First Quarter 2015 Client Letter

As many of you are aware, I periodically teach college courses – more for the sheer joy of it than anything else.  Heaven knows I have more than enough with the business to keep me busy, but I really enjoy helping people to learn about how investing works and what makes the world of stocks and bonds go around.

One of the basic theories in the investing world is the idea of “efficient markets”.  That is, stock prices – and, by extension, markets – reflect all relevant information and so represent the true value of the stock or market at any point in time.  The giant mutual fund company, Vanguard, is a big proponent of this theory.  If you subscribe to the idea of efficient markets, then it should be impossible to “beat” the market and you should merely buy a stock (or bond) index fund.  Perhaps this is why Vanguard likes the theory so much – they are one of the largest providers of index mutual funds.

Digging a little deeper into the idea of efficient markets, there are a few key assumptions worth considering.  One is that all investors are rational…. WAIT a minute!  Hold the phone!  All investors are rational?!  In reality, investors tend to be collectively, well, bi-polar (or manic-depressive, if you will).  Benjamin Graham, the father of value investing, noted this phenomenon in the 1930’s and attempted to explain it by creating a mythical “Mr. Market” character.  One day, Mr. Market is hyped up to buy stocks from you at any price.  Two days later, Mr. Market is begging you to buy those same stocks back.  He is willing to mark their prices down just to get rid of them.  The nice thing, according to Graham, is that we, as individual (and hopefully rational) investors, can choose to play his game or not.  The key is to remain calm and rational and focus on intrinsic value, not the whims of Mr. Market.

So just how insane are investors collectively?  Let me give you some examples just from this past quarter.  First, going back to the end of January, the Federal Reserve, the governmental agency that ultimately sets interest rates throughout the economy, released minutes from their January meeting.  What investors took away from these notes was that the Federal Reserve was on track to start raising interest rates and probably by mid-year.  Why would the Fed want to raise interest rates?  Because the economy was showing signs of getting stronger and growing nicely, thank you very much.  How did investors react to this idea?  They sold stocks.  They could not wait to dump them!  Apparently, the prospect of better earnings from the companies they own was a worse prospect than perennially low interest rates and weak earnings.

Fast forward to the end of March.  The government released information about job growth in March.  The expectation was for around 220,000 jobs created in March.  When the statistics were released, the actual number came in around 126,000 instead.  Oh my!  This was not good!  Job growth was very weak.  This must be a bad thing, right?  So, of course, the stock market rose!  Why?  The thought (according to our Mr. Market) is that if job growth is this weak, the economy is not strong enough to sustain rising interest rates, so the Federal Reserve is not likely to raise rates any time soon.  So what is an investor to do with situations like this?

Well, at the risk of giving away all of my secrets, the short answer is – nothing.  I am only partly joking here, of course.  In truth, more often than not, my job is to do absolutely nothing.  No trades.  No harm.  No foul.  There are certainly days when I feel like I have to DO something.  I have to do SOME thing.  I usually lie down until the feeling passes.  Seriously, I have found that more often than not, all I really need to do is little tweaks here and there, such as making sure that a particular stock is not too large of a position in a client account.  If it is, then we sell some shares to reduce the risk to the portfolio.

Apparently, I made some good “no calls” this past quarter.  Things went pretty well for us, as most accounts were up and by a nice margin over the broad stock indexes.  Much of this I attribute to controlling risk.  I would be the last to tell you that we picked all winners or that every stock did well for us.  We still hold, for example, Conoco Phillips (COP) and Marathon Oil (MRO) – two large oil companies that have been hurt by the plunging price of oil.  However, these were offset by holding Kohl’s Corp (KSS), a low price retailer that has actually benefited from the lower oil prices as consumers have spent a bit more in recent months.

This does not mean we are sitting idly watching the volatility pass us by.  We have actually taken advantage of much of the volatility we have seen.  We have used down market days to sell put options – which obligate us to purchase shares of the underlying stock – to collect some healthy option premiums.  We have used big up days to sell call options against stock positions – obligating us to sell the underlying stock.  We have done this on stocks that we are looking to sell out of anyway, hoping to increase our return from the sale by the option premium collected.

We will continue to look for opportunities that Mr. Market sends our way.  However, as Warren Buffett has observed, we really do not have to do anything at all, which gives us the chance to await the proverbial “fat pitch” – the slow pitch right over home plate that we can knock out of the park.  Until then, rest assured that I can usually be found doing nothing.  I could only wish that were true!

As always, we do truly appreciate the trust that you have placed in us with a portion of your assets.  If you have any questions or need to discuss any issues, please feel free to give us a call.

Sincerely,
Alan R. Myers, CFA
President / Senior Portfolio Manager
Aerie Capital Management, LLC
(410) 864-8746
(866) 857-4095
www.aeriecapitalmgmt.com

Fourth Quarter 2014 Client Letter

This past year was both predictable and unpredictable.  At the end of last year, we anticipated that, if companies were able to sustain their expected growth rates of 10%, we could see the stock market up a similar percentage.  In the end, we were pretty spot on, as the Dow Jones Industrial Average gained about 7.5% while the S&P 500 Index was up 11.4% for the year.   The key reason for this performance was a continuation of solid economic activity here in the U.S.  In addition, while the Federal Reserve finally ended their controversial bond-buying program in October, they have pledged to keep interest rates low, in their words, “for a considerable period”.  This promise of continued low interest rates helped feed the market, though having the Fed stop the bond buying did increase volatility.

In spite of our great prognostication ability at market growth, there were several things that no one could have predicted without looking like an idiot.  For example, no one would have thought that oil, which started the year near $100 per barrel, would finish the year around $50 per barrel.  And who would have thought that the best performing sector in the markets would be utilities – normally a defensive sector in times of recession.  This was an outgrowth of stubbornly low interest rates.  In fact, the yield on a 30-year Treasury bond, which started the year at 3.9%, ended at 2.75% for the year.  Interest rates were supposed to increase, not decrease!

