Review
“With so many global uncertainties, why aren’t stock prices falling?” Numerous advisors. Summer2014.
That was the question investors posed to us most often during the third quarter. That is, until U.S. stock prices began to fall broadly in September. Which was when many executives of companies in which we have invested … and whose businesses are doing quite well … began to ask us why their stocks had fallen so much.
Stocks of small growth companies significantly underperformed larger, mature, cyclical companies during the first six months of 2014 … and continued to underperform in the third quarter of 2014. Stocks of fast growing, small cap companies had significantly outperformed stocks of larger companies in 2013. This recent underperformance has taken place even though smaller companies are growing faster than larger ones. Stocks of large companies are performing well because they have been reporting strong growth in earnings per share despite modest revenue gains. This is because during the almost six-year-long, steady economic recovery in the U.S., most large companies focused on reducing operating expenses and not so much on increasing revenues. With increasing demand for their products and services, larger companies have begun to achieve price increases, further boosting their profits. They have also improved earnings per share by repurchasing their stock rather than investing profits to grow faster as many smaller companies have done.
We believe that as a result of the disappointing stock price performance and strong growth many small cap businesses have experienced year-to- date, these companies offer unusually attractive values. We think this is the analogue to real estate, large caps and emerging markets stocks that underperformed in 2013 and have outperformed in 2014.
“It just goes to show ya. It’s always something. If it ain’t one thing, it’s another.” Gilda Radner’s Roseanne Rosannadanna. Weekend Update. Saturday Night Live. 1978.
Negative news from around the globe dominated headlines in the third quarter. Anxiety over the spread of the Ebola virus created fears that business and tourist travel would soon fall. The conflict between Ukraine and Russia that culminated in a Malaysian plane being downed by a Russian missile didn’t soothe what Erica Jong used to call “fear of flying.” Especially since it took place soon after a Malaysian passenger plane disappeared without a trace over the Indian Ocean. ISIS beheadings of combatant and non-combatant hostages in Syria and Iraq terrorized not only citizens and armies in those locales but also global travelers, who either sought more inviting destinations or stayed home.
“Give peace a chance.”John Lennon.1969.
That song was written by John Lennon … with a little help from his friend Paul McCartney … and released as a solo record in 1969. Lennon was then still a member of The Beatles. “Give peace a chance” became the anthem of the anti-war movement in our country in the 1970s. “Give peace a chance” has not been any easier to achieve than it was when Lennon first wrote those lyrics 45 years ago. In Hong Kong, students took to the streets in pro- democracy demonstrations against the Chinese government. Investors found protests in a nation with the world’s second largest economy to be unsettling. In our global economy, unrest anywhere has the potential to affect economic activity everywhere.
Military conflicts, student demonstrations and citizen uprisings were so prevalent during the past three months that Hamas’ missile attack on Israel over the summer from tunnels in Gaza and Israel’s response seem like distant memories. Anti-semitic rallies in France, Germany and the U.K. have not faded from our memories, though, and seem to some reminiscent of Nazi gatherings in 1939. The only positive, we suppose, is Warren Buffett (Trades, Portfolio)’s observation that stocks generally rise during wartime since producing armaments creates jobs and stimulates our economy!
“We are accountable to the European people for delivering price stability, which today means lifting inflation from its excessively low levels; and we will do exactly that.” Mario Draghi. President, European Central Bank. October 2014.
Southern Europe’s economic depression and the disagreement between Germany, which is seeking to prevent monetization of southern Europe’s indebtedness, and southern Europe, which is looking to escape depression, didn’t engender investor confidence either. Despite Mario Draghi’s efforts to lead his continent’s economies out of their malaise with his version of Quantitative Easing, interest rates in Germany are negative six basis points! In a world where capital moves freely, interest rates on government debt in Italy were lower than in the United States! This, in our opinion, suggests that interest rates in our country will not increase significantly in the near term, because higher rates would further strengthen our currency and slow growth in America’s still highly leveraged economy. That would not be helpful to the competitiveness of U.S. businesses.
