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Episode 18 | Mario Gabelli, Holly Newman Kroft, Yra Harris
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This Week on Wall Street
Sharp sell-off sends Dow into first correction since 2011
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US equities suffered their largest weekly losses since 2011 amid concerns about China’s economic slowdown and a potential September Fed rate hike. The Dow and S&P 500 each fell 5.8% while the Nasdaq dropped 6.8% to become the final major index to go negative for 2015. The tech-heavy index’s leading component, Apple (AAPL), plummeted by more than 6% Friday and is now down 20% in the past month.
With the week’s steep losses, the Dow entered its first correction, falling more than 10% off highs, for the first time since 2011 and is now down 7.65% for the year. The small-cap Russell 2000 index held up best with a 4.6% slide, but joined the Dow in correction territory. The S&P 500 did suffer a nearly 10% pullback last September into October, and the most recent correction is a reminder of the volatile and fast-moving nature of modern markets.
Oil also continued its steep decline, ending the week down more than 6% with WTI crude prices briefly dipping below $40/barrel for the first time since 2009. Plummeting crude prices are largely a product of slowing Chinese demand and increasing supply as US stockpiles rose and Saudi Arabia’s production eclipsed levels not seen since 1980. Traders are also bracing for Iranian oil supply to further exacerbate the supply glut.
Concerns about the implications of a potential September Fed rate increase were also blamed for weighing on markets this week, but odds of a hike actually fell in futures markets after Wednesday’s release of the latest FOMC meeting minutes. The recent global economic soft patch, currency fluctuations and persistently low levels of inflation have Fed governors wondering whether it’s yet wise to pull the trigger.
Fixed income
The global equities sell-off and market’s dovish interpretation of the Fed minutes pushed investors into safe-haven US treasuries, sending yields to three-month lows. The 2- and 30-year treasury yields each fell 10 basis points to settle at 0.62% and 2.74%, respectively, while the 10-year yield fell 0.14% to 2.05%. However, credit spreads widened as high-yield corporate bonds declined in concert with equities and commodities.
Asia
While China’s devaluation of the yuan in and of itself was not enough to create a marked impact on the global economic balance, the decision is seen as confirmation economic conditions have deteriorated more significantly than previously thought. Friday’s news that Chinese manufacturing had slowed to its lowest levels since the financial crisis only reinforced those negative sentiments.
The Caixin/Markit China manufacturing purchasing managers’ index (PMI) fell to 47.1 and has been below 50, which indicates contraction, for six consecutive months. Amid a deluge of negative economic data, there is growing skepticism about China’s reported GDP growth of 7.0%.
US stocks had largely shrugged off weakness in Chinese equity markets until the last couple weeks, but this week’s sharp declines were too much to ignore. The Shanghai Composite accelerated lower by 4.3% Friday, after the weak manufacturing data, to bring weekly losses to greater than 11%.
Japan’s economy contracted by 1.6% annualized, with weak consumer spending and exports dragging on growth.
Investors also grew worried about the spectre of competitive currency devaluation after Kazakhstan removed its dollar peg and saw the tenge tumble more than 20%. Floating currencies around the globe fell in response, with Russia’s ruble falling 25% in the last three months. A stronger dollar will further drag on the earnings of US multinational companies.
Europe
European markets participated in the global equity retreat, with the FTSE 100 dropping almost 6%.
Greek Prime Minister Alexis Tsipras announced his resignation Thursday, triggering snap elections to be held on September 20 unless a coalition government can be formed. Greece's sovereign debt, only just recovering from protracted bailout negotiations, sold off on the news. While there are concerns an anti-austerity politician could threaten the newly-minted bailout deal, most structural reforms and payments at the heart of the agreement have already been made.
US economic data
On a positive note, the US housing sector continues to improve as July new and existing home sales grew at the fastest clip in eight years. Residential construction starts and existing home sales increased 0.2% while homebuilder sentiment, a leading indicator, also registered its highest reading since November 2005.
Core CPI, which excludes food and energy costs, rose 0.1% in July and 1.8% annualized, below the Fed’s desired level of at least 2-3%.
Corporate news
Media conglomerate Liberty Interactive, owner of home shopping network QVC, announced an acquisition to boost its mobile and digital presence, buying Zulily (ZU) for $2.4 billion. The deal represented a nearly 50% premium to the flash-sales retailer’s prior closing price.
Canadian drug maker Valeant Pharmaceuticals (VRX) announced its sixth acquisition of the year, a deal to buy Sprout Pharmaceuticals, maker of the 'Viagra for women' drug to treat low sexual desire, for around $1 billion.
