2017 3rd Qtr. Kildare Asset Mgt.-Kerr Financial Group client review letter

Making quick and easy decisions based on one simple and never-failing indicator has been the Holy Grail that investors have desperately searched for since the Buttonwood Agreement formed the New York Stock Exchange in the spring of 1792. And certainly over the years, there have been countless attempts to develop a foolproof system that would be the guaranteed road to riches.

Despite the well-intended (and some not so well intended) systems developed for making investment decisions as simple as using a smartphone app, the markets are not that easy. Corporate earnings, GDP growth, interest rates, valuations, budget deficits, and currency prices are just a few of the things that influence the financial markets.

And even if it were possible to include all of the many things that impact prices, we would then have to assign the proper weighting for each of them. Finally we would have to recognize that this is a dynamic situation and the amount of impact of these factors is constantly changing.

Of course, any system must also consider how much of the future values of these indicators are reflected in current prices. In other words, how much GDP growth (or any other influencing item) has been priced in. This is a very subjective variable.

This leads to the biggest obstacle to developing such a system – the requirement of measuring human emotions. This critical input is, unfortunately, the most unstable part of the analysis. Investor feelings and sentiment have a huge impact on the markets, contributing to push prices into bubbles as well as playing a part in panic selling. And as can be seen in hindsight, often times these emotions are flawed. A look back at 2017 provides a couple of examples of erroneous investor expectations.

Following President Trump’s election there were several widely held beliefs. The prediction for a stronger U.S. dollar was one expectation that investors assigned a high probability. This was based on the “Make America Great Again” theme which would result in faster economic growth and higher interest rates which would push the value of the dollar up.

Another forecast was centered on Mr. Trumps’ immigration policy. A shift to stricter conditions was expected to be hurtful to technology companies and their stocks. This was related to reduced access to skilled workers.

Both of these events turned out to be off target. The U.S. dollar has not only failed to rally, it has weakened significantly. Below is a chart that shows the Bloomberg US dollar index which is the value of the greenback vs. a basket of other currencies.[i] The index has been in a steady decline for the first 9 months of 2017. Obviously, this is not what Wall Street forecasted.

Likewise, strategists have been equally wrong regarding the technology sector in 2017. Whether this is correlated with the fall in the U.S. dollar or coincidence, tech stocks have outperformed this year. To be sure, it has been a strong year for the broad markets but few were predicting tech’s outperformance at the beginning of the year. Again, this demonstrates the risks of market forecasting.

Regarding the financial markets, not only has this year been hard to predict, it has been hard to explain. Given the social division, political polarity, and general acrimony, it is tough to understand that the stock market is at record levels. The explanation involves corporate earnings which have been strong. Also, despite all of the geopolitical problems, the global economy is doing pretty well. That society’s chaos has not derailed the economy could be a reason that the markets seem to be looking past these issues. Here are how the major averages have performed through September 30, 2017 and for the third quarter.

3rd Qtr. 2017

Dow Jones Industrial Average +4.94% +13.37%
S&P 500 +3.96% +12.53%
Nasdaq Composite +5.79% +20.67%
Russell 2000 +5.33% +9.85%

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.

3rd Qtr. 2017

+7.47% +12.94%

Your accounts grew in the third quarter and it was the best quarterly performance of 2017. And within the three months, September was especially strong. This was partially driven by the rally in the broad markets, but also gains in individual holdings. A couple of long time positions continued to appreciate. Hurco Companies and Layne Christensen Company both rallied after reporting earnings in early September.

As a reminder, 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 released their third quarter earnings report just after Labor Day and it showed that their growth continued. Noteworthy is the sustained expansion in their order book which should drive future revenue and profits higher.

I mentioned Hurco in the 2nd quarter review letter and pointed out that they didn’t have much interaction with institutional investors (no conference calls or presentations). I suggested that if they kept reporting strong results that Wall Street would find them. That might be happening and, if the operational trend continues, the stock could continue to appreciate.

Layne Christensen is a global water management, construction, and drilling company. They have had some challenges in some of its divisions which management is addressing. As is common in these situations, progress is not a smooth journey and investors sometimes take a cynical view.

Layne’s stock price had steadily declined for the first five months of the year falling from over $11 per share to the low $7’s or 37%. This was especially frustrating given the background of a broader bull market. The stock rebounded in June after the first quarter’s financial report showed some positive developments. Their second quarter earnings release at the beginning of September contained more news of improvement and the stock pushed to new 52-week highs.

Layne’s stock could keep moving higher as long as the improvements remain on track. Further the company has some new water related initiatives that look to leverage the company’s assets. This has been a long time holding and will remain in your account as long as the turnaround continues.

As is normally the case, there were some blemishes within your account and the most recent example is Dick’s Sporting Goods. As many know, Dick’s is one of the largest sporting goods retailers in the country. Beside the Dick’s stores, the company also owns and operates Golf Galaxy and Field & Stream stores. Sales for this fiscal year will likely exceed $8 billion. Guidance for net income is in the range of $2.80 to $3.00 per share.

As most people know, retailing is a competitive business and the current landscape is made tougher by the presence and strength of Amazon. The drop in Dick’s stock reflects investor pessimism concerning the company’s ability to compete. Dick’s shares reached an all-time high in November 2016 at $62.88. By the middle of 2017, it had dropped to the mid-30’s. I thought the selling was overdone and, at this level, it represented good long term value. In August the company reported its 2nd quarter results. The numbers were disappointing as well as the guidance for the future business conditions deteriorated. The stock fell into the upper 20’s.

I continue to think Dick’s offers good value. The stock trades at a single digit P/E multiple (as a comparison, the S&P 500’s P/E is above 20). The dividend yield is around 2.6% and is well covered. Wall Street analysts expect company revenues to grow to over $8.5 billion in coming years with projected profit stabilization.

While U.S. sporting goods sales are growing, the pace of growth is declining. Further, Amazon’s marketplace influence could continue to expand. However, there are reasons for optimism. Dick’s has a proven management team that has successfully grown the company to be a market leader. Several of their competitors (The Sports Authority, Gander Mountain, and Golfsmith) have failed which should help them in the future. Best Buy is an example of a retailer surviving tough times to eventually dominate the industry. Finally, the inexpensive valuation gives no credit for these bullish possibilities. I will be watching closely for signals for improvement or further weakening and act accordingly.

2017 has been an example of how tricky the financial markets can be. It would be hard to predict that stocks would trade at all-time highs when the headlines have been so negative. This is a reminder of how challenging the investment process can be. But from these challenges there arises the opportunities to help your investments grow. As always, I will continue to seek out these situations.

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

Jeffrey J. Kerr, CFA

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

[i] The Bespoke Report, October 27, 2017

Jeffrey J. Kerr, CFA

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

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