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  by Dennis M.
  O'Connor
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Past Commentaries

Current Commentary, Review and Outlook
July 19, 2013

Current Commentary

My last memo in March discussed the need for the market to break through S&P 1576 decisively and it has, to 1689 today. This is a strong bull market. Money has to be invested and the U.S. still offers more opportunity than anywhere else. The market is being fed by massive liquidity rather than by rapid earnings expansion. Earnings have been hard to analyze and harder to predict, which is why I don’t predict. In 2012, 88% of S&P 500 earnings were generated by 12 companies, 7 of which were money center banks. Aggregate first quarter 2013 earnings surprised to the upside because of a research and development tax credit that was extended by Congress. There were not strong earnings across the board however. Because of this I’ve created an earnings spreadsheet for every company in the S&P 500 Index. For 43% of the Brae Head aggregate of 130 stocks, first quarter earnings declined over the prior period.

There is a confirmed trend that while bottom lines (net incomes) continue to expand, top line (revenues) are not. That’s productivity in a nutshell. Significant long-term unemployment is a continuing drag on the economy. The consensus among most researchers I use, JP Morgan, Blackrock, Barclays, S&P Capital IQ, is that the loose money policies of the Fed are counterproductive at least and must end soon. I’d expect that Mr. Bernanke would rather not be in office to pull the plug and his term ends this year.

While recession in Europe and slowdowns in Asia are reflected in commodities and local stock prices there will remain insatiable global demand for energy. I have been favoring energy stocks.
Fracking is only one of a plethora of technological breakthroughs in energy exploration and production. Others include advanced semi-submersibles, subsea processing, multi-well drilling from a single pad (octopus drilling), supercomputing and seismic exploration (the energy industry is #2 to the defense department in supercomputer capacity), LNG technology (Shell is building a liquid natural gas production and storage ship that is six times larger than our largest aircraft carrier), and M2M (machine to machine) technology for remote supervisory control.

All these add up to increased productivity and eventually lower costs. Two companies that I favor in the sector are FMC Technologies and GE. Yes, GE. While relying less and less on the GE Capital division for earnings, GE Oil & Gas has become its fastest growing division, increasing revenues 16% a year for the last 3 years. I’ve also been shoring up positions in railroads and pipelines ( CSX, Norfolk Southern, Plains All American).

A disturbing trend is the 25% increase in crude oil prices in the last 7 months, from $89 to $111 today. This will only reinforce sluggish economic growth. The prospect for cheaper gasoline fades as well: yet another refinery in California has closed. None has been built in the U.S. since the mid ‘70’s.

I believe financials away from the money center banks have better opportunities and have been building positions in Bank of Hawaii, Ohio Valley Bank Corp, Bankunited, Triangle Capital, Fidus Investment Corp, and Leucadia National.

I continue to overweight manufacturing. In addition to United Tech, GE, Emerson, and Eaton among others, see Handy & Harmon (HNH) which position we have been building for a few years now. It is exposed to metals, manufacturing and welding, construction and roofing.

Regarding interest rates, they will rise, and when they do we will incrementally lengthen maturities, not before. At present we are still in very short duration mode. It seems to me that there is high risk in investing in debt that pays nearly nothing, regardless of credit quality.
Money market funds are paying ten cents per year per thousand, $10 per $100,000 per year.

On Active vs. Passive Investment Management

Recently there was an op-ed in the Wall Street Journal by Burton Malkiel, an economics professor at Princeton University and the author of “A Random Walk Down Wall Street,” which I would recommend to anyone seeking a comprehensive explanation of the stock market. In fact I used it as a supplemental textbook when I taught graduate finance.

Prof. Malkiel has long argued for passive index investing instead of using active managers. He does this by comparing index funds with mutual funds. Indexes are lower in expense ratios, representative of many sectors of the market, from narrow to broad. Actively managed mutual funds are significantly more expensive, in initial cost and in ongoing management fees. But the fact that supports his argument best is simply that few mutual funds outperform the market sectors they represent over time. And his argument is true as far as it goes. I’ve argued against mutual fund follies for as long as I’ve run this company. But he does not distinguish between mutual fund managers and private money managers. I actively manage private client portfolios and Prof. Malkiel presents no comparisons with the performance of money managers and investment advisers. They shouldn’t be lumped together with fund managers.

Consider a scenario of a 65 year-old who retired January 1, 1999. Acting on Malkiel’s advice to set it and forget it and save 30 or 40 basis points a year, the retiree put 100% of his or her retirement assets in an exchange traded index fund representing the S&P 500 Index, a proxy for the large-cap U.S. stock market. On December 31, 2008, ten years later, the retiree has lost 16.42%. Worse, he or she is 75 years old and is looking at a fixed-income landscape of zero interest rates. Which would be more likely at this point, panic or despair?

A qualified investment advisor, a money manager, would likely have prevented that scenario and in fact, over the same period, the Brae Head, Inc. weighted average aggregate returned 41.10%. For the 11 years ended in 2009 the S&P 500 Index total return was 5.7%; the Brae Head aggregate returned 65% for the same period.

While I still recommend Professor Malkiel’s book, his argument for passive index investing instead of active management is purely academic. Investing is not academic. It’s not a game.

Thank you for your continued confidence.


Dennis M. O’Connor