Investment Strategy by Jeffrey Saut
“As long as the roots are not severed… there will be growth in the spring.”
April 28, 2008
. . . Chauncey; “the gardener”
For the past few years, as spring has sprung and market pundits have expressed conviction about a return to robust economic growth, we have referenced the book “Being There” by author Jerzy Kosinski. The story revolves around a simple-minded man named Chance “the gardener,” who knows only gardening and what he sees on television. Indeed, for his whole adult life Chance has not ventured outside the grounds of his employer’s Washington D.C. manor. Eventually, however, the employer dies and Chance is cast out onto the streets, where through a mishap he encounters the wife of a D.C. powerbroker. Thinking her car was the reason for the mishap, she insists that Chance “the gardener,” who she interprets to be Chauncey Gardiner, come with her to her husband’s estate. Benjamin Rand (the husband) is completely taken with Chauncey’s simple, direct approach, and mistakenly attaches profundities to Chauncey’s ramblings about gardening. Viewing him somewhat as a savant, Rand introduces Chauncey to Washington’s elite, including the President. In one verbal exchange regarding current economic conditions Chauncey remarks, “As long as the roots are not severed there will be growth in the spring.”
Well, here we are. It’s spring again, yet this year instead of the typical cries of “As long as the roots are not severed there will be growth,” many Wall Street pundits are worried. Their worries center on the worsening housing/real-estate situation, and the resultant financial debacle, which has been magnified by the over-leveraged weaving of mortgages into a spider web of recondite “structured investment vehicles (SIVs).” As housing prices have fallen, and foreclosures have risen, said vehicles have collapsed with an attendant “hit” to the financial sector’s balance sheets that is now legend. Consequently, many financial institutions are currently in a “capital building” phase as they re-liquefy their balance sheets, implying major dilution for existing shareholders. Clearly, this is a negative backdrop for investing in the financial sector. We spoke of another negative implication for the sector in last week’s missive. To wit:
“Focusing on individual bank stocks (to buy) might be a bit myopic when the potential ‘real’ insight is that the past 28 years of financial market deregulation has reversed. Plainly something has changed, and changed materially. To be sure, the tidal wave of zaitechism began reversing with SARBOX and the reversal has been accelerating ever since. Recently the ebb tide has turned into a ‘rip tide’ as the spider web of financial engineering (our Japanese friends call it “zaitech”) was exposed by the collapse of many toxically structured investment vehicles (SIVs, SPIVs, VIEs, etc.) and punctuated by Bear Sterns’ bouleversement (BSC/$10.79). Consequently, the tide is now flowing ‘out’ after nearly three decades of financialization, which will no doubt crimp financial sector profitability with a concurrent compression in P/E multiples.”
Fortunately, we have been WAY under-weighted in the financials for years, and have totally avoided investing in the large-cap banks for nearly 10 years. Regrettably, we still feel that way despite the fact the financials could have a pretty decent trading rally as the short-sellers cover their shorts driven by the steepening yield curve. Indeed, many of the financial-related exchange-traded funds (ETFs) have broken-out to the upside in the charts, and in the process, closed above their respective 50-day moving averages (DMAs). Clearly this is a positive development. Similarly, many of the housing-related ETFs have done the same amid the near ubiquitous disbelief that this was impossible. While we agree that longer-term such rallies are likely a “bull trap,” and that the fundamentals will worsen, in the near-term we expect the price-strength to extend.
That same dis-belief is rampant with regards to the major market averages, yet hereto we are short-term positive. Manifestly, we turned bullish at the January 2007 “lows,” cautious at the subsequent February “highs,” and aggressively bullish on the March downside re-test of those January “lows” believing the re-test would be successful; and, that the ensuing rally would carry the averages above the February highs, eventually scooting into the 1400s basis the S&P 500 (SPX/1397.84). From there, if the envisioned pattern continues to play, we should see a decline. To reiterate, that decline should be measured by “if” the U.S. economy spills into a recession (we seem to be the only ones left that doubt it); and that then, the extent of the decline should be measured by if the recession is short-and-shallow or long-and-deep.
