Client Investment Letter October 2018

U.S. stocks continued their levitation act during the third quarter, driving the major indices to new all-time highs in both price and valuation. Your portfolio participated in kind and had a nice quarter, too. Risk appetite is as intense as ever, as seen in tight corporate bond spreads despite deteriorating credit quality, last year’s crypto frenzy rotating to cannabis stocks with little in the way of sales or earnings, or the vast outperformance of momentum over value.


International stock markets aren’t enjoying the same fate, though, as most markets around the world are in the red for the year. Trade disputes, political mayhem, weak commodity markets, and a toxic combination of a strong U.S. dollar and high dollar-denominated debt levels tend to do that. This may create opportunities in high quality, foreign-domiciled multinationals; we’re on the lookout.


But you don’t have to look overseas to find highly indebted sovereigns. The U.S. fiscal deficit has ballooned, which is atypical during economic expansions. Government borrowing is classically countercyclical, rising during recessions when stimulus is needed and then fading in recoveries. With the biggest bout of fiscal stimulus outside a recession since the 1960s, the deficit is climbing now despite decent economic growth, leaving the government less flexibility to respond in the next recession. Further, as interest rates rise, the federal government will soon pay more in interest on its burgeoning debt load than it spends on either the military or Medicaid. So while the tax cuts and government spending were largely applauded, the resulting deficit hangover will be a lasting headwind for future growth.


The fiscal largesse is somewhat offset by tighter monetary policy. The Fed increased rates last week for the eighth time this cycle and hinted at another hike this year, likely in December, and then three more next year. Its balance sheet normalization process, known as quantitative tightening, picks up speed next month when it begins letting $50 billion of its bond holdings mature every month, up from $40 billion per month. The four major global central banks will soon be net tightening in the aggregate. The unprecedented global liquidity behind a decade of risk taking and valuation expansion is now being removed, which could produce some speed bumps in the coming quarters as the impact of monetary policy is felt with a lag.


You’re benefiting from higher short-term rates, as we are able to invest excess cash in one-year Treasury bills yielding a risk-free 2.6%. That’s higher than the dividend yield on the S&P 500 for the first time in a decade. With ample cash in your portfolio that’s now generating a respectable risk-free return, we are well positioned to be selective buyers in a downturn instead of a forced seller at temporarily depressed prices. We were pretty active during the third quarter, exiting two long-held positions and adding a new name to the portfolio.


As you may recall, in our last letter we discussed the bidding war underway for most of the assets of 21st Century Fox (FOXA). Comcast’s $35 all-cash bid prompted Disney to increase its offer to $38 in cash and stock. Comcast bowed out, and Disney came away victorious. With FOXA trading to nearly $46, reflecting the $38 cash-and-stock offer plus around $10 per share in value for the remaining Fox assets that were not part of the deal, we sold our stake in FOXA for a nice gain given the tiny discount, a lengthy and uncertain regulatory approval process, and exposure to Disney stock during that time period. We had purchased FOXA in the summer of 2015 in the mid-$20s when fear of subscriber losses to streaming video was at a peak, so we are pleased with the return on this position over the past three years.


We also sold our small position in Mosaic (MOS) during the quarter given no signs of a turn in the ag cycle and the fact that the position was too small as it stood. We continue to like the secular “feed the world” investment theme – a combination of global population growth, the desire for more protein-rich diets and finite arable land that will require an increase in yields – and will revisit our exposure to it in the future.


With the proceeds, in September we initiated a new position eBay (EBAY). The company has a high quality, stable core Marketplace business growing in the mid- to high-single digits, and new initiatives are underway to accelerate its growth, which should begin to bear fruit.

More importantly to our thesis, EBAY has two intermediate-term drivers of incremental sales and operating profit that, in our view, are underappreciated and not currently priced into the stock: promoted listings that allow sellers to pay for prominent placement of their listings in search results on EBAY; and taking over the role from PayPal as a payment intermediator on the eBay Marketplace. With a healthy balance sheet and strong free cash flow (about a 6% free-cash-flow yield), the company is buying back $3.5 billion of stock this year and next year (roughly 10% of the company’s shares each year). Aggressive buybacks and valuation support should provide some downside protection, while delivering against these big, longer-term opportunities offer attractive upside.


We also increased our position in Nielsen (NLSN) after a disappointing second quarter earnings report caused a sharp sell-off that we viewed as overdone. In light of the weak results, the company announced its CEO was “retiring” and the board was reviewing strategic alternatives for its Buy business, which measures and analyzes consumer’s purchasing of packaged goods like soup, soda and soap. Soon after, Elliott Management, a large and well-respected activist investor, announced that it had taken an 8.4% position in NLSN and planned to push the company to consider selling itself. Apparently the board liked that idea, because just a few weeks ago, NLSN announced that it had, in fact, expanded its strategic review and was now contemplating selling the whole company; it has reportedly already received interest from several private equity funds. The stock has mostly recovered since the post-earnings nadir and we believe that a buyout will be a likely outcome given Elliott’s involvement, a management vacuum, and NLSN’s attractive assets.


Finally, in taxable accounts you may have noticed some additional trading activity. We are harvesting modest losses where we have them to offset large realized gains taken earlier in the year. We are mostly re-establishing core positions after the wash-sale period has passed, so our exposures to our best ideas will remain; we are simply attempting to provide the best after-tax return possible, which is one of the benefits of separately managed accounts.


As we enter the home stretch of 2018, rest assured we are managing risk first and foremost and remain confident in the outlook of the companies in your portfolio. We continue to weigh caution and prudence over aggressiveness and greed. To paraphrase legendary value investor Seth Klarman, the current opportunity set is not the only relevant one. That is to say, while pleased with the outlook for our existing holdings, there is a better, more attractive opportunity set yet to come, and we can’t wait to capitalize on it.

Penn Davis McFarland, Inc.
October, 2018