Trend Management, Inc. Year End Report 2011
Warren Buffett once said “If you stick around the markets long enough you will see some really strange things”. I think this year’s stock market trading will qualify as the strangest one I have seen in my 28 years of being in the business. As I type this letter the market for large cap stocks is going to finish the year about unchanged and the market for small cap stocks will be down five to seven percent for the year. During the year, the S+P 500 has fluctuated up and down on a closing price range of over 1250 points while finishing the year around 1250. To put that trading into perspective, the market basically had a trading range of 100% and yet it finished almost unchanged. How does that happen? We will talk about that below.
The economic statistics in the U.S. are getting better. A lot better. Consumer confidence had a record jump up in October, housing construction has gone positive for the first time in 5 years, automobile production is up for the year, the S+P 500 will have record earnings, GDP just made a new high, and bank lending is coming back in the U.S. Yet nobody cares. We can tell that nobody cares about the above good news in the economy because the public continues to pull money out of the stock market every single week (since 2008 they have pulled out over one half trillion dollars). With the public “fleeing” the market, that just leaves hedge funds and high frequency traders to determine which way the market will go on a short-term basis. A hedge fund’s opinion is only good until lunch time so they aren’t a group that sticks around for long. If there is a rumor about anything in Europe the market is good for a 2% move up or down based on that rumor. We have basically had 100% of those types of moves this year. With great certainty these funds have traded the market and yet don’t have anything to show for it (the average hedge fund lost money this year). Because so many investors lost money in 2008 almost everyone who trades and particularly those who trade on borrowed money (like hedge funds) have developed systems to try and protect themselves from another collapse like 2008. Most of those systems base their buy or sell decisions on the PRICE of the index they are trading. If the price goes up, they buy more; if it goes down they sell more. They want to trade with the “momentum” of the market while being in “synch” with the news. This type of trading was particularly true for the gold market in the second half of this year. When you don’t have the public in the market buying stocks or other assets on a long-term basis to help slow down these swings you get a crazy market like this one.
Huge frightening moves down followed by sharp rallies in the other direction with the end result being not much real change IN THE PRICE of what you own. It doesn’t make it easy to sleep when you have a market up or down 2% almost weekly. What does make us sleep well is that those same stocks the hedge funds are trading daily are actually real companies who as a group had a record year for profit. We hope these companies might buy back their own stock if they think it’s cheap, perhaps pay higher dividends to shareholders, or they may even buy other companies if it makes sense. Eventually those actions will bring the public back to this market because parking your money in cash at zero when inflation is at 3.5% doesn’t make much sense. We think next year the earnings for companies will matter more than the fears of what’s going on in Europe. Why do we feel that way?
When the stock market was screaming upwards in 1999 you could hardly find anybody who thought that the party was going to end. Oh you might have heard a little grumbling from somebody who sold stocks in 1995 thinking the market would correct and when it didn’t was mad because they missed out on all of the fun. Absent that guy, when the market peaked in March of 2000 at 1552, prevailing wisdom was that it was only going to be a temporary correction before the market took off again. With the market trading at 1250 eleven years later we now know that wasn’t the case. What happened? The answer is investors were paying too much for stocks back
then based on history. The average five year earnings for the S+P 500 in March of 2000 were $44.72. If you want to compare those earnings to say a U.S. 10 year treasury bond just take those S+P 500 earnings in 2000 of $44.72 and divide it by what you paid for those earnings of 1552 (the price of the S+P 500) and the yield to you is 2.9%. Ten year treasuries were yielding 6% at the time. So in March of 2000 you could take a sure 6% on treasuries or gamble that the earnings on the S+P 500 would grow rapidly (within 5 years) from $44.72 to at least $70 dollars to make up for the difference in yields. As we now know that bet didn’t pay off. Eleven years later we have the reverse situation. The average five year earnings on the S+P is $73.48 and you only have to pay 1250 to get that. If you take those earnings of $73.48 and divide it by 1250 you get an earnings yield of 5.88%. Today ten year treasuries are yielding 1.92%. We are in the EXACT OPPOSITE SITUATION as 1999. For anybody buying a treasury bond today to be right versus owning stocks the earnings on the S+P 500 would have to crater (down about 50%) and yet S+P earnings just set a record this year of around $97 dollars a share (remember the $73.48 we use is a five year trailing average). In 2000 investors were willing to bet on rapid growth in earnings and today they are betting on a rapid decline in earnings. We think a bet on a permanent decline in S+P earnings is a bad bet. It hasn’t happened since 1929 where earnings would have been this poor. When we do the math on what the market expects S+P’s earnings to be, we think the market is discounting a recession that is worse than the one in 2008-2009 period. We just don’t see that happening. A long-time client of ours who doesn’t buy green bananas anymore always asks us “Will he live long enough to see it?”. Though we aren’t good at predicting everyone’s life expectancies we think we can put a decent time frame on this for our green banana client.
