Client Investment Letter June 2017

“First slowly, then suddenly.” – Ernest Hemmingway

It has been another quarter of slow growth with few apparent changes in the market’s “no worries” attitude. The Federal Reserve persists in its gradual campaign to remove emergency accommodative monetary policy still in place, hiking interest rates in March and again in June, the fourth of this cycle. In another step towards tightening monetary policy, the Fed has laid out a framework to reduce the size of its bloated balance sheet by stopping the reinvestment of maturing government bonds and mortgage backed securities it has purchased.

The employment picture continues to improve with unemployment reaching 4.3% in May. Even the broader measure of unemployment, U-6, which takes into account all workers including those employed part time for economic reasons, is down to 8.4%, the low of this cycle. The economy appears to be near full employment, giving the Fed cover to continue raising rates.

The expected volatility in the markets has nearly touched all-time lows, while market valuations are very high; both measures are typically associated with elevated investor complacency.

While the water seems to be calm on the surface, there do appear to be some undercurrents just below. Long-term bond yields are plumbing their recent lows and the yield curve is flattening significantly. If the economy were really off to the races, long-term yields should be rising as markets discount strong growth and higher inflation. Instead, it seems the bond market appears to anticipate deflation, an unusual occurrence with the economy running at full employment. Furthermore, President Trump’s pro-growth legislative agenda appears to be mostly stalled in Congress. We would also note that the lion’s share of the broad market’s gains this year have been driven by a small club of mega-cap tech companies. Healthy markets are driven by broad participation, and narrow leadership may be a sign of a bull market’s exhaustion. For now, though, the major equity indexes appear to be ignoring some of these warning signs.

Both the stock market’s exuberance and the bond market’s skepticism cannot coexist indefinitely. Either the bond market is right in its indication of ongoing economic malaise, in which case stocks will eventually “catch down” to bonds as earnings underwhelm, or the stock market is correct in its enthusiasm, in which case the Fed will likely continue its tightening campaign. In either case, we believe it makes sense to prudently manage risk and play defense in anticipation of better buying opportunities in the future.

Regardless of which way the macroeconomic winds blow, the companies we typically like to invest in have many of the following characteristics:

  • Market leadership in an attractive industry
  • Favorable competitive environment with high barriers to entry
  • Innovation, superior brand equity, that drive market share gains
  • Opportunities for operating leverage driving margin expansion
  • Strong free cash flow generation and high-quality balance sheet
  • Shareholder-friendly management team with skin in the game
  • Robust capital return via stock buybacks and dividends
  • Consistently high returns on invested capital
  • Attractive valuation driven by market misunderstanding or controversy which we believe is unwarranted, with catalysts for multiple expansion

Companies with these characteristics, purchased at appropriate valuations, tend to thrive over the long-term irrespective of short-term market movements or setbacks in economic growth. At the moment, we own over a dozen companies that fit these criteria, but finding new ones that meet our valuation conditions has been daunting. As a result, you have a significant hoard of cash and equivalents, most of which has been tucked away into short-term Treasuries which are yielding a little more than 1% for the first time in almost a decade. We look forward to deploying this capital into more attractive opportunities when they arise, but in the meantime are happy to finally earn a little something risk free. We have also been investing in less cyclical parts of the economy like healthcare.

While we’ve owned Gilead and Inovalon for some time, in the first half of this year we added Bristol-Myers Squibb and Celgene. Bristol is one of just a handful of pharmaceutical companies leading the way in immuno-oncology, the latest, most exciting innovation in the treatment of cancer that works by enabling the patient’s immune system to selectively recognize and attack cancer cells. Celgene, too, is primarily focused on oncology, with a great pipeline and clear growth path that is trading at less than a market multiple. Political rancor around the reform of Obamacare and noise around drug pricing have impacted the industry, making valuations attractive for the first time in years. Aging demographics provide a secular tailwind as healthcare becomes increasingly important, regardless of politics or economic cycles. These are just the kind of “growth at a reasonable price” stories we love, but which have become harder to find.

While we can’t know for sure when other opportunities will be plentiful, we do know for sure they will be abundant at some point. Like Santiago in The OId Man and the Sea, we’ve been waiting patiently preparing for that day. When the time comes, we’ll be ready.

Penn Davis McFarland, Inc.
June 2017