Trapeze Asset Management commentary for the first quarter ended March 31, 2018; titled, “Don’t Worry, Be Happy.”
Q1 hedge fund letters, conference, scoops etc, Also read Lear Capital: Financial Products You Should Avoid?
This line, made famous by the Bobby McFerrin song, is certainly evocative and, surprisingly, controversial. Some argue that it’s wishful thinking or worse, akin to burying one’s head in the sand. For us, at its core, the line implies that a positive attitude is necessary to cope with life’s adversities—a sentiment we happen to agree with. In the investment business too, an optimistic attitude is essential. Though worrying should also be part of the investment process, it can’t be allowed to overwhelm the overall process.
Worry Top Down, Invest Bottom Up
We can’t take credit for the concept of worrying about macro events yet investing based on micro analysis. But we do concur that most of one’s time should be spent in this mode. Meaning, markets are on the rise most of the time, climbing a proverbial wall of worry. Thus, it usually pays to be fully invested, relying on individual investment selections. However, prolonged bear markets do occur when recessions are causing earnings and valuations to deteriorate. And, if as a result of worrying, the impact of those drawdowns can be lessened, then it’s certainly worth the fretting.
Our biggest regret in the last few years is not being more fully invested, to participate to a greater degree along with the rising markets. Why was that the case? Mainly, for two reasons: first, we have been somewhat worried; and, second, it has been unusually difficult to find attractive opportunities in what has been a fully valued market.
Worry Warts
Some live in a constant state of concern—doomers and gloomers. No way to live. Too much of a toll from elevated stress levels. It can also lead to inaction which, in the investment business, where one normally needs to be fully invested, is a poor course of action. We prefer to operate with a healthy dose of skepticism, wary of issues that might unduly impact our holdings and constantly watching our macro tools for alerts to a potential bear market.
Currently, there are quite a few things to be worried about. The political issues are downright depressing. The choices at the ballot boxes have been to select one’s least undesirable choice. And mismanagement abounds. Whether it’s federally, in the U.S. or Canada, or in most states and provinces, deficits are out of sight, at a time when they should be falling materially. Our leaders should be orchestrating budget surpluses in boom times. Globally, total debt relative to GDP is higher than at its peak in ’07. The Bank of International Settlement is now showing total nonfinancial debt of around 245% of global GDP, up from 210% prior to the Great Recession. At these debt levels, the next recession could cause more dislocations than usual.
This impacts interest rates too. The rise in interest rates has been meaningful already. Prior to it pulling back to 2.8%, the 10-year U.S. Treasury had lifted to above 3% from about 2% last September. While demand at recent treasury auctions has been strong enough to meet the supply, we should be concerned with the higher cost of carry as deficits and interest rates rise simultaneously causing incremental ever-higher needs for government funding which could require even higher interest rates to attract bond investors. Higher interest rates could also be competitive for equity markets which are already fully valued and cause problems for many businesses and individuals whose finances are extended from debts taken on at attractively low rates. Subprime auto loans and student loans are particular areas of concern. As long as rates rise gradually, the impact ought to be more manageable, but clearly these debt levels should be a concern.
Inflation itself could also cause interest rates to keep rising. The central banks, fearing deflation, have focused on a 2%, or higher, inflation target. Now essentially achieved (the most recent PCE at 1.9%), there’s always a potential for it to overshoot. Especially with commodity prices rebounding, for example, oil prices whose significant rebound has contributed to much higher gasoline prices, propelling non-core inflationary pressures.
And input costs in general have been on the rise. Various consumer staple companies, the ones whose earnings are supposed to be the most stable, have reported weaker earnings, primarily attributable to rising costs. With unemployment at such a low level too, now 3.9% in the U.S., the lowest level since December 2000, wages should begin to rise unduly. Certain industries are already suffering from labour shortages, for truckers or pilots, which will likely act to further exacerbate costs. Though, the counterbalancing disinflationary effects, for example, from the ubiquity and transparency of the Internet, continue to keep pricing highly competitive across most products and services.
