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Annual Letters

A recent WSJ article pointed out that General Electric’s (NYSE: GE ) annual report was downloaded only 800 times in 2013. No one has the time or patience to read annual reports anymore with all the jargon and legal disclosures involved; it’s no wonder. But there are some great company letters out there. Buffett with Berkshire (NYSE: BRK.A ) (NYSE: BRK.B ) always tops the list. My personal favourite is Amazon’s (NASDAQ: AMZN ) Jeff Bezos. He talks about the company’s strategy and culture. He believes that Amazon is the “best place in the world to fail,” a key reason for its success. “We all know that if you swing for the fences, you’re going to strike out a lot, but you’re also going to hit some home runs. The difference between baseball and business, however, is that baseball has a truncated outcome distribution. When you swing, no matter how well you connect with the ball, the most runs you can get is four. In business, every once in a while, when you step up to the plate, you can score 1,000 runs. This long-tailed distribution of returns is why it’s important to be bold. Big winners pay for so many experiments.” Free shipping with Prime membership has been a major beneficiary. He adds that “we want Prime to be such a good value, you’d be irresponsible not to be a member.” Click to enlarge Activision Blizzard (NASDAQ: ATVI ) is my next favourite. “If you had invested $100 in our company 20 years ago, it would have returned over $4,400 today – almost nine times more than the $520 the S&P 500 would have returned in that same period of time and almost five times more than Berkshire Hathaway, which we generally regard as the gold standard to measure just about everything against.” Any company that measures themselves against Berkshire is setting an incredibly high standard. My final pick is Under Armour (NYSE: UA ). It is known as an aggressive upcoming brand; in 2015, Under Armour’s athletes secured MVP titles in the four major US sports. “We feel Under Armour’s brand promise is to create products you don’t know you need yet, but once you have them, you don’t know how you lived without them.” The best companies tend to explain their strategy simply. The CEO goes on to talk about the opportunity in connected fitness, but he reminds us that he’s not forgetting to sell shirts and shoes! Decisive has a position in Amazon. The material in this article is for informational purposes only and in no way constitutes a solicitation of business or investment advice. The material has been prepared without regard to any client’s or other person’s investment objectives. Before making an investment decision, you should consider the assistance of a financial adviser and whether any investment or service is appropriate in light of your particular investment needs.

Wait Until You Get A Pitch Right Where You Want It!