To take advantage of the aforementioned potential stock market pattern, we have recommended numerous trading and investment positions. Speaking to the trading positions, we have continued to move stop-loss points “higher” as the rally has progressed; and would look to sell many of these positions into any “blue heat” upside type of hour toward SPX 1440. As for investment positions, while some of our recommendations have been stopped-out (read: sold), due to our “sell discipline” designed to manage the downside risk, others have done just fine. One that did okay until last Friday’s earnings “hairball” is Microsoft (MSFT/$29.83). We have often spoken about MSFT since hearing its story (see previous missives) from a particularly prescient portfolio manager (PM) at our March institutional conference. At the time the shares were changing hands around $28. If participants followed our strategy of scale-buying, they should have an average-weighted cost basis of around $29. Given that our fundamental research correspondents are re-thinking their ratings, we are using a $26 stop-loss point for this investment recommendation.
Clearly this year has proven to be a difficult investing environment. Still, we continue to fare pretty well with our trading recommendations, as well as our investment names like Delta Petroleum (DPTR/$26.54/Strong Buy), Schering-Plough’s (SGP/$18.64/Strong Buy) 8%-yielding convertible preferred “B” shares, Covanta (CVA/$28.77/Outperform); and don’t look now, but Strong Buy-rated Cogent (COGT/$9.78) “gapped” above its 50-DMA last Friday on big volume. We have liked the Cogent story for the past few months, believing this homeland security “play” should do well even if the U.S. economy slips into recession. With $5.00 per share in cash, Cogent appears “cheap,” and remains one of our individual stock recommendations. Yet while we love individual stocks, we also like ETFs, closed-end funds, closed-end notes, and particularly open-end mutual funds managed by PMs that have the skill-sets to navigate ALL investing environments.
To this point, we had dinner last week with Manu Daftary, captain of the Quaker Strategic Growth Fund (QUAGX/$27.93). We “warmed” to Manu’s investing style roughly four years ago when we first encountered Quaker Strategic. What really piqued our interest was that like us, Manu does not want to be “painted” into a “style box” (large cap growth, value, etc.). Rather, he wants to invest in any sector that he thinks will make his clients money. To quote him, “If we don’t like it, we don’t own it!” Moreover, Manu is always looking to manage the downside risk and is unafraid to hold “cash.” Clearly that “foots” with our investment philosophy, for as repeatedly stated in these missives since 1999, “Don’t let ANYTHING go against you by more than 15% - 20%!” Further, like Manu, we are always re-balancing positions (read: selling partial positions as they rally to keep their weightings in-line with the portfolio’s original object). This technique allows profits to accrue and gives us cash for other opportunities as they present themselves. Indeed, to believe that the investment opportunity “sets” that present themselves today are as good, or better, than any that will present themselves next week, next month, or next quarter is naïve. To take advantage of those opportunity sets, you need to have some cash! On average Manu maintains roughly a 15% cash weighting; but at times, like in 1999, has as much as 40%. Furthermore, like us, Manu is willing to take a “stand,” as seen by the fact that he currently owns NO financials, NO consumer discretionary, and NO tech/telecom in his portfolios. He continues to search for “alpha generators” that can generate growth without balance sheet issues, as well as in any kind of economic environment. Clearly, we are a big fan.
The call for this week: For the past few months we have fallaciously suggested that interest rates were going to rise, the U.S. dollar was going to firm, crude oil was subsequently going to decline (along with most other commodities), and that the major U.S. indices, led by the financials, were going to rally; emboldened by the steepening yield curve, which implies the economy is going to recover. While we are often early, over the years we have tended to be generally correct. And last week, that envisioned sequence materialized with the financials, and early-cycle stocks, coming to the fore. Even though we believe it is a “false move,” the difference between perception and reality is where investors’ opportunities lie! Verily, we think the real surprise, going forward, may be that inflation rears its ugly head in 2009, as seen in the nearby chart from our friends at the “must have” web site, “thechartstore.com,” of how many work-hours it takes to buy a barrel of crude oil. Just yesterday, we filled the tanks of our boat to the tune of $1,000 ($4.50/gallon for regular gas); as well, we bought steaks on the way home at $27.00 per pound, yet the Fed tells us there is NO inflation! Clearly, this is sophistry, and we continue to invest/trade accordingly . . .
