Letter – 2013 Q3

I feel like we’re climbing a mountain, reaching new heights, ascending ahead of most other hikers, but walking on a path that is getting narrower and has a little too much loose gravel.  The view is pretty good, but there is a little thunder in the distance and I can’t yet tell if it is coming our way or not.

So much for my literary prowess.  After taking a bit of a breather in the second quarter, the S&P 500 regained momentum at a time when most pundits thought we’d be in summer doldrums and early autumn fright.  Congress has shut down the government, and a possible default is again on the horizon.  If that didn’t scare you, we had Syria and the uncertainty over Federal Reserve policy and leadership.  But the S&P 500 gained 5.25% for the quarter, and we did considerably better.  Our average account gained 8.86%.

I’m particularly pleased that we were up by more than the market in both July and September, and still down less than the market when it moved lower in August.

The simple answer on the market rally is that stocks move for many reasons other than macro developments.  If there is great promise on treatment of cancer, stocks like Celgene can easily rally regardless of what is going on in DC or Syria.  Americans need cars and tires in good times and bad, and the average age of a car at 11.4 years is higher than at any time in memory.  So there is pent-up demand, and auto sales are now increasing. So auto dealer stocks and tire companies such as Goodyear are rallying.  Americans are nothing if not innovative and companies such as Linked In are creating real value for job seekers and networkers, and thus for shareholders as well.  Creativity also exists in the entertainment industry and if you are Lions Gate Entertainment (LGF) your stock goes up when you produce or own things such as The Hunger Games, South Park, Mad Men, Twilight, and a lot more.  Airlines have learned to be more fuel efficient, fly with full planes, and increase revenue with annoying things like baggage fees.  So airline stocks have rallied.  This country has a history of moving forward economically, though not exactly in linear fashion, during periods of dysfunctional government.

That is not to say that we should be complacent about the big picture.  Markets can turn quickly and we do our best to ride winning positions while maintaining a rigorous approach to limiting drawdowns, such as through the prudent use of stop-loss orders.  And we also know from history that changes in government policy can precipitate big selloffs in the stock market.

We do our best to judge macro-economic circumstances and try not to slip on “loose gravel”.  However, things in Washington are likely to be changing more quickly than a quarterly letter can intelligently discuss.  So we will limit our discussion of the budget battles and the prospect of a temporary lapse in the timely payment of government debt.  We do spend time internally on a variety of “what if” scenarios.  For instance, there is some feeling that the market likes to test a new Fed chairman.  Some investors may pull back because a new chairman is on the horizon.  Indeed, the markets crashed shortly after Alan Greenspan took the helm in 1987.  But that is not the norm.  We went back and looked at the S&P 500 Index at 20 and 50 days into the tenure of a new Fed chair and here is what we found in recent history:

Started Day of 20 Later 50 Later
Miller 3/8/78 87.84 89.78 98.62
Volvker 8/6/79 102.75 102.73 102.43
Greenspan 8/11/87 333.33 313.92 258.38
Bernanke 2/1/06 1282.46 1289.14 1289.12

I think the most important conclusion is that if you bought the index the day that Miller started, you’d have 19 times your money from appreciation alone – and a lot more from dividends!  And you’d have substantially more still if you picked the right stocks instead of just buying the index.  That is what we try to do for you, using a rigorous system of judging value, earnings momentum, and other criteria.  That we did quite well in the quarter just ended.

The health care sector has been strong this year and we have done well in it.  Celgene remains our biggest holding.  We have more than doubled our money, and have trimmed the position a tiny bit.  While the stock has had a good run and could pause, our system projects healthy returns on the stock even if earnings growth slows to the mid-teens annually.  We also own Regeneron, which has a drug that slows the loss of eyesight.  The company also has a very rich antibody pipeline that could produce a number of blockbuster drugs in the years ahead.  Finally, its chairman is former Merck CEO Roy Vagelos, who is one of the most respected people in the industry.  The stock is volatile but recently made another new high above $300.  The stock has gained 83% this year, and we have a gain of nearly 150% in our remaining position.  Jazz Pharmaceuticals (JAZZ) had a payback period of only 6.35 years at the start of 2013.  Despite a 72% gain this year, it is still reasonably priced.  It spends relatively little on R&D, and has grown by some smart strategic acquisitions.  One risk is that about 65% of its revenue comes from a single narcolepsy drug.  After a terrible 2008, the stock has had a stellar run in the past four years.  It is relatively small, with a $5 billion market cap.  We have smaller positions in some of the more traditional pharmaceutical companies such as Merck, Bristol Myers, and J&J.

