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Kuby’s Commentary

The Pendulum Swings

Oct 29, 2018

Last Week:

Ouch. The previous week’s sideways bottoming action gave way to a nasty sell-off, with the S&P 500 surrendering its remaining gains for 2018 after declining 3.9%. The Pendulum has quickly swung from greed to fear as the Volatility Index spiked to its highest level since early February. It wasn’t the actual earnings reports that fostered the selling wave, instead it was the more cautionary tone within the reports, particularly over rising material, labor, and interest costs, as well as general uncertainty over international trade and supply chain disruptions. The earnings themselves were quite good, in fact the blended (combines actual results for companies that have reported and estimated results for companies that have yet to report), year-over-year earnings growth rate for the third quarter is 22.5% today, which is above the earnings growth rate of 19.4% last week. If 22.5% is the actual growth rate for the quarter, it will mark the third highest earnings growth since Q3 2010. All eleven sectors are reporting year-over-year earnings growth. Eight sectors are reporting double-digit earnings growth, led by the Energy, Financials, Communication Services, and Materials sectors. Additionally, the economic data was also strong, with third quarter GDP slightly above expectations at 3.5%.

The combination of the decline in stock prices and the robust earnings growth has left the market trading at a reasonable 12-month forward P/E ratio of 15.5, based on approximately 10% EPS growth in 2019. A key risk is if those earnings gains don’t materialize as the economy slows while costs rise. The bond market seems to be embracing the possibility of a slowdown, as the yield on the Ten-Year Treasury declined 12 basis points to 3.07%, and the spread between the 10 year and the 2 year (viewed as a recession signal if it goes negative) tightened further to around 20 basis points. In short, the economy is strong, and valuations have gotten more reasonable, but the future seems more challenging as the headwinds have stiffened.

But don’t panic! A common behavioral mistake that can lead to sub-par long-term returns, is to succumb to the impulses of the fear/greed pendulum. Volatility is an unfortunate element of the stock market. The S&P 500 has averaged approximately a 14% correction each year since 1980, while advancing from around 100 to over 2600 today. Selling after those corrections would have significantly reduced an investors long-term returns, unless by some miracle one was able to pick the right moment to reenter the market. These painful sell-offs reinforce the importance for an individual to set a comfortable equity allocation range to stay invested through the ups and downs.

This Week:

The key economic event of the week will be the October jobs report that will be released on Friday. The consensus estimate calls for 190,000 new jobs with the jobless rate holding steady at a 48-year low of 3.7%. A much stronger reading would likely create havoc in the bond market and embolden the Fed to more aggressively raise short-term rates, while a much weaker number would stoke the recession concerns. The PCE reading for September out on Monday will provide greater detail on personal spending and inflation. Meanwhile earnings season will continue in full bloom, with 139 S&P 500 companies reporting results for the third quarter.

Stocks on the Move:

Advanced Micro Devices, Inc. (AMD)- 25.5%: Speaking of the pendulum swinging, just a month ago the Company’s shares reached their highest level in 12 years on enthusiasm over their new chips. Since then the shares have declined 50% as tech stocks in general have been under pressure, and the Company’s third quarter earnings underwhelmed investors. Advanced Micro Devices designs and produces microprocessors and low-power processor solutions for the computer, communications, and consumer electronics industries. AMD is a 2.47% holding in the North Star Opportunity Fund and AMD corporate bonds are a 2.63% holding in the North Star Bond Fund.

AMC Entertainment Holdings, Inc. (AMC) -10%: After opening slightly higher Monday morning on the strength of “Halloween” raking in $77.5 million in its debut weekend, the shares steadily slid the rest of the week as the market declined. AMC Entertainment Holdings is engaged in theatrical exhibition. It is principally involved in the theatrical exhibition business and owns, operates or has interests in theaters located in the United States. AMC is a 2.48% holding in the North Star Opportunity Fund and AMC corporate bonds are a 2.19% holding in the North Star Bond Fund.

AT&T, Inc. (T) – 11.6%: Third quarter profits of 90 cents a share fell short of expectations of 94 cents, while revenue, including the purchase of Time Warner, rose 15.3% to $45.74 billion. Analysts projected revenue of $45.65 billion. AT&T said it lost 346,000 traditional video subscribers in the third quarter and added 49,000 lower-margin DirecTV Now internet streaming customers. DirecTV Now’s growth slowed sharply from previous quarters. AT&T is engaged in provision of communications and digital entertainment services in the United States and the world. It provides fixed-line services, including voice, data, and television services to consumers and small businesses. T is a 2.09% holding in the North Star Opportunity Fund.

