Client Investment Letter October 2019

“Fundamentals make the market.” – T. Boone Pickens



The third quarter is now behind us. Fall is here and with it, cooler weather, football, the State Fair, and memories of delightful summer travel recently completed. Which got us thinking about the difference between a trip and a journey. A trip generally refers to traveling to a place and then returning, while a journey implies going from one place to another, not necessarily where you started. The equity markets took quite a trip, then, during the third quarter, with a deep swoon in early August on another Fed gaffe (“mid-cycle adjustment”) that was fully recovered by the end of September, with the markets ending up pretty much where they started.


The bumpy ride, it seems to us, is driven more than ever by algorithmic trading based on short-term momentum and political tweets, the positioning of quantitative-based strategies, and flows in and out of passive index products, namely ETFs. Over the long term, though, it is fundamentals and valuation that drives stock prices. And on that front, broadly speaking, earnings growth is sagging and valuations remain stretched. Against such a backdrop, new ideas are hard to find but are often created by the short-term noise. We initiated a new position in the quarter, which we will discuss below.


Years of central bank intervention in the name of extending the business cycle have led to historically low interest rates around the world. The unintended consequence is a misallocation of capital that has become evident everywhere you look: frothy private equity valuations, $15 trillion of global debt with negative yields, many European “high yield” corporate bonds with sub-1% yields, and the fastest pace of unprofitable IPOs since the tech bubble, to name just a few. Meanwhile, gold, the anti-central bank play, has surged to a six-year high.


As the quarter came to a close, two private-equity darlings – office-sharing company WeWork and e-cigarette maker JUUL Labs – came crashing down to earth, reportedly losing over 30% of their private-market value, culminating in the “resignation” of their respective CEOs. There has also been a surprising and persistent liquidity shortfall upsetting the usually tranquil interbank funding market, and a violent (but brief) shift from growth and momentum stocks to value. The IPO market has softened, with several highly anticipated new issues falling flat at quarter-end, compelling others to delay their offering altogether. We wonder, with the benefit of hindsight, whether any of these events will be significant.


For now, we are contending with flaccid growth in the world economy and a downturn in corporate profits, juxtaposed with a buoyant stock market that seems driven mostly by the non-fundamental factors discussed earlier. We are clearly late in the economic cycle, but how far away from the start of the next recession is anyone’s guess.


Recessions get a bad rap, but they are a normal part of the business cycle and, despite the Fed’s best efforts, they cannot be staved off indefinitely. All cycles ebb and flow, influencing not just economics and companies, but investor psychology, too. A corrective process cleanses the market’s excesses, ultimately making for a safer subsequent environment. But fear not, when a recession does eventually arrive (and it will), we do not expect anything like the last one, as the banking system is much healthier than it was heading into 2008. And, with our ample cash position, we will be ready to deploy your capital into high-quality compounders that, bought well, we can hold for years. From that perspective, the next down cycle of any significance will be quite welcome, as we will be able put your cash to work at much more attractive prices than currently available.



We feel good about our existing portfolio. We believe our names to be of the highest quality, with healthy balance sheets, good growth prospects with relatively resilient demand, reasonable valuations and, in most cases, offering attractive dividends. Several companies are in the midst of strategic actions that we believe will unlock shareholder value. We remain very positive on the prospects for our current holdings even through the next cycle, and in fact our first course of action on any weakness is to add to existing positions.


But we are also constantly on the lookout for new ideas, where high-quality growth companies get driven to depressed valuations on a short-term market overreaction that we believe is unwarranted. Our latest new position has become attractive due to short-term political noise, while the business centers around one of our key secular investment themes: health care cost containment. This is an ever-growing issue, as U.S. health care spending has grown steadily above the rate of inflation for many years and today comprises 18% of gross domestic product (GDP). Perhaps no company is better positioned to capitalize on this theme than health care industry bellwether United Healthcare (UNH).


UNH is widely known for its health benefits business, where it has a dominant position in Medicare Advantage, the most valuable growth market in managed care. It also has a big, fast-growing health-services business operating under the Optum brand that now accounts for 47% of operating profit. These complementary businesses benefit from growth in the other, with the health-benefits unit driving volume to Optum’s pharmacy care services, for example, and Optum’s data and analytics segment helping to lower medical costs at the health benefits business. In addition, UNH is advantaged by its vertical integration, as Optum’s large care delivery and pharmacy services organizations help the managed care business control its own costs.


In our view, UNH is at the center of a number of secular industry tailwinds that should drive sales and earnings for years to come, including: increasing focus on value-based care; aging U.S. demographics that lead to years of Medicare Advantage population growth; the shift from more expensive inpatient care towards outpatient settings to reduce cost pressures in the system; and the growing use of data and analytics in health care to improve patient outcomes. Political risk could be an overhang through next year’s election, but we believe the long-term prospects for the company will remain attractive and we are looking for opportunities to build the position on any weakness.


Today’s environment requires patience, caution and liquidity, all of which we have in abundance. As we settle in for the final stretch of 2019, we are moving forward judiciously and thoughtfully, never chasing trends but instead making reasonable, informed decisions. We are living through interesting times, and we look forward to navigating this journey with you.


Penn Davis McFarland, Inc.
October 2019