Despite many headwinds and amid great uncertainty, both the U.S. economy and stock market enjoyed a rather good year in 2012. Real Gross Domestic Product (“GDP”) grew around 2%, and the stock market, as measured by the S&P 500 Index, returned 16%. At the risk of sounding complacent, we believe that the fundamental trends that produced such favorable results in 2012 are still in place and should support another good year in 2013. We are not blind to the challenges and uncertainties that still face us, nor do we believe that the year ahead will be devoid of volatility. Rather, it is our view that the favorable forces can ultimately prevail over the unfavorable.
Let’s start with the unfavorable. First, although Congress and the administration have agreed on a short-term fix to the fiscal cliff, even the last minute compromise entails some degree of fiscal restraint (higher taxes coupled with marginally lower government spending) which may detract from GDP growth in 2013 by approximately 1-2%. More worrisome is the ever-growing federal debt. How soon and how seriously Congress decides to deal with entitlements and fundamental tax reform is an unanswerable question, but obviously one that poses great risk to the markets and one that could cause considerable volatility over time.
Second, the problems in Europe are not about to go away. Much of Europe is in recession, and the periphery (e.g. Greece) is clearly in a depression. Austerity measures are depressing growth and, in countries such as Greece, leading to social unrest, rising crime rates and a worrisome growth in neo-Nazi style political activity. It will take some time for Europe to regain its footing and healthy growth rates.
Third, China’s growth has slowed and the new leadership may pursue slower growth policies over the next few years. The new regime understands that China needs to evolve from an economy driven by exports and fixed investments to become more of a consumer and domestically driven economy. This will take time.
Fourth, U.S. corporate profit growth has stalled. The strong productivity gains seen in 2010 and 2011 have largely played out and therefore corporate profits are now more likely to grow in line with GDP rather than at a faster pace.
To segue from these unfavorable trends to the positive trends, we would point out that investors have been selling U.S. equities for some time. After two severe bear markets (2000-2002 and 2008) left equity returns negative for a decade, investors voted with their feet and abandoned the perceived “risky” stock market for the “safety” of the bond markets and the allure of faster growing emerging markets. Aided by a very aggressive easy money policy by the Federal Reserve, bonds have done extremely well. The only problem is that investment grade bond yields are at very low levels today and leave bonds exposed to principal losses when rates eventually rise. This may eventually turn into a favorable trend if investors rebalance portfolios back into equities when fixed income returns turn negative. When that happens, stocks should enjoy considerable support.
Now let’s turn to the favorable trends. As we have written before, housing, which has been in a five-year downturn, has now begun to recover. Sales and construction rates are up, unsold inventories are down and prices finally appear to be rebounding. Housing, therefore, has switched from being a drag on economic growth over the past five years to being a positive going forward. Second, the private sector has significantly deleveraged. The corporate sector has never been in better financial shape and the consumer is getting stronger. Third, monetary policy remains highly accommodative. Fourth, inflation is low and key commodity prices, especially natural gas, coal and oil, are low. The drop in gasoline prices adds spending power to the consumer. Fifth, unemployment levels are slowly receding. Sixth, manufacturing is beginning to return to the U.S. as the wage gap between the U.S. and China is shrinking due to a very rapid rise in Chinese wages, and the U.S. enjoys a distinct energy cost advantage stemming from lower natural gas and oil prices. Vast new unconventional oil and gas volumes could turn the U.S. into an energy exporter 10 to 15 years from now.
All this leaves us long-term bullish and short-term nervous. To deal with this tension we have focused our efforts in two ways. First, as always, we are avoiding, what in our opinion are, weak companies with questionable outlooks. Second, we are focused on companies that we believe have strong balance sheets, exceptional managements, and the ability to grow even in a weak economy. This growth is coming from a number of sources: market share gains, new products or technologies, or niche secular growth. Examples of secular growth include:
Health Care:
The combination of an aging population, the development of new modalities of treatment and the addition of an estimated 30 million currently uninsured people into the system means that growth should outstrip that of the economy as a whole. The risk is that reimbursement pressure could be a negative, but we carefully evaluate this risk in choosing our investments.
Energy Infrastructure:
The discovery and production of vast new domestic shale energy reserves indicates that the volume of natural gas and oil that needs to be transported from the wellhead to end markets should grow rapidly and continue to rise for years to come. Rather than invest in the commodity which has been under price pressure from these new supplies, we have chosen to focus on pipeline, processing and storage facilities that are essential to the exploitation of the commodity. Using the analogy of the Gold Rush, we would rather sell supplies to the miners (e.g. blue jeans), rather than take the risk of mining.
Mortgage Servicing:
Many banks need to get out of the mortgage servicing business both because they are ill equipped to handle the large backlog of non-performing mortgages and because they need to free up capital. This has given rise to a third-party, independent mortgage servicing industry that has very well defined growth characteristics.
New Aircraft Mega-Cycle:
Because of an aging, fuel inefficient aircraft fleet in developed economies and growth in demand for air travel in emerging economies, there is an enormous increase in the demand for new aircraft around the world. This demand could last for the next 10 to 20 years. We are playing this cycle in two ways: manufacturers of planes and components and financiers of new planes.
Water Infrastructure Upgrade Cycle:
Municipal water systems in the U.S. are antiquated and need upgrading. This is likely to require 20 to 30 years of increased investment which is expected to generate attractive growth for well-placed companies.
Growth of Latin American Middle Class:
There are numerous ways to capitalize on this development. We are currently seeing opportunities based on the demand for new movie theaters and other forms of entertainment.
Growth of Database Usage:
As the use of data has become a competitive advantage between nations and companies, the need to capture, manage and analyze that data has become more important and complex. Companies that offer services and products to tackle problems around data management should show attractive growth characteristics.
In addition to a focus on companies with sustainable, above average growth rates, we are also looking for companies with robust free cash flow that can be used to return cash to shareholders through dividends or share repurchases. Today one can find numerous strong growing companies with yields of 2.0 to 3.5%. Compare this to the 10-year Treasury bond yielding around 1.7%. We think the choice is a no-brainer.
As always at this time of year, we want to thank you for your loyalty and extend our best wishes for a healthy, happy and prosperous New Year.
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Past performance is no guarantee of future results. This commentary contains the current opinions of the author as of the date above, which are subject to change at any time. This commentary has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.
The S&P 500 Index is an unmanaged index which is widely regarded as the standard for measuring large-cap U.S. stock market performance. This index includes the reinvestment of dividends. The index does not incur expenses and is not available for investment.
Free cash flow represents the cash that a company is able to generate after laying out the money required to maintain and expand the company’s asset base. Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value.
© Osterweis Capital Management
© Osterweis Capital Management
