The stock market enjoyed spectacular results in 2013. Growth stocks were especially good performers. All sectors benefited from the Federal Reserve Board's expansionary tailwind, though. The average stock, measured by the Value Line Geometric Index (which weights every ticker equally), advanced 33.0% during the course of the year. Higher earnings per share contributed 8% (estimated); expanded price-to-earnings multiples accounted for the balance (25%). That's a trend that's been going on since the market recovery began in March 2009. Earnings have been trudging forward through economic headwinds that have made it difficult for companies to expand properly. Rather than invest in new assets and boost hiring most earnings improvement has been the result of productivity gains (layoffs) and financial engineering (buybacks). Stock performance has been good because of the expansion in P/E multiples, a result of easy money policies.
Growth stocks have done better because their incomes have risen faster. The rarity of better than average income growth tended to amplify that P/E expansion, sometimes leading to eye popping results. Acquisition activity reinforced the build-up in speculative fever. Biotech and new age software stocks have been the leading beneficiaries. Many companies have experienced tremendous stock price gains despite not having any earnings at all. Both groups typically spend more on marketing and R&D than they generate in total revenue, let alone cover overhead costs. Cheap money has made it easy for Wall Street to reward that approach, arguing it's a land grab and they can cut back on expenses later. It's kind of the same idea the Federal Reserve has been pursuing towards the whole economy. Lay out the money now and pull it back when everything returns to normal.
We've expanded Growth Stock Insider to include some additional investment options. The central core of the website continues to be fast growing undiscovered growth stocks. Those issues generally perform well in all types of economic conditions. Scott Billeadeau, who recently joined Walrus Partners as a portfolio manager, will help us write those stories. Scott's an industry veteran who has produced superior results in the emerging growth stock area for several decades. Besides bringing us considerable insight and experience he has a deft touch with these stocks, which can be tricky to handle at times when trading them in the market.
We've also introduced three new sections that promise useful diversification potential. Additional Wall Street experts with proven ability have been brought in the contribute those reports. Each of those blogs will be chock full of valuable information that will expand our investment horizons. Overall performance could be enhanced by the wider field of view. Risk exposure could decline, as well.
First off, though, we're going to highlight a blog we launched in 2012 when alternative energy stocks were at their nadir. Overcapacity swamped the solar power industry. Margins were compressed. Sales were barely growing. The headlines were full of bankruptcy stories, government failure, and as much doom and gloom as you could imagine. Along came Eric Ramsley, our web site's producer. As far as he could see -- and we came to see, too -- solar power actually was becoming cost competitive out in the real world. And the electric vehicle investments the Obama Administration made in 2009 looked like they might be bearing fruit, in particular at a tiny unknown California start-up known as Tesla Motors.
Eric took the bull by the horns, started working through the downtrodden green industries, and spotlighted a number of high potential candidates. That move panned out in a big way. And we're sticking with his basic plan. On the macro level oil and natural gas remain the world's primary energy drivers. And the development of horizontal shale drilling techniques probably will make the United States the world's leading energy producer again before long. That, more than any amount of Bernanke Bucks, probably will drive the country's economy forward over the next several decades. But in the small cap neck of woods green energy stocks offer excellent profit potential. Keep a close eye on this blog.
Dividend Growth Strategy
Most dividend investors look for yield and the price be damned. That works great until the interest rate curve starts climbing, causing the underlying asset values to fall. Recent research has demonstrated that a better way to go is to buy companies with a proven track record of increasing dividend payments. That way you get some immediate income. There also is a much greater chance of stock price appreciation. These companies typically are larger, more established growth companies that can afford to pay a portion of their earnings out as dividends while still investing in their operations to deliver future growth. Most are industry leaders will proven management teams and solid finances, similar to our smaller recommendations. They've captured a significant part of their potential markets, though, and have money to spare for shareholders.
Keith Wirtz, who's managed several dividend growth portfolios in the past and currently is forming another one at Walrus Partners, has agreed to write the blog. The companies he focuses on are top flight operations with a clear cut record of escalating dividends. Results have outperformed the general market on an historical basis. Risk also has been contained, below the market's norm.
Everybody on Wall Street talks about "unlocking shareholder value." A few companies actually do it. Analysts love to talk about stocks being worth the sum of their parts. Down in the trading pit, though, that's usually the last thing on people's minds. Companies that are out of favor for one reason or another sometimes have extremely lucrative divisions or subsidiaries that are camouflaged by the holding company's better known problems. Quite often, those nuggets don't receive any kind of credit in the market. Even if investors are aware and nod at them in passing they won't pay up because the units are locked away. The assets aren't worth anything to outside investors. They can't be monetized.
Mark Billeadeau, a contributing editor, has found a way to profit from those mispriced opportunities. Bolstered by the rising tide of liquidity that's become available, more and more companies are spinning off those divisions to shareholders, often in tax efficient distributions. Others take them public, selling a partial interest. The more adventuresome dream up custom tailored vehicles to get the job done. Mark analyzes those transactions to identify spin-offs that are worth more than what they're initially offered at. As investors become familiar with the new spin-off the stock price often improves. There's a gravitational pull moving the starting price up to where the fundamentals say it belongs. Other times Mark plays those transactions in reverse. Those deals benefit the holding company to a larger extent.
