Investors are fretting over a lot of things as of late.
China (FXI) announced January 19 that fourth-quarter GDP fell to 6.8%, with many noting that the measure was a 25-year low. Even if you believe that number, which may be a stretch in light of collapsing local stock markets in Shanghai and Shenzhen, the outlook can’t be much better. Steel mills across the country are reeling, and while published housing numbers don’t look that bad, we have a difficult time believing the Chinese banks are in good shape. HSBC (HSBC), Standard Chartered, and Citigroup (C) remain most exposed to what we would describe to be the growing likelihood of a contagion from weakening commodity-dependent sectors in the country. Intel (INTC) also sounded the alarm bell on China in its 2016 outlook released last week.
During the past few weeks, most of America has been absorbed with the prospect of taking home the unprecedented $1.5 billion Powerball lottery jackpot, and we believe the phenomenon was “so large” that it likely acted as a modest positive for many convenience stores selling tickets. Can you believe that? Though such a dynamic is incredibly difficult to factor into any valuation model and we’d be hard-pressed to call it a sustainable long-term driver, the Powerball lottery likely was a nice boost to Casey’s (CASY), CST Brands’ (CST) Valero, and Murphy USA (MUSA), if only that it brought quite a bit of traffic from those hoping to win the big payoff. Three winners took home ~$530 million each, simply an incredible sum. Congrats! In many ways, I think the lottery should have mandated 1,500 winners though, each to take home a million each. 1,500 people’s lives would have changed for the better, instead of just three…
In any case, investors have been handed the worst start to any year…ever. This should not be surprising to our readers. We’ve been pounding the table on the risks, not the least of which has been that the US markets have roughly tripled since the March 2009 panic bottom, and even a 10%-20% drop is rather uneventful in this context. Still, we’d be hard-pressed to find someone with a $2 million portfolio that would view a $400,000 haircut as uneventful. That’s part of the reason why the markets have been selling off – fear of losses sparked by profit taking. The other is quite fundamental: emerging market growth is waning–if China is any guide–Brazil (EWZ) and Canada (EWC) are in recessions, Australia’s (EWA) growth is waning, and the prospect of all 5 of our concerns coming to fruition as a result of impending rate hikes has only increased since the start of the year. If you haven’t read the ‘5 Concerns’ piece, it can be found here.
We’re working hard to stem the declines in the newsletter portfolios, and with a 35%+ cash balance in both, we’re pretty excited about the prospect of picking up (or adding to) some underpriced ideas as the market comes to us. From Buffalo Wild Wings (BWLD) to Chipotle (CMG) to Michael Kors (KORS) to PVH Corp (PVH) to Macy’s (M), we’re starting to see some bargains emerge in the market. However, valuation is as much as an art as it is science, and we’d wait for what we’d describe as a technical margin of safety, an increasing share price, before growing interest in shares. Chipotle is working aggressively to get its house in order, for one – the burrito-making giant will shut down all of its 1,900+ stores for a few hours February 8 to address food safety. We like the public relations move – if only that it catches the public’s attention that Chipotle is working to put the recent troubles behind it. It might just work.
Did you see the outperformance of the portfolio of the Best Ideas Newsletter hit an all-time high a few days ago? We know it’s difficult sometimes to process how the Best Ideas Newsletter portfolio can do so well when the market is swooning, but we typically run a conservative portfolio with ‘Valuentum’ stocks (undervalued equities that have relative pricing strength), and what we’ve found is that our ideas tend to outperform the market considerably when things are going well, while the portfolio’s outsize cash balance tends to cushion blows to the downside. It’s a great construction that offers investors a path to a high likelihood of superior risk-adjusted returns, and for those members that are following the portfolio, they are sitting on nearly a 90% gain and ~35 percentage points of outperformance relative to the S&P 500 (SPY) since inception. I think that’s really good.
The Dividend Growth Newsletter portfolio continues to stick with high-quality franchises from Altria (MO) to Microsoft (MSFT) to Apple (AAPL), and we like its low-teens annualized return, which has bested the return of the SPDR S&P Dividend ETF (SDY) by our calculations and our mid-to-high-single digit goals over rolling 3-5 year periods since inception. Some holdings, however, haven’t been painted in the best news as of late, however. Intel, for one, but HCP (HCP) hasn’t been the greatest performer either. What we want our readers to take away from the lesson on HCP is that it doesn’t matter how many consecutive years an entity has raised its dividend payout, the company can still encounter trouble. HCP has been the most recent example of that. A “pre-mature” move into the energy space with the diversified Energy Select Sector SPDR (XLE) has also dulled outperformance, but the alpha gained by removing extremely vulnerable stocks prior to the energy resource pricing collapse, has put our firm above all others, in our view. I think we’ve lived up to Barron’s calling us the “Survivor Guide for Oil Investors.” I’m proud of that.
