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Letter – 2015 Q4

This year was basically a long ride to nowhere.  After six good years, the stock market gyrated in part because investors spent much of the year fretting about a modest hike in interest rates and slowing earnings growth.  The S&P 500 Index provided a total return of 1.37% but that number masked the bigger picture.  All of the return was from dividends as the index declined by 0.73%.  Breadth was very narrow, with the market being led by the so-called “Nifty Nine” listed below.  These are growth stocks, and many of them are at pretty stratospheric price-earnings (PE) ratios, so it is hard to justify tying up too much money in them.  Given their strength and the weakness in oil, it is not surprising that growth stocks outperformed value stocks this year by a sizeable 9.76%.  Similarly, large-cap stocks outperformed the broader market by a considerable amount; the Russell 2000 Index returned a negative 4.38%, lagging the S&P 500 by 5.75%.  Even the large cap dominated Dow fell by 2.2%.  These factors created a year in which it was difficult for active managers to outperform the S&P 500 Index.  We did not, though I would argue that on a risk-adjusted basis, we may have.  In other words, it is very risky to have too much money in the high fliers that led the market this year.  But our bottom line was a loss of 2.89%.

As the Financial Times put it on November 27:

“to win you needed to fix on a few large stocks that already looked overvalued and hold on to them. This is an almost impossible strategy to justify; so many fund managers will have instead opted for the better long-term strategy of buying cheap value stocks, and underperformed in consequence.”

Here are the Nifty Nine, with trailing PE ratios in parentheses: Amazon (950), Ebay (15), Facebook 105), Google (32), Microsoft (36), Netflix (315), Priceline (27), Salesforce (100), and Starbucks (32).

These stocks propelled the Nasdaq Composite Index to a gain of 5.73%.  But compare those valuations to the trailing PE of 17.4 for the S&P 500 (SPX) as a whole (SPX 2043, trailing earnings $117.20).  While we have done very well in Google and Microsoft, it is pretty tough to be in Facebook and Netflix and Salesforce at such stratospheric PEs.  As we learned in 2000, such valuations can change at a punishing speed.  We were lucky (and we think smart) to have gotten into Amazon early in the year when the price-to-cash flow multiple was at a multi-year low.  That gave us a good entry point.

Amazon is a special case because the company can goose earnings at any time.  Rather than move cash to the bottom line, it plows a huge amount back into growing the business.  And while it is correctly perceived as a huge dislocator in the retail space, it is also a huge computing firm that is occupying more and more space of firms such as IBM.  We bought Amazon when it was trading at its lowest price to cash flow ratio in years, and it has more than doubled since.  It is amazing to look at Amazon versus both most traditional retailers – and against IBM.  IBM’s management seems staid while Microsoft has been re-energized by new leadership that has made them Amazon’s chief competitor   in cloud computing, and MSFT’s gain of 22% reflects that.  We own a lot, sorry it isn’t even more.   Of course, Amazon is also blowing away traditional retailers.  It is amazing to look at the stock’s performance versus many traditional retailers.  The total return comparisons are interesting:

Company Ticker 2015 Return
Amazon AMZN 117.7%
Microsoft MSFT 22.2
IBM IBM -11.1
Walmart WMT -26.3
Target TGT -1.5
Kohls KSS -19.0
Fossil FOSL -67.0
Sotheby’s BID -39.4

There were a few retailers this year that were very strong; among them were Home Depot +28.2%, Nike +31.2%, and Under Armour +18.7%.  In my mind, what these stocks have in common is very strong branding.  I suppose that goes for McDonald’s (+29.7%) too; I was dead wrong in my comments earlier this year about this company fading due to changing diets.  But it is hard to own that stock at a PE of 24 when revenues have actually been declining.  Fossil is a good example of what can happen when the air comes out of a once faddish and richly valued stock.

Stock Price 2015E 2016E Trail PE Forward PE
HD 133 5.28 6.15 25.2 21.6
NKE 63.2 3.7 4.25 17.1 14.9
UA 81.2 1.08 1.35 75.2 60.1

We own Home Depot, which is growing earnings at about 15% annually.  We bought Nike fairly recently.  But Under Armour is expensive like the Nifty Nine stocks noted above.  It is trendy, but is overvalued relative to its 3 year growth rate of about 22% and is subject to sudden downturns such as:

  • 59.6% between July 2007 and March 2008
  • 33%  between mid-July and mid-August of 2011
  • 20% between September2012 and January 2013
  • 18% between late September and mid November 2015

It can go up a lot as well, but is more of a speculation than an investment at this stage.

