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Client Investment Letter October 2015

The global situation has not changed dramatically since our letter to you in July. We said to expect more volatility to come and boy have we gotten it! Your portfolio is filled with high quality companies that will weather the current squall and emerge stronger than ever when the winds die down. Indeed, that cash position we’ve been hoarding will be put to good use buying new, quality companies that we are finally finding during the downturn and also adding to starter positions that were not yet full-sized when the market storm hit.

Our macro view is that developed economies are going through a major deleveraging cycle after having accumulated too much debt, along with the weight of excess baggage incorporated in tax laws, education policies, and a public sector whose policies are not always representative of the majority of its citizenry. The result is slow growth globally. The tool of choice has become a monetary one; quantitative easing, which worked to stabilize economies but is now causing painful distortions. We need intelligent fiscal reforms that will stimulate growth. There are whispers of such by one or two of the candidates for President next year. In the meantime, expect continued volatility as the market braces for the delicate handoff from a liquidity-driven environment to one supported by fundamentals alone.

There are few conventional signs that we in the U.S. are entering a recession, and we are not expecting one in the near future. QE, however, has inflated financial asset prices unsupported by miniscule revenue growth and with earnings growth coming primarily from margin improvements and stock buybacks. The result: a valuation problem. Hence, our 15-20% cash reserve, which penalizes portfolios on the way up but provides buying power during sell-offs. The correction we are experiencing in the equity market now is about price or capitalization rates. The earnings won’t disappear, but they will be capitalized at a lower rate until a mistrustful populace senses responsible fiscal policies. The chasm between high valuations and weak fundamentals can only be resolved by fundamentals improving enough to validate elevated valuations – which is the preferred solution – or valuations compress to be more reflective of softening fundamentals.

Then why own stocks when fear is ravaging stock prices? Because fear creates good buying opportunities and because absolute decisions in financial markets always lead to disaster in the long run. You may be right now and then, but not always. Many investors sold their stocks in 2008/09 and missed the rallies we’ve had these last six years. Since timing is never perfect, we try to sell our mistakes along with those we think do not have great prospects to reinvest in better names, but we always try to keep the companies we believe are in an exciting arena and are doing the right thing. We do believe in a little cash now and then, as we are holding right now. A stock is worth the discounted value of its future dividend stream; we call this its “intrinsic value.” We’ve owned some stocks for more than twenty years, and now their annual dividend is more than we paid for the stock. Voila! Financial security.

In the current market environment, most traditionally safe securities have little to no real (i.e. inflation adjusted) return potential. The 10-year “risk-free” Treasury yields just 2.0%. There is a good chance that inflation will run around 2% for the next 10 years. Indeed, that is the stated goal of the Federal Reserve. So bonds offer the prospect of no risk and no real return. We don’t think that is compelling. Your hard-earned money should be working for you, not just lying around.

How do we find companies that are going to grow intrinsic value? We start by looking for industries with long-term structural tailwinds:

In agriculture, where global population is growing and diets are becoming more protein rich, but arable land is finite. The only way to meet the demand of the growing world population is to increase yields. Hence, we want to own companies that can increase yields. Here, we like Mosaic and Monsanto. Similarly, our planet faces a serious water challenge. Less than 1% of the total water available on earth is fresh water, and this percentage is declining due to factors such as the draining of aquifers, increased pollution and climate change. Meanwhile, demand for fresh water is rising rapidly due to population growth, industrial expansion, and increased agricultural development, with consumption estimated to double every 20 years. Companies like Xylem are well positioned to address these problems. We also like technology, where changes are making the world more efficient or secure. We want to own companies that benefit from these technology changes. We like Checkpoint, Qualcomm, Apple, and EMC here. Energy infrastructure, when the U.S. finds huge new resources and needs ways to get them to market, we want to own pipelines (Enterprise Products Partners, Energy Transfer, Kinder Morgan) to do that. Even energy itself, where we think growing demand from emerging consumers’ emulating a developed world lifestyle and the comforts that come with it will continue to drive long-term demand for oil, and we have exposure via Apache, Noble Energy, and Schlumberger. We also see opportunity from demographic trends, where companies will benefit from an aging boomer population (TEVA) or as another large and fast-growing cohort, the Millennials, come of age and flex their spending power in different ways. Google, Apple, 21st Century Fox are plays on the rising Millennial demographic. Finally, the emerging market consumer is coming out of poverty and has growing buying power. Qualcomm, Apple and Las Vegas Sands all stand to gain from rising emerging market consumer wealth.

One segment of the portfolio where prices suffered dramatically last month was energy infrastructure (structured as Master Limited Partnerships). These companies own thousands of miles of oil and natural gas pipelines and are primarily paid fixed fees based on the volume of the hydrocarbons flowing through them as opposed to the price of the oil and gas flowing through them; they are, in essence, a toll road transporting energy for a fee. During the last month or so many investors have sold these stocks fearing that 1) the debt they use to fund growth will become unavailable and they will have to cut distributions to finance future growth; 2) they won’t be able to grow due to a lack of demand; or 3) the energy-company customers could go bankrupt. We believe these views are short-sighted and misinformed. In 2008, the debt markets were completely closed for months and oil hit prices comparable to today and yet the MLPs were fine. The current situation is much better than 2008. Then banks were imploding and the stress in the credit markets was extreme. Today, there is hardly any. Then oil hit $40 per barrel because demand imploded. Today oil is in the $40s because we have found a plethora of oil in the United States. How is that oil going to get to market? Only by way of new pipelines that have been contracted in advance. We believe the distributions for your pipelines are secure and, indeed, will grow in the future. Most of the market didn’t share our view this month, but we think it will eventually come around and, fortunately, your time horizon is longer than a single month. In the mean time you will keep collecting tax-deferred distributions. Indeed, as of the first week of October the MLPs have come roaring back.

There are always bumps in the road. Currencies fluctuate, temporary oversupply happens in every industry from time to time. The weather can impact agriculture in any particular season. But the companies we own are sound and have the necessary resources to survive the temporary bumps and thrive when they are over. Our first filter is on the quality of the company, its management and its balance sheet to ensure that the companies we own can manage through difficult periods.

Jeremy Siegel, an icon to professional investors spent over 400 pages in his book Stocks for the Long Run (5th ed.) justifying why one should own stocks. After examining asset classes and their returns for more than the last 100 years, he determined that a diversified portfolio of stocks outperformed every other asset class by a substantial margin. A subtitle for the book should be “how to keep your money.” As Warren Buffett has said, in the short term, the market is a voting machine driven by opinion. In the long term, it is a weighing machine driven by cash flows and dividends paid out from them. The companies that you own are sound and will come through this volatility fine.

Penn Davis McFarland, Inc.
October 5, 2015