Client Investment Letter April 2019

Since the late 1970s, the Federal Reserve has operated under a directive from Congress to promote maximum employment and price stability, commonly referred to as the Fed’s “dual mandate.” Price stability, in this sense, relates to a stated inflation-rate target of 2%. With inflation elusive and stocks nosediving in the final months of 2018, perhaps the Fed is also motivated by an unwritten third mandate to support risk assets.

After a three-year tightening cycle and a mission to reduce the Fed’s bloated balance at a run-rate of $600 billion this year, as recently as late September policy makers forecasted a handful of additional rate increases over 2019 and 2020. In early October, Chairman Powell’s comment that rates were “a long way from neutral” and, in any event, the Fed “may go past neutral” is what set off the fourth-quarter swoon, capped by the worst December stock-market performance since 1931 after he said the Fed’s balance-sheet reduction program was on “autopilot.” One sharp sell-off is all it took for the Fed to blink. Now, just a few months later, policy makers say that further rate hikes are unlikely – in fact the market is already pricing in a rate cut – and the quantitative tightening will conclude this fall, at which point the central bank will be left with a frighteningly large balance sheet in excess of $3 trillion.

The U.S. economy is running at stall speed and inflation is stubbornly low, so the pivot in monetary policy was certainly warranted. Indeed, the December 19 hike was probably ill advised. With nine hikes already this cycle (plus the policy-tightening equivalent of several hundred basis points of additional rate increases from balance sheet reduction), and acknowledging the lagged impact of monetary policy, the Fed may have inadvertently tightened us into a slowdown.

We are already seeing signs of slowing growth: earnings growth has decelerated and is entirely supported by record levels of stock buybacks, economically sensitive companies like FedEx and others have flagged weaker global growth, Treasury yields have collapsed, and the yield on 10-year Treasury bonds recently dipped lower than the three-month bill. An inverted yield curve has been a reliable indicator of approaching economic slumps, having proceeded every recession since 1960. Aging demographics and excessive debt loads are also acting as powerful secular headwinds on growth and inflation. Europe, China and many other international economies are slowing, too.

With all that said, this seems like a good place to remind you that recessions are a normal part of the business cycle and cannot be staved off indefinitely. Forests that become choked with too much overgrowth are prone to burn, increasing the risk of uncontrollable wildfires. Small, regular fires can clean out dry shrubs and small trees and play an important role in maintaining forest health. Similarly, recessions cleanse the market’s excesses, making for a safer subsequent investment environment.

While a run-of-the-mill recession cannot be ruled out, we in no way expect a catastrophic wildfire. The financial crisis a decade ago was driven by overleveraged banks; the U.S. banking sector has recapitalized and can now withstand even large economic stress. The corporate sector, on the other hand, is awash in debt – much of it of questionable credit quality – and this is of concern and bears close monitoring. But the risk, just to be clear, is not a repeat of the last recession.

Despite signs of a looming slowdown, however, stocks performed exceptionally well in the first quarter of 2019, largely recovering all of the losses from the final months of 2018. Your portfolio benefitted too, with many of our largest holdings outperforming the market. While bond yields are flashing growth warning signs, the animal spirits have been released in the stock market. Complacency has crept back in with the view that the Fed is here to save the day; valuations are rich, risk premiums are thin.

We continue to actively look for new ideas – and we did add a new name to your portfolio recently – but the opportunity set is small given the disconnect between high prices and subpar future growth. Our best investment right now is patience, as we sit with ample liquidity, waiting for better prices. Here is a discussion of recent changes to your portfolio.

As you may recall from our last letter, at the very end of December, Dell closed its acquisition of the tracking stock we owned in your portfolio (DVMT) for cash and shares in new Dell. While we like the company’s large stake in VMware, we are wary of its highly leveraged balance sheet and, given we were left with too-small a Dell position and were not inclined to add to it, we decided to sell it entirely.

In February we initiated a new position in Activision Blizzard (ATVI), a leading video game publisher. The shares stumbled badly in the last few months of 2018 and into early 2019, dropping almost 50% from their October highs, on issues that we believe to be largely temporary, providing an entry into an industry leader at an unusually depressed multiple.

Greater penetration of broadband internet, ever-growing computing power and cheaper storage, both locally and in the cloud, are transforming the video game business and its economic model. The shift to digital comes with much better margins and has helped to increase player engagement. High-quality content (think Call of Duty, Candy Crush, World of Warcraft, and Overwatch) and broad consumer reach increase length of play and average revenue per player, which generates high-margin sales and cash flow that Activision can re-invest in its franchises, talent and technology, which drives even more engagement, creating a virtuous cycle.

This year, the company is reallocating resources and making cuts elsewhere in order to invest even more heavily behind its top properties, increasing the number of developers working on them by 20%. We are buying the investment year at a trough multiple in anticipation of future growth ahead. We see longer-term upside from the company’s exposure to professional video gaming, known as esports, as well as from advertising and greater penetration in mobile, the largest and fastest-growing source of industry revenue. Due to our overall cautious market view, we initiated a small 1% position but will be building it up over time as opportunities present themselves.

Two strategic actions involving three companies in your portfolio are currently pending. At the urging of an activist investor, Nielsen (NLSN) last fall put itself on the auction block. That process should be nearing the finish line, and we hope to hear an update from the company imminently. Bristol-Myers’ (BMY) acquisition of Celgene (CELG) was contested by two large Bristol shareholders, but it now appears that the deal will be approved by shareholders on April 12. We like the combination as it creates the leading oncology company, it’s 40% accretive to Bristol in the first full year post-close, and it diversifies both companies’ product portfolios. From the perspective of Celgene shareholders, it de-risks the Revlimid patent cliff, provides upside participation on clinical success through a Contingent Value Right, and offers a big premium to where the stock had previously been trading. The largest proxy-advisory firms recommended approval which was the last major obstacle prior to the shareholder vote. We will have updates on both Nielsen and Bristol/Celgene in our next letter.

Until then, we continue to weigh caution and prudence over aggressiveness and greed. We are pleased with our recent performance and believe your portfolio is well positioned for whatever the future holds: If stocks continue to climb ever higher, your account will certainly appreciate as well. If, on the other hand, market volatility returns, we have plenty of dry powder to deploy into high-quality stocks at great prices that will benefit from the magic of long-term compounding.

Penn Davis McFarland, Inc.
April 2019