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Tapping into the Brewery Market

(January 11, 2009)

Dear Subscribers and Readers,

The financial markets should be a news-driven market this week, as Alcoa kicks off the fourth-quarter earnings season on Monday afternoon, followed by Infosys Technologies on Tuesday (this will be particularly interesting given the Satyam Computer Services scandal and the accompanying weakness in the Indian stock market).  The big news day is Thursday, as Genentech (note that the biotech industry was the sole industry that rose in 2008) and Intel report on Thursday after the market close.  The bulk of the earnings reports will come next week, starting off with Bank of America, CSX, IBM, Johnson & Johnson, State Street, and Suncor Energy on Tuesday.  Other news items that may have an impact on the financial markets include the European Central Bank's policy rate announcement on Thursday (January 15th), and the ongoing developments with respect to the $775 billion Obama fiscal stimulus and the potential release of the second batch ($350 billion) of the TARP funds.  If the ECB cuts by more than 50 basis points on Thursday, I expect a decline in the Euro, accompanied by a positive response in the global equity markets.

Before we begin our commentary, I want to update our DJIA Timing System's performance to December 31, 2008, and review our 7 most recent signals.  While subscribers can calculate our historical performance by tallying up all our signals going back to the inception (August 18, 2004) of our system, such a task would be very tedious.  Without further ado, following is a table showing annualized returns (price only, i.e. excluding dividends), annualized volatility, and the Sharpe Ratios for our DJIA Timing System vs. the Dow Industrials from inception to December 31, 2008:

DJIA Timing System Performance Statistics

To recap, our DJIA Timing System was created as a tool to communicate our position (and thoughts) on the stock market in a concise and effective way.  We had chosen the Dow Industrials as the benchmark (even though all institutional investors today use the S&P 500), since most of the American public and citizens around the world have historically recognized the DJIA as “the benchmark” for the American stock market.  In addition, the Dow Industrials has a rich history and has been computed since 1896, while the S&P 500 was only created in 1957 (although it has been retroactively calculated back to 1926).

Looking at our most recent performance and performance since inception, it is clear that most of our outperformance was due to our positioning in 2007 and the first half of 2008 – when we chose to go neutral (from our 100% long position) in our DJIA Timing System on May 8, 2007, and our subsequent shift to a 50% short position on October 4, 2007 at a DJIA print of 13,956 (which we closed out on January 9, 2008).  While we have stayed on the long side for the most part since mid January 2008, we have also made a couple of timely tactical moves during the May to June 2008 period.  While we are not happy with our performance in the second half of last year, subscribers should note that we were still ahead of the Dow Industrials by 11% in 2008, and 8% (on an annualized basis) over the last two years.  Our goal is to beat the stock market with less risk over the long run, and so far, we have done just that.  Today, we remain 100% long in our DJIA Timing System. 

Subscribers should remember that:

  1. It is the major movements that count.  Active trading – for the most part – only enrich your brokers and is generally a waste of time – time that could otherwise be spent researching individual stocks or industries;

  2. Capital preservation during times of excesses is the key to outperforming the stock market over the long run.  That being said, selling all your equity holdings or shorting the stock market isn't something I would advocate very often, given the tremendous amount of global economic growth that will inevitably come back sometime in the next few years.  I am not going to change my mind on this until/unless I see 1) a major policy mistake from the Fed, 2) the potential emergence of an inflationary spiral, 3) a major policy mistake from the Obama administration, such as protectionist policies or higher taxes, or 4) extreme overvaluations in the U.S. stock market.  At this point, I do not see any threat to the stock market on all four counts (versus late 2008, when valuations were overly high and when the Fed was reluctant to cut rates). 

Also note that our (annualized daily) volatility levels continue to be lower than the market's, given our tendency to sit in cash during sustained periods of time of market excesses, resulting in relatively good Sharpe Ratio readings across all time periods.  However, given my belief the stock market has probably made a solid bottom in late November, subscribers should not expect any outperformance from our DJIA Timing System for the foreseeable future, as we will probably remain 100% long in our DJIA Timing System for the time being.  We will update the performance of our DJIA Timing System at June 30, 2009.

Let us now begin our commentary by reviewing our 7 most recent signals in our DJIA Timing System:

1st signal entered: 50% short position on October 4, 2007 at 13,956;

2nd signal entered: 50% short position COVERED on January 9, 2008 at 12,630, giving us a gain of 1,326 points.

