Have you heard of this company? BCPC

From time to time, we highlight specific companies which we believe fit the profile of a classic Taylor Frigon growth company. These companies meet the criteria outlined by Thomas Rowe Price, Jr., in his 1973 circular "A Successful Investment Philosophy based on the Growth Stock Theory of Investing," which recommended investors seek out businesses with "capable, dynamic management operating in a fertile field for future growth." Previous posts discussing companies which meet these two broad criteria of good leadership and fertile fields for future business growth have included examinations of QuickLogic (QUIK), Amphenol (APH), and Tractor Supply (TSCO).*

Today, we will briefly examine specialty chemical supplier Balchem (BCPC).* Chemical companies are often extremely cyclical in nature, with both revenues and earnings fluctuating wildly based on the overall economic conditions or on cycles in their specific underlying markets (such as agricultural crop demands). This extreme cyclicality generally means that investors in chemical companies must be able to "get in" and "get out" at the right times (timing the market conditions), because simply owning the stocks of these companies for a long period of years will result in a lot of ups and downs with little actual net long-term growth. Trying to time markets is the very antithesis of the long-term growth strategy articulated by Mr. Price and the version of that strategy followed by Taylor Frigon Capital Management (for previous posts discussing this distinction further, see for example here and here).  

In contrast to many other chemical companies, Balchem has achieved remarkably steady and consistent growth, due to a variety of factors. First, the company's products are put to use in applications which serve some very distinct end-markets, such that their business has a good degree of market diversification. Second, Balchem has unique production capabilities involving products that practically no one else supplies to their markets, as well as involving technologies such as micro-encapsulation which make their chemicals more useful and valuable than they might be without encapsulation. Third, Balchem's products address numerous market applications in areas which could be characterized as "fertile fields for future growth."

Balchem is the largest producer of the chemical choline chloride, a source of the necessary nutrient choline, essential for brain and nervous system health in humans and for physical growth in chickens and pigs, which are raised worldwide as a source of food. Choline is also beneficial to the health and milk production of dairy cows during lactation, but it must be encapsulated in order to pass all the way through the cow's multiple stomachs to the intestine where it can be absorbed into the bloodstream. The sale of choline chloride to agricultural customers makes up the largest portion of Balchem's revenues, at about 46% of the company's trailing twelve-month revenues (split between choline for poultry and for pigs at about 33% of the total trailing twelve-month revenues and encapsulated choline for dairy cows at about 13% of the company's trailing twelve-month revenues).  

The company believes that the use of encapsulated choline for dairy cows is a relatively new application and that there is plenty of room for growth as the benefits of choline for lactating cows becomes more widely understood and adopted.

Balchem also supplies ethylene oxide gas and propylene oxide gas, which are specialty chemicals used to sterilize surgical equipment prior to surgeries (ethylene oxide) and to kill bacteria, mold and insects in nutmeats (primarily almonds) prior to being sold for human consumption (propylene oxide). Of these two gases (propylene oxide and ethylene oxide), Balchem is the sole US supplier of ethylene oxide gas, which is one of three methods which hospitals can select for the sterilization of surgical equipment, competing with sterilization by radiation or by contact with extremely hot steam. Of these, ethylene oxide is the most popular, followed by radiation and finally steam (steam is least convenient because in the other two methods the surgical tools can remain wrapped in their protective plastic tray-wrap, while in steam disinfectant they cannot). Ethylene oxide is increasingly more convenient than radiation because radiation cannot be used on a tray of equipment if there is any plastic component in any of the pieces of equipment -- if so much as a single screw on a pair of surgical scissors on the tray is made of plastic, then radiation cannot be used on that tray. Since plastic is generally less expensive than metal, manufacturers increasingly want to include plastic parts in surgical tools. There are also demographic drivers which generally increase the number of surgeries which are performed, as populations age in the developed world.

Balchem products are also used in the preparation of food for human consumption and as supplements for wellness. Choline is part of the B-family of vitamins and has been shown to contribute to normal liver function, normal metabolism of lipids by the body, and the maintenance of normal levels of homcysteine (an amino acid). It is necessary for the development of the brain and nervous system in infants and may also help prevent Alzheimer's and other dementia diseases. While choline is found naturally in many foods such as green leafy vegetables, adults who do not eat enough of these foods may benefit from choline supplements.