We are well diversified, in part with a company that is in the alternative investment business.  Blackstone is one of our major holdings.  It has done well for us despite varied performance at different points in the year.  A manager of alternative investments, it is doing a large number of creative and profitable deals, and has grown assets under management to over $200 billion.  It appreciated 27% in the first quarter, slowed to a 6% gain in the second, and added another 18.2% this quarter.  Most of the gain for the quarter came in just a few trading days; you have to ride out the periods that are flat or down.

Raytheon is well-positioned within the defense industry, given its leadership in electronic warfare and cyber security.  Plus there is the double benefit of a good dividend (2.8%) AND a strong stock buyback program.  This is one stock that has gained momentum as the year has progressed.  We bought it in February and have a 44% gain in it.

Goodyear has served us well.  We bought it at $12.40 back in April.  Value Line expects earnings to grow 28% over last year.  The stock is certainly cyclical, and its volatility is heightened by high debt, but the stock advanced nicely in the quarter, gaining 72% to $22.45.  It’s hard to believe, but this stock was lower in the first quarter of the year when so much else was rallying.

We’ve maintained a position in Google even though quarterly earnings announcements can send the stock 10 percent lower in a blink.  But they are incredibly innovative.  The recent TIME magazine feature on them noted everything from searches to glasses to auto-pilot cars.  I still have Google valued at a payback period of about 9.25 years.  That is more expensive than most of what I would buy, but you never know when Google is going to make another giant leap.  Moreover, I’m sure they could juice earnings at any time simply by trimming their R&D budget a bit.  But rightly, they choose not to do so.  The stock is 24% higher this year.  We can settle for that!

A large new purchase this September was Petrobras (PBR), the Brazilian oil giant, at a price of $13.62 (with small adds later).  It ended the quarter at $15.49.  The stock traded above $70 in 2008.  The major oil companies are having trouble discovering new reserves.  That is not the problem at Petrobras.  They own huge reserves deep in the ocean off the coast of Brazil, and will need huge capital expenditures to get at it.  The stock has also been punished by the sell-off in emerging market stocks and currencies.  But when it got to our purchase price, it had a payback period of 6 years, which projects a compound annual return of over 12% on the stock.  Value Line recently called it “compelling” at these levels.  I can’t pick bottoms, but it seemed like a good time to take a position.   So far, so good.

Micron is another recent purchase.  Earnings estimates for 2014 have improved dramatically:  the estimate was $0.01 back in February, $0.98 by July, $1.80 in August, and $2.06 most recently.  That matters – the stock was up 22% for the quarter and has nearly tripled this year.  We got in later than I would like, but still have a decent gain.  They are a huge memory chip supplier to Apple and others.  This is another company that we could get at a payback of under 6.5 years even though earnings prospects were improving dramatically.

Here’s another one that illustrates something about our investment perspective.  We bought Lincoln National back in the spring.  A friend who is well-respected in the insurance industry questioned why I would buy into what he felt was a second-rate company.  I basically said that if it is a second-rate company that is priced as a third or fourth rate company, it is undervalued.  It advanced 15% during the quarter.

The list goes on.

We don’t invest in a vacuum.  It is important to be conscious of overall market valuation because virtually all stocks have some correlation with the movement of the overall market.  Valuations have been relatively cheap in recent years as the market has recovered from the financial crisis.  We’ve reached a stage where the market seems to be pretty fairly valued.  The S&P 500 Index ended the quarter at 1681.55.  Its earnings are projected to be $110.40 in 2013 and $122 in 2014.  That translates to a current price-earnings ratio of 15.2 and a forward PE ratio of 13.8.  Relative to history and interest rates, that is neither rich nor cheap.  We also have to be mindful that earnings and earnings estimates can change, sometimes quickly.  To wit, the market was not particularly expensive at the beginning of 2008.  So we monitor earnings and fundamental developments carefully.

We don’t get everything right.  There are blown earnings, disappointing tests of promising drugs, technological changes that can leave anyone in the dust, etc.  And there are things we simply miss.  For instance, I was bidding $14 for Facebook a year ago (thinking that the downside risk was to $10) and it bottomed at $18 or so.  We missed a 150% gain in the stock.  But we didn’t have any really bad stocks this quarter, and that helped our overall results.  And we’ve had more than our fair share of winners.  I hope that continues, but needless to say, we can’t promise continuous out-performance – or out-performance at all.  We can promise that we will work hard, be vigilant, perpetually learn, and do our best to stay on top of stocks and broader economic developments.  We thank you for your confidence.  Contact us anytime.

* Past performance is not necessarily indicative of future performance. Results for individual clients may vary. Results are not audited. Byrne Asset numbers include all actively managed equity accounts and reflect the reinvestment of dividends and deduction of all fees. As one can not invest in an actual index, for comparative purposes we show returns and other statistics of the Vanguard 500 Index Fund, a mutual fund that very effectively tracks the performance of the Standard & Poor’s 500 Index.

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