In a low growth environment, there will still be winners

M2 Capital HoldingsAuthor: Patrick McFadden, M2 Global

Covestor model: M2 Global

Anyone who has followed the markets or invested in them since the Japanese earthquake earlier this year must feel a bit wrung out.  During the two months from early July to early September, with a mid point of August 8th, the market fell very sharply, then rebounded strongly.

Where we go from here will largely be determined by the macro environment – more precisely, the political solutions or lack of solutions concerning the maturing sovereign debts within the EU and the fiscal response of the Super Committee in the US.  The solutions in both case are relatively clear from a non political standpoint, but politicians will be making the decisions.

The result of this highly politicized environment is uncertainty, and as a result, high correlations between equity markets globally and stocks individually. The market looks like “Risk on Roulette”. This is unfortunate, as many indicators such as increasing money supply, low costs of capital, and lowered inflation portend good things for US equities if growth does not grind to a stop based on negative self fulfilling expectations.

In a low growth environment, there will be winners. Millions of newly wealthy 35 year olds in China and other BRIC nations will continue buying Apple iPads and Audi A8’s. We shared a number of opportunistic stock ideas based on value, growth and yield during the August crash ( The majority of these ideas remain valid, however our Apple surrogate, OmniVision (Nasdaq: OVTI), a company that supplied almost every camera chip in every Apple device over the last few years, has dropped drastically based on a potential for losing part of Apple’s business and the general forecast of lower economic growth.

Our experience with OmniVision leads us to believe such concerns are largely unfounded. OmniVision will sell nearly a billion camera chips in 2011, has a strong balance sheet and virtually no debt. Total stockholder’s equity is made up almost entirely by liquid and short term assets and the market value of the company has recently traded at a relatively small premium to this value.  Meanwhile, return on equity is nearly twice the firm’s cost of capital and top line revenues continue to increase, though they may not continue to increase at the double digit pace of the past quarters.  Nevertheless, the company is being valued as if they are going to shut the doors next year and dividend out stockholders’ equity.  (Yahoo Finance as of 9/10/11

Though we do not currently own OVTI in our Covestor model portfolio, if it were to drop below $15 on market weakness we would consider purchasing it.  We recommend interested parties take a look at the most recent 10Q, filed 9/8/11 (  and/or read research on the company produced by Raymond James’ Hans Mosesmann.

Even if the Europeans provide us with a Black Swan event, OmniVision at current levels (as of early 9/11) is attractive.  Also, we believe OmniVision will likely be somewhat less correlated to the overall markets and will be less likely to be sold heavily due to margin call pressures on hedge funds at the current price levels.

An interesting note on interest rates and cost of capital as a forward indicator:  Our discounted cash flow (DCF) model on OmniVision indicates a value of $50 per share (and management will clearly not sell the company for less than this value).  This figure assumes a 10 year Treasury rate at a more normalized long-term rate of 5%. Decreasing this rate to current levels in the analysis increases our DCF valuation by more than 50%, ceteris paribas, given a 10 year horizon.  A 10 year horizon is difficult to currently predict,  but this delta shows just how undervalued healthy growth stocks may be if domestic and global growth moderate and recover without a long-term, credit led stagnation.

Due to the current uncertainty we are hesitant to change the portfolio, either by purchasing undervalued growth stocks such as OmniVision or by purchasing yield through individual stocks such as STO & ARR or via diversified ETFs such as GLQ or HYF.

We believe our current position in MNKD, while volatile, is much less susceptible to high market correlations.

Gold, long-term Treasury bonds, shorting specific stocks or currencies have all shown attractive negative market correlations in the recent quarters, however at current prices these assets do not have a risk-reward profile that is appealing for us. Utilizing such asset classes or tools to hedge a more diverse portfolio may make sense but we are comfortable with the risk profile we currently hold.

Given our analysis of OmniVision, our ongoing conviction on Mannkind’s (Nasdaq: MANN) prospects should be telling.