3rd signal entered: 50% long position on January 9, 2008 at 12,630;

4th signal entered: Additional 50% long position on January 22, 2008 at 11,715;

5th signal entered: 100% long position SOLD on May 22, 2008 at 12,640, giving us gains of 925 and 10 points, respectively;

6th signal entered: 50% long position on June 12, 2008 at 12,172, giving us a loss of 3,572.82 points as of Friday at the close.

7th signal entered Additional 50% long position on June 25, 2008 at 11,863, giving us a loss of 3,263.82 points as of Friday at the close.

In the aftermath of the last great crude oil spike in 1979, global oil demand decreased by 10% over the next four years as many countries implemented more fuel efficient policies.  Indeed, it took more than 20 years for US crude oil demand to surpass its 1979 peak.  Oil demand from Europe and Japan never fully recovered.  Even today, total oil demand from Europe and Japan are still below their 1979 peaks.  Today, the final “blowoff” in oil prices last summer is still fresh in everyone's minds.  Even as the spot price of crude oil declined back to $40 a barrel, auto companies such as GM and Toyota are still moving full-speed ahead with their hybrid and all-electric technologies.  In fact, Toyota recently moved forward its plans to develop an all-electric vehicle to 2012, from its prior goal of “early next decade.”  The Obama administration is also going ahead with its investments on alternative energy solutions.  China, the other 800-pound gorilla, has committed to a goal of reducing its “energy intensity” by 20% over the next few years.  With solar power projected to achieve to “grid parity” as early as 2010 – and with global GDP growth still in the doldrums – it may decade another decade (or not at all) for global crude oil demand to return to its 2007 peak.  While I am looking for a short-term bottom to crude oil prices, I am definitely not a long-term bull on the general energy complex.

In retrospect, it is amazing that so many analysts and investors have forgotten that the energy sector (and energy prices) is a highly cyclical sector.  This is also the case with steel.  With the real estate market slowing down in China (and with the inevitable fall-out of the US commercial real estate market), there is no doubt that steel demand will literally fall off a cliff this year.  Watch for some highly indebted energy, materials, and industrials companies to file for bankruptcy later this year – on top of the bankruptcies that are already being filed in the retail industry.

For investors who would like to see more stable cash flows in their equity investments, look no further than the global brewing industry.  Historically, alcohol (in this case, beer) consumption growth has remained steady through recessions, rising taxes, and rising tariffs, with the exception of Prohibition and World War I and II.  With InBev acquiring Anheuser-Busch in August of last year, Molson Coors (TAP) is now the only major brewing company that is publicly traded in the US.  There are four favorable trends going for the company, which I will soon discuss, but first, here is a little bit of a background.

Formed by the merger of Adolph Coors and Molson Inc. in 2005, Molson Coors operates as a global brewer, marketer, and distributor of beers in the US, Canada, and Europe.  Molson Coors is the 6th largest brewer in the world today.  Within the US segment, the company operates two breweries (located in Golden, Colorado and Elkton, Virginia), capturing 11% of the US market (with the recent joint venture between the company and SABMiller's US operations, Molson Coors now has access to six US breweries).  Its US brands include Coors Light, Original Coors, and Coors Non-Alcoholic premium beers; George Killian's Irish Red and Blue Moon Belgian White Ale above-premium brews; and Extra Gold and Keystone Premium lower-priced beers. Within the Canada segment, the company operates six breweries throughout the country, capturing a 41% market share.  Its Canadian brands include Molson Canadian, Molson Dry, Molson Export, Creemore Springs, and Rickard's Red Ale.  Within its European (UK) segment, the company operates three breweries throughout the country, capturing 21% of the UK beer market.  Some of its UK brands include Carling, Coors Fine Light Bear, and Worthington's Caffrey's.  During 2007, the company sold 58% of its volume in the US, 19% in Canada, and 23% in the UK (its European segment).

