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  O’Connor
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Brae Head, Inc.

Past Commentaries

12/7/2017

Current Commentary

To My Clients, Friends, & Observers

This is a golden age. Corporate earnings are strong and growing. Globally economic growth is steadily improving – no developed economy is in recession. Commodity inflation is benign, particularly in energy. And there are fewer stocks available for investment – approximately 3,600 domestically, less than half than in year 2000. The principal U.S. equity indexes, S&P 500, DJ Industrials, DJ Utilities, NASDAQ Composite, and Russell 2000, have hit all-time highs in 2017. This in spite of the fact that no new money has come into the stock market for the last 10 years, according to Liz Ann Sonders, Charles Schwab’s chief investment strategist. Industrial sectors have also become less correlated, allowing greater flexibility to position portfolios for growth and downside protection, an advantage for stock pickers over indexers.

These trends could last a while. Even money market funds are starting to yield something. The Fed Funds rate is at 1.25%, with another bump expected at this month’s Federal Reserve meeting. Between now and 2021 we could see as many as nine rate increases, bringing Fed Funds to 3% by the end of 2020. That, in concert with an exhausted business cycle, could result in a flat or inverted yield curve, and that would signal a market peak and imminent recession. But that is two or three years away and over the horizon.

GDP growth has accelerated, exceeding 3% in the last two quarters. Leading and coincident economic indicators are expanding. Lagging indicators are neutral. Labor market indicators are robust, which is boosting consumer confidence. Core CPI ( the consumer price index minus energy) is up 1.7% year over year, 1.9% annually for the last 5 years, and only 2.0% annualized for the last 20 years – “as close to price stability as the U.S. has ever seen,” according to the American Institute for Economic Research, whose data I utilize. Oil is at a very manageable $60/barrel and gold has been stuck in a channel between $1250 and $1300.

Supporting this healthy news, these trends are global. Below is the Baltic Dry Index, a leading indicator of global industrial activity, through September of this year. The BDI line is blue; the S&P 500 is in green. While it has improved from 960 a year ago to 1260, it doesn’t indicate commodity inflation. The BDI was over 11,000 in 2008.

Baltic Exchange Dry Index (BDI)

& SP500 (green)

All this good news comes at a price. The S&P 500 trades at 25 times its trailing twelve months earnings as reported, exactly where it was in May but at a 10% higher price. Total market capitalization is at 130% of GDP, which is historically very high, but we are coming out of a protracted period of very low GDP. Real economic growth mitigates a lot of ills. High P/E ratios do not predict future market performance. Earnings do. S&P 500 (trailing 12 months, as reported) earnings should finish the year at approximately $115. Those earnings are projected to accelerate each quarter in 2018, ending the year at $134.43, as reported by Howard Silverblatt, S&P Senior Index Analyst. That implies a gain of 17% at the current P/E of 25. There is no decline visible yet in the rate of change in earnings, therefore, no signal inflection point. One has to be invested. There are fewer stocks available in which to invest.

A note on the tax bill, should it pass. The biggest beneficiaries would appear to be manufacturing industrials and financials. Rising rates are also benefiting financials.

The Market Bares Its FAANGs

Facebook, Amazon, Apple, Netflix and Google account for over 28% of the S&P 500’s return so far this year while being only 10.6% of the index’s capitalization. The total tech sector represents 23% of the S&P 500. These five stocks accounted for over 60% of the NASDAQ 100’s record gains through July. Of the five, the Brae Head composite includes Apple and Alphabet (Google).

Apple, Google and Facebook carry prodigious amounts of cash (too much) on their balance sheets and are extremely profitable; Amazon and Netflix, not so much at all. In fact, the financials for Netflix and Amazon make one wonder why anyone would invest in them at all.

I love Amazon. I pay $100 a year for a Prime membership which allows me free shipping, one-click ordering, and free access to thousands of movies and shows. I have bought industrial parts, rare books and music, common and uncommon household goods all on Amazon. Most of the time orders arrive at my door step in two days or less. It is an amazing display of technological and logistical genius and execution. What was born as “critical transaction software” in retailing some 35 years ago has matured into a complete supply chain, inventory, logistics, customer management and search engine machine. And nobody does it better than Amazon - yet.

Transaction management/monitoring software is essential for business today. The company that first revolutionized massive scale, high-efficiency retailing using superior technology  was Walmart. The technology that Walmart helped develop then is ubiquitous today. The same will happen with Amazon’s technology. Walmart (and many others) is busy dissecting and duplicating Amazon’s model right now. I don’t see a lot of barriers to entry long term.

In the September 23rd Wall Street Journal, NYU professor Scott Galloway wrote a thought-provoking article titled “Amazon Takes Over The World.” He discusses Amazon’s “boundless expansion based on avoiding both profits and taxes” and questions the social impact of such a disruptive, predatory business model. If Walmart threatened smaller retailers in every town they built a store, Amazon threatens the livelihood of every retailer, everywhere, without building any stores. And AMZN does it without making any money because investors are willing to capitalize it at ridiculous valuations.

What Jeff Bezos Knows

Here is why I don’t own a share of Amazon. It is priced at 292 times earnings. It earned $4.03 the past year at $1160 a share. Its net profit margin is 1.19%. This is not atypical of retailers by the way, which is why I avoid them. Its return on equity is 9%. (I like to see 20%). Its compound annual growth rate of sales has been 25% for the last 5 years. To get to a P/E ratio of 50 at the same price, it will have to grow its earnings at a 25% rate for the next 8 years, while Walmart et al play catch up. Maybe it will. In the meantime, it pays me nothing (no dividend). Its total debt is 175% of its equity and interest rates are rising, bad for leveraged assets with paper-thin margins.

I think what Jeff Bezos has created and executed is greater in scale and scope than what Steve Jobs did. I love the Amazon company but I wouldn’t own the stock. Maybe Jeff Bezos feels the same way. He sold over $1 billion of AMZN shares in May. He sold another billion in November.

The Brae Head, Inc. Composite Top Twenty Positions

Name

Ticker

Weighting%

Nationwide NYSE Arca Tech 100

NWJFX

15.68

Vanguard Small Cap Index

VSMAX

4.07

Lockheed Martin

LMT

2.95

Apple

AAPL

2.9

Eaton Corp.

ETN

2.27

Johnson&Johnson

JNJ

2.16

Vectren

VVC

2.15

Boeing

BA

2.05

Exxon Mobil

XOM

1.93

JP Morgan

JPM

1.89

Illinois Tool Works

ITW

1.58

Sarepta Pharmaceuticals

SRPT

1.59

Citizens Financial Group

CFG

1.52

PPG Industries

PPG

1.53

Discovery Communications

DISCA

1.45

Chevron

CVX

1.41

Douglas Dynamics

PLOW

1.39

Regions Financial

RF

1.33

UnitedTechnologies

UTX

1.3

Emerson Electric

EMR

1.3



Wishing everyone peace and prosperity I am,


Sincerely,


Dennis M. O’Connor