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Letter – 2015 Q1

The S&P 500 Index moved marginally higher in the first quarter, providing a total return of 0.95%.  The Dow Industrial Average declined a touch, and the broader market as reflected by the Russell 200 Index did the best with a gain of 4.3%.  The S&P 500 was down in January, up in February and down slightly in March – more or less a ride to nowhere.  We managed to post a total return of 2.73%.   We basically matched the market during the February rally and did better than the market in the two down months – which suggests good risk-adjusted returns as well.

Certain things did not change much from last year.  According to Morningstar, healthcare stocks overall gained 4.5% and biotech shares led the way.  Celgene returned another 14.9% this quarter.  Regeneron gained 19%.  United Therapeutics rose 37%; I’d love to own more of it but it is volatile as evidenced by drops of more than 4% in one-fifth of the weekly periods last year.   Pharmacyclics gave us a 100% return in just six months; I am waiting until August when the gain becomes long-term to realize the profit.  There is always some risk of a deal falling apart, so please let me know if you have a strong desire to take some money off the table before the gain becomes long term.

On the other end of the spectrum, the energy markets remain in a downtrend.  As a group, they were flat to down slightly (depending on whose measure you use).  Oil itself was weaker than the major oil companies.  West Texas Intermediate crude fell 10.6% from 53.27 to 47.60 this quarter.  The rig count is down sharply in the past year, which means that the development of new wells will diminish.  But production from existing wells does not slow immediately; they are a sunk cost.  And since domestic storage tanks are almost full, we have no place to store this excess production – and that forces prices lower.  Stocks such as Exxon and Chevron dropped less than oil itself, which suggests that investors are expecting a “V” bottom in energy stocks.  If that does not occur, these stocks may decline further since they have PE ratios of 22 and 28 respectively versus expected 2015 earnings.  Stated another way, the consensus among analysts is for the earnings of the oil majors to rebound by 40 to 70 percent in 2016.  While that is certainly possible, the stocks are too optimistically priced should that rebound not occur.  Accordingly, we have been underweighted in energy shares and that served us well in the first quarter.

Normally, low energy prices are seen as a spur to consumer spending.  Consumer discretionary stocks have been very uneven recently, but depending on the universe included, they gained about 4.6% for the quarter.  By some estimates, only about 25% of the extra money in consumers’ pockets from falling energy prices is being recycled back into retail sales.   There is room for more upside.

It is worth focusing on differences within the market – both among sectors and within these sectors.  Healthcare did way better than energy, and earnings trends were remarkably different.  Within healthcare, Bristol Myers did way better than Merck.  Within consumer stocks, Amazon did way better than Walmart.  And so on.  But people want to know about the prospects for the market as a whole.

So now what?  Is the market over-valued?  When will the Fed raise interest rates, and what will that do?  A few thoughts.  We’ve referred often to the relative value between stocks and bonds as measured by the equity risk premium – the earnings yield on stocks minus the yield on the ten-year treasury note.  The earnings yield is the reciprocal of the P/E ratio.  On March 31, the S&P 500 closed at 2067.89.  The consensus on S&P operating earnings for 2015 is now $120.87, which translates to a P/E of 17.1 or an earnings yield of 5.85%.  Compare that to the treasury yield of 1.92%, and you get a risk premium of 3.93% — pretty high historically.  Even if you say that real interest rates are a percent too low and make that mental adjustment, the risk premium is still in pretty favorable territory.  So that suggests a market that can continue higher.

If investing were only so simple.  Earnings estimates could gradually fall, as they often do.  We may see such declines if first quarter GDP growth comes in at under 1.5%, as more economists are starting to suggest.  Alternatively, interest rates could rise by more than is discounted in the market.  Some think that the Fed will raise short-term interest rates in June, more now seem to think it will be in September.  We lean in the latter direction for a few reasons.  First, the U-6 measure of unemployment, which provides a broader measure of the labor situation than the standard number now reported at 5.5%, paints a less robust picture.  Second, the dollar is very strong on its own and any hike in rates would likely strengthen it further – which would in turn hurt exports as well as the earnings of large corporations that get much of their revenue from overseas.  Third, the Fed may be mindful of warnings (especially from giant hedge fund manager Ray Dalio) that it could make a 1937 type of mistake; ie, tightening in a way that ends a recovery.

The only bad news in all this is that at times the market does worse in the anticipation of unwanted events than it does when such events actually occur.  Consider the taper tantrum of a year ago, or even the prelude to the Iraq war over a decade ago.

So now for a quick paragraph on the psycho-babble aspect of the market.  The Nasdaq Composite Index has reached the 5000 level for the first time since 2000.  Market technicians refer to this as a “double top”, as if that is in itself dispositive.  It may be true that certain price levels can have a psychological impact; witness Dow 1000 in the 1960s or the “double top” on the S&P around 1550 in March 2000 and October 2007.  But the valuations of stocks within the Nasdaq are very different today.  A quick comparison of PE ratios then and now makes that clear:

    Stock EPS
2000
Price
Feb.2000
P/E
2000
P/E
2015
Cisco 0.53 132.19 249.4 12.2
Intel 1.57 113.00 72.0 13.1
EMC 0.81 119.00 146.9 11.7
Microsoft 0.85 89.38 105.1 14.1
Apple 1.17 112.56 96.2 13.3

The biotech stocks may be a different story.  There are companies that have no earnings, but very promising pipelines.  We did an overlay of the Nasdaq Composite then versus the IBB biotech ETF now, and one can argue that the biotech is at the equivalent of 3800 on the Nasdaq when it was on its way to 5000.  This says to me that some caution in the form of appropriate risk controls is warranted.

As always, our focus is on the best relative values at a given point in time.  As you know, we look for stocks where estimated earnings suggest a relatively quick payback of the stock price.  We also keep a database of historical earnings as well as year-end P/E and price-to-cash flow ratios going back a decade or more, and look for the best relative values that way too.  For example, our data shows that Viacom has traded at an average P/E ratio of 14.8 since 2005 and now trades at a P/E of 11.7, so we own it.  There may be reasons such as competition from Netflix why it ultimately does not regress to the mean, but Viacom has faced various forms of competition all along.  Similarly, Taiwan Semiconductor has grown earnings at a double digit rate over the past decade, and the stock would be 10% higher if the P/E ratio were to regress to the mean.  We also see a lot of stocks that are trading well above their valuations of the past decade, and that helps to refine our stock selection as well.

This sort of methodology has worked well for us over time.  Our databases only get better.  We believe that they help us with a sound price discipline that beats the thematic investing that so many do with minimal regard to value.  We do not lose sight of the importance of risk controls to protect us when either we are wrong or the market is just plain weak.  While past performance is no guarantee of future results, we hope to continue reporting on good markets and good relative returns within them.  We appreciate your confidence and you know that you should feel free to get in touch at absolutely any time.


* Past performance is not necessarily indicative of future performance. Results for individual clients may vary. Results are not audited. Byrne Asset numbers reflect the addition of certain dividends and deduction of all fees. S&P numbers are based on the total return of Vanguard’s S&P 500 Index Fund.

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