The Beatings Will Continue Until Morale Improves

The U.S. stock market took a beating in the third quarter of 2015.  Most indexes fell around 10%.  Trading volume wasn't particularly high, moreover.  So the raw material exists for additional declines.  China was blamed more than anything else.  And the Communists who rule the country certainly deserve some criticism.  They tried to rig the Shanghai stock market, which backfired.  The Government continued to manipulate the real estate market and a range of other industries.  That central management worked well when China was transitioning from a rural economy, and the path forward was clear cut.  Now that China has grown more developed, its economy is more complex.  Policies that look promising on the surface sometimes create unexpected side effects.  Still, the basic approach remains intact.  China's new president is opening up more of the economy to private companies.  State owned enterprises are being streamlined.  The courts are being made more honest.  And a shift is underway to allow the citizens to enjoy the fruits of their labors.  In the past workers were paid short money.  Much of that went into savings because their was little to buy.  President Xi is raising incomes, expanding benefits, and re-orienting the entire economy towards consumer goods and consumption -- and away from industrial production and exports.

That's bad news for companies -- and entire countries -- that supply commodities that used to be consumed by China's industrial juggernaut.  In the past, when bankers from Boston ran the financial system, an adjustment process might have occurred.  But it would have been nothing compared to what Bill Clinton, George Bush, and Barack Obama have engineered.  Interest rates have been suppressed since the mid-1990s, when Robert Rubin left Goldman Sachs to become Secretary of the U.S. Treasury.  Capital was and continues to be mis-allocated as a result.  It was especially bad in the commodity sector.  Easy access to low cost credit caused a massive build-up in mining, energy, and even semiconductor facilities.  In the past those Boston bankers would have said, "Nothing lasts forever.  Your cost of capital is going up.  We won't be a party to some mindless expansion."  Benjamin Bernanke, Janet Yellen, and to a lesser degree Alan Greenspan went the other direction.  They kept interest rates artificially low to "stimulate growth," even if the growth was based on unrealistic projections.  Like corporate CEOs, they had to make their numbers, too.

Over-investment is not a problem in the United States.  Our financial policies created an enormous increase in liquidity.  But much of that went overseas.  And the rest disappeared in the bowels of the Federal Reserve.  The U.S. Government bought up nearly $4 trillion in bonds since 2008.  The Fed issued money to buy those securities.  But then it outbid the market for the freshly minted cash that stayed home, burying it away in "excess reserves" instead of leaving it in the economy.  Money supply growth remains 6% a year despite the so-called "money printing operation."  While much of the world is entering a Boom-Bust cycle, the United States is poised for something more along the lines of a Bust-Bust.  U.S. output remains far below its potential as a result of the misguided policies.

The U.S. economy has been struggling since 2009.  Bank regulations have prevented small business from building momentum.  That's enabled large corporations to impose a private regime of wage controls.  Anti-trust regulation hasn't been pursued at all.  That's allowed the big companies to control prices, too.  Ask anyone who gets cable television or takes an airplane flight.  The Legacy of Robert Rubin is amplifying the pressure.  When Rubin took charge Bill Clinton was in the same boat as Barack Obama -- Neither cared a whit about economics, finance, and business.  They took advice from "experts" and put on their stamp of approval.  The problem is, those experts have their own agenda.  In Rubin's case, he persuaded President Clinton that, "It's the bond market, stupid."  The official inflation target came down from 3%-4% to 2%, courtesy of Alan Greenspan -- who understood which side his bread was buttered on.  That helped Goldman earn a fortune with its bond trading.  It helped its rich customers.  It boosted merger fees.  It helped underwriting.  It also facilitated additional maneuvers, like eliminating Glass-Seagal.

Everybody always regales Ronald Reagan for crushing inflation.  And there is no question, he did bring it down from Jimmy Carter's double digits.  In 1981 inflation in the U.S. was 10.3%, Reagan's first year.  There typically is a 12-month lag for financial policy changes to take effect.  The next seven years inflation went 6.2% - 3.2% - 4.3% - 3.6% - 1.9% - 3.6% - 4.1%.  The one low number foreshadowed the 1987 market crash.  Reagan kept inflation at 3%-4%, courtesy of Alan Greenspan.  He knew that growth would be higher if there was more money in circulation.  People would use it.  They'd live their American Dream.  It worked.  GDP grew 2.6% in 1981 and declined -1.9% in 1982 as the adjustment took place.  Then GDP expanded 4.6% - 7.3% - 4.2% - 3.5% - 3.5% - 4.2% through the end of his presidency.

Today, the Wall Street - MIT - Princeton axis has decided the correct inflation rate is 2.0%.  When Ronald Reagan shot for 4.0% and came up short for some reason, the economy still had ample money to work with.  Under the Clinton-Bush-Obama slave ship approach there's plenty of money for Apple Computer and Google.  But nothing for the average American.  Barack Obama has made things worse, moreover, by implementing a raft of regulations on top of his unfair financial scheme.  Instead of stepping in to help the American people directly, his actions interfere with their ability to enjoy life.  He's as deluded as The New York Times and the rest of the Ivy Leaguers who can't or won't do the math.  "Reduce interest rates and our work is done!"  Well, not exactly.