Finally, choline chloride is also used as a clay-swell inhibiting agent in hydraulic fracturing, which has seen rapid growth in the United States for retrieving oil and natural gas from shale deposits (see chart above for the natural gas production from the Marcellus Shale in the northeastern United States since 2000). Approximately 25% of Balchem's trailing twelve-month revenues now come from industrial applications of choline for uses such as hydraulic fracturing. Because choline is non-toxic (in fact, it is actually beneficial to human health), it can be preferable to competing products which could also be used to prevent the swelling of shale clay during mining operations, such as potassium chloride (KCl).

We believe that Balchem exhibits many of the qualities of a classic Taylor Frigon growth company. The company also recently initiated a dividend, which they have subsequently raised successively.

* At the time of publication, the principals of Taylor Frigon Capital Management owned securities issued by Amphenol (APH), Balchem (BCPC), QuickLogic (QUIK), and Tractor Supply Company (TSCO). 

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Bullish counter-arguments to those declaring the end of growth

What's an investor to do in an environment in which many investment professionals and economists are declaring that strong business growth is a thing of the past, and that the only way companies will be able to grow their bottom lines will be through cost-cutting or acquisitions of other companies because organic top-line growth is pretty much finished?

The power of inflation, even at low levels, to destroy the purchasing power of money requires some exposure to investments which can help mitigate that destruction of purchasing power (see this previous discussion).  Fixed-income yields have of course been extremely low, and over long periods of time it can be demonstrated that fixed income investments lose out to inflation, even in periods when rates have been higher.  Some exposure to the growth potential of businesses is essential for individuals who hope to avoid the slow erosion of their purchasing power over time, let alone for those who hope to grow their wealth and increase their purchasing power over the years.  

But investors in recent years have been bombarded with talk of a new reality in which the pattern of long-term growth can no longer be hoped for in the future.  This new paradigm has been famously dubbed the "New Normal" by many pundits, a phrase and a concept attributed to Bill Gross of Pimco and explained in this "Investment Outlook" that he published in September of 2009.  There, he states:

Well, the surprise is that there's been a significant break in that growth pattern, because of delevering, deglobalization, and reregulation.  All of those three in combination, to us at PIMCO, means that if you are a child of the bull market, it's time to grow up and become a chastened adult; it's time to recognize that things have changed and that they will continue to change for the next -- yes, the next 10 years and maybe even the next 20 years.  We are heading into what we call the New Normal, which is a period of time in which economies grow very slowly as opposed to growing like weeds, the way children do; in which profits are relatively static; in which the government plays a significant role in terms of deficits and reregulation and control of the economy; in which the consumer stops shopping until he drops and begins, as they do in Japan (to be a little ghoulish), saving to the grave.

More recently, Richard Lehmann, an astute analyst of income investment whose opinions we respect, published a newsletter which takes up a similar dour outlook for future growth, but somehow finds a way to deliver some bullish comments at the same time (his analysis can be purchased at his website here).  Entitled "Why I'm Bullish," he argues that the economy is facing a period of low growth, saying: "the major drivers in our economy today are deleveraging, deflation and demographics, the three D's that spell economic malaise for the foreseeable future."  Because of these three factors, he believes, "rapid growth years will not be coming back for another decade or so."  

However, Mr. Lehmann finds some room for optimism, arguing that even if firms cannot hope for much top-line organic growth, they can at least buy some growth through mergers and acquisition, and they can at least grow their bottom lines through the cost-saving technologies and the savings that will come as older workers retire and are replaced by younger workers (who will start with lower wages and probably fewer employee benefits, he seems to imply without directly saying it).

He also argues that another silver lining to this gloomy outlook is the possibility that interest rates won't go up as much as many fear, since low-growth environments should not have much inflation (this is an argument which we believe has some flaws, as we disagree with the "Phillips Curve" connection between economic growth and inflation, and instead side with the monetarists who say that inflation is a product of monetary supply and demand and that inflation can be created in a low-growth economy: witness the "stagflation" of the 1970s).  

