Investing in the financial markets necessarily involves one’s ability to change perspective over time. Often the job of assessing what is important at any particular point becomes increasingly difficult in a period of heightened short-term volatility. Not difficult in terms of staying focused on the factual reality of the economy, corporate earnings, etc., but difficult in that the financial media feels compelled to come up with rationales for daily movements in asset prices. Possibly the single greatest task of any investor today is filtering out white noise. And there’s more of the white stuff than ever before.
So said the Contrary Investor, and I could not agree more given my sense the media is “long” volatility. Indeed, every time the market volatility picks up, so do my phone calls from the media as they attempt to “come up with rationales for the daily movements in asset prices.” Yet, filtering out the “noise” is where the real net worth changing ideas comes from, not the day-to-day movements of asset prices. For example, recall my strategy comments during 4Q99 when I noted that Dow Theory had registered a “sell signal” and consequently participants should not allow any investment position to go more than 15% - 20% against them. That advice was generally correct, and while contrary to the “noise” of the time, it saved participants a lot of dough if they listened.
Most recently, I have been in a cautious mode, believing we were involved in a short-term pullback that would carry the S&P 500 (SPX/1687.99) down about 10%. That strategy was working until the Syrian compromise wrecked the rhythm of the decline. Bear in mind, however, the anticipated decline was always couched within the context of a longer-term secular bull market. To be sure, I continue to think the odds of a secular bull market are high and that the economy will strengthen. Obviously, I am not the only one believing that, for last week I hosted a conference call with Mary Lisanti, portfolio manager of the AH SmallCap Growth Fund (ASCGX/$18.80). After my brief discussion about the equity markets, Mary began by stating:
This is the most interesting cycle I have ever seen in 35 years. And, that’s because there is an enormous amount of innovation occurring in the small capitalization universe of stocks. Part of the reason it doesn’t have that “feel good” environment is the way we tend to come out of these economic crises. We basically start to see a cycle of innovation, and it starts with the small companies. We currently have two things going on: 1) there is creative destruction in that the old ways of doing things are dying; and 2) the new ways are becoming established. And until those new trends become very firmly established, you don’t tend to get a lift in the economy and consequently people don’t feel good. It starts out very slowly, but we do eventually enter a virtuous circle of self-sustaining growth and low inflation, driven by innovation and creativity. I have never seen a cycle this strong. It’s across all sectors, in all areas we look at, and I think it came about because the economic crisis of 2008 – 2009 was so awful. Small companies live and die by what they do. They don’t have a brand to sell; they have either a product or a service to sell. When they are faced with an economy that drops 6% for a couple of months, and a credit crunch we haven’t seen since the Great Depression, small companies find innovative ways to do things differently. And, that’s really what we are starting to see. The small cap end of the market has done much better than the S&P 500. From where we sit, we see a lot of companies that are growing well in excess of what the S&P is growing. The world grows at 5% – 10% and the small caps grow at 10% - 15%; the companies we invest in are growing much faster – 35% or better.
We are a little different than others. We look at the world through the filter of change. In small caps it is all about change on the margin; and it’s about innovation and creativity, and the ability to deliver something the world wants. Every small company is trying to grow. What they need to grow, for any long period of time, is “demand pull.” We identify these “demand drivers,” and if you look at what’s going on in the world today, we see five demand drivers in the U.S. They are: the return of the U.S. household formation; the American Industrial Renaissance; the second generation of biotechnology; cloud-based information services; and the American oil shale play.
If those themes sound familiar, they should because I have been talking about most of them for a few years. They are also reminiscent of the “six rivers of growth” that Tom O’Halloran, PM of the Lord Abbett Growth Leaders Fund (LGLAX/$20.58) spoke of in another conference call I hosted three weeks ago. Those “rivers” were: the ongoing digitization of society; the dynamics of mass consumerism; the growth of emerging nations; the innovation of modern medicine; the American manufacturing renaissance; and the North American energy revival. Like Tom, Mary discussed select companies (mainly from the Raymond James research universe) that she owns in her fund. In the energy space she owns Kodiak Oil & Gas (KOG/$11.00/Market Perform) and Bonanza Creek Energy (BCEI/$45.91/Outperform), which she thinks have lots of oil near the surface of their properties. She noted that the housing recovery in the late 1970s, which lasted into the 1990s, is very similar to what is occurring now. To that theme, Mary suggested that U.S. household formations are growing very quickly and offered Lumber Liquidators (LL/$107.43/Underperform) as a play on that theme. Our analyst currently rates that stock as underperform due to valuation. However, Mary notes that new management from Home Depot (HD/$75.11/Market Perform) has lots of “levers” to pull, and for a company growing at 40%, LL is an interesting investment.
On the mass consumerism theme, Mary offered up Red Robin (RRGB/$68.92/Strong Buy), while Tom O’Halloran suggested Chipotle (CMG/$425.34/Market Perform). In the “digitization of society,” Tom likes Facebook (FB/$44.31/Strong Buy). In the energy space Tom mentioned Range Resources (RRC/$78.64/Market Perform) and Chart Industries (GTLS/$122.49/ Outperform). Both portfolio managers like technology, which they think has the best business model given that it is “asset light with big earnings leverage.” Along the technology line, 3-D printing, fiber optic lasers, and robotics/automation were all discussed with attendant stock ideas, which unfortunately are not covered by Raymond James. For more individual ideas from these excellent stock pickers, I suggest looking at the stocks they hold in their respective portfolios.
The call for this week: It’s 3 a.m. and I am in San Francisco seeing portfolio managers and speaking at events, but I will still be watching the markets. With the FOMC, and the potential for a Fed Head announcement (not Larry Summers as I have repeatedly opined), this week should prove interesting. Also of interest is that the SPX has broken above my 1684 “pivot point,” although it has not done so decisively. By “decisive” I mean it needs to stay above 1684 for more than three trading sessions and it must vault above that level by at least 3%. That would imply a close above 1689.05, which looks like it is going to happen this morning. To that point, the change in the D-J Industrial Average should help the upside breakout since the three stocks exiting the index have an average price of $15, while the new three stocks have an average price of $134.50. According to my friends at the invaluable Bespoke Investment Group, “A 10% gain in the three stocks removed – with the other 27 other stocks unchanged – would add just 34.5 points the Dow. The same gain in the new three would mean a 262-point rise.” In last Thursday’s Morning Tack I suggested this was going to happen and recommend recommitting some of the cash raised back in June. I still feel that way.
© Raymond James