One of the most successful investors in history received the only A+ from Professor Benjamin Graham (of Graham and Dodd “Security Analysis” fame) at Columbia: the chairman and chief executive officer at Berkshire Hathaway, Inc., which traded as low as $38 per share in the early 1970s and now trades around $219,000 per share. If you haven’t guessed who by now, it’s Warren Buffett. How does he do it? Well, the following are excerpts from financial media interviews back in the late 1980s: “The most important quality for an investor is temperament, not intellect. You don’t need tons of IQ in this business. You don’t have to be able to play three dimensional chess or duplicate bridge. You need a temperament that neither derives great pleasure from being with the crowd or against the crowd. You know you’re right, not because of the position of others, but because your facts and your reasoning are right. . . . Most investors do not really think of themselves as owning a piece of the business. The real test of whether you are investing from a value standpoint or not is whether you care if the stock market opens tomorrow. If you’ve made a good investment, it shouldn’t bother you if they close down the stock market for five years. You own a piece of business at the right price and that’s what’s working for you. . . . In 30 years of investing I have never bought a technology company. I don’t have to make money in every game. There all kinds of things I don’t know about-like cocoa beans. But, so what! I don’t have to know about everything. The securities business is the perfect business. Every day you literally have thousands of the major American corporations offered you at a price, and a price that changes daily, and nothing is forced upon you. There are no called strikes in the business. The pitcher just stands there and throws balls at you and you can let as many go by as you want without a penalty. In real baseball, if the ball is between the knees and the shoulders, you either swing or you get a strike called on you. If you get three strikes, you’re called out. In the securities business, you stand there and they throw U.S. Steel at $28 and General Motors at $80, and you don’t have to swing at any of them. They may be wonderful pitches, but if you don’t know enough, you don’t have to swing. And you can stand there and watch thousands of pitches, and finally you get one right there where you want it, something that you understand and is priced right – and then you swing . . .” On many occasions I have said, “The rarest thing on Wall Street is patience!” That quote is akin to Buffett’s quote, “If you don’t know enough, you don’t have to swing.” For most of last year, we didn’t “swing.” Then, in late August, our model told us to “swing” and we did. That was the week of the August 24, 2015 “lows” around 1800 on the S&P 500 (SPX/2091.58). The next time we “swung” was on December 11, 2015 when our model called for a “rip your face off” rally. About a week and a half later, we had to admit that was a bad “call.” In this business, when you are wrong, you admit it quickly for a de minimis loss of capital. So we came into 2016 with a defensive stance. But on Friday, February 5, CNBC’s Becky Quick asked me what the model was “saying” now. I responded, “It is saying we bottom next week” and we are tilting accounts according. It was during that week (February 11 to be exact) the SPX retested its August 2015 “lows” and the rest, as they say, is history. So where does this leave us now? Well, the consensus “call” is that we are either making a “top” followed by a big decline or we are at the top of the trading range that has been intact since October 2014 (~1800 – ~2130) and now the SPX is headed back down. That view is reflected in this excerpt from our friends at the Boston-based Fidelity organization: While this rally may continue to play out, the stock market may not break out of its year-long trading range until earnings growth stabilizes and the policy divergence between the Fed and other central banks ends. We are not of that view. Our work suggests the SPX will break out to the upside of the over-one-year trading range. As stated in prior missives, To me, this feels very much like 2013 where the markets ground down every short seller into the May timeframe before a near-term top arrived. If that pattern plays here, it would fit nicely with my internal energy indicator, whose energy would be totally used up by mid-May. It still feels like new highs to me. And maybe, just maybe, the S&P Total Return Index is pointing the way higher as it traded to new all-time highs while the D-J industrials notched new reaction highs (INDU/18003.75). Now, if the D-J Transports (TRAN/8085.98) can better its November 2015 closing high of 8301.80, we will have a Dow Theory “buy signal.” If not, it will be an upside non-confirmation and likely lead to a pullback in stocks. If the Trannies are going to make a new reaction high, it will have to come quickly, because as stated, by mid-May, the equity market’s internal energy should be totally used up. As for earnings season, while it is still a small sample of the S&P 500 companies that have reported 1Q16 earnings, 78.3% have beaten their lowered estimates (as of last Thursday). That is the best showing since 3Q09 and much better than the past few quarters. There have been some high-profile company “misses,” but the operative word (at least so far) for this earnings season is “beat.” Perhaps the better-than-expected earnings season is telegraphing stronger GDP numbers in the months ahead, although last week’s economic reports were on the softer side. This week, we get a slew of economic reports (Durable Goods, GDP, Core PCE, etc.) as well as the FOMC meeting. As I have repeatedly stated, IMO, if the Fed doesn’t raise rates this week, I doubt if they raise rates until after the election. However, the bond markets seem to think something’s afoot as the Roll-Adjusted Ultra Long Bond Future has broken down in the charts suggesting higher interest rates (chart 1). And, that could be what caused the Bloomberg US Dollar Index to try and reverse it downtrend (chart 2). Or maybe the interest rate complex is anticipating stronger GDP growth in China where energy and electricity consumption is strengthening and things like the Shanghai Steel Rebar Futures are surging (chart 3). It is also worth noting that, last week, Schlumberger said the crude oil surplus would be gone by year’s end and Caterpillar sees its business bottoming globally. The call for this week: Well, today is actually session 50 (I miscounted when I said last Friday was session 48, because I failed to account for one of the holidays) in the second-longest “buying Stampede” I have ever seen. As SentimenTrader’s cerebral Jason Goepfert writes, “The S&P 500 has gone 10 weeks since trading below a prior week’s low. This is the longest such streak since 2011 and among the most impressive since 1928.” That skein has left most of the macro sectors overbought. We are also within a week of the month of May where the market’s internal energy wanes. We have been steadfastly bullish since our model telegraphed the SPX would bottom the week of February 8; however, while we do expect an upside breakout by the SPX to new all-time highs, we are not real excited about adding to the many stocks featured in these reports since those February lows. In fact, according to one particularly brainy colleague, “Everything is expensive except emerging markets.” This morning, futures are flat as participants await the Fed meeting. Click to enlarge Click to enlarge Click to enlarge

The Stock Buyback Conundrum: Will Companies Keep It Up Much Longer?

