I write mostly about my global economic view and how they relate to my core beliefs, Today I want to shift gears and discuss some of the bottom up variables that I utilize when selecting an equity investment.
Let's begin with the most important ones, which are management and its strategies to succeed in a global competitive environment. I have long believed that great management, regardless of industry can achieve superior results and lead to stock outperformance on an absolute and relative basis to the market over time. Change at the top can often be an inflection point for positive (or negative) change in a stock.
McDonalds is a great example of how transforming your mental models can create exponential growth (Reference Peter Senge, The Fifth Discipline.) Stephen Easterbrook took over as Mc Donald's COO just 14 months ago and under his leadership he has turned this battleship around. Is there an industry more competitive than fast food? Remember that hamburgers, fries and soda are their DNA. So, how did he do it? Primarily by offering breakfast 24/7, plus new super value deals and upgrading the service at the nearly 35,000 stores worldwide! Have you noticed the stock performance since he took over? Pretty stunning!
My portfolio is filled on the long side with leaders who are willing to burst through the fixed mindset throughout their organizations, willing to shift the business mix, perhaps jettisoning older businesses while adding others thereby making the entity more profitable overall with higher growth and returns than before. This thinking out of the box-busting through pre-ordained mental mindsets about what business they are really in leads to innovative strategies. These strategies lead to revaluation of multiples over time. Identifying these companies early on in the process is our strength and one of the key reasons why we continue to significantly outperform all indices.
Our shorts generally have the opposite characteristics of our longs. Our primary concern with the shorts is whether an activist will appear to shake up or change management. Poor performance resulting from entrenched management unwilling to change their thinking opens the door for activists.
Superior stock performance is all about identifying both positive and negative change!
SEC rules preclude us from asking questions and getting answers from management that is not already public information, so we need to focus on their publicly announced strategy. Once you buy into the strategy, you need to know the top management to decide whether they have the capability to deliver on their plans. We recognize there will be bumps in the road when change is occurring so you have to be patient while continually monitoring whether management is staying true to its game plan.
Microsoft is a perfect example as their first quarter results were disappointing. However, the relatively new COO, Satya Nadella, remains on course for transforming the company with his vision which I applaud so I view this decline as an opportunity to possibly start a new position at a better prices. I initially bought Microsoft at $28 per share when Satya Nadella replaced long-entrenched Bill Gates protégé Steven Ballmer after he made clear his strategy to reinvigorate Microsoft. It was yielding over 3% at the time. I sold the stock at $44 nine months later as everyone recognized what I saw so I felt the stock was efficiently priced. I missed the move into the 50's but am taking another look now after a 9% decline Friday.
Another example is GE which I purchased at $19 per share after the board and management led by Jeff Immelt announced that they would exit most of the financial businesses and focus instead entirely on their industrial and healthcare segments where they are technological and market leaders. The market valued the financial side of their business which was 65% of te total mix two years ago at 10 times earnings and the industrial and healthcare side at 20 times earnings resulting in a combined multiple of 14. Once completed, which now included the purchase of Alston's industrial business and the return of well over $100 billion to shareholders, the new GE would be earning at a $1.50 per share rate. My target price was $30 for GE back when I bought it in 2014 at $19. The stock is now over $30 per share with more still more to come. I am a Jeff Immelt fan! It took a lot for him and the board to dismantle what Jack Welch had built. GE is now a dominant global industrial technology company with few peers. Maybe Honeywell, which we bought at $90 in 2014, is another one. Here Dave Cotes, Chairman, CEO and former GE exec, continues to do one great job.
Management and its strategies are clearly two of the key variables that we analyze before investing in a company. I will discuss some of the other variables in subsequent blogs but I wanted to lead with this one today as it has become even more apparent after so many first quarter earnings reports and conference calls how important management is. I am amazed at some of the great talent that we have in this country and are similarly disappointed in how some management remains entrenched in fixed thinking, causing them to falter. That's what successful long/short portfolio is all about.
I came out with a blog midweek entitled "One and Done...and More." The main conclusions were that the Fed was most likely done for the year with raising rates unless the global economic scene changed meaningfully for the better; Obama was in the Mideast jawboning the Saudis to come to the table with Iran and energy prices would not break appreciably from $42 per barrel unless there was a major increase in production by Saudi Arabia more than offsetting the decline in production elsewhere, mainly the U.S; S & P earnings estimates would increase for 2016 due to the weakness in the dollar; and the political landscape remains my biggest concern. I might add that quarterly earnings comparisons will get easier in the upcoming quarters and Trump may be refining his persona.
Let's briefly look at the other data points of importance by region:
Economic weakness in the U.S persisted in April as evidenced by a further drop in the PMI to 50.8 from 51.5 in March; retail sales dropped in March 0.3% which is the third month in a row that sales were flat or lower; and it is now estimated that first quarter GNP rose less than 0.5%. On the plus side is continued growth in employment however wage gains remain minimal.
Economic activity in the Eurozone continues weak as evidenced by a PMI reading of 53.0 in March, a fourteen month low; Germany's April PMI also declined to a nine month low of 53.8; and an open challenge to Draghi and the ECB easy money policy and negative rates is coming unsurprisingly from Germany. Naturally the ECB left its policy mix unchanged at its midweek meeting and even mentioned the possibility of further ease despite criticism from Germany. I found it particularly noteworthy that Eurozone government debt as a percentage of GDP fell in 2015, the first time since 2008. My view remains that governments need to stimulate consumption and investment and let debt levels increase slightly at this time. Risks remain to the downside and Germany needs to take note and join in.
Even though China's economy seems to be doing better as recent data points indicate, a number of financial experts including my former partner George Soros are raising red flags. Their concern is China is using too much credit and debts to fuel spending therefore financial risks are rising. I continue to believe that China's huge foreign reserves and controls over the banking system and forex mitigate that risk.
The BOJ along with the Japanese government appear to be planning additional measures to stimulate growth, higher inflation and a lower yen. The yen reversed and fell 2% on Friday in response to these comments.
Energy prices moved up last week, which caught the market and me by surprise after the failure of OPEC and other major producers to reach a deal last Sunday in Doha. Talk of another meeting in June was in the marketplace on Friday. My view is that energy prices are locked in a $35-$48 dollar range unless Saudi Arabia takes its gloves off and meaningfully increases production above 11.5 million barrels/day. If energy prices rise about $50 per barrel, watch all the shale production shut in come back on the market limiting any further price increases.
Let's wrap this up by saying that my core beliefs remain for the most part intact therefore there has been no change in my capital allocation. Earnings season so far has had a few surprises on both the positive and negative side causing some minor changes in our investments. New opportunities are evident too but I will have to squeeze down my portfolio to find room to add new names as I will not go above 95% net long. Liquidity remains key at all times.
I want to comment on the financials, which remain 15-20% of our portfolios. Reported earnings so far have met or beat expectations despite poor trading, a relatively flat yield curve and a large increase in reserves for poor energy loans. The group continues to sell at 10 times earnings, yields over 3% in most cases and remains a call on the economy. Some companies are definitely better than others and the difference mostly comes down to management and strategy.
So remember to review all the facts, take a long pause and reflect, consider your proper capital allocation with risk controls, do in-depth research on each investment idea including spending time with management reviewing strategies and ... invest accordingly!
William A. Ehrman is managing partner at Paix et Prosperite LLC.