It has been a very interesting summer as far as the equity markets go. Summertime trading can often be quite volatile and people tend to read too much into short-term movements. Clearly, the biggest global issue is the apparent slowdown in the Chinese economy, but if growth is anything close to the 7% growth that is projected, these fears might be overblown to some extent. While the stock market itself in the United States has been fairly flat, most emerging markets are in a bear market and many large global stocks are down by 20-45% year to date. Massive companies such as Apple, Wal-Mart, and American Express have been down significantly from their highs. However, even though most stocks have been down for the year, the S&P 500 has held fairly steady due to increases in the price of momentum stocks such as Amazon, Netflix, TESLA and Facebook. All of these momentum stocks are either not profitable on a GAAP basis, or they are priced in excess of 100 times earnings. While their business models are strong, market participants are pricing in the rosiest of futures for the companies and there is very little margin of safety. This is the type of thinking that tends to generate permanent losses of capital. Bonds, which have also been priced to perfection, have also been generating losses of late as spreads have widened on corporate credit.
It is important to understand that at T&T Capital Management (TTCM) we aren’t simply investing in the market. Instead we are investing in individual companies and then we are using conservative strategies, such as covered calls and cash secured puts, to generate income and reduce risk. None of our investments are betting on substantial global growth. We have very little exposure to China for instance, where valuations are still very expensive. I’d be extremely reluctant to invest in a widely diversified mutual fund or an index fund at current prices, which is why we are positioned very strategically to benefit from specific opportunities instead. One of our few positions that is exposed to China; (GM), also produces its cars that it sells in China, so while revenues might be lower due to the depreciating currency, the costs will be lower as well. GM yields close to 6%, and it’s been buying back stock at about 6 times earnings and is operating better than it has in decades. The European automotive market is improving and North American margins have caught up with Ford. While we have some exposure to energy, which has certainly hurt us, I believe that most of the losses have already been incurred. The positions now represent a much smaller portion of the portfolio and the long-term upside is considerably greater than the risks associated with it.
I realize pessimism is extreme in the energy markets and it is impossible to predict when the turnaround will occur. I can tell you that to get a sustained recovery, I believe $40 oil is more conducive than $60 oil. When oil rallied earlier in the year, companies like EOG and Pioneer Natural Resources started talking about how they were looking to add new rigs. This is often the aggressive wildcat mentality that exists in the space, but unfortunately it is also one reason why supply has remained stubbornly higher. Today’s lower prices eliminate any incentive to add rigs and will also necessitate the need for more CAPEX cuts.
Lower prices are the best cure for low prices, as it will result in a decrease in supply and an increase in demand. Demand has already picked up materially and non-OPEC supply has declined. The problem is that OPEC supply is incredibly high with countries like Saudi Arabia, Iraq, and now likely Iran producing at rates higher than they have in years. These countries are so highly reliant on energy that the lower oil prices are having a very negative impact on their respective economies. At some point, they will likely see a need to cut production and then combined with the reduction in supply that we should see in North America and much of the rest of the globe, prices should begin heading higher. The other key is that the U.S. dollar has been absurdly strong and I believe is more likely than not to head lower over the next few years relative to other currencies. This would also be a nice tailwind for commodity prices such as energy, although I’m not overly optimistic on commodities in general.
As a hedge on energy, we have invested in various airline stocks such as American Airlines and have also sold puts on them. We didn’t initiate positions until the stocks had declined by about 20% year to date, which gave us a great opportunity. American Airlines trades at about 5-5.5 times its 2015 earnings estimates, which is absurdly cheap. The company is aggressively buying back stock and is improving its efficiency. American Airlines is not hedged for fuel costs, which means that its earnings go up dramatically with lower oil prices. This is a great hedge and allows us to buy a quality company in a oligopolistic industry at a fantastic prices. Dividends and stock buybacks are likely to increase and the valuation should improve as well.
Lastly but most importantly, our financial stocks continue to show improving business fundamentals. Earnings have been very strong, valuations are still cheap, and future earnings are likely to continue to improve. We have a tremendous amount of puts expiring in January of 2016, so as time continues to decay on these options, we should see considerable growth in our accounts even if the market is fairly flat. If the markets did head lower, the put premium would offer us protection versus just being long stocks as you would be in a mutual fund or ETF. History has shown us that things can change very quickly, so the key is just being patient. We have several fantastic investment ideas that we are putting money into right now, with very low risks and high reward potential for the long-term investor. We have zero exposure to the really expensive areas of the market, which makes us feel very comfortable that we will hold up fine even in a negative market environment. As always, patience and discipline will be required but I’m quite optimistic on our prospects as things play out for the remainder of the year. Thank you very much and let me know if I can assist with anything!