February 2012

………….Monthly Thoughts and Comments

Earnings Round Up 2011

With 98% of the S&P 500 having now reported, here are the trends that we have seen.  Earnings for the year were up 9.2% and revenues were up 10.8% for the year.  Operating margins flattened out, up 0.3% for the year and net margins dropped by just under 2%.  Total debt rose by 5%.

Industrial, heavy equipment and chemical companies reported that business seemed to be doing well in most parts of the world.  A number of technology companies reported broad demand as well.  Europe was the weak sister, but it wasn’t as weak as the newspaper headlines would have suggested.  More on this below.

Individually, our companies issued extremely good reports.

Apple’s earnings blew the street away with earnings up 96% for the year and revenues up 68%.  Margins were up 20% on a gross basis and 18% on a net basis.  At the annual meeting CEO Tim Cook admitted the company had more than enough cash to run the company and they were considering all options.  We expect a dividend will be announced at some point this year.

Dynamic Materials (BOOM) surprised all of the analysts by reporting blowout fourth quarter earnings and margins.  We were closer than anyone else and our margin expectations were about 15% too low!  Earnings were up 133% for the year and revenues were up 35%.  The company guided up for 2012 expecting margins to grow from 27% to close to 29% and said that they were seeing increased interest in all of industry groups for bids for explosive welding projects.

They saw good demand from the Americas, the Middle East and Asia for energy, chemical and power related projects.

It seems to us that most of the analysts are mostly following company guidance rather than thinking or researching themselves, and thus we believe again that earnings will be higher than street expectations.

Cisco reported good earning, revenues and margins this quarter, unlike a number of their competitors.  Net income was up 23% year over year and revenues were up 11%.  Business was up along all product lines, with growth in most regions, although it was lower in Germany and France.  In addition, Cisco bought back shares and raised the dividend by 33% this quarter to $0.32 annually from $0.24 (currently a 1.5% dividend yield).

DuPont reported stellar earnings and revenues as well.  Both revenues and earnings were up 20% for the year.  Sales for the Agriculture division grew 17%, Performance Chemicals grew by 23%, Performance Coatings by 12% and the Performance Materials grew by 8%. Margins grew nicely as well, though primarily due to higher prices rather than increased volumes.

Goldcorp reported record earnings and cash flows, up 70% and 59% respectively.  Free cash flow rose 5.9% for the year and the dividend was raised 32% back in December, the third dividend increase in the past fifteen months.

Gold reserves grew by 8%, 80% of which was from new drilling.  Goldcorp is projecting 4.2 million ounces of gold production by 2016, up from 2.5 million ounces in 2011, a 68% increase in production.  At the same time, they have been lowering the cost of production.

Yamana Gold reported 76% growth in cash flows from operations for the year and earnings rose 59% for the same time period. Gold production was up 6% (largely due to higher prices) and proven and probable reserves grew by 9%.

The company is projecting a 13% rise in production for this year as several different mines will start to ramp up production throughout the year.  Street estimates are for $1.20 in earnings for 2012, but we think the estimates are likely to be too low.

Neo Materials just reported today and along with stellar earnings the company has agreed to sell itself for ~11.00/share.  We will look at the company buying them and decide whether we want to participate, but can comfort ourselves with a 30% gain in a year in the meantime.

Searchlight is the only company that has not reported yet, and it will report on or about March 16.

A Look From Above

“Good morning folks, this is your captain speaking.  We are cruising at 33,000 feet with a fair amount of cloud cover below us, making it hard to see everything going on.  However, our instruments and reports tell us that there is a bit of a headwind and that we should expect choppiness throughout the flight.  It may get pretty bumpy every now and then and we are likely to get hit with it without much warning, so please keep your seatbelts on and we will be just fine.”

That could have been the speech I heard during my last flight from New York or a good summary about the markets – life imitates art.

Though the clouds, here is what can be seen.  Any of these could result in the air pockets flyers and pilots always worry about.

GDP growth mixed:

1)    Europe experienced a slight slowdown in their forth quarter GDP, down 0.3%;

2)    China is now predicting only 7.5% growth for 2012, the first time in a decade they have predicted growth below 8%;

3)    Brazil had its slowest growth in several years, up 2.7%;

4)    The U.S. reported 1.7% GDP for Q4 2011 (this will get adjusted).

