, and earnings that make a stock attractive to us also tend to be the same factors that draw the attention of Wall Street--and the big money that provides the buying pressure.

Consider, for example, the case of Palo Alto Networks (PANW, $126), a cyber security company. A year ago (January 2014) PANW was trading at around $61 per share, and anyone who was paying attention to the news knew that hacking and cyber security threats were becoming a big issue. PANW then reported a series of quarterly earnings that beat analysts' estimates, and those Wall Street analysts started raising their earnings estimates and price targets for the stock. Over the course of 2014, the stock continue its move up, ending the year at $122 (up 100%). Many investors were no doubt scared off from the stock due to its high valuation (100 times earnings) and its strong advance. At $90 per share, the stock had already moved up 50%--this probably kept some investors sidelined. But big institutional investors kept buying the stock, and I have to think that part of the reason was their desire to own a problem-solving company that has the potential to be extremely successful in the high-profile area of network security. If you are an aggressive growth investor, you basically live for opportunities like this. Various statistical studies of winning stocks have shown that fundamental strength and growth in sales and earnings, combined with strong technical movement in the stock, are the attributes common to stocks that have outperformed the market significantly over long periods of time. The challenge, of course, is finding the stocks that have staying power as long term winners, as opposed to those of the "flash in the pan" variety. Having a growing addressable market such as the one that PANW faces certainly helps, as more companies spend more on protecting their networks.

While PANW may win the beauty contest, let's stretch the metaphor a bit further. Suppose we have two new entrants in the contest, a couple of beguiling, eye-catching beauties: one wears a sash bearing the name "bonds," and the other wears a sash reading "cash." If investors conclude, for whatever reasons, that there is too much risk in stocks, then bonds and cash may attract more votes. And then it may not matter how enchanting a stock like PANW is, if Wall Street just doesn't want to own stocks. It's hard to imagine that the charms of a near-zero real return in bonds and cash would be compelling enough to take the attention away from fast-growing stocks, but it can definitely happen if Wall Street concludes that a zero return is preferable to a negative one. So, while investors can have success in identifying the fundamental and technical strengths of stocks that will draw the buying power of Wall Street, the task becomes a bit dicier if the big investors pull away from stocks as an asset class.

Let me return to the issue of ownership before I wrap this up. For an example of classic ownership, I have to look no further than my own wife, who owns and operates a retail clothing store (The Pink Door, the Lilly Pulitzer Signature Store here in Memphis). My wife's focus is on increasing sales and keeping control over expenses, which is just another way of saying that she seeks to maximize her profits. At the end of any given business day, she can tell me how her sales came in and how they are tracking with the same period a year ago, and various other metrics of her store's performance. What she never mentions is anything whatsoever about what her business is worth. It isn't that she doesn't care about its worth--she just doesn't plan on selling it anytime in the near future. And, of course, if she maximizes her profits, the value of the business will increase over time. This is how, in economic jargon, she maximizes shareholder (ownership) value--by relentless attention to customer service, smart inventory decisions, marketing and promotions, etc. The point to appreciate here is that when we invest in a stock that doesn't pay dividends, we are entirely dependent on appreciation in the stock price for any return. And that appreciation comes only from other investors buying the stock.

So, as we search for those stocks with the attributes that will appeal to Wall Street, we need to keep an objective approach to the company's fundamentals. We should resist every temptation to fall in love with a "story" that isn't backed up by solid growth and other fundamentals. In other words, when we are judging the beauty contest, it is best to leave the beer goggles at home.

Life is short. Get busy.

Jim

Disclaimer/Disclosure: My family members and/or I own shares of PANW. Individual stocks are mentioned here for the sole purpose of illustrating investment concepts, and nothing stated here should be construed as the advice to buy or sell any security.

