“Fun, Fun, Fun” (Jeffrey Saut)

“Fun, Fun, Fun”

by Jeffrey Saut, Chief Investment Strategist, Raymond James

February 27, 2012

“... and she’ll have fun fun fun ‘til her daddy takes the t-bird away.”

... The Beach Boys, 1964

Except in this case it should be “fund, fund, fund” because I am in the Washington/Baltimore area speaking at conferences, renewing contacts on Capitol Hill, and seeing mutual fund managers. Some of the folks I will be seeing hang their hats at Friedman, Billings & Ramsey; aka, FBR & Co. I remember when in 1989 Manny Friedman scraped together $1 million and departed the Washington-based brokerage firm of Johnson, Lemon & Co. to formed FBR with his two partners Eric Billings and Russ Ramsey. The firm became a research boutique focusing on financial companies spurred by Manny’s prescient “calls” on the banks and real estate. That focus continues to this day, punctuated by a sagacious portfolio manager named David Ellison, captain of the FBR Small Cap Financial Fund (FBRSX/$18.31). I used to chat with David back in the 1980s when he was at Fidelity managing Fidelity’s Select Financial Fund. Interestingly, David currently owns a number of the smaller banks I have commented on in these missives. Even more interesting is that David is my kind of investor since when he can’t find attractive investment opportunities he is content to hold cash. Case in point, unable to find attractive investments going into the 2008 financial fiasco David held 60% of his fund in cash. Indeed, my kind of investor. Accordingly, participants wanting to fill the financial sleeve of their asset allocation model should consider David’s fund.

I spoke with yet another fund manager last week when I hosted a conference call for our financial advisors with Tom O’Halloran, who manages Lord Abbett’s Developing Growth Fund (LAGWX/$21.85). In its space LAGWX is the number one performing fund on a five-year basis according to Morningstar [replay (855) 859-2056; password 49023178]. While that fund is currently closed to new investors, the good folks at Lord Abbett have started another fund run by Tom using the same investment style. The fund is called The Growth Leaders Fund (LGLAX/$15.67) and is representative of the “smaller more nimble” funds I have championed for more than 12 years. The conference call began with some comments from me about the current state of the economy and the stock market. I concluded by noting that while the economy is not going to slip back into recession, GDP is also not likely to grow by more than 3.5% for awhile. In such an environment companies that can increase their revenues and earnings at a decent rate should produce good investment returns; and with that I turned the call over to Tom.

He began by talking about the four traits necessary for great companies. First, they must have a great business model. Second, the management team has to be competent and credible. Third, they must be operating in a healthy industry. And fourth, the company needs to demonstrate a competitive advantage. Tom believes that growing revenues, and earnings, at an outsized rate leads to stock outperformance and I agree. Interestingly, Tom uses technical analysis as an overlay to support his fundamental views. This is not an unimportant point because in this business price is reality! Ladies and gentlemen, I have seen a plethora of portfolio managers stay with losing positions far too long because they ignored the fact the share price was breaking down rather dramatically in the charts. By the time they saw the fundamentals deteriorate, the shares were off some 50% when if they would have had some kind of technical analysis discipline the loss would have been contained at 15% - 20%, but I digress.

Tom then discussed some themes like the Internet, the cloud, software, servers, social networking, the Internet gone mobile, healthcare, Americanism, the reindustrialization of America, etc. If that sounds a lot like me it should given this paragraph from last week’s letter:

“In addition to the theme that technology is making building more for less a reality, other themes I am encouraged by include: companies making products for American consumption are moving jobs back to the U.S.; the reindustrialization of America; Americanism; a move toward energy self sufficiency that will shrink our trade deficit; and then there are the themes outlined in the book Abundance: Why the Future Will Be Much Better Than You Think written by Peter H. Diamandis and Steven Kotler.”

Tom then proceeded to discuss select companies in the Growth Leaders Fund and why he owns them. Names mentioned included: Apple (AAPL/$522.41); Continental Resources (CLR/$94.75/Strong Buy); Google (GOOG/$609.90/Outperform); EMC (EMC/$27.52/ Strong Buy); Fortinet (FTNT/$26.99/Outperform); and Zynga (ZNGA/$12.93). Almost as if it were a “planted” question, one of our financial advisors stated, “You buy the kind of stocks that my clients should have some exposure to, but I am afraid to buy them because of their volatility.” My response was, “Precisely, and that is why you want to own this fund and let Tom manage the risk.”

Speaking to Tom’s position in Continental Resources, a lot of our energy stocks have gone parabolic over the past few weeks, including CLR. If you had followed our recommendation and made CLR shares a 3% position in a $100,000 portfolio when our fundamental analyst initiated research coverage, holding all the other stocks in said portfolio at a constant price shows that your position in CLR has now grown into a 16% portfolio “bet.” Accordingly, it makes asset allocation sense to rebalance that position back towards a smaller weighting and let some long-term capital gains accrue to the portfolio. The same can be said of other portfolio positions that have grown into too big of a weighting in portfolios. Also of note, our long-standing love affair with Wal-Mart (WMT/$58.79/Market Perform) ended last week with Budd Bugatch’s downgrade of WMT from Strong Buy to Market Perform, which has now become another rebalancing candidate.

As for the stock market, last week the S&P 500 (SPX/1365.74) eclipsed its previous reaction high, recorded on April 29, 2011 of 1363.61, and now stands at its highest level since June 6, 2008. The closing high, however, came on very low volume and with numerous divergences. The two most egregious are the lack of upside confirmation from the D-J Transportation Average (TRAN/5139.14) and the Russell 2000 (RUT/826.92). While there are clearly other divergences like the non-confirmation from the Operating Company Only Advance/Decline Line, the fact that there have been no 90% Upside Days this year, the narrowing leadership, too many three-digit stocks, etc., the Trannies and the Russell are indeed the two most worrisome. That’s because the RUT is more than 5% below its one-year high, while the Transports are ~9% below their one-year high. Historically, when the S&P 500 was at a fresh 52-week high, but the Russell 2000 and the DJ Transports were more than 5% below their respective 52-week highs, stocks have been vulnerable. Therefore, if I am going to err it is going to be by being too cautious (not bearish), consistent with Ben Graham’s mantra – The essence of investment management is the management of risks not the management of returns. Good portfolio management begins (and ends) with this tenant.

The call for this week: There have now been 37 trading sessions in 2012 and so far the S&P 500 has yet to experience a 1% Downside Day. This 37-session, or more, skein has occurred 11 other times in the past 84 years and has on every occasion except one seen the equity markets higher by the end of the year. Still, the rise since the “buying stampede” ended, which stopped on January 26, 2012 at Dow 12841.95, has felt unnatural to me. Surprisingly, the Industrials reside only 141 points above their intraday high of January 26th, causing one market maven to exclaim, “no wonder I feel like we’re in the Trading Twilight Zone.” Maybe there will be a resolution to that “unnatural feeling” this week when we experience Leap Day (February 29th). As our friends at Bespoke write, “There have been 21 leap days in which the market was open since 1900. ... The average performance of the Dow on leap days has been -0.05% with a median return of -0.22%. ... There have been three leap days that fell on a Wednesday (as it does this year) since 1900, and the index has risen once and fallen twice. The last leap day was February 29, 2008, and that day the Dow had a big fall of 2.51%.” I’ll speak to you next week.


Copyright © Raymond James

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