Finally, as if all that were not enough, on September 30th, The Wall Street Journal published an article titled, “U.S.Takes Asteroid Threat Seriously.”The paper noted that nuclear warheads scheduled for disassembly early next year are being retained “pending evaluation of their use in planetary defense against earthbound asteroids.”
The Death of Equities. BusinessWeek. August 13, 1979. Dow Jones Industrial Average 880!
Trading volumes in U.S. securities markets in 2014 remain subdued due to investor disinterest. This is reminiscent of the summer of 1979 when trading volumes in U.S. stocks were lackluster and bearish sentiment predominated five years after the 1973-74 bear market, which was considered at that time the worst bear market of a generation. Volumes in the summer and fall of 2014 are about half the shares traded in the years immediately preceding the 2008-09 Financial Panic. Lack of investor interest in equities persists despite widely available credit and historically low interest rates, which give businesses unusual opportunities to make successful investments and should make stocks more valuable. Credit markets that were “frozen” six years ago are now “open.” One example follows. We could list many many more.
In late September, we visited the Los Angeles headquarters of Air Lease, a leading airplane lessor in which we have been a shareholder since April 2011. “Ron, why has our stock fallen over 20% in the past month?” the four frustrated Air Lease executives with whom we met asked me. Their question is especially relevant since Air Lease shares could be worth four times as much in 10 years when their fleet will have increased by 2.5 times. That same question asked of us by Air Lease executives has become the question most frequently asked of us by the numerous executives who visit us and whom our analysts and managers visit every day.
Interest is a significant expense for Air Lease. Interest costs are significantly lower now than six years ago. A positive. For example, two weeks before our visit, Air Lease refinanced $1 billion debt. The company borrowed $500 million for ten years at 4.25% and $500 million for three years at 2.125%. The three-year loan was ten times over-subscribed! The lenders were principally investors in their stock! Another positive. Air Lease’s credit is now so strong it borrows about 80% unsecured. Six years ago, they were borrowing 20% unsecured. Another positive. Air Lease’s customers are doing well and are trying to lease more planes at higher prices. With 379 planes on order over the next seven years, Air Lease has one of the largest secured positions on plane manufacturers’ order books. That position has become even more valuable than six years ago. Another positive. Due to exceptional demand for planes, airplane manufacturers have decided to increase production. However, it will be several years before they can significantly increase production rates. Another positive. Finally, airline traffic, driven by growth in emerging markets, continues to double about every 15 years. The 21,000 planes in the world fleet are aging and close to the age necessitating replacement. This should mean demand for 5,000 new planes in the next decade. Air Lease’s more than 200 planes are the youngest fleet on lease, and they have another 379 that they ordered at favorable prices and terms at the depths of the Great Recession.
We think Air Lease’s book value and business, which cannot be easily replicated, have the potential to become three to four times as valuable in 8-10 years. That is when its fleet could reach more than 500 planes on lease. As a result, I am sure you can understand the frustration its senior executives and the business’ largest shareholders must feel following its share price decline in the past month.
Outlook
“Never mind.” Gilda Radner’s Emily Litella. Weekend Update. Saturday Night Live. 1977.
Once again, paying homage to Gilda Radner, who all those years ago had been one of my favorite entertainers, serves our purpose. This time we think Gilda’s brilliant, comedic instincts are relevant to investor angst created by the unsettling events we read about every day. These incidents remind me of that comedian’s elderly, hearing impaired character, Emily Litella. Gilda’s Emily reacted to the troubling events of her day with angry and confused editorials on Saturday Night Live in the 1970s.Whether editorializing about saving Soviet “jewelry,” “violins” on television, Presidential “erections,” making Puerto Rico a “steak” or the “deaf” penalty, Gilda always ended Emily’s dialogues with “Never mind”…after Chevy Chase explained in a loud voice how Emily had misunderstood the issues. We are pretty sure the same will be the case when investors recognize how little recent well-publicized concerns have impacted our economy. We think “it’s always something” will morph into “never mind” as our businesses and economy continue to grow.