At this point we'll interrupt the story with our market forecast.  Stock prices have marched higher since The Obamanomics were installed in 2009.  That trend should continue.  Interest rates will remain lower than their natural level.  P/E multiples will be artificially enhanced, as a result.  Fortune 500 level companies are likely to experience earnings slowdowns, perhaps a decline, due to their far-flung operations.  The strong U.S. Dollar causes foreign income to be translated at a lower rate.  Business activity is moderating overseas, although not as much as the Ivy Leaguers think.  Energy companies are under the gun.  Rather than enact an import quota on oil and help the domestic industry thrive the Administration prefers it drop dead.  (Nancy Pelosi - "Oil and gas is a Republican industry.")  Banking earnings are stymied by the interest rate policy and Dodd-Frank lending restrictions.  A cornucopia of rules and regulations block other efforts.

If earnings stall the indexes probably won't go anywhere, either.  We doubt that situation will be long-lived.  Low oil prices already are driving economic growth around the world.  Europe is improving.  China, for all its perceived problems, continues to expand at 7% according to the Government and 3%-4% in reality.  Not bad for a recession.  Once the earnings picture improves the Fortune 500 types will resume the stock buybacks, mergers, and special dividends.  That money will flow to institutional investors, who will reinvest it -- pushing the market back up again.

Small cap growth stocks are likely to roll sooner and faster.  Those stocks have been hurt by knee-jerk reactions.  They are are less liquid and more vulnerable to fleets of fancy.  When the first pigeon sells they all sell.  The underlying fundamentals are stronger than the Fortune 500, though.  Exports in total account for only 13% of U.S. GDP.  Many of these companies do less than that.  Even the ones that do conduct lots of international business should do well as the world economy rebounds.  Smaller companies are more nimble and often respond with superior products and services.  Well run operations have a great opportunity, one that promises to continue through the end of the decade.

Don't worry about the stock market.  Stay invested in a diversified portfolio of high potential Special Situations.

Back to the story.  Yes, we are a big fan of Donald Trump.  Right now he's acting up, to get attention and solidify his place in the presidential race.  But he'll settle down when push comes to shove, and he knocks out Jeb Bush and then Hillary Clinton.  The Trumpster is a real estate guy.  He makes things happen.  It's all about doing stuff, making the country great again.  Donald Trump isn't tied up with the bond traders like Bush and Clinton.  He sees the MIT economists as a bunch of losers.  Jeb Bush says he'll grow the economy 4% a year.  But he can't, not with his ties to Wall Street.  Neither can Hillary Clinton.  The Trumpster will clean house, put money back into the hands of the average American, and supervise an explosion in economic growth.  The rest of the world can join up and play along.  Or they can go screw.  If you're an American it's a winner either way.

Walter Ramsley
Executive Editor

The 2016 Election Outlook

America went through an economic malaise during the 1970s.  Personal incomes grew faster in those days than they have under the current regime.  But inflation was even higher.  Real progress was ephemeral.  That didn't stop the stock market.  It doubled, coming off a low base.  Those gains evaporated, though, as the financial engineering of the day reached the end of the line.  It took Ronald Reagan to display the necessary courage to restore the economy to a normal footing.  And that took Milton Friedman, the leading economist of that era, to design a common sense solution.  That approach was termed "monetarism."  It was implemented in practice by Federal Reserve chairman Paul Volcker.  They scuttled the Keynesian nonsense used by Jimmie Carter's team.  In it's place they installed a traditional market based system that let the people decide for themselves where interest rates belonged.  Volcker increased the money supply by 5%-7% per year.  That accommodated 3%-4% real economic growth, split half and half between productivity improvement and more people working.  The remainder provided some inflationary grease to the system.  Interest rates fluctuated according to the market's demand for money.  Price changes accelerated and then decelerated.  Economic activity ebbed and flowed.  It all stayed within a normal band.  The only real blow-up that occurred was the Savings & Loan collapse.  That was the result of federal regulations imposed during the Carter Administration that guaranteed the S&Ls would go broke.  The free market worked fine.  President Reagan was no genius.  But he was smart enough to know that the American people don't need Washington to decide how they should live their lives.

The 2007-2008 financial crisis was treated with Keynesian theories similar to the ones Carter tried.  The details were different.  But the basic strategy of appropriating the people's freedom of choice is identical.  The Federal Reserve decided what the level of interest rates would be.  It also created $2.8 trillion of Bernanke Bucks, cash that's been squirreled away in the bowels of the bank.  But that's cash that could resurface as the quantitative easing strategy unwinds.  Ever since Benjamin Bernanke gained control of the economy immense capital dislocations have taken place.  Productivity is below average.  Wages are below average.  Employment is below normal.  Everything is below normal, essentially, except for the people and who benefited from the Government's intervention.  Today's situation is completely different from how it would be if the American people been left on their own.  That was the case in Carter's time, too.

The question Wall Street is starting to contemplate -- What's going to happen if interest rates return to normal?

Even a minor hike could send the stock market into a significant pullback.  Unwinding Bernanke's quantitative easing program will be uncharted territory.  Several options are available.  None have been used in practice, though.  Printing the money was the easy part of Quantitative Easing.  Even that scared investors for a while.  Un-printing it, aka "removing the punch bowl," usually is less fun.  Doing that with techniques that never have been tried before might create real problems.  Even if nothing horrible does occur, the uncertainty is bound to exert pressure on market valuations.

A knee-jerk reaction could present an attractive buying opportunity.  It could be a great one.  Perhaps it's by design.  More likely it's just coincidence.  Either way, today the M-2 money supply in the U.S. is expanding at a 5%-6% rate.  Just like Reagan.  The natural short term interest rate might actually be 1%-2% at this stage of the game.  It could be that's where it belongs.  The unwinding may not represent much of a threat after all.  There are any number of explanations.  The most obvious is that the rich people really do have too much money now, they won't spend it, and they can't invest it because there aren't enough places to put it.  So they stash it in existing stocks and bonds, art, and real estate.  The corollary is that Government regulations are deterring investment.  It's hard to get a loan.  It's hard to get a permit.  It's hard to avoid prosecution for violating obscure rules.  The supply of investment opportunities is much lower than it should be.

