Gangs of New York (Saut)

Gangs of New York

by Jeffrey Saut, Chief Investment Strategist, Raymond James

April 18, 2011

“The appearance of law must be upheld, especially when it’s being broken”

... Boss Tweed, Gangs of New York

I love New York City! In fact, I wish I would have stayed there rather than moving to Atlanta in the early 1970s. Still, as I walked from the airplane into the terminal last Monday, I got the feeling I was traveling back in time since La Guardia is in need of a “refresh.” Proceeding to the taxi stand was likewise anachronistic as certain parts of my taxi were being held together with duck tape. Be that as it may, the trek into “the city” began. During the journey I preceded over potholed streets, decaying bridges, a tunnel that reminded me of my youth, and dead-zones that dropped numerous phone calls begging the question – What happened to those promised “shovel-ready” projects?! All in all, I felt like I was in a third-world country, not the greatest city in the world. Contrast that experience with Singapore’s Changi Airport. One arrives at arguably the best airport in the world, with over 80 airlines serving more than 180 cities. Despite the fact the airport has been open since 1981, it remains a benchmark for service excellence having won over 280 awards. Travel to and from the airport is modern and efficient, both by road and rail. Indeed, there are no potholed roads, no old taxis, no decrepit trains, no “dropped” phone calls ... well, you get the idea.

Nonetheless, last Monday began with visits to a couple of hedge funds. At noon I arrived at Yahoo’s new TV studio to do a segment on “Breakout” with my friends Jeff Macke and Matt Nesto. From there, it was off to see some portfolio managers (PMs) before the next media “hit” at Fox Business with another friend, Brian Sullivan. While I am kindred spirits with these media anchors, by far the highlight of last Monday was dinner with President Bill Clinton.

The President opined, “I like living in the 21st century.” He talked about technological breakthroughs like those from the TRIUMF Cyclotron, which may offer clues on how “matter” holds together. He also was pretty excited about genome research since it is offering insights on healthcare issues, and, potentially, ways to prevent serious illnesses. Climate issues were on his mind, along with water and topsoil (if that sounds familiar, it should since I have been talking, and investing, in those themes for decades). In fact, the President actually commented, “Only two countries in the world have 20 feet of topsoil remaining – Brazil and Argentina.” From there the topic shifted to the U.S. and the various “systems” that make our country what it is (law, courts, government, food, shelter, education, etc.). The President suggested those systems have become problematic because our leaders want to hold on to their power; therefore, they don’t want the “systems” to change. Yet systems need to evolve to stay great, just as great companies stay great by evolving into becoming young again. He continued, “You need a strong economy to empower change; and there is too little discussion on how we propose to do that given the country’s budgetary constraints.” He concluded with the question, “How do you propose to do whatever you are talking about?!”

Next, he focused on the world. To wit, “Unless we find a way to ameliorate the world’s ‘poor people,’ it is going to affect our country.” “There is too much inequality in the world,” he said, “with half of the world’s population living on less than $2 per day.” Moreover, the world’s population is growing faster than the ability to deal with that growth. Hereto, feeding that growing population is another theme we have harped on for years. The President believes that the systems of wealthy countries need to be built in the world’s “poor places” to effect economic change. He also stated, “Giving woman access to jobs has always lowered the birth rate because it delays marriage.” This, he thinks, would help slow the burgeoning population growth. All said, he was upbeat about the world’s prospects, believing the positives versus the negatives currently net out to the positive side of the equation. “To be sure,” he maintained, “a certain amount of instability is a good thing because it fosters creativity, but too much uncertainty is a bad thing.”

The President closed by noting, “The current budget debate is really a food fight begging the question – what type of country do you want?” Manifestly, people have to believe that they can shape their own future; and on that point, the environment is questionable. He avers we have two Americas living in a parallel universe with political views being argued abundantly about the nation’s issues rather than the facts. His “call to arms” – “Many of you are in a position to answer the HOW question; and, the world manifestly needs you to answer that question!”

