July Recap: Investors Reluctant to Commit Additional Capital

Includes: MMM, PCAR, SKT, WBA
by: Ben Marks

Not since March of 2009 have our clients expressed so much concern regarding the financial markets. Their concerns are centered on the Federal debt ceiling debate. Historically, times of uncertainty have created opportunities. This debate is so well publicized that the uncertainty is likely reflected in current market prices.

Index July 2011 YTD 2011
DJIA - 2.18% + 4.89%
S&P500 - 2.14% + 2.75%
NASDAQ - 0.62% + 3.90%

Democracy can be ugly sometimes. A wise man once said, “Laws are like sausages. It is better not to see them being made.” Loud and heated debates over spending cuts and increased tax revenues were daily headlines and hourly sound bites. These issues were being debated and tax law reform was on the table, indicating that the democratic process was at work again. The August 2 deadline for a raised debt ceiling and a more balanced budget loomed large.

While it remains a fluid situation, it appears that a compromise is at hand… imperfect, but hopefully a step in the right direction. Default is likely to be averted just in the nick of time as the debt ceiling is being raised by $2.4 trillion in two stages. A more balanced budget involves over $900 billion in spending cuts over the next ten years plus another $1.2 billion of cuts to be determined by the end of this year. Medicaid and Social Security appear to be exempt from the spending cuts.

It was unrealistic that the US government would default on their debt and incur higher interest rates for decades to come. The markets have been telling us this as yields on the ten year Treasury declined to 2.8% at month’s end. There is a cloud of uncertainty that could potentially slow economic growth and delay corporate spending as business leaders and investors have been paralyzed by indecision. A little bit of bad news has been going a long way this month, as investors have been reluctant to commit additional capital. However, a bit of good news on unemployment ---weekly new claims at 3 month lows--- caused a mini-rally toward the end of July.

It is always important to evaluate your tolerance to risk, but not be reactionary. Today’s headlines should not change your long-term objectives. Our strategy is to hold well researched, high-quality investments in which we are comfortable with the underlying business model and valuations. Stocks currently trade at a price-earnings multiple of 13 times expected earnings. Generally there is a relationship between price-earnings multiples and prevailing interest rates. Lower interest rates typically lead to higher multiples. With today’s low interest rates the S&P 500 Index should in theory be trading near 20 times earnings. If uncertainty diminishes, multiples may expand.

Investors’ appetite for risk is near an all time low, thus investments in large cap, defensive, US-based stocks have been among the best performers in July. For instance, one of our holdings in the Core Equity portfolio is Colgate (NYSE: CL), which reached new 25+ year highs during the month and reported accelerating revenue and earnings growth for the second quarter.

When the debt ceiling issue has passed, the market will focus on the next issue at hand, most likely unemployment. Minnesota public servants returned to their posts late in July. Everyone, including politicians, wants to see unemployment ratchet down from the 10% area.

During July we added Tanger Outlet Malls (NYSE: SKT) to our Alternative Strategy portfolio. Tanger is a pure-play retail outlet mall developer and operator with over 35 malls in 23 states around the US. Shoppers visit outlet malls in good times and bad, and the recent decline in gasoline prices make them relatively more attractive. Tanger malls have a 97% occupancy rate currently, for a steady stream of revenue. A recent acquisition added 4% to total square footage, and management is in discussions to acquire another 15% of space. With a 2.9% dividend yield, we believe SKT is very attractive from a total return standpoint. It is a conservative way to benefit from a) the financially-stressed consumer and b) any upswing in consumer spending (without the fashion risk).

To our Core Equity portfolio we added Walgreen (NYSE: WAG), the world’s largest drugstore chain with over 8,100 locations including 116 hospital sites. Prescriptions account for over 60% of total sales and market share has consistently expanded to 20%. EPS are likely to grow in the 13-15% range annually over the next 3 years on mid-single digit sales gains and modestly higher store count. Following a recent 29% cash dividend increase, shares yield 2.1%.

We sold shares of Verizon (NYSE: VZ) in the Core Equity portfolio during July. Market penetration with new smartphones is not living up to expectations for the second consecutive quarter. Valuation appears high versus peers, which is not warranted in our opinion.

3M (NYSE: MMM) reported revenues and earnings in line with expectations as four of their six divisions generated double-digit revenue growth. Volume rose 3%, slightly below expectations and higher costs cut into margins. The impact of the Japanese earthquake was in line with expectations, and 2011 earnings guidance was lifted on the lower end of the range. The CEO commented that we are “in an intermediate period of economic sputtering,” which sent share prices lower. We continue to believe that 3M has the R&D innovation pipeline to give them volume and pricing advantages versus other Industrials over the intermediate and long term.

Paccar (NASDAQ: PCAR) is the manufacturer of light and medium duty trucks under the Peterbilt & Kenworth brands. During the quarter truck volumes rose 26%, truck sales rose 66% and profits were up 150%. Management increased their estimate of European truck sales (nearly 60% of total). They reduced their US industry projections (40% of total) based on supplier constraints as demand has risen 50% this year. In the second half of the year production is still estimated to increase 25-40% from the prior year. These are in line with our estimates a few months back, and do not change our outlook. Inventories are at a five year low and backlogs are building while trucking tonnage and pricing are up. On July 11, the board raised PCAR’s dividend by 50%.

Disclaimer: The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investments and strategies may be appropriate for you, consult with Marks Group Wealth Management or another trusted investment adviser. Marks Group Wealth Management performs in-house analysis on companies. Statistical information on mentioned companies is obtained from company reports, news releases and SEC filings. The information set forth herein has been derived from sources believed to be reliable, but is not guaranteed as to accuracy and does not purport to be a complete analysis of the securities, companies or industries involved. Opinions expressed herein are subject to change without notice. Additional information is available upon request. Past performance is no guarantee of future results. Stock investing involves market risk including loss of principal. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise. Precious metal investing is subject to substantial volatility and potential for loss. Commodities are subject to fast price swings which can result in significant volatility in an investor’s holdings. International and emerging market investing involves special risks such as currency fluctuation and political instability.