The bottom of the World Wide Recession

Third Quarter Report 2015

This quarter the stock market suffered its first 10% correction since 2012. There were also new multi-year lows in commodities, emerging market currencies and junk bond prices. When you combine those four ingredients together it makes for a volatile market and we had that this quarter. We will outline our thoughts below for the market along with some comments on our individual stock holdings.

The markets are in flux because the world is fearful of another recession similar to what happened in 2008-9. To be more precise, the world is afraid that China’s economy is collapsing. China is the largest consumer of commodities in the world. The last twelve months decline in commodities is a sign to investors that the mess in China is real and not getting better anytime soon. The CRB index (a basket of 19 commodities) declined in 2008 from 470 to 203 before rallying to over 300 in 2011. The CRB index is now trading below those crash lows at 192.

This quarter we did buy a basket of commodities when the index was trading around 218. We are hoping we are near the low in commodity prices. The lowest the CRB has traded in the last ten years was on August 24th at 185. At that time oil was trading at $38 dollars a barrel (its $45 today). If we take out either of those lows this quarter it will be a sign to the deflationist camp that things are getting worse. Hence I would not expect stocks or anything else to be doing well at that time should commodities go below the August lows of 185. If we can hold those lows then I expect the stock market to be less volatile and trend upward. So in the short-term just watch commodities for a guide on what’s next in the stock market. For now, commodities are telling the stocks which way to go. For this quarter that was down.

If you are a consumer and don’t own stocks isn’t commodities going down a great deal? The answer is yes. The savings to fill up our car with gas at $1.95 makes us feel good. The same goes for natural gas at new lows which heats our homes. If you build a house and use copper or wood you would be excited to see these prices go down as well. However, if you are a producer of these goods and borrowed money to expand you facilities when prices were higher, you are not feeling as well. For now, Wall Street is focusing on the dark side of commodities going down. Companies produces this stuff and Wall Street has been actively selling them all.

At some point in this cycle the lower prices of commodities will cause the demand for products that are made with those commodities to go up. You and I will buy more of these products at a lower price causing demand to eventually go back up. Once that occurs WORLD WIDE, the bottom of this recession will be in.

We mention recession because we have said in previous letters that the world is in a recession. We still believe that the world is in one even if the U.S. is not right now. Europe, Latin America and Asia are just having a really bad time growing since the crash of 2009. We think the top of world growth was in August 2011. At that point Europe rolled over and we have not come back as a planet since.

This global recession has been ongoing for four years now but is finally getting acknowledged by the world community. As we stated in our last letter the effectiveness of printing money is diminishing in generating ECONOMIC growth but is still effective in pushing up stock prices. From a macro standpoint stocks will continue to be supported by the European and Japanese central banks printing over a trillion dollars this year. We think this money will help keep this bear market in the under 20% range (we were down around 14% at our worst in August).

However the money printing will not help those who don’t own stocks like it did early in the cycle. To do that, the world governments need to spend more money on some form of infrastructure. Whether it be bridges, bombs, schools or airports there is a lack of demand in the world that will need to be filled by fiscal spending. So far in the U.S. we have a potential deal of corporate tax cuts in exchange for Government spending on public works. We hope that goes through. It would be a bipartisan deal in a city not known for that lately. We shall see.

We believe this is the fourth market correction since 2009 where the market has gone down over 10%. They are all no fun and this one is no different. We think that once this one ends our stocks as a group will go to new highs. We will discuss some of our companies next and why we are positive on them. We won’t cover them all so feel free to call us on any not mentioned.

We wrote a lot about Maxwell in our last letter. This quarter they announced a restructuring of their business that lowers their breakeven costs dramatically. They also announced their first ultracap win in the United States with Cadillac. This is a very big win for them and one we hope is the start of more to come in

the auto sector. We think that the leadership at Maxwell is making the right decisions and the stock should respond to that. So far this quarter there have been four insider buys of the stock below 5 dollars. We view this positively.

Level3’s stock price had a really crummy quarter (down 19%). The market is fearful their enterprise business is slowing in the US. We don’t share that fear. We feel Level3 is in the perfect position to grow enterprise business for the next five years while AT+T and Verizon are distracted by pricing competition in cell phones. Level3’s largest shareholder also bought over 50 million dollars’ worth of stock this quarter. That shareholder has board seats that help give them insight into how the business is doing at Level3. We plan to hold this stock for another five years as they increase their enterprise market share in the US from the single digit levels to over 10%. We think they will be tough to stop from here on out. We expect Level3 to have free cash flow this year of 600 million plus and close to one billion next year.

Another poor performer this year has been Berkshire Hathaway. The stock has declined 14% this year from an all-time high of 150 to 129. Buffett has publicly stated he will buy his stock at 120% of book value and that target is 121.50. If the world’s greatest investor is willing to buy the stock if it goes down another 6% I am in no hurry to sell it to him at these prices. This quarter Berkshire also bought Precision Castparts for over 30 billion dollars in cash. This acquisition will be taking money that is earning virtually nothing in a money market and increasing that return (our estimate) to over 9%. This acquisition will insure higher earnings for Berkshire going forward.

Bgcp’s stock is also down this year by about 7%. This quarter they reported record earnings for q2. We consider the 56 cents a share dividend secure and likely to grown in the next 12 months. That dividend works out to a 6.5% yield with the stock trading at 8.5.

Apple’s stock was down 9% for the quarter. We view Apple as a cheap stock that is tarnished by the fear it’s the next Research In Motion Blackberry device. We don’t share that view because Blackberry’s didn’t have any apps written for its phones and the IPhone leads the world in that area. The apps make the phone hard to replace because they are written on the IOS operating system. We view IOS as the safest operating system in the world for phones and almost impossible

to replace. Apple has been a huge buyer of their stock and we continue to see that happening.

I want to finish up this short-review of our stocks by talking about Exxon. We have owned this stock and it’s been a poor performer this year. The decline in oil has really hurt their earnings which we didn’t see coming. We bought the stock because it was very cheap, the dividend was good and we thought it could whether the decline in commodities better than most. So far that thesis has been wrong. We feel like we missed some signs that should have kept us out of buying the stock when we did. We are ok holding it at these levels but we feel like we could have done a better job on the purchase of this stock. Hindsight is 100%. We feel we could have done a better job here and hope to learn from it.

As we write this letter the market is trying to go to new lows for the year. We feel the fourth quarter is going to be a volatile one similar to the third quarter. Be prepared for some crazy swings in your account this quarter. As we said above, if the commodity markets stabilize we think the markets will too. If they don’t, then the world will be fearing a repeat of 2008 and it will get real messy. We like what we own and are willing to sit through what happens next. We have cash left over from what we sold at the beginning of the year and will look to put it to work on market breaks. We will paraphrase Warren Buffett here because we think he says it best about markets, “In the short-term the market is a popularity contest, in the long-term it is a weighing contest based on how much money your company earns”. Right now stocks are not very popular. In the long-term we think they will produce record earnings. The earnings are what matter.

The Christmas party this year is December the 17th at Highland Springs. Put that date on your calendar and we hope you can make it. We will send out a formal invitation after Thanksgiving to remind you.


Mark Brueggemann IAR Kelly Smith IAR Brandon Robinson IAR