Catching The Falling Knife

Six month chart of Schlumberger (SLB)

from Charles Schwab

I have always found it somewhat comical how Wall Street comes up with expressions and metaphors to describe certain events and circumstances in the market, often without some explanation about what the terms are supposed to mean. A "Black Swan" event, for example, refers to some development or crisis that is totally unexpected, out of the blue. That is the experts' way of warning that something really bad could always happen that would roil the markets, but we don't know what that might be or when it might happen. Well, of course that is true. That is also known as "life." More colorful, albeit morbid, is the "Dead Cat Bounce," intended to describe a stock that is in a downtrend but pauses for a temporary move to the upside. Apologies to cat lovers everywhere. The "Risk On" trade is when investors and traders are favoring riskier assets such as stocks; "Risk Off" means they are piling into less risky assets such as Treasury securities. More obvious in meaning is the subject of today's post, timely because investors might be tempted to search for bargain stocks among the ruins of the energy sector. The danger with falling stocks is that they just might keep falling, inflicting a different kind of pain that is no less real than the wound from an ill-timed grasp at that falling knife.

Even someone whose only understanding of Wall Street is from watching Leonardo DiCaprio as the "Wolf" of that storied location probably knows that investing is all about buying low and selling high. So, it would be logical to conclude that a good time to buy energy stocks is when everyone else is throwing them away, that time being about right now. But here we need to understand two qualifiers to the general "buy low" rule. First, just because a stock has declined in price by a significant amount does not make it a bargain. If that $200 shirt you've been eyeing gets marked down to $100, it probably is a bargain, assuming you are going to wear it. (I could point to a few items in my closet that I bought primarily because they were marked down--I never wear them). If I buy the shirt at $100, I'm going to be quite frustrated if I then see it marked down to $50. My sense of having scored a bargain will evaporate quite quickly. At least, though, I have the economic "utility" of a shirt on my back, something that stocks offer only when they go up. Yes, we buy stocks so they will appreciate in value, and that brings us to the second point, a piece of wisdom offered by an analyst on CNBC (can't recall his name): "Valuation in and of itself is not a catalyst." That's important, because it reminds us that the unrelenting question we should ask about any stock is, What is Going to Make This Stock Go Up?

Where the oil stocks are concerned, we strongly suspect that it will take a mighty recovery in the price of oil to lift the shares out of the doldrums. I am amazed at the number of people who seem to think that oil, having fallen more than 50%, has hit its low, and that the risk is that the price per barrel will just languish here. Let's examine that assumption more closely, using the above graph of Schlumberger (SLB, $77) as our point of departure. SLB is the bluest of the blue chips in the oil service sector, and the decline in its share price from $118 to $77 ( about 35%) makes for a tempting investment. Furthermore, the stock pays an annual dividend of $1.60, which at a share price of $80 translates into a 2% yield. Before the stock broke below $80, I considered making the case that $80--and the resulting 2.0% dividend yield--would provide support--the lower the stock price of SLB goes, the higher its dividend yield, something very compelling in a world of rock-bottom interest rates. But that is assuming that business does not get so bad for Schlumberger that they have to cut the dividend. With a dividend payout ratio of just 30% (12 month earnings of $5.32), there is some cushion here, at least for now. But things could get a lot worse for stocks in the oil sector if the price per barrel of the commodity falls even further, as some analysts have suggested it just might, to somewhere around $40.

The economics behind all of this is that oil is a commodity. Unlike Proctor and Gamble (PG, $90), which can slap a brand name on some sodium flouride and call it "Crest toothpaste," the oil companies are faced with a price of oil that is set in the overall market, and no individual company pumping the stuff out of the ground can affect that price (OPEC could, but they have refused to cut production). If you were selling another commodity, say cotton, for example, as a cotton farmer, you would face the same situation. And if the price of cotton falls dramatically, your income would suffer, and you might postpone purchasing that new tractor you've been considering. That's exactly what's going on in the energy sector. The oil companies will not be making as much money, and so their demand for the services of SLB is going to wane. The price of oil has to fall far enough to sideline capital expenditure projects until, at some point, supply comes back into balance with demand. That's just how commodity cycles work. That's what economists call a "new equilibrium," and no one really knows whether that price is $50 or $40 or something lower. And no one knows when this will happen. So we have the issue that oil prices have fallen so much, and we don't know how much further they might fall, and we don't know when they might recover. This paints a pretty ugly picture for the sector, and every enterprise that depends on it.

