Action and Reaction


Newton’s Third Law:
For every action, there is an equal and opposite reaction 

As 2014 drew to a close, we had a front row seat to the market turmoil that may be best explained by summing up Newton’s third law: Nothing happens in a vacuum. The trick is to anticipate what the consequence of any action might be. When China’s growth slows and Saudi Arabia feels threatened, the New York owner of a bond issued by an oilman in North Dakota will be impacted. What else will happen as the current scenario unfolds?

Our CEO, Will Nasgovitz, recently presented to a group of local business executives. Highlights of his thoughts summarize our outlook for the U.S. economy.

Economic activity

Our investment discipline is driven by valuations, which are largely based on earnings, current and expected. There are five indicators we find consistently valuable in testing our economic assumptions, four of which are currently implying continued U.S. growth:

·         The yield curve is positive. A recession typically coincides with an inverted yield curve, which does not appear to be an immediate concern.

·         Jobless claims continue to improve. Historically, a 20% spike in claims has been a trustworthy indicator that the economy is heading down.

·         A good barometer of industrial activity, copper, is weakening. It ended the year down over 16% and broke a key support level of $3.00. The U.S. dollar strength and Chinese weakness are certainly factors.

·         Rail car loadings are up over 4% year-over-year*. This is an indicator Warren Buffet has made popular, and for good reason: Goods must be transported to where they are consumed.

·         S&P 500 performance, while impacted by growth scares, was positive in 2014, signaling investors’ confidence in the economic outlook.

The chart above shows that since late 2009 the S&P 500 Index has been picking up steam. The shaded areas represent periods of recession, which clearly coincide with S&P 500 periods of negative performance. To us, the current trajectory of this indicator demonstrates that the economy is on solid footing.

Capital expenditures are likely to be a key element

Additional context for our reasoning goes back to 2008 and 2009 – the Great Recession. Durable goods purchases and capital investments by consumers and businesses plummeted during this period, a common occurrence during recessions when historically these kinds of spending have fallen to about 23% of gross domestic product (GDP). This number plunged to a remarkably low 20% of GDP in the last recession, and we are still working our way out of this period of under-investment. The long-term average suggests an additional 10% or greater uptick from current levels; even a moderate improvement is worth multiple percentage points of increased GDP.

What would drive this investment by consumers and businesses? We believe it is a very human dynamic: Confidence. And we think we are headed in the right direction, albeit somewhat haltingly, as the data seems to show. Plus, capital improvements simply need to happen. The average age of a structure in the U.S. is 23 years old or in-line with what we saw in the 1960’s. Equipment, at seven and a half years old, is at the same age as the early 1990’s. The average age of automobiles on the road in America today is decidedly advanced at 11.4 years. That’s almost two years older than the average age for the decade prior to the 2008 financial crisis. Necessary infrastructure improvements combined with low interest rates are likely to drive a reversal of the recent pattern of lackluster capital expenditures – action and reaction.

How does Energy fit in?

Lower oil prices are clearly the story of the day. The portfolios we manage have been hurt by our Energy exposure. We did not anticipate the collapse in prices, coincident with the effective dissolution of OPEC. While there will be economic consequences in both directions, we believe the positives outweigh the negatives.

Positives: Americans consumed 135 billion gallons of gasoline last year. Gas prices peaked at $3.65 per gallon this past June, and they average $2.26 at present, which equates to $135 billion in incremental cash flow or about 1% of GDP. On a global basis, economists suggest that every $20 drop in oil prices raises growth by 0.5%.

Negatives: The substantial drilling activity in the U.S. has created many jobs over the last few years; we estimate it could account for 20% of all domestic job creation. Energy companies also make up 16% of the high yield bond market. With restructurings likely, negative implications for debt holders could be a foregone conclusion.

Our outlook

We read the same headlines as you do, and likely share the same concerns. Will China’s landing be hard or soft? Will Europe sink into financial despondency? What political hotspot will erupt next? How will Russia’s ruble crisis be resolved? Is the U.S. inevitably coupled to other economies, or can we navigate a more positive outcome for ourselves?

The answers to these questions are devilishly difficult, and we put forth a great deal of effort to understand how they will affect holdings. We do our best to maintain perspective and poise as macro events unfold, sometimes benefiting and occasionally hurting portfolio positions. But regardless of large-scale trends and events, our focus stays where it’s always been: on company fundamentals. Though 2014 has been challenging, what we’re seeing as we apply our 10 Principles of Value InvestingTM is encouraging. We are uncovering companies with reasonable valuations, strong balance sheets and earnings, and—even in the face of investor skepticism—management team confidence expressed in the form of insider buying. These are signals of opportunity. We will continue to rely on our disciplines as we have across market cycles for over 30 years.

*As of December 27, 2014.

Past performance does not guarantee future results.

The statements and opinions expressed are those of the author. Any discussion of investment strategies represent the portfolio manager’s views when presented and are subject to change without notice. Investing involves risk, including the potential loss of principal. There is no guarantee that any particular investment strategy will be successful. Economic predictions are based on estimates and are subject to change.

Sector classifications are generally determined by referencing the Global Industry Classification Standard Codes (GICS) developed by Standard & Poor’s and Morgan Stanley Capital International.

Data Sourced from Ned Davis: © 2014 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved. See NDR Disclaimer at For data vendor disclaimers refer to

Definitions: 10 Principles of Value Investing™: consist of the following criteria for selecting securities: (1) catalyst for recognition; (2) low price in relation to earnings; (3) low price in relation to cash flow; (4) low price in relation to book value; (5) financial soundness; (6) positive earnings dynamics; (7) sound business strategy; (8) capable management and insider ownership; (9) value of company; and (10) positive technical analysis. Earnings per Share: is the portion of a company’s profit allocated to each outstanding share of common stock. Gross Domestic Product (GDP): is the monetary value of all the finished goods and services produced within a country’s borders in a specific time period, though GDP is usually calculated on an annual basis. Yield Curve: is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. S&P 500 Index: is an index of 500 U.S. stocks chosen for market size, liquidity and industry group representation and is a widely used U.S. equity benchmark. All indices are unmanaged. It is not possible to invest directly in an index.


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