A return to a less centrally controlled economy could unleash another Golden Era.  The newspapers and television shows always look at politics as a matter of Democrats against Republicans, or liberals versus conservatives.  The real battle in 2016, if you're interested in economics, will be Keynes versus Friedman.  Central control versus freedom of choice.

Frankly we've had enough of Bill Clinton and his bond traders.  The fellow who reversed Reagan's approach was Robert Rubin, previously the head of Goldman Sachs.  "The stock market means nothing.  It's all in the bond market."  Rubin shoved down interest rates and kept them there, like a tried and true bond guy.  He had a few good years as the U.S. technology sector exploded by coincidence, revolutionizing the way people live.  Productivity went through the roof.  Rubin attributed all that innovation to low interest rates.  If you're a hammer everything looks like a nail.  If you're a bond trader, it's all low interest rates.

Mitt Romney planned to heave the money changers out of the temple and restore Reagan's formula for growth.  He ran a terrible campaign in 2012, though, and lost an election he couldn't lose.  Hopefully the Republicans will nominate another pro-growth candidate in 2016.  If they don't -- this may sound a little hard to believe  -- the best person to get the country moving again could be Elizabeth Warren!  Her personality probably rules out any chance of winning.  And even if she did, Senator Warren might shoot herself in the foot by over-regulating the economy.  But the bond traders would get the boot.  That would be a major accomplishment.

Walter Ramsley
Executive Editor

Oil Spill

The decline in gasoline prices was the big story during the fourth quarter.  Crude oil prices began that downward move earlier in the year.  The price per barrel was more than $100 before prices gradually started to fall.  Many industry analysts pointed to the U.S. Dollar's surge in value as the culprit.  That reinforced downward pressure on commodity prices in general.  Some commodity exporters reduced gasoline subsidies as a way to help balance their budgets.  That caused consumption to drop in several countries that buy political support with energy and food subsidies.  Worldwide growth was moderating anyhow due to sanctions against Russia in Europe, a completely new government strategy in India, and a transition towards a more consumer based economy in China.  The United States and the more with-it parts of Africa, Southeast Asia, and South America continued to expand, keeping the worldwide numbers reasonably intact.  But crude production outpaced demand, fueled by predictable gains in the United States and more sudden bursts in Libya and Iraq.  Those countries have massive reserves and moved fast to make some money as military hostilities abated.

Saudi Arabia and its Middle East partners were expected to cut output to keep supply in balance and prices steady.  That's their traditional role and there was no indication they wouldn't do it again.  Of course, they kept output running at full blast this time around.  It was so out of character and economically unnecessary a lot of people, ourselves included, assumed the Saudis had an ulterior motive.  We figured it was exerting pressure on Iran to agree to an ironclad nuclear treaty, and was helping the U.S. force Russia into a Ukraine deal in the bargain.  That still seems like a logical explanation although a second narrative has emerged.  That one describes Saudi Arabia as becoming fed up with the United States policy towards Syria and Iraq and the rest of the Middle East.  And as retribution it's crushing the American energy revolution.

More likely, the whole thing has just spun out of control.  None of it was planned to go the way it did.  The worldwide supply and demand equation for crude oil remains pretty close.  Inventories built up in 2014 due to Libya and Iraq moving into the market, combined with modestly slower consumption growth.  Some technical factors added to the imbalance.  For instance, natural gas liquids (NGLs) are a fracking by-product.  They get mixed in with gasoline and other crude based products.  Ethanol production increased, too.  But the size of the supply-demand imbalance is far smaller than the price decline would suggest.  Wall Street and the hedge funds perhaps amplified the move.  But that tail could wag the dog in a completely different direction if sentiment changes.

It's impossible to predict how the situation will be resolved.  American drillers seem to require $75 oil just to break even with their existing cost structure.  Those costs are coming down in a hurry, though.  Some basins already enjoy lower break even points.  It's extremely unlikely that the market price will return to $100 a barrel any time soon.  Indeed, triple digit oil prices may not be seen again for years.  The marginal cost of production is coming down due to America.  And offshore reserves are being developed at $50-$60 break even points.  Prices eventually will have to rise above those break even points to allow for some profit.  Otherwise the development won't occur.  But the industry is poised to remain on course.  Today's low prices will bolster economic activity and build demand.  They'll also stimulate innovation and cost reduction.  No doubt some jackass companies will help Iran and Russia and Venezuela and Iraq to modernize their energy industries.  But most of the investment almost certainly will gravitate to America.  The outlook is a little crazy today but $1.79 a gallon is an interesting place to start.

All of the energy related stocks we follow were impacted by the plunge in crude oil prices.  Those declines were amplified, moreover, by further weakness in the U.S. natural gas market.  Prices in that segment are below replacement cost these days, as well.  Computer Modelling, a long time favorite, is experiencing an upturn in business among a lot of its customers.  Alternatively, orders are falling in the Canadian tar sand segment due to the high cost structure there.  The Keystone XL pipeline might improve the situation.  Just as likely, U.S. frackers in North Dakaota will hijack the pipeline for their own benefit.  The company supplies software that helps oil and gas producers maximize production from the fields they're working on.  The fracking revolution already has improved the hit rate on new drilling to 90% compared to 10% in the old days.  Even so, the formations are complicated.  Computer Modelling helps producers attack their fields efficiently, getting more bang for the buck.  A more traditional oilfied supplier, Profire Energy, offers computerized hardware systems that remove impurities when oil and gas (either) are lifted out of the ground.  Business has moderated temporarily as customers husband their financial resources.  But Profire has penetrated a very small part of the market to date.  It faces little competition.  And it has developed two more high potential products using the positive cash flow it generates from its core business.