So, even as consumers enjoy the boost in real income resulting from cheaper energy, there is much carnage unfolding in the energy sector. Some of the marginal operators have issued a lot of debt in the junk bond market, so we might see some dominoes start to fall there. The boost to the economy from lower energy prices is thought to outweigh the negative effects in the energy sector, and that is probably true if the deflationary pressures don't spread too far and wide. I am just thankful that I don't own a truck stop in the North Dakota oil fields.

Life is short. Get busy.

Jim 

Disclosure/ Disclaimer: My family members and/or I own shares of SLB and PG. Individual stocks are mentioned here for the sole purpose of illustrating investment concepts, and nothing stated here should be construed as the advice to buy or sell any security.

Reading The Tea Leaves For 2015

I have never been one to make a lot of predictions, but I do believe it is both helpful and important to gather up our observations and apply our brain power to developing a picture of what the world is likely to look like in the future. The trends, themes, and "facts on the ground" that have informed our investment strategies do not obey the rules of the calendar, so turning the page to 2015 really provides us an opportunity to assess our game plan, rather than some signal to make major changes because the world has changed with the dropping of the ball in Times Square. So, here we go with some thoughts for the New Year.

As I have written previously, in order for the stock market to continue to do well, it will have to make the transition from being driven by higher price/earnings (P/E) ratios to being driven by higher earnings. The Federal Reserve's unprecedented monetary stimulus has kept interest rates at extremely low levels, and this has inflated P/E ratios as investors are willing to pay more for each dollar of future earnings. The Fed has stated that it will be watching the employment situation very closely in determining when to start raising interest rates. So, when we have seen much better than expected jobs numbers, the market has tended to sell off. This is the stock market in full-blown "Good news is bad news" mode. So, the Fed has already taken away the proverbial punch bowl of Quantitative Easing, and the next step will be the first in a round of interest hikes. The good news is that this will (we would assume) accompany a stronger economy that is producing more jobs and improved corporate earnings. That transition, though, is likely to give investors a very bumpy ride.

As I wrote in the last post, I am leaning toward the stronger economy thesis, and that could make the Consumer Discretionary sector an area worth our attention. My goal, though, is to find stocks that stand to benefit from long-term, secular trends; a stronger economy is just an added tailwind for those stocks. In fact, three of the stocks I mentioned last time--VISA (V, $259), Mastercard (MA, $84), and FedEx (FDX, $171)--are not even in the Consumer Discretionary sector, but do stand to benefit from a more robust economy (as well as from the longer term trends we considered). The fact that Disney (DIS, $93) had to turn away Christmas visitors to its Magic Kingdom in Orlando and Disneyland in California because the theme parks had reached maximum capacity is not, by itself, the basis for an investment, but there is a lot more to like about the company. ESPN, arguably, is the most important piece of Disney's business, with sporting events fast becoming the last remnant of watching live television broadcasts. And it is now less than a year until the release of the new Star Wars movie. Does it really make sense that Apple (AAPL, $108), with a market capitalization of $647 billion, is worth four times more than DIS (market capitalization of $160 billion)? This is not a knock against AAPL, which has developed the most ubiquitous piece of technology on the planet, the iPhone (if you don't believe that, just try having a conversation with someone who is incessantly checking their text messages). But DIS has Luke Skywalker, Mickey Mouse, the Marvel characters, Frozen, ESPN, and ABC all under its roof. That's quite a collection of assets, and while any movie studio can make an animated or live-action feature, only Disney can cast what are now Disney characters in films--and market them as toys, games, stuffed animals, etc. I have recently discovered that our grandson, whose favorite character has been Thomas the Train, is now a huge Mickey Mouse fan. So, I'll raise a glass to Mickey and live football games. Pass the Skittles and the Ro-Tel, please.

