Client Investment Letter 2015

The global markets have been on an unusually steady ascent since 2011, with no major corrections in developed markets over this timeframe. The Federal Reserve and other global central banks have been good pilots, providing a measured amount of gentle thrust from low interest rate policy to speed the liftoff of prices. Nearly every asset class has benefited – stocks and bonds, private companies, real estate, even art – and the riskier the asset, the steeper its ascent has been. However, no matter how skilled the pilot, even the smoothest flight will experience turbulence when air conditions change.

Through July, the U.S. markets have gained virtually no altitude this year. What are the signs that air conditions may be changing? The headlines have been filled with stories about Greece. Greece itself is not particularly relevant to the global economy, with a 2014 GDP of $238 billion or less than 0.25% of global GDP. While Greece may have longer-term implications for the Eurozone, whether it remains in the monetary union just doesn’t matter that much to the global economy in the near-term. That said, we are well aware that sometimes even seemingly small events can have unpredictable effects that can come from unexpected places. For the time being, though, policy makers have done what they do best: kicked the can down the road yet again. Until Greece’s debt is reduced to a sustainable level via debt relief, we are going to see this Greek tragedy play out over and over again.

China, which accounted for 13.4% of global GDP, is a more serious worry. It has been a major driver of global growth and there are real signs of trouble in its economy. The margin-driven stock market bubble that expanded to dizzying heights has popped and is now in a bear market, despite the government’s attempt to manipulate prices. Construction is in a slump, bad debts are quickly mounting, and second quarter GDP expanded at the slowest pace in six years. China’s transition from a state-driven economy to a consumer-driven one is going to be bumpy. While we think China has the reserves and financial wherewithal to smooth over problems in the near-term, in the long-term if the government fails to allocate capital efficiently (or to allow the market to do so), then there will likely be more trouble ahead for China.

Apart from Greece and China, there are other indicators signaling that turbulence may be ahead. While the broad-market indices like the S&P 500 still stand near a new all-time high, beneath the surface market leadership is getting narrower. In other words, rather than broad-based strength that propels healthy markets, fewer stocks are participating today, a sign that the bull market is maturing. S&P 500 earnings growth has stalled, driven by shrinking profits in the energy sector and slowing sales growth from multinationals adversely affected by a strong dollar.

After a smooth climb for many years, investors have grown complacent in their assessment of risk, which typically occurs in the final stages of a bull market. Pockets of excessive risk taking, a sign of greed, are showing up in seemingly ridiculous private-market valuations, the fervor of investors to finance early-stage biotech IPOs despite years of expensive, uncertain clinical trials before there’s any hope of earnings, and brisk M&A activity (and the market’s positive reaction to it, usually taking up the stock of both the target and the acquirer). Finally, the Federal Reserve has signaled its intention to very gradually begin raising interest rates by the end of the year, possibly as soon as September. A reduction in support from the Fed, or the market’s perception of such, is going to make it hard for the markets to climb higher.

Like any flight crew, we can’t control the turbulence that comes. We can only respond to it and try to make the ride as comfortable as possible. Our first line of defense against an increase in market volatility is our cash position. We have been steadily growing it throughout this long ascent, and at around 18% on average, it is as high as it has been in recent memory. Why hold cash that earns nothing? The answer is that it will allow us to take advantage of opportunities when great companies go on sale. We can be nimble and act quickly. In the meantime, we are willing to sacrifice some near-term performance for the long-term benefits of buying great companies at attractive valuations.

This then begs another question: If we think the markets are so frothy, why don’t we go to all cash? No one can time the markets. Over any long period of time, quality companies bought at reasonable valuations should perform much better than cash. So given the option of hanging on to quality companies at reasonable valuations (in many cases deferring capital gains in the process), often collecting dividends that are higher than income offered from bonds, or just going to cash, we prefer to hold on to the companies. The key word here is quality companies.

Quality companies are prudent in their balance sheet usage, never putting their equity holders at risk on account of excessive debt. Quality companies find ways to grow their business through innovating, developing new products or services, geographic expansion or acquiring weaker competitors. Quality companies earn consistently high returns on capital over a long period of time and are managed by good stewards with skin in the game.

Your portfolio is filled with such companies and we are delighted to own them; so long as they keep performing, we plan on holding them for a very long time. The cash we have raised has come from selling companies where our original thesis either played out or was no longer valid, or the valuation became so stretched and the weight in the portfolio became so large, that we felt it best to trim the position from a risk management perspective. In many ways, the high cash position is a product of previous successful ideas and a dearth of near-term opportunities given current market conditions and our outlook that cloudy skies lie ahead.

At the present time, bonds offer little opportunity in our estimation without bearing excessive interest rate risk or credit risk, and in our view investors are not being compensated to accept either. Shorter-dated bonds offer returns not much greater than cash with less liquidity. Longer-dated bonds also offer little current income for the prospect of substantial mark-to-market risk when interest rates rise. Longer bonds are also exposed to the risks of inflation, as the par value you receive at maturity will be worth less than it is in today’s dollars. For these reasons, we prefer to steer clear of bonds for now. High dividend paying stocks are serving as an income replacement, while cash is serving as the volatility cushion that fixed income has historically provided. One day, we hope bonds are a meaningful portion of our portfolios again, but we aren’t holding our breath for now.

