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Nicholas F. Galluccio is President and CEO of Teton Advisors, Inc., based in Rye NY, which runs a family of listed mutual funds under the family name of Teton Westwood, and representing a range of investment strategies. Teton Advisors is itself listed under the ticker "TETAA." It is affiliated with Gamco Investors, Inc. (NYSE: GBL), a large and well-known diversified asset manager and financial services firm.

Nick was a journalist early in his career, starting as a staff writer at Forbes, and moving into the financial services business as a semiconductor analyst at Lehman Brothers Kuhn Loeb. He and I first met during the 25 years he spent at Trust Company of the West, where he was Group Managing Director and headed smallcap value and midcap value funds. Seven years after TCW was acquired by Societe Generale, he joined Teton Advisors, and has built the platform to $1.2 billion in assets under management (AUM). Today he is at the helm of Teton, and runs the Teton Westwood SmallCap Equity Fund.

I asked Nick before the national election if we could talk after the election in broad strokes about the state of the economy, the vigor of the recovery, his outlook for 2013, and generally about which sectors he finds most promising going forward. He agreed, and we met shortly after Thanksgiving at his offices in Rye.

JA: To start off, I wonder if you have some thoughts you could share about the overall economy, the fiscal cliff or other issues, and what your crystal ball says about 2013.

NFG: We think the US economy will get stronger as we go through 2013. Capital spending was constrained during the extended campaign as business managers and investors put off spending until the outcome of the elections was known. And of course there was a long-running debate over the fiscal cliff. Now we believe that the pent-up need for capital expenditure, which had been delayed during the campaign, will begin to be implemented, which will have a positive effect on the economy.

We are seeing a recovery in housing, underscored not only by the builders themselves, but by good results from companies like Home Depot (NYSE: HD), which had strong comps up 4.3%, and Lowes (NYSE: LOW); both of those are riding at 52-week highs.

The tech sector has been impacted by slow spending by consumers and a slight inventory build throughout the supply chain, but we think that spending will be stronger in 2013. And we think that the Christmas season will show good retail sales comps this year, better than it has been in many years.

It's important to recognize that the European economic situation has been a drag on the US economy, as consumption of US products by Euro-zone consumers dropped. We believe the biggest declines from the downturn in the European Community are now behind us, which may not be much of a plus, but it will be less of a minus or a drag on the economy.

Finally we are seeing a very accommodating Federal Reserve, with all signs pointing to QE3, which will actually expand the capacity of the Fed's balance sheet. We're speculating that Chairman Bernanke may be replaced by someone like Janet Yellen, current Vice Chair of the Fed and head of the San Francisco Fed. If she were to succeed Chairman Bernanke, we believe her leadership would continue to foster the accommodative monetary policy established over the past several years under Bernanke.

JA: Does that mean you see a strong recovery in 2013?

NFG: We believe we will see a somewhat stronger economy, with growth improving from sub-2% to better than 2%. That still represents a rather anemic economic outlook, which will change for the better when we get some major tax and entitlement reform, which would instill the confidence among business leaders necessary for them to jumpstart capital spending. And let's not forget that the consumer needs to believe the country is on the right path. We need exemplary leadership from both our President and his Republican counterparts.

JA: Do you think Washington will come up with a solution for the fiscal cliff? Will they just kick the can down the road?

NFG: My gut says that they will do something this time. The Tea Party was partially discredited in the election, and that means that the extreme right wing of the Republican party may lose some clout, with the likelihood being that the Republicans will regroup right of center. It behooves the Republicans to work out a compromise with the Democrats. On the other hand, Obama only won by a margin of 2.4% of the popular vote, not what you'd call a mandate. He wants to leave behind a legacy, and will move from far left to just left of center, in order to get things done. He has to make some changes, and I believe he will. He hasn't shown the kind of leadership that Clinton and even Bush did. If he wants to leave a legacy in four years, he is going to have to cross the aisle toward compromise.

JA: And Grover Norquist and the tax pledge?

NFG: Outdated.

JA: What is it going to do to the market?

NFG: We have been in a bull market since the bottom in about March of 2009, Since then the market is up over 100%. We have had a correction since the election, and that correction has discounted a lot of the negatives. If we make any progress toward resolution of the fiscal cliff, we will enter the next phase of the bull market in 2013. I believe we are in a secular bull market. It is ironic that as the market moves up on relatively low volume, retail investors have continually sold equities. Retail investors have had net redemptions every month of 2012, even with the market moving higher. Over the past five years, domestic equity mutual funds have had $500 billion of net redemptions. At some point the retail investor will come back to the market and money will start to move back into equities. That would be a driver of the next phase of the bull market.

