Minneapolis Portfolio Management Group | info@mpmgllc.com | 612.334.2000
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Market madness and the value of fundamentals

Market Summary – 1st Quarter, 2013

Few can appreciate the coming of spring as much as Minnesotans. The promise of longer days and fairer weather is thankfully delivered by our favorite annual rite of spring – the NCAA Division I Basketball Championship tournament.

Each year collegiate teams representing a broad array of athleticism and playing styles converge to participate in a single elimination game tournament with the hope of advancing through several rounds and winning the national championship (here’s hoping that the University of Minnesota’s new Coach Pitino can experience such success – something that would be welcomed even more than an early spring!) Though the talent levels and resources of the teams may differ greatly, the teams that experience the greatest (and most consistent) success are those that are well coached and well-grounded in the fundamentals of basketball.

q112 cartoonThe same idea applies to investing. Focusing on investment fundamentals has been the most important factor contributing to our long-term success. So what are the fundamentals of our value-based investment philosophy? Find businesses that provide needed products and services to the growing parts of the world. Don’t follow the hot trend or what works in the short run if it leaves you vulnerable in the long run. Look for healthy balance sheets and superior management. Be patient and wait for the market to recognize value. Most important: remain disciplined and never overpay for a business.

These tenants of investing seem simple to follow, but many self-proclaimed experts can easily lose their focus. A seemingly endless array of fear merchants has procured significant airtime and column inches in the past few years in order to share the “wisdom” of their latest prediction for dire times ahead. In the wake of the financial crisis, a sudden surplus of “doom-and-gloomers” was understandable. But now the bull market is beginning its fifth year, demonstrating that in most cases these ominous forecasts were just dead wrong.

The real shame of this is that too many investors missed out on the market’s now complete recovery from the downturn of 2007-2009. Rather than having been distracted by the so-called experts wearing their own fancy uniforms and oftentimes representing big institutions, investors would have been better served by instead focusing on fundamentals. We have emphasized this point for several quarters. If macroeconomic-driven market hiccups are good for anything, it is in providing an opportunity for astute investors to acquire positions in great businesses at bargain prices.

Throughout this period of macroeconomic uncertainty, we’ve remained focused on our primary objective – finding great businesses that will create wealth for our clients. To do this we conduct research, speak with management teams and identify companies that provide products and services that, in many cases, are necessities of life.

Where the opportunities lie
Though the pundits in the media choose to highlight stories about macroeconomic disasters that fail to materialize, far more interesting stories about the changing world are being ignored. We see significant opportunities for sustained future expansion in a number of sectors. It is within these sectors that we believe we have identified the companies best positioned to succeed.

Perhaps the most significant statistic is that the world’s population is expected to increase from seven to eight billion people by 2025, or more than 200,000 new citizens of the world per day1. The epicenter of this growth is found in the emerging markets of the Asia Pacific region. The rapid expansion of a global middle class could generate $30 trillion in annual consumption by 2025 – increasing by almost 2.5x from 2010 levels and representing the biggest growth opportunity in the history of capitalism2.

Here are some of the key sectors that we think will be at the center of the world’s investment opportunities in the coming years, and a small sample of current holdings in the MPMG All Cap Value Composite that we believe are poised to capitalize on those opportunities.

Food and Agriculture
A first step for those reaching the middle class is to improve their diet, often moving from a grain to a protein based diet. This creates a number of challenges in terms of food production. For example, it takes approximately 10 times as much seed, fertilizer, water and land to produce a calorie of protein as a calorie of grain. Further, the land in emerging markets is not particularly fertile, meaning that more food must come from less farmable land.

Production efficiency is vital to meet the increased demand. DuPont (DD, $49.823) known by many as a chemical and manufacturing company, is repositioning itself as a company that feeds the world. Their drought-resistant seed (Pioneer brand) produced outstanding yields despite the dry summer of 2012. Another holding is Agrium (AGU, $93.263), a leading producer and marketer of nitrogen fertilizer and potash.

Water
Along with the need for more efficient food production, the world faces a shortage of its most precious resource – water. Less than 1% of the planet’s water is fresh, and it is threatened by the draining of aquifers, increased pollution and climate change. Yet demand for fresh water is expected to double every 20 years as population expands, and industrial and agricultural needs grow. By 2025, about a third of the world’s population will lack adequate fresh water supplies. Even the United States wastes significant amounts due to aging and underfunded infrastructure. These challenges create opportunities for growth in the $500 billion global water industry.

Offering a broad spectrum of products and services supporting the transportation, treatment and testing of water worldwide, Xylem (XYL, $28.603) is the largest, publically traded “pure play” on water. Two other portfolio holdings are Siemens (SI, $106.213) and 3M (MMM, $107.683), conglomerates that are developing groundbreaking solutions to the world’s water dilemma.

