The flood of earnings reports was the main event last week. I have to admit that I was concerned as corporations went into the year optimistic that 2015 would show more rapid growth at the outset than 2014 and planned accordingly, both in operating expenses and capital expenditures. As we now know, the economy in the first quarter came in surprisingly weak for all the factors that we have discussed many times before and the dollar was surprisingly strong. Both factors undoubtedly would weigh on first quarter reported results. I also knew that market participants would aggressively sell stocks that failed to meet former estimates. Now that the earnings results and conference calls are in for many corporations, I can breath a sigh of relief as results, at least so far, are at or near expectations despite the aforementioned headwinds. If you add back translation losses due to the strong dollar, actual operating results for many companies actually beat expectations. If anything was proven once again, it is that this is a market of stocks rather than just a stock market and some are a lot better than others.
I wrote a short blog this week titled "Invest Overseas or Domestically?" as most of the pundits prefer the overseas markets to here. I listed all the reasons why that view could make sense: 1: QE is occurring in many of the foreign markets; 2. Interest rates are lower, which favorably impacts market multiples; 3. Foreign currencies are weak, benefiting their exports and affording translation gains; 4. Economic growth is accelerating off the bottom; and 5. Market multiples are lower on forward earnings. All of these facts are true to some degree, but they really miss the major point, which is globalization.
Most of the major companies domiciled here or abroad compete everywhere. Just like you value a company before inventory adjustments (IVA), you should add back or subtract currency gains or losses depending on where a company is domiciled to see its inherent earnings and valuation. For instance, most U.S multinationals had excellent performance in local currencies, but when translated back into dollars they got penalized. On the other hand, foreign multinationals got a boost from a strong dollar but were weaker in local currencies. Just take a look at P&G's first-quarter results compared to L'Oreal's, which is domiciled in France, to see what I mean. If you are a U.S investor and are investing overseas because you expect that a strong dollar will benefit foreign domiciled companies reported results, just buy the dollar or short the foreign currency. Once again, it comes back to the specific company fundamentals no matter where it is domiciled rather than the market. Also, globalization leads to a convergence of interest rates due to capital flows, which puts market multiples over time on a level playing field. Think about it–stay ahead of the curve and don't follow it. The key is not yesterday or even today. It's all about tomorrow.
Let's look at events by region and conclude with some thoughts on investing in today's markets and how companies are changing and differentiating themselves from the pack.
We want to invest in companies with increasing growth rates and higher returns on capital, companies that will be revalued over time. We remain short those companies unwilling to bite the bullet and move forward in a different way in order to better compete globally and enhance shareholder returns.
1. It became abundantly clear from key company reports so far that the U.S economy accelerated ever so slightly as we moved through the quarter. Many companies have announced a reduction in operating costs below initial budgets to be conservative so as to maintain or even improve operating margins and grow operating earnings in a slower than expected economic environment. What happens to operating margins if growth accelerates over the next several quarters as we expect? Margins expand and free cash flow is even larger than the forecast. Cap ex for many of these companies remains beneath depreciation. Honeywell and United Technologies are two examples of stocks in our portfolio. Both companies really do invest for the future while still generating free cash flow equal to 90+ percent of cash flow. There is more than enough free cash flow for each of them to make large bolt-on acquisitions, reduce debt, increase dividends and even accelerate share buy backs. This is a theme throughout corporate America and dominant in our portfolio. Maybe not in the energy and commodity areas, which are under pressure from lower prices as supply/demand remains out of balance. We remain short several of these stocks.
2. Greece, Greece and more Greece make up the bulk of the news out of Europe, unfortunately. No real progress to date, but a lot of rhetoric from both sides. The Greek government went so far as to take funds from the cash reserves of state agencies to help pay its bills. The next important date to watch is May 6, as interest payments come due to the International Monetary Fund. Will there be a substantive deal by then? I still doubt it, and if something is patched together, I don't have much faith that the Greek government will adhere to it without a revolt from its people. Is there a Plan B if Greece defaults? While none of the finance ministers admits to it, I have to believe that one is in place. And Greece will exit the Euro.
Outside of Greece, the economic news for the Eurozone was mixed, but the reality is that each month is actually better. Germany continues to lead the way and is the prime beneficiary of a weak Euro. However, the dollar has declined over the last few weeks, as we had anticipated. Watch to see if this is a new "counter trend" move or something longer lasting. I still believe that the euro is in a secular decline until there is financial and regulatory union amongst all European countries, but that won't happen for years down the road, if ever.
3. The Chinese government needs to instill stability and confidence in its system. The government is being forced to support the yuan to prevent capital flows from leaving China. Quite a change from years past. Notwithstanding continued economic weakness in China, the government continues to move forward on many financial and regulatory fronts to build a sounder foundation for the future. Getting there from here may not look so good, but remember that is relative to China's past growth phenomenon. Growth above 6.5 percent for the year isn't that bad. The Chinese stock market continues to hit new highs.
4. Japan has exceeded my expectations on many fronts so far this year. The Nikkei is now above 20,000 and is up 15 percent just this year. Prime Minister Abe continues to make many of the right moves to build a stronger foundation for future growth. Weakness in the yen has benefited the country's largest industrial companies, such as Toyota, which is reporting record profits. The key for the longer term is getting the country's budget in shape and for wages to increase so that domestic consumption accelerates. If Japan and the United States conclude successfully the Pacific free trade pact, as I expect, it would be a major positive development for Japan.
5. Energy prices have continued to move up over the last few weeks, recovering from an oversold position. On one hand, drilling in short-term projects continues to be cut back, but on the other hand, global production continues to rise and Iran is looking to increase production by over 1 million barrels per day immediately after a nuclear agreement is agreed to by the June 30 deadline. The spin in the papers is that the reduction in drilling could lead to a spike in prices down the line if there is a demand increase. That is a large exaggeration. If prices recover much more from current levels, expect drilling to recover quickly, especially for the low-hanging oil shale projects. As is, inventory levels continue to build substantially week after week. Watch storage capacity!
The financial markets around the world rose last week as optimism keeps building that the global economic recovery is underway, albeit slow by historical standards. Currently there is no shortage of money, labor and commodities so inflationary pressures are several years down the road. Monetary authorities everywhere are hoping that the recovery will lead to price increases rising to 2 percent per per year. Sort of amazing! Do I think that interest rates are ridiculously low in some areas of the world? Absolutely! Would you buy an interest rate instrument with a negative yield unless you felt that the world was coming to an end? No! Globalization has crept into the financial markets everywhere, as capital flows freely from one market or region to another. Conservatism at all levels and the need for corporations to keep evolving to survive and thrive go to the heart of our investment thesis.
Listening to managements discuss first quarter results and their plans for the future was certainly a sigh of relief for me as my thesis for successful investing was reinforced by some many of them. I really suggest that you read the transcripts of several of these calls. Start with Alcoa and end with Microsoft. We own both stocks. Positive change is everywhere as the status quo leads to a slow death like for Kodak, Xerox and even IBM.
I want to thank all of you for your comments. This has been one of the best periods in my investment career. Our funds have outperformed the average several times while keeping our net invested exposure below 95 percent with unusually low turnover.
This really is a time to review all the facts, step back and reflect on all that is happening both on a macro level down to each company; decide on asset allocation and regional emphasis; and do your homework on each company you are interested in investing in. There is a difference.
