“Trees Don’t Grow To The Sky”

That is what the old timers were saying just before the stock market crashed in October of 1987.  The Dow had hit a high of 1956 in 1986  and a year later, was just short of 3000 before the crash.  Before the crash, some were saying that the market had gone too far too fast and there would be a correction.  Take profits! Obviously, they were right.  The Dow lost 1000 points by the end of November, 1987 and it took three years before the Dow closed at 3000 again at the end of 1990.

We think that investors are nervous now, and the recent 500 point drop in the Dow may just be the beginning of a correction.  Of course, it may not be, too, but there is nothing wrong with taking profits and reloading.

We sold several stocks earlier in the month to take some profits, but also to move Lockheed and PPG out and replace them with something with more immediate promise.  Since then, we have also added Intel and Bob describes our thinking about the changes we made elsewhere in this letter.

The election of Senator-elect Brown in Massachusetts a few days ago left no doubt that the electorate wants the government to head in a different direction.  We will have to see how the President and Congress react to what is clearly a rejection of business as usual in Washington before investors regain enough confidence to start buying stocks again in a big way. 

I read an interesting article in Barron’s recently in which Richard Koo, the Chief Economist for the Nomura Research Institute in Japan opined that our government was taking the wrong approach toward turning our economy around.  His opinion was based upon what the Japanese had done trying to come out of their recession twenty years ago.  The result was another recession.

I hope someone in our government had an opportunity to read the article and give it some thought before they charge down the wrong road too quickly.  The Japanese are still trying to come out of their double dip recessions.  And Mr. Koo said that even a small increase in interest rates in Japan (which is what is needed) would be devastating to the economy.  They are afraid that taking the medicine that is needed to turn their economy around will kill the patient.  That’s pretty scary!

James M. Mendell, President

New purchases

Noted below are thumbnail sketches of five companies that show strong potential for share price growth in this uncertain but expanding economic climate.  As is nearly always the case, investment opportunities are hidden within the dissipating dark clouds of a dying recessionary period. 

Ross Stores, Inc. (ROST)

Ross has two chains of off-price retail apparel and home accessories stores in the US.  Last year, it operated 956 stores which sell branded and designer apparel, footwear, and home fashions for the entire family, as well as gift items, linens, and other home-related merchandise offerings such as small furniture and furniture accents, educational toys and games, luggage, gourmet food and cookware, watches, sporting goods, and fine jewelry.

Ross reported 3Q EPS of $0.84 vs. $0.44 in the year-ago quarter.  Excellent numbers in the quarter came about despite a challenging retail environment, as the frugal consumer continues to favor the off-price sector. Compelling values combined with strict inventory control lifted gross margin and drove the solid results.

Operating margin increased 380 bps, with gross margin increasing 340 bps (the result of substantial gains in merchandise margin, leaner inventory, much lower than expected ‘shortage’ results and lower freight costs as a percentage of sales and leverage on buying and occupancy costs).  Ross remains an interesting share holding with above-average appreciation potential going forward. 

To be sure, some might question how why or why the firm’s retail offerings can grow in an economy where many are without jobs, or threatened with loss of a job, one needs to consider that many Ross customers are trading down in a difficult climate, making choices they might not have made in the halcyon days of the recent past.

The Proctor & Gamble Co.  (PG)

AFA sold PG holdings in the past when the firm stumbled with poor growth.  Happily, the new CEO has turned things around again.

The firm has nearly $80 billion in sales and is the world’s largest manufacturer of household and personal care products.  50% of total sales come from North America, 35% from Europe, 10% from Asia, 5% from Latin America.  The biggest divisions are Beauty (30% of total sales), Fabric & Home Care (25%), Baby & Family Care (17%), and Health Care (12%); the remaining 16% of sales are split evenly between Snacks & Pet Health, Blades & Razors, and Batteries & Braun.  Some of PG’s most familiar brands are: Pampers, Charmin, Bounty, Olay, Crest, Pantene, Clairol, Downy, Tide, Ariel, Head & Shoulders, Gillette, Braun, and Duracell.

Here, people are buying for the most part, necessity goods from a company that typically enjoys good results in uncertain markets anyway but betters those results when economic circumstances settle down.

Merck & Co, Inc. (MRK)

MRK is a leading manufacturer of human and animal health care and specialty chemical products. Leading product names include Singulair (asthma); Vytorin, Zocor (cholesterol-lowering agents); Fosamax (osteoporosis); Crixivan (HIV/AIDS); Vasotec, Prinivil (angiotensin converting enzyme (ACE) inhibitors for high blood pressure and angina); and Prilosec (gastro.)

MRK’s estimated 8.3% compound earnings growth for the 2009-2015 period is the highest of the large pharma companies.  Its current trading multiple of 10.3x 2010 EPS, on the other hand, is in the middle of the pack.  MRK offers the best pharma choice in terms of expected growth.  MRK’s current product portfolio and, more of interest, is its attractive mid-late stage pipeline which warrants an 8% premium to its sector peers.  Necessity products.

Hewlett -Packard Co.  (HPQ)

Improving world economies are encouraging business and information technology spending.  A year-end budget ‘flush’ is in progress which this augurs strong growth for HPQ, a major IT supplier.  Year 2008 was characterized with a serious contraction but now, the horizon shows continued improvements and increasing budgets with 5%+ year/over/year growth in the sector. 

Indeed, component shortages have held back revenue volume to some extent.  The demand and revenue improvement should boost operating leverage. The EDS acquisition (Ross Perot’s former Electronic Data Systems) shows promise.  Companies exiting the economic downturn will increasingly turn to outsourcing, which should boost demand for HPQ which offers top-quality shares that are ranked favorably for year-ahead performance. 

As well, HPQ’s plans to purchase 3Com, a leading networking, switching, and security products business boosts HPQ’s presence in the very profitable and rapidly expanding networking market as well as 3Com’s China business which is 55% of its Y09 sales.

Intel Corp.  (INTC)

Intel has a dominant position in a market sector widely seen as very attractive–microprocessors for PCs.  As well, the firm has a strong lineup of products that will help it gain microprocessor market share.  Intel also has a history of very capable execution that has enabled the company to build a strong leadership position in microprocessor technology.

In 4Q09, INTC reported revenue of $10.6 billion up 28% year-over-year from a healthy holiday selling season, better-than-expected consumer demand for notebooks, and the ramp up of innovative new products.  Revenue growth was widely distributed, e.g. the Americas up 15%, Asia Pacific up 12%, Japan, 8%, and Europe 15%.

Exxon Mobil Corp.  (XOM)

XOM is the dominant major international oil company, with operations around the globe.  The primary business is energy, with involvement oil and gas exploration and production, refining and transportation, and marketing petrochemicals.  The firm has operations in 200 countries.  As economies worldwide return to a growth mode, energy is the foundation that helps sustain that growth and XOM, as a major energy play, will enjoy increased revenue and earnings.  Profits should start to recover later this year–When XOM fortunes are down, historically, it has often been a ‘buy’.

 Robert L. Briechle

© AFA Financial, Inc., February 2010

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