Client Investment Letter January 2021

“You can’t always get what you want, but if you try, sometimes, you might just find, you get what you need.”  – The Rolling Stones


2020 was emphatically a year nobody wanted. But we got what we needed to make it through. Namely, we received huge support from the Federal Reserve with a one-two combination of rock-bottom interest rates and emergency lending and asset purchase programs galore. Congress also passed large fiscal stimulus which delayed serious pain for millions of families and businesses. And, finally, we got highly effective vaccines in a remarkably short time that will bring life back to some semblance of normal. Meanwhile, your portfolio of companies proved to be pandemic resistant and then some, with most of your companies thriving despite the chaos while others appear poised to exceed their former greatness when life returns to normal.


Several clients have asked us how the market can be so high with things still so bad. There is no one answer, but rather a confluence of things going on in the market today. First, low interest rates have had an impact on all asset prices. In general, rational people determine what to pay for investments by discounting future cash flows back to the present. The 10-year U.S. Treasury yield is the most common risk-free interest rate, which is tethered to the Fed funds rate used to set monetary policy, with an additional spread based on the riskiness of those cash flows. So, let’s say you were expecting a stream of $100 each year for five years from an investment. To find the value today, you would add up those cash flows discounted back to get their “present value.” Let’s assume that at the beginning of the year you required a 5% return, made up of a 3% risk-free rate and a 2% excess return because these cash flows are coming from someone riskier than the U.S. Treasury. In this example, 5% is the discount rate.  The present value of the future cash flows would be $432 (we’ll spare you the math).


Now, assume you drop that required discount rate down to 2% because the risk-free rate fell to zero thanks to the Fed. The new value is $471. Even though the cash flows are still $100 per year for five years, the present value of the future cash flows went up 9%, to $471 from $432, thanks to a lower discount rate entirely driven by a fall in the risk-free rate. So, if you assume that earnings and, therefore, cash flow are eventually back to pre- pandemic levels, but you also assume rates remain low, it makes sense for values to be up.


This effect is even more pronounced on cash flows that are far in the future. Let’s assume that you are buying the same stream of $100 cash flow for five years, but you won’t start getting paid until year 11. The value of said cash-flow stream today discounted at 5% is $265. But dropping the discount rate down to 2% makes the value of those same cash flows $386. This time, the value goes up by 45% (to $386 from $265).


This explains a lot about what is going on in the markets today. Growth companies with little in the way of earnings today, but potential for big future cash flows a long time from now have gone up a lot because lower interest rates have a big impact on how investors value them. Software-as-a-Service companies, clean energy companies, electric vehicle companies, and many recent IPOs would fall into this bucket. Valuations are sky high and it is hard to argue with people about what earnings are going to be in 2030 because nobody knows. On the other hand, stable companies with good cash flow now and less uncertainty and excitement about the future have not participated as much. Examples might be drug companies, banks, and traditional energy companies. It has been a two-speed market, with hyper-growth concept stocks, mostly in tech, and everyone else. The caveat is that if interest rates move higher as growth recovers, this trend is likely to reverse.


Low interest rates aren’t the only thing going on in the market, though. We see some clear signs of increased speculation as people who historically might have bet on sports took up betting in the stock market during the pandemic shut down (anecdotally with their stimulus checks). Dave Portnoy, President of Barstool Sports, has been the poster boy for this new type of market participant as he took to day trading and sharing his trades on Twitter during the pandemic, often without even knowing the name of the company he is supporting, much less anything about its business, only its ticker symbol. The surging client account numbers at retail brokerage companies from Robinhood to Schwab is evidence of a new fast-money investor class that has engaged with the markets and, unsurprisingly, these new players seem to be most interested in buying more of what’s working right now (i.e. price momentum) than fundamentals. This cycle has played out hundreds of times throughout history and many people who are speculating will buy things they come to regret. The increased speculation has only served to amplify the two-speed market. There are numerous high-growth concept stocks that are way overvalued with naïve speculators piling in, but we also see pockets that are undervalued, and this is our focus.


We found one such company in Liberty Media SiriusXM this quarter. Controlled by legendary media and cable mogul, John Malone, Liberty Media SiriusXM is a tracking stock that owns stakes in various other publicly traded companies including: SiriusXM, the satellite radio company that also owns Internet streaming service Pandora; Live Nation, the concert promotion company and owner of Ticketmaster; The Atlanta Braves, a Major League Baseball team; Formula One, a globally renowned car racing circuit, and iHeartMedia, a large radio conglomerate. Liberty Media Sirius XM trades at a 35% discount to the value of its holdings which is reason enough to be interested. Additionally, within 12-18 months, Liberty will gain control of Sirius’s cash flow via tax-free dividends because it will cross the 80% ownership threshold. We believe Liberty will then use Sirius’s excess cash flow to repurchase its own shares and close the discount. Basically, we have a combination of buying good assets at a discount, a catalyst to close the discount, controlled by one of the best capital allocators around.


We have a handful of other items on our buy list, but we remain patient and are not concerned about missing out. In general, we are focused on purchasing things that will benefit from the return to normal but where that is not already reflected in the stock price. We think it will be hard for the market to ignore improving fundamentals this year. If the Fed keeps rates low as promised and we get the vaccines rolled out without too many hiccups, it should be a decent year with a meaningful recovery in earnings, though we see limited room for further multiple expansion. Eventually, there will no doubt be a bill to pay for the pandemic in the form of higher inflation, higher taxes, more expensive debt, or some combination of them all and a concomitant pull downward on multiples. But first, the world deserves to party like Mick Jagger when this pandemic is over, and it probably will. Dealing with excesses that spring up due to easy money and structural overhangs from high government spending and increased wealth and income inequality will wait for another day.


We look forward to seeing you in person again soon. Thanks for the trust you place in us, and for your resolve and patience during this most turbulent year. We continue to work hard focusing on your wealth, so that you can focus on your health. We’re in the office if you want to come for a socially distant visit, but we are also happy to speak on the phone or via Zoom. We wish you all a 2021 filled with good health and prosperity.


Penn Davis McFarland, Inc.
January 2021