We’re buying industrials like Cat, Deere and Cummins

Author: Ben Dickey, BSG&L Financial Services LLC

Covestor models: Pure Growth and Growth Plus Income

Disclosure: Long stocks mentioned below

The first quarter of 2012 came in with fairly good growth, both in GDP and employment gains. However, the second quarter results stumbled. The second quarter GDP growth was revised down recently to 1.3%.

We have now seen GDP output decline from 3% growth in the fourth quarter of last year to 1.9% in the first quarter of this year and now down to 1.3% growth in the second quarter.  The PMI Index is showing a slight contraction in orders, employment and shipments for the third quarter. Employment gains have been slim.

Although our economy is still being impacted by outside global factors, some foreign governments are trying to do the best they can to stimulate their economies and increase world demand. In China, the People’s Bank of China is providing more stimuli to encourage growth. The Bank of Japan is liquidity by adding buying debt, like the United States. The European Central Bank has promised to “do everything it takes” to keep the Euro stable and buy bonds to support growth.

In the United States, another critical factor causing the slowdown is the massive fiscal cliff that the economy is facing at the end of the year. The expiration of the “Bush-era” tax cuts, the temporary reduction of the payroll tax cuts, and the extended level of unemployment benefits will all expire on December 31st.

Compounding the problem is the “sequestration” of government spending, due to the failure of the Super Committee, which is also scheduled to take effect starting in January, 2013. Not knowing whether or not the economy is going to actually go over the cliff at year end has many businesses in a wait and see mode of operations. Most major corporations have placed expansion plans on hold until a clearer picture unfolds.

As a result of the economic slowdown, overall market sentiment has turned extremely pessimistic. I believe that businesses will not have a clear understanding of the resolution to the fiscal cliff scenario until after the election in November.

However, amidst all the doom and gloom with the U.S. economy is one area of bright sunshine. A byproduct of the weakening world economies is falling commodity prices, at least in the near term. Overall, even with all of the negativity, our economy does continue to expand, albeit at a slower rate.

There are several market segments doing well. WTI prices recently breached $100/Barrel intraday.  It has recently pulled back to around $90/Barrel. The world is consuming about 90 million barrels per day of petroleum.

The largest difference between oil and most other types of energy is supply. The major challenge is the replacement of declines in the major existing fields.  The world is losing about four million barrels of oil per day per year by declines in production from exiting fields.  The world demand is also increasing by about one million barrels per day. The United States is the only non-OPEC country to increase production year over year.

This leads to a reduction in worldwide spare capacity. Thankfully, major technological advances in the oil & gas industry have allowed the U. S. to increase their oil production for the first time in over twenty years. As companies learn more about drilling in shale formations, they are decreasing the space between wells and pad drilling, meaning they can drill four or more wells from one location.

Both of these items reduce the cost of drilling wells. There is also a move to lessen the use of ceramic proppant and replace it with sand which is cheaper. This will increase the profitability of the energy and production companies we recommend that are drilling in the shale plays.

The low natural gas price is reducing operating costs for many manufacturing companies.  Utilities, where they are able, are changing from burning coal to burning natural gas for electricity production.

For the first time, more kilowatts are being produced from burning natural gas than from coal. This should help lower utility costs to both the commercial and residential user, helping the U.S. economy.  In addition, the increased production of natural gas liquids such as ethane, propane and butane has lowered the input costs for the chemical industry.

As a result, chemical companies are moving production back to the U. S. from overseas which is causing plants in the Gulf Coast to expand capacity at a strong clip. Several chemical producers we follow have shown nice price gains recently.  New pipelines are under construction.

The lower leg of the Keystone XL pipeline from Cushing OK to the Texas gulf coast refineries is finally under construction. This should be finished my mid-2013. The new pipelines will lower transportation cost from the Eagle Ford, Permian Basin and Marcellus shale’s to the refineries.

The lower transportation cost provided by the new pipelines will make the U.S. chemical industry even more competitive. The Keystone will bring more crude oil to the refineries, allowing us to lower the amount of imported oil and allowing the refineries to improve their profits as well as improve the profit of the producers in the Williston Basin.

Throughout the world, emerging market economies have slowed down, but still have a growth rate of mid to upper single digits. China and India have slowed as export demand for goods going to Europe have slowed. However, an increasing middle class in these markets is beginning to make these countries less dependent on exports. In addition, Mexico, Indonesia, South Korea, Central America and the Philippines   are growing at faster rates than the BRIC countries.

