Archive for January, 2007

2007-01-08 :: 2007 Investment Strategy

Monday, January 8th, 2007

One of the advantages of riding on an airplane for 12 hours is that you get some quality time to think about things. For me, I used it to clarify and formulate our investment strategy for 2007. Below, you get to see the draft version of the Investment Strategies newsletter that will hit the mail in a few days after being proofed, reread, printed etc….


The tides of change that are pushing forward investment returns for 2007 and beyond will be strong. The major investment themes we have utilized in our portfolio construction are maturing and amending, while other considerations are becoming clearer. In this writing, I will update you on where we are and where we are going, as well as how we intend to make money, in this complex world.

In past issues, I have started with the analysis and ended with the investment conclusions based upon the analysis. A number of you readers have asked that I provide a summary of the investment strategies at the beginning, then follow up with the supporting analysis. So, in an effort to make this reader-friendly, I am amending the format so that if fits with this suggestion. At the end you will now find specific investment conclusions which implement the strategies.

Investment Strategies

  1. Our primary investment thesis over the last several years has been that the demographics of the emerging market economies, wherein 500 million people are moving into the middle class thereby causing a surge in demand for housing, autos, and consumer durable products, will drive a demand fueled bull market in commodity stocks. The supply of available commodities used to produce these products will continue to be limited. Energy and metals producers will be the big winners as their stock prices experience the double whammy of significantly increasing earnings and earnings-multiple expansion.
  2. The dollar is in a multi-year bear market, encourage privately by the government’s actions but derided publicly by the strong dollar policy. The dollar is now driven more by overseas investors’ purchases and sales of dollars and treasury securities than by the Federal Reserves interest rate and open market practices. The detailed issues surrounding this problem are enumerated by Jim Jubak as:
    1. Driving the foreign investors’ activities are the huge trade deficit which puts a significant amount of dollars in the hands of foreigners at a time when they are trying to figure out what to do with the dollars they already have.
    2. The slowing US economy has our economy trailing the growth rates of Europe and Japan, projected to continue at least for the first half of 2007.
    3. Interest rates have likely peaked in the US at a time when the rest of the world is still in tightening mode.
  3. The demographic changes in the emerging market economies are coming at a time when the baby boomers of the developed economies are beginning to retire. This results in a monumental shift in anticipated GDP growth rates away from the developed world to the emerging market economies. This, coupled with the need to fund retirement incomes and health care for aging populations in the developed world shift the investment risk away from emerging market economies to the developed world.
  4. Technology spending is set to increase significantly starting in 2007 and lasting for several years, driven by corporate profits and retained earnings, in response to several government, business, and consumer initiatives.
  5. Health care investment by the industry itself will increase in response to the baby boomers appetite for longer active lives and in reaction to the significant number of name brand drugs coming off patents through the end of the decade. This will lead to a number of mergers as small cap health care innovators will be acquired by large cap companies trying to maintain a competitive advantage.
  6. As the Federal Reserve begins to lower interest rates in 2007, a number of cyclical and rate driven investment opportunities will provide opportunities to balance and diversify portfolios in potentially high return sectors.
  7. Within the energy sector, oil that is located in politically stable areas of the world will have more value than oil in dangerous locations. This means that Canadian Oil Sands and Deep Water Gulf of Mexico oil fields, the companies that drill them, and the companies that service them will be valued highest in this industry sector.
  8. Private Equity and Hedge Funds have taken a number of companies private over the last few years. This presents opportunities we can capitalize upon and dangers that we must recognize.

Demographics Drive Returns

Over the past few years, our clients have been the beneficiaries of the energy and metals boom as earnings have rocketed higher and earnings multiples have expanded. Demand for raw materials in China, India, Brazil and Russia have put upward pressure on the prices of the commodities themselves as well as the stock prices of the companies that produce them. From May to September, 2006, we saw the commodities and their producers correct from high levels – a natural working of the markets. Beginning in October until this week, that expansion resumed and took us back to May levels. This week, reports of slowing world-wide economic growth again caused a sell-off in commodity prices.