So what do we have to look forward to for 2015?  Will the markets, already at record highs, continue to climb this year?  Will the U.S. economy continue to grow, fueling more earnings growth from companies?   Here are a few things on our radar:

  1.  With oil just below $50 per barrel, we are already seeing companies canceling energy projects.  This will eventually cause oil to find a floor and possibly rebound, though $100 oil is not likely any time soon.  This will be a net positive for the economy, as fuel prices have fallen dramatically, but there will be job losses, too.  The net effect is a little murky.
  2. Greece is again in the news (much like two years ago) with an election.  There is another need for a Greek bailout and the threat of Greece leaving the Euro.  Frankly, the Euro has held up as a currency longer than I ever expected, so I would not be surprised if Greece exits and others follow suit down the road.
  3. Slowing growth in China – growth largely supported by excess government spending – could cause a slowdown in U.S. growth.
  4. There is a chance for increased volatility around the Fed’s first rate hike.  While this is widely anticipated and one of the most telegraphed hikes in history, there could still be some jitters.
  5. There is almost certain to be more volatility in the stock market than we have seen in the past few years.  One key reason for this is the ending of the QE bond-buying program by the Fed.  This program continued to pump cash into the financial system, which, rather than find its way to capital investments by companies as hoped for, managed to find its way into the stock markets.  With this source of liquidity gone, we will return to a more normal level of volatility in the stock market, though that make take a bit getting used to again.  It is a bit like being on land too long and then heading back out to sea.  It takes a bit to get your sea legs under you.
  6. There is always the threat of a “black swan” event that no one sees coming.  Markets hate uncertainty and there are enough “hot spots” around the globe to fuel plenty of fear and uncertainty.  With North Korea, Russia, ISIS (or ISIL), Iraq, Syria and who knows what else is brewing that has not made headlines yet, there is plenty to be cautious about.

With all of those issues, one could easily be pessimistic.  I am more optimistic.  While I do not discount the risks I have enumerated above, there is still a lot to like about the markets and stocks in general.  This is especially true if the focus is on the right area.  Many of the stocks that did best for us last year did well regardless of what happened in the world.  Some of our best performers included Fisher nut producer John B. Sanfilippo & Son (JBSS), UnitedHealth Group (UNH) and Kayne Anderson Energy (KED), which holds shares in a number of oil and gas pipeline partnerships that make money for simply transporting these commodities around the country.  Do you see a common theme here?  They are all focused on the U.S.

I have been focusing on U.S. companies, lately.  There is still room for growth left in our economy and this will continue to feed earnings.  This does not mean there are not risks.  In spite of great job growth over the past year, when the U.S. economy added almost 3 million jobs, there is anecdotal evidence of labor shortages among skilled workers.  The unemployment rate that I prefer to look at, called the U-6 rate, also measures underemployed and people who no longer “officially” counted.  This has fallen to 11.1% as of the end of December, down from 13% at the end of 2013, but still well above its long-term trend line around 9% annually.  So there is still room for job growth.  The question is, do these workers have the right skill set for the jobs we need.  As long as job growth can continue and the economy gets boosts like lower oil prices (more money in people’s pockets), we should continue to see earnings growth among companies.

As always, we do truly appreciate the trust that you have placed in us with a portion of your assets.   If you have any questions or need to discuss any issues, please feel free to give us a call.

Alan R. Myers, CFA
President / Senior Portfolio Manager
Aerie Capital Management, LLC
(410) 864-8746
(866) 857-4095
www.aeriecapitalmgmt.com

Third Quarter 2014 Client Letter

This was a moderately tough quarter and not just in the markets.  The U.S. is once again embroiled in a conflict in the Middle East with ISIS, which is a new terrorist group in Syria and Iraq.  The Ebola virus is spreading in central West Africa and only recently entered the U.S.  We saw falling oil prices largely driven by a strengthening U.S. dollar (oil is priced in U.S. dollars around the world, so if the dollar is stronger, it takes fewer dollars to buy the same amount of oil).  Europe is in the midst of a recession and their version of quantitative easing.  Meanwhile, our Federal Reserve continues to taper its bond-buying program, which has led to increased stock market volatility.  In spite of all of this uproar, the broad indexes seemed to paint a picture that all is right with the world.  The Dow Jones Industrial Average and the broader S&P 500 Index both ended the quarter with modest gains.  But was this reality?

Oftentimes, we talk about stocks based on their ‘market cap’ or market capitalization.  What we are referring to is the market value of all of the shares outstanding for a company.  Typically, analysts and financial advisors will segment stocks into small capitalization stocks (small cap), mid-cap stocks and large cap stocks.  There is no hard and fast rule for what constitutes each area.  A good rule of thumb would be that a small cap company has a total market capitalization of less than $2 billion, a mid-cap company would have a market capitalization between $2 billion and $6 billion and a large cap company would be worth more than $6 billion.

What does this have to do with us?  Well, it has a lot to do, actually.  While the broad indexes were up slightly for the quarter, if you dig beneath the surface, you would find a very different picture.  In fact, while the Dow and the S&P 500 indexes were up, these indexes tilt heavily towards large cap stocks.  Mid-cap stocks actually fell 4.33% and small cap stocks fell 7.65% for the quarter.  This did not help, as we tend to lean more towards the mid-cap and small cap space for investment ideas.

We still had a reasonably good performance, in spite of the tilt towards the more volatile small and mid-cap space.  There were some accounts that showed small losses for the quarter, but we do not worry about a single quarter.  You can also rest assured that I am not sitting by, idly twiddling my thumbs or singing Monty Python’s “Always Look on the Bright Side of Life”.  I have been actively seeking ways to minimize losses while keeping us invested as much as possible.

