Client Investment Letter October 2017

“Habit rules the unreflecting herd.” – William Wordsworth

Perhaps simply out of habit, risk-on trades continued in the third quarter as the herd pushed assets to new highs. Speculative fervor, both man-made and computer generated, drove everything from small cap stocks to junk bonds, cryptocurrencies, real estate and even thoroughbred horses.

The rapid growth of non-fundamental investment strategies, like computerized strategies using artificial intelligence, risk parity strategies and ETF flows are all contributing to the steady march higher with unusually low volatility. What remains to be seen – because it’s a new phenomenon without historical precedent – is what happens when these trends reverse. We suspect fundamentals such as cash flow growth and valuation will matter again, as they always do in the long term.

As we’ve noted in our previous letters, valuations are stretched to historical highs. Investor complacency, narrow leadership and a fading pro-growth legislative agenda remain causes for concern. The economy continues its slow-but-steady growth and unemployment remains low. Where we have seen some developments since our last letter, though, are in the areas of Fed policy and geopolitical headlines.

On the former, the Fed has recently announced plans to start shrinking its $4.4 trillion balance sheet in October and recent hawkish commentary has set market expectations for another interest-rate hike in December, the fifth of this cycle. The accommodation behind a decade of risk taking and valuation expansion is now being removed. On the geopolitical front, tensions with North Korea have clearly escalated, and while we hope and believe that cooler heads will prevail, when volatile actors are involved, the risk of conflict cannot be ruled out.

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. We expect these companies to continue to thrive no matter which way the geopolitical headwinds blow. It is becoming increasingly more difficult to find reasonably priced companies that fit our criteria, though. We believe the opportunity set will be significantly broader in the future than it is now, so we’re playing defense with high levels of cash and equivalents, waiting for our pitch.

We trimmed our long-held Apple position into the excitement of the new iPhone cycle, and we expect to pare it a bit further in the coming months. While Apple will remain a core holding for the foreseeable future, it’s a victim of its own success in that the iPhone – one of the most impactful consumer products of the past decade – drives 63% of sales. As such, the stock is highly influenced by iPhone cycles and, following a 39% year-to-date gain through the September 12th new-product event, we felt it prudent to trim a little bit into the excitement.

We also exited our position in Mattel during the quarter. We continue to believe there is a big opportunity for management to reignite sales growth and improve the company’s margin structure, but it’s going to take new CEO Margo Georgiadis quite a bit longer to implement change than we originally believed and details of her strategy are still unclear to us. With a lengthened time horizon required but increased execution uncertainty, we’re moving on.

We are parking the proceeds from these sales – as well as the rest of your cash – in short-term Treasuries which are yielding about 1.25% 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, we’re happy to earn some risk-free income.

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

Penn Davis McFarland, Inc.
October 2017