So, with all these experienced market observers declaring a "New Normal" for 10 or 20 years, should investors resign themselves to a future in which "rapid growth" is just a fond memory of a long-lost past?  Are we witnessing the "death of growth investing"?  The recent slaughter of the share prices of the market's "growth darlings" seems to put an exclamation point on the arguments of those who, like Bill Gross, have declared the end of such growth.

We would disagree, and -- as long-term growth investors who have been at this in a professional capacity for many years -- we find our own reasons to be bullish in the face of these dire pronouncements:

• First, we disagree with the idea that the end of growth in the economy is a foregone conclusion, or that the days of "childlike wonder" are gone and we all have to become "chastened adults."  We believe that innovation drives economic growth, not demographics, not consumption, not easy money or credit, and certainly not government stimulus.  While we agree that bad government policy and excessive regulation can and do impede innovation and growth, we do not believe human beings will ever stop innovating, and that generations coming up behind the Baby Boom generation will prove to be every bit as innovative as the great innovators of that generation.
• Second, although bad government policy and intrusive regulation are real and present obstacles to growth, investors should remember that these policies and regulations can be changed, and that even just a few positive but simple changes can unleash tremendous growth in an economy.  The recent history of the past several decades is replete with examples of economies in which just a few positive changes sparked outbursts of pent-up innovation and growth, in countries such as China, India, New Zealand, Israel, and many more.  Some of these countries are still far from ideal in terms of regulation or government interference, but even small improvements saw big results: the same can happen in the US where pundits who predict a growthless "New Normal" for 20 years are ignoring the fact that things can change for the better long before 20 years go by.
• Setting aside these first two points, which challenge the long-term "New Normal" or "death of growth" thesis, and granting for the sake of argument that we could face such a gloomy lack of strong growth for an extended period, we still believe that investors should consider the fact that there will always be exceptional companies which can experience tremendous growth, even if the majority of companies are stuck in the kind of non-growth described by Mr. Gross and Mr. Lehmann above.  This was true during the 1970s, and we believe it is still true today, even if we are facing a "New Normal" for the wider economy at large.
• Finally, we would point out that during periods in which such growth is generally harder to come by, those businesses which do manage to distinguish themselves as having rare innovation and top- and bottom-line growth will fetch an even greater premium than they might be able to command in a more positive economic climate.  In fact, we would argue that the very reason that the prices "ran away" on some of the stocks which recently suffered a punishing "momentum correction" was that those companies were showing outsized growth relative to the broader market-at-large (at least in revenues, although some of them have yet to "flip the switch" on earnings profitability, as we discussed in this previous piece).

In summary, we believe there are good reasons to be bullish on true growth-stock investing, even in the face of the declarations of a "New Normal," or the end of "rapid growth years for another decade or so."  We also believe that there are not too many market participants voicing these types of opinions right now, and that the generally gloomy and pessimistic environment we are currently experiencing may be an opportunity for investors who can select companies with exceptional growth potential.

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"Real investing" and the latest "momentum meltdown"

The meltdown of former high-flying "momentum" stocks has accelerated recently, and investors are being treated to a barrage of bearish commentary declaring that the plunge in these stocks is just the leading indicator of the arrival of a long-overdue catastrophe.  

In particular, there is a contingent of commentators whose stated view for the past seven years has been that any supposed "recovery" from the economic crisis of 2007-2009 has been an illusion built upon another massive expansion of credit, engineered by the US Federal Reserve and other central banks around the world, and that the illusion could not go on forever.  Many of these pundits are now pointing to the ongoing "momentum meltdown" as a sure sign that the "credit party is over" and that a severe and prolonged recession must be right around the corner.

An excellent representative website where such contrarian opinion is on full display is David Stockman's Contra Corner, where former Congressman and Reagan administration cabinet member David Stockman publishes articles with his own analysis and articles from his guests, all of which generally share the diagnosis of the economy described above.  In addition to his experience in politics, Mr. Stockman also worked at Wall Street investment bank Salomon Brothers, was one of the original partners of the Blackstone Group, and started his own private equity fund, and so investors should consider his insightful analysis of the current situation very carefully.

