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Client Investment Letter January 2017

“…For the loser now
Will be later to win
For the times they are a-changin’.” – Bob Dylan

In trying to characterize the past twelve months, we are struck by one simple word: change. After years of sub-par growth, income inequality and financial repression, populist votes both here and abroad spoke loud and clear for a change in the status quo. The people in both the U.K. and the U.S. decided they’d rather go down a different path, even one with greater risk and uncertainty, than continue with more of the same. Outside of politics (or because of it), global interest rates changed course as well, bottoming after over 35 years of almost constant declines. Oil prices found a floor in February and then nearly doubled. It was quite a year for change.

An important concept that’s central to our investment process is mean reversion. Put simply, over the long term, things tend to move back towards their long-term averages. There are many examples of mean reversion in financial markets, whether it’s earnings multiples, business cycles, earnings power in cyclical businesses, interest rates, or foreign exchange rates. Even outside of finance, the rule of mean reversion applies to everything from weather to sports. Last year’s lowly Dallas Cowboys are this year’s Super Bowl contender. Perhaps this quantitative concept is best captured by the old saying “what goes up must come down.”

One thing that didn’t change much this year is equity valuations: they were rich last year and have only gotten more extreme in their overvaluation. The current cyclically adjusted earnings multiple is significantly above its post-war average, making it more difficult to find attractively valued companies. Going back to the notion of mean reversion, high multiples are eventually always followed by multiple compression as stocks decline faster than earnings.

As a result, we believe a certain amount of caution is warranted here, which is why we continue to carry a larger than typical cash position. One might argue that lower interest rates justify higher multiples since the value of a stock is determined by its expected future cash flows discounted back at a rate that is driven by the risk-free rate. However, as interest rates are now rising, this pillar of support for higher valuations might give way. We will need a sizeable pick-up in growth to justify continued high valuations.

Will we get real growth? The markets have rallied since the election on the assumption that all of President-elect Trump’s pro-growth agenda – tax cuts, deregulation, infrastructure spending – will be pursued and implemented without pushback, and will work as intended. He’s already made America great again, if the recent stock-market gains are to be believed, and he hasn’t even been inaugurated yet. At the same time, euphoric investors also assume that none of Trump’s anti-growth campaign promises – trade, tariffs, immigration – will be realized. There’s clearly elevated political risk with the ultimate policy outcome and its effectiveness uncertain. We are also mindful of the fact that after Ronald Reagan’s inauguration in 1981, the S&P initially declined substantially before a multi-year bull market was launched from a mid-single digit earnings multiple.

Meanwhile, the Fed is now at the beginning of a tightening cycle as it tries to pull off the most challenging monetary perfect-landing in history, unwinding years of unconventional accommodation. Threading that needle carries risk of a policy mistake. Higher interest rates, as a result of expected fiscal largesse and rising inflation, will weigh on the economy if they keep going up. In addition, the U.S. dollar has rallied strongly to multi-year highs, making it more difficult for U.S. multinationals to compete globally and weighing on corporate profits from overseas.

That said, we remain cautiously optimistic on the economy and the prospects for continued growth, but we aren’t willing to bet the farm on it as valuations are high and the market and economic cycle is long in the tooth. As a result, we continue to plot a middle course: a portfolio of high-quality, attractively valued companies, in many cases paying above-average dividend yields, but while also maintaining a large cash position that will allow us to take advantage of any corrections.

Speaking of cash, the recent rise in short-term interest rates has provided us the opportunity to actually earn something on a portion of our cash reserve. We recently purchased short-duration Treasury bills that offer better yields than money market funds while we wait for better opportunities.

The concept of reversion to the mean mostly helped your portfolio this year, and in other cases we believe it is set to provide gains to you in the year ahead.

The energy producers and service providers (including pipelines) that we bought last year when they were under pressure benefited from the large bounce in oil prices and contributed favorably to your portfolio. With the development of unconventional natural gas and crude oil supplies across the U.S., we continue to like our exposure to stable, fee-based energy transportation that’s key to getting new energy supplies to market.

Likewise, Qualcomm, a leading tech company that had a string of unusual bad luck in 2015, regained its footing this year; it was the single largest positive contributor to our performance. Qualcomm continues to be one of our core holdings within our largest sector weighting, technology. Technology allows us to do things better, faster and cheaper than ever before, and technological innovation that can improve living standard seems to know no bound. We like our positioning in this important sector where we see a rare combination of high growth rates in sales and earnings but with reasonable valuation.

One sector that fell out of favor this year was healthcare. Whether because of endless front-page stories about drug pricing, or a broader move out of defensive sectors, the healthcare sector has been unloved this year. However, given aging demographics and the desperate need to control escalating costs of care, we are confident that interest in the sector will come back. We added some new companies in the space this year that we believe are unusual values, and we are looking for new opportunities.

Another sector that had a slow year was agriculture. Crop prices are in their fourth year of weakness, one of the longest agricultural downturns on record. Despite this lengthy cyclical slump, the global population continues to rise and diets are becoming more protein rich, but arable land is finite. The only way to meet the demand of the growing world population, then, is to increase yields. Our agricultural businesses should benefit from this trend for years to come. Your stocks were helped by several mergers in the sector (including Bayer’s all-cash bid for Monsanto), but nothing will generate strong returns like improving fundamentals. In the meantime, we will continue to collect handsome dividends and wait for the Bayer-Monsanto deal to close.

In closing, we are very confident the change that started in 2016 was just the beginning and we expect more to come in 2017. Your portfolio is positioned to take advantage of change. If the economy accelerates, your equities will benefit. If instead, things slow down and the market trips, we have an ample cash reserve to buy great companies at better prices. You can be assured that we will continually assess the changes that occur and make mean reversion work in your favor.

Penn Davis McFarland, Inc.
January, 2017