Green energy investments have been hammered, too.  Highpower International is a leading manufacturer of lithium-ion batteries used primarily in consumer electronics at this stage.  But the company is expanding quickly into the electric vehicle market in China.  That business is being stimulated by poor air quality in many Chinese cities.  The government has made it a top priority to eliminate as much of that pollution as it can by converting from gasoline to electric and hybrid vehicles.  Sevcon is involved in that business, as well.  Both companies have partnered with top tier bus and car manufacturers.  That's critical because everybody and their Uncle Wang is diving into the business.  Building poor connections could lead to disaster.  Making good ones could propel financial performance to spectacular levels.  Both companies have solid foundations but have seen their shares fall of late due to the oil price pressure.

The drop in energy related shares exerted a drag on our performance during the December quarter.  Up to that point we had been ahead of the market, despite significant headwinds that dimmed overall small cap performance.  Last year investors swarmed into index investing.  The macroeconomic scene remained difficult to fathom.  So investors found safety in numbers.  Rather than pick stocks they invested in the market.  That flow of funds lifted prices for those stocks that were part of the indexes.  The ones that didn't belong, though, their performance lagged.  Statisticians use a measure termed "relative strength" to compare how an individual stock performs against a particular index, like the S&P 500.  A rating of 100 means the stock appreciated the exact same amount.  A value of 110 means it outperformed by 10%.  Last year the average relative strength rating of all U.S. stocks was 91.  That means the average stock appreciated 9% less than the S&P 500.  The big cap index, which attracted all that money, was up 11% for the year.  The average individual stock, though, rose a mere 2%.  That trend is continuing so far in 2015.  But value is value and money is money.  A slingshot in the other direction seems inevitable.

It's hard to say what will trigger that.  Wall Street analysts live and die in the short term.  The first thing an aspiring stockbroker learns to say is, "You have to buy this today!"  They earn their keep on commission.  "Steady as she goes" isn't a money making sales pitch.  We were disappointed when the American people rejected Mitt Romney and re-upped with The Obamanomics in 2012.  But that was their right.  And here we are, slogging to the finish line.  We've discussed the administration's "Groundhog Day" economic policy several times in the past.  The American people finally have started to fight back and push forward despite the obstacles it creates.  But nothing has changed enough to make us think a meaningful improvement will occur before the next president takes over in 2017.  It could take even another year for that group to re-tool everything.

The recent stock market volatility seems like much ado about nothing.  Oil prices will recover somewhat but they likely will stay low by historical measures.  Interest rates will stay low unless the Federal Reserve artificially drives them higher.  Everybody thinks the Fed is aggressively holding rates down today by intervening in the Treasury market.  The data suggest otherwise.  Money supply growth is 4%-5%.  The velocity of money is at 60 year lows.  No wonder there is no inflation.  The U.S. Dollar is up because the amount in circulation isn't growing nearly as fast as before.  The underlying economy is okay, which provides a nice cover story.  But incomes aren't going up.  And the rich have so much money, the supply of capital far exceeds the investment opportunities that are available.  Dodd-Frank legislation stymied housing investment.  It also reduced new business formation, typically the biggest engine supporting jobs, income, and economic expansion.  Barack Obama attached a tax hike and a bullet train to every piece of highway and airport legislation that was proposed.  The only thing everyone did agree on was to spend more on fighting wars in the Middle East.  That could have produced a high rate of return, if we had managed the outcome the way Harry Truman did in Germany and Japan.  Unfortunately, a different approach was followed.

More positive news is being reported in the developing world.  Back in 1998 currency woes drove most emerging nations into deep recessions.  That's occurring again in some cases.  Russia, Nigeria, Venezuela and a few other dictatorships that rely on commodity exports are in trouble.  But many lesser followed nations have modernized their economic and legal systems, becoming more business friendly in the process.  Large swaths of Africa and South America have reduced their dependence on exports and diversified with greater emphasis on services and local directed manufacturing.  Less graft has allowed infrastructure investments to flourish, as well.  Foreign investors have moved into countries like Zambia and Chile, insulating them from the latest currency and commodity moves.  Larger countries like India and China are transitioning in that direction, too.  While worldwide economic growth is sure to slow a bit as a result of recent events pockets of strength are likely to hold up, keeping the overall picture intact.

Several stocks we follow have been impacted by knee-jerk reactions to the general currency and commodity trends.  LRAD, for example, is bidding on several Middle East projects.  Investors are worried the decline in oil money coming in will cause the projects to be cancelled or delayed.  But Saudi Arabia is committed to maintaining 4%-5% GDP growth even if oil prices remain at depressed levels.  A political transition is underway there, as well.  Domestic spending is virtually certain to be maintained by the new leadership to preserve political support.  SuperCom also is pursuing several emerging market contracts.  The company implements digital identification systems that help countries collect taxes and keep track of their citizens' comings and goings.  Some projects probably will be delayed until economic conditions stabilize more.  But a number are moving forward, laying the groundwork for sustained sales and earnings growth.  SuperCom also is developing a mobile payment system for less developed economies, allowing users to spend and collect digital funds using old fashioned cell phones that cost much less than the iPhone-6.  Evolving Systems also emphasizes the Third World.  One prospective contract, aimed at Russia, might go forward despite the recession that is occurring there.  More likely, that project will slip as the government marshals its diminishing cash reserve.  Still, Evolving is closing in on several other contracts in better situated nations.Those deals, like SuperCom's, foreshadow extended recurring revenue streams.  They also encourage competitors and nearby countries to adopt the technologies, providing additional leverage.

