Buy the Bullies

Bob Irish Reporting: Delray Beach, FL.                           

On Monday, I e-mailed the Investor team with a question, curious to see how they would answer. The question: "What’s on top of your Christmas wish list?" Andrew Gordon was the first to respond. But instead of e-mailing back, Andy called me just as I got back from playing nine holes. "You mean for the U.S. economy, the global economy, the markets, or investors?" Andy asked. "Something having to do with investments. I leave it up to you." "High interest rates along with gas breaking three bucks again." "You’re certainly taking the path less traveled," I laughed. "I’m serious. I can’t wait for interest rates to go higher," Andy said. "You’re that afraid of inflation?" I said. "Not at all. It will mean the recession is truly behind us. Same is true for higher oil and gas prices." "Do you really think that will prevent people from complaining about gas prices?" "That’s my point. Which should they prefer? Complaining about not having a job? Or complaining about how much they have to spend on gas to get to work?" "That’s a no-brainer." "But I’m also thinking of stock investors. Where do you think people will go once rates turn higher and bond prices begin to fall?" "That’s easy. They’ll be rushing into the stock market. I don’t know how much of the roughly $67 trillion invested in bonds will be looking for a new home, but it’ll be a big chunk." Just One Problem Remember... we’re talking about wishes here, not predictions. Even the government doesn’t know when they’ll raise rates again. And the Fed’s so-called independence is a joke. Raising rates is as much a political as an economic decision. And next year’s elections will complicate things even more. Of course, a lot depends on how the economy is doing. If it’s coming on strong, chances are the government will raise rates at some point next year. But it’s no gimme. The government loves to manipulate markets, the dollar, and investment sentiment. And keep in mind that we’re outsiders. The government does not have our back (only our taxes). If they somehow do the right thing by us, it’s either by pure accident or the fear of voter backlash in the next election.

One Economy, Four Takes

Whether you’re looking for bad news about the economy, good news, or you’re sitting on the fence, I have just the news bulletin for you. No matter what your view of the economy is, it was confirmed yesterday via the newswire...

1. In a speech at the Economics Club, Bernanke said that it looks like a recovery has begun but "we still have some way to go. The economy confronts some formidable headwinds that seem likely to keep the pace of expansion moderate."

Bernanke’s public statements are parsed more than Tiger Woods’s these days. Let’s give him a politically motivated "cautiously optimistic" rating.

2. A panel of purchasing and supply executives (at a teleconference sponsored by the Institute for Supply Management) also weighed in. They said that the manufacturing sector will increase employment next year by 1.5% and that the service sector will decrease employment by 0.6%. It’s a mixed picture, at best.
3. CEOs have climbed the first couple of rungs on the ladder of optimism. Most still aren’t ready to step up hiring or spending, but they say sales will do better. The CEO Economic Outlook index bounced back to 71.5, up from 44.9 in the third quarter. That’s the highest reading since the third quarter of 2008.
4. The smart asses at Goldman Sachs put in their two cents and it’s bullish. They forecast 4.4% growth for 2010, and a higher 4.5% for 2011. What do they know that everybody else doesn’t? Oh, yeah. What’s good for Wall Street is good for the U.S.

A Better Way of Taking the Economy’s Pulse

You’re going to get a million predictions between now and the end of the year. Those from economists, you can trash. Their record is abysmal. But even those from businessmen in the private sector are no more than educated guesses.

Instead of paying attention to what all those folks have to say, let’s take a look at how the economy is doing based on a couple of bellwether companies...

• FedEx is the world’s biggest cargo airline. It flies everything from electronics to financial documents. It flies domestically and globally. If it transports more cargo, you can be sure economic activity is increasing. If it transports less cargo, the economies it serves are falling.

The company says it did better than it (and analysts) expected. It notes that growth in its domestic overnight and international "express" units had climbed each month in the quarter that ended November 30.

• Another of my favorite bellwethers is 3M, which makes everything from industrial equipment to office supplies. It expects its 2009 earnings to come in below Wall Street’s expectations but is preparing for a much stronger 2010.

