Archive for May, 2007

Parker Hannifin

Thursday, May 31st, 2007

Look at this chart. This is the sort of company I love. It has great earnings, its earnings growth rate is great, and the market is recognizing that earnings growth with an expanding multiple.

There is strong demand for machinery companies’ products as well as for their stock.

If we are managing your money, you likely own this company, or Ingersol Rand, or another of the machinery stocks. If you are managing your own money, the basic industries that are providing the machinery that is allowing for the world’s growth to speed ahead are the place to make money.

Mark

Market Correction Coming?

Wednesday, May 30th, 2007

The chart above is courtesy of Helen Meisler at TheStreet.com. You see that we currently have an investor optimism reading above 95. Historically, anything above 90 has preceded a market correction. The correction can be a few weeks away; once markets start moving away from fundamentals and get either over valued or under valued, that momentum can continue for a significant period of time. Generally there is a catalyst that ignites a correction (maybe the first signs of the Fed changing its bias back to tightening based upon food price inflation numbers???) and the optimism quickly drops off 20 or 30 points (just check out the graph).

We are in the process of placing some stop limit orders under some of the companies that will likely be impacted the most by a correction. The use of stop limit orders allows us to maintain market exposure while the move continues upward, but helps to protect on the downside once a correction takes place. There have been a number of other technical indicators that are signaling that this advance is pretty long in the tooth. This graph just makes it more visually discernible.

Mark

New Investment Strategies Newsletter

Monday, May 28th, 2007

Below you will find the text from our at-the-printer investment strategies newsletter…it introduces the theme discussed in an earlier blog post about Food Price Inflation…check back to this blog as we will be discussing specific investments that we’ve begun to add to client portfolios that fit with the food price inflation theme…if you have any questions, feel free to email or call.

Mark

PS – sorry for the underlines later in the article…I can’t get rid of them here in the blog…

This issue of Investment Strategies has been a long time coming. Since I last wrote, an entirely new investment theme has emerged, upon which we have been acting and which I wanted to share with you. This theme has far reaching impacts for the stock and bond markets that I believe are being ignored by most of the investment community. This is good news for our clients and the money that they have entrusted to us.

In past issues of this writing, those of you who follow it have read about our faith in the energy and metals stocks to be the big winners in this first decade – and maybe the second and third decades – of the new century. You know that our thesis has been based upon the demographic factors in Asia that have nearly a billion people moving from subsistence living into the middle class. This demographic change is happening to the largest extent in China and India, but Vietnam, the Philippines, South Korea – as well as other non-Asian economies, like Brazil, Russia, and Eastern Europe – are adding to the trend.

The initial impact of this trend, which we spotted a few years ago and which caused us to shift our investment emphasis to energy and metals, has provided our clients with huge investment returns compared to our competitors, 2006 not withstanding (hey, all themes take a break once in awhile, and after the huge stock price increases over the preceding four years, it was time). This year, we’ve seen a return to the earnings-based investment fundamentals that have driven up the stock prices of energy and metals companies.

As the middle class grows in these third-world countries, their demand for housing, consumer durables, and autos increases. These demands have caused China to be the world’s biggest importer of petroleum and metals, and the biggest consumer of them after the United States. This demand, in spite of the Chinese government’s desire to reduce their economic growth rate to the 8% level from the near 11% level, shows no sign of slowing – particularly given all of the infrastructure building that is happening in anticipation of the Beijing Olympics.

The next phase of this move to the middle class is a change in diet. A primarily rice-based diet is steadily being supplanted by a desire for meat and processed food. This shift is the basis for the newest investment theme we have been acting upon in recent months: Food Price Inflation.

Food Price Inflation

As the demand increases for meat and processed food in the third world, the prices for food world-wide will increase. As it currently stands in the U. S., consumers have just started to see the beginning of price increases at the grocery store. For the first four months of 2007, US food and fuel prices within the Consumer Price Index have increased 25% (led primarily by increased fuel prices, but food prices have begun to increase as well).

Most of the food price inflation has thus far been absorbed by the producers and not passed along to the consumers. This is evidenced by the Producer Price Index for unprocessed foods increasing 25% over the last 12-months while prices for processed foods have only increased in the mid-single digits. Soaring feed grain prices have just begun to force producers of meat, eggs, dairy products and processed foods to raise their prices. The CEO of Smithfield Foods recently was quoted as saying that the leap in corn prices will not longer be absorbed by his company, saying that “the meat industry hasn’t got a price increase in 30 years.” Expect to pay higher prices for food in coming months – and years.