In addition, as I mentioned near the top of the letter, we are seeing more volatility due to the QE program ending.  In the past, whenever there was a small dip in the stock market, buyers would step in.  The investment world was awash with cash from this bond-buying program.  With the tapering of the quantitative easing program, the amount of cash to flow into the stock market is reduced which is likely to lead to greater volatility – or, actually, a return to more normal levels of volatility that we have forgotten about.  This may mean we do a bit more trading than we have done in the recent past.  However, this will also create opportunities for us, but that does not mean that we will buy a stock just because the price has fallen.

So what am I doing to help mitigate the risks from this volatility?  Well, as you may recall from last quarter’s letter, I mentioned that I have started using the 200-day simple moving average as an indicator of when to sell securities we own.  I chose this specific indicator for several reasons.  There are a number of popular moving average ranges that traders will employ, from a 10-day moving average to 50-day up to a 250-day moving average.  The shorter the period used, the smaller the losses you might suffer, as the moving average will identify a change in the trend sooner.  There is a cost to this, however.  Typically, if you use a shorter moving average, you end up trading more frequently.  “We’re in the stock.  No, we’re out.  No, we are back in.  Now we are out again….”  Using a longer period means that we may have to endure a bit more volatility in the short-term but we also trade less frequently.  I want to use a signal that will allow us to be investors, not traders.  In addition, the 200-day moving average is popular with many traders making it a broadly watched signal and one that many others will follow as well.  I am still looking for fundamentally sound companies trading at reasonable prices.  I am also primarily looking for us to be long-term investors in the stocks we buy.  However, if the trend in a particular stock changes, I have no problems with selling.  We can always come back and buy the stock again if things change for the better.

I continued to use this moving average this past quarter to help mitigate risks in several stocks we own. We saw, for example, Standard Motor Products (SMP) stock fall below its 200-day moving average.  We have nice gains in this stock, so we trimmed some shares.  In addition, we sold options against our position in this stock.  We took in about $1.40 per share for each option, which mitigates much of the drop in price.  Currently, it looks as if our options will expire worthless.  If so, we will be able to rewrite new options later this month.  However, if the stock closes above $35, we will happily sell (that is the price where we would be obligated to sell our stock) and, given the premium we took in, collect our $36.40 per share to move to greener pastures.

As always, we do truly appreciate the trust that you have placed in us with a portion of your assets.   If you have any questions or need to discuss any issues, please feel free to give us a call.

Alan R. Myers, CFA

President / Senior Portfolio Manager
Aerie Capital Management, LLC
(410) 864-8746
(866) 857-4095
www.aeriecapitalmgmt.com

Second Quarter 2014 Client Letter

With apologies to The Fifth Dimension (and, at the risk of dating myself), up, up and away in my beautiful, my beautiful…bubble? As the market has continued its inexorable climb the overarching question seems to be how much further can we go. After all what can go wrong? The only risks we currently face are military situations in Eastern Europe… and the Middle East…and China’s slowing economy…and oil prices rising…and, well, you get the idea. In spite of this great wall of worry, the long-term outlook for the U.S. economy is positive. Earnings expectations are for 4% growth per quarter for the next several quarters for the S&P 500 companies. The stubbornly high unemployment rate is slowly creeping downward. The best measure of the unemployment rate is not the officially announced number of 6.1% at the end of June, but is probably a number officially known as the U-6 rate. This rate measures all those unemployed plus those marginally employed (part-time work because that is all they can find) plus all those that have dropped off the official unemployment rolls but are still actively looking for work. This number currently stands around 12.1% of the labor force but that is down significantly from the 17.4% rate in October 2009. Prior to the 2008 financial crisis, the long-term average for this measure was around 9%, so we are slowly creeping close to normal.

The truth is we probably have more room to the upside, though I will readily admit that stocks are getting pricey. As you may recall from my last quarterly letter, one of my new “toys” for evaluating the overall health of the market is the CAPE ratio – the cyclically adjusted P/E ratio. This ratio stood at 21.29 times operating earnings as of the end of the first quarter, which was a small drop from the year-end number. While this may seem high, the average of this ratio since 1998 has been around 23 times operating earnings. This would argue that we still have a little bit of “wiggle room” for stocks to continue higher.

Regardless of what ratios may indicate, there is still a real danger of stocks being in a bubble. There has been much talk and speculation about that very topic. If you search “stock market bubble 2014”, you get something like 52 million hits. The list of articles include everything from predictions about when the bubble will burst (assuming we are in one, of course) to how to protect yourself from the bubble bursting to articles debunking the bubble idea. The simple truth is stocks may be a bit ahead of themselves largely because they are the only game in town. The Federal Reserve has worked to drive down interest rates, which makes bonds a terrible investment currently. The key reason for the low interest rates has been to entice businesses to invest. If borrowing costs are low, businesses should be eager to borrow money to invest in new property, plant and equipment. However, that is just not happening and one side effect has been to drive investors into more risky (read: stocks) assets. This has sustained the stock market’s rise. The argument is that when interest rates start to rise, money will come pouring out of stocks and into bonds which tend to be safer investments, thus bursting this investment bubble. This argument has some merit. The key issue, though, is timing. When will interest rates start to rise? How quickly will they rise? How quickly will investors shift their investment choices from stocks to bonds?

With no clear-cut answer to these questions, we fall back on an old Wall Street maxim – never fight the tape. That is, when momentum is moving in your favor, you do not try to move in the other direction. One good way to do this is to use technical analysis to help make decisions on when to buy and when to sell. I recently read a couple of articles published by a former business school professor of mine. He has done some work on technical analysis – specifically a naïve measure called a “simple moving average”. His conclusion is that using simple moving averages has the ability to capture trends. In other words, you can “see” when a stock is going up and when it might be going down and take appropriate action based on the moving average. Actually, the idea of using moving averages is not new. In fact, some of the most successful commodity traders of all time use technical analytic tools such as moving averages to choose when to buy and when to sell.