FedEx is more upbeat than 3M, but only slightly.

Let’s Not Get Carried Away

It’s a good sign that the global economy (with the U.S. bringing up the rear) is recovering. But let’s not get carried away. Can FedEx guarantee that Greece won’t default? Can 3M guarantee that Israel won’t bomb Iran? Does either company know how bad commercial real estate defaults will get next year?

As an investor, you should always expect the unexpected (or unwelcome) so you’re never caught off guard. So how do you invest in a fragile global recovery that could go into reverse at a moment’s notice?

Stay Away From the Small Fry

Small companies go up a lot slower after their initial bull-market surge. Yes, they’ve done uncommonly well since stocks bottomed in March. It’s been a nice little run. But now, Andy says, that’s coming to an end.

According to Ford Equity, since the March lows the 20% of the market with the smallest companies outgunned the 20% of the market with the biggest companies by 72 percentage points. That’s a pretty big margin. In other bull runs (during the first nine months), small companies have averaged only 21 percentage points better.

What’s going on?

Many of these small companies were going for nickel or a dime on the dollar, Andy says. They weren’t just down. They were on life support. So when they rallied, it was from a much lower base than the bigger companies. In addition, investors overdid their buying. Now, these companies are on the expensive side. And many are still potential victims of the bullies in their sectors grabbing their market share.

Andy’s right. But what makes me really nervous is that small companies are so dependent on banks. They get about 90% of their financing from banks. By contrast, big companies get only 30% of their financing from banks.

And these days, banks aren’t lending to small companies. That’s why the Obama administration wants to use the unused TARP money to help out small companies. Small companies create 64% of the jobs in this country, something the ruling party is painfully aware of as it nears the next cycle of elections.

Simon Says

The big bully companies historically do much better than smaller "growth" companies in difficult times.

For example, when stagflation ruled in the 1970s, the big dividend-paying companies accounted for 72% of the total return of the market.

Compared to the vulnerable small fry, the bullies are about as cheap as they’ve ever been, says Andy. John Buckingham, the Chief Investment Offices of Al Frank Asset Management, agrees.

Buckingham says that "In the last 10 years, larger-cap stocks have basically gone nowhere, whereas small and midcap stocks have done very well. We're seeing today a lot of opportunity in the larger cap space and ... we are moving up the market-cap spectrum."

Whatever kind of economic growth we get next year, these bullies are going to do better than those cheap little stocks that investors brought back from the dead, says Andy.

Andy likes Simon Properties, a bully that is making good on its promise to swallow up the minnows. It’s buying mall owner Prime Properties for $2.3 billion. And it’s not even using up all the cash it’s been hoarding to take advantage of "opportunities in the marketplace." That’s bully-speak for buying struggling companies for pennies on the dollar.

Simon is flush with cash. And it’s doing what big bad companies should be doing: beating up their little brothers... grabbing the best deals out there... getting bigger... and capturing market share along the way.

Andy Gordon makes the point that "Investors are scared of struggling sectors. But struggling sectors are precisely where the best bargains are and where the bullies grow the fattest. McDonald’s, Philip Morris, Intel, and fertilizer company CF Industries are all bullies – getting bigger by feeding on the minnows."

Here are some of IDE’s favorite bullies...

• Andy’s INCOME portfolio: Coke is up over 30% since April.
• Ted Peroulakis: Procter & Gamble is up 21% since May.
• Steve McDonald: Potash is up over 40% since mid-year.
• Rusty McDougal: International Royalty Corp is up 425% since last December.

Andy’s Kind of Bullies

The big companies are not only financially strong. Many dominate their sectors with marketing muscle, superior product quality, and leading brands. The ones Andy likes the best are the globals that pay dividends and go for a discount.

"It’s going to be their decade," Andy says. "Just as much, if not more, than last decade belonged to the small and medium-sized companies."

Invest Safely,

Bob Irish
Investment Director