Slow economic growth combined with abundant capital promises to keep the stock market in good shape.  Big Cap stocks have become overvalued with the index style investing of the past several years.  A return to a more logical approach that looks at individual performance is brewing.  Don't worry about the general market.  Stay invested in a diversified portfolio of Special Situations.

Walter Ramsley
Executive Editor

2014 - Third Quarter Review

Small cap stocks fought an uphill battle in Q3.  Investors around the world reduced risk in response to a cacophony of geopolitical and economic factors.  The back-of-the-envelope move was to shift funds into more secure investments.  In ancient times, say ten or twenty years ago, that would have entailed selling shares in vulnerable companies and buying into safer ones.  Nowadays, with the trend towards indexing, there's less discrimination involved.  Investors make a short-cut decision that big cap stocks are safe and small cap stocks aren't.  Or they move in and out of entire industries with sector specific ETF's ("Electronically Traded Funds").  That's a convenient strategy for massive portfolios.  But the tail can wag the dog for individual stocks.  Good companies get thrown out with the bad.  And that creates opportunities.

That ETF gravitational pull dragged down our performance.  Walrus Partners' S-2 fund endured a -2.70% decline in the September quarter.  That was less than the Russell 2000's setback of -7.36%.  But our showing was below that of the major indexes, like the S&P 500, which benefited from the changing flow of funds (+1.13%).  We only had two stocks (UQM Technologies and Napco Security) that reported lower than expected financial results.  The fund's mediocre performance mainly was due to diminished investor confidence.  That probably stemmed from slow growth in Europe, questions about China, conflict in Ukraine and Iraq, and the Ebola crisis.  Even the U.S. looked peakid despite the fact it continues to outperform the rest of the world.  Real personal income still is lower than it was before the 2008 collapse.  And the unemployment rate would be 10.4% today if the work force participation rate was the same as it was back then.

Strong business performance didn't necessarily translate into stock price gains.  Our largest holding, Profire Energy, posted spectacular June period results.  Our estimates for the oilfield equipment manufacturer were pretty aggressive but the company topped them, nonetheless.  Despite that the share price fell -8%.  It's now trading at 20x earnings despite the fact it is capable of growing 50% compounded or more over the next several years.  Industry factors explain the short term pressure.  Slow economic growth worldwide combined with expanding U.S. oil production caused crude prices to slide over the summer.  Saudi Arabia ordinarily would have scaled back output to buttress the market.  But the Saudis are relying on America to stabilize the Middle East and contain its arch enemy Iran.  The decline in price could make it easier for us to extract a nuclear deal with the Persians.  It also may put the squeeze on Russia, helping us in Ukraine.  Profire is continuing to race along with a unique product aimed at a huge market with little direct competition.  When the big picture improves substantial appreciation is possible.

Highpower International bucked the trend.  Those shares advanced +66% as the company found new and large markets for its lithium batteries.  Highpower already is well established in the consumer electronics area.  The company specializes in plastic lithium power supplies for cell phones, laptop computers, and a wide range of similar devices.  This year it penetrated the electric vehicle and solar back-up segments.  New capacity is coming on line.  Margins are poised to widen as those economies of scale are realized.  Sevcon is another likely beneficiary of the electronic vehicle ramp-up underway in China.  Up to now China has been a copy-cat economy.  Air pollution has become so severe, though, that it has taken the lead in electric vehicles.  Sevcon is a well-established provider of computer controls for battery-powered vehicles, both on- and off-road.  A recent venture with a huge Chinese partner could multiply the company's size over the next few years.

Several stocks are poised to take off in the short term.  Cyanotech is a producer of natural astaxanthin, a nutrional supplement that reduces sunburn, macular degeneration, and joint pain.  It also boosts athletic performance and may have anti-aging characteristics.  Demand is booming.  The company already owns 50% of the specialty retail market.  Now it's expanding distribution with larger retailers like Vitamin Shoppe, Costco, and Whole Foods.  A costly legal battle is coming to an end.  That expense has eaten up most of Cyanotech's earnings over the past two years.  As those costs reverse and the business continues to expand reported income could soar.

Northern Technologies is virtually unknown even among small cap aficionados.  Earnings are growing faster than sales in the core business.  And total income is being amplified by the company's entry into the oil and gas market.  Northern has a unique way of preventing steel from rusting while it's being shipped or sitting in inventory.  At the end of the manufacturing process steel typically is painted or processed in some way, which prevents rusting.  But while it's sitting around steel can rust in a hurry.  Northern provides a simple solution to the problem.  It also operates around the world, providing multinational customers with an end-to-end solution.  Now the company is protecting offshore oil platforms and onshore storage tanks.  Earnings growth is gaining further momentum as a result.