Other issues continue to make headlines. Trade wars and geopolitical instability in a number of regions have made investors jittery. These real-world problems cause short-term volatility but also threaten to disrupt global growth which should already be slowing from higher interest rates and cost pressures.
These factors could act to reduce the central banks’ need to quell growth and prolong this cycle even further. And while lower corporate taxes could lead to lower tax receipts (which fortunately have been at recent highs from a continuously strong economy), which in turn could exacerbate deficits, the U.S. is now in a more competitive position which should continue to lead to capital spending in the U.S., spurring growth.
Not only have interest rates been rising, both at the administered short end and at the market-driven longer-term rates, monetary aggregates have been shrinking. Quantitative easing has turned to tightening, albeit at a slackened pace, which also acts to impede growth.
Valuations of the overall stock markets remain elevated too. Though as the market stagnates and earnings continue to grow, especially with the lift from lowered tax rates in the U.S., valuations become less stretched. On a positive note, this has enabled us to find more potential investment opportunities recently.
And psychology has not been exuberant. The commitment of traders has been extremely bearish of late for U.S. stocks, which is bullish, and similarly, it’s been bearish on bonds. Perhaps that’s another reason interest rates just came down somewhat.
Getting Perspective
Corporate earnings, the engine of the stock market, are still rising smartly. In the most recent quarter, S&P 500 earnings per share grew by 25%, boosted by corporate tax rate reductions and share buybacks, with 78% of companies exceeding estimates. And, there’s never been a recession with corporate earnings rising. However, the market tends to anticipate the deterioration that accompanies a recession.
Therefore, to weigh all of the top-down issues, we rely heavily on our two macro models. Since recessions are normally triggered by tightening monetary policy, our economic composite mostly looks for an inversion of the yield curve (where short-term rates—90-day T-bills—rise above 10-year bond rates). While there’s been a flattening of the yield curve, there is still no sign of the inversion we look for. And when combined with its other economic statistics, our Economic Composite (TEC™) is not alerting us to a recession. Nor is our market momentum indicator (TRIM™) suggesting an imminent bear market in most markets. This tool normally triggers during a correction, once a TEC™ signal has already triggered. That said, a few emerging markets have triggered TRIM™ sell signals, so our level of concern has somewhat heightened.
Our tools were designed to better time when our worrying should cause action. When our tools alert us, then we would attempt to exit positions and/or hedge (where authorized by client accounts) in order to limit the impact of a significant market decline. Meanwhile, despite all of the worries or, perhaps because of them, a global recession seems unlikely and that allows us to be more confident in our fully invested stance.
From a bottom-up standpoint, we focus on the highest quality bargains we can find. Overall stock market valuations are elevated—at or above fair value, the medium-term outlook for stocks in general is not favourable. Accordingly, at this stage we feel that bottom-up stock picking is essential to help offset the risk of holding positions that might be impacted unduly by negative revaluations.
So we continue to analyze companies where we see competitive advantages and expect consistent growing earnings streams—the ones whose businesses have strong operations and financials (with a view to mitigating losses) and FMVs (fair market values) that are persistently growing. And when for any number of reasons, due usually to a temporary operational setback, the share price has fallen sufficiently below our estimate of FMV, we look to purchase. And we prefer to sell when positions rise to our FMV, especially when they coincide with ceilings in our TRAC™ work because we then become fearful of potential declines.
Our preference, as long as we can find a sufficient number of undervalued companies—stocks trading 20% or more below our estimated appraised values—is to be fully invested.
Our Strategy
The stock markets’ full valuations are making it difficult to find bargains. Large cap bargains are scarce but the increased volatility of the markets has allowed us to find several more companies that have passed our due diligence process. We found a few positions with favourable earnings outlooks trading at wide enough discounts to our estimates of their FMVs. We continue to add large cap positions to our All Cap portfolios and look to add more when our current smaller cap positions are sold once they rise close to our FMVs.
