Searching for the Market’s “Sweet Spot”

 

By John Derrick
Director of Research
U.S. Global Investors

 

Investing in today’s market isn’t easy. With more choices (stocks, bonds, options, futures, currencies) and access to different markets and select sectors than ever before, it’s overwhelming and difficult to sift through and decide what investment is best for you. That’s where professional active money managers step in.

 

One of U.S. Global Investors’ “sweet spots” is investing in global small-and mid-cap companies. We generally define these companies as having a market capitalization between $1 and $10 billion. Ten billion sounds like a lot but is relatively small compared to market caps of companies such as Apple ($301 billion), Johnson & Johnson ($181 billion) and Coca-Cola ($149 billion).

 

We like small and mid-cap companies because they tend to be less volatile than micro-caps, but still nimble enough to grow at faster rates than large companies.

 

Recent returns reflect historical patterns: The S&P SmallCap 600 Index outpaced the S&P 500 by 3.7 percent for the trailing 12 months as of May 31, 2011. Bloomberg News reports that “for every $1 invested in the S&P SmallCap 600 at the beginning of the five years ended May 31, investors would have made 28 cents, while earning 18 cents for the S&P 500” over the same time period.

 

One of the reasons small-and mid-cap companies present opportunity for active, professional investors is because their market is generally less efficient and trading volumes are much lower. The daily average trading volume for companies in the S&P 600 is 373,240 shares over the past 30 days versus 5.6 million shares for companies in the S&P 500, according to Bloomberg News. This means that large purchases or liquidations can have a greater effect on a share’s performance.

 

Analyst coverage from research firms can also impact a small company’s performance. Research from Bloomberg News shows that “when S&P SmallCap 600 stocks followed by six or more analysts are ranked by their average rating on May 29, 2010, companies in the top fifth posted gains of 32 percent during the 12-month period that ended May 31, compared with 20 percent for the bottom fifth. It’s almost the opposite case for larger companies: For S&P 500 equities with 20 or more recommendations, companies with the lowest ratings returned 33 percent versus 27 percent for the highest.”

 

We compared the S&P analysis to the performance of our Holmes Growth Fund (ACBGX), which is a multi-cap strategy with a good representation of these small-and mid-sized companies. The Holmes Growth Fund had a 30.5 percent return over the same time period (5/28/2010-5/31/2011).

 

The Holmes Growth Fund was able to achieve this return by investing in non-household names which show above-average revenue growth, above-average earnings growth and above-average return on capital.

 

Return on capital essentially measures what a company is earning in relationship to the capital invested. For example, if a company has $1 million of capital invested and is making an annual net income of $200,000, and then it has a 20 percent return on capital—which is fairly good.

 

We actively screened these companies and selected those which we believed would grow faster than peers. For example, companies such as Altra Holdings, Brigham Exploration, Core Laboratories and Rackspace Hosting have been some of the best small- and mid-cap companies which have exhibited these traits. Over the past year, we believe these carefully researched companies have added value for the Holmes Growth Fund shareholders.

 

Index Summary

 

• The major market indices were lower this week. The Dow Jones Industrial Index lost 1.64 percent. The S&P 500 Stock Index declined 2.24 percent, while the Nasdaq Composite lost 3.26 percent.
• Barra Growth underperformed Barra Value as Barra Value finished 2.16 percent lower while Barra Growth declined 2.32 percent. The Russell 2000 Index closed the week with a loss of 3.54 percent.
• The Hang Seng Composite Index finished lower by 2.90 percent; Taiwan declined 2.30 percent, and the KOSPI lost 3.16 percent.
• The 10-year Treasury bond yield closed 1 basis point lower at 2.97 percent.

 

Domestic Equity Market

 

The figure below shows the performance of each sector in the S&P 500 Index for the week. All ten sectors declined. The best-performing sector for the week was utilities which declined 0.74 percent. Other top-performing sectors were healthcare and consumer staples. Information technology was the worst performer, down 3.25 percent. Other bottom performers were financials and consumer discretions.

 

Strengths

 

• The paper packaging group was the best-performing group for the week, up 5.2 percent, driven by increases in both of its members (Bemis Co., Inc. and Sealed Air Corp.). Sealed Air Corp. gained after suffering a sharp decline last week from its announcement that it had agreed to buy Diversey Holdings Inc. Bemis Co., Inc. announced this week that its tender offer to acquire shares of its Brazilian subsidiary, Dixie Toga, had been approved.
• The home furnishing group was the second-best performer, up 2.5 percent, led by its single member, Bed Bath & Beyond on rumors of renewed leveraged buyout (LBO) chatter.
• The distiller and vintners group outperformed, rising 0.75 percent on the strength of its member, Brown-Forman. The stock gained after it reported a 26-cent-per share gain from the sale of its Fetzer vineyards to a Chilean wine producer for $238 million.

