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Client Investment Letter 2014

Newton’s first law of motion states that a body in motion at a constant velocity will remain in motion unless acted upon by an outside force.  The first three quarters of 2014 were a period of unusual calm on Wall Street with the equity markets acting like a body in motion ascending at a steady pace.  Volatility levels declined to near all-time lows during the summer and U.S. GDP gained significant momentum from a weather-dampened -2.1% annual rate in Q1, to +4.1% in Q2, and +3.9% in Q3.  Feeling confident that the economy remains on a steady course of gradual improvement, the Federal Reserve finally ended its Quantitative Easing (QE) program.  Investor anticipation of the end of the program proved to be a strong force that sent shockwaves through the market in mid-October.  The S&P 500 index fell 8% from its highs in mid-October, only to rally to new highs by the end of the month as other central banks globally exerted their own forces with promises to provide support for their economies through aggressive QE of their own.

Always opportunistic, we took advantage of the brief correction to start positions in two companies we have been patiently waiting to buy for over two years: ABB and Xylem.  ABB is a leading provider of power and factory automation equipment. Power infrastructure is a promising market as developed world electric grids have become decrepit and need to be upgraded while emerging markets are expanding their grids.  Governments and utilities deferred power investment in the wake of the ‘08/’09 recessions, but such investments cannot be deferred indefinitely.  When spending resumes, ABB is well positioned to garner its fair share of the business.  Factory automation has become increasingly important in an economy where labor costs to employers including things like healthcare are constantly on the rise.  To maintain competitiveness factories have had to replace expensive, error-prone, and sometimes union-represented labor, with machines that can work longer and more reliably for less total investment.  We expect this trend to continue and ABB to prosper as a result.

Xylem’s corporate slogan “Let’s Solve Water” pretty much tells you what you need to know.  They sell pumps, valves, wastewater treatment equipment, filtration gear, and all kinds of controls and systems having to deal with the movement and treatment of water.   The company was spun-off from industrial conglomerate ITT in October of 2011 and we have been tracking it closely since then.  We finally got an opportunity to buy at a favorable valuation in mid-October.  The world’s water problems remain significant.  We have too little clean water and it is often in the wrong places.  This is true in the United States where the growing Southwest is short water and it is also true in many other parts of the world.  China for instance has both water shortages in the North and significant water pollution problems.  With very few countries unaffected by some kind of water constraint, we expect Xylem to be selling into a favorable market for decades to come.

In recent weeks, you may have read that the price of oil has collapsed.  What drove the change in price?  It was a confluence of factors including lots of new supply from North American shale plays like the Bakken and Eagle Ford, waning demand due to slowing economic growth in China and Europe (which is once again flirting with recession).  While the speed and size of the price move from nearly $100 earlier this year down to about $65 at the time of this writing was surprising, we do not think it heralds a drastic change in the oil landscape.  The simple truth is that the cheapest and easiest oil fields have been drilled.  New higher cost methods have been developed to extract hydrocarbons from basins that historically haven’t been accessible.  This is true for both offshore drilling and for onshore horizontal drilling.  While we don’t know where the price of oil will go in the short term, we do know that the incremental costs of finding new sources of oil are rising.  We expect this trend to continue.  Meanwhile demand growth, driven primarily by emerging market middle classes, should continue long-term.  Ultimately, that should mean a stable or rising oil price and plenty of demand for new wells and resource discoveries.

Informed by this view, we took a new position in Schlumberger, the largest global provider of oilfield services, at the end of November.  While earnings estimates may face pressure near-term, long-term state owned oil companies, majors, and independent oil companies are going to continue to rely on Schlumberger to help them discover, drill, and maintain production of hydrocarbons.  Schlumberger has one of the best balance sheets in the industry and will be able to take advantage of excessive commodity volatility to further consolidate their already strong position in the industry.  Should major competitors Baker Hughes and Halliburton complete their planned merger this should also have positive pricing implications for Schlumberger as more industry concentration tends to be good for all remaining players.

