With most of the major companies first quarter earnings reports now in the books, there are a few interesting themes emerging that could impact the market for the remainder of the year. As a backdrop, earnings in the most recent quarter were relatively solid, but negative surprises were found in virtually every sector, supporting our long-held view that stock selection remains critically important. Ultimately it still comes down to innovation and execution. Companies that can consistently deliver new products, while enhancing productivity through effective cost control and efficient production will continue to gain market share.
Below the surface, I sense that the activist investor movement is having its desired effect on management of underperforming companies forcing them to focus more intently on improving shareholder returns. As an example, IBM, which has lagged the S&P 500 by a wide margin over the last five years, recently hiked its dividend 33% and also announced an additional $15 billion share repurchase program. I suspect we’ll see more of these financial moves going forward.
On a related but more subtle note, I am starting to hear rumblings of what I think could eventually emerge as the next phase of corporate restructuring. I believe there is a growing list of large, under performing companies that may consider spinning off certain business units in order to enhance shareholder value. I would put General Electric, Wal-Mart, Microsoft, 3M, and Citigroup on this watch list. All of these stocks have significantly lagged the S&P 500 over the last two and five year time periods. Shedding under performing businesses or spinning out non-core business units to shareholders could both unlock shareholder value. If this trend emerges it would be a significant positive catalyst for the overall market.
Alternative energy - The next big thing and the U.S is lagging...
Alternative energy is moving into the mainstream around the world in response to the growing concern over global warming. Notably, the U.S. is lagging behind in this important secular trend. Both the private sector and the public sector are becoming more focused on alternative energy. Wind power has grown substantially, and the cost disadvantage continues to narrow between solar, wind, and fossil fuels. Even nuclear energy, long the lightening rod for environmental groups like Greenpeace International, is now being championed as an environmentally friendly solution to global warming. In fact, the former director of Greenpeace, Patrick Moore, is one of the leading advocates of nuclear power.
To date, renewable fuels account for approximately 20% of the world’s total electricity, with virtually all of this coming from hydropower plants. In contrast, wind and solar account for a little more than 1% of total electricity generation. Governments around the world have spent billions on research and development of renewable energy over the years through tax credits, subsidies, and mandated targets. Germany, Japan, as well as Denmark are ahead of the U.S. in terms of adoption of alternative fuel sources. Denmark has been particularly successful as it has increased the percentage of electricity generation from renewable fuels from 3% to 25% over the last fifteen years, despite an absence of hydropower capability. In its place Denmark uses wind, solar, and biofuels like wood and straw. The Denmark success story resulted from a partnership between the private and public sector. In essence, investment by private industry was supported by price subsidies and capital grants from the government. In contrast the U.S. has relied predominately on individual states to implement renewable-energy policies instituted at the federal level. With few exceptions, this politicized approach has been unproductive.
A problem that won’t go away…
At the same time, it is interesting to note that China is set to earn the dubious distinction of surpassing the U.S. as the top greenhouse-gas emitter. What makes this fact even more worrisome is Beijing’s refusal to limit greenhouse-gas emissions, the number one cause of global warming, according to the scientific community. With China’s double digit economic growth, and near total reliance on coal, the pollution problem is going to worsen over time and may more than offset reductions in emissions from Europe, the U.S. and Japan. How this gets resolved on the international political scene is a difficult question to answer. I do find it interesting to note that a U.S. geological survey study notes that nearly a billion people around the world live close to sea level. Undoubtedly, Beijing is well aware that the vast majority of this threatened population lives in Asia.
With all this as a backdrop the mood of the market has turned decidedly positive. In the near-term, corporate earnings growth and M&A activity may be enough to drive the market higher as long as the economy muddles along and inflation remains under control. The additional potential for massive corporate restructuring at some of the market bell weather stocks further strengthens the bull market argument.
Longer-term, we may have our all-important secular trend in Alternative Energy. But that trend is just beginning, and despite the excitement, the environmental and political challenges are formidable. Meanwhile, the rumblings in China may be distant, but they are rumblings worth paying attention to nonetheless.
