2013 First Quarter

Posted by David Tillson 2013 First Quarter 

 Readers of our past commentaries know that we believe there are two sides to investing: the science of the business as well as the art. Analyzing a business, understanding its numbers, its competitive positioning, and its potential earnings power or true worth – that’s the science. The art is trickier and relates more to timing, understanding human behavior and how it drives decision-making. We believe the latter is more likely to often create opportunities, or risks, in terms of assets becoming mispriced. With stocks recently setting new highs, only marginally above levels set in both 2000 and 2007, investors are now appropriately asking: “So, now what?” Opportunity or risk?

As long term investors, we confess market timing is not our game, but we see today as starkly different from those two prior highs. Not only were valuations richer during these periods, but the broad-based view in both 2000 and 2007 was that risks were negligible (i.e. “it’s different this time” with regard to tech valuations and “35x leverage is fine for a bank because home prices never fall”). We don’t believe this complacency exists today. Stock valuations remain reasonable and the current recovery has come despite persistent concerns that risks are lurking everywhere. That angst is still reflected today in anemic yields of U.S. Treasuries as well as in the enormous amount of liquidity earning next to nothing in bonds and cash that has yet to return from the sidelines. Perhaps the most anticipated event of the moment is the possibility of a third consecutive spring-into-summer market selloff. 

We are contrarians at heart, so we prefer this kind of market sentiment to 2000 and 2007. We recognize stocks have had a nice run and that it is unreasonable to expect more +10% quarters. We also note concerns around weaker corporate revenue growth, slower GDP growth in the EU and in China as well as sovereign balance sheets (including our own) becoming larded with unprecedented levels of debt. But just as “to a hammer, everything looks like a nail,” we often think about problems at the macro-level the same way we view them at the company level: as potential opportunities. Contrast today with 2007 and you’ll find that two out of the three key constituencies that drive the U.S. economy have already overcome huge problems of excess. U.S. consumers have de-levered meaningfully even as their most important asset – their home – has finally found price stability as supply and demand have reconciled. U.S. banks have also de-levered and are now recapitalized to a point where they have excess liquidity. What’s missing is loan demand. U.S. corporations are flush with cash, have cut costs, and are now even more productive – in fact due to an energy production boom in the U.S. and wage inflation in China, U.S. manufacturing could positively surprise everyone in the next few years. Today, the lone holdout in terms of an opportunity meeting up with a crisis or chronic problem appears to be U.S. federal and public finances. 

Stockton, California, has recently gained national recognition as the largest U.S. city ever to file for bankruptcy. The city’s tax base has declined some 70%. There are simply not enough dollars to pay the salaries of current employees, let alone pensions and lifetime health coverage for all retirees plus a dependent, no matter how long they have worked for the city. Stockton’s bankruptcy application has sparked a battle between the organization representing public employees’ pension interests (CalPERS) and the owners and insurers of Stockton municipal bonds. While the outcome is uncertain, there are a couple of items to bank on: bondholders will suffer some loss of principal and workers’ pension and health care benefits will be reduced. The city of Chicago and Mayor Rahm Emanuel are embroiled in a similar battle. 

Their retirement system for teachers, police, firefighters and other city workers is underfunded by almost $24 billion. As the mayor recently stated “the system is not honest to employees and is not honest to the taxpayers.” Even in Washington there are some early signals of a potential reckoning point. The President’s budget proposal has something for all to dislike but in acknowledging that entitlement reform needs to be part of a solution by putting it in his budget, a potential middle ground between the parties has been broached. The more important takeaway in these examples is that directional progress is being made when a problem reaches an untenable point – as a result there may be investing opportunities. 

While we pay close attention to macro events, it is not how we invest. We are focused on individual companies. Often some of the best opportunities are found in businesses that are uniquely positioned to tackle “macro” problems. One such example is the emerging global food crisis. The supply of arable land and water is shrinking at the same time crops are becoming more expensive due to droughts, developing economies eating more meat, and the increasing demand for bio-fuels. Monsanto is uniquely positioned through insect and drought resistant seed technology to improve crop yields. The accompanying drought map of the US from last summer underscores the need for solutions to a growing global problem. With projections for the world population to approach 9 billion in 2050 and a finite amount of arable land and water, we believe Monsanto’s yield improving technologies will only grow in value because they address a problem that is likely to get worse.

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Another large macro problem where we see a potential opportunity is U.S. health care costs and subsequent reform. We own CVS because it has a business model with meaningful competitive advantages, which also stands to benefit from a major revamp in U.S health care. First, it has a large Medicare and Medicaid pharmacy businesses - programs that are set to grow under the Affordable Care Act. Second, it has a large business serving health plans, which are poised to add 30 million uninsured lives in 2014. Last, and perhaps most important, is the change in the rationale for payments to healthcare providers, as the U.S. moves from fee-for-service to outcomes-based payments. Patient adherence to medication regimens will become more crucial in this model. CVS launched Maintenance Choice which offers customers more flexibility in how they receive medications, either in-store or through the mail. They found that many customers actually prefer to visit a store to pick up their prescriptions. Not only does this benefit the retail portion of the store, but this choice has increased adherence to medication regimens. On top of this, the trend towards branded drug patent expirations is also a boost to the pharmacy which typically makes 2-3x the profit margin on generic drug sales than it does on branded. A third such macro problem is the U.S.’s chronic dependence on foreign oil. This problem has recently undergone a major sea-change for the better. Oil and natural gas production growth in the U.S. has partially helped cut our imports of oil nearly in half since 2006. Companies such as Halliburton and Schlumberger have developed new technologies to more efficiently unlock previously uneconomic oil reserves trapped in shale rock. It has led to an energy production boom in the U.S. that has also created a pressing need for more pipelines, storage tanks and processing plants, an infrastructure opportunity likely to create thousands of jobs. 

We remain vigilant for these kinds of investment opportunities where we believe a business is uniquely positioned to tackle a macro problem that offers potential growth regardless of the economic cycle. But, in closing, we should answer the question posed earlier “So, now what?” Stay invested. While it’s possible we may endure another growth scare this spring, the price for safety - cash yielding effectively 0% and 10- Year US Treasuries yielding 1.7% - is too dear when viewed on a longer term basis. We believe that the U.S. is in the midst of a sustainable recovery and that today U.S. stocks are still one of the most attractive choices for investors.