For the S+P to be earning twice what the Treasury bond yield is occurs very rarely. In fact it has never happened in the last 35 years until the crash of 2008-2009 and this year. We are witnessing something very strange versus history. Usually stocks yield less than treasuries because stock earnings grow and treasury bonds interest payments don’t. In the last ten years S+P’s earnings are up 64% which is a little slower growth than historically normal but still decent. As a base history case the average earnings yield on the S+P 500 since 1990 is 4.89% and the average yield on the ten year treasury was 5.24%. When you see today’s huge gap between the ten year and the S+P earnings yield it means we have a confidence issue the market is dealing with. That issue is Europe and what happens to the Euro currency if it collapses. We are on record as saying that Greece should default and leave the Euro. We still feel that way. We don’t see a painless way out for them. Their best bet is to leave the Euro, devalue their currency and become a cheap tourist attraction to boost their economy. We thought this would happen in September but it did not. We still expect them to get kicked out or kick themselves out of the Euro. We think the world economy and the banks can handle their default. More than likely the stock market will sell off on this news but we think it will be temporary. When you have two years to prepare for an event it is not going to be a surprise. What has kept EVERYONE on edge is what happens if somebody like Italy or Spain defaults? That fear is THE FEAR the market is dealing with and up until the last two weeks of December we didn’t see an end to this issue. We now think we see the end of that fear for the next two years and we will explain it next.
If I loaned you money for three years at 1% and you could buy a three year government bond from the country you live in at 6% would you do it? For the vast majority of investors the answer is yes. This is what investors call a “carry” trade. You are going to make a 5% return on your money (I get 6% and I pay you 1% which means I make 5%) with no risk unless your government goes under. It’s free money. This trade is what the European Central Bank (ECB) just offered in December to all of their banks. You can borrow an UNLIMITED amount from the ECB at 1% for three years and do whatever you want with it. The ECB will also make this offer to you again in February if you want to do it again. Last week European banks borrowed almost 500 billion Euros to take advantage of this offer. Why does this solve the Euro crisis, in our opinion, for the next 3 years? Let’s use Italy as our test case example for this trade. If you are a bank in Italy you have to own Italian bonds to do business, because it’s what your clients own for the most part. In the U.S. our banks own our treasuries because it’s what their clients own and our government encourages them to do so. Italy has the fourth largest debt of all the world’s economies. That said, their budget deficit is only 25 billion a year which is very small compared to the U.S. budget deficit of over one trillion. The reason Italian bond yields have gone up to the 7% range is that they have to roll over 300 billion dollars worth of bonds in 2012, as well as borrow an additional 25 billion to fund their budget deficit. In this fear driven market investors are worrying that when those 300 billion in bonds mature the current owners WONT roll over their money into new Italian bonds, but will flee with that money and go somewhere else with it. If that was to occur then Italy is in trouble. That’s the fear we have been dealing with for two years now. With the ECB giving the banks of Italy UNLIMITED money for the next three years it won’t take the Italian banks long to figure out how to borrow at 1% and invest it at 7% in their own bond market. In essence the ECB is letting the banks fund their own government’s debt market while allowing the banks to make a boat load of money risk free on that 6% spread. By doing this the ECB is going to bail out both the banks (who need to raise capital) and their host countries for the next three years. So we can’t figure out how Italy can go broke when they have somebody willing to lend any amount of money they need to their banks at 1% to buy Italian debt. The only way this “system” would fail would be if the Italian banks say “No thanks” we don’t want this money or they borrow the money but don’t buy their own Italian debt. Because demand was so strong for this money (500 billion euros) we know the banks took the money. Now we have to wait and see if they can figure out how to make 6% with minimal credit risk. Based on this long winded paragraph we are betting the crisis is over for the next two years plus (except for Greece) and that the stock market will figure it out sometime in 2012. When it does, we expect to see a pretty strong bull market ensue in U.S. stocks. A fair target for the S+P 500 today is 1500 or 20% from here. A reasonable target three years from now would be over 1750 or 40% from here. Please remember we have been wrong before so don’t chisel that prediction in concrete. That said, it’s our job to tell you what we think is the most probable event based on what we know today and we think a 20% up move in stocks is the most logical outcome from the ECB solving this mess. Feel free to come by the office and we will show you more detail on how we got there.
