April 21, 2015

Market Summary – 1st Quarter, 2015

The causes, risks and opportunities that await investors.

We are in the midst of three potentially transformative developments that may signal an important pivot point in the evolution of the economy since the Great Recession:

• First, the dollar has strengthened to levels not seen since the start of the millennium.
• Second, oil prices have fallen by more than half in a matter of months.
• Finally, there’s an increasing likelihood that the Federal Reserve will begin raising short-term interest rates.

Viewed in isolation, each of these events may have negative consequences for the market, at least in the short term. However, this myopic viewpoint obscures the big picture. Taken in their totality and viewed with a long-term perspective, these developments are likely to promote a stronger period of economic growth.

We don’t discount the concerns brought about by a stronger dollar, falling oil, and potentially higher interest rates. The knee-jerk reaction to all of these developments may very well be negative. However, we believe that it is more likely that these three developments represent an inflection point, and signal that the economy has moved well beyond the kind of environment that required significant central bank intervention. We believe that we are pivoting from a crisis-management based economy to a normalized economy. The real recovery we’ve all been waiting for since the end of the Great Recession in 2009 may, at last, be upon us.

A time of transition
From 2009 until late last year, the Federal Reserve artificially stimulated the economy and indiscriminately inflated the price of all assets. It was a big reason why we have seen a lack of dispersion in performance among individual stocks. In other words, the market has not distinguished between strong and weak companies; therefore, the stock prices of both have moved together much longer than historically normal. Without quantitative easing to equalize the market, we believe that stronger and better-managed businesses will receive premium valuations compared to their less competitive peers. As this environment emerges, it will be important to be not only in the right place, but also to avoid being in the wrong place.

Let’s consider the causes and consequences of these three major developments, as well as how MPMG has positioned investors to benefit from this changing environment:

The dollar’s resurgence
What’s happened?
The dollar has risen by more than 20% on a trade-weighted basis against other currencies over the past year.

Why it likely happened:
A stronger currency reflects the expectation by investors that interest rates which can be obtained in one currency will become more attractive than interest rates in another. For now, the money is moving into dollars with the expectation that the relatively stronger U.S. economy will drive rates higher. Strong currencies, however, tend to be temporary and self-correcting. When a currency gains value, it alters trade balances by reducing exports and boosting imports. This spurs growth in the foreign exporting nations and ultimately increases those currencies, while weakening the dollar. In other words, the rally in the dollar likely won’t continue indefinitely.

The conventional wisdom:
The headline story is that the stronger dollar is harmful to U.S. corporations, particularly for multi-national companies whose overseas earnings are reduced when they are translated back into dollars. In addition, goods produced here become more expensive overseas and less price competitive with goods made elsewhere with weaker currencies. These factors may combine to hamper earnings of multi-national companies in the short-term.

What the conventional wisdom misses:
There have been three major periods of a strong dollar since 1973 (excluding the flight to U.S. quality during the Great Recession). In each case, a long period of a strong dollar coincided with higher stock prices. From October 1978 to March 1985 the dollar strengthened by 52.6%, while the S&P 500 (excluding dividends) rose by 76.2%.  From July 1995 to February 2002, the dollar appreciated by 34.2%, while the S&P 500 rose by 103.2%. More recently, from July 2011 through February of 2015 (most recent USD data), the dollar appreciated by 15.8% and the S&P 500 rose by  59.4% – and this period is still underway.

While U.S. multinational companies may face earnings headwinds due to currency trends, almost all of them hedge some part of their foreign currency exposure. Furthermore, it is likely that these foreign exchange headwinds are temporary, and that they do not necessarily result in a decrease in demand for products and services. The types of businesses that MPMG invests in create needed and differentiated products and services, so a stronger dollar is not a permanent impediment to these businesses.

How MPMG captures the opportunity:
Smart businesses use their currency strength to expand and fortify their presence in foreign markets, which can now be achieved at a relative discount. A prime example occurred in early April when one of our positions, U.S. based FedEx Corporation (FDX, $166.67¹), announced the acquisition of Netherlands-based TNT Express. The acquisition will greatly improve FedEx’s competitive position internationally, and should be highly accretive to earnings. The relative strength of the dollar was cited as a key factor enabling this acquisition.