In a recent article entitled "It Didn't Snow in San Jose: the Q1 Housing and GDP Rollover is Not Due to Weather," Mr. Stockman argues that "the US economy is freighted down with 'peak debt' and is incapable of the kind of credit-fueled rebound cycle that the Fed has orchestrated in the past," and concludes by saying:

In short, this time it is different.  The debt party is over.  The era of financial retrenchment and living within our means has begun.  It might even be that "selling the dip" is about to become the new normal.  Even this morning's Wall Street Journal could not powder the pig.

Another article on the same website, this one written not by David Stockman but by syndicated writer Wolf Richter and entitled "The Accelerating Momo Reversal: Crashing Like Its 2000 All Over Again," points out that web-radio company Pandora "has plunged 42% in six weeks, taking it back to where it was in September," Twitter is down 44% from its high in late 2013, and network security company Imperva "has crashed 64% from its peak last year."*  He implies that the plunge in the "momentum" names will soon make its way to everything else, saying:

It's different this time, we're ceaselessly told, even on NPR.  For one, the "Tech Bubble," as it's officially called now, is not tied to the larger stock market this time.  So its implosion will be contained.  I remember hearing the same in 1999.

He too concludes that the Fed's easy-money rampage of the past seven years will eventually lead to certain disaster.

Before we discuss a few points where we differ with the arguments made in these two articles and others like them, we would first like to point out that there are many points on which we agree with the general tenor of these arguments and with their frustration at the Fed's and the government's increasing interference with the system of free enterprise, as well as with their assessment that such interference is almost always harmful to the majority of the citizenry and almost always leads to negative consequences of some magnitude.  

We have published many criticisms of the Fed's attempts to "over-steer" the economy (see this previous discussion entitled "Fed over-steering, 2008 through 2014," which contains links to other criticisms we have posted of the Fed's over-steering, beginning in 2008).  

We have stated many times that the Fed should have long ago gotten out of the "emergency" mode which they have maintained since 2008 (see for example this previous post).  

We have labeled the excesses of the welfare state, which are directly connected to the easy-money policy of central banks, "The Question of Our Time" and discussed that subject in numerous previous articles such as this one and this one.  

We have pointed out the serious risks to fixed-income investors created by these welfare-state excesses in posts such as this one and this one. 

And, we have argued that crony capitalism, which is intimately related to all the above problems and which features prominently in the discussions on Mr. Stockman's Contra Corner, is a huge problem that robs the general public in order to deliver profits to a well-connected minority, in previous posts such as this one and this one.

Where we differ with the general tenor of the analysis written by many of those who share our views about all of the above problems, is that these egregious problems have been central features of the US economy since at least 1913 and of most other supposedly "free" economies in the world as well over the same time period.  Aspects of crony capitalism, credit expansion, Fed over-steering, and the rest have always been at work to enrich certain well-connected groups at the expense of the economy at large -- and while these factors have certainly led to unnecessary and painful recessions and financial crises, it would be a serious error to say that all of the innovation and all of the good businesses that have been created by individuals on their own or working together over the years were the illusory products of credit bubbles and cronyism.  We believe that economic growth happens in spite of the often-deleterious actions of government meddlers and central banks, not because of it -- and we would include the recovery that has taken place since 2009 as well.

While we agree that the current public sector "credit bubble" is far more egregious than anything seen in previous decades, we disagree with those who say that this central bank-induced "easy money" is solely responsible for all of the economic growth of the past eight or twelve or fifteen years, and we are really no further today than we were in 1999.  On the contrary, we would argue that even a moment's reflection will show that it would be ridiculous to argue that technology has not changed much since 1999 or even since 2005 or 2006 -- there have been tremendous changes, changes which have added demonstrable value to many consumers (who don't buy technology products because they are forced to but because they want to) but also to many businesses, large and small.

In fact, in the article by David Stockman linked earlier, he mentions corporate profit margins, which he notes are "already way above their historic range," and he argues from this that the current multiple on the S&P is too high.  However, we would argue that one of the real differences between the situation in 1999 and the situation today is that corporations (and businesses of all sizes) have been forced to become much more efficient and much more disciplined on spending, and that technological advances (which have been astonishing since 1999) have contributed to this in a very real and measurable way.  The businesses which have created those technologies have real products and add real value -- it would be a mistake to say that they are all just a "credit-bubble illusion." 

