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Letter – 2017 Q1

The S&P 500 Index peaked at 1552 in the year 2000, and after the tech crash, got back to 1576 at the top in 2007.  Recently this index briefly touched 2400 – over 50% higher than these previous highs.  In early 2009, fear was rampant.  Now those prices look incredible.

The good news is that stocks are great long-term investments.  The bad news is that they are not without risk, and there have been long periods in which stock returns have been muted or worse.  So we do our best to combine solid risk management with owning stocks that have an attractive mix of growth and value attributes.

In the first quarter of this year, the S&P provided a total return of 6.07%.  The Russell 2000 Index, which measures a broad universe of small-cap stocks, cooled off to return a more modest 2.02% after soaring in the weeks immediately following the Trump election.  Our average account gained a healthy 5.80%; our more aggressive accounts were generally ahead of the S&P 500 and our more conservative accounts lagged it slightly.

So the news is good.  We are at or near full employment.  Consumer confidence is at the highest level since 2000.  Inflation is under control.  Burdensome regulations are being cut.  Tax cuts may be on the horizon.  Companies may soon repatriate billions of dollars currently held overseas.  There is a focus on infrastructure.  So stocks are rallying.  What’s not to like?

The question is how much of this good news is already reflected in prices.  And while there will always be hiccups, or are there things that could cause a long-term change in the trend of stock prices?

There are risks out there.  The Fed is almost certain to continue raising interest rates.  Political instability here or abroad could wind up being bad for the market.  Valuation itself could at some point cause stocks to decline of their own weight if valuations become unsustainably high.  But defining such a level is difficult.  One measure of valuation that we follow is the so-called Shiller CAPE Index.

Shiller and Valuation.  Robert Shiller is a professor at Yale, perhaps best known for the Case-Shiller Index of housing prices.  But he also analyzes stock market valuation.  CAPE stands for cyclically adjusted price-earnings, which is based on average inflation-adjusted earnings from the previous 10 years.  The current stock price is the numerator, the earnings figure is the denominator.  The CAPE ratio is a higher number than the current PE ratio, because earnings from ten years ago are bound to be lower than current earnings.  The ratio can obviously vary depending upon the pace of earnings growth over the past decade.

The ratio has limited predictive value; no bell goes off when it hits a certain number.  But it still offers useful perspective.  Shiller’s data goes back to 1871.  I arbitrarily decided that 1962-present provided sufficient “modern” data.  The current CAPE ratio is 29.0.  That is in the richest decile of all data since 1962.

What happens when the market reaches top decile valuation?  Well, it got there in January 1997 and nearly doubled from there in the next three years.  Then came the tech crash.  So there can be great upside momentum, but also heightened risk of large declines from these valuation levels. In the current bull run, we did not reach the top decile until December.  And the CAPE ratio has been as high as 44 – clearly bubble territory, but well above today’s level.

At these heights, one thing that we do is use so-called trailing stop-loss orders to prevent large drawdowns.  Stop-loss can be a misnomer; often such orders are used to lock in gains and avoid giving back too much of an unrealized profit.  There is opportunity cost associated with such an approach; one can be stopped out on a temporary downdraft only to have a rally continue.  The opportunity cost is in some sense an insurance premium that offers some protection in the event of a large down move.

As mentioned in our last quarterly letter, we have developed a market-neutral strategy that is designed to do well in both bull and bear markets.  We buy stocks that seem relatively cheap, and sell short an equal amount of stocks that seem too richly valued.  Of course, shorting stocks has unique risks.  But results over the past nine months have produced returns in the high single digits, and if such results continue we will likely offer this strategy down the road.

Variance Among Sectors.  There was enormous variance among industry sectors in the first quarter.  The S&P Technology Sector Index was up 12.6%, but the S&P Energy Sector Index was lower by 6.7%.  Energy stocks did a good job of anticipating the recovery in oil prices, and in so doing, got a bit ahead of themselves.  The pace of tech innovation is high – artificial intelligence, implants that can restore motion in cases of paralysis, big data, drones, and more.  In a century, we’ve gone from “horseless carriages that fly” to the moon and to driverless cars.  We google in ten seconds what we looked up in an hour at the library.  We click a mouse and merchandise quickly shows up at our doorstep.

Growth stocks returned to favor, outperforming value stocks by 5.2% – but that is to a large extent a reflection of tech v energy.  Financials cooled off after a torrid post-election run, but still gained 2.5%.  And health care reclaimed a leadership role with a gain of 8.4% after lagging last year.

Foreign markets have come alive.  Emerging markets in general have been frustrating since their enormous gains in 2009.  The valuation differentials between US and emerging market equities are about as stretched as they have ever been, and emerging markets are finally reacting positively to that.  A rebound in commodity prices has helped there.  The FTSE Emerging Index was up 12.6% for the quarter.  Finally, European markets are showing signs of life.  European earnings are upticking for the first time since 2009.  Moreover, monetary policy is easier now in Europe.  The FTSE Europe Index was up 6.5%.  We have shifted some money from US stocks to Europe and emerging markets.

Individual Names.  We’ll focus on individual names more in the next letter.  But Amazon continues to be one of our largest holdings.  We value it on its cash flow rather than on its earnings, and have bought it when it trades down to 30x cash flow.  That is a justifiable price given the company’s growth.  They are moving into the Middle East and into food delivery.  The stock moved from $749.87 to $886.54 this quarter – a gain of 18%.  It is affecting the fortunes of many other consumer stocks that find it hard to compete.

We’ve owned Toll Brothers for over a year, and noted then that the stock should be higher since its earnings are the same as in 2004 when the stock was twice the price.  There was frustratingly little movement in the stock for most of last year.  But since the election, it has gone from about 27 to 36.

On the downside, we have no disasters to report.  As noted, energy was weak.  Chevron dropped from $117.70 at year-end to $107.37, and Exxon fell from $90.26 to $82.01.  We lightened our exposure somewhat for now.  The auto sector also started to weaken, and Toyota fell 7.3% but it still seems to be a good value with a PE ratio of under 10.

Prices Now and Then.  Just for some perspective, here are some selected prices at the low in March of 2009 and now, adjusted for dividends and stock splits.      This brings to life the notion that stock selection does indeed matter.  It also indicates that some companies that had experienced rapid growth are still fine companies, but are no longer growing at an extraordinary pace.

2009 Recent Pct Chg
Amazon 60.49 886.54 1366%
Apple 10.76 143.66 1235%
Cisco 11.55 33.80 193%
Disney 15.14 113.39 649%
Exxon Mobil 49.66 82.01 65%
Home Depot 14.60 146.83 906%
JP Morgan 13.33 87.84 559%
Pfizer 8.64 34.21 296%
Procter & Gamble 34.27 89.85 162%
Target 20.84 55.19 165%

This lookback is just perspective.  We can’t just say we should have bought the low.  If you bought the Dow in 1931 when it was already down 80% from its high, you still lost nearly half your money before the market actually bottomed.  But at some point, you have to know that value will win out.  And back in ’09, we did indeed buy the bank stocks almost perfectly.

We’re not always even nearly that good, as we reminded you last year.  But we continually improve our quantitative database and our perspective, and refine our overall judgement.  This has produced good results so far this year and we’ll do our best to continue in the vein.  As always, we are available whenever you need us.

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