A Cold Wind in August – 2015

The Vast majority of publicly traded Standard & Poor’s 500 stocks were in the red on Friday August 20, 2015

Markets of all sorts behave this way from time to time: As the price of homes was spiraling downward nationwide in 2009, a friend of mine, who owned a beautiful home with private stairs descending to Thousand Steps beach in Laguna Beach, for which she’d paid $23,000,000 in 2005, was getting no offers, even with the listing price reduced to $16,000,000. Did this mean the house was in a bad location, or somehow flawed? No, “the market” decided for a while, that beach front real estate was not worth what it once had been. After six years of economic recovery, comparable homes are now “worth” over $20 MM once again. No doubt, the coming days and weeks will find the media spotlighting a few geniuses who predicted this “crash”, some of whom will make the case for a new bear market and perhaps for a financial meltdown. When I hear such performers, my eyes drift to my bookshelf and the tattered cover of the 1974 book How You Can Profit from the Coming Devaluation, one of a series of Harry Browne books that predicted financial collapse back in the days of high inflation and a prolonged bear stock market. That book propelled me into the financial world. Gold and silver and other commodities were profitable investments in the second half of the 1970’s but with time I learned that Mr. Browne’s outlook, which sometimes seemed merited, was not a reliable guide to investing. Would I had stumbled upon the Berkshire Hathaway annual report, penned by Warren Buffet, back then, but they weren’t promoting it in bookstores.

I, for one, believe this selloff to be a normal part of a secular bull market, eventually setting us up for a buying opportunity. But it could get rougher.

Here’s a telling Buffet quote: “be fearful when others are greedy and greedy when others are fearful.” This week’s fear may not yet be deep enough to mark a bottom, but I am finding certain potential investments more tempting than they were just a few weeks ago. I suspect we may be in for some months of poor performance before a capitulation phase marks the turn around. In fact, the market could dawdle for as much as another year. Before consuming nations can benefit from low commodity prices there will be companies and nations, especially third world producers and their lenders, who will suffer from the same factors.

The ferocity of the selling on Thursday and Friday August 19 and 20 has the feel of a summer raid. While many professional investors are on vacation, it’s a wonderful time for short term traders to take advantage of a thin market and push quotations below widely followed chart points. Chartist or their more sophisticated equivalent, algorithm driven trading systems, are vulnerable to this form of attack. A good technician behaves like a robot, buying when the specified signals are good and selling when signals are bad. No judgment, just mechanical behavior. Foolish. Human beings like me try to be in touch with the underlying nature of the investments we choose: the factors of demand, supply, product distribution channels, unique company specific positives, and importantly, management talent.   Even when chart points suggest a problem, I must bring to bear 40 years of experience to decide when to hold ‘em and when to fold ‘em. This is not mechanical, it is not easy, it is sometimes wrong, but it has served our clients pretty well through a number of market swoons.

Leading up to the current correction I have tried to do job number one: reducing exposure to short-term volatility. As in the past, the fundamental diversification of your portfolio serves to dampen the downside threat. I try to select better quality companies that have high free cash flow, strong returns on equity and low or modest internal leverage. Most portfolios hold fixed income securities that usually benefit when stocks go down. Preferred stocks, for example, were hardly moved last week. When there is an absence of outstanding investment opportunities, your allocation to cash rises. All three of these approaches are on display for your portfolio. If you compare the behavior last week of the US stock market with the change in percentage value of your portfolio you will likely find what you gave back is a lot less than that of the stock indexes.

Is this a time to seek alternative investments? Gold? Precious stones? Classic cars? In my opinion the answer when it comes to “real” assets is “absolutely not.” Gold is the favorite of those who have little confidence in government, paper currencies, or today’s modern economic system.   Gold has well served those who are subject to abhorrent regimes (as it served my grandfather when he escaped Communist Russia.) However, I do not believe we are about to see the collapse of organized first world governments or blood in the streets. My guess is the current gold rally will be short-lived. These commodities may gain when inflation and or political unrest are rampant, but inflation is not an issue and at least here in the States, we look headed for an orderly change in the Presidency next year (but an interesting election to be sure!)

Real assets of many classes appear to offer few opportunities due to waning demand from China and a glut of oil and natural gas production. The sell-off for industrial commodities, however, is good news for industrial companies like PPG, Goodyear, Rollins and Sherwin Williams who source raw materials for their manufacturing and services.

Should you turn to real estate as an investment? My answer is: “yes, but”…I believe we are entering a secular bull market for housing driven by the 90 million – strong millennial generation. For some clients I have already taken a relatively small position in an effort to benefit from this trend: the SPDR Homebuilders S&P Index exchange traded fund (XHB). Rollins is another company that benefits from Millenials de-nesting. We also own real estate in the form of two real estate investment trust both of which held up relatively well in the sell-off. The one area where inflation is running hot is rentals. This suggests that Millenials will be out house hunting. I am on the hunt for another opportunity that can benefit from building, buying and furnishing homes, stay tuned.

For a few clients, I reduced your exposure to bellwether Apple Computer a few weeks ago because I did not like the way the stock reacted to what was fundamentally an excellent earnings report. We now know that what Apple was telegraphing, a slowdown in China, a significant market for the company. Nevertheless, I did anticipate a slowdown in Apple’s growth. We own the stock as a maturing income play. Apple continues to pay a decent dividend and is likely to raise that dividend and repurchase stock. Their cash hoard runs to $200,000,000 – a lot of fire power. You have no doubt noticed that your exposure to the financial sector has grown this year with the addition of Goldman Sachs, US Bank and New York Community bank.   The underlying assumption behind the purchase of these financially sound banks was the belief that short term interest rates will soon rise, improving net interest margins. This month’s broad equity weakness, along with international pressure, appears likely to delay a rate rise by the “Fed”. While this change in perceptions has dampened demand for bank shares, I want to underscore my belief that we are unlikely to see a banking crisis develop as it did in 2008. Reorganization and strengthening of banking regulations through the Dodd – Frank act and the Volcker Rule give me this confidence. Further, these banks we own, pay dividends and should continue to pay us rent even while share prices go through a corrective phase.
As you know I’ve trimmed but defended our significant exposure to oil and gas pipelines. The oil and gas glut that is now so apparent is bad news for exploration companies, that is, who find and produce energy. But the toll roads that carry energy from producer to consumer, from refinery to trains and barges will continue to see demand for their services. Sure, the rate of buildout of additional pipelines and related infrastructure will likely slow as North American production levels off over the next few years but I don’t believe there’s any chance that either Enterprise Product Partners Kinder Morgan or Spectra energy will suspend or reduce its dividends, substantial sources of income for our clients.

Those of you who have allowed me to be of service for a while, already know my approach: own good businesses that pay us rent and be patient. Sometimes “the market” will love these companies, sometimes “the market” won’t love them. So what?   Look for your regular dividends and interest to drop your my account. Others who are too leveraged, not properly diversified, or poorly advised may be offering us some good deals in coming weeks and months as they surrender to their emotions!

[1] A cautionary reminder: Having suffered through owning and managing residential real estate earlier in life, I have a distaste for owning real estate directly because of the management hassles and exposure to vacancies, unruly tenants, taxing authorities and endless maintenance calls. Having been “stuck” with rental property during the housing bear market of 1981-84, I frequently warn folks about the inability to turn real estate into cash when an emergency arises, which always seems to occur during a financial contraction. This sort of liquidation risk does not exist with exchange traded real estate investment trusts (REIT’s) which have been part of our client portfolios for some 15 years now.