To be fair, Mr. Stockman is not saying that they are, but articles such as the second one linked above, which describe "anything in the social media space where the business model, if there's one at all, is based on collecting and monetizing personal data," implies that the high valuations some of these types of companies have been receiving is the sure sign that we are in a 1999-situation and getting close to the end of the party. Once again, there are points of this argument which we agree with, and we have written about companies whose leadership have made the business decision to put growth ahead of profit quite recently (see this post, for example), but while we agree that some of the valuations in that space are highly debatable, we would disagree that this necessarily signals a "return to 1999," or that this fairly specialized part of the tech market is indicative of every other company investors can choose to own.

In short, we believe that this investment climate calls for the same discernment that investors have had to exercise in previous decades, and that it is very rare to find a period of time in which things were so good that careful consideration on a company-by-company basis was not important, or so bad that there were absolutely no innovative companies which were bringing new value through new solutions which investors could be rewarded for owning.  We have written before that the 1970s was a time of incredibly erroneous monetary policy from the Federal Reserve, as well as extremely intrusive government policy including price controls and all sorts of cronyism, and yet there were opportunities during that period which could lead to tremendous returns, as the late Dick Taylor, who managed money during that decade and during the 1960s, often explained.

We believe that in reality, ownership of stocks in well-run, innovative businesses is really one of the best defenses against misguided government and central-bank policy -- and that such ownership is virtually necessitated by the very same inflationary policies created by the "credit-bubble" activities Mr. Stockman and the other writers are describing.  Stocks have proven to be a much better defense against such policies than even ownership of gold, as we discuss in this previous post. 

These are certainly very unsettling times for many investors, and the "momentum meltdown" of the past several weeks has hit the stock prices of many companies which we own as well, companies which we feel should not be unfairly lumped in with some of the others whose business models (or lack of a business model) are easier to criticize.  We agree that the "emergency" policies that have been in place since 2008 are damaging to the economy at large, and that cronyism and the other problems which Mr. Stockman and the writers in his Contra Corner decry are real problems of which everyone should become more aware.  

Nevertheless, in this situation as in those we have faced in the past (and we managed money through the crash of 1987, the 2000-2002 bear market as well), we believe the only real solution which works for the long-term accumulation of wealth and the protection of purchasing power is a return to what we call "real investing" -- the ownership of well-run businesses which are creating innovation and adding value to their customers.

* At the time of publication, the principals of Taylor Frigon Capital Management did not own securities issued by Pandora (P), Twitter (TWTR), or Imperva (IMPV).

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Investment Climate, April 2014 -- “WhatsApp?”

We recently published our latest quarterly Investment Climate update for April, 2014, entitled "WhatsApp?"

You can also read previous Investment Climate updates here, and Taylor Frigon whitepapers here.

At the time of publication, the principals of Taylor Frigon Capital Management did not own securities issued by Facebook (FB).

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Fed over-steering, 2008 through 2014

The Federal Reserve Open Market Committee (FOMC) and Fed Chair Janet Yellen recently released two statements which reiterated their "overall commitment to maintain extraordinary support for the recovery for some time to come."  While financial markets rallied on each of these statements, we believe that the Fed has really run out of options in terms of "supporting recoveries" and what's more, we believe that efforts by the Fed to steer the economy almost always end up doing more harm than good.  However, since investors cannot control the Fed and their attempts to steer the economy, they should instead focus on selecting investments that are least threatened by the damage which the Fed's steering is likely to cause.

The first recent statement was released by the FOMC at their regularly-scheduled March 19th meeting (text here) and the second was a speech by Janet Yellen on March 31st (text here).  To understand them, investors should know that the Fed is using two tools to add extraordinary stimulus to the economy, which it has been using since the economic crisis of 2008 and 2009.  Those two tools are:

•  an extraordinarily low fed funds rate which targets the interest rate for the shortest borrowing periods (targeting 0% to 0.25%, the lowest fed funds rate ever, a target which has been in place since late 2008), and . . .
• a policy of buying Treasury and agency debt (agency debt refers primarily to mortgage-backed securities packaged up by government-sponsored "agencies" such as Fannie Mae and Freddie Mac) in order to artificially increase the demand for that debt and thereby artificially depress the interest rates on such debt instruments (if demand for agency debt or Treasury debt falls, then those agencies must raise the rates on that debt in order to sell them, but if demand for them is artificially boosted then those rates can be lower and the debt can still find a buyer -- because the Fed has become a huge buyer).  This second policy is called "quantitative easing" (or "QE") and the chart above shows the debt purchased by the Fed, which becomes an asset on the Fed's balance sheet, with the growth in Fed assets labeled for QE 1, QE 2, and the current QE 3.