Housing and Infrastructure
Following the collapse of the housing market five years ago, we are in the early stages of a housing recovery. New home starts have improved after reaching a low point of 600,000 in 2010, but are still significantly below the long term average.

Likewise, home prices are starting to rebound yet home prices in the U.S., on average, remain 14.4% below the 2007 peak.

In the meantime, a shadow inventory of homes – foreclosures not yet on the market and currently owned and occupied homes waiting to be put up for sale – is expected to emerge. While it can temper demand for new homes, most homes being put on the market need some updating first. That creates additional demand for housing related products and services, not to mention the millions of existing homes and buildings which need improvement.

Ingersoll-Rand (IR, $56.163) is the leading provider of HVAC systems (heating-ventilation-air conditioning), a basic component of any home. We believe that it has outstanding earnings leverage in its sector to benefit from a domestic construction recovery. Other attractive firms include Stanley Black & Decker (SWK, $79.243) a global leader in the sale of power tools and other related products; Briggs & Stratton (BGG $24.093) the world’s largest maker of small, air cooled gasoline engines found in lawnmowers and power generators; and Scotts Miracle Gro (SMG, $45.433), a leader in turf and horticultural products.

Big Data
Every day, we create 2.5 quintillion bytes of data – so much that 90% of the world’s data has been created in just the last two years. Big data comes from everywhere, whether it be credit card purchases or climate information to cell phone GPS signals. Big Data involves using powerful computers to crunch all of this data, find efficiencies, increase automation and personalize goods and services in amazing ways.

An example of Big Data in action lies in the possibility of personalized medical treatment. One of the companies that has benefitted from this trend is Life Technologies (LIFE, $68.003,4). It has developed a tool that maps the entire human genome in less than 24 hours, rather than the weeks it used to take. This means that gene sequencing can move from the lab into the clinic (a much larger market) and be used to develop personalized medicine. Along with more effective treatment of diseases, it could save $300 billion per year in medical costs. Other companies poised to benefit from Big Data include Oracle (ORCL, $33.463), providing the hardware and the software to analyze this data; Cisco Systems (CSCO, $21.543), a builder of secure networks to handle the dramatic growth in data; and NCR (NCR, $28.203), a leading manufacturer of ATMs and point-of-sale kiosks that collect much of this data.

Energy
Energy’s role in our portfolio has evolved. In the late 1990s, as we invested in big oil companies, the price of a barrel of crude (around $92 now) was down to $12/barrel. Since that time, we’ve evolved from concerns of “peak oil” to a technological revolution that’s led to amazing finds of oil and natural gas in the U.S. In 2012, domestic oil production in the U.S. reached its highest level in 20 years and is likely to continue.

The change is due to the technology of fracking and horizontal well drilling. The number of horizontal wells in the U.S. has exploded, from 1,900 in 2003 to more than 45,000 last year. It’s not just by land, but by sea as well. 2012 was the best year ever for deepwater and ultra-deepwater drilling, with oil finds exceeding previous records by 40%. The number of natural gas wells in the U.S. reached 500,000 in 2011, up from 300,000 in 1999.

We view the opportunity in energy today not in the commodities but in the “picks and shovels” needed to produce and distribute the commodity. Chicago Bridge & Iron (CBI, $56.463) designs and builds infrastructure for the natural gas and oil industries. Its services include building liquefied natural gas plants and storage facilities, as well as fabricating pipelines. Recent acquisitions have also given it a foothold in the electricity-generation business. Another attractive company is National Oilwell Varco (NOV, $68.863), the dominant provider of equipment for drilling rigs.

Fundamentals drive wealth accumulation
The professionals who tout the value of fundamentals are not likely to garner the headlines or the prominent seats with the talking heads on TV. Because bad news can always be found, the fear merchants will continue to market themselves by seizing on each nugget of negativity as a harbinger of looming disaster.

At nearly any time in the history of investing, somebody could make a case for why you should take your money out of the market. Unfortunately for them, being a pessimist can be expensive. Those who built and maintained wealth over time did so by focusing on fundamentals – investing in inexpensive companies that are poised to benefit from the world we live in.

~MPMG

Although the information in this document has been carefully prepared and is believed to be accurate as of the date of publication, it has not been independently verified as to its accuracy or completeness. Information and data included in this document are subject to change based on market and other condition. All prices mentioned above are as of the close of business on the last day of the quarter unless otherwise noted.

The information in this document should not be considered a recommendation to purchase any particular security. There is no assurance that any of the securities noted will be in, or remain in, an account portfolio at the time you receive this document. It should not be assumed that any of the holdings discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable. The past performance of investments made by MPMG does not guarantee the success of MPMG’s future investments. As with any investment, there can be no assurance that MPMG’s investment objective will be achieved or that an investor will not lose a portion or all of its investment.