April 27, 2012

For many years one of the principal long term challenges to the American economy has been ensuring a continued supply of energy.  The global supply of fossil fuels was thought to be dwindling fast. Much of it was in the hands of hostile regimes in unstable parts of the world. In the last several years, however, vast deposits of natural gas have been discovered across the United States. The gas is relatively easily available due to new drilling techniques. The natural gas boom has already had a major impact on the energy industry. Now as the implications of having a huge, cheap, domestic supply of energy continue to unfold, we are seeing increasing benefits across other sectors of the economy. A recent piece in the Financial Times argues that natural gas could potentially transform the U.S. economy in the way the tech boom did in the 90s:

Ten years from today, the CEA and Federal Reserve chairman will again celebrate a decade of unexpected strong growth. This time the credit will go to countrywide gains from the very low energy prices found only in the US. Low-cost energy will have spawned an export surge in all sorts of goods, from chemicals to tyres. Fracking and the other technologies that gave us low natural gas prices will have added more than 1 per cent a year to US growth, repeating the 2000 surprise. Today, few realise that the US stands on the cusp of significant economic gains stimulated by low energy costs. … As a result of these circumstances, the benefits of low-cost energy supplies will spread throughout the US economy, stimulating exports of goods and services and creating millions of jobs.

Another piece in the New York Times tells a similar story and details how the gas boom is revitalizing U.S. manufacturing:

The rapid development of shale gas technology has helped reduce energy imports and, in some cases, encouraged companies producing petrochemicals, steel, fertilizers and other products to return to the United States after relocating overseas. Natural gas exports are growing and terminals built to hold imported supplies are being repurposed for international sales. The American petrochemical industry, for example, uses natural gas as both its primary raw material, in the form of liquid ethane, and as an energy fuel. And cheaper prices have led to a major expansion of capacity in the United States.

While these developments are highly encouraging, it poses difficult investment questions. A major shift like the shale gas drilling boom is easy to identify, but it is more difficult to participate in it as an investor. This is because the drilling boom has created a supply glut that has driven down the price of natural gas. The low price of the gas has taken its toll on the profit of the very companies driving the boom, the natural gas producers. It’s also a long term process. Factories and vehicles cannot switch fuels over night. New pipelines and fueling stations must be built and factories and vehicles refitted.

Despite the fact that natural gas prices have dropped 80% in the last four years, there have been other ways to participate in the boom than investing in natural gas producers. One way in has been natural gas drilling services companies that have profited from the increase in drilling activity without being hurt as much by the drop in prices. Another has been investing in gas pipeline companies that get paid based on the volume of gas that goes through the pipelines and not on the price of the commodity.

We’ve also seen the benefits of natural gas spread to other sectors as the above articles mention. One small cap company we follow was primarily involved in servicing water and sewer pipes. They are now expanding their business by working to maintain the increasing number of pipelines being built to transport natural gas. Another company that makes nutritional supplements found that one of the chemicals it was already producing could be used in “fracking”, part of the natural gas extraction process. This provided a new, unexpected source of revenue.

The sudden, unexpected rise of shale gas drilling is an exciting development. It shows that the conventional wisdom about the economy—such as the impending threat of “peak oil”—is often wrong. It also shows the hazards of acting (and investing) on the basis of long-term forecasts. Things happen, and sometimes they are so big that they change everything. One thinks of the collapse of the Soviet Union in the political sphere. In the economic sphere such a development appears to be the sudden and unexpected rise of natural gas. Alas the cost of wealth is always vigilance. That never changes.

March 14, 2012

Stocks have staged a big comeback, rising more than 100% from the darkest days of the financial crisis exactly three years ago. But is this rally justified by the companies’ fundamentals or is this just a speculative bubble that is setting us up for another big fall? Looking at corporate earnings and valuations–rather than the soaring stock prices–can give us a sense of how companies are really doing. Fourth quarter earnings season (when companies report results for the last quarter and for the full year of 2011) are just finishing up. How did things look?

