The Trump bull market is being tested for the first time as the stock market registered a modestly lower quarter and the S&P 500 Index threatened to break below its 200 day moving average for the first time since January 2016. In my view, President Trump tempted fate by tweeting repeatedly about the stock market as an affirmation of his administration. More recently, he doubled down by spooking investors about another trade war.
“Trade wars are good, and easy to win”, he said. The stock market disagreed with that notion. As talk of a trade war increased, stocks sold off sharply. This should not be shocking. In June of 1930 when President Hoover signed the Smoot-Hawley tariff bill, the stock market plunged by 25%. The present situation is quite different, but it is still unsettling. Hopefully, the current actions are a successful negotiating ploy and not the start of a series of miscalculations that escalate to an all-out trade war. The fact that the market has held above its 200 day moving average so far is one sign that the market sees this risk as contained – at least for now.
We tend to tighten our risk parameters a bit when the market falls, and more so if and when it closes below its 200 day moving average. Such a close in and of itself has no predictive value. Indeed, oftentimes it turns out to be an excellent buying opportunity. But history shows that every so often, it marks a change in trend. Since I see capital preservation as job one, I’m willing to trade away some upside potential unless and until things seem to settle.
Beyond that, we simply try to find the best investments at any given point in time. We collect a lot of data on earnings, revenues, and cash flow for about 3000 companies. We look at growth rates, and we look at valuation ratios. We consider return on assets (ROA) and return on equity (ROE). We evaluate insider activity and levels of short interest in a stock. We apply weightings to all of these measures and use them to rank stocks against each other – both against our entire universe of stocks and also within broad industry groups. We tend to buy stocks in the top decile of our ranking system. Many stocks stay top ranked for long periods. For those that don’t, we will either sell outright or place stop orders to lock in gains – or if an investment doesn’t work as anticipated, we use stop orders to limit drawdowns.
So let’s review some of our top holdings and how they stack up using these criteria. One of our largest holdings is Amazon. We had a 373% gain on the initial part of the position at quarter-end. I’ve said in previous letters that we don’t own more of it because historically it has had wide price swings – drops of up to 40% within a year – in the context of a huge run-up. One of those drops just occurred at quarter-end on fears of retribution from the Trump Administration tied to Bezos’s ownership of The Washington Post. Despite Trump’s claim that Amazon is being subsidized by the US Postal Service, the postal service itself says the opposite is true (accordingly to Bloomberg). The company has grown its operating cash flow by 32.3% per year on average over the past five years, so I have regarded it as a good buy when it trades at 30-32 times cash flow. Its latest figures show operating cash flow of $37.39 per share. If my analysis is valid, a decent floor for the stock should exist at around $1200 per share. I’ve seen the stock trade well above a 40 multiple of cash flow; that implies a stock price of about $1500. So it got ahead of itself at the $1600 peak. If cash flow growth slows to 25% over the next five years and the multiple contracts to 25 as well, we would still realize a return of about 11% annually from the quarter-end price of $1447. Obviously, if growth contracts more sharply than that, investors would be punished by the double whammy of lower than expected earnings and a contracting price-to-cash flow ratio. But Bloomberg reports that Amazon still only accounts for about 4 percent of total U.S retail sales, according to e-commerce consultant One Click Retail. So there is still room to grow; this is why we still see Amazon as attractive.
Another major holding is Intel. We have a 150%gain in our initial stake here and are about breakeven on shares we added later. Intel has nearly doubled its revenues since the 2008-09 financial crisis due in part to the company’s investments in artificial intelligence, autonomous vehicles and cloud computing infrastructure. Depending on what press release you read, earnings either fell sharply or rose by 34%. The decline shows up in a GAAP measure that reflects a one-time transition tax on foreign earnings. The 34% increase is a more accurate reflection of economic reality and also reflects the reduced corporate tax rate going forward.
Microsoft is another large holding. It is highly ranked but not in our top decile. However, Satya Nadella has really moved the company into cloud computing and the stock has acquired new momentum since he became chairman.
We also have a good size position in Applied Materials – another top decile holding. This stock can be volatile, and I don’t want us to be overly concentrated in tech stocks. As recent days have shown, they can sell off suddenly and violently. The company produces manufacturing equipment used to fabricate semiconductor chips or integrated circuits. Cash flow has averaged annual growth of 18% over the past five years and has recently accelerated. But cash flow fell 80% in 2008-09. Perhaps more instructive is that operating cash flow fell by about two-thirds between late 2011 and late 2013. So not all our chips on this one, so to speak.
While we try to maintain a reasonably balanced approach, growth stocks have been a better place to be in the past year. According to consulting firm Cliffwater, growth stocks outpaced value stocks by 5.5% in the first quarter after beating them by a full 12 percent last year. Measured using Vanguard growth and value ETFs, the spreads were 3.8% for the quarter and 10.8% for last year. Those are unusually large gaps. This reversed the trend in 2016 when the Vanguard value ETF beat their growth ETF by 10.6%. In 2015, growth beat by a little bit. In the two years prior to that, growth and value showed virtually equal gains.
The chart above is quite demonstrative. Value stocks have produced reasonable returns over a 10 year time horizon, but have still lagged the S&P 500. This year the lag is more pronounced than usual. This list is illustrative – you do not own all of these stocks but a good cross-section of industry groups is represented. Also, the data was collected after the close on Tuesday April 3 – so it is not pure quarterly data. But the point is the same.
We are constantly doing this sort of analysis in building portfolios. We realize that consumer staple stocks such as Procter & Gamble or utility stocks are generally a more stable ride than Amazon or Applied Materials. So we try to optimize what offers the best returns with what fits your risk tolerances. We’re always happy to refine or adjust those parameters. That said, this year so far has shown that stocks that seem to have very little risk can be frustrating to own – at least at times like this. On the other hand, Amazon has been great until President Trump zeroed in on it with his tweets. I still think it is an excellent long-term investment. We are constantly monitoring, re-evaluating, and exploring new opportunities. We are happy to discuss any of this or any financial planning issues at any time. Thank you for your continued confidence.