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Adapt or Perish

Now, this would be a natural place to write about a solar power stock, but I’ve done enough of that in recent issues. Instead, I want to write about a nifty little Brazilian company. And here’s why. In my mind, the world’s stock markets are linked by conduits that channel money this way and that, every minute of every day, always reacting to the latest news and the resulting changes in perception.

ExxonMobil is the largest company in the U.S., worth $52 billion according to the stock market. In part, this is because most of us have paid the company money at one time or another, and are likely to do so in the future. Me, I still pump my own gas at a Hess gas station, which is not only the cheapest around but also the closest to my house.

But when traveling, I sometimes use ExxonMobil, and I’m happy to do so. They’re one of the brands the world depends on. But it won’t always be so, and today I want to talk about how ExxonMobil will die in the future.

Slowly, to be sure, but inexorably.

Let’s start with one of the cornerstones of the Cabot philosophy, the fact that companies, just like people, have lifecycles. They are born, they live and they die. The worst companies die quickly and are little-noticed by most people.

Here in Salem, for example, a little independent bookstore named “Feed Your Head” recently closed after little more than a year of operation. I never got around to visiting, though I’ve bought many books from Amazon in that time, sitting right here at my computer.

The best, on the other hand, like AT&T, Microsoft, and Wal-Mart, become known far and wide for their ability to serve their customers, their ability to adapt as the world changes ... and their ability to reward long-term investors.

But all companies die eventually, and over the years I’ve found it fun (and profitable) to look for the early warning signs.

So let’s start with a parallel to ExxonMobil, a company by the name of General Motors.

GM makes cars. ExxonMobil supplies the stuff that makes them go. And they’ve both had a good century.

In fact, GM celebrates its 100th birthday in 2008, and that’s a real achievement for a company. But you wouldn’t want to have been a shareholder in GM in recent years; since 2000 its stock has lost 72% of its value!

But would you have been smart to hold GM stock until 2000?

Not really. Because while that market top did bring an all-time high price of 95 for the stock, the fact is that the stock had hit 55 way back in ... get ready ... 1965!

That’s right. It took 35 years for GM’s stock to appreciate its final 73%! Over the same period, the Dow Industrials gained 1,250%!

My goal, of course, is to beat the market. I assume it’s yours too.

But GM has failed miserably at that job over the past 42 years. In short, the best time to sell this stock was 1965 ... when it was making the sporty 375 horsepower Chevy Chevelle SS.

Now, we all know that one of GM’s big problems in recent decades has been the added cost of paying U.S. wages and benefits to its employees, a market reality that allows its competitors to compete on cost. But we also know the company failed to adapt to the changing marketplace; it kept producing rear-wheel drive gas-guzzlers while Toyota and others offered front-wheel drive gas-sippers ... and then hybrid cars.

As a result, GM’s stock has been falling behind since 1965.

ExxonMobil (XOM), meanwhile, has hit all-time highs this year ... and it has succeeded in beating the market since 1965. In short, it’s been a great investment.

But it won’t be a great investment forever. Helping it in recent decades has been the fact that the majority of its costs and revenues are outside the U.S. More recently, shareholders have benefited from the strength of natural resource stocks in general and energy stocks in particular, as China’s ravenous appetite for power has driven prices up. ExxonMobil’s after-tax profit margins in recent years have run between 8% and 11%!

But there’s an early warning sign in the numbers. The number of mutual funds that own XOM in June 2005 was 1147. The number that owned it in June 2007 was 947. In short, the pros have been pulling out.

Short-term, this is likely related to the stock’s valuation; it’s now trading at 12 times estimated earnings, yet earnings are expected to grow just 6% next year.

Long-term, however, I think shareholders of XOM should consider some bigger problems.

First is the fact that the world’s supply of oil and gas is slowly running out. Granted, the higher price of oil has made it economically feasible to extract the harder-to-reach deposits, and this is a trend that can persist for a very long time. But one side effect of these high prices is that consumers are beginning to look for alternative sources of energy.

Second is the world’s growing willingness to take action to forestall the effects of global warming, again by turning to alternative sources of energy, and by simply reducing their burning of fossil fuels. I have no doubt that this is a trend that is just getting started.

Third is the very real progress being made by solar power firms today. These companies are still so small that to ExxonMobil they’re like gnats biting at an elephant’s tail. But technological advances, combined with growing economies of scale, mean their solar products will be increasingly cost-competitive with fossil fuels in some applications. And government incentives will help.

Now, I’m not saying that you should go out and sell your XOM shares today ... but I am saying you should think about it. Back in 1965, no one imagined that GM would underperform the market from then on. U.S. auto manufacturers had 96% market share back then, and G.M. had the lion’s share of that.

But that was the year Ralph Nader’s “Unsafe at Any Speed” was published, the year that perceptions began to change. Less than a decade later, the oil shocks and the drive toward more efficient cars made clear to most observers that the era of GM’s dominance was over.