First the good news. With the earnings season now ending, the results generally came in better than expected and earnings of the companies in the S&P 500 grew on average 5.64% and sales 5.53% when compared with the fourth quarter of 2010. This was the ninth consecutive quarter of earnings growth as companies have bounced back strongly from the depths of the Great Recession in 2009. Of the S&P 500 companies, 65% reported earnings above the average estimate issued by the big Wall Street banks and brokerage firms.  Apple (AAPL), Intuitive Surgical (ISRG), Intel (INTC) and McDonalds (MCD) all announced earnings and sales higher than analysts expected and higher than the previous year, just to name a few standouts in our clients portfolios.

Now for the not-so-good news. While earnings have been increasing over the last several quarters, they have been doing so at a decreasing rate. The 5.53% average earnings growth of the S&P 500 was a sharp slowdown from the third quarter of 2011 growth of 14.89%. The 65% of companies that beat estimates sounds impressive, but actually this is below the average percentage of companies that beat estimates.

To make matters worse, if you take out the two biggest contributors to this quarter’s earnings, AIG and Apple, earnings growth for S&P 500 companies slows from nearly 6% to 1.2%. Apple reported earnings more than double the previous year’s, and the troubled insurance giant AIG benefited from weak comparisons from the year before.

What is the cause of this mediocre earnings season? Part of this slowdown of growth is simply the result of tougher comparisons. In the first quarter of 2011 when earnings grew more than 50%, the numbers were being compared to the recession lows of 2009. Now we are looking at the fourth quarter of 2010 for comparison, when the economy was well out of recession. But in addition to tougher comparisons, companies are now facing a deeply troubled economic environment in Europe and a slowdown in the rapid growth of developing countries in addition to the lackluster domestic economy.  In numerous earnings reports this quarter we read about the effect of higher costs, weak demand in Europe and slowing emerging markets. Looking ahead to this quarter, if these trends continue we could very well have a decline in total earnings for the first quarter of 2012.

But what is remarkable is how well companies have fared in this difficult environment.  We also saw in this quarter’s earnings reports extremely high profit margins, record cash holdings and increasing dividends. Companies are in good shape even with earnings slowing down. Historical valuations are also low, given the long rally. The Price-to-earnings ratio based on forward earnings of the S&P 500 is at 12.5 compared to a historical average P/E of 14.6. By comparison the market P/E during the internet bubble of the late 1990’s reached as high as 40. While there is always the possibility of a market correction after a long rally, the current valuation suggests that stocks could still have some room to run.

The weakening earnings trends means that earnings growth is less likely now to fuel a continued rally in the near-term, but there could be other things that push stocks upwards, like more signs of an improving US jobs or housing market, or a partial resolution of the European debt crisis. This week the positive results from the Fed’s recent round of stress tests of big banks drove the market up. What’s really striking about the current market is how so many investors, scarred by the financial crisis, are remaining on the sidelines. As more people take note of the tremendous rally and become dissatisfied with record low yields of bonds, they may start to put their money back into stocks and mutual funds and ETFs and push the market higher.

March 5, 2012

There has been some heated debate recently over the state of the individual investor. This is undoubtedly a difficult time for small investors. There has been the “Lost Decade” for stocks, and now the “War on Savers,” as critics of the Federal Reserve Board call the Fed’s program to keep interest rates low for several more years. From Occupy Wall Street to the Tea Party there has been a growing perception that the deck is stacked against the little guy. Despite all of this some of the leading lights in the financial world are now calling this a golden age for small investors. So which is it?

From a mechanical point of view, it’s a lot easier to be informed than it used to be. The author of popular finance blog “Abnormal Returns”, Tadas Viskanta argues, “There has never been a better time to be an individual investor.” His blog post on the subject set off a firestorm of debate. According to his argument technology has transformed investing. Despite the many looming macroeconomic worries, investing is cheaper, easier and more transparent than ever. Viskanta writes, “Never before have investors had access to data, analysis, opinion and social tools that are commonplace today.”  He goes on to list the financial innovations, from exchange-traded funds to new social media tools that have made investing increasingly inexpensive and accessible to amateurs.

