August lived up to its reputation as the worst month of the year for equity investors with the S&P 500 down 5.68%. The month started with an agreement between Congress and the White House to raise the U.S. debt ceiling by $2 billion and avoid default. On the 4th of August the U.S. suffered the historic indignity of having its debt downgraded from AAA to AA+ by S&P. Last Friday during a much anticipated public presentation, Federal Reserve chief Ben Bernanke delayed any call for immediate monetary stimulus.
Ironically, interest rates declined after the S&P downgrade due to concerns over Eurozone debt, which drove investor demand for U.S. debt as a comparative safe haven. Ten-year Treasury yields declined from 2.8% to 2.1%. The desire for investors to reduce risk provoked a sharp sell-off in equities across the board. Indiscriminate selling reduced valuations on everything from sleep well at night or “SWAN” stocks to the epicenter of the concerns, European banks. Most asset classes went down in unison, other than Treasuries and gold.
In a rollercoaster month, ears were tuned toward Ben Bernanke’s every word for signs of solace. While his speech at the Fed’s annual economic conference in Jackson Hole did not define the Fed’s next steps, for the second time in August his assurances that “a range of tools are available” were well received by the markets.
We agree with Mr. Bernanke that our economy suffered in the first half of the year from ongoing disruptions from the Japanese earthquake and higher energy costs. We also agree with his assessment that a significant portion of capital in this country…both human & mechanical---lies dormant. While many Industrial companies have strong orders in hand, we have seen them battling shortages of components due to supply constraints. Without strong Congressional leadership on tax and other matters, business leaders are hesitant to invest in any type of capacity. Perhaps a little inflation, in the 2-3% area, would be just the thing to prevent us from becoming another Japan.
We are adjusting the portfolios to take advantage of some of the indiscriminate selling in high quality, large cap stocks with exposure to faster growing economies. This month we bought Deere & Co (NYSE: DE), the $32 billion revenue manufacturer of agricultural, construction and forestry equipment. We anticipate record U.S. farm revenues on higher demand & prices along with strong yields. The farmers’ balance sheet is the strongest in years, and prices for some of the farmers’ key inputs (oil & fertilizers) along with Deere’s major raw material (steel) are declining from the highs earlier this year. Deere has a growing presence in the Emerging Markets of the former Soviet states and Eastern Europe along with South America. We also bought shares of Nestle S.A. (OTCPK:NSRGY), the global food & beverage company with revenues exceeding $100 billion annually. Nearly 60% of sales are generated in developing and emerging economies. Nestle is a market leader in higher growth categories such as instant coffee, premium pet foods, infant feeding, non-dairy creamers, and candy bars (Kit-Kat) which generate above average unit growth and pricing flexibility. In a higher cost environment, the company has proven its ability to grow and expand profit margins.
Our Hewlett Packard (NYSE:HPQ) investment thesis included a movement away from hardware (ie, personal computers) toward higher-margined services. However, when the company pre-released disappointing earnings and forecasts for 2011 revenue and profits, it also announced a potential sale or spin out of its Personal Computer division. Additionally, management announced a $10 billion acquisition of a high-growth UK software business. This is a revolution rather than the evolution we had expected from the new CEO. Shares tumbled 20% overnight before recovering 10% by month-end. Lacking a near term catalyst, shares may languish over the intermediate term. We are evaluating other opportunities in the Technology sector.
Donaldson Co. (NYSE: DCI) reported earnings that increased 25% from a year ago and 7 cents ahead of consensus estimates. Revenues were ahead of estimates due to strength in its largest division, Engine Products, +25%. Emerging Markets continued to drive total sales and now account for 12% of the total. With strong orders in hand, the filtration supplier also introduced revenue and profit guidance for the coming year that was above prior estimates, and we anticipate EPS growth of 20%.
Medtronic (NYSE: MDT) reported earnings that were down 1%, but in line with consensus estimates of 7% revenue growth. Its largest division, Cardiovascular Products and particularly the international business, led the revenue gain. Perhaps most importantly, Omar Ishrak the new CEO reiterated guidance for 10% EPS growth in the coming year. He also announced changes in the R&D pipeline, with greater emphasis on economic value at both the customer and societal levels to drive growth…indicating its intent to be the low cost producer. We continue to own Medtronic as it trades at a discounted valuation versus its long-term estimated growth rate.
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