Haymaker - July 7th, 2023

Investment Ideas Edition

“There is no avoiding war; it can only be postponed to the advantage of others.” -Niccolo Machiavelli

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If That Was Hell, What Is This?

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“War is hell!”, exclaimed William Tecumseh Sherman. He certainly was qualified to make that declaration, considering he was the Union general who led the “March to the Sea” that broke the back of the South during the Civil War. In the process, he implemented a strategy he called “Total War”, laying waste to a 60-mile-wide moving band on his way through Georgia. Along the way, his troops burned Atlanta to the ground as so memorably recreated in the cinematic classic, Gone With The Wind. (By the way, inflation-adjusted, it remains the highest-grossing film of all time.) By 1865, few Southerners would disagree with his terse statement about war.

What would Sherman think about Russia’s war in Ukraine with its treatment of civilians as targets to be annihilated without remorse? Of course, Adolf Hitler and, eventually, the Allies engaged in this as well, using what were at the time terrifying weapons. But even Hitler’s V2 rocket attacks on England were ineffectual compared to the barrages of drones and missiles on civilian sites in Ukraine. (Obviously, the use of atomic bombs by the U.S. on Hiroshima and Nagasaki, instantly killing over 100,000 people, forever changed the nature of war.)

On nearly a daily basis, we have been inundated with heart-wrenching images from Ukrainian cities like Kyiv. Frankly, when the war began, I feared it would be much worse. It seemed implausible that this comparatively small country would be able to defend its populace from waves of Russian bombers, drones and its heavily touted hypersonic missiles. But years of military build up prior to the invasion¹ gave them more than just a fighting chance, it created a battlefield scenario wherein the invading party was forced to drastically reconsider its strategic objectives/priorities and tactical approaches.

In addition to its air force, Russia’s vaunted army has also underachieved, recalling its ill-fated invasion of Finland in 1939. As a historical sidenote, that poor performance encouraged Hitler to believe the then-Red Army would be a pushover for his blitzing Wehrmacht and Luftwaffe. That, along with declaring war on America after Pearl Harbor, would be his undoing.

There has been precious little good news to come out of this horrific conflict, beyond Ukraine’s valor and tenacity, but one that has emerged lately has been the performance of the recently deployed Patriot missile system (MIM-104). Ukraine reported this week that in a single day in May, a Patriot missile system shot down five Russian aircraft. Even the Russian military admitted four were destroyed, nearly simultaneously.

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As you may know, the Patriot technology is 40 years old. Consequently, there were reasonable doubts about how it would perform against Russia’s latest and greatest weaponry, particularly its hypersonic missile, the Kinzhal, which can fly at nearly 4,000 miles per hour or roughly five times the speed of sound. This is twice as fast as the objects the Patriot was originally designed to intercept.

In early May, a Ukrainian-operated Patriot battery shot down a Kinzhal for the first time. On May 16th, it detected six hypersonic missiles heading its way, apparently targeting the Patriot battery itself. It took them all out, destroying the last Kinzhal nine seconds before impact. Russia initially declared that it had destroyed the Patriot system but it was subsequently proved to have incurred only minor damage.  Undoubtedly, this news ruined Vladmir Putin’s day… and for good reason. As reported by The Wall Street Journal, since then the Patriot has been able to defend Kyiv from most Russian aerial attacks.

Unfortunately, thus far, there have only been two Patriot surface-to-air (SAM) missile defense systems delivered to Ukraine. The Patriot’s prime contractor, Raytheon, has said it will deliver five more before year-end. The Journal quoted Raytheon’s CEO Greg Hayes: “We have been very surprised at its effectiveness.” The Russians likely have been, as well. Reportedly, the Pentagon has, too. Fortunately, its software was able to be upgraded to achieve this extraordinary success rate. It also helps that the capabilities of the Patriot’s radar system are highly resistant to countermeasures, like radar jamming. Apparently, it is able to rapidly shift frequencies to prevent being jammed.

Presently, there is a two-year waiting list for Patriot deliveries. (Ukraine has presumably moved to the top of the list, for obvious reasons.) Taiwan is aggressively upgrading its Patriot defense system and it’s likely the results in Ukraine will expedite that. At this point, it evidently has two Patriot battalions, but it supposedly needs 10 to adequately defend itself from an onslaught of Chinese missiles. A potential blessing from the horrors in Ukraine might be that Russia’s thus-far disastrous encounters with the Patriot serve as a deterrent to Xi Jinping.

Obviously, the cool thing about the Patriot, besides the fact it works so well, is that it is a defensive weapon. Unsurprisingly, it doesn’t come cheap. Each system costs about $1 billion and launchers can handle 16 missiles, also known as interceptors. These munitions cost up to $4 million each. The Patriot can interdict an incoming object up to 30,000 feet and as far out as 100 miles. As some have said, it’s like hitting a flying bullet with another bullet. In other words, this is truly astounding technology.