Health Insurance Innovations is the only stock we added in the quarter.  The company is a leading provider of Short-Term Medical health insurance policies.  Those offer the same coverage as major medical plans, but they fall outside the new Obamacare rules.  Short-Term plans are for a fixed period, usually 6-12 months.  They don't automatically renew.  And they only are sold to people who pass the physical exam.  Because the plans are sold exclusively to healthy people, they cost 40%-50% less than comparable Obamacare plans.  The company recently expanded into the general health insurance market, as well, with the launch of a website that displays information on virtually every plan that's available coast to coast.  Individuals do the research themselves on the site.  Then, after they've narrowed down their choices, they contact one of Health Insurance Innovations' call centers.  The company helps them select the best one.  It earns a commission when the transaction is complete.  Deal flow has risen dramatically.  That trend could accelerate further when the Obamacare open enrollment period begins in November.  The closing rate is higher, too, because the call centers are dealing with informed customers.  In the past a lot of phone calls were from people inquiring from scratch.

The outlook for the stock market as a whole remains decent.  Reported earnings probably will moderate in Q3, and perhaps for a few quarters after that, in response to the strengthening U.S. Dollar.  Foreign income will translate at a lower rate.  But real business performance will be largely unaffected.  Most U.S. companies retain their foreign earnings overseas.  Returning those funds makes them subject to steep taxes.  If the money never moves currency translation becomes an academic exercise.  Foreign results also might be diminished by slow going in Europe.  Up to now Germany has blocked a full scale stimulus effort.  Germany itself is sliding into a period of negative growth, though.  The money is likely to begin flowing before long, to prevent the mother ship from sinking if nothing else.  That could benefit the entire region.

QE-4 is winding down in the United States.  Many investors worry that the lack of bond buying will lead to a crash.  What they forget is that the U.S. money supply has grown 7% annually no matter what the QE situation has been.  Any extra money has been sucked out of circulation and stored as excess bank reserves by the Federal Reserve.  Overall liquidity won't be meaningfully affected by the program's end.  Interest rates are likely to stay low, perhaps for the entire duration of President Obama's second term in office.

Special Situation growth stocks could enjoy strong gains once conditions stabilize.  Our 2015 earnings estimates (see the following table) suggest an average year-over-year improvement of +94%.  Our portfolio's average PE multiple for 2015 is 17x.  Sentiment on Wall Street has turned negative.  Once everything converges a sturdy uptrend could develop.

Walter Ramsley
Executive Editor

( Click on Table to Enlarge )

Special Situation Investing

The U.S. stock market has come under renewed pressure.  In the short run prices are falling across the board.  Before long, though, the fear is likely to dissipate.  Investors then will put all that cash back to work.

Special Situation growth stocks thrive in periods like this.  Capital always seeks out its highest return. Every once in a while the market loses its bearings and measures those returns in non-financial ways, like website clicks or probable barrels of oil reserves.  It invariably comes back to money, though.  Special Situation growth stocks produce the best returns because they consistently make money, they increase those earnings quickly, and the price to get into the stocks isn't particularly high.  They are under priced in relation to their true value.

Special Situation growth stocks share a number of characteristics.  They're in the "Post-venture, Pre-institutional" segment of the market.  The companies are out of the development stage.  But the stocks still haven't been picked up by the mutual fund community to any meaningful extent.  They have several years of experience with clear-cut track records.  Finances are solid.  Management is proven.  The products and services have unique elements, so margin potential is high.  The companies are scalable with superior returns on invested capital.  Some external financing might be necessary to fund exceptionally fast periods of growth.  But dilution tends to be modest because cash flow generation usually is sufficient to support growth internally.

There are three basic types of stocks we focus on.  The first are "natural breakouts."  These often are the most profitable.  They also are the most difficult to find.  This group consists of companies that are middle of the pack growth companies -- that catch fire.  They've spent years cultivating their business.  Now it's taking off.  If you wait too long to purchase these shares they get discovered by other investors instead.  Get in too early, you run the risk of buying the story instead of the facts.  The only way to discover a "natural" is to scan the universe for signs of acceleration, and dig down into every one.  Most are aberrations.  But a few are the genuine article.  In those cases the payoff can be terrific.  Examples include Profire Energy ("American") and Highpower International ("Fuel Forethought").

The second group are established growth companies with upside kickers.  Investors are inundated with stories about companies that are gonna' do this or gonna' do that.  In their younger days those investors probably were swept up by some of these stories.  They've learned the hard way that it's a hard world.  Very few of these things ever pan out.  So investors as a group don't pay a premium for them in the market.  Special Situation growth stocks already have a proven business, though.  That gives them an edge.  The core operation is delivering 15%-25% growth or more.  Unlike the start-ups that investors are accustomed to, new initiatives at these companies tend to be well thought out and adequately financed.  Their success rate is higher.  Not all of those initiatives prove successful.  It's still a hard world.  But even when they don't you haven't paid for the kicker.  And the core business keeps rolling along.  Examples include Northern Technologies ("American") and Pure Technologies "(International").

We include a handful of high risk selections, as well.  Management at these companies have an established track record, either in development work or at previous employers.  But the commercialization phase is just starting.  Risk is elevated because there is no core business to pay the bills if things get delayed.  It's do or die.  But this type of Special Situation growth stock normally has a disruptive technology aimed at a huge industry.  Even modest penetration can lead to unusually high stock price appreciation.  Because of the risk we have to keep this segment to a low percentage of the entire portfolio.  The payoffs can be fantastic, though.  Even small positions can amplify the portfolio's entire return.  Examples include Tesla Motors ("Fuel Forethought") and Lightbridge Technology ("Fuel Forethought").