The US, Canadian, and UK brewing industries have consolidated over the years and are highly concentrated.  For example, Anheuser-Busch has seen its US market share steadily rise from 10% in the early 1960s, to 30% in the early 1980s, and to over 50% in the late 1990s.  While its market share has declined slightly in recent years (due to rising popularity of craft beers and imports), it is still very high at 48.2% in 2007.  Similarly, Coors' domestic market share rose from 3% in the early 1960s, to 7.5% in the early 1980s, and to over 11% by the late 1990s.  Molson Coors' domestic market share remained steady at 11.1% at the end of 2007.  With the latest joint venture between the company and SABMiller's US operations, “MillerCoors” now has a 30% domestic market share, resulting in an industry resembling close to a duopoly.  The Canadian brewing industry is highly concentrated as well, with Molson Coors capturing a 41% market share (slightly more than its second largest competitor, AmBev ABV).  Similarly, the UK Office of National Statistics has also classified the UK brewing industry as an oligopoly.  The high concentration in the US, Canadian, and UK brewing industries results in a very high barrier to entry to would-be competitors, as these brewers enjoy significant economies of scale and high marketing budgets.  I also expect beer sales to gain at the expense of wine and spirits sales in 2009 as the economic recession continues (consumers tend to “trade down” during economic downturns), partially reversing the gains in market share made by wine and spirits in 2007 and over the last five years.

There are four favorable trends going for the company: 1) Historically, the global brewing industry has provided a steady cash flow for investors.  With an increase in industry consolidation last year, these cash flows would be as stable as ever, 2) Favorable demographics, as more of the “echo boomers” reach legal drinking age in the US.  Standard & Poor's estimates this increase in the number of legal-age drinkers should add a further 1% growth in beer volume consumption, as this age group tends to prefer beer over wine and spirits, 3) Continuing consolidation in the industry, with Molson Coors at a perfect spot to take advantage of any integration issues stemming from InBev's acquisition of Anheuser-Busch, and as the integration of Molson Coors and SABMiller's US operations should result in significant cost savings (Molson Coors expects an eventual $500 million in cost savings, which is very achievable), and 4) Lower input costs, with the price of Barley having declined by 40% since its peak last summer.  With an expected $200 million in synergy cost savings in 2009, I estimate that the company could easily earn $3.70 a share in 2009, especially given its new competitive position in the US and the anticipated shift away from wine and spirits as the economic downturn drags on for most of 2009.  I am conservatively assuming a P/E of 15, which is in the mid-range of its historical valuation.  This would put TAP at a price of $55 a share.  This is a somewhat conservative estimate given the company's new competitive position in the US and its additional $300 million in annual costs savings to be realized starting in 2011 (note that my 2009 P/E of 15 does not integrate the additional $300 million in projected savings).  Subscribers who want to be long-term owners of companies with steady cash flows should look more closely at TAP.

Let us now discuss the most recent action in the U.S. stock market via the Dow Theory.  Following is the most recent action of the Dow Industrials vs. the Dow Transports, as shown by the following chart from July 2006 to the present:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (July 2006 to January 9, 2009)

For the week ending January 9, 2008, the Dow Industrials declined 435.51 points while the Dow Transports declined 190.31 points.  Both Dow indices are now in “no-man's land,” as they again declined below the December 8th resistance highs late last week.  The relative strength in the Dow Transports is welcomed.  With the trucking industry poised to benefit from the infrastructure spending stemming from the Obama stimulus (trucking companies lose approximately $8 billion per year just sitting in traffic), I expect the Dow Transports to continue to exhibit relative strength over the next few months.  With tax-loss selling and hedge fund liquidation now over and with the Federal Reserve and the Bank of Japan both adopting a “quantitative easing” policy, global liquidation pressures have most probably peaked.  I also continue to believe that the vast majority of the world's central banks would do everything in their power to stem the liquidation pressures in the financial markets.  In the meantime, I am now looking for a 50 basis point cut from the European Central Bank this Thursday.  Should they fail to deliver, the stock market could experience some short-term weakness.  That said, while there are still landmines in various emerging market countries (such as most of central and eastern Europe) and individual stock investments, I urge subscribers to take a longer-term view and to try not to time the market on a day-to-day basis, given the most compelling valuations in the US equity market in decades and the emerging innovative/Schumpeterian growth forces that will inevitably be unleashed in the next 5 to 15 years.  We remain 100% long in our DJIA Timing System.

