Client Investment Letter March 2018

“What investors then need…is an ability to both disregard mob fears or enthusiasms and to focus on a few simple fundamentals. A willingness to look unimaginative for a sustained period – or even to look foolish – is also essential.” – Warren Buffett

The new year started off a lot like the old, with rampant speculation producing the best January performance in two decades on the back of the passage of tax reform. January 26 marked the high, though, and as the quarter progressed, market conditions decidedly changed. Greed turned to fear as volatility spiked, triggering an unwind of crowded positions dependent on volatility remaining at historically low levels, which only exacerbated the move.

After a brief respite, the selloff picked back up in the final weeks of the quarter, led by the popular megacap tech stocks like Facebook, Amazon and Tesla. Among the most widely held positions in the portfolios of hedge funds and other institutional investors – and represented in hundreds of passive ETFs – the crowding into the same dozen momentum stocks drove the technology sector to 25% of the S&P 500, its highest level since the end of the dot-com bubble. As we’ve seen time and again, groupthink creates additional risk as everyone heads to the exits at the same time.

Fortunately, our exposure to this set of megacap tech stocks is limited to Apple and Google; both are supported by reasonable valuations, in our view, and the former we had already trimmed twice.

Apart from the forces driving increased volatility, economic growth remains moderate and we appear to be at or near full employment. With inflation perking up, the Federal Reserve continued to embark on its tightening cycle, increasing rates for the sixth time this cycle and suggesting there are as many as six more hikes coming this year and next. The balance sheet normalization process – otherwise known as quantitative tightening – continues as well. The unprecedented liquidity behind a decade of risk taking and valuation expansion is now being removed, and with it a key pillar of market support.

Even considering the first market correction in many years, valuations are still at historical highs on nearly every metric. With valuations stretched and other headwinds still lingering, we continue to sit on large amounts of cash. The upside to short-term rates inching higher is that we are now able to earn a decent risk-free return on your cash while we patiently await better opportunities. We expect market volatility to remain significantly higher than in recent years, which should occasionally provide us with chances to invest the cash we have been hoarding for a sustained period.

Our current holdings are high-quality industry leaders with outstanding sales and earnings growth potential that is not entirely reliant on the business cycle. They have strong balance sheets and management teams, and many pay healthy dividend income. Their valuations are acceptable, if not outright bargains. It is still difficult to find reasonably priced companies that fit our criteria, but we did find one such gem this quarter and initiated our first new position in quite some time. We also made some adjustments to two existing holdings.

We trimmed our Apple position for the second time in January into the excitement of the new iPhone cycle, which seems like a modest disappointment relative to hopes of a supercycle. While Apple remains a core holding, the stock is highly influenced by iPhone cycles and, following a large run into the iPhone X release, we felt it prudent to trim the position again.

We also added to our position in Dell Technologies Class V (DVMT), a tracking stock economically tied to the performance of VMware, a leader in virtualization and cloud infrastructure software. On news that Dell was considering various strategic options that may impact this structure, the linkage between the two securities became unglued, and we used that opportunity to round out our DVMT position as we expect the discount to narrow and, in any event, we like owning VMware at a cheaper price.

Most recently, we established a new position in Nielsen (NLSN), a leading global performance management company that provides its clients with a comprehensive understanding of what consumers watch (“Watch”) and what they buy (“Buy”). In our view, while the market is overly concerned about the tepid outlook for the relatively small U.S. Buy business, we believe that it will stabilize, and eventually turn, driven by better technology and product offerings and a more top-line focused customer. A recent large contract win with Walmart is a case in point. In the meantime, we see the Watch audience measurement business as the biggest driver given its outsized growth and profitability, while NLSN has line of sight to over $400 million in annual cost savings that will protect earnings. We believe that NLSN has all of the characteristics of a core compounder, and with a 4.4% dividend yield and the stock at historic lows, we see a favorable risk/reward at current levels.

Finally, we would be remiss in not providing an update on our long-held position in Qualcomm. The extended hostile takeover battle with Broadcom came to an ugly end, and investors were forced to say farewell to a large premium offer. We were enormously disappointed with the board’s handling of the entire situation, which culminated with a secret, desperate request to the Committee on Foreign Investment in the United States (CFIUS) to examine an imagined national-security threat. Never mind that Broadcom was weeks away from re-domiciling to the U.S. and is run by American citizens.

Prior to that foolhardy move, Qualcomm raised its pending offer for NXP Semiconductors by 16%, which Broadcom specifically prohibited in its offer for Qualcomm. Meanwhile, the NXP deal is still pending Chinese regulatory approval and, while we remain hopeful it will ultimately close, the status is uncertain. The legal fight with Apple continues, and we don’t expect a resolution for some time.

In a vote of protest at the recent annual meeting, a near majority of shareholders – ourselves included – expressed their discontent by withholding support for all of the Qualcomm directors, including the CEO. So management has its feet to the fire to improve operations, close the NXP transaction and settle with Apple, which will all take some time but would provide upside from current levels. CFIUS has confirmed what we already knew: Qualcomm is a national champion in wireless technology. A third-party buyer has said Qualcomm is worth over $80 per share. Now it is up to management and the board to unlock this value or risk getting tossed out by activist investors at the next annual meeting.

We are always appreciative for the trust you’ve placed in us. With volatility finally returning, we believe the current environment is setting up for more exciting investment opportunities in the near future, and we look forward to capitalizing on them on your behalf.

Penn Davis McFarland, Inc.
April 2018