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Client Investment Letter February 2016

In good times, it’s easy to forget that markets are cyclical and investor sentiment, expressed through the market multiple, swings from greed to fear and back again (often at a far more rapid pace than business fundamentals). As the six-year ascent fueled by the Fed’s zero interest-rate policy and cheap credit runs out of steam, higher volatility and an eventual setback should come as no surprise. The unavoidable down cycle never feels good, no matter how brief or shallow, but it is, in fact, both normal and healthy.

In recent weeks, investors’ appetite for risk has noticeably changed with little warning or catalyst. The pendulum has started to swing from greed back towards fear as investors grapple with the realities of a slow-growth environment. Sales growth is harder to come by, especially for multi-nationals, margins are contracting from record-high levels, and debt-funded share buybacks and M&A that have long aided earnings growth are now fading away. All of this warrants a lower multiple than the historically high valuation the market enjoyed last spring.

Over the course of the past year or so, we have been sitting on an unusually large cash position as a result of a lack of high-quality companies trading at reasonable valuations, as well as lingering concerns about the underlying health of the broader market. While we admittedly felt a little foolish as the market continued its march to new highs without our full participation, we remained disciplined in our process and now feel like we are extremely well positioned for the current market turbulence. We like to buy when others are fearful, and we currently have the liquidity to do so.

While no single catalyst triggered investors’ sudden angst, the primary focus at the moment is the unrelenting drop in oil prices, China’s economic growth hiccup, and a lack of confidence in the Federal Reserve’s ability to normalize policy after a years-long monetary experiment.

Crude oil has continued its steady downward spiral, recently trading at under $30 a barrel from a recent peak of over $100 in mid-2014, with both parts of the supply-demand equation culpable for the imbalance. On the supply side, OPEC has remained steadfast in maintaining production regardless of price, Russia is pumping the most crude ever, and the lifting of sanctions on Iran threatens to add an unwelcome source of new supply. Though U.S. producers have cut oil output by 500,000 barrels per day, progress is coming slowly. Meanwhile, signs of sluggish demand in China and other emerging markets continue to surface. And because oil is priced in U.S. dollars (USD), the strong dollar has served as a headwind, too.

The USD’s strength is partly the result of the divergent path taken by global central banks. The Federal Reserve tightened monetary policy in December for the first time since 2006, and then projected a 2.4% Fed funds rate by the end of next year. The market views that as too hawkish given the delicate state of the economy, particularly the manufacturing sector, with no inflation in sight. More broadly, investors are suddenly worrying that the Fed, with its hands tied by the zero bound on one side and a weak economy unable to handle even small rate hikes on the other, is no longer able or willing to backstop risk and that the so-called “Fed put” has been removed.

While the Fed is tightening policy and talking tough, other central banks around the world are still easing. Further, with the slide in commodities, resource-based economies across the emerging markets are experiencing severe downward pressure on their currencies. Governments with currency pegs to the U.S. dollar are spending hundreds of billions of dollars of reserves to defend the peg or, in China’s case, to control a measured devaluation. All of this adds to the force behind the USD’s strength.

China is in a particularly challenging spot as it makes the difficult transition from an economy driven by manufacturing the rest of the world’s trinkets to one led by its own rising consumerism. The handoff has been made that much harder by too much debt. The Chinese economy is clearly slowing down, likely even more so than the official data suggests. The currency is under pressure, but the government is fighting a significant devaluation with its $3.3 trillion arsenal of foreign reserves, even though that policy is contrary to buoying growth. Policymakers have taken extreme measure to suppress market forces – even “disappearing” CEOs and arresting short sellers – which usually doesn’t end with the intended outcome.

So how do we believe this will all play out? Our base case scenario is that the U.S. continues to chug along at its meager 1-2% growth rate but avoids recession; the Fed puts the brakes on its path of tightening and backs off its hawkish tone; and the price of crude oil remains depressed for a while longer but starts to gradually rebound later this year or during the first half of 2017 as greater supply cuts take hold. China remains a wild card. We believe China will continue to slow down but will escape a hard landing, though we are cognizant of the risk of a more meaningful devaluation.

None of these issues are new, but in recent months they have culminated in greater risk aversion and increased volatility. The good news is that volatility creates opportunity for nimble investors. High-quality companies that we have wanted to own for some time are finally trading at attractive valuation levels. Market selloffs are indiscriminate, taking down good companies along with the bad. Investors often overreact and incorrectly extrapolate future events in a linear way. While we are still positioned rather defensively given our expectation of continued volatility, we are beginning to find some attractive new investments and we expect you will see more new companies in your portfolio in the coming weeks and months. Recently, we added two new healthcare positions to your portfolio.

Gilead Sciences is the dominant provider of HIV and Hepatitis C drugs. The market worries that Gilead’s earnings have peaked as it now has over 85% market share in its core markets, and that its key drugs will face near-term competition that will weigh on pricing. We see a strong company, with a fortress balance sheet, that’s generating $18 billion in free cash flow per year and plenty of opportunity to deploy that cash to acquire early stage drugs on the cheap, reigniting sales growth. And at just 7x earnings, we feel like Gilead is a bargain.

We also added a new position in a small company called Inovalon. Inovalon uses big data analytics and a proprietary database of over 127 million patients and 10 billion medical events to find patterns of inefficiency in the healthcare system and eliminate them. Its customers, primarily health insurers today, report a return of 5-7x on what they spend on Inovalon’s analytics solutions. Secular tailwinds of the aging baby boomers and ongoing pressure to reduce the cost of health care should provide years of growth for Inovalon.

We had a nice win in December when JAB Holding, a private investment firm that manages the wealth of Austria’s billionaire Reimann family, offered to buy Keurig Green Mountain for $92 per share in cash, a big premium from where it was trading previously. The deal is on track to close in late March, and will increase the cash position in your portfolio by about 4%. Given the stock is currently trading at just under $90 and we see little to no deal risk, we intend to hold the position until it closes.

We are always grateful for the trust you’ve placed in us, especially during these challenging times. We cannot be sure of how long the higher volatility will persist, or the ultimate magnitude of the down cycle in risk assets. But we do believe the current environment is setting up exciting opportunities for our portfolios – opportunities that we haven’t had in several years – and we look forward to capitalizing on them on your behalf.

Penn Davis McFarland, Inc.
February 2016