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As far as investments go, Raytheon is certainly worth a look. It broke out to a multi-year new high in the spring of last year. As most Haymaker readers know, that’s an extremely positive development in the way my team and I evaluate stocks. However, since then it has essentially gone sideways, probably due to the severe bear market of 2022. This year it is down slightly, severely lagging the S&P. This is after having risen almost exactly as much as the S&P fell last year, about 18%. By the way, most investors now seem to have amnesia that the NASDAQ crashed by 32.5% in 2022. 

However, it is another one of its co-contractors on the Patriot program that attracts me more. One appeal is that it supplies the razor blades to Patriot systems or, more appropriately, the bullets. Those 16 interceptors need to be replenished now that they are being fired, and that’s likely to happen with increasing frequency, particularly as more deliveries are made to Ukraine. It’s also a fairly safe bet that myriad other countries are going to be ordering more Patriots based on its extraordinary performance over there. Hopefully, though, they won’t be fired anytime soon.

A P/E ratio on this company in the 16 to 17 range, below the roughly 20 times earnings at which the the S&P is trading, is another plus. The dividend yield is around 2.7% and it has grown that at an unusually rapid 12% annual clip over the past decade. It, too, had a major upside breakout in early 2022 and went on to crush the S&P over the course of last year. Again, though, it has badly trailed the market in 2023’s first half. My belief is that there is another up-leg coming soon.

Realistically, the Patriot alone won’t be the main driver of either companies’ sales and earnings. It’s a nice kicker, though, in a world that is rapidly arming. This includes Japan, which, since WWII, has understandably been military-spending-shy. Europe is also dramatically amping up its outlays on defense thanks to Putin’s aggression.

Another revelation by the war in Ukraine is the generally superior performance of U.S. weapons. That should create a favorable environment for leading U.S. defense contractors for years to come. The big breakout, or upward range expansion, by the two main Patriot suppliers is sending the same message.

With the stock market trading at one of the most expensive levels in history, only surpassed by 2000 and 2021, playing some defense right now is appropriate. What better way to do this than with a company that has provided Ukraine with such strong protection against Russian brutality?

Champion Picks

Defense industry (particularly those contracted to manufacture in-demand weapons systems)

Oil and gas producer equities (both domestic and international)

Japanese yen

Gold & gold mining stocks

Farm machinery stocks

Select financial stocks

U.S. oil gield services companies

S. Korean stock market

Copper-producing stocks

For income:

BB-rated bonds from dominant media companies and healthy automakers with upgrade potential

BB-rated intermediate term bonds from companies on positive credit watch

Certain fixed-to-floating rate preferred stocks

Select LNG shipping companies

Emerging Market debt closed-end funds

Mortgage REITs

ETFs of government guaranteed mortgage-backed securities

BB-rated energy producer bonds due in five to ten years

Select energy mineral rights trusts

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Contenders

While I realize the city-state of Singapore’s stock market is not exactly top of mind for most Haymaker readers, its recent price declines merit some positive attention.  Further, my great friend and partner, Louis Gave, has upgraded his view of it in a private conversation we recently had. Since early April, Singaporean shares have declined about 10% in U.S. dollar terms, even as the S&P and, especially, the NASDAQ have been on a rollicking roll. It’s now trading at just 11.5 times its forecasted earnings for this year.

Louis believes Singapore is positioning itself to be the Switzerland of Asia. The self-inflicted reputational damage Hong Kong has suffered due to a series of crackdowns, and the increasing realization that the rule of law there is merely what Xi Jinping says it is, have combined to create an advantage-Singapore situation. In other words, Singapore has a prime opportunity to be the new financial hub of non-China-controlled Asia. Frankly, that’s most of the continent, with numerous Asian countries increasingly wary of Chinese domination. (Those are my views, not Louis’.) It further appears that there is a brain-drain occurring, as some of China’s best and brightest decamp from the once free and dynamic Hong Kong to a much less repressive regime in Singapore.

In addition to having corrected lately, it is down 25% in price from its late-2021 peak.  More compelling is that it is 44% below its 2007 high, again on a price-only basis. (The total return with dividends has been a modestly positive 8.6%, less than 1% per year). 

At this point, I’m not moving it back up to Champions status, but it’s vectoring that way. It’s also fair to note that Singapore is a tiny nation with a limited number of world-class companies. However, its financial system is formidable and that is its true ace-in-the-hole in our heavily financialized world.

