Discipline in a Volatile World?
Market uncertainty seems to be here to stay. Despite a resilient US consumer and a decent economy which has driven positive returns for the US stock market, headlines and international weakness continue to cause volatility and uneasiness amongst investors. With a US election next year, a potential impeachment process, Britain possibly leaving the EU with or without a deal, and ongoing tension with China and Iran we do not see current market volatility subsiding soon. From an investor perspective there is an upside; volatility produces opportunity particularly for those who know what they are looking for and are bold enough to act with conviction. At Bainco, when uncertainty mounts, we rely further on our disciplined investment process to reinforce our confidence in our portfolio and to give us conviction to take advantage of opportunities.
Stick with the Plan
Each time we begin a new relationship with a client, we go through the process of creating an investment policy statement (IPS). The goal of structuring an IPS is to understand as many dynamics as we can in a family’s financial life that may impact their ability and willingness to hold investments when market conditions change. With an understanding of cash flow needs, risk tolerance, and total assets we then recommend an allocation which provides the framework to navigate challenging market conditions. By reviewing and adjusting the IPS as life changes occur, we can invest with a plan and the individual can focus on other important things in their life while knowing their money is being managed as agreed.
Within each IPS there are ranges around each asset class allowing for shifts when appropriate. We continuously review and if appropriate, adjust our portfolios to reflect the current market climate and capitalize on the opportunities we see. For instance, we are currently near the midpoint of our equity allocation targets but due to the distinct strength of the US economy relative to international peers, we continue to be overweight US stocks. With an ongoing global manufacturing slowdown, we have reduced our exposure to cyclically linked holdings and economies. In our fixed income portfolios, we have extended the average maturity in our bond portfolio to reflect the expected further drop in interest rates. Given the limited returns being offered in mid to short term municipal bonds we have adjusted our holdings to favor taxable bonds including corporate bonds and US treasuries. These small tilts within an asset class can make a big difference in portfolio performance as illustrated by US stocks out-performing global equities by 170% since the end of 2009.
“We continuously review & if appropriate, adjust our portfolios to reflect the current market climate & capitalize on the opportunities we see.”
As client asset allocations are structured to have the right balance between growth and liquidity, we don’t make shifts lightly. Any change in our asset allocation will be based on strong fundamental data identifying significant opportunity or risk. As is human nature, there is a tendency to try to be early and maximize returns, but a mistimed shift can not only have a negative impact on returns, it can change the risk profile of the portfolio. As data builds, we begin by making small adjustments within an asset class instead of between them to reflect uncertainty or opportunity. As an advisor of taxpayers, we are also mindful of the tax impact of a shift. We don’t let the taxes stop us from making a good investment decision, but we embrace tools such as covered calls and put options that allow us to reduce some of the risk in an investment and avoid a potentially onerous tax bill.
Choosing the Building Blocks
With a market outlook in hand and a clear asset allocation framework, we then work to determine the key trends and any fundamental factors that may drive relative performance. The core of our stock portfolio is aligned with the dominant secular trends in each industry group. Secular growth is defined as growth that occurs or persists over an indeterminately long period of time despite changes in the business cycle. Investments that are linked to these trends form the building blocks of our portfolios and should drive the growth necessary to meet the objectives and needs identified in the client’s IPS.
The transition to electronic payments is a great example of a long tailed secular growth trend. Each year fewer and fewer transactions are taking place with cash or check and more and more are occurring by electronic methods such as credit cards and ACH (direct transfer between bank accounts). Visa, the credit card network provider, has been a critical player and beneficiary in this trend and a portfolio holding since 2009. The company went public on March 18, 2008, two days after JP Morgan bought Bear Stearns at the behest of regulators as the Financial Crisis escalated. JP Morgan was the largest of the 16,600 banks that collectively owned Visa and the IPO provided critical cash to those ailing banks. Due to the strength of the business, leverage to the explosive trend of payments, and strong cash flow profile, the company did not falter. In 2009 Visa was able to grow revenues 10% and EPS 19%. This led to dramatic outperformance during the recession and well beyond as the underlying trend is still in place today. If you participated in the IPO and held through 9/30/19 you generated a total return of 980%, to $174 today versus a 123% return for the S&P.
