First Quarter Report 2014
The markets were choppy this quarter. The S&P 500 was up, the Dow was down, bonds were up, commodities were up, and emerging market stocks were down. From the data, it’s pretty hard to come up with a theme. We expect more sloppy markets for a while, as the world tries to handicap what a Fed taper looks like. So far this year, it’s a stock-pickers’ market, and we have had some successes.
As is our tradition, let’s start by talking about what isn’t working: American Public. Try as it might, it just can’t seem to catch a break. American Public’s business is online education, and it thrives in military, security, terrorism, and law enforcement classes. However, government budget problems are causing military personnel real, short-term issues regarding whether they will get “free” money to go to school.
Thirty-four percent of American Public’s business is with active military personnel of the U.S. government. Sixteen-percent is retired military personnel, using veteran’s assistance benefits to pay for classes. Sales to active military soldiers were down nine-percent year over year, while sales to retired military personnel were up twenty-nine percent. Why the huge discrepancy between retired military enrollment versus active military? The answer is government funding.
The 2013 sequesters and budget fights hit the benefits active military personnel receive, but not the retired military benefits. Without boring you with too much detail, an active military soldier now does not know whether funding for his schooling is available on a predictable basis. A retired soldier does know. Hence, American Public’s sales are doing great in one sector, and not another.
We think a measure of predictability will return to the active soldier’s benefits, at some point. In what quarter it happens is anybody’s guess. If I were a soldier and I could receive $4000 per year free, (16 credit-hours a year at American Public) I would wait to enroll, until the uncertainty is pay out-of-pocket for tuition, when military benefits will pay for it, if you wait? In the meantime, we like the valuation of American Public stock and view it to be a very good value.
Speaking of value, have you followed Maxwell Technologies this quarter? In our last report, we cautioned you to be prepared for some poor earnings this year. Maxwell reported in February, and the earnings were as bad as predicted. It still hasn’t received the Chinese diesel bus order we wrote about last quarter, either. The news drove the stock lower in February. But all the bad news aside, the stock went up 75% this quarter to 14.
What happened? Operationally, not much this year, but quite a bit has on the news front. Maxwell is now designed into electric busses in China, which we didn’t know about last year. It is predicting multiple wins with tier-one auto companies in 2015, which we didn’t know about, either. Maxwell is also in discussions with Corning on some sort of joint venture in the solar industry. It is winning business in the U.S. diesel truck business, too.
All this was announced this quarter via its conference call or meetings with Wall Street. Start trying to guess how much this could move sales and it’s a very large number. L-a-r-g-e.
The bad news is, this revenue stream is six- to twelve-months away. Revenues will start out slowly, then grow rapidly. We think there is a chance the market may be a little too excited in the short- term, and not excited enough in the long-term. This is already a big position for us, so we can’t buy much more for clients without violating capital allocation rules on initial positions. That said, we don’t mind if Maxwell Technologies grows its way to an outsized position in your account. This could be a fun stock in the next eighteen months, if Maxwell is telling the truth (we think it is). Be prepared for some wild swings in the stock as the market sorts this out.
The last happy stock we’ll talk about is Royal Gold. It rose right after we bought it, and hasn’t looked back. That’s the good news. The bad news? The reason we predicted it would go up hasn’t happened yet. Are we just lucky here? Or is our logic correct: the European Central Bank (ECB) will print money, causing gold to rise.
We think the odds the ECB will print money are better today, than three months ago. Three months ago, we didn’t know Russia would invade Crimea, and European leaders would be so shocked by it. Didn’t they learn anything when Russia invaded the Republic of Georgia years ago? Apparently not.
Europe must now spend more on defense, which is a plus for Europe’s jobless situation. The economic win-win for Europe in higher employment for defense, and its need to grow the economy, seems like a reason to accelerate money-printing by the ECB. And this will help gold.
