CWS Market Review
May 26, 2017
“The single greatest edge an investor can have is a long-term orientation.”
– Seth Klarman
On Thursday, the S&P 500 closed at yet another all-time high. The index is already up 7.8% this year, and we’re still in the merry month of May. Last week, the market had a slight jitter, and I thought the recent quiet period might be coming to an end.
On Wednesday, in fact, the S&P 500 was on track for one of its narrowest days (meaning the difference between the daily high and low) in decades, but an afternoon surge put that off. Last week, Wall Street was alarmed when the Volatility Index jumped above 16. But once again, the index collapsed. On Thursday, the VIX closed at 9.99. That’s only the seventh sub-10 close in the last 20 years.
It’s as if the low-volatility, slowly upward-trending market is reasserting itself after a momentary disruption. No matter what happens, we keep returning to a market of micro changes that are mostly rising.
In this week’s issue, we’ll look at two of our recent Buy List earnings reports, from HEICO and Hormel Foods. Even though the report from HEICO was quite good, and the report from Hormel was mediocre, both stocks fell. Such is Wall Street. I’ll have more on that in a bit.
But first, I want to discuss this week’s Fed minutes, and what the central bank plans to do with its enormous balance sheet. I still think the Fed is making a big mistake by raising interest rates next month. Let’s hope cooler heads prevail.
What Will Happen to the Fed’s $4.5 Trillion Balance Sheet
On Wednesday, the Federal Reserve released the minutes of its last meeting. The minutes revealed largely what Wall Street had expected, and I feared. The Fed acknowledged the weak spots in the economy, but it still sees the need for another rate hike. I just don’t get it.
If the rate hike happens, and I’m afraid it will, then this would be the fourth hike of this cycle. The Fed seems to believe that the sluggishness in the economy during the first quarter will soon pass. I sincerely hope they’re right, but I haven’t seen the evidence just yet. I think the Fed has become overly concerned about the idea of being “behind the curve.” Chairwoman Yellen has said that if we don’t raise rates beforehand, then we’ll require faster rate increases later. What’s so awful about that?
I should be clear that one rate hike probably won’t sink the economy. Even after a fourth hike, real interest rates will still be quite low by historical standards. The facts are clear: wage growth is iffy, inflation isn’t a problem, and there are few signs of an economy overheating.
I like to keep an eye on the spread between the two- and ten-year Treasury yields. Over the last 30 years, whenever the spread turns negative, the economy has soon gotten bad. The current spread suggests the Fed can raise rates four more time. That would be three after a rate hike in June. I suspect that means that a rate increase wouldn’t hurt the economy, but it decreases our breathing room for further hikes.
What was interesting about these Fed minutes is that they give us a preview of what the Fed intends to do with its massive balance sheet. Let me rephrase that: the Fed’s gigantic, massive, world-devouring, $4.5 trillion balance sheet. The central bank has been reinvesting the proceeds of its bond holdings into still more bonds. The plan presented at the FOMC meeting is to pull the plug on all that reinvesting. In other words, just let the current holdings mature.
According to Binyamin Appelbaum at the New York Times, the Fed “would begin by keeping a fixed amount of the monthly proceeds and then increase the cap every three months until proceeds were no longer being reinvested.” What’s the downside of this? Probably not much, assuming the economy avoids a recession. That’s even more reason why the Fed should hold off raising interest rates next month. Now let’s take a look at this week’s Buy List earnings reports.
HEICO Earns 53 Cents per Share
After the bell on Tuesday, HEICO (HEI) reported fiscal Q2 earnings of 53 cents per share. That was three cents better than Wall Street’s estimate. The details look pretty good. Net sales rose 5% to $368.7 million. For the first half of the year, net sales are up 8%. I was pleased to see HEICO’s operating margin edge up from 19% a year ago to 20.8% for this year’s Q2.
Laurans A. Mendelson, HEICO’s Chairman and CEO, commented on the Company’s second-quarter results, stating, “We are very pleased to report record quarterly results in consolidated net sales, operating income and net income driven by record net sales and operating income at both operating segments. Our outstanding performance principally reflects increased demand and operating efficiencies within both of our operating segments, as well as the excellent performance of our well-managed and profitable fiscal 2016 acquisition.”
Best of all, HEICO raised its full-year guidance. This was the second increase this year. Unfortunately, the company doesn’t guide for EPS, but they do for a few other metrics.
HEICO now sees net sales rising this year by 8% to 10%. The previous forecast was 6% to 8%. For net income, HEICO projects growth of 12% to 14%, up from 9% to 11%. HEICO also projects cash flow from operations of $270 million. That’s up $10 million from the previous forecast.