Falling oil
What’s happened?
The price of a barrel of crude oil on the New York Mercantile Exchange dropped from a high of $107.30 on June 20, 2014 to a low of $42.43 less than nine months later. It has hovered near the $50/barrel level or below for most of 2015.

Why it likely happened:
Productivity improvements in the exploration and extraction of oil and gas have led to an unprecedented surplus in oil. Proven oil and natural gas reserves have increased 63% and 35%, respectively, since 2000². Storage facilities for oil are at or near capacity. In the face of tepid world GDP growth, the demand for oil has not swelled to meet the excess oil production. It’s a classic supply-demand scenario that has driven prices lower.

The conventional wisdom:
Businesses in the energy sector have mostly seen their stock prices plummet, as the market price of their key output (oil) has fallen. The damage could be widespread, given that the energy sector has been one of the strongest sectors of the economy in recent years. A strong dollar has exacerbated the fall in the price of oil, as oil is denominated in dollars. Many “here and now” analysts are quick to point out that a strong dollar makes oil more costly in other countries, crimping global demand and ultimately applying further downward pressure on oil prices.

What the conventional wisdom misses:
“The availability of cheap, abundant, reliable energy is what separates the wealthy from the poor and fuels economic growth,” states Robert Bryce in his acclaimed book, “Smaller Faster Lighter Denser Cheaper.”

Improved efficiency in producing energy is a boon for economic growth. Businesses should be more willing to expand, as a key input cost is now less expensive and more available than it has been in decades. In addition, the world economy may experience greater growth for a longer period of time. This is because lower energy prices keep inflation at bay; low inflation permits low interest rates, which, in theory, should extend periods of economic growth.

The current oil surplus has shifted the narrative away from oil depletion (the decline in oil production of existing wells.) For all the positive news surrounding the shale-led energy revolution, the fact remains that the average shale oil well declines at a rate of between 60 and 91 percent over the first three years³. This stands in stark contrast to the 5 percent annual decline for an average conventional well. This oil well depletion will need to be replaced.

How MPMG captures the opportunity:
MPMG sold its Canadian oil sands investments prior to the collapse of oil, as we felt that their fortunes were too tightly linked to the price of oil. We shifted our focus to energy construction, engineering and service businesses that provide the “picks and shovels” to the energy sector. We subsequently narrowed this focus in the fall of 2014, in anticipation that the glut of oil would reduce the North American rig count. The recent selloff in stocks of energy companies created real buying opportunities. We recently added Exxon Mobil Corporation (XOM; $85.13¹) to the portfolio. Exxon is a global energy leader with unrivaled oil and gas assets. It can weather low energy prices due to its operational scale that yields many cost efficiencies that its competitors lack. It also provides investors with an attractive 3.3% dividend yield¹.We also stood by Chicago Bridge and Iron Company (CBI; 49.72¹), an engineering and construction firm whose stock price declined in line with oil despite only 5% of its business being exposed to oil exploration and production. Chicago Bridge and Iron’s earnings continue to advance, and we expect the market will once again recognize the value of the stock.

Expected interest rate increases
What’s happened?
Federal Reserve Chair Janet Yellen said that interest rate hikes may happen “later this year.” We haven’t seen an increase in the federal funds target rate in nearly eight years, and it has been set at 0 to 0.25 percent since December 2008.

Why it is likely to happen:
The Federal Reserve has two legislated goals: price stability (modest inflation) and full employment. With the unemployment rate at 5.5%, the economy is near “full employment.” The Fed is now likely to turn its attention to keeping inflation in check. Even though inflation indications are mixed, the federal funds target rate has remained near zero. As a result, the Fed currently lacks an important tool to execute its goal of full employment – the ability to lower short-term interest rates. Lowering interest rates theoretically stimulates economic growth and contributes to job creation. Raising rates now would provide the Fed with the flexibility to cut rates (if it needs to) in the future.