Some facts are more interesting than others. For example, Liz Ann Sonders, chief investment strategist and perma-bull at Charles Schwab, recently acknowledged that “…there has not been a dollar added to the U.S. stock market since the end of the financial crisis by retail investors and pension funds.” Let the reality sink in for a moment. “Mom-n-pop” investors as well as pension funds have not added to their U.S. equity positions during the seven-year-plus bull market. That includes the last three months in which major bank clients (e.g., hedge funds, private clients, institutional investors, etc.) have been net sellers. Since every buyer has a seller (and vice versa), what group or groups had enough of a buying presence to push the S&P 500 14.2% off of the February closing lows? Corporations. Click to enlarge The notion that corporate share buybacks have been influential in propping up stocks is nothing new. On the flip side, the extent of the influence may be much greater than previously realized. Standard & Poor’s 500 Index constituents acquired roughly $182 billion of stock in the first quarter of 2016 alone. Even today, with real yields ticking up from 0.0% to 0.4%, companies may not wish to pass up the perceived opportunity to fund share acquisitions through ultra-cheap debt issuance. Unfortunately, debt-funded buybacks present a number of challenges. First of all, total debt levels for U.S. companies have doubled since the Great Recession. While many analysts focus solely on the current ability for companies to service their debt obligations, the capacity for companies to do so changes when borrowing costs increase, free cash flow sinks and/or net income declines. Consider free cash flow after dividends. This refers to the cash flow from operating activities excluding fixed capital expenditures and dividends paid. In Q4 of 2015, companies spent 101.7% of free cash flow after dividends. 101.7%! Not only was that a sizable year-over-year jump from Q4 2014 when the ratio chimed in near 81%, but it demonstrates that S&P 500 corporations (in aggregate) are now spending every free dollar on the support of stock prices. If they continue to spend every dime to support stock prices, rather than growing respective businesses via capital expenditures, the inevitable stagnation would hinder long-term profit prospects. A second significant challenge to the buyback game? Companies that have spent more on stock buybacks are underperforming relative to those that have spent less on buybacks. At some point, buyback activity may be reined in by executives who become cognizant of the underachievement, particularly if there are cash flow concerns. It follows that the stock market’s only buyer would require another major group to step up its participation, or the selling pressure would overwhelm current prices. There is a third, more ominous complication associated with debt-funded buyback activity. Specifically, what would happen if credit conditions tightened? Even a modest tightening similar to what transpired in the first few months of 2016 would lead to trouble for corporations looking to finance and acquire shares. Whether spreads between treasury bonds and corporate bonds (e.g., investment grade, high yield, etc.) widen, or whether global growth concerns slam the world’s financial institutions again, it is not far-fetched to imagine easy money access becoming a little less easy. One way that a few folks are evaluating the current climate for stocks as well as the liquidity of corporations is by addressing the “Buyback to Free Cash Flow Ratio.” The higher the ratio, the more troublesome the environment. Unfortunately, at the current moment, the ratio is dangerously high – near the highest levels since the Great Recession ended (58.3%). And since corporations haven’t really slowed their insatiable appetite for buybacks just yet, the rising ratio represents aggregate free cash flow (S&P 500) dropping 9.5% on year-over-year basis. Translation? Stocks could fizzle out from their effervescent levels. Click to enlarge Total debt levels rising, net income declining, free cash flow falling, CEO realization of stock underperformance, higher borrowing costs/credit access issues. Any combination of these items is likely to inhibit the buyback support to overvalued S&P 500 equity prices. Granted, there are eternally bullish advocates like Liz Ann Sonders who claim that retail investors and pension funds will pick up the slack when corporations stand down. (Really? These groups will suddenly add substantially to their stock allocations after seven years?) Ms. Sonders also believes that a softening in buybacks would simply morph into capital expenditures, and thereby boost corporate growth prospects going forward. The problem with that assumption? “Core CapEx” has rarely looked worse at a time when the Fed is not considering additional emergency easing measures. Click to enlarge For roughly one year, our tactical approach to asset allocation has called for a defensive bias. We downshifted our moderate growth-and-income clients from 65%-70% diversified growth (e.g., large-cap, small-cap, foreign, etc.) to 45%-50% high-quality stock. Appropriate ETFs in this arena include iShares MSCI Quality Factor (NYSEARCA: QUAL ), PowerShares S&P 500 Quality (NYSEARCA: SPHQ ) and/or iShares MSCI Minimum Volatility (NYSEARCA: USMV ). We lowered moderate clients from 30%-35% diversified income (e.g., investment grade, higher yielding, foreign, etc.) to 25%-30% investment grade bonds. Appropriate ETFs for investment grade assets include SPDR Nuveen Municipal Bond (NYSEARCA: TFI ), iShares 7-10 Year Treasury (NYSEARCA: IEF ) as well as Vanguard Total Bond (NYSEARCA: BND ). The resulting 20%-30% cash/cash equivalent allocation has buffered against several volatile 10%-plus corrections (i.e., August-September and January-February). We anticipate putting the cash back to work at lower prices when the S&P 500 reaches a bearish low-water mark (1705) and/or the Federal Reserve announces a fourth iteration of quantitative easing (QE4) . Indeed, we concur with the assessment that the expansion of the Federal Reserve’s balance sheet has been responsible for 93% of stock gains since the bull market inception in March of 2009. Click here for Gary’s latest podcast. Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.