Special Situation growth stocks don't grow on trees.  You need to know what to look for.  And it takes a lot of looking.  Computer screens are great at generating leads.  Watch the news.  Study the IPO market.  There's no end to where the ideas can come from.  The key is to know what you're looking for and to do the work yourself.  Even at the institutional level -- perhaps especially at the institutional level -- the last thing you want to do is listen to a research analyst or broker's buy recommendation.  That ship has sailed by the time they figure it out and finally tell you about it.  Do the work yourself.  Then trust it.

Sound portfolio management controls risk and helps generate consistent, superior returns.  Academic studies suggest 5-8 stocks provide sufficient diversification.  We generally own 20-25 stocks ourselves, to make sure the volatility is kept in check.  Every stock you buy looks like a winner the day you buy it.  Experience shows that 10%-20% won't work out as expected, though.  And only 10%-20% are going to achieve their maximum potential.  The 60%-80% in the middle are solid growth companies.  That component frequently outperforms the market all by itself.  The super winners invariably are bigger than the losers, moreover, lending further ammunition.  Our advice is to equal weight the portfolio.  Nobody can predict how each stock will go.  Use a systematic approach.  Do the basic analysis correctly.  The math will take care of the rest.

It's pretty simple.  Special Situation growth stocks have a well established track record of success extending back to the mid 1970s.  We think that trend will continue.


Walter Ramsley
Executive Editor

Don't Cry for Me, Argentina

Everybody had a good to reason to explain why the stock market caved in last week.  Our comments last month discussed how investors had ignored a series of threats while bidding prices up to record levels.  Last week those threats caught up.

Potential policy changes at the Federal Reserve are the greatest concern.  The decision earlier in the year to eliminate "quantitative easing" created a sell-off in April.  That proved to be a shot across the bow.  At last week's meeting, though, the bond buying program dropped to $25 billion per month -- down from the $85 billion pace Ben Bernanke originally set up.  That grabbed people's attention.  By October it will be zero.  Whether it's myth or reality, most investors believe (deep down) that stock prices levitated 30% in 2013 because of quantitative easing's stimulative powers.  Now they're afraid valuations will reverse course once the money is withdrawn.  Corporate earnings have expanded 15% during the two years that QE-4 has been in place.  So even if valuations return to where they began the pullback shouldn't be a full retreat.  Still, in this day and age most money managers are graded on how well they do every quarter, if not every month.  There are a lot of itchy trigger fingers out there.

Argentina's bond default got a lot of people thinking about the potential for unexpected side effects.  That particular situation is small potatoes.  Argentina had the funding in place to complete a refinancing -- one that included a substantial write down.  An American hedge fund insisted on full repayment and hung up the deal, causing a technical default.  The larger question investors began to ask is, "What about Russia?"  That's a big time country with complicated and vast financial ties.  Might the bank sanctions now going into effect cause some missed payments?  And what would that cause?  And while we're at it, if the Federal Reserve tightens how's that going affect the Third World?  The U.S. Dollar already is undervalued.  If it just returned to normal currency values could plummet in some weaker economies, like Brazil.  If interest rates go up in America, that would make it even more of a pressure cooker.

Those are genuine concerns.

Lucky for the people who live in America, none of this presents a major problem.  Indirectly it sure could, if you're invested in a Philippines rubber plantation or something.  But the U.S. economy is well insulated from those financial dangers.  And quite frankly, the fighting in Syria, Israel, the Ukraine, and Africa doesn't have anything to do with us, either.

Some economists say the U.S. economy is gaining momentum.  Others say that may be true but it doesn't matter because so many idle resources still exist.  The official unemployment rate is 6.2%.  But if the same number of people were in the work force today as there were in 2007, before the crash, the rate would be 10.2%.  Clearly, some people have left the work force and are never coming through that door again.  Still, if there was money to be made a lot of those non-workers would be back in a flash.  On top of that, corporations have amassed unprecedented cash reserves.  Capital spending has been low and the outlook remains mediocre.  If a pick up ever does materialize a handful of companies might have to borrow to fund their expansion efforts.  On balance, though, the spending would be financed internally, alleviating any pressure on interest rates.

The economy could be slowing down a little, in fact.  Consumer spending is going nowhere.  Housing is nothing special.  Government spending is up in some areas (health care) but down in others (military).  Back to school spending is off to a ho-hum start.  Things could change.  Right now, though, it looks like 2%-3% real GDP growth is here to stay.

The stock market is its own animal.  The elimination of QE-4 could exert a direct impact on market liquidity.  Then the question becomes, "Where do you put the cash instead?"  It's not going into the economy.  Dodd-Frank continues to prevent small businesses from starting up and expanding.  The Affordable Care Act adds further costs and regulations.  The regulatory apparatus in general weighs on businesses of all stripes and sizes.  Corporate buybacks will continue.  Money created by the European Central Bank will gravitate to America.  And quite frankly, the U.S. money supply grew at 7% a year before QE-4 and it grew at 7% a year while it was in place.  The extra money was siphoned away and deposited as "excess reserves" at the Federal Reserve.  The whole thing has been a smoke and mirrors job.  Market liquidity is unlikely to change much, if it all.

We think the market will be fine.  We think America will be fine.  Over the long haul corporate tax rates are certain to decline, increasing earnings.  Economic activity should accelerate once the more onerous regulations are modified to encourage more realistic and productive behavior.  That will boost sales growth, leveraging profit margins.  The rest of the world should grow.  U.S. companies will participate in that, too.  American oil and gas production is on the rise.  Less money for OPEC.  Lower costs for us.  And less need to defend far flung oil reserves.

Don't worry about Argentina.  Don't worry about the stock market.  Remain invested in a diversified portfolio of high potential Special Situations.

