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25th Oct 2016

There was the king who held a chess tournament among the peasants and asked the winner what he wanted as his prize. The peasant, in apparent humility, asked only that a kernel of wheat be placed for him on the first square of his chessboard, two kernels on the second, four on the third and so forth. The king fell for it and had to import grain from Argentina for the next 700 years. Eighteen and a half million trillion kernels, are enough, if each kernel is a quarter-inch long (which may not be; I’ve never seen wheat in its pre-English-muffin form), to stretch to the sun and back 391,320 times.

That was nothing more than one kernel compounding at a 100 percent square for 64 squares.

And with that story Bill Priest (Epoch Investment Partners) began his presentation at GIBI (Great Investors’ Best Ideas), which is a fundraiser for the Michael J. Fox Foundation for Parkinson’s Research. I had the pleasure of chatting with Bill the night before at the “speakers’ dinner” held at Shad Rowe’s wonderful home here in Dallas, but I digress. Bill noted that at square 32 on the chessboard you would have 4 billion grains of wheat and at square 64 you have more wheat than has been harvested in recorded history. His point was that technology is just now moving on to square 33 of said chessboard with the back-half of the chessboard bringing with it amazing advances in technology.

The first speaker at GIBI, however, was T. Boone Pickens. Boone began by stating that what has happened with energy prices this year is what he had expected to happen last year. He said inventories are down and demand is up, which is good for crude oil’s price. In November of 2014, he noted, there were 1609 drilling rigs operating in the U.S. That number fell to below 400, but now there are ~550 rigs back at work. T. Boone opined that there will never be 1600 rigs working again in the U.S., but that the rigs currently operating are the best, fastest, most efficient and productive rigs he has ever seen. His “price deck” for year-end 2016 is $60 per barrel with a price deck of $70 for 2017. As written in last Friday’s Morning Tack:

Boone stated that since “they” started drilling in the Permian Basin that field has produced 50 – 60 billion barrels of oil and he expects that same type of production will occur again in the years ahead given the technology advancements. He concluded with four stock recommendations, the only one of which favorably rated by our energy analysts is Pioneer Natural Resources (PXD/$187.00/Strong Buy).

Up next at the symposium was Lisa Hess, from SkyTop Capital Management, who discussed the automobile revolution. She thinks the big winners over the next 10 years will be lithium batteries, natural gas, and electric cars, while the losers will be the “Big Three”; and, that the revolution is happening faster than anyone expects. Think about Siri for the car, collision avoidance systems, cabin overheating technology, and the quest for a lighter car. To this last point, she offered up Constellium (CSTM/$5.60) as an investment idea, which has a favorable rating from our correspondent research organization. According to Lisa, CSTS’s bullet points are: 1) it is one of four companies that can supply high-quality cast aluminum parts to the auto industry; 2) the company is poised for strong growth; 3) it has a new CEO; 4) it just received a new long-term contract; and 5) CSTM has a “cheap valuation.” The shares are down due to a bad acquisition, but the new CEO has written down a lot of that acquisition’s cost, issued some $425 million of bonds for liquidity purposes, and one of its major competitors has been acquired. She concluded that CSTM is a great way to invest in the auto revolution.

Caroline Cooley, from Crestline Investors chimed in by asking, “Did 87% of the stock pickers suddenly become stupid?” Her inference was that active managers have not outperformed the indices for quite some time and therefore passive investing has thrived and has grown 200% over the last ten years. Obviously this is a topic Andrew and I have written about ad nauseum. She, like us, thinks investors are doing the exact wrong thing, at exactly the wrong time, by selling actively managed funds and purchasing passively managed funds. If you want to invest using her reasoning she believes two of the best sectors for alpha (outperformance) are Consumer Discretionary and Technology. Obviously, we agree. Epoch Investment Partners’ Bill Priest also agreed with the active versus passive argument in his presentation and as previously stated he thinks technology is the new macro driver. He also believes the value of a company is driven by cash flows, a point that was drilled into my head by my father. Dad use to say, “Money is the blood of a company and the cash flow statement is the veins!” Bill concluded with, “If you can’t earn enough to reinvest in the business at a rate above your average weighted cost of capital, you should ‘return’ capital to shareholders via share repurchases or dividends.”

Ray Nixon (Barrow, Hanley, Mewhinney & Strauss LLC) likewise began his presentation with the active versus passive argument with the statement, “Passive investing is up from 5% of the equity markets in 1995 to 41% currently, yet he drilled down further into why you should be selling passive and buying active management. As for passive investing, Ray averred it is indeed low cost, has diversification, there is no risk management for portfolios, and no chance for excess market returns (“this is my 500th best idea!”). Active management gives investors the potential for outperformance, it can be structured to meet a client’s needs, you can control the characteristics of the portfolio, and there tends to be a portfolio rebalancing discipline. He also emphasized that most of the time when passive has outperformed active management for a long period of time it has tended to be followed by a difficult equity market. His three tenets of investing are: 1) low price to earnings ratios (P/Es), 2) cheap price to book value, and 3) the stock pays a dividend. One interesting stat he offered was that since 1950 dividend growth in the S&P 500 averaged +5.3% per year, but that in the 2010 – 2015 timeframe it has grown by +13.8% per year; and, that “Baby boomers like mailbox money!” In conclusion Ray talked about two stocks, one of which carries a favorable rating from our fundamental analysts. That company is Phillips 66 (PSX/$80.35/Outperform). He believes PSX to be undervalued at 14x earnings, it pays a decent dividend, it has a Master Limited Partnership (MLP), and crack margins are depressed. Moreover, Warren Buffett has a ~15% ownership in the shares.

Obviously there were a number of other speakers at the 10th annual GIBI Investment Symposium, but I have run out of space in this missive to discuss them. I will say the two highlights of the week were the gracious dinner I had at Shad and Michele Rowe’s home for the speakers at the GIBI symposium last Monday. Then there were the two dinners I enjoyed at John Mauldin’s (Mauldin Economics) condo with his fabulous fiancée Shane.

The call for this week: Well, here we are, at the last week of October, which our models suggested would be the end of the window of vulnerability for the equity markets. Indeed, in late August, with the S&P 500 (SPX/2141.16) trading around 2193, our models telegraphed that mid/late-September represented a potential timeframe for a market decline. At the time, Andrew and I suggested raising some cash to take advantage of new investment opportunities, despite our consul that any pullback would likely be small (3 - 6%). Subsequently, the SPX declined into its 2100 – 2120 support zone, rallied back to 2180, and then retested the 2100 – 2120 level for an intraday top to bottom pullback of 3.6%. Sometimes it takes three downside retests before a correction is complete and this week we should find out if that is true this time. Meanwhile despite some recent softening economic stats, the Philly Fed survey has hooked up (stronger economy – Chart 1), 68% of the companies reporting 3Q16 have beaten the earnings estimates (Chart 2 - foots with our transition to an earnings driven secular bull market), bullish sentiment stinks (read: bullish – Chart 3), our model is turning bullish, and there is plenty of internal energy stored up for a decent market move if it gets going.


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