 

Weaknesses

 

• The building products group was the worst-performing group, down 11 percent. The Case-Shiller home price index, released last week, which showed home prices were entering a double dip, could be a possible reason for Masco Corp’s decline.
• The homebuilding group was the second worst-performing group, losing 9 percent. Its members D.R. Horton Inc., Lennar Corp. and Pulte Group declined as the slowdown in home sales enters its fifth year.
• The tires and rubber group lost 8.6 percent led by its single member, Goodyear, which fell after a J.P. Morgan analyst cautioned investors on the company because of significantly weaker demand for tire replacements.

 

Opportunities

 

• There may be an opportunity for gain in merger & acquisition (M&A) transactions in 2011. Corporate liquidity is high, thereby providing the means to pursue acquisitions.

 

Threats

 

• The end of quantitative easing currently scheduled by the Federal Reserve for the end of June might result in a weaker economy.

 

The Economy and Bond Market

 

U.S. Treasuries rallied modestly this week as the economic outlook remains cloudy and concerns continue to build on growth prospects for the second half of 2011.

 

After a disappointing employment report last week, the weekly initial jobless claims data did nothing to inspire confidence. After showing steady improvement for roughly six months, the trend in initial jobless claims has been in an uptrend for the past three months and indicates a weak job market will likely persist.

 

Strengths

 

• Mortgage rates continued to fall, hitting the lowest levels of 2011, at 4.49 percent.
• China, the world’s largest auto market, announced a “cash for clunkers” program offering up to $2,800 for old vehicles to boost sales.
• The trade deficit unexpectedly fell by 6.7 percent, which should be a positive for second quarter GDP growth, but much of that improvement came from disruptions from Japan.

 

Weaknesses

 

• China auto sales fell 3 percent in May on a year-over-year basis.
• Import prices unexpectedly rose 0.2 percent in May. On a year-over-year basis import prices have risen 12.5 percent.
• In a recent survey, 43 percent of Americans believed the U.S. was in a recession or depression.

 

Opportunities

 

• The Fed may be forced into another round of quantitative easing if employment and the economy do not improve soon. This is not a consensus and the market is applying low odds of this occurring, but if it were to come to pass the fixed income markets would likely rally.

 

Threats

 

• Another Greek bailout appears inevitable and other bailouts are likely to follow, increasing the eventual risk of default and potentially threatening the global banking system.

 

Gold Market

 

On Friday, spot gold closed at $1,531.35, down $10.60 per ounce, or 0.69 percent for the week. Gold equities, as measured by the Philadelphia Gold & Silver Index, fell 4.69 percent. The U.S. Trade-Weighted Dollar Index moved up 1.46 percent for the week.

 

Strengths

 

• The top forty global mining companies are poised to break through the $1 trillion asset mark this year, due to record levels of cash, property and equipment on balance sheets, says a new PricewaterhouseCoopers report. According to the company’s report, Mine 2011: The game has changed, total revenues for the top forty mining companies increased 32 percent to $435 billion, breaking the $400 billion mark for the first time. Net profit rose 156 percent to $110 billion and net debt was reduced to $46 billion.
• South Africa’s gold output rose 1.5 percent in volume terms in April while total mineral production rose 12.4 percent compared with the same month a year earlier.
• Scotia Mocatta, a global leader in precious and base metals trading, noted that “one thing is for sure, even if gold gets caught up in commodity / equity sell offs, dips are there to be bought as gold is increasingly recognized as a currency in its own right!”

 

Weaknesses

 

• Nevada’s Governor Brian Sandoval signed Senate Bill 86, which repeals a state law that allowed the mining industry to use the power of eminent domain to take private homes and ranches for mining, smelting and related activities.
• Many are urging the Obama administration to extend for 20 years a mining ban on one million acres around the Grand Canyon National Park. In 2009, U.S. Secretary of the Interior Ken Salazar issued a federal order calling for a two-year "time-out" from all new mining claims in the Arizona Strip near the Grand Canyon. The lands were blocked from new exploration and mining activity. Supporters of the ban cite the extreme environmental effects of mining.
• State-owned mining company African Exploration Mining and Finance Corporation would “never” be bailed out at taxpayers’ expense should it fall on difficult times, according to Mines Minister Susan Shabangu. “Bailouts from the state would never be an option,” Shabangu noted.

