Jan 14 2015
2014 was unique in its way; Sharp drop in oil prices, Russian annexation of Crimea, World cup soccer, Ebola epidemic, regime change in India, elections in Brazil, power shift in the congress and finally positive ending of S&P 500. Though market was started with rumble in the year 2014, it ended with humble 13.69% return beating 83 percent of large blend mutual funds.
Last year our winners in the portfolio were Southwest Airlines, Spirit Airlines and Berkshire Hathaway; Google and Holly Frontier were our laggards. As we predicted consolidation in oil refiners that has not materialized. We believe Holly Frontier has properties at strategic locations and has excellent cash flow trading at lower multiples yielding nearly 10 percent with special dividends; could be an easy acquisition target by bigger oil firms. Though Google had lackluster year in 2014; new product innovations, market leadership and lower price multiples will improve Google price in the year 2015. We are still holding both Holly Frontier and Google. Also last year our Long term value portfolio returned 15.1% net of fees versus S&P 500 realized 13.69% with dividends included.
Year 2015 is going to be very interesting year due falling commodity and oil prices, lower unemployment rate, strengthening dollar, lower trade and lower fiscal deficits and wage inflation and possible interest rate hikes. At the beginning of this year all leading economic indicators are showing positive trend. Uptrend in average weekly hours, decline in initial unemployment claims, expansion in manufacturing with new orders and steepened yield curve among the all major economies is very good beginning.
As we predicted in the last year’s review (http://investing.covestor.com/2014/01/2014-trends-watch-oil-glut-airline-oligopoly) there was so much inequilibrium between oil supply and demand. Recent oil correction is well deserved and shot in the arm for many global economies. It all started when we waged two-pronged war in the Middle East. Oil prices spiked up due to fears of supply constraints, though they never realized. Oil prices drastically moved up from $26 a barrel in January 2002 to $143 in July 2008 right before the recession. It was a startling gift to oil producers while domestic consumers were squeezed hard due to oil price spike. Oil producing countries including OPEC nations enjoyed surplus wealth due to higher oil prices. Unfortunately ones pain was others gain.
However technological innovations in shale oil extraction, slack in global oil consumption, advances in energy efficient automobiles and electric vehicles reversed the oil price trend. We have started producing more oil domestically than importing from the foreign markets. Eventually glut in the oil supply made its magic in the market. Finally we are at a stage that we don’t need to worry too much about exogenous shocks related to oil on our economy.
All these boom days’ oil producing countries highly relied on oil wealth and never able to diversify their economies. They spent their excess wealth mostly on public spending, oil subsidies and wage increases. Prior to 2015, most of the energy rich nations prepared their fiscal budgets looking backwards. In order to balance their fiscal budget the price of the crude oil needs to be at above $100 for the oil rich Middle Eastern nations. As you can see in the above IMF chart the breakeven prices are ranging from $55 for Kuwait to $180 for Libya to balance their fiscal budgets. At this crude price $55, are these Oil supplying countries able to cut their oil production without dipping into their sovereign funds or cutting spending abruptly without any domestic turmoil? I seriously doubt it. The next stop for oil is below $50 or even at the $40 range?
How much impact lower gasoline prices have on the economy?
As per AAA average gas price average gas price per gallon last year was $3.301 and as of now the average gas price is $ 2.168 that is $1.133 cheaper than last year. As per BLS in 2013 average family spent $2418 on gasoline that is average family consumed 616 gallons of gasoline. Out of 126 million households we consumed 78 billion gallons of gasoline. With $1.133 gasoline price drop the impact on our economy is $90 Billion ($87,708, 611,760). If we add jet fuel and diesel from industrial consumption the impact on our economy is tremendous. Eventually all these saving this will add up on lower cost of goods and higher consumer spending and there by significant impact on out GDP growth in 2015. Some of the economists arguing that capital expenditures from energy companies will decline in 2015 due to lower profits may have negative impact. We believe overall net gains from consumer spending has lot more impact on the economy than reduction in oil industry capital expenditures due to the fact velocity of the money at consumer level is lot higher than capital spending by big firms and also oil industry expenditure is not all spent within the boundaries of the country, and third of our energy consumption is from abroad.
Who will benefit from energy savings?
Every family gets impacted from the oil price drop. On average every family saves at least $700 if the prices stays as at $2.168 a gallon, but in many parts of the country average gallon prices is below $2.00 and the trend is downwards. As you can see in this chart (compiled from BLS data), an average family spends 13% of its income on food, 18 percent on transportation. Most probably excess savings from gas
pump will be spent on consumer staples than luxury items. In our opinion excess marginal spending will benefit grocery stores like Wal-Mart, Costco, Kroger and SUPERVALU. Next level of beneficiaries are casual restaurants like Panera bread and Starbucks café. Other big winners are going to be in the transportation industry particularly corporations like FedEx and Southwest airlines.
What we see year ahead?
At recent survey at Barron’s magazine market seers on average predicted 8 percent return on S&P 500; however we believe this year we are expecting S&P 500 return will be higher than last year returns. We see lot of tail wind to our economy due to decline in energy prices and accelerated consumer spending and real wage growth which is stagnant for the long time.
European and Japanese economies may be struggle to come back to normalcy; Russian economy will end up into recession due to decline in energy prices and economic sanctions by Western countries. Yield curve in Russia is already inverted. Sorry, tough days ahead for Russia. Many Asian countries including India, China and other south eastern Asian nations also enjoy sharp decline in current account
deficit simply due to energy prices. Whereas Korea and Germany have highest percentage of their GDP tied to exports will face headwinds due to global slowdown. Other end In US our exports contribute only 14 percent of our GDP, global weakness have little impact on us in the next year. However many multi-national firms face headwinds due to stronger dollar and weaker global markets especially in Europe.
Airline industry will have another exceptional year (third in a row) due to lower competition in the domestic market and lower oil prices. However this year all airlines may not end up winners. Open air agreements with foreign carriers bringing heavy competition to major carriers in the trans-Atlantic market from gulf airlines. That will put price pressure and vigorous competition among airlines.
Almost all airlines charge for luggage and some even charge for carryon bags. All the major airlines cutting loyalty miles for economy class travelers. Only exception for all these trends is Southwest airlines. It has adopted exceptional customer service and follow egalitarian approach with single class of seating and never charge for bag fees. That is the durable competitive advantage. Southwest is also expanding its services to Caribbean and Mexican destinations and going to start direct international service from Houston Texas. Other airlines to watch is Copa airlines based in Panama. A well-run company dominant in the Latin America flies to most of the Latin America and North America has partnership with United Airlines Star Alliance trading at lowest multiple generating abundant free cash flow.
We also foresee 2015 is going to be the last year for Sears and Radio Shack companies. Their cash burn rate does not justify their existence any more. With same kind of high cash burning rate, sooner or later JC Penny may also join the cliff jumping party.
With ubiquitous cheaper internet data plans, 2015 is going to be a remarkable year for cloud players. All new personal computers, tablets and electronic devices will come with thin hard drives and heavy cloud drives. Eventually cloud storage players like Google, Apple, Amazon and IBM take major chunk of consumer business.
Finally we see Apple pay will be adopted by all mainstream retailers. If Apple can bring department of motor vehicles in their customers list, there is no need to carry our wallets because you have your driver’s license, insurance card and all electronic cash stored in the Apple phone.