Walter Ramsley
Executive Editor

Don’t Look Back… …Something Might Be Gaining On You – Satchel Paige.

If you’re a regular reader of these pages then you know that we harbor a fondness for most things baseball. The game is at once purely American and thoroughly idiosyncratic. It’s a game of inches and it’s a game of wits. A contradictory pass-time: games have no time limit yet speed is highly rewarded. It is a treasure trove of wit and wisdom, too, that at once illuminates both the game and life. Small wonder that it can also provide guidance to students of the markets, as well.

U.S. markets continue to blithely skip along, oblivious to a multitude of gremlins on their trail. Punk GDP metrics, signs of a re-awakening of inflation, contradictory employment numbers, chaos in health care markets, frightening portents in Syria and Iraq, stalled de-leveraging of American households’ balance sheets and so on and so on.

As of this writing, most professionals are waiting, with some trepidation, to hear about one of the bigger gremlins: first quarter U.S. Gross Domestic Product (GDP) growth. Markets have been in full Bull mode for well over a year now, based at least in part on the assumption that the U.S. economy is finally shrugging off the funk it's been in since the end of the “Great Recession” over 5 years ago. GDP growth has been below its long term trend ever since then.

Because so many people are interested in this number every quarter, the Commerce Dept. actually does this calculation 3 times. A flash estimate is produced once the first 2 months of a quarter are “in the can.” After the quarter is completed a full quarter estimate is then calculated. Finally, once all the numbers are in, a final report of the annual rate at which GDP grew in a quarter is published.

The flash estimate for Q1, 2014 came in last month at a rather anemic +0.1%. The chill winter weather that brutalized much of the industrial heartland and the trucking and rail lines that traverse it got most of the blame for the number being on the light side. It is tough to get to work when your car is snowed in, frozen solid or your bus doesn't show up in the morning so most economists looking over Commerce's shoulder expected this figure to be lower than even the modest recent trend.

Eyebrows shot up like Roman candles when the full quarter estimate came out at a -1.0%. Cold weather was again blamed for turning down the thermostat  on the economy. But there were other factors at work, it seems. Investment, one of the 4 main components of GDP, and the most critical one for job creation, was looking very “molasses in January”-like, too. Since most investing these days, be it in stocks and bonds or plant and equipment, happens inside of computer spreadsheets and networks, the weather is not as huge a factor as it is in consumption (people can't get to the mall) or export (goods can't get to shipping terminals). Health care services spending also took a surprising dip. This not a great portent for either the benighted Affordable Care Act or for the final Q1 GDP growth rate.

We could be in for a lower “real” number than either of those estimates, perhaps as low as    -2.0%. Many strategists are assuming that there will be a robust snap-back from what they think is an entirely weather-related phenomenon. We'll see. Consensus expectations for 3%+ growth this year will need to be adjusted downward in a major way if Q2 does not show a big reversal. A lower GDP rate ultimately means that companies' competition for their share of the business pie gets tougher because there is less growth to go around.

What else might be gaining on the markets? Inflation, for one. Our main takeaway from the most recent Fed Open Market Committee meeting is that “Core Inflation” may, in their view, be starting to heat up. This Core Inflation measure is what the Fed uses to guide them in fulfilling their mandate to promote price stability; it removes energy and food prices because of their volatility. Now, when we do our budget every month, food and energy are pretty big factors in figuring if there will be “any month left over when the money runs out.” According to the Fed's math, inflation has been in check for several years, even though most everything that people spend money on costs more.

Should price inflation by the Fed's measure heat up, then we're all in for some tough decisions. The Fed, too. They'd like to keep borrowing rates at the rock bottom levels they've engineered. But higher inflation could force them to raise those rates, which would translate into an increase in the cost of capital. Typically, that's not good for stock prices. However, some believe this could ultimately be a good thing, since the rate structure we have now is artificially imposed and is grossly distorting capital investment policies. If forced to decide, we'd join the latter camp.

On the world front, fractiousness in Eastern Europe and turmoil in Iraq and Syria could be bringing an end to the relative stability we've experienced in oil prices. If we've heard it once we've heard it a thousand times: oil price increases act on the economy much like a tax increase. Please, don't let our peeps in Washington, D.C. know that: judging by their behavior, they think tax increases are a good thing.

Perhaps the biggest something that might be gaining on us is the national debt. It has now surpassed the nation's GDP and it is growing at a faster rate. Should the rate of interest that the Federal government pays to carry this level of debt increase, it alone could blow out our government's already dysfunctional budgeting capabilities.

So, there are plenty of “somethings” that might be gaining on us. Moreover, left to themselves, the capital markets are the best mechanism we have for discounting what may  lie ahead and allocating resources accordingly. Almost by definition, markets don't look back, they look forward. Normally, a rising market is telling us that all of the somethings we talk about and fret over are already known, already “built in” and that something better is coming along. And, normally, we can't ever quite completely believe it. That's why we always return to our core belief in Special Situation investing. Government meddling, foreign intrigues, even “Black Swans” come and go. But there are always Special Situations, companies discovering new needs that people want to satisfy and devising new ways of making things or doing things to satisfy them. Dozens, if not hundreds, of such companies. They don't all succeed but they all go their own way. They don't look back. They don't have time to.

PS Bonus Satchell Paige quote: “My pitching philosophy is very simple; you gotta keep the ball off the fat part of the bat.” Can the Federal Reserve keep our economy off of the fat part of inflation's bat yet keep the ball over the plate? Sounds like a tough job for a rookie pitcher like Janet Yellen.

R. Russell Last, CFA

Walrus Partners, President