Second Quarter, 2011
Dear Clients and Friends of Grisanti Brown & Partners,
As the short term market fluctuations dominate the headlines, our focus remains on the long term. Even though your portfolio gave up some ground in the second quarter (less than 2%), the Grisanti Brown portfolio is still up over 30% in the last year, and remains slightly ahead of S&P 500 Index and nicely ahead of the Russell 1000 Value Index for that period. By any measure, the second quarter was a weak one for the market, with six down weeks in a row from May into late June, its worst losing streak in nine years. Then, the last week of June was one of the strongest in years, with the market up 5.7% for the week, and your portfolio up 6.5%. How does one make sense of the slump, the surge, and the uncertain road ahead? The remainder of this letter is taken up with our survey of the macro landscape, and then a brief portfolio update. But at the end of the day, what matters is whether your portfolio companies appreciate in value. We believe they are materially undervalued, partly because of the uncertainty which pervades the current market environment. As these issues are resolved (for reasons discussed below), we believe this valuation gap will close. You can assess our reasoning in detail, because we have included a review of each of our portfolio companies in the accompanying Summary of Investments. We want you to know what you own, and why.
Lift-Off or Scrubbed Mission?
The current economy and the stock market remind us of an event from the 1960s that, if you’re old enough, you probably remember too. Like much of America, our family would gather around the (newly-color, tube-filled) TV set to watch the launch of each successive Apollo spacecraft. The rocket was gargantuan – it looked like a skyscraper – and you just couldn’t believe enough energy could be packed inside to hurl it up into space. When the countdown reached zero, and the engines started to project hellfire hundreds of feet in every direction, the rocket still just stood there for a second, then two, then three. You see, we all thought, it’s just too heavy: it won’t take off. Then, excruciatingly slowly, the rocket began to inch upwards.
And so we find ourselves with a gargantuan economy that has been stimulated with trillions of dollars of deficit spending, and interest rates that have counted down to zero, but the rocket’s not leaving the ground. Investors are scared, the market went down sharply in May and June. The question is, of course, will the economy finally take off? (Or even inch ahead slowly?) For reasons set forth below, we believe the slowly-turning U.S. economy will gather momentum, and your portfolio, which is well-positioned for a slow economic recovery, should perform well in the second half (as it did at the end of 2010, when economic strength lifted the GB&P portfolio by 16% in the fourth quarter).
But this is not, as the technical term goes, a slam dunk. Let’s first be dispassionate and acknowledge the negatives that surround us. The U.S. budget issues are serious and becoming quite urgent. European nations are performing emergency surgery to save Greece, only to have Ireland and Portugal awaiting treatment. Unemployment in the United States just isn’t getting any better, consumer confidence is down, and gas prices are up. As of June 30, the Fed has stopped its program of buying back treasury securities to force down long-dated interest rates (called “QE2”). Finally, Japan, the third largest economy in the world, suffered its greatest shock since the end of World War II earlier this year. Isn’t it time to pick up our investment marbles and go home?
We think the answer to this question is “no”. Our conclusion is one that reasonable investors can differ over. After all, if a bright future was so obvious, stock prices would be much higher. But nonetheless, after thoughtfully considering not only what has transpired, but what we believe lies ahead, we think there is reason for some optimism. The stock market is a discounting mechanism. It ‘knows’ all the ugly news laid out in the previous paragraph. The more important question is whether the upcoming news will be better or worse. We think better, and, since you’re likely to have your own (and possibly divergent) opinion, we would like to take some time to go through our reasoning.
In reverse order, Japan is coming back strongly, as industrial production surged in May and is expected to climb again in June. Ironically, the Japanese economy should actually be stronger in the third quarter than it otherwise would have been if the earthquake had not occurred, because businesses like auto companies and semiconductor manufacturers are working overtime to make up for lost production. The effect of the expiration of QE2 is difficult to handicap. We do not believe it had other than a psychological effect on the markets, and its passing could be a positive if investors realize that business fundamentals remain relatively strong even without it. (We distinguish here between the poor economic fundamentals, like unemployment, and business fundamentals, like profit margins and cash on balance sheets, which are quite strong.)
While job creation in the U.S. has clearly been disappointing, we also look at hours worked per employee, as tracked by the labor department. In past recessions employers have added hours to current employees before hiring new ones. This statistic is showing strong improvement and is finally nearing pre-recession levels. For this reason, we expect employment to get slowly better in the second half of this year.
