2017 2nd Qtr.Kildare Asset Mgt-Kerr Financial Group client review letter

Not only did June mark the end of 2017’s second quarter, it was also the eighth anniversary of the end of the Great Recession. This recovery has had plenty of detractors so may it surprise many that this has become the third longest economic expansion since World War II. Only the dot-com boom (10 years – 1991 to 2001) and the 1960’s (9 years – 1961 to 1969) are longer. To put this into further perspective, the average post war expansion is 58.4 months (just shy of 5 years) according to the National Bureau of Economic Research.

When measuring by strength, however, this expansion is not as impressive. Normally an economy that has been expanding for so long would show both above average and accelerating growth. This is not the case for the post-2009 recovery which has a compounded annual growth rate of 2.1%, well below the 3.6% rate of the 1990’s and the 2.8 % of the 2000’s.

Of course, the causes for this below average growth is the subject of intense debate. Much of this deliberation revolves around the impact of the Federal Reserve and monetary policy. Both have played important roles in trying to stimulate the economy as well as stabilize the markets. And both have been controversial in their execution and their effect.

The severity of the financial crisis, according to our central bankers, called for drastic and aggressive measures. The Fed has used “unconventional” to describe their methods which included ‘operation twist’, ‘QE’ (quantitative easing), ‘QE1’, ‘QE2’, and ‘QE infinity’. In contrast to the fancy terminology, the strategy has been simple. It has three basic components – reduce interest rates, print money, and use that newly created money to buy bonds in the open market.

Fed critics believe that these policies and strategies have distorted the markets. Interest rates are unnaturally suppressed which distorts market prices and discounting calculations. Further, some think that the economic recovery would have been much stronger absent central bank meddling.

The magnitude of these programs is illustrated in this chart. The blue line represents the assets owned by the Federal Reserve which consist of securities such as bonds. Prior to the financial crisis, the Fed’s balance sheet normally ranged between $700 million to $900 million.

The blue line spikes at the beginning of the crisis. And after this initial jump, the Fed’s holdings steadily climb until 2014. For the past couple of years, the balance sheet has been steady at approximately $4.5 trillion or more than quadruple the typical balance before the financial crisis.

This shows how dramatic the QE programs were. And while the economic impact of this monetary policy is unclear, the chart shows that the stock market, as measured by the S&P 500 (red line), has benefited. This leads to the question of what happens when the Fed starts to reverse these programs. In June, Janet Yellen and Mario Draghi both introduced the idea that their central banks will start shrinking their balance sheets.

This could increase stock market risk. Alex J. Pollock, senior fellow at the R Street Institute, wrote in June, “The Fed’s problem is now simple and obvious: once you have gotten into positions so big relative to the market and moved the market up, how do you get out without sending the market down? The Fed is expending a lot of rhetorical energy on this problem.”

Of course, the hope is that the economy is strong enough to continue to expand during a gradual reduction of monetary policy help. However, markets have gotten accustomed to central bank involvement and any change could be a headwind. The Fed and ECB’s goal (and challenge) is to gradually remove the elixir without disrupting the markets. The risk is that the addiction is greater than it appears.

Returning to 2017’s second quarter, the stock market advanced further. The gains were less than the first quarter but still respectable. Here is a break down for the major averages for the second quarter and year-to-date.

2nd Qtr 2017

Dow Jones Industrial Average +3.32% +8.03%
S&P 500 +2.56% +8.24%
Nasdaq Composite +3.86% +14.07%
Russell 2000 +2.12% +4.29%

Using a size weighted average, here is how the average Kildare Asset Management-Kerr Financial Group client’s account performed. This is calculated after all fees and expenses.

2nd Qtr 2017
+2.72% +5.83%

There were a few notable developments within your portfolio. First, Hurco Companies, Inc. had a good quarter. Its stock rose 10% with the majority of the move happening in June after the company reported earnings. Hurco is a machine tool manufacturer. They produce high end machines with proprietary software and sell them globally with typically over 50% of sales to Europe. The company has a strong balance with no long-term debt.

Hurco has made two acquisitions during the past few years that expands their product offering into other sectors of the market. From the company’s recent results, it looks like they are gaining some acceptance. Annual revenues exceed $200 million and for the past three quarters, for the first time, they have received over $60 million of orders in each quarter.

Hurco is a small company with a limited amount of shares outstanding. Further, they don’t communicate with Wall Street well. Management does not do earnings conference calls nor investment presentations. I speak to Hurco’s chief financial officer (Sonja McClelland) regularly and have encouraged her begin doing earnings conference calls to broaden investor awareness. Whether that happens, if the company continues to grow, Wall Street will find it.

Layne Christensen, which has had some successful recent quarters, and Ares Management, LP (alternative asset manager) were small drags on performance. Both stocks were flat to down slightly. Ares has been especially frustrating as it traded above $22 in the first quarter and closed the second quarter at $18.00. We are still receiving a good yield with a dividend of 6% (assuming a $20 cost basis) and the company has been growing assets and developing new sources for future growth. I think both positions will contribute to performance over time.

On the morning of the last day of the quarter, we received good news that another position was being acquired. Parkway, Inc., a real estate investment trust (REIT) which owns offices in Houston, announced that they were being bought by Canada’s Pension Plan Investment Board. As you may recall, Fortress Investment Group announced in the first quarter that they were being taken over which moved the stock much higher and helped first quarter performance.

Parkway was a late 2016 spin out from Cousins Properties, a much larger nationwide REIT. Cousins’ desire to unload the Houston properties was understandable given the trouble that oil and gas companies have encounter during the past few years.

Despite the challenges, Parkway was attractive because of a cheap valuation which priced in a lot of the negatives. Furthermore, management had a history of re-building real estate companies and there was significant potential over time.

In February, Parkway announced that it sold 49% of one of its properties to a joint venture that included the Canadian Pension Plan Investment Board. They obviously liked the situation and saw value in the whole company. The acquisition is valued at $23.05 per share which is a one-time $4 dividend and $19.05 in cash. The deal is expected to close in the fourth quarter.

Looking to the second half of 2017, the markets will deal with issues such the federal government’s debt ceiling, tax reform, geopolitical tensions, and domestic social acrimony. Add to this the possibility that the Federal Reserve and other global central banks may be cutting back on monetary stimulus.

On the bullish side, corporate earnings are growing and business sentiment is optimistic. And internationally, both developed and emerging markets are expanding. As long as none of the challenges gets out of hand or some other event upsets the global economy, further growth is expected. I will continue to monitor the events looking for opportunities while managing risk.

Thank you for your business and continued confidence. Please contact me with any questions.

Jeffrey J. Kerr, CFA

Kerr Financial Group
Kildare Asset Management
168 Water Street
Binghamton, NY 13905

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