 

Opportunities

 

• Ethiopia is set to hit its target of more than doubling mining exports to an annual $1 billion ahead of schedule, the country's mining minister told Reuters. Ethiopia is expected to earn around $500 million from mining exports in the financial year to next July, the mining minister said.
• Chile and China signed agreements to increase cooperation in mining during a visit by China's Vice President Xi Jinping. The governments also confirmed financial cooperation and development funding accords between Chile's Banco Estado and China Development Bank, both state-owned. China, a top importer of commodities, is by far the biggest buyer of copper from Chile, the world's top producer of the metal.
• Sprott Asset Management chief investment strategist John Embry believes this summer will be bullish for the price of gold. "I don't like putting numbers and dates in the same sentence because you always make yourself look bad - but I would be very surprised if it doesn't take out $1,650 this summer and maybe headed towards $1,800 over the next three months," he said. To back up the statements, Embry points to a number of macroeconomic factors that are likely to have a bearing on gold prices over the next few months.

 

Threats

 

• Peru’s newly elected president Ollanta Humala has raised concern for Peru’s mining industry. President Humala has suggested Peru could impose a windfall tax of up to 40 percent on mining companies and raise the corporate tax rate from 30 percent. Royalties could be raised to 5 percent from 3 percent.
• Tanzania, one of Africa's top gold producers, is considering a "super profit" tax on earnings from minerals as one of the ways to fund its five-year development plan. "Revenue from the mineral resources will be one of the important sources of financing the medium-term plan. Considering the increasing trend in mineral prices, it is optimal to introduce a super profit tax on the windfall earnings from the mineral sector," said President Jakaya Kikwete.
• A report indicated that the majority of gold mines in South Africa will shut down within a decade. Despite the gold bull market of recent years, with the price of gold rising sharply, South Africa’s gold reserves are becoming depleted at a rate that, within 12 to 14 years would mean the end of the industry for the country.

 

Energy and Natural Resources Market

 

 

Strengths

 

• BP published its June 2011 Statistical Review of World Energy this week, which recorded a 5.6 percent increase in global primary energy consumption, the largest since 1973. China’s energy consumption grew by 11.2 percent to make up 20.3 percent of the world total, eclipsing the U.S. for the first time.
• Mexican mining production rose 15 percent year-over-year in April and 66 percent month-over-month to 31,893 tonnes and reportedly includes full production at the Buenavista del Cobre mine.
• The latest European stockholder steel shipment data highlights the positive demand conditions for the regional steel sector in late first quarter. Flat product steel sales were up more than 10 percent year-over-year, exceeding the 2007 record annual average for the first time since the global financial crisis.
• Ukraine’s coal production rose 9.9 percent to 33.9 million tonnes in the first five months of the year from a year earlier, reported the Energy and Coal Industry Ministry.
• The latest data marks total U.S. oil demand at a strong 19.13 million barrels per day, up 0.22 million barrels per day week-over-week, continuing with an upward trend of the weekly reading which began the month of May at 18.16 million barrels per day. The data shows that the weakness earlier in the month pertained primarily to refinery and petrochemical plant outages rather than the falling away of underlying demand in the U.S.

 

Weaknesses

 

• According to the China Iron and Steel Association, daily output of crude steel in China during the last week of May fell 3.46 percent week-over-week reaching 1.915 million tonnes.
• The China Association of Automobile Manufactures reported that vehicles sales in China shed 13.95 percent month-over-month to 1.19 million in May 2011. China’s automobile sales dropped for the second month in a row pointing to slowing demand after Beijing stopped offering incentives and introducing new limits on car purchases earlier this year.
• Preliminary data suggest that total oil products demand in April in the three largest European markets (France, Germany and Italy) fell by 3 percent year-over-year, similar to the decline seen in March, with most of the decrease due to very low sales of heating oil (down 29 percent year-over-year) resulting from very warm weather.

 

Opportunities

 

• The president of Baosteel’s stainless steel unit reported this week that he expects stainless steel consumption in China to grow 5 to 7 percent annually over the next five to ten years.
• Global natural gas use may rise more than 50 percent by 2035 from 2010 levels and meet more than a quarter of global energy demand, according to the International Energy Agency.
• The U.S. Department of Agriculture estimated corn plantings at 94 percent complete, below the five-year average pace of 98 percent, leaving about 5.5 million acres (2.2 million hectares) of the projected 92.2 million yet to be seeded.