Chart from Bloomberg LP; Comments from GB&P
Gas prices seem to have peaked. And as far as consumer sentiment, the market tends to perform well following periods of low consumer confidence, as again, the market had already discounted the current pessimistic mood into lower share prices. Lower gas prices are a significant determinant of consumer sentiment, so that should become a tailwind as well.
When historians look back on this period, we are convinced one theme they will focus on is the enormous debt burden weighing on both families and governments. The two largest macro problems now facing investors are debt related: the U.S. deficit and European sovereign debt. We believe that the European debt issues are akin to a chronic disease. It must be managed over time, and will not go away, but the patient will probably be able to live a useful life in between treatments. We come away from discussions with our European clients believing there is a will on the part of the wealthy European nations to work through these issues that is not fully appreciated in the United States. Without putting too fine a point on it, European economic union (represented most importantly by its single currency, the Euro) is not just an instrument of economic convenience, it symbolizes a future of unity versus a past of war and enmity. It is, in short, a deep line in the sand and we believe painful steps will be taken by those who have the wherewithal to make it endure (read German and French taxpayers).
Finally, we think there will be some accommodation between the warring parties in Washington. A meaningful assortment of spending cuts and some revenue enhancements (Washingtonese for ‘tax increases’) will be forthcoming in the next several weeks. From a cynical standpoint, your local congressman may or may not be partisan, egotistical, and dumb, but you can count on the fact that he (or she) is extremely interested in getting re-elected. There are a lot of well-heeled supporters (both individuals and larger interest groups) on both sides of the aisle that would suffer greatly if the debt ceiling doesn’t get raised and the markets are thrust into turmoil. We believe those feelings are being made known as we speak, and we think this problem gets solved, at least for the short term.
Portfolio Review
There is an up-to-date review of each of our portfolio companies in the accompanying Summary of Investments. In June shares of energy, fertilizer and trucking stocks, and the two financial stocks we own (JP Morgan and Goldman Sachs), suffered as investors feared a double-dip recession and (in the case of the financials) higher costs from regulation. For the reasons already discussed, we think these fears are misplaced, and in fact in the last week of June these shares surged, making up much of their lost ground. On the other hand, the more defensive holdings in the portfolio (Abbott Laboratories, Pfizer) and the technology stocks performed well. We used June’s slump to sell two companies that met our investment goals: Pfizer and Chubb. Each was a long-term holding and each appreciated sharply over the last year (Pfizer up 57%; Chubb up 34%). We used much of those proceeds to invest in several portfolio holdings that had gotten especially hurt in June, including Goldman Sachs and Microsoft. Goldman is now trading below its liquidation value, meaning the market is attributing no value to its franchise, its personnel or its future cash flow. We purchased Goldman at an opportune time in the depths of the 2008 crisis, and we think market sentiment is once again too bearish on this stock. Microsoft is suffering as investors believe the meteoric growth of the iPad will hurt profits. While the iPad phenomenon is real – and it’s a product that seems like magic – there is little evidence that the PC market will suffer huge and immediate losses. We think any decline in PC sales will be slow and manageable, as at the current time we believe most iPad purchases are in addition to the user’s PC, not as a replacement. Cash flow and earnings continue to grow at Microsoft, and the stock is selling at the same valuation it did when the Dow Jones Industrial Average was trading below 7000 in March 2009.
A new portfolio company, Marathon Petroleum Corporation (“MPC”), was received when our investment in Marathon Oil was split into two parts. MPC represents the refining assets of Marathon, and we remain bullish on the prospect for refiners located in the middle of the country. For complex reasons, oil in the “Mid-Con” (as it is called in refining jargon) is about $10-15 cheaper than oil on the east coast or imported oil. This unprecedented pricing advantage means record profit margins for Mid-Con refiners. MPC has the majority of its assets in Ohio, Kentucky and other Mid-Con sites, and now, post-split from Marathon Oil, we have a ‘pure’ investment in those favorably located refineries. It has performed well since the spin-off. It gives us a second way to play the refining resurgence, as Valero, the nation’s largest independent oil refiner, remains the portfolio’s largest position.
Finally, we are pleased to inform you that we have hired a new analyst, Jared Wein, who was working for a boutique research firm before joining us in June. We already have him learning the intricacies of oil refining, fertilizer and industrial gases. (With that job description, we hope he survives the quarter.) We look forward to reporting back to you after the third quarter, as the resolution to some of the issues we discussed – like the U.S. debt ceiling negotiations and the end of QE2 – will be more apparent. We welcome any comments or questions you may have regarding the description of your portfolio companies in the accompanying Summary of Investments, and we have included the annual update of our privacy policy for your review.
Grisanti Brown & Partners LLC