Investment Strategy by Jeffrey Saut
“Relative Performance?!”
A man wakes up from a 20-year coma. He immediately calls his CPA/financial planner. "Excellent! My IBM is worth $6 million. And my Microsoft is worth $8 million." As he is asking about his AOL stock, the operator cuts in and says, "Please deposit another $3 million for the next 3 minutes."
. . . Anonymous
We could not help reflecting on this quote last week as we watched the equity markets trade higher while the dollar traded lower. Interestingly, from its recent reaction high at 85.25 (1-26-07), the Dollar Index has lost 4.6% of its value. Meanwhile, the DJIA has gained 3.4% from that same 1-26-07 date, leaving foreign investors scratching their heads and lamenting, “What rally?!” The view from the Dollar Index’s peak (roughly 121) in January 2002 renders the same results as the DJIA has rallied 25.8% from that date while the Dollar Index has lost over 33% of its value. In fact, for the DJIA just to be EVEN in “real” terms with its dollar value of January 2002, it would need to be trading at 13700. Measured in ounces of gold, the results are worse because changing the DJIA’s “measuring stick” from dollars to gold means the senior index needs to be changing hands at 31500 just to hold its value relative to the price of gold. These are not unimportant points for the astute investor who is attempting to increase the value of his/her portfolio in “real” terms. As Dr. Marc Faber noted in a recent article:
“The Dow goes up, it’s a ‘bull market’, the Dow goes down it’s a ‘bear market’. But, in reality, bull and bear markets are far more complex. Let’s assume we have just five asset classes. Real estate, stocks, bonds, cash, and gold (or a hard currency for which money supply growth is kept at the rate of real GDP growth leading to stable prices). At present, it is clear that the Fed is printing money. So, all asset prices except bonds will rise in value. But, some asset prices will increase more than others. Since October 2002, the Dow Jones has rallied in US dollar terms, but against gold it has depreciated.
“So, we can say that, yes, the Dow has been in a bull market since October 2002 in dollar terms. But it has been in a bear market in gold terms. This is an important point to understand. In case we should experience continuous monetary inflation, which could lift, over time, all asset prices such as stocks, real estate, and commodities, some asset classes will increase more in value than others. This means that some asset classes while rising in value could deflate against other asset classes, such as happened with the Dow against gold since year 2000. I have pointed out in earlier reports that since 2002, all asset prices rose in value. But recently, some diverging performances emerged. Bonds started to decline and seem to be on the verge of a significant long term break down. I have also mentioned in earlier reports that, in times of monetary and credit inflation, such as we have now in the US, bonds are the worst possible long term investment.
“Another asset class, which has recently begun to depreciate against gold, are home prices. Since last summer, home prices while only declining moderately in dollar terms, have declined significantly in terms of gold. So, whereas it took over 500 ounces of gold to buy a typical house in the US last summer, now, it only takes around 380 ounces of gold. In other words, home prices have declined over the last 9 months by 25% against the price of gold!
“What I really want every reader to understand is that bull and bear markets are extremely complex and an asset class that seems to be in a bull market may not necessarily be in a bull market when compared to a hard currency such as gold.”
Complex indeed, for most of the asset classes we have embraced over the last six years (oil, natural gas, coal, timber, cement, fertilizer, grain, precious/base metals, diamonds, uranium, foreign stock markets, water, etc.) have VASTLY outperformed the U.S. equity markets on a relative basis. By the way, this outperformance has historic precedence, especially when the currency is declining due to excessive money supply growth and inflation. A case in point would be the Weimar Germany era where the stock market gained 100%, but Germany’s currency lost 200%. Other examples can be found in Argentina, Brazil, Hungry, Zimbabwe, etc., which is why we are always measuring ourselves in “real” terms as we attempt to produce returns that will be in excess of the U.S. dollar’s debasement. For example, since January 18, 2007, the stock market is up roughly 3%, but crude oil is up 28% ($50/bbl to $64/bbl). Therefore, if you measure the DJIA in terms of barrels of oil, the stock investor has underperformed by some 25% relative to crude oil as can be seen in the nearby chart from our friends at “thechartstore.com.” Moreover, notice that at the peak it took 842 barrels of crude oil to “buy” one share of the DJIA (12-31-98); now it takes roughly 200 barrels. So measured in barrels of oil, the DJIA has lost 76% of its value!
