Investment Review
JS Asset Management
John K. Scheider
April 13, 2010
Performance
In December 2008, I wrote the prospective returns of our portfolio would be the best of my investment career. The long term outperformance of value investing is well known, the single minded dedication through the ups and downs is the tough part. The dedication of all JS Asset employees to our fundamental, deep value approach and fortitude of our clients has allowed us to successfully manage through the financial crisis of the past two years.
Today, the U.S. is once again seeing a growing economy and recovering housing and auto markets. We remain upbeat in our outlook for U.S. equities and believe we are still in the early innings of the value cycle. We continue to find exciting new investments. All of our holdings trade considerably below intrinsic value. Based on our models, the median stock shows over an 80% upside to our price target. We use conservative P/E assumptions as a margin of safety. Of the nearly 500 stocks on our monitor list only a handful have P/E targets over 15x. As Warren Buffet said, “Big opportunities come infrequently. When it’s raining gold, reach for a bucket not a thimble”. As always, we invest with an 18-24 month time horizon and there will always be bumps in the road.
The primary driver behind the quarter’s outperformance was the Financial sector, primarily Banks. Homebuilders, Autos, Retail, Telecom Service, Energy, and Health Care all had a positive attribution. We were overweight some of the best performing sectors – Financials and Consumer Discretionary and underweight some of the worst performing sectors – Telecom Service, Energy, and Health Care. The only laggards of substance were Merchant Energy Producers.
Economic Outlook
The U.S. great recession has ended and the recovery appears more robust than generally forecasted. The U.S. GDP grew 5.6% in the fourth quarter, the fastest quarterly pace since 2003. The economic consensus forecast for 2010 of less than 3% growth is likely too low and we believe could be closer to 4%. The U.S. is seeing a strong manufacturing recovery with industrial production up 8.3% over the past eight months. Exports are strong despite Europe’s weakness. Inventories remain low. Meaningful parts of the U.S. economy such as Housing and Autos remain below scrappage rates and will significantly boost GDP as they recover. While productivity generally improves after the end of a recession, the surge over the last three quarters of 7.4% was the highest in over thirty years! This is yet another sign that corporate earnings leverage will be great.
Stocks – “The Mother of all Cycles”
We continue to project that corporate earnings will have a powerful recovery. Due to cost reductions undertaken during the downturn, the earnings improvement will be more dramatic then any cyclical recovery we have seen in the last thirty years. In fact, reported earnings have beaten estimates for four quarters in a row. In the third quarter of 2009, top-line growth returned. In the fourth quarter, with over 70% of companies exceeding revenue expectations, earnings grew by almost 30% and cash flow by 40%. The S&P 500 earnings (ex. TARP repayment charges) were over $77/share annualized, in the fourth quarter. The market is not expensive on trailing valuations and the economy has just started turning up.
The U.S. Housing industry is cyclical. Housing starts have peaked at over 2 million units per year only to collapse to 1 million several times over the last forty years. Trend-line demand is 1.65 million homes per year, according to Harvard. This housing cycle was much worse, bottoming at half of the prior low – roughly 500,000 units. That low construction rate has allowed the inventory of both new and existing homes to be absorbed. Home prices across the U.S. bottomed in April 2009 and have moved steadily higher. Due to this recession’s high unemployment, the number of households shrank - the unemployed moved in with friends and family. As employment recovers faster than the housing stock, vacancy will dry up and homes will appreciate again. Since 2006, there has been little new home community development. Home prices need to rise significantly for the economics of converting raw land into developed land and into finished houses to work.
We remain overweight Financials, especially Banks. In the second and third quarters of 2009, U.S. banks saw credit get less bad. In the fourth quarter, inflows of new non-performing loans declined. We believe total non-performing assets will peak in the first half. Non-performing construction loans, which have particularly high loss severity, are already declining. Net interest margins expansion continues. Thus, we expect significantly improved bank earnings over the next few quarters. Capital ratios are the best they have ever been. The industry will soon be recognized as over-capitalized, allowing dividend growth, stock repurchases and acquisitions. Oddly, financial stocks do not reflect the bullish outlook – banks are scraping along their historic lows. Many of the banks we own are selling below book value, versus their historic 2-2.5x.
Whether it is Autos, Heavy Duty Trucks, Retail or IT Equipment, we continue to find good investments in some underappreciated cyclicals. During the market malaise the phrase “the new normal paradigm” was widely publicized and we found good entry points for stocks of companies which were experiencing extremely depressed revenues and margins due to dramatic declines in unit sales. For example, the U.S. auto industry volume, which once stood at 17.4 million units per annum, dropped well below the 16 million unit trend-line to hit 9.1 million units. Investors were convinced the new normal was probably closer to 12-13 million, yet stocks were still undervalued based on this metric.
There has been a notable uptick in dividend and buyback announcements recently and we expect this trend to accelerate. We see three key drivers of the payout up-cycle: (i) cash balances are at record highs (with cash accounting for 12% of total market capitalization); (ii) cash flows are strong; and (iii) Financials resume normal payouts with 200% upside for dividends, as the write-off cycle ends and regulatory uncertainty abates. Across sectors, Financials have the most excess cash, followed by Industrials and Technology.
Stock-picking is “dead”; long live stock-picking
Institutions around the world are “de-risking” their portfolios by selling stocks and boosting investments in alternatives to reduce volatility. Many are abandoning equities completely by “immunizing” their portfolio. What is ironic is after the equity market and interest rates collapsed they are moving collectively into bonds. After a decade of poor equities returns, pessimism is high and cash levels are above average. It seems everyone is an asset allocator focused on macroeconomics, currencies, politics, and inflation. Investors have seemingly given up on active investing focusing on ETFs and indexing instead. We believe these trends are a mistake. Bottom up stock picking and value investing works. In a world where volatility is shunned, we embrace it when appropriate. We expect, just like last decade, that value investing returns will be above the long term norm this decade. We think the risk will be well rewarded. It is time to focus on fundamentals, as we always do.
(c) JS Asset Management
