Client Investment Letter March 2017

Since our last letter to you there have been some notable developments. President Trump was inaugurated, the Fed increased interest rates for the third time and hinted that more hikes are coming, and economic growth appears to have stalled, with the Atlanta Fed now projecting just 0.9% first-quarter GDP growth as of this writing.

Hope is beginning to wane that the new administration’s pro-growth agenda of tax cuts, deregulation, and infrastructure spending will be implemented quickly, if at all. With the reflation trade starting to fade and economic growth slowing, Treasury yields are lower today than they were in mid-December. And the Fed’s increase of the overnight Fed fund rate has caused the yield curve to flatten.

Taking the above conditions and adding high valuations and excessive levels of complacency, there is reason for caution in the health of the broader market. That said, there are over a dozen individual companies that we believe have bright prospects and are attractive investments. Furthermore, we aren’t counting on an impending recession this year, just a continuation of stall-speed growth rather than the acceleration the markets seem to be counting on. Many of the names you’ve seen in your portfolio for a long while we continue to have high conviction in, and we are always on the prowl for new opportunities.

We capitalized on two such opportunities during the first quarter with new buys of Bristol-Myers Squibb and Celgene. Bristol is one of just a handful of leading pharmaceutical companies 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. The company stumbled last year, and the market’s overreaction finally provided us an entry into this high-quality, fast-growing company. Celgene, too, is primarily focused on cancer, and the stock looks reasonably valued to us given its exceptional growth profile, deep late-stage pipeline, and strong free cash flow generation.

With our confidence in our existing core holdings and sporadic new ideas, yet caution in the overall health of the broader market as the Fed embarks on a new tightening cycle, we continue to plot a middle course: a portfolio of high-quality, reasonably valued companies, in many cases paying above-average dividend yields, but while also maintaining a large cash position that will allow us to take advantage of any broad-market correction.

The recent rise in short-term interest rates has also provided us the opportunity to actually earn a little something on a portion of our cash reserve. We continue to purchase Treasury bills that will now pay rates of nearly 1.0% while we wait for better opportunities. After a thirty-year bond bull market that brought yields down to historic lows – and with credit spreads still inexplicably tight – we have a long way to go before there are real opportunities in fixed income, but we’re happy to finally earn some modest risk-free return on our cash.

For now, we continue to focus on defense, always cognizant of downside protection, while growing your portfolio slowly and prudently. As they say, defense wins championships. But we believe the current environment is setting up for many exciting opportunities for offense, and we look forward to capitalizing on them on your behalf when that time comes.

Penn Davis McFarland, Inc.
March 31, 2017