Mark manages a portfolio that's built with corporate spin-offs. Results have outpaced the general market since inception. It's impossible to predict when these opportunities will arise. The number of ideas that Mark writes about here may be sporadic at times. But he has plenty of old stories to tell, which are instructive in themselves. And some of those are still going strong. These reports appear in our new "Guest Columnists" section. We will recruit additional writers with unique investment ideas, as well.
We had to scramble the name a little to prevent Google and the NSA and all the other search engines out there from zeroing in on us. Hopefully you get the picture. There are hundreds of stocks in the market today that trade at fabulous valuations without the benefit of an underlying earnings base. Others rely on accounting gimmicks, perfectly legal under modern S.E.C. regulations, yet gimmicks nonetheless. These reports will be anonymously written, for obvious reasons. And quite frankly, most if not all will offer positive credit to the management teams involved. As we indicated earlier, Wall Street drives a lot of companies to produce short term metrics that don't always prove sustainable over the long haul. And even when a strategy makes sense, conditions can change. The best laid plans of mice and men can come undone for reasons even the mice don't understand.
Most short cellars are grumpy souls who hurl damaging allegations that tend to have elements of truth in them, but often are hyperbolic. Most companies really are on the level and are trying the best they can for shareholders. Still, the stock market is the stock market. Celling short is a good mechanism for hedging a portfolio. And thoughtful research efforts can uncover overvalued issues even when the overall market is advancing. We'll be interested to hear your feedback on this section.
Market Outlook for 2014
We've been researching growth stocks our entire career. When we first began on Wall Street our supervisors taught us, "Don't worry about the market. Find some winning stocks and stay invested in them." That remains excellent advice.
For those of you who want to worry, start with the idea that valuations are elevated and investor confidence is at euphoric levels. That's nearly certain to foreshadow a drop at some point. But conditions like these lasted for years during the Vietnam War, the Reagan Era, and during the Internet Boom. Remember how long it took before housing prices finally declined. In every case you could say it was a fluke the sell-off happened at all. What if Egypt hadn't attacked Israel and set off the oil embargo. What if the banking regulators had figured out a way to transition the S&Ls into the mainstream banking industry. What if the broadband Internet had been deployed a few years earlier. In the 1950s nothing major went wrong and the market just rolled.
In 2014 the United States financial system is in uncharted territory, with all the Quantitative Easing that's been taking place. The easy part of the easing process is over. Now the economy appears to be coming to life. The question everyone has been asking from the start may finally be answered: "What if it works?"
When Benjamin Bernanke initiated the Quantitative Easing program in 2008 the Federal Reserve held $500 billion of securities. The U.S. banking system had excess reserves at the Fed (deposits the banks could demand back at a moment's notice) totalling $6 billion. Today, the Fed holds $3.8 trillion in securities. The banks have $2.5 trillion in excess reserves at the Fed. That money used to trade in the commercial paper market or the fed funds market, financing inventories and receivables and whatever else required short term funding. Today it sits at the Fed earning 0.25% interest, which is higher than a bank can earn in those other markets. The Fed is keeping that money out of circulation by outbidding the market.
During the past 12 months the Federal Reserve says it purchased $85 billion a month in securities in the open market -- $1.02 trillion in total. Over the same time the M-2 money supply in the United States increased by $634 billion. That's a gap right there of $386 billion. But it's worse than that because new money entering the system usually multiplies at a 1.5x rate as banks make loans off those reserves. Before the crash it was closer to 2.0x. So all the talk about "printing money" is technically correct. It's just that most of it has disappeared into the bowels of the Federal Reserve, categorized as excess reserves. It doesn't count in the money supply because it doesn't move.
What if it starts moving? The new Federal Reserve chief, Janet Yellen, could have a challenge on her hands if the economy genuinely accelerates and the banks withdraw the funds it has on deposit at the Fed. It's their dough. They're entitled to it. But if the money comes out quickly the M-2 numbers are going to surge, threatening inflation and who knows what else. Ms. Yellen could start selling the Fed's bond portfolio to soak up the cash. That would address the problem. But it might propel interest rates to unpredictable levels. Alternatively, the Government could freeze the money, Argentina style. That seems unlikely. But who knows.
An interesting twist might occur if some big players in the U.S. financial system figure a way to profit from such a crisis. George Soros brought down the Bank of England in the 1990s. Is there anybody out there today with the gumption and the resources and the brains to create a run on the Federal Reserve Bank of the United States? The Obama Administration has been hammering the banks and hedge funds with gigantic fines, brutal regulations, even prison sentences. As the saying goes, "Friends come and go. Enemies accumulate."
It's an unlikely scenario. But if you want something to worry about, that's not a bad one.