Let’s talk about some of our stocks briefly. For the most part our stock selections did worse than the S+P this year. They had done better the previous two years but they definitely under performed this year. Why? The answer is we are invested for an economic recovery and the market doesn’t believe one is going to occur. Even though Berkshire, Johnson and Johnson, Corning, BGC Partners, Wal-Mart, Wells Fargo, American Public, Liberty Interactive, Cintas and Maxwell had good or record earnings their stock prices didn’t really do much. At some point the market will notice this as we mentioned above. We expect each of those companies to have better earnings next year. Though BGC partners had record earnings they are going to have a slow fourth quarter due to lower trading volumes caused by investors concerns of Europe and the bankruptcy of MF Global. We view this as a temporary problem and not a long-term issue. Right now BGC is paying over a 10% dividend yield to us so it’s ok to sit and wait on trading volume to come back. For the rest of this letter I would like to talk about a few stocks and our view on the economy in more detail.
Let’s start with our old favorite Level3. Level3 has finally fixed its past issues and will report record earnings next year (I am including the increased shares they issued to buy Global Crossing when I say this). Because of their merger with Global Crossing they now go to Asia and Latin America which are growing very rapidly. Level3’s reward for this merger was to see their borrowing costs DROP BY 4% this year while getting a credit upgrade by S+P. Yet the stock dropped from a midyear high of $40 to $17 at year end (It started the year at $14.50). It’s pretty rare when a company’s stock doesn’t go up a lot, when they are able to borrow at 4% less than they use to but that’s what happened this year. This would be analogous to your personal FICO score going from 600 to 800 and your creditors still view you as a bad credit risk. For the year Level3 will grow their revenue by 8% with earnings increasing at double that number. We think that revenue growth rate number is sustainable for many years to come. Level3 has over 6 billion dollars in net operating losses they can use to shield them from paying any taxes on earnings which are now coming soon. Those NOL’s amounts to around 9 dollars a share in tax free benefits. With the stock trading at 17 the market is basically saying the network that they spent over 100 dollars a share on is worth $8 or 8% of replacement value (17-9=8). We find this valuation nuts but it is what it is. If the NEW Level3 continues to grow revenue at 8% a year they will have yearly free cash flow of over $2.50 a share starting in late 2013. We hope they take that money and plow it back into the network where they say their payback on new money spent is around 18 months. In the enterprise market (large and small business) they have around a 3% market share while being the low cost provider for bandwidth. The opportunity they have here is huge. The wind is at their back, the balance sheet is fixed, they control their own destiny from here. Our timing on this stock has been horrible and we have confessed to that in the past. In 2007 Level3 was right where they are today and they messed up the integration of the networks they bought and it set us back 4 long years while they fixed it. We think this time they get it right and we don’t just make 15% on this stock from last year but a whole lot more.
What’s wrong with Berkshire? We get that question a lot. Why is a AAA rated company down 5% for the year when they are reporting record pretax earnings? When a company’s earnings go up and the stock goes down usually management tries to buy back its stock if they think it is cheap. For the first time EVER Buffett actually did buy back some stock in q3. We don’t know how much he bought back in q4 yet but we are guessing it’s over a half a billion dollars worth. He told investors he would buy back his stock at up to 10% over book value. We place that price target at $74 dollars a share and the stock is at $76 as I type this. What we find interesting is that the world’s greatest investor is telling you at what price he will buy back his own stock and yet the stock really hasn’t responded by going up much. More than once in the past I had wished that I knew what he was buying before everyone else was told through an SEC filing. Today we know that information and it doesn’t seem to matter? Why is that? Our best guess is that he is 81 and the market is worried about who takes over for him when he dies. Thirty years ago Berkshire was correctly viewed as a one man show but that is not the case today. Berkshire is now a collection of fantastic businesses that have over one billion dollars a month in free cash flow. That won’t stop when he dies. The market is saying he won’t be around to invest that cash at some point and I agree. He has hired two guys to help invest the money and their track records are good but I agree they won’t be as good as Buffett was. What the market is missing though is that if the stock stays here Buffett or the board of directors will just keep buying back Berkshires stock which will eventually drive up the stock price.
When you have a billion dollars a month in free cash flow you need to invest and the market cap of your stock is 126 billion it would only take 10 years to BUY BACK all of Berkshire’s stock and take it private. Heck he could start paying dividends to shareholders if he wanted to and the yield would be around 10% at today’s stock price. If by chance the stock doesn’t go up in the next five years he could spend 60 billion buying back stock AND THEN pay a dividend to the shareholders who are left. That yield would be around 20% to the investor. This won’t happen but I hope you get the point. We view this stock as a very good buy right now.