In the two statements mentioned above, the FOMC and Janet Yellen basically declared that the Fed will continue both of the above policies until the Fed determines that the "outlook for the labor market has improved substantially" (the statements also use the term "maximum employment").  However, the Fed has been slowing the rate at which they are buying agency debt, and the rate at which they are buying Treasury debt.  They also said that at some point after they wind up their quantitative easing, the Fed will begin to "remove policy accommodation," that is to say "raise the target fed funds rate" again from its current unprecedented low level.  They do not say anything about "unwinding" the Fed's balance sheet -- that is to say, reducing the huge bulge of assets that they have accumulated under QE 1, QE 2, and QE 3 shown in the chart above (now well over $4 trillion of assets, primarily Treasury and agency debt).

While the Fed's statements argue that these policies are designed "to encourage consumers to spend and businesses to invest, to promote a recovery in the housing market, and to put more people to work," and while Janet Yellen's March 31st speech declares that "There is little doubt that without these actions, the recession and slow recovery would have been far worse," we disagree with both of these assertions. We have long argued that the Fed should focus on price stability, and stop trying to "steer the economy" -- see for example "The Fed's oversteering and the wreckage of the past decade" (07/23/2009); "Why do we want the Fed to steer the economy" (09/01/2010); and "Likelihood of Fed over-steering increases" (01/25/2011).  When the Fed tries to steer the economy, history shows that they almost always over-steer and cause a tailspin of some sort.

We also believe that the Fed has probably run out of options for steering the economy, as a direct result of the enormous asset purchases.  Economist Brian Wesbury has pointed it out in an important new commentary entitled "Repudiating Milton Friedman" (dated 03/31/2014). With all those excess reserves, Brian Wesbury explains in his analysis, the Fed can try to raise the fed funds rate all it wants, but that won't stop the banks from deciding to use their excess reserves to make loans and thus to increase the supply of money into the system.  And that, he explains, could lead to the runaway inflation that many pundits have long predicted from these excess reserves, but which has not materialized thus far.  This is because the Fed had previously said those excess reserves would be temporary, and because the artificially low interest-rate environment made lending less attractive.  If the Fed is now signalling that it will someday raise rates without unwinding those excess reserves, then all bets are off and the M2 money supply could finally expand at a very rapid pace.

This is why Brian called his piece "Repudiating Milton Friedman," because Milton Friedman famously said that inflation is always caused by too much money chasing too few goods.  If the scenario described above takes place, Brian notes, the Fed may have to try to stop banks from lending by creating regulations that order them not to loan.  Such regulation would be at odds with trying to influence money supply using the old tools of supply and demand (tools which don't work very well if you leave the banks with such a swollen supply of excess reserves).  

These are serious concerns and all investors should understand the reasoning behind Brian Wesbury's analysis.  He points out that the initial flood of money entering circulation could boost stock prices well above their current levels, but that the ensuing inflation and the severe Fed counter-reaction that it will undoubtedly trigger could create a major negative shock to the economy and the markets.  It will be yet another example of the horrors of Fed over-steering.  

So, what is an investor to do?  The Fed's machinations with the money supply make it certain that over the long term, their dollars will lose purchasing power, and thus it is imperative for investors to own assets that can help counteract that long-term loss of purchasing power. The Fed's machinations also make fixed-income investing extremely hazardous for the foreseeable future, in our opinion -- something we discuss in a previous post entitled "The crisis facing fixed-income investors."  

Ultimately, we believe investors are best served through the ownership of assets, including equity in well-run, growing businesses, and we believe that those equities must be selected very carefully with the above monetary-supply scenarios firmly in mind.

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