……………..Thoughts and Comments


Market Valuations

About two weeks ago Caterpillar (symbol: CAT) lowered its guidance for earnings – in 2015. CAT will announce Q3 2012 earning in a few weeks – October 22. I know that the markets are supposed to be forward-looking but this seems just a wee bit silly to me. Even CAT noted in their second quarter conference call on July 25:

[W]e expect that over the next couple of quarters, that some of those clouds will clear a bit, and we can start forming a little bit better picture of 2013. And while none of us know at this point what those outcomes will be, we do know that U.S. elections will be over in the fall, and we think chances are good there will be a resolution to the fiscal cliff. The leadership change in China will also happen later this year, and after another quarter or 2, we’ll get a better sense of the effectiveness of the easing measures the Chinese have already taken and any additional measures they may take to improve growth.

Given their concern of the lack of clarity out just a few quarters, is it really reasonable to be making much of a prediction for 2015?

A startling bit of disingenuousness comes from a subsequent comment on SeekingAlpha:

Indeed, it’s clear that the move wasn’t a complete surprise; Caterpillar lowered its 2015 earnings target by 14.3% at the midpoint, yet the stock fell just four percent, counting a one percent dip in late-afternoon trading yesterday. Clearly, investors had been expecting some kind of cut in future expected earnings. But even the small drop in share price, to $88.14 as of 1 pm Eastern, has opened up a large buying opportunity in Caterpillar shares.

A 4% move on double the average daily volume doesn’t show surprise? As of this writing Caterpillar is below $85 — another “small” 3.6% drop for a total of a “small” 8% drop in the past week.

The good news is that this is an unusual and unique situation, right? The answer we are finding is “wrong!” In fact, more and more analysts seem to be basing buy recommendation on earnings projected out to 2015 – 3 full years out! It has been our experience that when investors start to take earnings and just extrapolate until the stock looks cheap, things never end very well.

The stock market (using the S&P 500) is currently trading at ~16.5x trailing earnings. We are entering the fifth year of the current economic expansion (if you can really call it that), which makes the economic cycle long in the tooth. Plus, 2013 will be the year after an election, a time when Presidents typically inflict economic pain if they think it is necessary. These factors, combined, make us less than sanguine about most stocks’ current prices.

We have taken some profits off the table and reduced positions in the more cyclical sectors. We expect that more attractive entry points will appear with some patience.

Stock Ideas

Gold Miners

Gold mining stocks have come alive in the past several months. While we would not be surprised by a pull back after an average of 20% moves in that time, we believe that the gold mining stocks, which have been severely undervalued for some time, should continue to appreciate relative to the metal itself.

Not only are the miners severely undervalued based on the price of gold but the miners are starting to slow their capital expense spending, focusing more on profitability rather than on additional volume.

The biggest expenses for miners are wages and energy. Limiting the expansion of mines will lead to reductions of headcount. Nothing can directly be done about energy prices, but slower mine expansion, along with price pressure due to shifts in the supply side of the curve, should lead to a rise in profits.

Last month, after our Fed announced the new Limitless QE plan, and the BoE announced another round of QE and the ECB promised the same, China and S. Korea bankers warned that they would look for a currency other than the U.S. dollar. “Therefore, Korea and China need to make concerted efforts to minimize the negative spillover effect arising from the monetary policies of advanced nations,” announced Bank of Korea governor Kim Choong-soo.

The IMF reported last month that South Korea raised its gold holdings by nearly 18 tons – in less than one year, this doubled the amount of gold they hold. At the same time, China has become the largest buyer of gold in the world.

The global economic money-printing tailwind, combined with industry fundamentals, makes mining stocks very attractive.

Apple (we have found a worm)

We have owned Apple twice now in the past three years, each time having seen our investment rise dramatically. The last time we purchased was in mid-October and November of 2011, at prices at or below $400/share. At that time, we felt the stock was undervalued. Our selling criteria were either (1) a price-to-earnings multiple of 18 or greater or (2) clear indications that the company, without Mr. Jobs, had lost its innovative edge.

We have sold our shares in Apple.

Investors have earned about 60% on their money in the year and we have now confirmed, unfortunately, that Steve Jobs is gone (we still aren’t sure about Elvis, but we don’t have any money riding on that). While Tim Cook may be a very good operator, he is not the creative force – this we already knew. What we weren’t sure of, but now are, is that innovation no longer drives product development the way it did under Mr. Jobs. Apple company is quickly turning into a standard big company, much like Microsoft and others: lots of cash, but not lots of leadership.

We have seen a number of signs in the past several months that have convinced us that the risk/reward is no longer in our favor. These include interviews that have convinced us that there are changes in the thought process at Apple. Where once creative developments were the corporate driver, now creative juices have been replaced by a more corporate mentality.

There are more and more indications that Apple is becoming a company that is following trends rather than leading them:

(1) The iPhone 5 is merely an incremental update. Yes, it is thinner and lighter, but that is tweaking, not innovation.

(2) The rumored smaller-screen iPad –something Jobs ridiculed – shows the company reacting to its competitors’ moves rather than focusing on its own vision for the iPad.

(3) Introducing music streaming is another copycat move, emulating half a dozen existing services. This is not a game-changer like Apple’s music delivery system enabled by the iPod and mp3s. It’s me-too-ism on a business model that hasn’t worked well for others.

(4) Apple TV? Jobs said for years that Apple was playing around with this idea. But the current rumored direction provides little that web-savvy viewers can’t already get from Hulu, the networks’ web sites, or existing services.

When valuing the company, given our belief that the creative leadership is gone, we find that the current trailing P/E of almost 16x is fully valued, not cheap. As the old adage goes, “Bears make money, bulls make money, but pigs get slaughtered.”


Q3 Earnings

Third quarter earnings start in the middle of October with Alcoa. We will review earnings in next month’s issue.


Alan E. Rosenfield                                                                                                                               Managing Director

October 2012


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