Consistent with this vein of thinking, we believe the secular bull market is alive and well in “stuff” (hard assets) driven by the insatiable demand fostered by the “Chinas” of the world. We also think there remains numerous special situations available to the prudent investor in the U.S. equity markets that can produce returns in excess of the rate the U.S. dollar is being debased. Last week was yet another example as our recommendation on Canadian-based water-stock Groupe Laperriere & Verreault (GLAGF/$35.95/rated Outperform by Raymond James Ltd.) leaped 40% in price when the company decided to sell its process group to FLSmidth for C$950 million and spin off to shareholders its water treatment and pulp/paper groups.
Another example would be last week’s surge in the share price of Schering-Plough’s 4.3% yielding convertible preferred (SGP+M/$69.88). Recall that we have been bullish on these shares for the past two and a half years when they were trading in the low-$50s and yielding 6%. Well, last week Schering reported better than expected earnings, with a concomitant rise in the share price, causing our pharma analyst to downgrade the shares (SGP/$30.71) from Strong Buy to Market Perform. We agreed and advised investors to rebalance their convertible preferred holdings by selling half of this investment position. We further opined that those seeking to stay with the healthcare theme consider using the freed-up funds from that sale of Schering to purchase 2.4% yielding, Strong Buy rated, Johnson & Johnson (JNJ/$65.12) given that it is selling at its largest free cash-flow yield in 17 years. For the more growth-oriented healthcare investor, we suggested Davita (DVA/$54.96/Strong Buy) since DVA shares currently sell for a modest premium to the market multiple at ~17.5x our $3.15 EPS estimate for this year and ~15.5x our $3.57 EPS estimate for 2008. These multiples are attractive given our view that this company is capable of a 20% CAGR over the next three years. Now that we are more comfortable with the new Kidney Disease Outcome Quality Initiative (KDOQI) guidelines (as discussed in a recent company brief), we feel investors will once again focus on the strong growth prospects for this company that we expect will drive the shares toward our $68.00 price target over the next 12 months.
Another growth-oriented name added to our recommended list was brought under research coverage last week, namely Houston Wire (HWCC/$28.33/Outperform). Simple stated, Houston Wire & Cable is one of the largest wire and cable distributors in the U.S. End markets include communication, energy, engineering/construction, general manufacturing, infrastructure, petrochemical, transportation, utility, and wastewater treatment (sure sounds like “stuff” to me). The company has a 42% return on equity, a 27% return on assets and a 36% return on capital. Revenues have grown from $173 million in 2004 to $214 million in 2005 to $324 million in 2006 with an attendant ramp in earnings.
The call for this week: Last Friday’s option-induced Dow Wow (+153 points) seemed more like a crescendo to the rally than the beginning of another new “leg up.” Indeed, we’ve had the crashett (2-27 to 3-06), the subsequent rebound (3-06 to 3-12), the perfunctory downside retest (3-12 to 3-14), and the rally back to new highs with a potential speculative upside blow-off last Friday as the markets embraced the Bernanke “put” just like they embraced the Greenspan “put.” Yet, the equity markets rarely discount the same thing twice and with EVERYBODY thinking their special stock is going to get the next private equity “bid” . . . well, we’re skeptical. And yes, we did see the article titled “GM’s Chinese Partner Looms as a New Rival” with the tag line “Learning From Detroit, Shanghai Automotive Pushes Its Own Cars.” And yes, this is precisely what we wrote about on March 26, 2007, to answer the question, “When will the Chinese stop buying our bonds?” Our answer was, “When they no longer need us” . . . Heads up!