Flexsteel Industries, Inc. (FLXS) -19.6%: For the first quarter, net sales were $113.5 million, down 5.3% to prior year quarter. Gross margin as a percent of net sales for the quarter ended September 30, 2018 was 19.2% compared to 21.8% for the prior year quarter. Higher labor costs drove approximately 200 basis points of deterioration in the fiscal first quarter in comparison to the prior year quarter. Selling, general and administrative (SG&A) expenses were 17.8% of net sales in the quarter ended September 30, 2018 compared to 15.2% of net sales in the prior year quarter. The first quarter SG&A expenses include $1.3 million pre-tax expense for one-time severance and ancillary costs related to the September 9, 2018 retirement of Karel Czanderna, former President and Chief Executive Officer. On an after-tax basis, the expense represents $1.0 million or $0.13 per share. The Company’s SG&A expenses increased 40 basis points to support its strategic digital marketing investment aimed at directly influencing consumers as they dream and plan on-line for future furniture purchases. Quarter results were also impacted by higher costs associated with the new business information system, initial phases of relocating the Dubuque operation to its new facility and lost volume leverage, partially offset by the classification of certain rebates as a reduction of sales to be consistent with ASC Topic 606. Flexsteel Industries manufactures, imports and markets residential and commercial upholstered wooden furniture products. The products offering include sofas, loveseats, chairs, rockers, desks, tables, convertible bedding units, and bedroom furniture. FLXS is a 1.88% holding in the North Star Micro Cap Fund and is a 1.30% holding in the North Star Dividend Fund.

Rocky Mountain Chocolate Factory, Inc. (RMCF) -13%: Total revenue decreased 5.6 percent to $7.8 million during the three months ended August 31, 2018 compared to $8.3 million, and net income decreased 19.1 percent to $751,000, or $0.13 per basic and diluted share during the three months ended August 31, 2017. Rocky Mountain Chocolate Factory Inc is an international franchisor and confectionery manufacturer. It produces an extensive line of chocolate candies and other confectionery products. RMCF is a 1.86% holding in the North Star Dividend Fund.

Rocky Brands, Inc. (RCKY) +10.9%: Third quarter net sales increased 1.9% to $65.9 million compared to $64.7 million in the third quarter of 2017. The Company reported third quarter net income of $5.0 million, or $0.67 per diluted share compared to a net income of $2.2 million, or $0.30 per diluted share in the third quarter of 2017. Jason Brooks, President and Chief Executive Officer, commented, “We delivered another quarter of solid year-over-year improvements highlighted by strong gains in gross margin and operating profit. The strategic initiatives that we’ve been executing over the past 12-months continued to drive sales growth in our two highest margin channels – wholesale and retail. Our commitment to developing compelling product that serves the needs of our consumers in the work, western, outdoor and commercial military segments of the market coupled with enhanced marketing programs and improved service levels is fueling our success. With our portfolio of authentic brands, internal manufacturing capabilities, and differentiated direct business-to-business model, we are confident that the Company is well positioned to achieve profitable growth on an annual basis and generate increased shareholder value over the long-term.” Rocky Brands is a designer, manufacturer and marketer of footwear and apparel marketed under a portfolio of brand names including Rocky, Georgia Boot, Durango, Lehigh, Creative Recreation and the licensed brand Michelin. RCKY is a 4.85% holding in the North Star Dividend Fund and a 4.51% holding in the North Star Micro Cap Fund.

Trinity Industries, Inc. (TRN) – 20.5%: Reported adjusted earnings per common diluted share of $0.39, excluding $0.20 per share related to an impairment charge in the Energy Equipment Group and transaction costs related to the planned spin-off of Arcosa, Inc., compared to $0.43 in the year earlier period. “I am pleased with the continued momentum in market demand experienced by a number of our businesses during the quarter,” said Timothy R. Wallace, Trinity’s Chairman, CEO and President. “Trinity’s consolidated third quarter financial results reflect a variety of market conditions in our businesses as well as activities associated with the anticipated distribution of Arcosa, Inc. to Trinity shareholders on the first of November.” During the third quarter of 2018, the Company repurchased 1,356,484 shares of common stock at a cost of approximately $50.0 million, bringing year to date repurchases to $150.0 million, excluding fees, and leaving approximately $350.0 million remaining under its current authorization through December 31, 2019. Trinity Industries Inc is a diversified industrial company. The company owns businesses providing products and services to the to the energy, transportation, chemical, and construction sectors. The company generates its revenue from Rail group. TRN is a 1.83% holding in the North Star Opportunity Fund and TRN corporate bonds are a 2.50% holding in the North Star Bond Fund.

The information provided in this commentary is not an offer to sell or the solicitation of an offer to purchase any security, product, or brokerage service. The information is not intended to be used as the basis for investment decisions, nor should the information be construed as advice designed to meet the particular needs of any investor. This commentary is presented to illustrate examples of the securities that North Star Investment Management Corporation and/or its affiliates (“North Star”) may have bought for client accounts and the diversity of markets in which North Star Investments may invest, and may not be representative of current or future investments. You should not assume that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this commentary will be profitable or will be equal to any corresponding performance levels that might be indicated. Past performance is no guarantee of future results. Investments in securities involve risks including the possible loss of the principal invested. North Star and others associated with it, including employees, may have positions in and effect transactions in securities of companies mentioned or indirectly referenced in this commentary. North Star may buy, sell or hold these securities in proprietary or client accounts. North Star will not be providing regular updates or advising you of any changes in the views expressed herein. Investors should consider their investment objectives, risk tolerance, and financial situation and needs before investing in any security. Tax considerations, commissions, fees and other costs should be carefully evaluated with one’s investment and/or tax advisors. Information provided is obtained from sources deemed to be reliable, but North Star cannot guarantee the accuracy or completeness of the information. This material may not be reproduced, distributed or transmitted to any other person in whole or in part without the prior written consent of North Star. A copy of North Star Investment Management Corporation’s Form ADV Brochure, Privacy Notice and Business Continuity Plan summary can be obtained by calling 312-580-0900.

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