A lot has stayed the same though. IBM’s (IBM) quarterly results, released January 19, continue to reveal the firm is the very best example of a company that has “poor earnings quality.” Yes, you read that correctly: poor. Revenue declines, a lower tax rate and share buybacks helped the firm to a beat, but the outlook looks grim, in our view. We think Warren Buffett fell into the trap of thinking too simply from an earnings-per-share standpoint and pegged his “margin of safety” on buybacks that he likely thought would propel IBM to meeting its prior operating earnings per share goals. Not even the Oracle of Omaha himself could have predicted how bad things would get for IBM though. We’re still not touching shares, which have fallen from over $200 in early 2013 to indicated levels in the mid-$120s post-report. We’re not sure the sledding is over for Big Blue, with 2016 guidance coming up short.
Netflix (NFLX) continues to add new subscribers at a nice clip, but one has to have an incredibly high risk-tolerance to jump into an equity that is trading at north of 200 times earnings. The company throws off a lot of cash flow, but it’s hard to get past that multiple, especially if we are staring down an eventual slowing environment in the US, prompted by weakness elsewhere in the world. The US is certainly a beacon of strength, but it is not immune to everything, and 2016 will be the year where we could potentially bear witness to the “Asian Contagion” or the “Latin American Currency Crisis” or both—two things we had warned about extensively in the summer months of last year. No longer are the world’s countries isolated; the Financial Crisis of 2008-2009 revealed how interconnected we are just a few short years ago.
If anyone truly cares, Twitter (TWTR) experienced an outage on January 19 that sent its shares tumbling to a still-lofty market capitalization of $11 billion. I think Twitter is fun, and I think there’s a lot that Twitter can do to help itself move along the technology curve to greater adoption and simplification of use, but at the end of the day, Twitter is no Facebook (FB) or LinkedIn (LNKD). For one, Twitter is not yet sustainably profitable on a GAAP basis, and from the perspective of a small business owner (me), it’s very difficult to build trust in a mere 140 characters. Sometimes it actually works against professionals. For example, do you really want someone that you depend on to limit his/her thoughts to 140 characters? You get what I’m saying? We wouldn’t touch Twitter with a 10-foot pole, and we’ve outlined that view in the past.
Icahn continues to shake things up at AIG (AIG), rated 9 on the Valuentum Buying Index. We continue to believe that AIG may be the only meaningful idea within the insurance space, and the company has performed incredibly well since it registered one of the highest ratings on the system. The financials industry, in aggregate, however, continues to feel a lot of pain, as the yield curve has flattened a bit to start the year. The long bond has faced pressure and many have started to worry about banks’ exposure to energy loans. Remember the Savings and Loan Crisis of the late 1980s, with Texas and the energy sector being the “epicenter of the thrift industry meltdown.” Home construction permits fell 26% year-over-year in Houston in the third quarter. JP Morgan’s (JPM) CEO Jamie Dimon noted in mid-January that he wishes he could put up more loan loss provisions due to soured energy loans.
And how can we forget…energy resource pricing continues to swoon. West Texas Intermediate (USO) is now hovering in the high-$20s per barrel, and the lifting of sanctions on Iran will only be the latest incremental boost to global oversupply. In the US alone, commercial inventories of crude oil are at 80+ year highs for this time of year, and the global natural gas (NGAS) situation speaks to overabundant supply (200+ years at current levels). The case for higher energy resource pricing is muted, and many of the most leveraged upstream players include Legacy Reserves (LGCY), Devon (DVN), Chesapeake (CHK) and Continental Resources (CLR) are simply in a world of hurt. Midstream equities tied to Chesapeake, in particular, including Plains All American (PAA) and Williams Partners (WPZ), soon to be a part of the Energy Transfer Equity (ETE) umbrella, may be in for even more pain.
We had been expecting some tough sledding in 2016, but we’re equally excited about setting up with some great entry points on new ideas. In my view, now is the most important time to be paying attention to the markets, even if it means sitting and watching with patience. Depending on what kind of bargains the market serves us up this year, for example, we could be putting anywhere between 10%-15% or more of the allocation of cash in the newsletter portfolios to work. We’re pretty excited about the potential deals to be had, and we hope you are, too. That’s all for now.
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