Despite all the negative economic news, the market has improved over the last few weeks.  Our Federal Reserve has added QE Infinity; intending to buy $40 Billion of mortgage backed securities per month for an indefinite period of time. This, along with Europe, China, and Japan adding to the flood of money flowing into the world, should help keep a floor under commodities, especially oil.

BSG&L has a long term investment horizon. This belief causes us to stay with an overweighting in our basic portfolio allocation to industrials in our Growth Portfolio.

We like Caterpillar (CAT) as the best choice for heavy industrials. They recently lowered their forecast for 2015, but are increasing earnings for the fourth quarter. The forecast for three years from now will be revised several times before 2015 arrives. They are the behemoth in this business.

Their sales in China and India have slowed, but their geographical diversity helps them.  We still like Deere & Company (DE), Honeywell International (HON), United Technologies (UTX), Emerson Electric (EMR), and Cummins (CMI) in the industrial sector as well. Several of these stocks are dramatically over sold.

As the market settles down we will add to our positions. When the U.S. economy improves, these companies will show large gains.  In the energy service sector we like Helmerich & Payne (HP), Cameron International (CAM), Halliburton (HAL), Mitcham Industries (MIND) and Schlumberger (SLB).

Second quarter earnings slowed for several of these companies, but they should show marked improvement in the upcoming earnings period.  Our commodities and energy holdings have changed very little.  We continue to like Continental Resources (CLR), Anadarko Petroleum (APC) and EOG Resources (EOG) in energy.  EOG and Continental Resources have shown large increases in production year over year.

We are adding to our position in Oasis Petroleum (OAS) and Whiting Petroleum (WLL).  They have increased production year over year by almost 150%.  We still like industrial commodity producers Peabody Energy (BTU), Freeport-McMoRan Copper & Gold (FCX), Cliffs Natural Resources (CLF), and Southern Copper (SCCO).

Industrial commodity prices have seen a large pull back, pulling these company’s share prices down.  Our belief is you should be building your cash position for now and let the markets settle down.  I think you will be able to purchase these companies at good value prices before the end of the year for another good upward move.

As we have been saying for quite a few months now, the pipeline companies and commodity MLP’s are experiencing tremendous growth although their stock prices have been impacted by the drop in oil and natural gas prices.

We think this is an excellent time to add to these positions for the long term increases in stock price and distribution amounts that we think are coming.  As a result, in our Growth and Income Portfolio we continue to add Kinder Morgan Energy Partners (KMP), Linn Energy (LINE), Enterprise Products Partners (EPD), SandRidge Mississippian Trust (SDT) and SeaDrill Limited (SDRL).

These companies have good dividend rates of between 6% and 10%.  There is over $31 Billion of pipeline construction either under construction or at the contract placement phase.  As new technology increases the output of oil, natural gas and natural gas liquids, this production will move through the new pipelines.  We believe the above companies will show tremendous growth over the next ten years.

Just to restate, I believe the European debt problem and the upcoming U.S. elections have us concerned about market activity for the rest of this year.  Hedging this volatility, in my opinion, will be hard.  Gold last year was as volatile as the stock markets.  I believe copper and oil will be the inflation hedges going forward.

Central Banks around the world have injected so much liquidity into markets, that when it is put to work, commodities will move dramatically in price. BSG&L is a long term investor.  We believe if you are patient, build cash and buy good companies on pull backs, your portfolio will have good growth over the long term.
Disclosure: Performance discussed is net of advisory fees. The index comparisons herein are provided for informational purposes only and should not be used as the basis for making an investment decision. There are significant differences between client accounts and the indices referenced including, but not limited to, risk profile, liquidity, volatility and asset composition. The S&P 500 is an index of 500 stocks chosen for market size, liquidity and industry, among other factors.

The investments discussed are held in client accounts as of September 30, 2012. These investments may or may not be currently held in client accounts.The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or that investment decisions we make in the future will be profitable.

Certain of the information contained in this presentation is based upon forward-looking statements, information and opinions, including descriptions of anticipated market changes and expectations of future activity. Covestor believes that such statements, information, and opinions are based upon reasonable estimates and assumptions. However, forward-looking statements, information and opinions are inherently uncertain and actual events or results may differ materially from those reflected in the forward-looking statements. Therefore, undue reliance should not be placed on such forward-looking statements, information and opinions.