I recently returned from Russia, as well as having visited India a couple of years ago. I can attest to the shift in the population from subsistence living to middle class standards. Where once were bread lines and communal apartments you now find McDonalds and condominiums. Where once you saw young adults tilling small plots of land to grow rice or vegetables you now see them commuting to work at call centers in suits and ties.

The impact of 500 million people increasing the demand for safe housing, appliances, cars, electricity and petroleum is almost incalculable. The Earth’s current population is only 6.5 billion, and this shift represents 8% of everyone on the planet wanting items that can only be produced by copper, steel, zinc, and oil.

This is a secular shift that will impact investment returns until 2050 when its anticipated that the earnings of the average Chinese worker will equal those of comparable workers in the US. There will always be cyclical pullbacks like in 2006 and early 2007, that is to be expected. However, the long term fundamentals for energy and metals producers as investment options cannot be ignored and should comprise overweight positions in any diversified
portfolio.

Supply V. Demand Creates Opportunities

Oil prices have fallen back 25% from this summer’s highs based upon relative calm in middle eastern supply chains and the warmer than normal world-wide climate so far this winter. This drop has camouflaged the fact that the supply of oil available to meet demand is precariously close. The International energy Agency projects global oil demand at 86 billion barrels a day in 2007, with production of supply at 85.4 billion barrels. Since this projection, OPEC announced two production cuts, and will continue until oil normalizes above their $60 per barrel target.

Energy markets have been calm recently, but given this tight relationship between supply and demand, any turmoil could disrupt supplies and lead to new highs in oil prices. Oil in politically safe areas of the world not subject to terrorist disruption or political blackmail is more valuable than oil in the Middle East, Africa or Russia. Oil that you can count on producing is worth more than oil you hope will be there.

The huge reserves in Canadian Oil Sands and deep below the Gulf of Mexico are feasible to produce at current price levels. If prices drop too much lower, then energy companies will not tap these resources and they will be deducted from the supply figure anticipated for 2007. This is another factor putting a floor under the commodity price near current levels.

Copper prices have fallen back from $4 to $3 based upon the anticipated global economic slowdown. Traders in copper look at the short term not the long term. Long term, demographics will push demand up at a time when no new copper mines are planned, and when they do get planned, it takes 10 years for them to become productive.

Additionally, China announced that it was going to diversify its reserves away from dollars and into metals. The potential increase in demand as China starts to buy copper, zinc, and gold only adds a further floor to investments in metals. It also means that the dollar will come under further pressure as China foregoes holding dollars in its reserves, choosing instead to buy metals to hold.

Dollar Down – Exports Up

The US Dollar is weak, there is no question about that. The trade deficit, the slowing US economy, and the likely increases in rates around the world at a time when we will likely be easing rates will continue to push the dollar lower. Couple that with the prospect that China will not be buying dollars in the same levels as past years, and you have downdraft that will pull the dollar lower in 2007, continuing its fall over the last few years.

This is not all dire, unless you like to travel to international locations. If you export goods abroad for sale, this provides an added incentive for foreigner consumers (remember those 500 million emerging market consumers moving into the middle class) to buy US made goods.

According to the Bureau of Economic Analysis, the total production of goods and services sold or shipped abroad in 2006 has risen to 17.6% of total US output, up from 13.5% in 2003. The share of corporate receipts from overseas sales has risen to almost 26% from 18% in 1998. In 2006, exports to Europe were up 20% and those to the Pacific Rim are up 15%. The weak dollar in 2007 will continue this growth, helping to correct the trade deficit that is helping to push the dollar lower in the first place.

The Federal Reserve is currently in dollar support mode. They know that central bankers in developed and emerging economies may not sit on dollars forever if the dollar falls too-far too-fast. So, they have to talk it higher while at the same time engineer the increases in overseas sales that will curb the trade deficit.

