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Letter – 2016 Q1

This year got off to a frightening start as the stock market fell sharply and steadily from the opening bell through January 20.  By key measures, the only other times the market was this volatile at the outset were in 1932 and 2009.  While those years were moments of historic financial stress, presently our economic environment is fairly steady, if uneven. Trailing 4 quarter GDP growth has been between 1.5% and 3.1% since the beginning of 2010. Industrial production is weak, as is wage growth and labor participation, but at 1.7% inflation is under control and at 5% our unemployment rate is widely envied.  The S&P 500 Index recovered its losses by quarter-end and wound up with a total return of 1.3%, but the broad market as measured by the Russell 2000 Index was still down by 1.5%.  The bottom line is that we got off to a rocky start, but we recovered nearly all of our early losses as of quarter-end. As of this writing we have more than recovered.

If we were running a hedge fund, we’d buy these market dips more aggressively.  But our first priority is capital preservation, so we do our best not to let accounts decline at a faster rate than the overall market, even if that means cutting back on certain positions.  Normally, superior stock selection has made up for what amounts to an insurance premium. Normally, but not always and not this quarter.  However, the Russell 2000 Index fell over 25% from its peak in June 2015 to its recent bottom in February, so a focus on capital preservation has been even more warranted than usual.  Even so, we probably sold a little bit more than we should have.

The other striking change this year has been the shift in market leadership.  Health care stocks have been strong in recent years, but quite weak so far this year.  Conversely, energy stocks have been weak in recent years, but strong so far this year.  The S&P Healthcare Index fell 5.5% in the first quarter while the S&P Energy Index rose 4.0%.  Even commodity stocks have rallied counter to a long-term bear trend.  Some gold stocks, in a multi-year bear market, rallied over 50% for the quarter.

We have a database of over 2500 stocks.  We look at various indicators of value such as price/earnings ratio and price-to-cash flow for each stock, and then rank each stock accordingly.  We do the same thing with a variety of growth indicators.  Since there is information in prices, we add a small momentum component, and assign each stock an overall ranking.  We break the database into deciles.  On balance, we would expect our top decile stocks to do the best.  The first quarter of the year was remarkably counter-intuitive.  The 250 stocks in the worst decile on average outperformed the 250 stocks in the top decile by 6 percent.  This is simply not normal.  It is explained in part –but only in part – by the turnaround in oil and commodity stocks, which have terrible earnings momentum and very high PE ratios now.  But it is no wonder that a recent Financial Times headline blared “Worst performance in two decades” for active managers; price movements have been less rational than the norm.

Some of our longer term and profitable holdings simply did not start the year particularly well.  Celgene returned an unpleasant negative 17.5% for the quarter, but we have a long-term gain of 166% in the stock.  Disney dropped 5.9% on fears that millennials watch less conventional television – thus threatening ABC and ESPN.  JP Morgan dropped 8.9% as some analysts see banks as choked by too much regulation and an unprecedented amount of regulatory fines.  Interestingly enough, Harvard economist Gregory Mankiw points to a swing toward over-regulation of banks as a cause of the decline in productivity.  Health care is the sector that has led the market for several years, but it was the worst of the major sectors this quarter.  Biotech stocks got hit the hardest.  Regeneron is no longer one of our biggest holdings; we cut back on it as it has fallen sharply along with most biotech stocks.

Of course, we’ve had some good news too.  Reasonably stable stocks such as Verizon and Exxon Mobil are off to a good start.  The supply/demand imbalance is shifting in the energy markets, and meanwhile XOM pays you a 3.5% dividend to wait for a bigger turn.  Since oil storage capacity is limited, the decline in crude prices has been dramatic.  It will not take much of a shift in the supply / demand balance to reverse that.

Verizon gained 18.1% for the quarter and has a 4.25% dividend yield.  I think some of it is simply that investors are willing to pay a premium for stability.  Taken to an extreme, that of course becomes self-defeating.

Taiwan Semiconductor has screened as one of our most promising holdings, and it was up 16.3% for the quarter.  This is our system working at its best.  Also in the technology arena, we took a modest position in FireEye, a leader in cyber security firm whose clients include about 200 of the Fortune 500 corporations.

We keep looking for pockets of opportunity.  After the proverbial seven lean years, the housing market looks like it may be poised for some strength.  In 2004, Toll Brothers was trading at $68 per share – with revenues per share of $26, cash flow per share of $2.83, and earnings per share of $2.52.  Today it trades at $28 per share – with revenues per share of $30, and cash flow and earnings estimates slightly higher than the 2004 numbers.  Yet the stock is nearly 60% below its 2004 level.  All the research shows that we are back to a housing shortage; the supply of existing homes is at the lowest level in a decade.  Toll is also addressing the millennial market by building more in urban areas.  It has a stable balance sheet.  So it has become our largest new position.

We also initiated a position in Nuance Communications in January.  It is the leader in voice recognition technology and is reasonably priced at 11 times estimated earnings for this year.  The product is very user friendly and accurate.  Of course, there is always the risk of one of the tech giants coming out with a competitive product.  But there is also the chance that one of the giants will decide that it is easier to buy Nuance than to compete with it.

We also added a bit more to the airline sector – which is still inexpensive.  And we added to our position in Amazon – it just keeps expanding its footprint and we have gotten in when it gets to the bottom of its historical range of multiple to cash flow.

We are at a stage where further appreciation in the market is likely to depend on renewed earnings growth.  The market was actually pretty resilient given the estimated decline of 6.9% in year over year first quarter earnings.    Though there are signs GDP growth has slowed somewhat recently, the Fed’s recent reversal of policy – halting previously planned increases in interest rates – demonstrates that authorities are committed to keeping the economy moving in a positive direction. As Yellen recently said, it is “appropriate…to proceed cautiously in adjusting policy.”  Even so, there will no doubt be spasms before certain Fed meetings.  The Brexit vote in June will probably spark some anxiety as well.  But as noted above, the economy is in pretty good shape, and there are many reasonable values in this market.

Thank you for your continued confidence.  Please call on us any time you have questions about investments, long-term planning, or any related matters.


* 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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