The organic orgy of healthier eating continues, even as I continue to enjoy one of my favorite comfort foods, the chili and tamales from Huey's here in Memphis. It's worth noting that long-time favorite holding Whole Foods Market (WFM, $50) is down 12% over the past year while Kroger (KR, $63) was up 61%. The latter seems to be doing everything right, while the former has suffered from the curse of familiarity and high expectations.  WFM is actually up about 30% over the past three months after hitting a low of $36 in the summer, and while the stock may not return to its glory days, it still has room to grow. Two companies that make the healthier stuff are  Hain Celestial (HAIN, $55; recently split two-for-one) and Whitewave Foods (WWAV, $34).

On the subject of health, pharmacy chain CVS has quit selling cigarettes and re-branded itself as CVS Health. I guess it doesn't make sense for the cashier to ask if you'd like a pack of Marlboro Reds to go with that Z-Pak prescription as you're coughing on all of the other customers in line. This is probably the future of health care, with nurse practitioners staffing the CVS walk-in Minute Clinic. I have some friends who visited their local CVS Minute Clinic when they came down with the flu, and I expect this to be a continuing trend. Another thing about CVS Health (CVS, $95) that I like is its strong dividend history--dividend growth, to be specific, an average annual dividend growth of 10% over the past twelve years. Although the yield is only about 1.4%, I much prefer dividend growth over high current yield. CVS pays out just 34% of earnings in dividends and is rated A+ by S&P.

Most people, it would seem, have devoted a majority of their attention to either loving or hating the Affordable Care Act (ACA, or "Obamacare"), and very little attention to figuring out what it actually means for the health care system. What it should mean is that more people in the population will have health insurance--and fewer people uninsured. For companies that deliver healthcare, that should mean more paying customers (even if it is the insurance doing the paying). A company such as HCA Holdings (HCA, $73), which operates hospitals and surgery centers, could see its bottom line enhanced by having fewer patients who can't pay. The problem, though, is that reimbursement issues could offset some of those positive effects. How it will all shake out is still somewhat murky,but the ACA is one of those "facts on the ground," and whether we love it or hate it, we need to watch closely for how it might affect our investments.

The ACA aside, there are other enduring trends and themes in healthcare that we have considered before. Reducing costs in the system is one of them, and  that is why the generic drug companies continue to look interesting. We first looked at Actavis (ACT, $260) when it was known as Watson Pharmaceuticals, and the stock has had a stellar run since then. Shares are up some 300% over the past three years. Now it appears that ACT has beat out Valeant Pharmaceuticals (VRX, $144) in the bidding for Allergan (AGN, $212), the maker of Botox. While I would never recommend buying a stock on takeover speculation alone, I do suspect that a number of these specialty drug companies could be attractive acquisition candidates.

In future posts we'll continue to look at any number of stocks that should benefit from a stronger economy and improved incomes. A note of caution about the market here, though. Many of the stocks mentioned here have appreciated sharply over the course of this bull market, and they may be the very ones to fall the hardest in a meaningful sell-off. It is always important to view our money invested in stocks as being needed only for some distant tomorrow--that is, we shouldn't need those funds for at least three to five years. That allows us to take market declines in stride, without having to reach for the antacid. This long time horizon actually gives individual investors an edge, because we can sit tight while others panic. Things may get unpleasant, but they don't have to be deadly. And just how unpleasant could they get? Well, it is not unusual for the market to correct by 10% to 15% in the course of an ongoing bull market. A  15% decline in the Dow Jones Industrial Average from its recent high of around 18,000 would put the index just above 15,000. That would make some headlines. The market has started off 2015 with a bang, but the bang is a move down, so far. These may be some transitional labor pains, leading to the birth of a new market that is driven by a more robust economy and an improved employment picture that can break free of the midwife of Federal Reserve stimulus. And who doesn't hope for a healthy baby?

Life is short. Get busy. And Happy New Year!

Jim

Please post any comments or questions to the Comments section.

Disclosure/Disclaimer: My family members and/or I own shares of V, MA, FDX, DIS, AAPL, WFM, HAIN, WWAV, CVS, ACT, HCA, and VRX. Individual stocks are mentioned here for the sole purpose of illustrating investment concepts, and nothing stated here should be construed as the advice to buy or sell any security.