Meanwhile we continue to sell into strength when our positions rise to our FMV estimates and buy on weakness when stocks fall to entry points far enough below our FMV appraisals that offer us sufficient potential upside and downside protection. Otherwise we try to wait patiently until our holdings rise to our estimates of their FMVs.
Our outlook for both precious metals and oil & gas, where we remain overweighted, is still positive. Gold prices should firm with rising inflation and precious metals are normally a good hedge against rising global inflation and debt levels. Oil inventories continue to drop back to normal and the market has been in deficit for the last few quarters. With both gold and oil in bull markets, in our view, we intend to maintain exposure to these sectors as long as we can find individual stocks that are attractively valued and meet our risk-reward criteria.
Our Portfolios
The following descriptions of the significant holdings in our managed accounts are intended only to explain the reasons that we have made, and continue to hold, these investments in the accounts we manage for you and are not intended as advice or recommendations with respect to purchasing, selling or holding the securities described. Below we discuss each of our new holdings and updates on key holdings if there have been material developments.
All Cap Portfolios and Recent Developments for Key Holdings
Our All Cap portfolios combine selections from our large cap strategy (Global Insight) with our best small and medium cap ideas. We generally prefer large cap companies for their superior liquidity and lower volatility. Importantly, they tend to recover back to their fair values much faster than smaller stocks, so they can be traded more frequently for enhanced returns. However, our small cap positions are cheaper, trading far below our fair value estimates; therefore, our All Cap portfolios currently hold a meaningful position in small caps.
Most of our small cap company holdings trade well below our estimate of their respective FMVs. These are smaller, less liquid holdings which are potentially more volatile; however, we continue to hold these positions because we find their risk/reward profiles favourable.
All Cap Portfolio Changes
In the last few months we bought several new large cap positions including CVS Health, Comcast, Kraft Heinz, Liberty Media Sirius XM, Berkshire Hathaway and Daimler—all summarized in our Global Insight portfolio review below. We sold Hitachi as it ran up to a TRAC™ ceiling, close to our FMV estimate. And we sold Sabra Healthcare REIT, Molson Coors Brewing, Johnson & Johnson, and Hanesbrands when each broke down through a TRAC™ floor.
In the last few months, there were no material developments at the companies that represent our key holdings.
Global Insight (Large Cap) Portfolios and Recent Developments for Key Holdings
Global Insight represents our large cap model (typically with market caps over $5 billion at the time of purchase but may include those in the $2-5 billion range) where portfolios are managed Long/Short or Long only. A complete description of the Global Insight Model is available on our website. Our target for our large cap positions is more than a 20% return per year over a 2-year period, though many may rise toward our FMV estimates sooner should the market react to more quickly narrow their undervaluations. Or, some may be eliminated if they decline and breach TRAC™ floors. At about 75 cents-on-the-dollar versus our FMV estimates, our Global Insight holdings appear to be cheaper, in aggregate, than the overall market.
Global Insight (Large Cap) Portfolio Changes
In the last few months we bought several new large cap positions including CVS Health, Comcast, Kraft Heinz, Liberty Media Sirius XM, Berkshire Hathaway, Royal Caribbean Cruises, Prudential Financial and Daimler. We sold CGI Group, Hitachi and China Unicom as they ran up to TRAC™ ceilings, close to our FMV estimates. And we sold Molson Coors Brewing, Johnson & Johnson, and Hanesbrands when each broke down through a TRAC™ floor.
CVS Health believes its $69 billion combination with Aetna will revolutionize the consumer health care experience and is a “natural evolution” for both companies. Over time, significant synergies are expected. CVS’s core retail and pharmacy businesses should generate close to $7 per share of earnings this year, which equates to a 9.2x P/E multiple at current levels. Even with the deal uncertainty and pressures from Washington over drug prices, this is far too low for a company with a leading market share, 15% return on equity, and expected earnings growth of 5 to 10% over the next five years. Our estimated FMV is $90.