United Technologies (UTX) is in talks to buy ventilation and home security products-maker Nortek (NTK) for around $1.5 billion, according to the Wall Street Journal.
While earnings season is largely complete, a few notable reports came through this week. Wal-Mart (WMT) saw its quarterly profit fall 15%, leading the company to lower guidance for the year. Deere (DE) profits fell 40% amid weak demand and a stronger dollar, causing the stock to drop more than 8% Friday. Hewlett-Packard (HPQ), in its final report before splitting into two companies in November, suffered a 13% drop thanks to weak PC sales and a strong US dollar. The stock initially spiked Friday on the report, but finished only marginally higher thanks to broad market weakness.
Week ahead
- Tuesday: US new home sales
- Wednesday: US durable goods orders
- Thursday: US second quarter GDP, US jobless claims, US Fed Jackson Hole Symposium, Japan CPI and unemployment rate
- Friday: US personal income and outlays, US consumer sentiment
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Episode Playback
A bottom-up and top-down look at the market
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Did you miss Sunday's show featuring Mario Gabelli? Watch all segments, extended interviews and web extras at WallStreetWeek.com
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Episode Feature
Climate changing for water stocks?
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Value investors often find attractive valuations in boring parts of the stock market, and what’s more boring than water? While it doesn’t generate the same excitement as biotechnology or social media, water is an essential part of life and industry, with price-inelastic demand and significant barriers to entry.
Mario Gabelli, this week’s guest on Wall Street Week, has a bullish thesis on several companies within the water service industry. Water scarcity concerns have arisen due to the drought in California, prompting investors to kick the tires on investments in desalinization companies. However, Gabelli’s bullishness on water has less to do with scarcity than with the need to improve dilapidated water service infrastructure and equipment.
“[My investment thesis on water] has nothing to do with the drought in California. It has to basically do with the fact that water consumption is 10% for consumption, 30 or 40% for industry, and 60% depending on what country you're in, for agriculture. So, how do you get water? How do you treat waste water? How do you process it? How do you bring water from New York to California? Can you desalinate? How do you solve this problem? And so we look at that infrastructure support. Who makes the equipment? Who services it? Who does the processing, and who finds it?”
Despite Gabelli’s positive view of the sector, many water stocks have suffered from significant weakness in recent months. One recent bearish catalyst was earnings from Franklin Electric Co. (FELE), an Indiana-based manufacturer of submersible electric pumps and irrigation systems. The company reported a 40% drop in year-over-year earnings, leading to concerns of a similar slowdown in the rest of the sector.
Gabelli believes Franklin Electric’s weakness triggered an overreaction in other water stocks that has created an even deeper value opportunity.
“Short-term you have some challenges with seasonality. For example, it's a little wetter in the Midwest than it should be. California's [drought] is okay for the water industry… The question is a three-year timeframe.”
Gabelli offered a list of his favorite stocks within the water sector.
“The names are fairly simple that we own. We're buying Xylem Inc. (XYL), which is a spinoff from IT&T… It's a little nervous short-term because of what happened to Franklin Electric (FELE). Their stock dropped, which is good.
And then there are several other companies in the water business, like Badger Meter (BMI), who is down because of certain air pockets. I am very interested in a company called Mueller Water (MWA), which makes fire hydrants, among other things.
Gorman-Rupp Co. (GRC) has big pumps to move water. Then you have companies that have the ingredients to test water if you want to know whether you're meeting EPA requirements, or you have some problems in some countries. So, there are those examples.”
Xylem (XYL) is a $6 billion market cap producer of technologies for water and wastewater applications that has fallen around 13% since late June. Badger Meter (BMI), a smaller player with an $860 million market cap, is a Milwaukee-based manufacturer of water meters and related technologies that has recovered about half of its sharp June earnings-induced decline of around 14%. Mueller Water (MWA), one of North America’s largest manufacturers and distributors of fire hydrants, pipe fittings and valves with a $1.4 billion market cap, has dropped almost 20% since February. Gorman-Rupp (GRC), an Ohio-based pump manufacturer, has the smallest market-cap on Gabelli’s list at just over $600 million.
With recent market weakness, many assets have once again gone on sale. According to Gabelli, water stocks are among the bargains at which investors should take a hard look.
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Investment Primer
What is Private Market Value (PMV)?
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In Episode 18, Mario Gabelli discusses the concept of Private Market Value (PMV), an influential concept in value investing he is credited with pioneering, so we decided to include a primer on the topic.