We employed this strategy this past quarter. One of our holdings, TESSCO Technologies (TESS), had fallen below the 200-day moving average, thus signaling future weakness. We had already sold some shares in the first quarter of this year as the stock had run up tremendously, but based on this new information, we sold out of the stock completely. It turns out that we have been right, as the stock has continued to lag the market since we sold.

Many of you may have noticed a relatively new mutual fund appearing in your accounts. I am slowly moving cash into a mutual fund that invests in “floating rate loans”. Floating rate loans are senior loans to corporations that adjust their interest rate periodically. These loans are typically a great investment during a rising interest rate period. The mutual fund we are using, the T. Rowe Price Floating Rate fund (PRFRX), has a current yield of just over 3.5% and we can trade it with no fees as long as we hold it for at least 90 days. This is why we are scaling in to the fund. Eventually, this will be where we park our cash in client accounts. That way, clients will earn something rather than nothing as most cash holdings currently earn. There may be a little bit of cash left in some accounts to allow for selective opportunities that come along but the tendency will be to invest as much of the cash as possible.

As always, we do truly appreciate the trust that you have placed in us with a portion of your assets. If you have any questions or need to discuss any issues, please feel free to give us a call.

Sincerely,
Alan R. Myers, CFA
President / Senior Portfolio Manager
Aerie Capital Management, LLC
(410) 864-8746
(866) 857-4095
www.aeriecapitalmgmt.com

First Quarter 2014 Client Letter

This past quarter brought back a long-lost friend to the investing world – volatility.  We saw the S&P 500 Index try to break out to new highs  before dropping nearly 6% in early February, then climbing to new highs in early March before backing off a bit to close up a measly 1.3% for the quarter.  There were several key reasons for this volatility.  These included the Russian invasion of Crimea, the lackluster earnings reports from companies reporting year-end results, the continued weak jobs recovery and the incessant snows that seemed to occur week after week, slowing consumers and prompting many companies to forewarn of weakened earnings this quarter. In fact, we have had a few companies (very few) start to report first quarter earnings and the trend is not good, so far, with almost half reporting earnings below expectations. 

In looking at where we currently stand, it would seem that stocks might be a bit overvalued.  One of the newest “toys” that I have found to play with is something called the CAPE ratio – cyclically adjusted PE ratio.  Dr. Robert Shiller of Yale University developed this measure.  It is essentially the current price of the S&P 500 index divided by the average, inflation-adjusted earnings over the past ten years.  Currently, this number is a bit above “normal”, which would flash a caution signal.  So does this mean that we should sell everything and retreat for cover?

The short answer is “no”.  Just because the market is overvalued, does not mean that every single stock is overvalued.  In fact, most of the stocks and portfolios that we have created for clients are not highly correlated with the market.  What that means is that when the broad stock market zigs, we don’t tend to zag along with it or nearly as much.  Instead, we tend to fall less than the broad stock market.  Much of this is due to our attempts at risk control.

Let me explain a bit further.  As many of you are aware, we had a stock blow up on us this past quarter.  We came into the year with a number of clients owning shares in an oil pipeline company called Boardwalk Partners.  When Boardwalk reported their 2013 earnings, they also dramatically cut their dividend.  We had expected a potential cut in their dividend of ten cents or so from the $0.53 per share they were paying.  Instead, they cut the dividend TO ten cents per share!  This took us completely by surprise.  It did not just surprise us.  Several other well-respected analytical agencies (Morningstar, for instance) were also caught completely off guard.  The stock price plummeted and we bailed out of our shares.  We lost all faith in management to provide adequate guidance or leadership.  In spite of this setback, almost every account showed gains for the quarter with most accounts even beating the broad stock market.  Many of the accounts that simply matched the index performance were holders of Boardwalk shares.  We would attribute this ability to earn positive returns even in the face of adversity to our risk control for clients.  So we return to the question at hand and reiterate that we do not think there is any need to sell out of stocks in spite of the broad market risks. 

This does not mean that we will not sell anything.  In fact, during the quarter, we did selectively take profits on stocks that have done well, selling out of some shares of TESSCO Technology (TESS), for example.   This stock had grown to an uncomfortable level in many accounts.  By selling some shares, we added cash to client accounts and reduced client risk.  We will continue to monitor holdings for advantageous opportunities such as this.

While it may seem counterintuitive, we would actually welcome a bit more volatility.  As I mentioned above, we currently see the broad stock market as relatively fairly valued, if not a bit overvalued. This plays out in our not being able to find good buying opportunities.  With increased volatility and the potential for market pullbacks, we would expect to have bargains presented to us.  We have a shopping list ready but we are just awaiting the right price for some of the names on our list. 

One last thing that I wanted to touch on was a recent report that many of you saw on the CBS News program “60 Minutes”.  The segment included an interview with noted author Michael Lewis about a new book he has just released titled “Flash Boys”.  The book was about something called “high frequency trading”.  Several of you have asked me if this high frequency trading or HFT affected us.  Indirectly, yes.  The way we see this played out is in the price that we pay.  What happens is that we enter an order to buy, say 5,000 shares of XYZ Company stock at a maximum price of $54.50 per share.  Some HFT firm will see that order before it actually gets to the exchange because they have a faster computer than anybody else.  This trader will then step in, buy 5,000 shares of the stock for $54.495 per share, then turn around and sell it to us for $54.499 per share.  Now, on the surface of it, we came out a bit better by 0.001 cent per share.  However, this is not necessarily fair.  Why were we not given the opportunity to purchase the stock for $54.495 per share?  Prior to HFT’s, we might have had the opportunity.  This is what Michael Lewis was talking about when he was saying that the markets are rigged.  The answer to this problem is actually an easy one – restrict high frequency trading.  The stock exchanges sell the rights to get quotes faster to these traders and the SEC can restrict the exchanges’ ability to do this.  But that is a topic for another discourse.

As always, we do truly appreciate the trust that you have placed in us with a portion of your assets.  If you have any questions or need to discuss any issues, please feel free to give us a call.