I will now continue our commentary with a quick discussion of our popular sentiment indicators – those being the bulls-bears percentages of the American Association of Individual Investors (AAII), the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys.  The latest four-week moving average of these sentiment indicators increased from -12.9% to -8.8% for the week ending January 9, 2008.   Following is a weekly chart showing the four-week moving average of the Market Vane, AAII, and the Investors Intelligence Survey Bulls-Bears% Differentials from January 1997 to the present week:

Average (Four-Week Smoothed) of Market Vane, AAII, and Investors Intelligence Bulls-Bears% Differentials (January 1997 to Present)

With the four-week moving average of our popular sentiment indicators having (convincingly) reversed from a historically oversold condition, chances are that the stock market will continue to rally for the foreseeable future, as the stock market has typically performed well when this sentiment indicator reverses direction from an extremely oversold condition.  Moreover, the ten-week MA (not shown) is still in an uptrend, after hitting an extremely oversold condition just five weeks ago – suggesting that the stock market could rise further before it experiences a significant correction.  Again, given the end of tax-loss selling and hedge fund liquidation, the inevitable release of the remaining $350 billion in TARP funds, the compelling global equity market valuations, the sheer amount of global investable capital sitting on the sidelines, and the easing in the money/credit markets, I believe we are in the midst of the biggest buying opportunity of our generation.  For now, we will remain 100% long in our DJIA Timing System.

I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index.  For newer subscribers, I want to again provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator going forward.  Quoting the International Securities Exchange website: The ISE Sentiment Index (ISEE) is designed to show how investors view stock prices. The ISEE only measures opening long customer transactions on ISE. Transactions made by market makers and firms are not included in ISEE because they are not considered representative of market sentiment due to the often specialized nature of those transactions. Customer transactions, meanwhile, are often thought to best represent market sentiment because customers, which include individual investors, often buy call and put options to express their sentiment toward a particular stock.

When the daily reading is above 100, it means that more customers have been buying call options than put options, while a reading below 100 means more customers have been buying puts than calls.  As noted in the above paragraph, the ISEE only measures transactions initiated by retail investors – and not transactions initiated by market makers or firms.  This makes the indicator a perfect contrarian indicator for the stock market.  Since the inception of this index during early 2002, its track record has been one of the best relative to that of other sentiment indicators.  Following is the 20-day and 50-day moving average of the ISE Sentiment Index vs. the daily S&P 500 from May 1, 2002 to the present:

ISE Sentiment vs. S&P 500 (May 1, 2002 to Present)

Since the most recent bottom of the 20 DMA of the ISE Sentiment Index in early to mid October, both the 20 DMA and the 50 DMA have reversed convincingly to the upside.  Historically, a reversal of the ISE Sentiment index from an immensely oversold level has been the most powerful indicator for an upcoming or a continuation of a rally.  That said, the 20 DMA of the ISE Sentiment Index is now getting slightly overbought (relative to its readings over the last two years) – suggesting that the market could experience some short-term weakness next week.  However, given that the 50 DMA is still near oversold levels, there is a good chance that bullish sentiment (and thus the stock market) has further room to rise over the intermediate term.  As I have mentioned before, as long as one is under the age of 60 and is in a reasonable state of health, then one should be buying US equities aggressively with one's long-term savings.

Conclusion: While U.S. equities are generally a “buy,” subscribers will need to be very selective if buying individual stocks, given the ongoing deleveraging phase not just in the retail industry, but potentially in the energy, industrials, and materials sectors as energy and commodity demand continue to exhibit weakness over the next few years.  As I mentioned before, subscribers will also need to be very careful with buying “yesterday's winners,” as the stock market's “favorites” tend to change in a new bull market.  For investors looking for an undervalued stock with relatively stable cash flows, I highly recommend taking a look at the global brewing industry, or specifically, Molson Coors (TAP).

Going into 2009, I expect global liquidation pressures to ease further, although there are still further “shoes to drop” – primarily in Central & Eastern Europe, and in the commercial real estate market.  More importantly, the compelling valuations in the US equity market are too difficult to ignore.  For those with a long-term timeframe, this represents the greatest buying opportunity of our generation.  I am still constructive on US, Japanese, and Chinese equity prices in the longer-run, as the world starts to focus on sustainable, Schumpeterian Growth vs. Ricardian Growth over the next few years.  We will stay with our 100% long position in our DJIA Timing System.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

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