July 2011

Monthly Thoughts and Comments


U.S. Credit Rating

So while the media hyped the debt ceiling issues and fueled speculation of a government default, investors and traders remained focused on the economy and our long-term debt problems, knowing full well that Congress’s failure to raise the debt ceiling would not trigger a government default.

To many, the final outcome was of no surprise: Congress did raise the debt ceiling and did not address the long-term debt issues.  One of the results of their action, or inaction, was that S&P downgraded medium term credit issued by the United States to AA+ from AAA – the first time since 1917.  The other credit rating agencies have maintained their AAA status.

The question now is what will happen and what should investors do?  The short answer is, continue the course of action we’ve taken all year long.  First, the markets have been choppy and we expect this to continue for a little while.  Second, sensing that marketplace risks were increasing too much earlier in the year we began increasing our cash positions some time ago.  The result is that our portfolios have plenty of cash on hand, providing two benefits: a good defensive posture against the market drops, and the ability to invest at good price levels as the opportunities arise.  Finally, as you will see in the earnings review below, the companies in which we maintain positions are very profitable, solid companies, and we believe there is significant upside potential in them so we will not only continue to hold but add to our positions.  While that doesn’t mean they won’t show price volatility, our investment strategies remain focused on long-term trends and not so much on short-term price moves.  Maintaining this focus, as we have for many years, helps keep us from getting caught up in the emotions that often accompany frantic short-term market moves, and as already stated, enables us to take advantage of volatility when and as opportunities arise given the extensive amount of cash we have on hand.

Whenever the markets are turbulent and there is a great deal of uncertainty, as is now the case, our adherence to fundamental analysis is reinforced, because over time fundamentals drive business and we are investing in businesses.


Second Quarter Earnings Results

In general the media report earnings based on the number of upside or downside surprises and the size of those surprises.  At the same time, many analysts base their earnings projections on company guidance, but since many companies manipulate the guidance to their advantage this method is less than worthwhile.  We look at the momentum or trend, not only for earnings but also for revenues, as well as the drivers of any increases or decreases (margin expansion, price increases, etc.).  From a big-picture point of view, we also want to look at earnings by sector and industry, as not all areas of the economy react in the same manner.

Our strategy for the past year has remained consistent: invest in those companies and sectors based upon their long-term (3-5 years) fundamentals.  In the equity portion of our portfolios we believe that the most attractive sectors and industries have been and will continue to be those in the basic industrial and infrastructure areas.  A majority of growth will come from continued development of the emerging markets.  Thus agriculture, specialty chemicals, energy, commodities, communications and equipment associated with these areas should prosper.  At the same time, the debt problems in much of the developed (and some emerging markets) suggest that fiat currencies are at risk, creating opportunities in gold related investments.

We continue to maintain a portion of portfolios in fixed income that is high quality and of short duration (the average duration is currently under two years). While there is nowhere near the potential appreciation or upside as with stocks, the fixed income provides protection from a recession and from stock market volatility.

During the second quarter, here are the earnings results so far:

1)    Industrials, chemicals, energy and commodity related companies have done quite well again this quarter.  Increases were seen in both earnings and revenues.  Increases in both were due to a combination of increased demand and price increases.  It seems that price increases were the bigger part of the equation.  Having pricing power is a good indication of demand, but also is a warning of inflation and so we will watch the trends over time.

Heavy equipment companies saw revenues and earning increase, but costs rose faster than price increases and thus margins were often narrower, and in some cases earnings were lower than expected because of this.  While these stocks often sell off on such an earnings miss this is shortsighted.  As long as price increases are coming, margins will come back and earnings and revenues will be even higher, thus this is often a good time to buy.

Most industrial companies found that growth was much stronger outside of the United States and Europe although there are more indications of China showing some softening.

In our portfolios, both large cap and mid/small cap industrials reported excellent results.  Two we want to highlight are Dynamic Materials and DuPont.