Comcast Corporation is the largest U.S. cable provider and serves more than 26 million high-speed internet customers. Other major assets include NBC Entertainment, Universal, Bravo, USA Network, and three major theme parks. Cable Communications (e.g., high-speed internet, video, and voice) represents approximately 60% of revenue and produces over 70% of operating income. Much has been written about “cord-cutting” and the death of traditional television, but Comcast’s future is tied to the growth of its broadband services. In its most recent quarter, Comcast experienced an 8% jump in high-speed internet revenues. While its underlying businesses are healthy and experiencing strong growth, investors are currently focused on its proposed acquisition of Sky and a potential bidding war with Disney for Twenty-First Century Fox. Ultimately, we believe Disney will be victorious in its pursuit of Fox. However, should Comcast win, we believe the combination would create an entertainment powerhouse with the necessary scale to compete with Netflix and other over-the-top providers. The key risk is that egos overrule sound judgement and Comcast overpays. Once the drama dies down, we believe investors will refocus their attention on the underlying strength of its businesses and the large disconnect between its current share price and our $41 FMV estimate.
Consumer staples stocks continue to experience sluggish growth and margin pressures on rising input costs, a tight freight market, and rapidly evolving consumer preferences. The Consumer Staples Select Sector SPDR ETF (XLP) is down nearly 12% over the last year, drastically underperforming the S&P 500. Kraft Heinz is experiencing many of the same challenges as its peers. However, we believe Kraft has the brands, scale and technology required to compete in this rapidly changing, digital-first world. Kraft’s three-pronged innovation strategy of evolving iconic brands, optimizing the portfolio, and expanding into whitespace is already yielding results. Unlike many peers, Kraft is seeing improvement in consumption trends in most countries. On its Q1 earnings call, management noted that ’18 will see strong adjusted EPS growth and a “significant step up” in cash generation from lower capital expenditures and lower cash taxes. Our estimate of FMV is $80.
Liberty Media (Series C) Sirius XM is a tracking stock for Sirius XM, the dominant satellite radio company. At time of purchase Sirius XM was also undervalued, in our view trading at about a 15% discount to our FMV estimate. Liberty though was trading at a more substantial 35% discount. Odd, given that Sirius is essentially the only asset of this tracking stock which owns over 70% of Sirius XM making the net asset value calculation of Liberty quite simple. Potential catalysts to close the valuation gap are a takeover by another communications/media enterprise or more visibility into Liberty’s valuation as ownership above 80% would cause consolidated accounting and allow for a tax-free dividend, which could be just over a year away at Sirius’ share buyback rate. John Malone is likely planning other means to close the gap. The primary risk to Sirius’ business is competition from Internet radio stations in vehicles which seems unlikely and, even so, some time away. Our FMV estimate is over $60. We previously owned Liberty and sold it when it got to our FMV target, which has since lifted materially, especially given the tax changes at Sirius.
Berkshire Hathaway once again is trading at a substantial discount to our appraisal of its FMV ($350,000 per A share) which is unusual for such a large, high quality organization. This mostly domestic company was a prime beneficiary of the tax cuts, lifting its FMV considerably. The market is perhaps concerned with competition in the insurance business or the impact from potential catastrophes. Investors may also be questioning whether the company has lost touch with its roots and may have invested too much in more capital intensive businesses. We believe that management depth is particularly strong at what is now one of the largest companies in the world. And, downside should be limited by its diversity, the nature of its businesses, its cash hoard and the fact that it trades at 1.35x book value, just above the level Buffett insisted it would buy back shares.
Royal Caribbean Cruises, the second-largest global cruise operator, has fallen from recent highs, mostly attributable to concerns about rising fuel prices. However, fuel costs amount to just 8% of revenue, the third largest cost behind commissions paid to travel agents and payroll. Furthermore, as at the end of Q1, close to half of fuel costs for this year and ’19 are hedged via fuel swap agreements. The company’s “20/20 Vision” seeks to further improve return on invested capital and achieve $10 per share of annual earnings by ’20 (this would represent a doubling of earnings since ’15). Cost savings efforts and new innovations (e.g., tinted windows, more fuel efficient ships, advanced water filtration systems) that are a part of the plan could mean that net margins rise, even if oil continues its ascent. Our FMV estimate is $135.