We have been in a sustained period of disinflation since 1982. This has been a very profitable time to own long-dated treasury bonds and common stocks, subject to some typical (albeit violent at times) market corrections. Prior to August 12, 1982 (the date of the bottom of the equity bear market that started a decade earlier), inflation was rampant and it was devaluing both stock and bond markets. There were a number of factors that contributed to the inflationary cycle – the 1973 Arab Oil Embargo; the baby-boomers’ demand for housing, consumer durables, and autos (hmmm…that sounds vaguely familiar); and the failure of the 1973 Peru Anchovy harvest which (along with Russian grain purchases that increased demand) triggered runaway grain prices and food price inflation for grain products, meat, eggs, dairy products, and processed foods – anchovies were used two-fold in 1973: as additional protein enhancers in feed grains for cattle and in fertilizer (the reduced supply of feed grains and fertilizers pushed prices grain prices up).

There is a saying that history never repeats itself. But from an investment standpoint, rising energy and food prices in the 70’s seem eerily familiar. The demographic demand-based influences of the 70’s are being repeated today, with the middle class move in the Third World replacing the baby boomers, and honey bees replacing anchovies potentially limiting supply of some agricultural products.

Colony Collapse Disorder, as further described in US House of Representative Bill HR 1709 ( you can read about it at http://www.govtrack.us/congress/bill.xpd?bill=h110-1709 ), is a distressing situation. In today’s Chicago Tribune, they note that nationwide, the bee population has dropped by a third. World-wide, the bee population is collapsing and no known cause exists. Nine countries in Europe as well as Brazil are impacted, all – along with the United States – provide much of the agricultural products that feed the world.

Bees are a critical component to the production of 1/3 of the American diet, equating to $15 billion of the US economy; nationwide, 35% of the bees have disappeared, and in some critical areas its up to 90%. All of the world’s food baskets are being hit at the same time. “If the bee disappears off the surface of the globe, then man would have four years left to live,” said Albert Einstein. “No more bees, no more pollination, no more plants, no more animals, no more man.”

I’m not saying that we ar
e going to lose all the bees. Rather, I think we just need to extrapolate what happened with the 1973 anchovy harvest to today: we can expect some supply shortages in the agricultural products that rely heavily on bees to pollinate crops. Of particular concern will be the fruit crops and alfalfa, which is 100% bee pollinated. If the alfalfa harvest is less than normal and alfalfa prices go up, watch for increased dairy prices at the store.


Economic Considerations

If our thesis is correct, this has far-ranging impacts on the economy. No longer will the Fed have the ability to try to stimulate the US economy by lowering interest rates – an Alan Greenspan populist favorite move – knowing that inflation is in a secular disinflationary cycle. The Fed could juice the economy with low interest rates without fear that inflation would heat up in any significant manner

Alan Greenspan is retired, and his timing could not have been more perfect for his legacy. Ben Bernanke, upon assuming the role of Fed Chair almost concurrently with the start of this new secular inflationary cycle, has been spelling it out for us in his speeches and writings: he sees his job as primarily inflation fighting, not stimulating the economy. The analysts on CNBC that continue to call for a Fed rate cut based upon a slowing of the economy will surely be disappointed by this new Fed perspective.

With a US Current Account deficit of 7% of GDP, and the dollar in a sustained bear market, Mr. Bernanke has to assure the foreign holders of our Treasury Bonds that he is not planning to significantly and speedily devalue our currency. His job is being made more difficult by others in our government who have a different agenda – getting re-elected.

It is popular in Congress to deride China and call for their currency to move significantly higher against the dollar – both political parties do it. There is logic to this in that a lower dollar makes US exports to China cheaper for Chinese consumers, a fast-growing market. This logic says that more exports to China means more jobs in the US. China, though, happens to be the largest foreign holder of our Treasury Bonds. To accomplish the significantly higher move in their currency called for by Congress, China would need to dump their holdings of Treasury Bonds on the world markets, which would drive bond interest rates significantly higher. This would be disasterous for Treasury Bond investors world-wide, and for the US Economy since we rely so heavily on foreign buyers of Treasury Bonds to fund our current account deficit.

Our Treasury Department appears to understand this and is working to cause a gradual devaluation of the Dollar against the Yuan, which has fallen from 8.3 to 7.6 Yuan to the Dollar over the last two years. As long as this policy of a gradual devaluation continues, there should be no run on the Dollar and Mr. Bernanke can fight inflation by maintaining current interest rate levels. Unfortunately, as food price inflation begins to become more noticeable to consumers, he will likely have to raise rates. If Congress is successful in causing China to significantly increase the value of the Yuan in short order and investors sell Treasury Bonds, he will likely have to raise rates faster and higher than he might otherwise need to in order to defend the dollar.