After reflecting on the former President’s words overnight, I spent a few hours Tuesday morning listening to Goldman Sachs Asset Management’s (GSAM) Jim O’Neill, who coined the acronym BRIC (Brazil, Russia, India, and China) some six years ago. Over that timeframe the BRIC’s equity markets have returned a stunning 817%. Recently, Jim has invented another acronym, the “Next 11” or N-11 (Bangladesh, Egypt, Indonesia, Iran, Mexico, Nigeria, Pakistan, Philippines, South Korea, and Vietnam), which GSAM believes have the potential, combined with the BRICs, to become the world’s largest economies in the 21st century. Obviously, that strategy “foots” with me since I have been talking about it ever since China joined the World Trade Organization in 1Q01. Importantly, Jim thinks, and I agree, that the BRICs and N-11 countries will be able to compensate for any sluggishness in the U.S. Additionally, Jim hinted that China has engineered a “soft landing,” although he does think China’s growth may disappoint this year because its government wants to slow the economy to provide more solid, long-term, growth. These are not unimportant points, for Jim O’Neil’s comments, when combined with President Clinton’s, have formed many of the strategies we have employed to “bend” portfolios over the past 10 years. We continue to embrace these themes and advise tilting portfolios accordingly.

The balance of last week was spent doing more media, conversing with my New York-based “gang” and seeing various money management “gangs.” In such meetings, after a brief top-down overview of the economy, interest rates, inflation, the equity markets, etc., the conversation turned toward individual stocks. At a number of accounts it was interesting to find that Williams Companies (WMB/$31.05/Outperform), a name we have continuously recommended, was heavily owned by the institutions we were seeing. It will also be interesting to see what happens when Williams’ offering documents, discussing that company’s pending spinoff, are released, giving investors the ability to value the embedded “options” within the two companies. Our sense is said documents will permit participants to more accurately value those “options” with an attendant “hop” in WMB’s share price. We also got traction with the Utica Shale Gas story, and its positive impact for 5.4% yielding EV Energy Partners (EVEP/$54.56/Outperform) given the potentially undervalued embedded “option” of EVEP’s 230,000 acres in that Utica resource.

Two other ideas we discussed with PMs last week, concurrent with the recent rotation into healthcare, were Covidien (COV/$53.80/Strong Buy) and Hospira. Covidien’s story has these drivers: 1) a shifting business mix toward higher margin med-devices (vascular products in particular); 2) recent FDA approval for “Pipeline Embolization Device” (PED) for treatment of brain aneurisms with approval coming two months early, providing upside to FY2012 numbers; and, giving us expectations of accelerating revenue growth and margin expansion. As for Hospira (HSP/$56.00/Outperform), it is a specialty generic pharma and medical device company. The macro story includes an industry-wide shift to generic drugs, an approval of Taxotere (breast/prostate cancer drug) two weeks earlier than expected, and the belief that “biosimilars” (like generics, but not exact chemical copies) will be as accepted here as they are in Europe. That combination leaves HSP trading at 13x 2012 estimates, in line with its peers, but below its historical average of ~14.5x. We expect mid single-digit revenue growth, yet mid-teens EPS growth, which leaves the shares undervalued.

The call for this week: I began this missive with a quote from the movie “Gangs of New York” that reads, “The appearance of law must be upheld, especially when it’s being broken.” I recalled that quip sparked by a remark from a particularly bright fellow last week who opined, “Only when the American people insist that sound business practices, and moral standards, be brought back will we be able to give the people of this country a future.” Unfortunately, as President Clinton averred at the U.N., “Political views (are) being argued about the nation’s issues rather than the facts.” The result seems to have left our government in stalemate mode. Similarly, the equity markets seem to be in stalemate mode recently as since the February 18th peak there has been not much desire to either Buy or Sell. This is confirmed by the Lowry’s organization, whose Buying Power Index has dropped by a mere 42 points, while Lowry’s Selling Pressure Index has risen by a paltry 16 points! To us, all the equity market appears to be doing is recharging its internal energy to garner enough power to burst above the February 18, 2011, intraday high of 1344. Last week was just another step in that direction for when the S&P 500 (SPX/1319.68) violated the 1320 – 1325 trading “fail safe” zone, it quickly traded down to ~1303, which was the 38.2% retracement of the recent rally mentioned in last Monday’s letter, before rallying into Friday’s close. All of which brings us to this week where we sense the weakness is likely to linger into mid-week before the internal energy is fully recharged for another leg to the upside.

Copyright © Raymond James