The Fed will not let the dollar go into free fall against other currencies. If it has to it will increase interest rates to defend the dollar until it can resume a measured decline. On November 29th, the dollar edged toward such a free fall against the euro, hitting a 20 month low. Fed Chairman Bernanke came out with an announcement that US inflation was uncomfortably high and that the Fed’s next decision would be whether to raise interest rates again, not lower them.

Interest Rates Fall in 2007

Despite the Fed Chairman’s remarks, I think that the second half of 2007 will give us a series of interest rate cuts, taking the Fed Funds rate below the current 5.25% to 4.75%. Talk of raising rates to fight the fall of the dollar, really is just talk. A weaker dollar is so beneficial to the US and its need to increase exports that I find it unlikely that the Fed would derail the growth we are seeing in exports unless the fall became so severe as to potentially cause a negative global financial event.

PIMCO, a leader in economic analysis and bond management, states that nominal GDP is targeted at a 5% growth rate by the Federal Reserve. Nominal GDP reflects the return on the nation’s capital and our ability to pay our bills. Similar to the way all interest yields reflect a real and an inflation component, growth rates net of inflation are the true way a country pays its bills.

According to their analysis, nominal GDP for 2007 will likely show 4% growth (2% real growth plus 2% inflation), or 1% below target. Their position is that the Fed must cut rates a level 1% under the nominal GDP in order to keep the leveraged assets (housing, stocks) from being liquidated at the margins. In this case, their analysis shows that Fed Funds should eventually reach 3%, and will likely decline to 4.25% in 2007.

In my opinion, last week’s employment report contained numbers that will cause the Fed to delay any rate cuts until later in the year, giving us fewer than PIMCO anticipates. The job growth in the non-farm payroll number was far above what any economist had anticipated.

The traditional Fed playbook says that when unemployment reaches the bottom of the acceptable range (in this case we are below 4.5% unemployed in the US) then you must increase rates in order to stem wage-induced inflation. I don’t believe we’ll see any further rate increases based upon the fear of wage-induced inflation as wages have grown below inflation levels this cycle. However, this will serve to delay the start of any rate cuts until the Fed is comfortable with the level of employment. Additionally, it gives them a further excuse to use in their verbal defense of the dollar.

Full Employment in Developed World

Demographic changes in the developed economies show that the populations are aging, while those of the emerging economies are quite young. This means that as the United States and Europe wrestle with the concept of how to fund the retirements and health care needs of their post-WWII baby boomers, the emerging economies are putting younger people to work in growing numbers.

Unemployment at record lows is no
t just a phenomenon in the US. The Eurozone has unemployment rates at 14 year lows and Canada is at 30 year lows. In the developed countries, the employable labor force has not grown as a percentage of the population like it has in past years due to the fall in the birthrate after the baby boom.

According to Don Coxe, of Harris Investment Management, this could be the first economic recovery on record where there are not enough qualified people to hire at a time when businesses are in hiring mode due to the drop in the birth rate over the past decades. If this is the case, then there will be a cap on economic growth in the developed world subject to the availability of technology to replace people.

If this is the case, then global economic growth will accelerate its shift from the developed world to the emerging economies, making them a bigger part of the global economic pies sooner than originally anticipated.

Additionally, the anxiety over how to fund the retirements and health care needs of the baby boomers will increase based upon this demographic shift, requiring actions by governments and individuals sooner than hoped for by politicians.

