Trend Management, Inc. Third Quarter Report 2016
On February 24th, 2015, the S&P 500 closed at 2115. On September 26, 2016, the stock market closed at 2151, gaining 1.7% over the prior nineteen months. That may seem like a boring market, but we know it wasn’t.
During that time-frame, we had two, 10% corrections in the S&P 500. Six, straight quarters of declining earnings helped increase the pressure on stocks. The U.S. economy has not entered a recession, but has slowed some. We expect the upcoming election to generate some stock market volatility, over the next thirty days. Political uncertainty usually increases investors’ anxiety, and this year is no exception. We have stated in the past, the United States president is the second-most powerful person, relative to the stock market. Most powerful is Federal Reserve chair, Janet Yellen.
Investors have been on edge, since the world watched asset values evaporate in 2008. To ease concerns, central bankers in Europe and Japan have, and continue to print a lot of money to help raise asset prices. Until two years ago, the U.S. printed around $4 trillion to lower interest rates, in the hope it would increase the value of stocks, bonds, and real estate. In hindsight, we can say the strategy worked.
If inflation ever results, Europe’s and Japan’s central bankers will stop printing money, instead taking money from the system to slow the inflation. A withdrawal of money would cause stocks and bonds to struggle.
The chart illustrates year-over-year change in the amounts of money circulating in the U.S. From the third quarter of 2015, circulation started to increase, with M2 at a new, three-year high this quarter. So far, the increase in M2 has led to wage gains over 2%, but overall inflation, as measured by consumer prices is at only 1.1% per year.
The Federal Reserve’s mandate is to hold inflation around 2%, and have full employment. We think those boxes can be checked. If inflation rises above 2%, we anticipate the Fed starting actions to slow down the stock and bond markets. We have bought commodities, gold stocks, and foreign stock markets we think will go up during this phase.
Both the Republican and Democratic parties indicate plans to dramatically increase fiscal spending. As we know, what politicians say, and what they do, may not be the same things. However, there appears to be a consensus to increase government spending as a percentage of GDP. If a big increase in fiscal spending passes Congress in 2017, it will trigger a greater acceleration in M2, than we have had so far. If it occurs, we predict the Fed tightening the market more than it expects. We know it is strange to say, when the economy picks up, it increases the likelihood of stocks struggling, but that’s how we see it. At that point, we’ll then discuss a greater cash position or owning fewer, cyclical stocks.
For now, we view the stock market as ahead of itself, but not horribly so. We think it is priced to earn between 4% and 5% per year, over the next ten years, but our stocks are priced to double that return. We consider our managed accounts as a market of stocks, not a stock market. In other words, companies we own and hold for long periods of time can withstand the overall market’s ups-and-downs. We will sell them, when they become over-valued, or do something we don’t like. That happened this quarter, with Microsoft.
Five years ago, we bought Microsoft for most of our accounts at around $27. In 2011, its business was fantastic. We sold it, this quarter, at $56.47. Why? The once-wonderful Windows franchise is being damaged by “cloud” technology, yet Microsoft is spending massive amounts of money to support its new Windows, as well as cloud infrastructure. Although we doubt its investment can be recouped in a timely manner, two things pushed us into the sell camp.
We forecast Microsoft stock’s future returns to be in the low, single-digits--before it spent $26 billion in cash for LinkedIn. We didn’t view the LinkedIn acquisition as a good use of Microsoft’s cash. It had already spent $8.5 billion for Skype, receiving little in return. Microsoft also bought Nokia for $7.5 billion, then a year later, wrote off $8.5 billion on its investment. That may be a new, modern-day record for blowing cash in an acquisition, but buying LinkedIn was the last straw. We wished them well, and moved on.