Governments print lots of fresh money

1)    The EU finished its second quantitative easing by lending over $700 billion at below market rates to European banks for three years;

2)    China just lowered the capital requirements at banks by another 0.5%;

3)    Brazil lowered capital requirements on banks, and urged banks lower their lending rates;

4)    The Fed, while announcing that they do not have plans for any more spending right now, are floating several types of quantitative easing to try and push long interest rates lower.  They also announced that they intend to keep interest rates at effectively 0% for at the next two years.

5)    Greece has “completed” their bond swaps, declaring they have not defaulted.  Investors probably don’t agree since they took haircuts of 74% and ?International Swaps and Derivatives Association, the regulatory authority on credit default swaps decided that CDSs should be paid, saying Greek did in fact default.  Even with this, many are already predicting that the new bonds will end up in default as well as Greece simply cannot pay off such large amounts of debt.

Market Volatility

1)    While market volatility dropped in January and February of this year, March has had it’s first 1% movement;

2)    Over the last six months, the markets have been very volatile, dropping 9.6% in two weeks in September, up 16% in October, down 9.8% in November, up 8.8% between the last week of November and the second week of December, down 4.4% over the next ten days and then, finally, up 4.3% to the end of the year;

3)    Inside the indexes it was even more volatile; industrials, technology and materials stocks were down and defensive stocks were up, making it look like the markets were predicting a major worldwide recession;

4)    The first two months of 2012 were a complete reversal of the last three months of 2011.  The average industrial, technology and materials stock were up between 18% and 30% while the average defensive stock was flat to down a percent or two.

Earnings seem to have catapulted the industrial, technology and materials names offsetting traders’ headlines with fundamentals after the first of the year.  While these companies were sold off hard in December, they completely reversed the trend in January and February.

For example, during December, traders dove into the “defensive” stocks like P&G, McDonald’s and Coke and sold the industrials, technology and materials stocks because of the latest news headlines.  By the end of the year, Apple was trading at 11 times very low earnings estimates; DuPont was selling for 9 times earnings, along with Microsoft and BHP Billiton.

Then in January, traders turned around and did the opposite.  They sold P&G (down 3% for the year), McDonald’s (flat) and Coke (flat) and bought the aforementioned stocks, which are up between18% and 30%.  Many of these stocks are more reasonably priced now, although certainly in the long run, they are not expensive.

The question now becomes what to do?  Should one take profits and then jump in later or sit tight?  Europe has not solved their problems, but they certainly have stabilized their situation for the time being.  China’s leverage will become a problem, but when is quite impossible to tell other than we know that binges can last much longer than expected before the floor collapses.

The Bottom Line…

While the U.S. economy slowly growing, Europe is struggling and China is feeling the impact.  At the same time, China, India and the rest of Asia are also struggling with inflation, along with Brazil and Canada and the Middle East.

Stocks are not over-priced, but many are not as cheap as they were two months ago.  Bonds in the U.S. are yielding between 1%-3% for shorter maturities, which means that investors are losing money to inflation every day they own it.  At the same time, these maturities are not long enough to benefit from a run to the safety of bond if economies slow down.

Given the continued crosswinds, big bets do not make a lot of sense.  Industrials, technology and specialty chemical companies are still amongst our favorites due to their valuations, positive long-term economic trends, and growing cash flows, which will allow them to raise their dividends and the ability to raise prices.

With most of the world printing money as fast as it can, we would continue to own gold mining stocks.  While the stocks have underperformed the metal in 2011, it is not because the companies are not producing good results.  At some point in time, investors will recognize this, and the combination of inflation from the printing presses with the extremely low valuations of the stocks will result in significant appreciation.

Finally, we believe that cash, while not returning any type of current return, provides safety from volatility and will allow investors to buy assets cheaply when the next sudden drop occurs.

Above all, we continue to stress patience and focus on long-term valuations.  Don’t let headlines or traders make your decisions for you in times of panic or hysteria.

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