Jason Zweig, the prominent Wall Street Journal columnist, weighed in on the debate with a story of his first stock purchase as a teenager in the 1970’s. Then, the only source of information on the company was writing away in the mail for the company annual report or else a trip to the public library to wade through large, dusty investment guides. Once he bought a stock, he faced commissions of up to 50% of his earnings, and was so disgusted by the whole process he didn’t but another share for years.

Zweig’s anecdote pretty well settles the debate. Leaving the state of the market aside for the moment, things are pretty good for investors these days. The internet offers vast amounts of free information that only recently was available only at great cost to professionals.

The ease of making trades with a few clicks and the enormous amount of free information out there, however, comes with its own threats. As Viskanta warns, many innovations are a “double-edged sword” and should be avoided. Despite the technological advances, we still have “innate behavioral biases” that give us a tendency go with the crowd and to buy high and sell low. As Zweig puts it, “Yes, Wall Street is still a dangerous place. But it used to be worse.”

Ben O’Brien

February 24, 2012

The Dow Jones Industrial Average, the index of 30 leading large-cap stocks, has been flirting with the 13,000 mark all week.  The last time the index closed above 13,000 was in May 2008. Right on cue, there were a slew of headlines in the financial press trying to assign significance to this number. While some market commentators argue that there are important psychological implications for investors when a major index reaches an apparently significant round number, at O’Brien Greene we prefer to measure market performance in terms of more substantial numbers like corporate earnings.

A recent article in the New York Times Magazine “Why Do We Still Care about the Dow?” goes a step further and makes the case the Dow itself is an outdated measure of market and the economy:

In the postwar boom of the 1950s, the economy was growing so fast, and the benefits were so widely shared, that following 30 large American companies was a solid measure of most everyone’s personal economy. Back then, the U.S. was a largely self-sufficient country, so Asian or European economic troubles didn’t matter much. … [Now] rather than being a useful indicator, [the index] is an anxiety-amplification device. It reflects investors’ own reactions, and often hysterical overreactions, as they progress through the turmoil.

Any index will have limitations, and the Dow is certainly not perfect. The real problem, however, is not so much the indices as the way the media tends to abuse them, announcing their fluctuations with great hype hundreds of times a day. The Times says that Charles Dow, who founded the index in 1896, believed that the index should be checked and studied on a quarterly basis. This sounds about right. While it’s hard to avoid following the indices more frequently these days, investors shouldn’t attach too much importance to them except over quarters and years. Nor should they get too worked up about the index reaching a round number.

Ben O’Brien

February 15, 2012

In a preview of widely-read shareholder letter, Warren Buffett makes the case for stocks compared to bonds and gold. There is nothing new here, but we agree with Buffett on this point and the message is always good to hear:

My own preference — and you knew this was coming — is our third category: investment in productive assets, whether businesses, farms, or real estate. Ideally, these assets should have the ability in inflationary times to deliver output that will retain its purchasing-power value while requiring a minimum of new capital investment. Farms, real estate, and many businesses such as Coca-Cola, IBM, and our own See’s Candy meet that double-barreled test. Certain other companies — think of our regulated utilities, for example — fail it because inflation places heavy capital requirements on them. To earn more, their owners must invest more. Even so, these investments will remain superior to nonproductive or currency-based assets.

Whether the currency a century from now is based on gold, seashells, shark teeth, or a piece of paper (as today), people will be willing to exchange a couple of minutes of their daily labor for a Coca-Cola or some See’s peanut brittle. In the future the U.S. population will move more goods, consume more food, and require more living space than it does now. People will forever exchange what they produce for what others produce.

Our country’s businesses will continue to efficiently deliver goods and services wanted by our citizens. Metaphorically, these commercial “cows” will live for centuries and give ever greater quantities of “milk” to boot. Their value will be determined not by the medium of exchange but rather by their capacity to deliver milk. Proceeds from the sale of the milk will compound for the owners of the cows, just as they did during the 20th century when the Dow increased from 66 to 11,497 (and paid loads of dividends as well).

Berkshire’s goal will be to increase its ownership of first-class businesses. Our first choice will be to own them in their entirety — but we will also be owners by way of holding sizable amounts of marketable stocks. I believe that over any extended period of time this category of investing will prove to be the runaway winner among the three we’ve examined. More important, it will be by far the safest.