Last year, HEICO earned $1.86 per share. If we assume no change in shares outstanding, that implies 2017 EPS of $2.08 to $2.12. Wall Street had been expecting $2.05 per share.
Unfortunately, shares of HEICO dropped 3.4% on Wednesday. I listened to the earnings call, and it seemed fine to me. Perhaps some folks were expecting more. I can’t complain too much about the share price, considering HEI hit a new high on Tuesday. Perhaps the drop was due to some price jitters. I’m lifting my Buy Below on HEICO to $75 per share.
Shares of Hormel Drop on Turkey Issues
On Thursday morning, Hormel Foods (HRL) reported fiscal second-quarter earnings of 39 cents per share. That was a penny below expectations. The culprit is apparently an oversupply of turkeys. Hormel’s Jennie-O Turkey Store saw its volume drop 6% and sales fell 8%.
Turkey prices are near a seven-year low. The issue is that some folks were afraid of another outbreak of avian flu. As a result, they ramped up production. To their credit, Hormel acknowledged the problem and was careful to explain that it’s not a long-term one.
This was, by no means, a lousy quarter for Hormel. Their grocery-products division did quite well, as did their international business. I often tell people that Hormel is a lot more than Spam. Well, it’s a lot more than turkey as well. Most importantly, the company is standing by its full-year forecast of $1.65 to $1.71 per share. However, they now say they expect results to be at the low end of that range.
Shares of Hormel get dinged for a 6.4% loss on Thursday. I’m not bailing out at all. This is still one for the long term, but I will lower my Buy Below on Hormel Foods down to $35 per share.
Buy List Updates
One of the lessons of investing is that periodically, the market freaks out. Sometime the reasons are good; many times, they’re not.
Last September, shares of Cognizant Technology Solutions (CTSH) plunged after the company said that an internal investigation revealed that the company may have violated the U.S. Foreign Corrupt Practices Act. Cognizant notified the SEC and DOJ. The same day, the company’s president resigned.
That day, the stock got crushed. At one point, CTSH dropped down to $45.44, which was a loss of 17.4% for the day. By the closing bell, the stock had shed 13.3%.
The good news is that we waited the mess out, and on Thursday, CTSH is at a new 52-week high. The stock is up 47% from its post-plunge low.
To quote Warren Buffett, “the stock market is designed to transfer money from the active to the patient.”
I also wanted to highlight the surge in Stryker (SYK). This company doesn’t make a lot of news, but it’s been a steady winner for us. The shares have rallied 32% since mid-November. The company has turned out good earnings reports, plus we got a dividend increase. The shares just closed at another 52-week high.
Shares of Alliance Data Systems (ADS) got a nice boost on Thursday after Signet Jewelers said it was selling ADS $1 billion worth of prime accounts. That represents 55% of Signet’s credit portfolio. The two companies agreed on a seven-year deal in which ADS will become the primary credit source for Signet’s business. Shares of ADS rallied 3.3% on Thursday.
The board of directors at Cerner (CERN) approved a $500 million share-buyback plan. At the current price, the plan represents 2.3% of CERN’s outstanding shares. CEO Marc Naughton said, “Given our strong balance sheet and expected strong cash flow, we are well positioned to continue investing in growth while also returning value to shareholders through share repurchases.”
Over the weekend, Barron’s highlighted Ingredion (INGR). The stock is a favorite of David Anguilm, a portfolio manager:
One favorite is Ingredion (INGR), which makes sweeteners and nutrition ingredients, like ones that make crackers crisper, and pharmaceutical products like intravenous solutions. The stock has pulled back amid concerns about changes in foreign trade. Anguilm sees demand rising from a growing middle class in emerging markets and aging populations in the developed world.
Ingredion “generates strong and consistent cash flows, has a healthy balance sheet, and has a history of returning cash to shareholders,” he says. Ingredion yields 1.7% but has grown its dividend by 170% over the past five years. Its payout ratio is 26% of earnings, “which we believe will allow for attractive dividend growth in the years ahead,” says Anguilm, who recently added to the fund’s position.
That’s all for now. The stock market will be closed on Monday for Memorial Day. I’m taking some time off, so there will be no issue next week. The Memorial Day weekend traditionally marks the beginning of summer. On Tuesday, we’ll get the latest reports on personal income and spending. On Thursday, we’ll get the ADP payroll report, plus the ISM report for May. Then Friday is Jobs Day, when we’ll get the latest employment figures for May. Be sure to keep checking the blog for daily updates. I’ll have more market analysis for you in the next issue of CWS Market Review!