Wednesday, September 18, 2013

The (Smart) Trend is Your Friend: Stocks Moving Higher

In the world of investing, you have to see things a little bit differently than everyone else.  You don’t win by following the “big dumb trends”.  These are the things that everyone already knows about.  These trends are - at best - fully reflected in the stock price.  At their worst - they create the types of bubbles we have seen balloon out of control and then pop. 

The danger in the stock market comes when everyone starts to see things the same way.  When investors start all herding together towards the same industry (see Technology in the late 1990s and early 2000s) or stock (Apple’s recent tumble from $700) or idea (homes will never decrease in value) - that is when things are most dangerous. 

Investors who buy or sell based upon what that they read about in the Wall Street Journal or see on CNBC don’t find out about the party until after it has happened.  They miss out on the biggest returns before the trends start or get scared out of good opportunities. 

A key to long-term stock market performance is
to pick up on the small trends and historical information to project a reasonable expectation out into the future.  Over the past few months, we have observed several “small, smart trends” that we believe will influence the markets over the next 6-8 months:

Industrials Pushing Forward

Companies like Emerson Electric Co., W.W. Grainger, Cummins, and Dover Corp. are all moving to new highs - despite lackluster fundamental (earnings and dividends) performance over the past 12 months.  This makes little sense.  How can a stock move higher without underlying value also increasing?  Has the market overvalued these companies? 

On the surface, it appears that way.  When you dig a little deeper, a story starts to unfold.  First of all, very large and sophisticated investors are pouring a ton of money into these companies.  Everyday investors cannot drive stocks like this - it takes a lot of money to drive these huge corporations’ stock prices higher.  Institutional investors clearly see something in the future that leads them to place very large bets ahead of the fundamental value.  What do they see?

These companies have technology and expertise that the world needs and cannot grow without.  They all do different things, but all of them have something to do with capital goods.  They produce things that other corporations buy to make products for end consumers (you and me).  These companies are all technology leaders in the industry.  Diesel engine manufacturer Cummins, Inc. is making significantly more durable, efficient, high-quality engines than they were even a few years ago. 

The large push into Industrial stocks is a bet that the global economic outlook is improving and will lead to better earnings for the companies that drive economic growth (Industrials).  The United States economy is muddling along, but Europe has started to turn up.  The larger European countries have shown positive GDP growth numbers and are expected to continue improving.  A stronger Europe means more demand for other nations’ goods, which will spur investment - especially from the emerging market nations such as Brazil and China.


Low rates and high levels of cash have driven purchases and acquisitions.  Verizon Wireless’ $49 billion bond issuance was the largest in history.  They used the proceeds from the sale to buy out Vodafone’s 45% stake in Verizon’s spectrum network. 

This acquisition and many others like it have never made more sense than now.  Even with the slight uptick in interest rates, money is still extremely cheap.  The above-average pace of acquisitions and investment of business cash will continue as long as it is.

Activist Shareholders

There have been many activist shareholders speaking out to influence the companies they have a large stake in.  The view of activists is that every major company in the U.S. has got some fat in it - things that reduce profitability.  They believe that a more focused strategy leads to a leaner and more easily managed enterprise and ultimately higher earnings. 

These activist investors are looking for companies with sustainable long-term growth prospects that can be improved.  They are going for companies currently growing at, say, 7% that - with a little fat trimming - could grow at 10%.  Take Pepsi, for example.  Activist investors want Pepsi to spin off its underperforming beverage unit to create a snack food growth machine.  If that were to happen, the growth prospects for the snack giant would increase dramatically - along with a drastic increase in earnings multiples.

Whether it is making the business more efficient or influencing the way it distributes cash to investors - we believe the majority of these activist shareholders are positive for the stock market as a whole.  The influence of these investors could be a driving force for the market looking ahead.

Are You Taking Enough Risk?
The stock market is all about taking measured risks.  There is only so much information you can gather before you have to put your money on the table.  Whether it’s about the Fed tapering, crisis in Syria, the U.S. Federal budget, or anything else - a bit of pessimism and fear is a good thing in the stock market.  It creates opportunity. 

Investors who are willing to take risks that others are not will likely gain a profit for it.  If you sit around and wait for all of the bad news in the world to clear up, it’s already too late.

DISCLAIMER: Donaldson Capital Management, its clients, and employees own shares in GWW, EMR, and CMI.