Sincerely,

Alan R. Myers, CFA
President / Senior Portfolio Manager
Aerie Capital Management, LLC
(410) 864-8746
(866) 857-4095
www.aeriecapitalmgmt.com

Fourth Quarter 2013 Client Letter

If you have not been living under a rock for the past year, you are probably aware that the stock market has been on quite a tear of late! For 2013, the broad stock market, as measured by the S&P 500 Index, ended up almost 30% for the year and closed the year at an all time record high. The more popular Dow Jones Industrial Average (DJIA) also closed the year up 26.5% at its all time high.

So what led to this skyrocketing market? As it turns out, there are two basic components that go into the calculation of the value of an index. One is the amount of net income the companies in the index earn for the year. The second is how much investors are willing to pay for those earnings. For example, if the total net income from all of the companies in the index totaled $100 and investors were willing to pay 10 times those earnings, the index would be $1,000 at that point.

With this information, we can look at both of these components to see what drove the gains for the year. Earnings grew 4.93% year-over-year through September. However, if we look at analysts expectations for the full year, earnings are expected to be 11.8% ahead of last December. If we assume that companies really do end the year with a bang and report earnings that are pretty close to what analysts expect, then about 12% of the market gains were due to companies making more money, which is a good thing. This is more proof that our economy really is getting better, albeit grudgingly. But where did the rest of the gains come from?

Well, at the end of 2012, investors were willing to pay about 16.5 times the total earnings of all of the companies in the index. As of the end of 2013, investors were willing to pay about 19 times the expected earnings for the entire year through December (assuming analyst estimates are pretty close). The Price-to-Earnings ratio (PE ratio), which is what this measure is called, grew 15.5% for the year. Investors were “bidding up” what they were willing to pay for stocks. This is an indication that investors were taking on more risk throughout the year. In other words, even as earnings were growing for companies in the index, investors were paying higher premiums to purchase this stream of earnings. It was almost as if investors were chasing stocks as the only place to invest – which they were, in large part.

So, with investors taking more risk with stocks, it was hard not to do reasonably well this past year. Just about all stocks gained ground. We had quite a number of successes in client accounts such as Navios Maritime (NMM), which ended the year about 35% higher than where we purchased it, and TESSCO Technologies (TESS) which gained 82% for the year. Among the new names we added in the fourth quarter were John B. Sanfilippo & Son (JBSS), which processes and sells nuts primarily under the Fisher brand name, and a convertible preferred stock from National Health Care (NHC). This last holding is a class of stock that is convertible into shares of the common stock at about $65 per share. The common stock is currently selling for about $53 per share, so for now, we are happy to collect the dividend. Currently, the shares pay a healthy 5.35% dividend based on our average purchase price. If, as we suspect, the company continues to do well – it runs 130 assisted living and retirement homes around the nation, so it should be a big beneficiary of an aging population – then as the common stock continues to climb in value, eventually our share values will climb as well.

The inevitable question is what can we expect for this year? Are the gains of 2013 sustainable? With the economy continuing to get better, companies are likely to continue their earnings growth. Analysts expect the companies in the S&P 500 Index to grow their earnings by about 9.6% this year. We think that may be a bit too optimistic, but we do expect continued earnings growth. The bigger question, though, is what investors will be willing to pay for those earnings. If investors maintain their same tolerance for risk, we could see stock gains in line with the 10% growth in earnings. If investors increase their appetite for risk – that is, if they pay more for that stream of earnings than they currently are paying, we could see another 20% – 30% gain. However, that would approach bubble territory for stock prices and that would really cause us to cut back on our equity exposure. If investors become more cautious, we could see the index actually fall a bit. For example, if earnings do increase as analysts expect, but investors become more cautious and only offer to pay the 16.5 times earnings they were paying at the start of 2013, the index would actually fall about 5% for the year. If earnings fall short of expectations, this would lead to a larger pullback.

The bottom line is that we enter 2014 cautiously optimistic. While we have been talking in broad generalities about stock indexes, keep in mind that we are not buying the indexes. We are buying individual securities. We have focused on a healthy mix for client accounts. We have some stocks that have great growth potential such as TESSCO Technologies (TESS) and Kohl’s (KSS). We have some stocks that pay higher dividends such as Navios Maritime (NMM) and National Heathcare preferred (NHC-A) which can help limit our downside risk. Lastly, we have some big name companies that offer stability but continued growth potential such as Wells Fargo (WFC) and United Healthcare (UNH). The one thing we will keep an eye on is the risk tolerance of investors. If it appears that investors are reducing their risk tolerance, then look for us to become more defensive in our holdings.

As always, we do truly appreciate the trust that you have placed in us with a portion of your assets. If you have any questions or need to discuss any issues, please feel free to give us a call.

Sincerely,
Alan R. Myers, CFA
President / Senior Portfolio Manager
Aerie Capital Management, LLC
(410) 864-8746
(866) 857-4095
www.aeriecapitalmgmt.com

Third Quarter 2013 Client Letter

We come to the end of another quarter and the market just seems to keep rolling along.  The S&P 500 finished the quarter up 4.7% and up almost 18% for the year to date.  We continued to hit new highs for both the Dow and S&P during the quarter before we fell off at the end of the quarter in the face of political turmoil over the U.S. budget and debt ceiling.  The new highs in the indices came in spite of many companies having warned of lower earnings for the second quarter and delivering on these warnings. 

This trend of companies warning of lower-than-expected earnings underscores what we think is a weak growth environment and fragile recovery.  The warnings by companies also pointed out the over-optimism of many analysts.  It’s not that companies earnings did not grow.  They just did not grow as quickly as many had hoped.  Operating earnings for the S&P 500 companies was about 3.7% higher for the quarter over the same period last year.  This was in line with the growth in the overall economy for the second quarter which was about 2.5% for the quarter. 