We are long-term negative on the euro surviving in one piece. Right now, the market doesn’t share our view, which is why gold has performed so poorly, until this quarter. If Russia is allowed to annex Ukraine, and Europe doesn’t defend it, I expect a real rush for the exits from the euro. It just makes sense. Would you keep your savings in euros, when it could convert to Russian rubles next week? Me, neither. We still like gold here, and our best bet is to own the stock, Royal Gold.
The lack of response by the free world to issues in Crimea will embolden other countries to take a shot at land grabs, while the world’s police are asleep. China has pushed to take over more territory in Asia, as has Iran, in the Middle-East. This will make the markets more event-driven than I would like.
In our 3rd quarter 2012 Report, we reviewed what happens to the stock market during wars or regional conflicts. The average decline was 16.5%, and it took about three months for declines to play out. (These numbers included the Gulf wars, World War II, and the Vietnam War, to name a few.) The
fooler in this study was once the decline was over, the market went up and rarely looked back. The phrase “War is good for business” is awful, but based on our work, is factual.
We will continue monitoring what is sure to be more conflicts this year. For now, we think the printing of money worldwide is the most important determinant of what we should do next.
We did sell one long-term position this quarter: Cintas. We sold out, because Cintas was overpriced, based on our expectations for the company. We hope to find a new home for the cash, soon.
Our final thought for this letter is a comment on Warren Buffett’s announcement in his annual report this year. He stated, when he dies, he has instructed the executor of his estate to put 90% of his wife’s inheritance in an S&P 500 index fund. The rest will be placed in cash.
What I find interesting is the greatest asset allocator of our time believes this is the best way to care for his widow’s finances over the next ten or twenty years. Buffett made one decision for his executor. Buy stocks and hold them, is the message. The reason I bring this up is I doubt five-percent of the world’s financial people would recommend Buffett’s approach. The typical breakdown is 60% stocks and 40% bonds. Sometimes, a mix of 50% stocks, 30% bonds, and 20% alternative assets. In Buffett’s case, it’s almost all stock and some cash—with the 10% cash an interesting way to smooth out cash-flow needs (see below).
Most financial plans factor-in a 4% withdrawal of the account’s value per year for living expenses. If it’s assumed the S&P 500 pays 2% in dividends, it represents a cash-flow to the account of 1.8% (90% times 2%). If no money is withdrawn from the account, and stocks go nowhere, after Year One, the ratio is 11.8% in cash, and 88.2% in stocks.
In our opinion, Mr. Buffett’s approach says you’re better off in the long term to ride out stock market ups-and-downs, and use the 10% cash as a buffer to avoid selling stocks during a period like 2008. Keep in mind, Mr. Buffett is very well aware of what a disaster 2008 was.
Let’s say, hypothetically, $100,000 was invested in October 2007, according to Buffett’s 90/10 system (the worst month to open a stock account seen in our lifetimes). Let’s say the S&P 500 was at 1550, which was then, a new high. We would invest $90,000 at 1550, for a total of 58 shares of the S&P
To fund the cash shortfalls in years 2012 and 2013, we would need to sell about two of the 58 total shares, which is calculated in the value of the stock portfolio in 2013. After six years, the account would basically be where it started, despite investing in the worst market in our history.
The key to Buffett’s thinking in our opinion, is the cash cushion to prevent selling stocks during a really bad, economic time. Basically, you could wait five years before selling anything to fund retirement needs. Based on history, during those five years, the earnings of the S&P 500 will probably be at least 25% higher. Earnings gains will help support the account going forward. Starting in Year Six, to fund retirement needs, you will liquidate 2.2% of the portfolio per year, (some years more, some less) for the rest of your life. That key is, as always, don’t panic during the decline. If you do, you will have made a bad decision, leaving yourself in really bad shape.
We doubt many will emulate Mr. Buffett’s estate planning, but we wanted to pass it along, and let you think it over. Warren Buffett is a genius, and his publicly announced strategy relates to a real problem we all face.
As always, call us if you have any questions about your account.
Mark Brueggemann IAR Kelly Smith IAR Brandon Robinson IAR