Deal or no Deal
During the third quarter of 2019 the markets were fixated on the U.S./ China trade situation and the prospects of a deal or no deal. The daily stock market indices gyrated to the Tweets and headlines of U.S./China trade and ended with mixed performance for the quarter.
During the third quarter of 2019, the S&P 500 Index gained 1.2%, the NASDAQ Index was down 0.1%, The Russell 2000 Growth Index was down 4.4%, and the iShares Barclays 7-10 yr. Treasury Bond ETF (IEF) gained 2.2%.1 Despite the varying returns of the quarter and the lack of performance in smaller companies, what happened during the latter part of the quarter was fascinating, as measured by the small-cap Russell 2000 Index (R2K) and the large-cap Russell 1000 Index (R1K).
In the first two months of the quarter from 6/30-8/27 small-cap companies led to the downside. But, in a turn of events from 8/27-9/30, smaller companies outperformed the larger companies. Rotations are commonplace, but leadership in the small caps during a period of economic political uncertainty is quite noteworthy. It fits into my view of just how inexpensive smaller company valuations appear.
1 These returns are priced based and exclusive of dividend reinvestment.
From a daily perspective with all the headlines and uncertainty surrounding U.S./China trade, it has been reinforced on more than one occasion that it is impossible to confidently call the market’s near-term direction. This is the reason it is best to concentrate on purchasing reasonably priced businesses with real growth in sales and earnings. Investor complacency sometimes reverts to simply buying the hot headline names or trying to identify a pattern that has worked in the past, many times not truly vetting the financial viability of a business. This strategy may finally be changing.
What is happening in the Initial Public Offering (IPO) market could give us insight. For some historical context, as reported in a presentation by Investor’s Business Daily, Amazon funding pre- IPO was $10 million, Uber Funding Pre-IPO was $25 billion. Uber (UBER), the well-known ride sharing company, went public in May at $45.00 per share with a valuation of approximately $82 billion while reporting $1.8 billion in adjusted losses in 2018. On October 11th shares of UBER closed at $30.13, a 30% loss. Lyft (LYFT), it’s competitor which IPO’d months prior to Uber hit an opening high of $88.60 and now trades for approximately $40, less than half. Peloton Interactive Inc. (PTON), the cardio exercycle company, closed down 10% on the day of its stock market debut on September 25th.
Waning investor appetite can be also seen by the cancellation of highly anticipated IPO’s of WeWork (WE), the shared workspace real estate company and Endeavor Group Holdings, Inc. (EDR), the Beverly Hills, CA entertainment company which owns events such as Miss America and the Ultimate Fighting Championship. Yes, some IPO’s like Beyond Meat (BYND) have survived and done well, so far, but the takeaway is that the investment banks and companies do not take on the arduous and expensive IPO process without having confidence in a successful IPO.
In addition, many market favorites such as Netflix, Facebook, and Tesla, to mention a few, have struggled over the past 15 months like Icarus in Greek mythology from flying too high. In times of flux, like we are experiencing now, it is sometimes wise to revisit areas of the market, which have fallen out of favor or have been ignored. These unloved and unpopular names can become a profitable value opportunity if a change in market leadership unfolds. One unfavored sector that may have seen stock prices pushed down too low is oil. Paris-based International Energy Agency argues that (oil) demand will grow, albeit slowly, past 2040 yet many headlines are calling for peak oil demand due to a myriad of reasons. One prominent theme is the electric vehicle. Investors have been caught up in its exciting development, but most durable changes happen over a long period of time. In my perspective the tipping point for electric cars is not here yet.
The repeatability and discipline in following and executing a proven investment process with strong conviction even when an area is out of favor, is an edge to investing over the long term. Better outcomes stem from minimizing guessing and not paying too much for a good idea. Our method is to seek out investments which exhibit growth in current sales coupled with growing earnings per share and then strongly vetting out its sustainability. Once a business has passed our initial growth metrics for possible inclusion into a portfolio, a determination of a reasonable valuation needs to be calculated in the context of growth rates, margins, economic environment, and market acceptance. In terms of market acceptance one can think of tobacco and related products. While a sin product may be growing, the premium paid for its growth may not equate to the premium paid for the growth of a new gaming app, for example. Areas experiencing increased demand are sometimes not readily visible but are often connected to products or services that we use more and more in our daily lives.
To find these opportunities, one has to be a stock detective and scour the earnings reports and financial filings of companies to understand which ones can provide a repeatable business model to sustain growth. It could be arms-length ideas such as the security software in our electronic devices or hardware for the build-out of 5G networks or devices used for drug development. A common trap investors face is succumbing to buying enticing new ideas which are not mainstream in an effort to get in first or not miss-the-boat. This strategy can work in the short run for some, but many can pay dearly if the growth doesn’t materialize or fades away.
Our success comes from being patient and waiting for an actual sales and earnings growth trend to develop, giving more validity to an investment. Of course, some of the growth will be reflected in a higher stock price, removing some potential gain, but more importantly some of the risk can be reduced. No matter how good a growth story sounds, they all involve a degree of risk.
As in every earnings reporting period we look forward to screening the stock universe for the companies which exhibit sales and earnings growth and appear mispriced by the market. We like to purchase companies with premium growth characteristics which trade at a discount to our value estimates.
The economic landscape here in the U.S.is similar to what it was at the end of the second quarter, but the rest of the world shows signs of slowing which we will be monitored closely.
As a recap:
- The US economy should continue to expand.
- The China trade situation is material in the minds of investors and continues to be a current drag on the valuation of companies involved directly and indirectly with China. The skirmish is a necessary obstacle in correcting China’s reported unfair trade practices, cyber and intellectual property theft of U.S. technology. Over time, the drag should dissipate with trade and prices recovering. However, this could be a prolonged process.
- Overall, US stock market prices are expensive and do not adequately reflect the implication of our strong dollar on exports in a slowing global economy as well as the negative growth effects caused by trade and geopolitical frictions.
- Federal Reserve comments signal the possibility of an upcoming rate cut most likely as an insurance policy against trade tensions and slowing growth outside of the U.S.
- The recession boogeyman is back in the closet, for now.
To our existing clients, I extend my sincere thanks for your business. You have our continued commitment to your success. To prospective clients, I invite you to come and grow with us.
Very truly yours,
Martin L. Yokosawa