In short, the secular bias for interest rates has shifted to higher rates, not lower rates. Any recession that might be on the horizon may temporarily reduce short-term rates on a cyclical basis, but the general direction of rates through the end of the decade will be up.


Investment Considerations

An investment environment of rising interest rates is not a friendly place to be. If you look back at the decade of the 1970’s to 1982, you will see that the Dow Jones Industrial Average returned a net 0% in all that time. That is not to say that people didn’t make money, but you had to be a very active trader, successful market timer and short-side investor to make money – things most people and institutions are not – as the market fell and ran up to the old high then fell back again.

During this time, the commodity stocks – energy, metals, ag, and gold – were in a major bull market phase. The stocks in industry groups that are inversely correlated with the commodity stocks – technology, financials, consumer stocks – were in a sustained bear market. The P/E ratio on the S&P 500 dropped to low single digits during this period as investors continued to devalue the non-commodity stocks. The energy stocks, as a percentage of the S&P 500, increased from low single digits to 25% of the entire capitalization of the S&P 500.

I started my career in this business in the early/mid-1980’s. I didn’t experience the pain of my mentors who lived through this, but I did learn from their retelling of their experiences. The Dow finally broke out of its bear market bottom on August 12, 1982. The US and Great Brittan had made an assault on inflation when the Regan/Thatcher/Volker plan to crush it from the supply side began to make impacts. The high interest rates that dried up the supply available of credit and sent economies into deep recessions, actually was good for the stock market.

Stock markets, being leading forecasters of economic activity, projected that the draconian measures enacted by the trio above would be successful and that corporate earnings would again begin to rise. This was the beginning of the end for the commodity stocks that soon went into a 20-year bear market just as the P/E on the S&P 500 began its move from 6 to 46 in 2000 (and coincidently back to 18 concurrently with the energy price inflation that began shortly after 2000).

I believe it is unlikely that we will see the severe inflation that we had in the 70’s, the double-digit interest rates required to combat it, nor the extreme devaluation of the US stock market to single digit P/E multiples. I do believe it is instructive, though, to learn some of the lessons that worked and employ them in our portfolio management strategies today.


Investment Strategies

Since we have been properly positioned in energy and metals companies for the past few years and have benefited from the demographic changes described earlier, it is now time to examine how we are going to profit from the food price inflation theme while balancing the impacts of other themes.

  1. Remain overweight the base metals stocks: core investments that will continue to benefit from the world’s
    demographic changes.
  2. Remain overweight the energy stocks, with an emphasis on the Canadian Oil Sands stocks: oil in safe areas of the world, will become even more valuable as oil in dangerous or geopolitically troubled areas depletes or becomes too dangerous to extract.
  3. Maintain positions in gold and gold stocks: when the concept of food price inflation becomes more widely accepted, gold will be viewed quite favorably as an asset and should make an assault on its historic highs.
  4. Reduce exposure to consumer and financial stocks: history shows that they will lose value as their P/E’s are reduced in favor of commodity stocks.
  5. Increase exposure to agribusiness companies: earnings will be strong through the end of the decade, if not longer – watch for P/E’s to increase along with earnings.
  6. Reduce fixed income duration: rising inflation is bad for bonds, no way around it.
  7. Maintain exposure to emerging markets: growing financial influence, increased economic growth, and positive demographics make them less risky than previously thought, from a portfolio management perspective.


Summary

Since the last publication of this newsletter, BankChampaign, N. A., has reorganized itself. We have added an new Vice President of Wealth Management, John Clausen, to our staff. He has taken over much of the administrative work performed by Mark Ballard, allowing Mark to concentrate on the strategic issues of the bank and the investment management business. The newsletter, as well as our blog – which you can access from a link at www.bankchampaign.com, should be more current sources of information on our investment strategy for clients and friends from this point forward.

Our investment returns continue to be superior. Our since inception (May, 1991) average annual return for equity management is XX.XX%, and our since inception (May, 1991) average annual return for blended portfolios of stocks and bonds is XX.XX%. If you have a need for our Investment Management Services, please contact Mark Ballard or Andy Thorman. If you have a need for our Trust and Fiduciary Services which incorporate the investment strategies discussed herein, please contact John Clausen. Our number is (217)351-2870.

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Thanks and sources for the research contained herein include: Don Coxe of BMO Financial Group; Ken Duft, College of Agricultre, Washington State University; Barry Ritholtz, Ritholtz Research and Analytics; and Shannara Johnson at Investor Insight.