In terms of our outlook for the world economy in general, it is little changed from the last several years.  We expect the U.S. economy to improve more slowly than a “normal” recovery. So far this has meant real GDP growing somewhere around 2.0%.  The recent strengthening of the dollar should provide a near-term headwind for U.S. exporters.  Furthermore, Europe appears to be sliding towards recession, growth in China is finally slowing after years of a breakneck pace, and Japan recently returned to recession.  With slowing growth or declines in the three largest economies after the United States, large multinational businesses should face some significant headwinds in the year ahead.  On the positive side, the significant fall in oil prices should be a welcome boon to consumers, akin to a tax break.  Unemployment continues to improve both here and abroad.  Furthermore, central banks in Europe, Japan, and China are working to ease policy and improve economic growth in their economies.   We view sustained U.S. GDP growth of 4.0%+ that many economists, including those at the Federal Reserve, have been hoping for (for several years now we should note) as somewhat unlikely.  We expect the global economy to continue to muddle along.  One area we see for lots of opportunity is in fiscal policy both domestically and abroad.  Investment in quality infrastructure, financed at historically low rates, should create real value for countries where politicians can finally stop bickering long enough to make things happen.  Streamlining global tax codes and removing various “tax expenditures” and other incentive distortions seems like common sense to us.  We won’t hold our breath, but we can hope politicians come to their senses, can’t we?

Whether we like it or not, structural inflation is being built into our economy via fiscal irresponsibility as best demonstrated by programs such as Social Security and Medicare.  The simple truth is that both of these programs are well past the point of no return in terms of becoming unsustainable.  Future benefits will need to be cut AND taxes will need to be raised to fund promises that have already been made.  The taxes may be levied on corporations to make them palatable to voters, but such taxes will only be passed on to consumers in the form of higher prices.  We have seen just such a dynamic play out recently as the ironically-named Affordable Care Act has driven up insurance prices for consumers.  Hopefully, when the time comes, the economy will be strong enough to bear the extra burden of paying to fix these troubled programs.  Otherwise, we may face the unhappy prospect of the return of stagflation (the unpleasant combination of low growth with inflation).

Equity valuations are full, with few bargains to be had in general, but they don’t seem excessive. The equities we hold are generally dominant players in their industries with clean balance sheets, reasonable valuations, and a high likelihood of sustained cash flow growth which will allow greater returns of capital to shareholders in the form of dividends and stock repurchases over time.  No matter how the macroeconomic winds blow, we expect that the companies we own will have staying power and work diligently to generate value for shareholders.  We will raise cash if we think the market offers us prices significantly above fair value for the high quality businesses we own.  Likewise, we will selectively buy companies that we think the market is offering “on sale” such as our recent purchases.

Bonds are offering generational lows in terms of yields in the U.S and in Europe bond yields are as low as they have been since the early 1800s.  At present prices we continue to think bonds mostly offer “return free risk” and thus have generally avoided them.  Our recent equity purchases of ABB, Xylem, and Schlumberger offer dividend yields of 3.8%, 1.6%, and 1.9% respectively – greater than or equal to the yields on five year U.S. Treasuries with the prospect for significant dividend growth over time.  It is hard to see why one would want to tie up money long-term in bonds when quality equities will throw off the same cash from dividends and offer the prospect for long-term growth.  Cognizant of what we view as a fair degree of complacency in the market, we have been carrying a higher than usual amount of cash with the view that we will have better investment opportunities for such cash in the future when markets are less sanguine.  We continue to think this is the proper course of action even though we sacrifice some yield in the short term as a result.  When forces, wherever they may arise, create opportunities in 2015, we’ll be ready to take advantage of them thanks to the cash we are keeping on hand.

We thank you for the trust you place in us and wish you and yours a happy and healthy holiday season.

Penn Davis McFarland, Inc.
December 2014