Sometimes the best defense is a good offense

In our last newsletter, we lamented the general absence of “animal spirits” in the U.S. economy. We noted that since the financial crisis in 2008, deflation resulting from debt reduction within the private sector has been offset by bouts of spending and money-printing by the U.S. Treasury and the Federal Reserve. These opposing forces have kept the economy in a holding pattern for nearly four years. Job growth, real incomes and consumer sentiment remain mired at recession levels, while corporate profits have returned to pre-recession highs. Record amounts of cash have accumulated on big-company balance sheets, while the word “uncertainty” is heard over and over again in the financial media.

[quote]“Even in a do-nothing stock market, every investor’s portfolio should have some portion…that reflects future possibilities rather than present-day problems.”[/quote]

This is the environment we’re stuck with as investors. A five-year snapshot of stock market returns (including both the crisis and the recovery) shows little progress. The S&P 500, adjusted for dividends, is within 1 percent of its level from mid-2007. Our portfolios are generally built for such an environment, with decided overweights in larger, dividend-paying businesses in more stable industries such as insurance, cable and telecom. We’ve also held more cash than normal over the past several years, as well as a position in corporate bonds. As a result, we’ve weathered the storm okay; we just haven’t made much money.

That said, our message this quarter is about risk-taking and opportunity. Even in a do-nothing stock market, every investor’s portfolio should have some portion playing offense, some portion that reflects future possibilities rather than present-day problems. We’ll discuss some of our investment selections in this vein, which are the result of our thinking on global trends in manufacturing, as well as our opinions on the ongoing substitution of computer systems and software for human labor. We’re also trying to take advantage of thematic opportunities in the aerospace and energy markets; we’ll briefly describe these as well.

There’s a joke in the factory automation business about the ideal factory of the future. This factory takes exactly one man and one dog to operate. The man is there to feed the dog, and the dog is there to keep the man away from the machines! These machines don’t get tired or take coffee breaks. Today, roughly 4 percent of the U.S. population provides all of our domestically manufactured goods, and 1 percent provides our food. In 1940, these ratios were 11 percent and 15 percent, respectively, and they continue to decline. We’re doing more with less because low-cost foreign competition demands it. Recently there’s been talk of a U.S. manufacturing renaissance, as Chinese wages equilibrate with our own and cheap domestic shale gas drives down energy costs. So whether you provide the systems integration expertise to automate entire factories (Rockwell Automation), or the industrial hydraulics for a single assembly line (Parker-Hannifin), there’s opportunity in selling and servicing the equipment that allows a plant to operate “lights out”.

Next on the list of sectors with the possibility of long-term promise is semiconductors and software. Moore’s Law, which states that the cost of a given amount of computing power will fall in half every 18 months or so, remains the touchstone of the information revolution. It defines the attractiveness of the tech sector in a deflationary economy, even as it forces the rest of the business world to keep pace. A great example is the recent cost crossover in the realm of solid-state memory. Flash memory, like that used in iPhones, tablets and cameras, is now cheaper per Gigabyte than mechanical disk drives in certain highend applications. The fact that it is lighter, more durable and uses less energy than hard drives is the icing on the cake. SanDisk, our longtime holding in the sector, suffered at the hands of rival Apple during the first half of 2012, but is expected to rebound with orders from several new customers in the second half.

In the software realm, security and efficiency of data are all the rage, as cloud computing takes hold. We discussed the cloud revolution in our last newsletter, as well as the need for tools to assure that one’s data aren’t hijacked for nefarious purposes. Firms such as CA, IBM and Opnet are helping both business and government use, protect and manage their data more efficiently.

Perhaps the best possibility for upside in the portfolio comes (literally) from above! The aerospace industry appears set to take advantage of the steady growth in worldwide air traffic over the past 20 years. Overseas, entire new fleets are needed to welcome a burgeoning middle class to the jet age. Here in the U.S., aging fleets of gas guzzlers like the MD-80 and 767 are being replaced with revolutionary, fuel-efficient airplanes such as the Boeing 787, and redesigned workhorses such as the 737 Max. Boeing’s backlog currently stands at more than 4000 airplanes, equating to nearly seven years of production at current rates. All of these planes will need engines, avionics and ongoing service. General Electric and Honeywell should benefit as two of the biggest makers and servicers of critical aviation components.

Finally, we’re thinking that the aforementioned bonanza in domestic shale gas may be for real. We still have some unanswered questions regarding decline rates and costs to refrac existing wells, but the technical, cost and regulatory winds all appear to be blowing in the direction of massive new usage of natural gas. During the second quarter of 2012, for example, domestic utilities generated as much electricity burning natural gas as coal, marking a sea change for the industry. There are lots of potential ways to play the gas boom, including producers, servicers, equipment makers, gas gatherers and pipelines. We’re biding our time and doing our homework, as recent rig counts have fallen and the industry bloom appears to be off the rose. Eventually, as with the broader stock market, things will bloom again, and when they do we need to be ready.

By Charlie Smith

Nathan Boxx, Bradley Newman, Jason Seltzer

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