Technology Spending Set To Increase

Based upon research by the Change Wave Alliance, a group of 9000 businesses that report into a central data base, we are at the beginning of a technology upgrade cycle that will rival the bull market of the late 90’s. They have identified six technology upgrades that will hit over the next 24 months, causing $1 trillion to be expended in the technology area, and Tobin Smith of Change Wave writes:

  1. Windows Vista Upgrade – based upon historical data of past upgrade cycles, upgrading to Microsoft’s Vista will create $12 in related IT upgrades, or $200 billion spent in technology upgrades required by the new operating system.
  2. Internet Protocol Version 6 – the US government is kicking off a $125 billion upgrade of the government’s IT and phone system infrastructure with the military, but in the next couple of years the entire government will be 100% digital over 100% IPv6-capable equipment. Asia and Europe will be forced to follow suit or abdicate a competitive disadvantage to the US. This means IPv6-capable PC’s, routers, switches, software, etc., will all be manufactured, purchased, and installed.
  3. High-Def TV – February 17, 2009, is the scheduled date for all analog TV signals to be converted to digital. Over the next couple of years, all TV’s that are not digital capable will have to be upgraded at the same time that High-Def sets, even though more expensive, are becoming more affordable.
  4. Internet Protocol Television – all of the high-def TV’s need high-def service. New service requires a lot of new hardware capable of transmitting and delivering 300 plus high-def channels.
  5. WiMAX Broadband Cellular – broadband cellular does not even use a cell tower; over the next 36 months, wireless broadband will provide opportunities for a lot of new gadgets and applications.
  6. Clean Energy Technology – so far, 46 countries and 23 states have mandated clean energy alternatives, from solar energy, LED solid state lighting, nuclear plants, clean coal, etc., as a means to help achieve energy independence.

Health Care’s Big Push

Last month, Pfizer announced that it was pulling the plug on a new cholesterol drug in its supply chain. The stock dropped 11% in one day in what is sure to be seen, in retrospect, as the key moment when big drug stocks realized that they need to begin acquiring pipelines from biotech firms instead of developing their own. Over the next three years, the large cap drug companies have $68 billion of branded drugs coming off patent. This loss of revenue, writes Tobin Smith, will cause the big drug producers to acquire smaller biotech companies in order to generate 10 to 15 pipelines to replace the expiring patents.

Additionally, with baby boomers hitting the retirement trail, their desire to lead active lives in retirement will generate opportunities for medical devices as well as drugs that will give them this opportunity.

Mergers, Private Equity and Hedge Funds

It is estimated that there is $2 trillion in private equity capital ready to take cash flow intensive businesses private, moving their stock out of circulation. This presents opportunities, for example in the mining sector, where Freeport McMoran will be the only copper producer in the S&P 500 after their merger with Phelps Dodge. As private equity takes companies private and mergers reduce the number of companies available for investment, the remaining companies are the asset of choice when developing diversified portfolios.

Hedge funds, with their esoteric computerized investment models are well positioned to rock the financial markets and increase volatility as they buy and sell huge blocks of stocks and options. The can cause massive changes in value in a matter of minutes as the computers buy and sell before human money managers know it is happening. We have seen this increase in volatility at times during 2006, pushing down entire investment classes in spite of strong fundamentals of the underlying investments.

A recent Wall Street Journal article noted that 71% of all corporate debt currently outstanding is of junk quality, up from 30% just three years ago. The huge increase is due to the practice of Private Equity to use debt to buy the equity of high cash flow generating companies, take them private, then use the cash flow to pay off the debt. This issuance of the debt is a fact, the pay off is currently only theoretical as we have not experienced a recession that might negatively impact the ability of those companies to continue generating that cash.

One of the reasons that past recessions have reacted so positively to interest rate reductions by the Fed is that debt was used for capital expansion of companies. As interest rates dropped, the expanded capacity provided more income combined with the lower debt payments to increase bottom line income, ultimately expanding employment and the economy in a recovery. This debt did not expand capacity, so a lowering of rates by the Fed in a recession will impact only one side of the equation. The cash flow required to service the debt, even at lower interest rates, may not be there if cash flow from operations does not also increase – a tough thing to have happen in a recession if you do not have increased earnings capacity.

Investment Conclusions

this section will be in the final version that you receive in the mail…