A quick overview of some other things we did right and wrong, before we move on to a look at next year.  In addition to picking a number of the tech winners, we also continued to do fairly well in certain airline stocks.  We’ve viewed General Electric as a great value as it has transitioned from too much of a financial services company back to its roots as an industrial powerhouse.  The stock returned 26.9% this year.  Although health care stocks cooled off in the second half of the year, we still did well in a number of them.  Our few remaining shares of Incyte Corporation were up 48.3%.  Regeneron tacked on another 32.3%.

We also did some things that were just plain wrong this year.  Virtually anything we did in materials and commodities was doomed; no matter how low a P/E ratio got, earnings estimates just kept plummeting.  Viacom was a major disappointment due to fear of changing TV viewing habits.  We had only a very small exposure to Valeant but it collapsed by 43% in the fourth quarter of the year.

We were hurt by a decline in Blackstone from $33.83 to $29.24.  While this company remains the leader in the alternative investing space and will do well as alternative investing gains market share, the year-over-year comps were bad as overall asset appreciation was slower than in 2014.  The prospect of higher interest rates didn’t help either.  Meanwhile, the stock provides a yield of 9.74% – so the total return was much better than the pure price change – and I think it remains a good long-term investment.

One other thing that hurt was the decline in master limited partnerships such as Enterprise Products Partners (EPD) and others.  The consensus was that pipeline companies were volume-dependent rather than price dependent.  But they got hammered along with the rest of the energy sector.  They are largely retail products and probably got oversold in the worst of the energy downdraft.  While I think these holdings remain great long-term plays, they certainly didn’t help our results this year.

I sound like a broken record on Celgene – in some periods it rallies sharply, and in other periods such as much of 2015 it is flat.  But its five year average annual return is 37%, no thanks to the 7.1% gain his year.  Its prospects remain strong but it won’t keep up such huge returns while growing earnings at 15%.  Just when I was about to apologize for maintaining such a big position in it, the stock rallied 10% in one day in late December as one piece of significant litigation got settled on very favorable terms.

So what about next year?  I certainly can’t promise outsized returns in a year during which interest rates are likely to rise at least slightly.  However, stocks are likely still the best place to be.  There is a smart analyst at Sanford Bernstein who crunches data on the likelihood of stocks outperforming bonds over the long term; he gives global stocks an 85% chance of outperforming bonds over the next decade.   Earnings for the S&P 500 companies are predicted to rise by about 8% in 2016.  Energy stocks are a good bet for a rebound as demand for oil tends to rise a bit each year and rig counts are finally declining in the US – which has emerged as the world’s key marginal producer.  Since there is limited storage capacity for petroleum products, a slight imbalance between production and consumption can cause huge price swings.  The daily imbalance of about 1.5m b/d is projected to fall to half that amount in early 2016.  It may finally be a year in which European stocks add to returns rather than detract from them since their central bank is still in easing mode while the Fed is starting to tighten.  Technological innovation continues.  In 2001, only one of the ten largest US companies was a tech firm; now six of the ten are.  The SPX equity risk premium remains quite attractive at 3.55% with a forward earnings yield of 5.83% versus a 10 year Treasury yield of 2.27%.  This premium has remained in the same general range for about two years and is comparable to the levels seen in 2009.

In sum, this year certainly wasn’t great but it was hardly terrible.  We have analytic tools that over time should identify relatively attractive stocks and eliminate a lot of the less attractive names.  We weight a variety of growth and value indicators and add a small momentum component since there is often information in prices.  For value, we use P/E and price-to-cash flow ratios.  For growth, we use past and projected growth in earnings, revenue, and cash flow.  For momentum, we use pure price appreciation over various time frames.  We have built a good track record over the years by ranking stocks in each of these categories, and buying the stocks that combine the best of these measures.  Stocks in our top decile greatly outperformed stocks in our bottom decile, which indicates that our overall approach is still very sensible. But this year, although the logic that we use showed a positive skewing, it was not by enough to beat an SPX that was propelled by very few stocks.  We expect that nothing fundamental has undergone a secular change, so our approach should continue to work well over time even though 2015 was an aberration.

Thanks for your continued confidence.   As you know, we are here to serve your needs well not only in terms of direct investing, but also in terms of long-term planning and projections, tax efficiency, cash management needs and anywhere else we can help.  Please don’t hesitate to call on us.

* 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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