Singaporean stock market

Top-tier midstream companies (energy infrastructure such as pipelines)

Uranium

Short-intermediate Treasurys (i.e., three-to-five year maturities)

Japanese stock market

European banks

U.S. GARP (Growth At A Reasonable Price) stocks

Telecommunications equipment stocks

Swiss francs

Singaporean stock market

Intermediate Treasury bonds

Small cap value

Mid cap value

Select large gap growth stocks

Utility stocks

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Down For The Count

In our June 16th Haymaker, I warned of trouble ahead for longer-term Treasurys.  While it hasn’t exactly been a rout, the long Treasury ETF, TLT, is down about 3% since then. Yields, of course, move inversely to prices, so those have been breaking out to the upside from their recent trading range, rising above 4% on both the 10-year T-note and the 30-year T-bond. For the 10-year, it touched its peak for the year while the 30-year actually exceeded its 2023 apex. The yield on the two-year Treasury also hit a 16-year new high yesterday before backing off slightly. My bottom line on bond yields:  watch out above!

The trend toward higher government bond yields is global in nature. It’s my anticipation that this will continue, particularly in the U.S. where the amount of money the Treasury needs to raise is likely to swamp the market’s ability to absorb this supply. Credible estimates are for net-new issuance to be in the $2 trillion range between now and year-end. This deluge of new debt will be exacerbated by the Fed’s resumption of its balance-sheet shrinkage, known as Quantitative Tightening (QT).  This continuation is in the aftermath of the bank rescue program that temporarily reversed QT. Thus, the Fed will be adding another nearly $500 billion to the supply surge as it sells down its massive trove of government bonds. Wall Street at large seems blissfully ignorant of the severe dislocations this may cause. As a result, the negative reaction — should this situation become as messy as I fear — has the potential to be violent.

Long-term Treasury bonds yielding sub-4%

Homebuilders stocks

Electric Vehicle (EV) stocks

Meme stocks (especially those that have soared lately on debatably bullish news)

The semiconductor ETF

Junk Bonds (of the lower-rated variety)

Financial companies that have escalating bank run risks

The semiconductor ETF

Bonds where the relevant common stock has broken multi-year support.

Profitless tech companies (especially if they have risen significantly recently)

Small cap growth

Mid cap growth

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IMPORTANT DISCLOSURES

This material has been distributed solely for informational and educational purposes only and is not a solicitation or an offer to buy any security or to participate in any trading strategy. All material presented is compiled from sources believed to be reliable, but accuracy, adequacy, or completeness cannot be guaranteed, and David Hay makes no representation as to its accuracy, adequacy, or completeness.

The information herein is based on David Hay’s beliefs, as well as certain assumptions regarding future events based on information available to David Hay on a formal and informal basis as of the date of this publication. The material may include projections or other forward-looking statements regarding future events, targets or expectations. Past performance is no guarantee of future results. There is no guarantee that any opinions, forecasts, projections, risk assumptions, or commentary discussed herein will be realized or that an investment strategy will be successful.  Actual experience may not reflect all of these opinions, forecasts, projections, risk assumptions, or commentary.

David Hay shall have no responsibility for: (i) determining that any opinion, forecast, projection, risk assumption, or commentary discussed herein is suitable for any particular reader; (ii) monitoring whether any opinion, forecast, projection, risk assumption, or commentary discussed herein continues to be suitable for any reader; or (iii) tailoring any opinion, forecast, projection, risk assumption, or commentary discussed herein to any particular reader’s investment objectives, guidelines, or restrictions.  Receipt of this material does not, by itself, imply that David Hay has an advisory agreement, oral or otherwise, with any reader.

David Hay serves on the Investment Committee in his capacity as Co-Chief Investment Officer of Evergreen Gavekal (“Evergreen”), registered with the Securities and Exchange Commission as an investment adviser under the Investment Advisers Act of 1940. The registration of Evergreen in no way implies a certain level of skill or expertise or that the SEC has endorsed the firm or David Hay. Investment decisions for Evergreen clients are made by the Evergreen Investment Committee. Please note that while David Hay co-manages the investment program on behalf of Evergreen clients, this publication is not affiliated with Evergreen and do not necessarily reflect the views of the Investment Committee. The information herein reflects the personal views of David Hay as a seasoned investor in the financial markets and any recommendations noted may be materially different than the investment strategies that Evergreen manages on behalf of, or recommends to, its clients.

Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this material, will be profitable, equal any corresponding indicated performance level(s), or be suitable for your portfolio. Due to rapidly changing market conditions and the complexity of investment decisions, supplemental information and other sources may be required to make informed investment decisions based on your individual investment objectives and suitability specifications. All expressions of opinions are subject to change without notice. Investors should seek financial advice regarding the appropriateness of investing in any security or investment strategy discussed in this presentation.

1. For more on that, see the linked article: https://politicstoday.org/ukraine-military-transformation/