The goal of value investing is essentially to buy something for less than it’s worth. The financial media often focuses on the most exciting and highest momentum stocks, but value investors often find the biggest bargains on stocks the market has fallen out of love with. Buying stable companies with historically consistent cash flows allows investors to enjoy a margin of safety along with potential price appreciation.
While investors often pay a premium for growth – buying companies that make little or no net income – value proponents hold stocks to a different standard. Columbia Business School credits Mario Gabelli with pioneering the concept of Private Market Value (PMV), which he describes as the price an informed industrialist would pay to purchase assets with similar characteristics. Essentially, PMV represents the price an individual would pay for a stream of cash flows in a private setting away from public markets.
Host Gary Kaminsky and Gabelli discussed the concept of private market value on this week’s show:
Kaminksy: “So, the idea, just so the viewer understands, it's as though you were using your money to buy a business. Forget that it's a publicly traded entity. It's a privately-owned business. It generates revenues. It has earnings. You're borrowing money to basically buy that business. You're trying to figure out at what point you can get an acceptable rate of return for buying that business.”
Gabelli: “Right. In today's terminology, 40 years later, it would be, what would private equity pay to buy a public company, to take it private, knowing full well a strategic, that is a corporate buyer having synergies would pay more?”
In addition to analyzing private market value, Gabelli also coined the term “catalyst” to apply to events that help a stock to unlock hidden value. While GAMCO looks to buy companies trading below private market value, they may also look for companies that carry potential synergies for strategic acquirers. Gabelli has become well known for owning companies that are eventually acquired. Catalysts can also include regulatory changes, industry consolidation, share repurchases, spin-offs or changes in management.
Gabelli further explained private market value:
“I would sit down, I'd write a great idea on a great stock, and somebody would say, 'why buy any stock?' So, I came up with the idea of saying, 'look, if a company is publicly trading, what is it worth if you and I chipped up to buy it?' At the time it was called bootstrap financing, which became leveraged buyouts, which is private equity today.
So, we talked about if a company is publicly traded, what would it be worth if it went private? That is private market value. Because we were not academics and had no tenure, with the client money that we were able to gather immediately we said, 'we need a catalyst.' What will make us surface the value – the spread between what it's trading for, and what it's worth?”
Gabelli’s stated investment objective for clients is to achieve an annual return of 10% above inflation, selecting stocks with the potential to provide a 50% return over two years. GAMCO’s sell decision is made when a security’s price begins to sell at or near private market value, or the expected catalyst happens or fails to materialize.
Have more questions about private market value? Email us at prosper@wallstreetweek.com
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Week Links
Stampede to the exits
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Analysis
High Risk, High Returns? Not Quite. (BloombergView, Noah Smith)
Did We Just Witness the Best Risk-Adjusted Returns Ever? (A Wealth of Common Sense, Ben Carlson)
Quarterly Financial Reporting is Needed, Productive, and Good (Aleph Blog, David Merkel)
Bonds
"Go anywhere" bond funds pose risks that investors can't see (Reuters, Jessica Toonkel and Jennifer Ablan)
Heading Off Bond-Market Tantrums (BloombergView, The Editors)
Treasuries Speed Trading Vaporizes Price Gap With Futures (Bloomberg, Alexandra Scaggs)
Hedge Funds
This Ain’t Your Grandfather’s Hedge Fund Industry (Pragmatic Capitalism, Cullen Roche)
Hedge Fund Fees: The Rorschach Test of Investing (CFA Institute, Will Ortel)
Fed
U.S. Lacks Ammo for Next Economic Crisis (WSJ, Jon Hilsenrath, Nick Timiraos)
Economy
American economy blues: Everything you need to worry about (Fortune, Joshua Brown)
Investing
Investing: The index factor (FT, John Authers)
MLPs: The More You Know… (ThirtyNorth Investments, H. Clark Gaines, Jr.)
Corporate
Inside Amazon: Wrestling Big Ideas in a Bruising Workplace (NY Times, Jodi Kantor, David Streitfeld)
An Amazonian's response to "Inside Amazon: Wrestling Big Ideas in a Bruising Workplace" (LinkedIn Pulse, Nick Ciubotariu)
China
IMF delays China’s bid for global reserve currency status (FT, Shawn Donnan)
Potpourri
Online Lender Social Finance’s Latest Fundraising Implies $4 Billion Valuation (WSJ; Peter Rudegeair, Telis Demos and Rolfe Winkler)
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