Our last paragraphs are going to be about something we wrote about over a year ago. If you hate optimistic talk about America you can skip this. When we wrote about the rebirth of American manufacturing and how the U.S. economy is poised for some strong growth in the future the response we got wasn’t positive. Blah or “yeah right” would be a better description of what we heard. We can’t blame people for feeling that way after watching a 30 year decline in the middle class and manufacturing occur in this country. Trying to predict the end of a long-term trend like that is dangerous from a forecasting standpoint but we did it anyway. We want to revisit this idea but discuss it from a different angle. When we talked about the rebirth of manufacturing we focused mostly on how the Chinese currency would have to go up versus the dollar and how that would make our goods produced in the U.S. more competitive. Since we wrote that letter the Chinese Yuan has gone up about 8% which we think is good but we think that’s just the start. Its going higher whether they like it or not and every one percent increase in their currency improves our ability to compete with them. What we DIDN’T talk about last time is something that is just now being talked about which we think has HUGE ramifications for investors over the next 10 years. Energy costs. Somewhere around 2005 a technology called fracking became commercially feasible for drilling natural gas and oil. We can thank a former vice president who happened to be a past CEO of Halliburton for getting legislation passed to make this technology more available. Of course he did it to benefit his old company (what a shock) but it’s going to benefit the U.S. a lot more. What fracking has done is lower the cost of natural gas in this country to a price lower than anywhere else in the world except the Middle East. Oil is trading at $100 dollars a barrel worldwide but an equivalent barrel of oil priced in natural gas is trading at $16 a barrel in the United States. Oil is 6 times more expensive than natural gas at today’s prices and it has a smaller carbon footprint. There are environmental concerns about fracking that I won’t go into in this letter but we feel the fears are over blown based on what we have researched. Some groups hate anything that isn’t solar power and I think fracking is an easy target for those groups. It’s new, it’s from an oil company and that’s enough to not like it. So why does lower natural gas prices and west Texas crude oil prices matter to U.S. manufacturing?
Nucor is a steel company who has complained a lot about how the Chinese are unfair competitors. They complain about how the Chinese manipulate their currency and how they try and dump their EXCESS steel below cost into the United States. The have said the same thing about some steel companies in Brazil. About 9% of the cost of producing steel is the cost of natural gas. The price of natural gas in China is NOW about twice what it is here in the U.S. (In Europe it is higher than that) versus being equal five years ago. In other words, Nucor now has a 9% cost advantage in energy costs when it produces steel in the U.S. versus their Chinese competitors. The same thing goes for their Brazilian rivals. Nucor just built a plant in Louisiana to take advantage of this new edge. Not to be outdone a Brazilian company actually decided to build a steel mill in the U.S. rather than in Mexico this month. Why? They said the cost of energy in the U.S. is 30% lower than the cost of energy in Mexico. Even with lower Mexican wages it was cheaper to produce in the United States. We are seeing the same thing occur in the plastics industry where cheap natural gas is making it better to produce here than not. The U.S. is sitting on a huge amount of natural gas so we won’t be running out of natural gas anytime during my lifetime. In fact a strange thing is also happening on oil imports from the Middle East and OPEC. We use to import in to the U.S. 50% of our energy needs and now its 40%. There are now projections that we could be off of OPEC oil by the end of the decade if this production trend continues. What this means for America is huge. We are going to have a lower currency versus our main competitors (China, Korea and Japan) and now we have a cost advantage on the energy we use. Obviously this is good for our economy and the middle class that has been hollowed out over the last 30 years when we shipped our manufacturing jobs overseas. We are aware that the Chinese are working on fracking as well but we view them as being years behind us and not close to catching up. Korea, Europe and Japan don’t have any natural resources like we do to take advantage of this, so fracking is not going to help them. As the jobs come back to this country I look for inflation to come back as well but that’s down the road. Please keep in mind that if you want to ship something into the USA you can always tack on about 15% for the cost of freight which helps our cost advantage against imports as well. So to sum it up, we are bullish on the American economy going forward. It’s not a popular view on the TV talk shows but its how we see it. We have some investments based on this idea but we will have more over time.
We want to thank everyone for their support of Trend Management. As you can tell we are pretty optimistic about the next few years. The first quarter could have some S+P downgrades of Europe for investors to deal with but we think the table is set for a few good years in the market. Enclosed is a copy of your privacy statement. If you have had any changes in your financial situation, please get in touch with us so we can update your account.
Mark Brueggemann IAR Kelly Smith IAR Brandon Robinson IAR