In January, the Covestor Reasonable Price model’s net returns outperformed the S&P 500 Index (SPX). This year is off to a promising start. I've said regularly that investing based on the economic headlines is not for me. However, having been a fixed income trader for eight years (at Credit Suisse in the 1980s) I am predisposed to follow economic data, and my overall take is that the economy here continues to improve slowly. GDP growth was negative in the fourth quarter, but averages out to roughly 1.5% for 2012. In addition, corporate spending data on software and equipment, showed a 12.4% annual gain in the fourth quarter. A bearish interpretation of the report might conclude that defense and other sequestration cuts will be serious headwinds to growth, but (coincidentally) Federal Open Market Committee minutes also came out and disclosed that the Fed intended to maintain their massive bond buying program, providing oceans of liquidity to the financial system. Where and when that process ends is anyone's guess, but Fed Chairman Ben Bernanke's term has another year to go and the current speculation for his successor is Janet Yellen, who is also dovish with regards to monetary policy. In the meantime, employment seems to be improving as revisions to fourth quarter reports showed gains averaged 200,000 in the October-to-December period. January is a difficult month, I believe, despite being a historically good month for equities. Re-allocating and rebalancing programs can skew prices, so I am not reading too much into January's performance. One factor that I suspect did contribute to the market's strength is a return of hedge funds to US equity markets. After some hedge funds underperformed in both 2011 and 2012, according to press reports, I would guess that most hedge funds are fearful of missing another strong market, a mistake that might cost them their jobs. After all, how long can you persuade someone to pay exorbitant fees, commit to lockups, and then underperform the S&P 500 by 10%? In addition, equity mutual funds are beginning to see inflows and if large institutions, such as the bigger college endowments, choose to allocate more funds to equities that would provide a tailwind as well. Coupons on most treasury instruments are miniscule, and if rates go back up the commensurate drop in bond prices may compel investors to think carefully about their bond holdings. I think people have been scared away from equities by the events of the past 12 years, and no doubt there are large, structural issues to address. However, in addition to the ultra-friendly Fed, valuations are, generally speaking, reasonable in my opinion. I also believe that earnings will be strong this year. Some of the indicators I follow have begun flashing yellow, particularly the AAII Investor Sentiment Survey released on February 7, in which 54.3% of investors described themselves as bullish, and only 22.3% described themselves as bearish.
This is not to change my overall constructive view, and my portfolio is fully invested, with only a smattering of cash as a result of trimming some investments.But for those clients who are highly sensitive to monthly changes, I may begin putting on hedges, or adding some cash. Regardless, picking the right stocks and paying the right price can generate positive returns, and that is where I will focus my attention. One stock that I like is Weatherford International (WFT). The company’s shares have dropped from $45 a few years ago to $26 in early 2011 and then touched $9 in December, after the company had to restate earnings as a result of tax-related inaccuracies in a number of countries where they operate, and also after a variety of governmental probes. WFT has been on my radar for some time, as I like the energy industry broadly speaking and I like turnaround stories too. What really got me interested was studying the list of insiders who have recently purchased shares, which includes the Chief Financial Officer, the General Counsel, the SVP for compliance (who bought 95,000 shares in three separate transactions), the VP for taxes (50,000 shares in two transactions) and several Directors too. These are all outright purchases which took place between November 15, 2012 and January 17, 2013 at prices mostly in the $9 - $11 range. Other insiders exercised options, and while there's no telling for sure why they did, one possible explanation is that they want to start the clock ticking for the one-year holding period for tax purposes. WFT operates in over 100 countries, providing a variety of products that are used in (mostly) land-based drilling. It carries more debt than I would like to see, which, along with the company specific issues, could explain why it trades below peers on a few metrics: 1.0x price/sales ratio (1.6x average for the others) and 1.1x price/book ratio (2.1x for the others), according to The Motley Fool. However, if the company succeeds in addressing these issues, I believe the valuation gap will shrink, if not disappear. And, if energy companies rebound after their poor showing in 2012, the whole complex could get re-rated higher in which case WFT gets an additional bump in my opinion.
There is the risk that falling oil prices would drag down names in the industry, however that is a hedgeable risk. Given all the negative news around the company, the commitments by insiders, and the company's guidance to generating free cash flow in 2013 (in a December presentation), I think shares of WFT offer a compelling risk/reward here and I recommend buying them up to $13.25.Correction: In last month's commentary I stated incorrectly that Tronox's Chairman had bought shares at $25, when in fact it was the company that bought shares at an average of approximately $25 in its buyback program. The Chairman did get shares as part of his compensation. The investments discussed are held in client accounts as of January 31, 2013. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable.
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