The conventional wisdom:
The reflex reaction to higher interest rates is to sell stocks ahead of what will be slower economic growth and lower profitability by businesses. In addition, many of the high frequency and algorithmic trading machines that dominate trading volume on the stock exchanges today are programmed to buy and sell stocks based on various factors. Therefore, economic news and rumors on the direction of interest rates have the ability to move markets.

What the conventional wisdom misses:
Higher short-term interest rates should not be confused with monetary tightening. The goal of monetary tightening is to slow down economic growth, and there is no sign that this is on the Fed’s agenda today. When the Fed raises short-term rates, it is designed to influence the capital markets into pushing up long-term interest rates. That increases the cost of borrowing for new investments. Any financial endeavor will need to prove it can produce a return greater than the cost of capital. Since higher interest rates increase the cost of capital, some projects are put aside because they can’t generate sufficient profitability after rates have risen. That takes money out of the economy and slows growth.

It is important to remember that we are not in a normalized interest rate environment. Rates are still at or near historic lows, and a gradual increase in interest rates from here will likely do little to dent the desire for additional borrowing and investment. Rather, we believe that this indicates we are pivoting from a crisis-management based economy to a more normalized economy. Furthermore, the Fed has stated its intention to keep rates “below levels the (Federal Open Market) Committee views as normal in the longer run.” Modest rate hikes by the Fed should not be considered tightening in the traditional sense as it is not designed to slow economic growth.

How MPMG captures the opportunity:
Bank of New York Mellon Corporation (BK; $40.49¹) is a world leader in investment, custody, and administration services. Lending and investment margins were hurt in recent years with low interest rates. Rising rates could turn what was a multi-year drag on earnings into a multi-year boost in earnings. Popular, Inc. (BPOP; $34.99¹) is the largest bank in Puerto Rico, a territory that has suffered through an eight-year recession. Operational challenges forced Popular to refocus its efforts on loan quality and efficiency. It is in the unique position of having access to the Federal Reserve’s discount window (similar to U.S. banks) but with the ability to lend funds at a higher rate due to a relative lack of banking competition on the island. This results in real earnings power that will become even more evident as interest rates rise.

A discerning eye towards value
The masses may panic at headlines of a stronger dollar, falling oil prices, and potentially higher interest rates. A smart investor recognizes the challenge, digs deeper and understands the causes behind these headlines. Doing so can reveal excellent investment opportunities. We maintain that in times like these, investment success will necessitate owning the right businesses at the right price. Just as important will be avoiding the lesser quality and overpriced businesses that fail to offer value. As our economy pivots from the crisis-management mode that began in 2008 to a more normalized economy, investors should ignore the market’s potential negative knee-jerk reaction and recognize that attractive investment opportunities are plentiful.

In House News
We are excited to announce that our office is relocating! After 11 years on the 19th floor of the iconic IDS Center in downtown Minneapolis, we are moving to…the 28th floor of the IDS Center. Please feel free to come and visit us at our new home in Suite 2825…don’t worry, our famous chocolate tortoises will be following us up to our new home.

^{1Price as of close on April 6, 2015}

^{2U.S. Energy Information Agency}

^{3Post Carbon Institute, “Drilling Deeper,” David Hughes, October 27, 2014}

Although the information in this document has been carefully prepared and is believed to be accurate as of the date of publication, it has not been independently verified as to its accuracy or completeness. Information and data included in this document are subject to change based on market and other condition. All prices mentioned above are as of the close of business on the last day of the quarter unless otherwise noted. Market returns discussed in this letter are total returns (including reinvestment of dividends) unless otherwise noted. 

The information in this document should not be considered a recommendation to purchase any particular security. There is no assurance that any of the securities noted will be in, or remain in, an account portfolio at the time you receive this document. It should not be assumed that any of the holdings discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable. The past performance of investments made by MPMG does not guarantee the success of MPMG’s future investments. As with any investment, there can be no assurance that MPMG’s investment objective will be achieved or that an investor will not lose a portion or all of its investment.