Prudential Financial has been steadily lowering the risk profile of its variable annuity business. At the policy level, Prudential has increased the minimum age of first withdrawal for new policies and reduced the rollup guarantee period. Its other businesses, such as investment management, individual insurance and workplace solutions have been growing quickly, reducing the earnings contribution of the annuity business (variable annuities now account for just 24% of total earnings, much lower than peers such as Lincoln and Brighthouse). Overall, we view Prudential as one of the premier U.S. financials, as evidenced by its diversified business mix, above-average return on equity and earnings growth profile. Our FMV estimate is $120.
Most associate Daimler with its sleek, high performance luxury cars and SUVs. We’re attracted to something a bit more mundane: a turnaround in its trucking business. Fiscal year ’16 truck unit sales fell 17% due to weakness in key regions such as Turkey and Latin America. Now, just 18 months later, Daimler’s truck book-to-bill ratio is the highest in 12 years. Strong growth in China, new models, and electric car initiatives should boost free cash flow to over €6 billion in ’19. Our fair value estimate is €85. Though a global slowdown would be a risk given its cyclical business, Daimler appears to trade too cheaply given its stellar balance sheet, high level of profitability and its status as a leading global brand. We just purchased a position following a recent price decline which appears to be due to tariff concerns. President Trump, as only he can, just argued that he doesn’t want to see any more Mercedes driving down 5th Avenue.
Income Holdings
The 10-year U.S. government bond yield has jumped to just shy of 3%. High-yield corporate bond yields have risen too, to 6.3%. The spread between the two, at about 330 bps, remains historically narrow. Over the last 20 years a more normal spread has been around 500 bps. So either 10-year governments are too high or high-yield bond yields have much further to rise, which is more likely the case. We continue to believe most government rates and investment grade bonds aren’t yielding enough given potential risks. In fact, investment grade bonds are down approximately 5% year to date.
We continue to hold a number of undervalued income positions and collect outsized interest income on these positions. Our income holdings have an average current annual yield (income we receive as a percent of current market value of income securities held) of about 9%. Though there is risk from higher interest rates, which would compete with our holdings, and specific business and credit risk for our corporate positions—bonds, REITs, preferred shares and income funds. We sold Sabra Healthcare REIT after it triggered a sell signal in our TRAC™ work and we converted our Gran Colombia Gold convertible debentures to common shares, which we subsequently sold.
Of note, regarding our holdings in our income accounts: Enerdynamic Hybrid Technologies restructured and we received a new short-term secured debenture for most of our original debenture’s principal amount, and we received common shares for the balance of the principal, and all interest arrears.
“In every life we have some trouble. But when you worry you make it double.”
There are certainly issues to worry about. And new ones, like the recent political events in Italy, are sure to crop up. But blowing them out of proportion may only act to cause worrying for the sake of worrying, as suggested by the lyrics above. The balance of the evidence today still argues for a positive outlook. Inflation is picking up but gradually. Interest rates are rising too but remain historically low. And the government authorities, other than the bluster from Trump, seem to be reacting appropriately.
The current expansion is the second longest recorded, after the ’90s boom. And stock market valuations remain full. So we will constantly monitor our overall market risk tools in an attempt to time the end of the bull market. Meanwhile, since alerts have not yet triggered, we will continue to hold shares, and buy others, as long as they’re trading below our FMV estimates. We will worry top down but invest bottom up, buying well managed, appropriately leveraged, high quality enterprises with ever-growing earnings, at discounts to our estimates of their intrinsic value.
Herbert Abramson and Randall Abramson, CFA
May 31, 2018
