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Letter – 2016 Q4

It was a profitable year.  It didn’t start that way.  We endured the harshest January in years and then Brexit before the market turned upward after the presidential election.  So we rode a bull, but it was a bit like a mechanical bull that did its best to throw you off.  It was also a strong bull, with the total return on the S&P 500 at 11.86% — about half of it coming after the election.

First some long-term perspective.  I was at Lehman Brothers in the summer of 1987 when the Dow reached a peak just above 2700.  It was too high, and crashed.  A generation later, we approached Dow 20,000!  Even before dividends, the market has increased over 7-fold in this period.  The lesson?  Stay the course.  Of course, the other lesson is manage risk – there is no more Lehman Brothers.

Arguably there are times when we manage risk too carefully in order preserve capital in down periods.  The concentration in large cap growth stocks had led to both stability and good returns in recent years, but that category lagged this year.  Many active managers had similar results; the average return of all 1,425 large-cap growth blend funds tracked by Morningstar was 3.14% in 2016.  However, the average of all 1,365 large-cap blend funds was 10.27%.  The trend away from large caps was compounded after Election Day, when mid and small cap stocks led the rally.  The cost of regulation is proportionally higher for smaller firms, and investors perceive relief for them in a Trump Administration.

Early in the year, energy prices plunged to their lowest levels in years, dragging down equity markets and leading to predictions of recession.  Particularly due to a sharp selloff in the energy stocks, we started the year behind the 8-ball.  Since mid-year, we’ve done considerably better.  Yet we did not foresee how rapid the rebound would be after the Brexit shock.  The damage was in the Euro and the Pound, not in stocks.

But it still amounted to a year in which our stock portfolios trailed the S&P 500 by more than I would like.  But that was true of active managers in general this year, as noted particularly in the large cap growth segment of the market.  The modest gainers included Google +1.8%, General Electric +4.4%, Disney +0.6%, Home Depot +3.5%.  Given that most prognosticators thought the market would be up only modestly this year, those seemed like stable and safe investments, but they were a drag on our relative results.

Our stock selection system uses a lot of data.  We compile a number of growth measures, and sort our entire database.  We do the same thing with some traditional value indicators.  Then we add our own calculation of “payback period” – how long it will take projected earnings (if realized as estimated) to equal the price of the stock.  We also look at a stock’s price relative to its valuation ratios over the past decade.  Then we do our best to evaluate whatever developments might not be reflected in those numbers, and invest accordingly.

Needless to say, there are constraints.  One is taxes, at least for non-retirement accounts.  The larger the unrealized capital gain, the harder it is to sell.  A perfect example is Celgene.  While it had a return of negative 2.4% this year, we have a gain in it of 211%.  We’d rather not incur a tax liability unless there is a compelling reason to believe there is a fundamental change in the company’s outlook.  This applies to the health care sector in general; it has led the market over the past decade and given us some healthy unrealized gains.  But this sector lagged this year in part due to increased government scrutiny of pricing practices.

One account that is in a developmental phase is a proprietary long/short account.  For clients, as noted, our tendency is to buy stocks in the top decile of our ranking system.  In the long/short account, we buy the top decile but also sell short stocks in the bottom decile.  This approach has generated a 14% annualized return since June 30.  It is seen as a riskier strategy and generates higher trading costs and many short-term gains, but if it keeps doing this well, we may offer it as a separate product.  If you would like to know more, let me know.  But those results, though too short-term for any major conclusions, have lent credence to our overall approach to stock selection.

Despite this rigor, we simply missed some of the best-performing stocks of the year.  For instance, Nvidia has moved from just making chips for computer games to providing chips for self-driving cars – a major shift that I should have caught sooner.  I know from experience that a few big winners can drive good results for an overall portfolio, and we were lacking in home runs this year.

We did have some excellent performers this year.  Ironically, the energy stocks that plunged the most early in the year turned into the best performing sector of the year.  We bought steel stocks after the election and caught a big rally.  Many of the airline stocks did well toward year-end, after being trendless for much of the year.  But we also had a number of misjudgments and took more short-term capital losses than usual this year.

Looking ahead, the big question is whether the optimism over Trump fiscal and regulatory policies will last.  It is hard to tell whether it is a short-term euphoria over unbridled capitalism, or the beginning of a period like the 1980s where the market basically tripled.  There are several reasons for optimism.  First, the country is hungry for infrastructure investment, and that is a core interest of the President-Elect.  Second, commentators have often failed to distinguish between the price of credit and the availability of credit.  Monetary policy has produced cheap credit, but regulatory policy has had a tendency to fight the last war when it comes to lending standards.  I heard Harvard Prof. Gregory Mankiw say that this restrictiveness has cut American productivity growth by 0.5% per year.  A Trump-induced change there would do a lot to spur GDP growth.  No wonder bank stocks have rallied so strongly since the election.

A countervailing concern is our debt burden.  At some point, it may come into sharper focus and hamper the economy.  Some analysts look at debt as a percentage of GDP, and others look at the rate of creation of new debt with a notion that too much too quickly can be dangerous.  Of course, that is what critics said in the 1980s.  But debt problems don’t have to originate in the US.  There are widespread concerns that the next recession could be triggered by a collapse of the debt markets in China.  And speaking of China, increasing trade tensions with the Chinese could end badly.

As noted, the change in political outlook affected the performance of different sectors in the stock market.  We’ve highlighted the gains in financial stocks and steel and other infrastructure plays.  But utility stocks, which did well as interest rates fell, did not fare so well as rates rose following the election.  We did not undertake a wholesale portfolio shift, and so we gave back a bit of profit on our utility holdings.

We are mindful of other forces that may be at work.  For instance, the bull market in recent years has been powered higher by companies buying back their own stock.  Often, they issue debt to do so.  If interest rates continue to rise, this will not be as cheap or attractive a proposition going forward.

In good times and bad, the market generally provides opportunities.  As the tech bubble burst early in the decade, housing stocks did well.  Technology continues to transform our economy, and our position in Silicon Valley Bank has been particularly profitable.  We’ll continue to look for these opportunities, and hopefully do a better job of uncovering them in 2017 than we did in 2016.  Thank you for your trust and confidence in us.  We are always available to discuss any long-term planning issues or other financial needs or questions.  Please don’t hesitate to contact us any time you think we might be helpful.

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