“The sun will come out tomorrow.”Annie.
In one quarterly business update after another, America’s corporations report their growth is accelerating to above trend. U.S. GDP is now experiencing greater than 3% real growth, higher than at any point in recent years. This is helped somewhat by a rebound from first quarter 2014 below trend growth that had been depressed by an unusually harsh winter that made commerce quite difficult. However, nearly all businesses that we have visited recently indicate their growth prospects are improving at an accelerating pace.
Federal Reserve Chairman Janet Yellen and Vice Chairman Stanley Fischer have stated that our economy no longer needs the support of significant asset purchases for our nation’s recovery from the Great Recession to be self-sustaining. We regard that as a positive. So is capital spending that is beginning to increase significantly. Greater capital investment is necessary to replace aging and now highly utilized plant and equipment. New investment will also increase our production efficiency, boost GDP and create more jobs.
Domestic energy production has more than doubled in the past six years to more than eight million barrels per day, while imports have fallen about 40% to nine million barrels per day. This is the result of sharply increased production from our nation’s enormous shale reserves.Along with increased domestic energy production comes lower gasoline prices that benefit consumers, significantly more jobs due to a manufacturing renaissance resulting from lower energy costs, less reliance on energy supplies from politically volatile Middle East nations, and a negative impact on the economies of several nations that are not U.S. allies and depend on high energy prices.
Housing continues to provide significant growth opportunities for our economy. Housing starts have more than doubled from their unusually depressed levels five years ago. However, they still remain at less than one million starts per year, while inventories of homes for sale remain very low. Housing starts today are less than half the 2.5 million housing starts of 1972, when the U.S. population was more than 100 million fewer than it is now!
Berkshire Hathaway’s recent purchase of a large new car dealership indicates that investor Warren Buffett (Trades, Portfolio) is optimistic not only about the possibility of Berkshire’s ability to “roll up” other auto dealers and provide car financing. He clearly also believes that a high level of new car purchases can be sustained since the average age of cars on the road has reached 11.2 years, and disposable household income is improving. When I became an investment analyst in 1970, the average age of cars in America was seven years!
U.S. corporations have not repaid much of their debt in the five years following the 2008-09 Financial Crisis. Further, of late, they have been increasing their borrowings. Regardless, debt servicing expense as a percent of earnings has fallen about 35%. First, because interest rates are at the lowest level in the history of our nation. Second, because corporate earnings have increased about 30% during the period due to better expense management, modest capital expenditure growth, stable labor costs and lower interest rates.
Unemployment in our country is declining as our businesses continue to add 200,000 plus jobs per month. Unemployment fell below 5.9% in September, down from more than 10% in 2009. In conjunction with our improving economy and improving jobs picture, the federal government’s annual fiscal deficit has fallen from $1.4 trillion in 2009 to an estimated $400 billion in 2015!
Despite all the good news about our economy, we believe that global political uncertainties are the principal reason stock prices do not exceed their median levels of the past hundred years. U.S. equities are presently valued at around 15.2X 2014 earnings. The normal range in which stocks have traded for most of the past 100 years is 10X to 20X earnings. Rarely above. Rarely below. Further, stock prices are inextricably linked to our economy. In September 2014, the Dow Jones Industrial Average topped 17,000. U.S. GDP is expected to reach $17 trillion this year. In 2007, the Dow Jones Industrial Average was 14,000.The nation’s GDP was $14 trillion. In 1960, when Kennedy became president, the Dow Jones Industrial Average was 600. The nation’s GDP was $520 billion, less than the value of Apple today! Our nation’s economy has grown at a compound annual rate of 6.7% per year in nominal terms since 1960. Our stock market has grown at an annual rate of 6.4% per year. When annual dividends of approximately 2% are added to stock appreciation, stock prices have approximately doubled every 10 years for the past 55 years. We see no reason that our nation’s economy and stock markets will not continue to achieve these historic results over the long term.
From Ron Baron (Trades, Portfolio)’s Baron Funds Q3 2014 Report.