This stalemate in Congress over the debt ceiling leading to the first governmental shutdown since 1996 is not helping this fragile recovery.  The shutdown began when some Republicans demanded a repeal of or, at least, a delay in the Affordable Care Act (aka “Obamacare”).  This has since become a cry for negotiations on budget cuts.  While we readily acknowledge that budget cuts are needed and entitlements reformed, the manner in which Congress arrived at this point has been less than stellar.  We presume Congress and the President will work this out sooner rather than later, but the longer this shutdown continues the more we run the risk of a recession.  However, we still have the Federal Reserve continuing its bond buying program.  While this quantitative easing or QE program does provide a sort of floor underneath the market, it cannot sustain the markets forever and will not keep stocks from falling.  The key is to not panic and to find ways to take advantage of these dips.

Given the turmoil in the markets, it’s a bit tricky to figure out where we stand.  For example, we recently attended a luncheon sponsored by the Baltimore CFA society.  We were treated to an okay crab cake and a talk by Dr. Jeremy Siegel author of the book Stocks for the Long Run.  Suffice it to say that  Dr. Siegel is very positive on stocks, well, for the long run.  He argued that stocks are very undervalued at the moment.  His talk was very interesting and provided us with some new insights to follow up on as we continue to research new investment ideas.  No sooner had we digested the crab cake and Dr. Siegel’s outlook, when we saw a chart on CNBC’s show Options Action indicating that stocks might be near a peak level.  The chart indicated investors are now at a point of having borrowed on margin more to buy stocks than they ever have before. The last two times margin debt was this high was just before market tops in 2000 and 2007.

So what’s an investor to do? Do we run for cover or do we wade in and start buying more?  The one thing that is certain in the markets is uncertainty.  The key to beating uncertainty is not to try to “market time” – that is, to try to pick the market bottom or top – but to focus on quality stocks that show growth potential while managing themselves conservatively.  If we believe that we are in the early innings of an economic recovery – and we do – then we should be buying on these dips. 

This past quarter saw minimal changes for client holdings.  We added one company to client accounts in the third quarter.  This was mattress material maker Culp Inc (CFI) which we bought across a number of client accounts.  Culp is a relatively small company but is the industry leader in mattress material.    Not only is this a play on a continued recovery in the economy, but it is also an indirect play on a housing recovery.  The only other change of note was the elimination in a number of client accounts of one ETF, or exchange-traded fund.  We sold off all of the iShares S&P Global Energy ETF (IXC).  We had written options against our position several times in the past and we finally had our shares called away from us this past September.  The fund was just not performing up to the standards we had hoped and many of the companies in the fund were no longer the bargains they were when we first bought shares.

Going forward, we are prepared for volatile times ahead and we already have ideas on how to take advantage of this volatility.  Do not be alarmed if you see stocks appearing in the next quarter that do not pay dividends.  While we have focused on dividend paying stocks in the recent past, we did not always do so.  Sometimes, finding a great investment means finding a company that can make better use of its capital by reinvesting it rather than paying it out.  We have a couple of names on our ‘watch list’ that meet this criterion but we are awaiting a better price.  Just because we purchase a stock that does not pay dividends does not mean we have lost our minds.  We will continue to focus on companies with great prospects and a margin of safety selling for a fair price. 

As always, we do truly appreciate the trust that you have placed in us with a portion of your assets.  If you have any questions or need to discuss any issues, please feel free to give us a call.

Sincerely,

Alan R. Myers, CFA
President / Senior Portfolio Manager

Aerie Capital Management, LLC

(410) 864-8746

(866) 857-4095

www.aeriecapitalmgmt.com

Second Quarter 2013 Client Letter

We have just come to the end of another quarter and things keep rolling right along. As expected, we had another interesting quarter with much excitement along the way. After a bang up first quarter, we rolled on into April and May with a string of ever higher closes week after week. We finally peaked at 1669.16 in mid-May before the market paused to catch its breath. By late June, we got word from the Federal Reserve that their quantitative easing program – their addition of cash into the banking system via bond purchases – was not going to last forever. This spooked the markets for a week or so as interest rates spiked a bit and stocks sold off. However, things began to recover towards the end of June as reality began to set in that a strengthening economy was probably not such a bad thing after all.

The big news as we head into the second half of the year is the Fed’s tapering – eventually. Everyone knew it had to come. It was always a question of “when” not “if”. Until the June Fed meeting, the timing was left very open-ended with a ‘we’ll taper when unemployment reaches an acceptable level’ type of talking point. After the June meeting, Fed Chairman Ben Bernanke stated the Fed could start tapering “within the next few meetings” which would indicate towards the end of this year or early next year – not a surprise to most everyone. However, this news sent shivers through the markets as interest rates popped and stock prices fell. Here is why both happened…

If the Federal Reserve reduces the amount of bonds they purchase, this has two effects. One is to reduce the amount of cash going into the monetary system (i.e. our economy). The second effect is to raise interest rates and this is what chilled markets. If interest rates rise, newer bonds with higher coupon rates (i.e. interest rates) will be more attractive than older bonds with lower coupon rates. Markets tend to be forward looking, so with traders anticipating rising interest rates, they sold bonds, especially Treasury bonds that, while safe, tend to have the lowest interest rate. If you can purchase a safe Treasury bond that guarantees you 4 – 5% interest, you are more likely to do that than to purchase a stock that pays a 2% dividend and offers up the chance to earn 6 – 7% but with a lot more risk involved. It comes down to a question of a safe 5% versus the possibility of 8 – 9% but with a lot more risk and even a good chance at losing some of your principal. Many investors – retirees, especially – would prefer the safety of the higher yielding bonds.

So where does that put us? We have been gradually adding stocks that either are immune to interest rate increases or my benefit from this increase in rates. We have added UnitedHealth Group (UNH), a health insurance company that could be a beneficiary of the implementation of the Affordable Health Care Act (aka “Obamacare”). In addition, UNH will benefit from the aging population as one of the top providers of supplemental Medicare insurance. We have also followed Warren Buffett into one of his long-time favorites as we have added shares of Wells Fargo & Company. This is currently one of the best run banks in the country, having steered clear of any controversy during the financial crisis and even stepping in to rescue Wachovia Corp, which was a victim of overreaching, bad management and too many bad mortgages on their books.