“Investments that are linked to these trends form the building blocks of our portfolios and should drive the growth necessary to meet the objectives and needs identified in the client’s IPS.”
Another secular growth trend, cloud computing, is pervasive through our portfolio today. Microsoft, Google, and Amazon are directly selling cloud services and Salesforce, Adobe, Ansys, and Apple are all leveraging the cloud to distribute their product and services. Going one step further, almost all our portfolio companies utilize the cloud to better serve their customers and lower their technology costs. The best businesses are always on the lookout for ways to improve their business as well as better serve their customers. Apple, for example, uses the cloud to provide an integrated ecosystem that replicates the experience on every device and platform. Their cloud storage offerings only generate a small percentage of their revenues, but it has become the technology that makes their unrivaled ecosystem possible.
Trends Outpacing the Market
- Artificial Intelligence
- E-Commerce / Digital Payments
- Cloud Computing
- Clean Energy
Today there are many strong trends and the related companies are significantly outpacing the market in both sales and earnings growth. Genomics, E-Commerce, Robotics, clean energy, and Artificial Intelligence are just a few beyond cloud computing and electronic payments in our portfolio. Although we are confident most of these trends will continue for the next several years, new trends will emerge, and the primary beneficiaries can change over time. Over the past 20 years as mobile devices grew in number and value, market leadership changed multiple times. Nokia was the early leader and eventually was overtaken by Research in Motion (Blackberry) and now Apple dominates that market. A clear example of how one must continually review one’s position and be open to new investments. A consistent application of a disciplined investment process should continually align the portfolio with the best growth trends.
Pick the Weeds not the Flowers
Legendary Fidelity manager Joel Tillinghast famously remarked “Pick the weeds and not the flowers”. It is essential to acknowledge that no one is going to get every investment right and circumstances change. One should act decisively and move on from the losers while supporting the winners. This seems to be an obvious tactic, but a series of psychological faults steer the typical investor in the wrong direction. By reviewing the company against its peer group, we either gain conviction to hold a good company or we realize that there is a better investment to be made and we move on. We look to our time-tested quantitative screening tools to help us identify changes in leadership and to be unemotional when a stock needs to be sold. Unlike investing in private markets, public investing allows you to quickly change your mind when the data changes and taking advantage of that ability creates performance.
“We look to our time-tested quantitative screening tools to help us identify changes in leadership and to be unemotional when a stock needs to be sold.”
As we mentioned previously, we are more than happy to own multiple stocks leveraged to a given trend. This is particularly true early on as the trend is developing and the leadership may not have emerged. Today we have a strong portfolio of medical device and diagnostic companies that are all capitalizing on the rapid growth in medical technology, specifically Boston Scientific, Thermo Fisher Scientific, and Stryker. If they all continue to perform well by growing their earnings and continuing to innovate, we may very well maintain each position, but we may choose to sell one and rebalance more weight into another that may be performing at a higher level. Consistent monitoring of company financials and listening to management presentations are keys to assessing relative performance and are essential for building conviction in challenging market environments.
Apple is a stock we have owned in many client portfolios for more than a decade. There have been many times when selling the stock outright was tempting due to difficult product cycles, tough quarters and the passing of their legendary founder. We have maintained a position as the company has continued to embody several critical attributes of a market leader. First, they have consistently been able to sell their products at higher prices with better margins than peers. Second, they have maintained their competitive position as the market leader. Lastly, they continue to innovate. When they stop innovating, we will stop investing.
When times get tough it is hard to find comfort in owning an index. At the market low in 2009 there were companies trading at prices less than the cash on their balance sheet and some that were about to go out of business. Having a deep understanding of the attributes and risks associated with each holding allows you to stay invested in challenging markets, avoid poor investments, and hopefully, enjoy strong returns when markets improve.
“When times get tough it is hard to find comfort in owning an index.”
We hope the above commentary helps provide insight as to our discipline and our outlook for staying invested in Quality Growth Companies. If things change, we are prepared to adjust our asset allocation and the “building blocks”. We hope that you enjoy the upcoming holidays and look forward to writing a year end update for you in January.