Despite our broad market concerns, we continue our search for high-quality companies. And, though more difficult to uncover today, we are still finding individual securities that offer us the opportunity to own great businesses at reasonable prices. This year we initiated new positions in Mattel, Las Vegas Sands, Keurig Green Mountain and Monsanto.

Mattel is a leading global toy company that has generated good returns for years selling brands like Barbie, American Girl, Hot Wheels and Fisher Price. The former management team forgot that kids have short attention spans and skimped on new product innovation. A new management team is now in place and has a real sense of urgency on renewing Mattel’s many strong brands, managing costs, and getting new toys to market more quickly. While the turnaround will take time, the company pays us a 6% dividend yield while we wait to see the results of new management’s improved focus on innovation.

Las Vegas Sands is the largest gaming company in the world, and, despite its name, the company generates the lion’s share of its operating profit in Asia, where it is the market share leader in Macau and Singapore. Due to a sharp decline in Macau gaming revenue, driven largely by China’s anti-corruption campaign, Macau-oriented casino operators have fallen out of favor. We believe that sentiment has overshot, offering an entry into a structurally advantaged growth story at a reasonable valuation for long-term minded investors. The future growth of Macau will come from mass market gamblers, as infrastructure improvements will make visiting Macau easier for millions of Chinese consumers who will come to enjoy entertainment, dining, and shopping, and they will stay longer and gamble at one of several themed hotels. Las Vegas Sands is most geared to the mass market and will be the largest beneficiary of this shift. We believe that its geographic diversification, best-in-class properties and convention-based business model are attractive assets, and the company’s strong balance sheet and 5% dividend yield provide some downside support while we patiently wait for trends in Macau to improve.

As the leading producer of innovative, single-serve coffeemakers and a multi-brand portfolio of hot-beverage pods, Keurig Green Mountain is really a technology company in the beverage business. Coke owns 16% of the company and is a strong strategic partner. We believe that Keurig will grow U.S. household penetration from about 16% today to over 30% in the years ahead, which is consistent with penetration rates in other developed markets. This fall, the company is entering the cold beverage market with a new product called Keurig Kold that will dispense carbonated or still beverages at 38 degrees within 60 seconds. The addressable market for cold beverages is estimated at $50 billion, five times larger than hot beverages, and Kold will launch with a portfolio of strong, leading brands from Coke and Dr. Pepper. The company poorly executed a product rollout last fall, and the market has extrapolated that trip-up, pricing in a bear-case scenario that household penetration has peaked and Kold will flop. We believe the recent missteps are only transitory and view this as an attractive opportunity to buy the stock.

The world’s population is expected to grow to 9 billion by 2050. With a growing number of people on the planet and a finite amount of arable land, global food security is a major challenge; we’ll need to double the amount of food currently produced with the same amount of land. The only solution to this is agriculture technology, and Monsanto is leading the way as the largest global provider of genetically modified seeds. We have long admired the company, but always deemed it too expensive. Instead, we purchased Syngenta, another seed provider which also has a dominant position in herbicides, pesticides, and fungicides. Monsanto apparently was keen on Syngenta, too, and in April it launched a takeover bid for the company with the vision of designing seeds to work in conjunction with certain biocides. Syngenta apparently doesn’t share the same vision, however, and its management team, defying logic and pleas from shareholders, has refused to enter into discussions with Monsanto. Deal uncertainty has compressed Monsanto’s valuation, offering us an opportunity to buy the better business as cheap as it has ever been.

Apart from these new additions, not much else has changed. Lower commodity prices have weighed on our energy names, hurting performance, but all of the companies have quality reserves and good balance sheets and we believe patience will be rewarded. We expect energy demand to continue to grow long-term and the collapse in rig counts will reduce supply in the oil and gas markets relatively soon. This should bring the markets back to equilibrium and we expect our companies to benefit when it occurs. The pipelines continue to have lots of growth opportunities thanks to the abundance of shale oil and gas in North America and the need to transport these hydrocarbons to market.

Our technology investments have generally done well this year with good growth from Google, Apple and Check Point. Qualcomm’s chip business has lost some market share, and the company had to settle a royalty dispute with the Chinese regulators, but we expect it to recover from these challenges. In the meantime, there is an activist shareholder that is driving for change and management is listening, agreeing to evaluate all alternatives to increase shareholder value. Oracle and EMC continue to transition their business models to the new cloud model, and we expect them to succeed in this endeavor.

As you are wrapping up your summer travels, we hope your return flights are turbulence-free. We’ll be doing our best to navigate the market and keep the financial ride as comfortable as possible, even though we should all expect more bumps along the way than we have experienced in the last few years. Thanks for the trust you place in us and, as always, call with questions.

Penn Davis McFarland, Inc
July 31, 2015