Wells Fargo has been in the news, and the news isn’t good. We are big fans of Wells Fargo, but some proverbial heads are going to roll. Wells Fargo likes to cross-sell products to its customers. For example, a Wells Fargo checking account is considered one transaction. Add a credit card to the account, and it’s a second transaction. A loan would be a third transaction. Wells Fargo averaged six transactions per account, which was fantastic compared to their competitors. Until Wells Fargo pushed its cross-selling culture too far.
Approximately 5,300 Wells Fargo were fired over the last five years, for not reaching upper management’s aggressive transaction quotas, or for creating fraudulent transactions. Upper management was aware of the latter practice in 2013, but did very little to stop it. It’s doubtful the CEO will keep his job, and likely to also take a huge, monetary hit.
Opening accounts customers didn’t authorize is a form of identity theft. Some people experienced credit-rating downgrades, resulting from multiple credit card accounts they didn’t know they had. Wells Fargo was fined $185 million, and public perception of its banking practices is horrible. We estimate the ultimate damage to be in the $1 billion to $2 range.
Because Wells Fargo’s profits from fraudulent account transactions was small, we don’t need to reduce our earlier earning’s estimates. It averaged a $22 billion net income over the last three years. We were surprised Wells Fargo screwed up like this, but it can afford to pay a price, and it will. We still think it will earn over $22 billion in the future, before write-offs. For now, we will collect its 3.3% dividend yield, and see how systemic this event was. There will be more headlines to come, but we don’t consider this event a reason to sell Wells Fargo stock.
The last stock to update is American Public (APEI). This is the cheapest stock we own, and it continues to be a problem. APEI’s stock market valuation is $310 million. Of that, $125 million is cash sitting on the balance sheet. It has no debt. When you back out the $125 million, the market is valuing the company at $185 million.
In the past five years, APEI has an averaged net income of $39 million. If it continued earning $39 million per year for another five years, it could take its excess cash on the balance sheet and buy back the entire company. Although APEI qualifies as cheap, it isn’t predictable, which is the problem.
Corinthian College and ITT, two for-profit education stocks, were put out of business by the current administration’s regulatory policies. Those companies had different business models from APEI, which we did not like. That said, today’s political climate has cast a shadow over the whole group. At this time, our confidence is low, regarding exactly when the situation will clarify for for-profit education companies.
The military is a strong, APEI niche market, but we were wrong in our analysis, and predicting its pretax profit. The logical question is, what do we do now? A stock four times cheaper than the market is great, but we aren’t sure which way the pretax will go. Another for-profit education stock, Apollo, (University of Phoenix) with a much bleaker future was bought by a private equity company, earlier this year. We think there is a decent chance APEI may also receive a buy-out bid. We don’t like to own stocks betting on an event like a buy-out, but it could be our exit.
In the meantime, we think APEI has ways to fix its own problems and make the stock go up. If we were APEI, we would jettison everything related to Title IV money. Downsize the organization and concentrate where it already has an advantage: military/law enforcement, and its nursing school business. Those specialties are very valuable online courses for the military, and for society. At the same time, we’d recommend taking the $125 million on the balance sheet and buying back one third of the company at these prices.
Whether APEI downsizes and focuses, and/or initiates a stock buy-back, we think the market will drive the stock to a more normal valuation (over $30). We do try to buy stocks twice as cheap as the market, because occasionally you run into a mess and need that margin of safety. So far, this stock qualifies as a mess. In the short-term, we consider the risk to the downside is limited, due to APEI’s large cash position and no debt.
We continue to believe the major, world economic trend investors will need to deal with is the dollar’s decline over the next five years. It will be led by an increase in the price of oil, and an exploding U.S. trade deficit. The premise and prediction guide managing our accounts.
Our Christmas party is later than usual, on December 22nd, from 6 p.m. to 8 p.m., at Highland Springs. There will be a buffet, and the band will play from 6 p.m. to 7:30 p.m. We will also be celebrating Brandon Robinson’s engagement to Jessica Young. Please join us in the festivities.
Sincerely,
Mark Brueggemann IAR Kelly Smith IAR Brandon Robinson IAR