 

Threats

 

• China’s National Development and Reform Commission (NDRC) warned thermal coal producers against price increases, and indicated fines of up to five times the revenue generated. The NDRC has been trying to stabilize the coal market but rising international prices is leading to discontent among miners, according to Bloomberg News.
• Allegations of serious malpractice from a short selling specialist sent shares in Sino-Forest plunging by two-thirds, despite strong denials of the claims by the Toronto-listed timber group. The shares shed 70 percent in two sessions after the allegations, wiping about $3 billion off the company’s stock market value.

 

Emerging Markets

 

Strengths

 

• The China Banking Regulatory Commission (CBRC) has announced guidelines to support lending to small enterprises with loan sizes of less than five million yuan.
• Taiwan has allowed tourists from mainland China to travel freely with daily permits capped at 500 people.
• Ecorodovias toll road traffic in Brazil grew by 17 percent in the first five months of this year. The shares of the company have outperformed the broad index by 16 percent year-to-date due to its defensive nature.
• Mexico’s consumer price index in May declined by 0.74 percent month-over-month bringing the annual inflation to 3.25 percent. Lower electricity rates have been one of the main contributors.
• Russian wheat exports are set to resume with the lifting of the export ban imposed after a severe drought last summer.

 

Weaknesses

 

• China might reduce toll fees on highways and bridges to reduce transportation costs, affecting toll road revenues.
• Export growth slowed noticeably to 19.4 percent year-over-year in May (compared to. 29.9 percent year-over-year in April), below market consensus of 20.4 percent. Import growth rebounded strongly to 28.4 percent (vs. 21.8 percent year-over-year in April).
• The Bank of Korea raised its policy rate by 25 basis points to 3.25 percent, which may depress housing prices and increase the debt burden for leveraged Korean consumers. For the health of the Korean economy, the rate increase is necessary to dampen inflation expectations.
• Appreciating RMB is flowing to Hong Kong’s housing market and causing sharp price increases, particularly for high-end properties. Inflation expectations are also driving Hong Kong residents to favor property purchases.
• The China Banking Regulatory Committee is looking to increase risk weightings for bank loans. This move potentially increases bank’s capital costs.
• Following flat auto sales, China saw total sales down 4 percent year-over-year in May at 1.38 million units. Passenger vehicles and commercial vehicles were down 0.11 percent and 14 percent year-over-year, respectively.
• Investment banks are cutting China’s 2011 estimated GDP growth rate.
• A shocking irregularity in credit activities at La Polar, a low-cost retailer in Chile, may necessitate an impairment charge of nearly $400 million for the company with non-performing loans at 40 percent of portfolio vs. 9 percent in the sector. The stock lost nearly 45 percent this week on the news.
• May’s Emerging Europe purchasing managers indices (PMI) confirm that the region’s manufacturing industry is losing the tailwind provided by the global economic recovery. The slackening comes amid monetary and fiscal tightening in China and Europe.

 

Opportunities

 

 

• Chinese demand for thermal coal is a long term phenomena due to its increasing power consumption. China has just removed its import coal tariff to allow more coal to sell in China market. This is positive for coal from Indonesia and a reflection on tight domestic coal supply. Recently, the market speculated China may put a price control on the spot coal price, which is still not expected to change the positive demand-supply for the coal miners.
• Has the sell-off in the Peruvian market on the news of Ollanta Humala becoming President been overdone? We remain optimistic that the new government will not derail pro-market policies of Peru, the fastest growing Latin economy, and a major commodities producer. After a plunge in the aftermath of the election result, the Peruvian bourse has recouped most of the losses as market participants are reassessing a new political landscape. Cencosud, a Chilean retailer with 10 percent of sales in Peru, announced it will move ahead with a $220 million expansion plan in that country.
• The news that sugar production this year in Brazil will be less than expected has been supportive of the price for this commodity, up 20 percent in June.
• During next week’s St. Petersburg Forum, China and Russia could sign a contract for 68 billion cubic meters per year starting in 2015, but the price may or may not be agreed upon. VTB Capital believes the formula for the price will be close to that for Europe, which is linked to the oil price with a six to nine month lag.

 

Threats

 

• Although we don’t believe there is a high probability of a hard landing in China, there are risks that could lead to slower GDP growth. These risks include a chronic power shortage, auto sales deceleration, weak PMI, property market corrections and monetary tightening.
• There are indications that Brazilian regulators may not authorize on competitive grounds a merger of Perdigao and Sadia that created Brasil Foods (the largest global poultry exporter) two years ago. A final vote is expected on June 15.
• A 63 percent devaluation of Belarus currency since March 31, will have a negative impact on the earnings of telecom companies operating in the country.

 

(c) US Global