We have also been looking at reducing some of the risks in the portfolios, having sold off all of our holdings in one bond fund, the iShares Barclays TIPS (TIP). We eliminated this fund largely because of price risk – the share price of this Exchange Traded Fund (ETF) was falling and, with no catalyst for inflation on the horizon, there was nothing to entice buyers to this fund. We also eliminated our holdings in Sensient Technologies as we felt this stock was getting ahead of itself on a valuation basis.

Going into the second half of the year, while the Federal Reserve’s QE program will still act as a support to the markets, we think there is going to be an increased focus on company fundamentals and growth as the economy continues to inch forward ever so slowly. We do see one big cautionary note. A recent report from financial publisher Thomson Reuters noted that 93 companies in the S&P 500 index have issued negative preannouncements to their upcoming quarterly earnings report versus only 14 companies with positive announcements. Why is this significant? This is a much higher ratio of companies with bad news than is common. Typically, we see a ratio of 2.4 companies warning investors ahead of time for each company that cannot wait to brag. This quarter, the ratio is over 6.6 times (see the article here). This is a little bit worrisome and may be indicative of the economy running out of steam for the moment. This is partly why we have been a bit more cautious of late and still hold a fair amount of cash in client accounts. If the volatility we expect does materialize, we anticipate taking advantage of this situation by adding some new positions to client accounts.

And, as always, we truly appreciate the trust you have placed in us and the opportunity you have given us to manage a portion of your assets. If you have any questions or need to discuss any issues please feel free to give us a call.

Sincerely,
Alan R. Myers, CFA
President / Senior Portfolio Manager
Aerie Capital Management, LLC
(866) 857-4095
www.aeriecapitalmgmt.com

First Quarter 2013 Client Letter

It seems like only yesterday we were here saying nearly the same thing.  The market went on a tear this past quarter, with the S&P 500 Index rising 10% and the larger cap Dow Jones spiking 11.3% for the quarter.  By the end of March, U.S. stock markets had surpassed their all-time high previously reached in October of 2007.  Much of the optimism driving the market arose from the agreement in early January to avoid the so-called “fiscal cliff” – the expiration of lower tax rates and the dramatic cutting of government spending which, taken together, could have easily thrown the U.S. economy into a recession.  And, once again, these gains more often than not came “in spite of” rather than because of some major catalyst.

In spite of the deal to avoid the fiscal cliff, a tax cut on Social Security contributions was allowed to expire which impacted take-home pay for everyone.  In addition, the deal did not avoid the so-called sequestration which promises to cut some $850 billion in government spending in this year alone.  Over in Europe, all was still not in order.  Italy held elections in February which resulted in a convicted felon (former Prime Minister Silvio Berlusconi) and a comedian (Beppe Grillo) being elected to Parliament.  And, in late March, a bank crisis in Cyprus dominated headlines with the big news being that bank depositors were going to lose some of their deposits to bail out their failed banks.  Meanwhile, European markets managed to finish the quarter up just over 7% (in local currency). 

Warren Buffett, as most of you know by now, is not only one of my heroes, but is often considered to be one of the greatest investors of all time.  From 1966, when he began running Berkshire Hathaway, to the end of 2012, the overall stock market (including dividends) has returned an average of 9.4% annually.  That means that $1,000 invested in the U.S. market in 1966 was worth just over $74,000 at the end of 2012.  During the same period, the book value of Berkshire Hathaway increased by almost 20% per year – twice the U.S. market return.  The result?  That same $1,000 invested in Berkshire Hathaway’s book value would have grown to over $5 million!

This is why Warren Buffett’s views are worth heeding and why his annual letter is greeted with eager anticipation each year.  I confess to eagerly reading it each year – even reading past letters from time to time.  One of the themes both in his most recent letter and in many recent interviews is the idea of dealing with uncertainty.  Buffett points out that uncertainty – much as we have in the current markets right now – has been a constant in the United States since about, oh,  1776.  The only variable is whether people ignore the uncertainty (typical for boom times) or fixate on it (as happens during crises). 

Right now, people are focusing on the problems – stocks are overvalued, we’re due for a correction, the Fed is artificially inflating asset prices, the economy is weak – and yet, we are seeing new all-time highs in the stock market week after week.  The truth of the matter is there are issues.  The Federal Reserve is artificially inflating asset prices (i.e. stocks) through low interest rates, but stocks really are the only game in town.  The interest rate on a 10-year Treasury bond is currently around 1.9% and, if you factor in inflation, this means that someone that buys a 10-year Treasury bond today and holds it until it matures is actually losing money!  Buffett stated in a recent interview on CNBC that at some point interest rates will rise, but even with that risk, he much prefers stocks over bonds, saying that today “the dumbest investment is a government bond.” 

While there is an element of truth to what he says, this does not mean that we should avoid bonds altogether.  Bonds do have a place in a portfolio, but we need to be aware of the risks and manage around those risks.  The biggest risk, of course, is that interest rates are going to go up at some point, but probably not until next year.  The Federal Reserve has said they intend to maintain a low interest rate environment until the unemployment rate drops to around 6.5%.  Given that we are currently officially around 7.6% unemployment, we still have a ways to go.  We have already prepared client accounts for the eventuality of rising interest rates, adding the PowerShares Senior Loan Portfolio ETF (ticker: BKLN) to client accounts at the start of the year.  This fund invests in bank loans – short-term loans by banks to businesses for inventory, for example.  These loans are 3- to 6-months in duration, so the interest rates are quick to adjust to any changes.  Our intent is to gradually migrate more of our bond holdings over to this security as interest rate risk rises, eventually moving back into longer term bonds as interest rates stabilize. 