Dynamic Materials (symbol BOOM) is the largest fabricator of specialty metal products used in the oil and gas, petrochemical, alternative energy, hydrometallurgy, aluminum, shipbuilding, power generation and industrial refrigeration industries.  Revenues were up over 41% year over year and earnings were up 26% over the same time period.  In addition, margins were up and the company increased guidance for earnings, revenues and margins for the year.  70% of their business came from the Middle East and Asia.  Besides the exciting numbers, the management team seems to be more optimistic about business going forward.  Always fairly cautious, they are seeing continued increases in interest in their services, a very pleasant change from a much more subdued prior two years.

DuPont, which is a newer holding for us, is attractive for their exposure to agriculture and food processes and specialty chemicals.  Earnings were up 17% from the prior year and revenues were up 19% versus the prior year – impressive for a company with $32 billion in sales.  Revenues were up due mostly to prices increases (again not a bad sign).  Sales in emerging markets were higher than in the industrial economies, growing 29%, and now account for almost one third of total sales.

2)    Fast food restaurants and related products like soda also did fairly well, again due to growth in the emerging markets and price hikes.  Margins compressed again due to commodity price increases, but again this should be a short-term issue only.  Typically these stocks are quite defensive and while they are not cheap, they have performed quite well.

3)    Consumer products were weak as were many restaurants.  Revenues were soft and volumes were down because consumer spending continues to drop (since February).  Increased earnings and sales were primarily due to price increases, not volume increases.

4)    Financials earnings were up, but from a very low base. Most of the banks are making money from trading and investment banking, not lending.  We believe that there are still many problems in bank real estate portfolios and have no interest in investing in this sector because: 1) this is the last decades leaders and they usually become followers for a long time.  Look at technology stocks as an example; 2) we don’t like owning companies where we cannot understand their balance sheets and cannot fathom the risks they are taking.

5)     Most technology companies had reasonably uninspiring results and some utilized financial engineering to help.  The semiconductor area is weak and Korea is reporting getting weaker. Interestingly, Microsoft, which has been ignored for a decade, had very good earning with strength in all areas except for PC sales, which is not a surprise.  Apple, again the standout had remarkable earnings due to massive iPhone sales in China.

6)    Gold stocks continued to show fantastic profits, yet the stocks themselves have been underperformers, both relative to physical gold and to other stocks.  However, we believe this is an opportunity rather than an issue.  When gold stocks reported earnings, the average cost of energy was close to $100/barrel.  Since then, oil has dropped to $80.  If they can mint money at $100/barrel of oil, guess what they will do at $80!  Furthermore, with the value of gold rising, their asset values are rising, and the stocks will reflect this over time.

Gold has yet to show any sign of market peak as most investors in the U.S. do not have significant exposure, and most countries are just starting to build inventories.


Making Sense of the Results

Second quarter earnings were quite good, as we have related.  However, there are headwinds due to: 1) recent economic numbers are getting weaker; 2) QE2 (the second Quantitative Easing Program the Fed instituted in hopes of stimulating the U.S. economy) ended in June and the removal of this excess capital is impacting the economy and the stock markets negatively.

Our view is that we are in a bifurcated economy. The combination of unknown expenses in the U.S. and Europe due to talk of increased taxation, higher healthcare costs, greater costs due to regulation, the downgrade of U.S. issued debt and the continued resistance from government leaders to address these issues, is restricting growth in the developed markets.  Emerging markets, on the other hand, will continue to grow, albeit weaker than in the past year due to inflation (exported by the developed nations who are artificially keeping interest rates low).

Furthermore, we expect a QE3 to be announced in the next month or two.  This will likely inflate stocks and definitely increase inflation around the world.

Given this outlook, we believe that the industrial/infrastructure businesses should continue to do well.  We especially like the agriculture and specialty chemical space.  At the same time, gold continues to be an excellent hedge to the debt issues plaguing much of the world.  Finally, as a hedge against a recession, we continue to keep a portion in short-term fixed income and a smattering of defensive stocks.


Alan E. Rosenfield                                                                                                                               Managing Director


Next Month: In the next month’s Thoughts and Comments, we will look ahead at the global economy.  If you have any questions, please contact us at info@harmonyam.com or ARosenfield@HarmonyAm.com

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