For several years, money has been flowing out of the equities and into the bond market. Money keeps coming into fixed income, and at some point that will turn. As rates move up, investors at the lower rates will get burned, and many will move back to equities. Many fixed-income investors are actually losing money, adjusted for inflation. If rates were to move back above 2-1/2%, there would be many reasons to be bullish on equities. Overall sentiment among retail investors is still bearish, but valuations are very cheap, at decades-low levels. The S&P is selling at 14 times earnings and smallcaps are at 8 to 12 times earnings. Even though retail investors don't yet have an interest in small caps, it is a great opportunity for contrarian-minded investors.

JA: Would this be a second leg of a bull market then?

NFG: Coming out of a recession, small caps usually lead the market higher. Small caps get sold down hardest in a downturn, and then they gain faster coming back out of a downturn. We believe that in 2013 we could have a credible strong fundamental underpinning to surge in small caps, because their valuations have fallen further than large caps. And when liquidity comes back into the market, it acts as a slingshot with small cap equities.

JA: What sectors would be the most interesting if that happened?

NFG: The hardest-hit sectors have been industrials and technology, because they are the most sensitive to economic changes. Likewise, as car companies and auto parts companies had a good 2010 and 2011, inventories built up. After we exited 2011 we had a destocking of inventory, but now those inventories have come back into balance. With housing picking up, the economy will begin to restock in earnest, which will create the next leg up in the cycle. Stocks have already discounted a weakened economy, so valuations are very good for buyers.

In the industrial sector we like suppliers to the commercial aircraft industry. The global aircraft industry has designed more fuel-efficient planes, which the airlines badly need. The buyers, however, are both the aircraft leasing companies and the airlines, which have restructured over the last several years with some big bankruptcies. The backlogs of Boeing and Airbus show a growth in demand for many years. Remember that the international carriers are healthier. The order book is full, and no one wants to drop out of the queue because it is hard to get back in line. We own Woodward Inc (NYSE: WWD), Hexcel Corp (NYSE: HXL), Moog Inc (NYSE: MOG.A and MOG.B), Carpenter Technology (NYSE: CRS), and the smallest market cap of the group, AAR Corp (NYSE: AIR).

JA: Any other sectors?

NFG: Energy is very interesting, particularly oil and natural gas. We believe there is great promise in horizontal drilling, as well as in hydraulic fracturing, both of which will be essential to move the US to be the largest fossil fuel energy producer in the world by 2035. Fraccing may have problems state by state, but overall there is too much national need for it to get stopped. We believe it will go ahead in Ohio, Pennsylvania, upstate New York, Wyoming, Montana. In the energy space we own Patterson-UTI Energy (NASDAQ: PTEN), which is a major high-tech horizontal driller that is hired by energy majors and independents. On the E&P side, we own Energy XXI Ltd (NASDAQ: EXXI), which is a beneficiary of Exxon divesting energy assets in the Gulf of Mexico. We also own Approach Resources (NASDAQ: AREX), a natural gas exploration company with properties in the Permian Basin in West Texas. And we own Comstock Resources (NYSE: CRK), which has most of its assets in the Gulf of Mexico, Texas and Louisiana. We believe that natural gas will be the energy of the future.

JA: How about one more?

NFG: Financial services. We have about 14% of our portfolio in regional community banks that are primarily home and small-business lenders. Most of the charge-offs in that industry have already been taken, so going forward the provisions will decline and the bottom lines will improve. We see a pickup in demand, both from small businesses and from homeowners. These banks will see profits from mortgage origination, mortgage servicing, and mortgage refinance, even if the mortgages themselves are securitized and sold to others. In addition, these smaller banks will be making car loans, home equity loans, and small business loans.

I read the FDIC reports, and a few quarters ago we saw the first pickup in several years in loan demand, although that pickup was rather small, in single digits.

In that area we like ViewPoint Financial (NASDAQ: VPFG), an over-capitalized Texas bank that has a balance sheet that needs to be converted to loan volume. We also own Washington Trust Bancorp (NASDAQ: WASH), a clean Rhode Island-based bank that has a significant trust department and an attractive lending franchise in the corridor including Connecticut and Massachusetts. We also own Oriental Financial Group (NYSE: OFG) which, in spite of its name, is the best-capitalized bank in Puerto Rico.

JA: So I take it you believe there will be a meaningful step taken on the fiscal cliff before Santa Claus gets here?

NFG: We think there will be a first step toward a solution before the end of the year, yes. Even so, investors are braced for the worst, which is reflected in their redemptions from equity funds, and the bears that caused the correction after the President was re-elected. Since then all indications are that both sides are willing to compromise.

JA: Many thanks for your time and for sharing these thoughts with us, Nick.

Source: Nick Galluccio On Economic Recovery Outlook For 2013, Equity Valuations, Sectors To Watch