One of the key things we focus on in our investment analysis is cash flows – both to the company and from our investments.  We have recently been more focused on companies that pay dividends than in past years primarily due to the lack of income from other sources.  When we return to a more normal interest rate state, we expect that we will focus a bit less on dividend yields and more on the total return potential from a stock.  We are trying to be discerning in our security picks though, as there are some stocks that are looking expensive by historical standards and this does give us pause.   We are selectively trading when we find opportunities to earn a good return.  For example, we have purchased shares in Guess? Inc. (ticker:  GES) across client accounts up to three different times now and we either have or expect to earn between 7% and 8% on each of these trades in about three months’ time.  While this is a lot more trading than normal, when offered this sort of opportunity, we are going to take it.

As always, we truly appreciate the trust you have placed in us and the opportunity you have given us to manage a portion of your assets.  If you have any questions or need to discuss any issues please feel free to give us a call.

Sincerely,

Alan R. Myers, CFA

President / Senior Portfolio Manager

Aerie Capital Management, LLC

(866) 857-4095

www.aeriecapitalmgmt.com

New Record on the Dow Jones Industrial Average… Now What?

We had quite a week in the markets last week with the DJIA breaking through its all time highest closing price on Tuesday and then continuing that trend the rest of the week with higher closes each day through the end of the week.  The previous high for the Dow was hit way back in October 2007, on the eve of the financial meltdown. The financial press had a field day with the news.  Business network CNBC even went so far as to schedule a special program on the Dow hitting a new all time high Tuesday night.  From the euphoria we are seeing you would think that happy days are here again.

The reality of this situation is very different, though.  In spite of this record run and the continued crowing about individual company stocks hitting all time high prices, not everyone thinks everything is coming up roses.  In fact, if you thought Congress was divided, you should talk to financial folks.  No one seems certain about whether the markets are going to continue to climb higher or if we are on the brink of another meltdown.  There are great arguments on both sides of this debate.  So let’s examine them and see where we think we are going.  As an aside, as much as I am writing this for your benefit, I am also writing this for mine as well, as I am just as curious about where we are going as the next person.

In the bull camp to start is, simply, the inexorable climb.  It’s almost a case of a self-fulfilling prophecy.  If investors expect stocks to increase in price, they will buy stocks which will, of course, drive up the price.  Adding fuel to this bullish fire is the fact that a large amount of cash is still sitting on the sidelines.  That is, many investors have still not jumped on the stock bandwagon, meaning there is plenty of money to continue to drive demand for stocks.  There are additional tailwinds to push the market higher, or so the bulls claim.  Chief among them is the low interest rates on bonds, artificially induced by the Federal Reserve.  The Fed has effectively set interest rates at zero, keeping interest rates low in order to spur investing.  With long-term interest rates at minute levels investors have to look elsewhere for income and the one place they are going is to stocks, especially stocks that pay dividends.  Further, the bulls point out, company earnings are expected to get better and, since a company’s value is predicated on its earnings, this should continue to lead to higher stock prices.  Many bulls point to key measures of value such as the price-to-earnings ratio to show that the stock market is not overvalued at the current level and arguing for there being plenty of room for stock prices to continue to increase.

However, the bear side of the ledger has some pretty compelling arguments as well.  To start, the bears point out that earnings are actually slowing down.  In fact, earnings have fallen for the two quarters and may fall again this quarter.  Add in higher payroll taxes – workers had been given a break in how much they paid into Social Security over the previous two years, but that ended this past December – and the sequestration – the $85 billion in budget cuts coming this year – and you have a recipe for a slowing economy, reduced consumer demand and possibly a recession.  Bears point to a leaked email from Wal-Mart that announced a steep drop in sales in February driven primarily by the payroll tax increase which disproportionately hit their clientele.  Further, the bears point out that while the market is making new highs, trading volume is pretty light relative to what we would expect (see the bull argument about “money on the sidelines”).  Lastly, the bears point out that the Federal Reserve can only do so much and will eventually have to stop artificially depressing interest rates.

So where do we come down on this debate?  I am firmly in the middle.  I subscribe to many of the bear arguments – the artificial inflation due to low interest rates, the slowdown in spending due to sequestration hurting rather than helping the economy among them.  But I also subscribe to many of the bull arguments, as well.  Stocks really are the only game in town at the moment and there really is a lot of money on the sidelines (we are included in that, as we currently have roughly 20% of client funds in cash).  So what tips the scales for us?  Well, at the moment, it’s this chart (courtesy of StockCharts.com):

As you know from some of our past writings, we are fans of a style of charting known as “point and figure” charting.  This style doesn’t track every single price change in a stock or index but looks for shifts in momentum.  When the chart is in a column of X’s, the momentum is bullish and when the chart is in a column of O’s, the momentum is bearish.  As you can see, this chart of the DJIA is in a column of X’s at the moment.  There is a method of estimating how far up (or down) a stock might move from the past movements.  Based on this chart, we could see the DJIA climbing to 14,750 or so before running out of steam.  However, one thing to keep in mind is that charting – in fact, any kind of technical analysis – is not infallible.  Trying to read charts does not guarantee success and it certainly is not a guarantee of what is to come, but it can tell you a little bit about the psychology of the markets at the moment.  The psychology of this market is a grudging bull apparently as it continues to eke out gains little by little in spite of the wall of worries.

Given this sentiment, we continue holding good stocks with solid fundamentals.  However, we are keeping some cash on hand as we anticipate more volatility this year.  We know the Fed will eventually take their foot off the gas and this could have a negative effect on stocks, at least in the short run.  Over the long term, we continue to be bullish on stocks in general.  We have also started to refocus the fixed income side of our accounts to prepare for the increase in interest rates that is inevitable, though we have not sold any of our bond funds just yet.  There is no real need to panic as we see more potential for either a mild recession at worst or, at best, a grudgingly slow continued recovery.  In either case, it will be some months before interest rates really start to tick back up.  Stay tuned as this wonderful drama continues to unfold!