So might this be the watershed year that marks the beginning of ExxonMobil’s long decline? Or might the company’s uptrend last a few years longer? There’s no question that management is capable ... probably more capable than General Motors’ management was in 1965. But when global forces conspire to drive consumer demand to products your company doesn’t provide, there’s no escaping the inevitable.

And maybe Al Gore’s “An Inconvenient Truth” is the mass-market communication vehicle that will do for ExxonMobil what Ralph Nader’s 365-page book did for GM.

Unlike GM, which gets 62% of it revenues from the U.S., ExxonMobil gets the majority of its revenues (69%) from non-U.S. operations, and while this has been an asset in recent years, it won’t protect the company from these expected changes; these changes are global in scope!

For the final word, as always, I look at the chart, and here’s what I see.

From 1991 through 1999, XOM’s performance roughly equaled the performance of the market. But since then it’s handily outpaced the market, as natural resource stocks have outperformed traditional growth stocks. XOM has more than doubled since the end of 1999.

On the other hand, short-term, there’s some reason for concern, in the form of a triple-top at 94-95 that stretches back to July. If XOM can break above this top on good volume, it’s likely to continue climbing. But if it can’t, that’s one more reason to consider selling.

Long-term, I’m keeping an eye on it, confident that its best days are over.

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Now, this would be a natural place to write about a solar power stock, but I’ve done enough of that in recent issues. Instead, I want to write about a nifty little Brazilian company.

And here’s why.

In my mind, the world’s stock markets are linked by conduits that channel money this way and that, every minute of every day, always reacting to the latest news and the resulting changes in perception.

When interest rates rise, money flows out of equities and into bonds and money markets and that tends to pull the prices of equities down.

When interest rates fall, the reverse happens; money flows out of those increasingly lower-yielding instruments and back into equities, causing prices to rise.

And the same can be said for sectors, too. When money rushed out of the mortgage sector this fall, it went elsewhere; some, no doubt, went into the hot solar power sector.

But sometimes money can’t leave its sector. Some institutional managers are required to maintain minimum weightings in sectors. And some sector specific funds are required to always remain heavily invested in their designated sectors.

So consider the homebuilding sector. The index of homebuilders has lost 46% since its February-April-May peak (a triple-top, by the way), and some stocks have done far worse. KB Homes (KBH) is off 62%. Lennar (LEN) is off 69%. And Pulte Homes (PHM) is off 70%!

A lot of money has left the homebuilding sector, and I don’t think it will return anytime soon. But some of the money has simply flowed to more distant homebuilding stocks, like that of the biggest builder in Brazil, Gafisa (GFA).

In Brazil there’s no massive problem of unscrupulous lenders and unqualified borrowers. Instead, business is healthy, and the future is bright.

Back in November, Paul Goodwin of Cabot China & Emerging Markets Report, wrote the following:

“Gafisa, founded in 1954, is one of the largest builders in Brazil ... it now operates in 39 cities and 17 states. Rio de Janeiro and Sao Paulo still account for about 90% of business, but the potential for expansion is enormous. Gafisa’s partnerships with other construction companies across Brazil have produced a land bank sufficient for 2-3 years of development.

In its more than 50 years of operation, Gafisa has completed over 900 projects. Projects have run from hotels for international giants like Holiday Inn and Howard Johnson to condominium developments and site preparation for subdivisions.

The company’s versatility and vigorous expansion strategy have produced good numbers for Gafisa. Revenues grew 11% in 2004, 25% in 2005 and 62% in 2006. At the same time, earnings increased from $0.14 a share in 2004 to $0.54 in 2006. Recently-reported Q3 earnings were up 30%, year-over-year, on a 124% rise in revenues. After-tax profit margins have averaged a little more than 9% over the past four quarters and reached 10% in Q3.”

Looking at the chart of GFA today, I see a stock that just came public in March 2007; it’s still little known to most investors. But the stock has beaten the market since then, and has built a strong level of support at 35. As I write, with both the 25-day and 50-day moving averages at 36, the stock looks ripe for an advance.

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Editor’s Note

Gafisa may never be mentioned here again, but it will be followed in every issue of Cabot China & Emerging Markets Report until it is sold. And that’s not the only reason you should take a look at this report. According to Hulbert, Cabot China & Emerging Markets Report was the top performer of all investment newsletters in 2007, with a gain of 74.1% ... which follows its #1 performance in 2006! Part of the credit, of course, goes to the strength of Chinese stocks. But part goes to editor Paul Goodwin’s adherence to Cabot’s proven system of growth stock investing, and his use of a simple but effective market timing system.

If you’re looking for top returns on your investments in the year ahead, I recommend a no-risk trial subscription.

To get started, simply click the link below.

http://www.cabotinvestors.com/eccihcwa06.html

Yours in pursuit of wisdom and wealth,

Timothy Lutts
Publisher
Cabot Wealth Advisory

Timothy Lutts is Chairman Emeritus of Cabot Wealth Network, leading a dedicated team of professionals who serve individual investors with high-quality investment advice based on time-tested Cabot systems.