A Rapid Recovery to Start the Year

To Our Investors and Friends,

Following a -9.2% return for the month of December (the worst December since 1931), in January the S&P 500 posted one of the best starts to the New Year, up 7.9%. Oil prices (WTI) rebounded 18.5% to just under $54 a barrel. The 10-year Treasury Bond dropped five basis points to 2.63%. The spread between the 2- and 10-year remained at 18 basis points and is still inversed at the short end of the curve.  The new economy, represented by the Russell 1000 Growth and Russell 2000 Growth indexes, rebounded 9.0% and 11.6% for the month, respectively. Both are starting the year off slightly ahead of the Russell 1000 and 2000 Value indexes.

January’s gains are being fueled by positive resolutions to a number of market concerns. The most important one is fears of rising interest rates, which were calmed by the Fed’s comments to the market this week. Recession concerns are also dissipating as companies report earnings and provide confidence that the economy may be less robust than in recent months but shows no signs of recession. The market still needs the China Trade War to be settled and the Mueller probe to conclude to tamp down the last elements of uncertainty. We think both of these matters are likely to be resolved by the end of the quarter and should set the stage for double digit returns from here for the next 11 months of 2019. The S&P 500 needs to move up another 8.4% to make an all time new high, which we believe we will likely see by year end.

We are in search of the next generation blue chip companies, those companies that can grow several hundred percent in size over time. This is a rare breed for sure, but we have been searching for such companies over the last 25 years and have more than Malcolm Gladwell’s suggested 10,000 hours to develop such an expertise. We believe there are an increasing number of companies that meet our criteria, which are all benefiting from the current golden era of growth environment. This environment has been created by the culmination of a technology savvy generation of Millennials that are increasingly making investment decisions, the rapid dissemination of new ideas enabled by the internet, and global markets that allow every company to go after much bigger opportunities. As we discovered over the last two months, volatility is ever present with this group, but it should enable us to find good buy points in even the most sought-after growth companies.  

Over the last decade, the first Golden Era of Growth beneficiaries, FAANG, drove the performance of the market.  Over this time frame, Facebook stock (FB) advanced approximately 460% (after its challenged 2012 IPO), Apple stock (AAPL) gained approximately 1,190%, Amazon stock (AMZN) increased approximately 2,820%, Netflix stock (NFLX) grew approximately 6,470%, and Alphabet (formerly Google) stock (GOOGL) expanded approximately 570%. This compares to the Russell 1000’s 370% gain and the S&P 500’s 227% advance over the last decade. We think the market is going much higher over the next decade, and that it will be led by the next generation blue chips. We are passionate about finding these next generation growth beneficiaries and believe our long term philosophy will help us capitalize on them. We are very excited about the future, and invite you join us on this journey.

All the Best to You,

AKW

Rage Against the “Yes” Machine

To Our Investors and Friends,

The S&P 500 had its worst quarter since the Great Recession in 2008, down approximately 14%, knocking the last 15 months of gains out of the market. Oil prices (WTI) fell even harder, ending the quarter down 38% to just over $45 per barrel. The 10-year Treasury Bond dropped 37 basis points to 2.68%. The spread between the 2- and 10-year is now 18 basis points and has inversed at the short end of the curve.  The new economy, represented by the Russell 1000 Growth and Russell 2000 Growth indexes, fell 15.9% and 21.7% for the quarter, respectively.  

The reasons for the market correction are clear…fears that the combination of tighter monetary policy and a global trade war will result in a deceleration in the economy, if not a recession.   We believe the severity of the correction can be attributed to the market’s overemphasis on the short term, driven by a combination of quant funds that immediately respond to changes in conditions, and passive investments that don’t respond at all to new conditions.  In fact, we have to go back to 1987 to see what an overreliance on new technology can do to the market when many participants act in unison. The “Yes” Machine is a quantitative algorithm written by humans that is 100% reactive and 0% anticipatory.  These machines do what they are told, with little regard to the price level at which they are transacting.  The effect is amplified when fund liquidations create indiscriminate selling pressure. Although humans are not as fast as machines, they are far better at anticipating what may come next, if given discretion to do so.  In 1987, after the market swoon, there was no recession. In the end, it was a healthy correction within a robust bull market. We think that is the most likely scenario for this correction as well, and we are positioning the strategy with this view in mind.  

Still, the damage has been done. The market needs to regain its confidence, which likely comes with new fundamental information to bolster it. This can be a firming up of trade relations (especially with China), the end of Fed tightening, a resolution of the Mueller investigation into the Trump White House, or simply a reaffirmation of a positive economic outlook one company at a time.  We think this correction process likely lasts through the first quarter of 2019, and likely will be followed by a meaningful recovery in the second half of 2019.  

We will use this correction to first identify and then own companies that have the right ingredients to become the blue chips of tomorrow…the Millennial generation’s Blue Chips.  We think the economy continues to change from one dominated by capital equipment to one dominated by software and services.  The Baby Boomer Blue Chips are largely capital intensive and often subject to boom/bust cycles.  The Millennial Blue Chips are often driven by more predictable subscription software and service businesses that should ultimately be far more profitable.  We are very excited about the future, and invite you join us on this journey.

All the Best to You,

AKW

November’s Tepid Rebound: The End of the Correction?

To Our Investors and Friends,

The S&P 500 rebounded 1.8% in November, roughly 25% of what the market lost in October. Oil prices (WTI) continued to fall, ending the month down 22% to just over $50 per barrel. The 10-year Treasury Bond fell 14 basis points to 3.01%. The spread between the 2 and 10-year is now a mere 20 basis points.  This flattening of the yield curve is certainly causing some investor concern.  Our favorite growth proxies, the Russell 1000 Growth and Russell 2000 Growth indexes, rebounded to finish up .9% and 1.5% for the month, respectively.  Weak oil, continued interest rate concerns, and worries over a potentially escalating trade war suggest that the correction that began at the beginning of the quarter may not be over yet.  

We do not think we are going to have a recession, and believe the evidence so far suggests this market correction is nothing more than a pause in a longer bull market.  The internet revolution is touching just about every industry in profound ways…morphing business models; replacing a focus on lumpy capital spending to more consistent services spending (the software as a service model is the best example of this); and improving management decision-making based on data.  But our concern is that some of the great stocks that drove the market over the last ten years are getting tired, and their leadership is waning.

The stock that most exemplifies this change is Apple (AAPL), which fell 18.4% during the month.  Apple is a mature growth company - its 9% revenue growth rate over the last 5 years is projected to slow to mid-single digits over the next few years (a 50% reduction that may still be optimistic).   The company has a following amongst both growth and value investors, and likely is no longer going to lead the market.   It was a standout over the last 5 years, increasing over 120% vs the S&P 500’s 53% gain.   The company generated $94 billion in cash flow last year and paid out almost $14 billion in dividends (1.6% yield), while buying back $72 billion in stock.   With this kind of cash generation, the stock can participate in market appreciation, but with slowing growth, we don’t think it leads anymore.

Microsoft (MSFT) is a different story and overtook Apple as the S&P’s biggest component this month.   The company has produced revenue growth of around 7% for the last 5 years and accelerated to double-digit revenue growth recently as cloud revenues, which are increasing much faster than the overall company, continue to drive the business.  The company generated almost $40 billion in cash over the last year, paying out $13 billion in dividends (1.7% yield), while buying back a much more modest $11 billion in stock.   Microsoft is investing in its cloud business, which should bolster future gains in revenue and ultimately stock appreciation.

The market is exhibiting behavior that suggests it will consolidate well into the new year before moving higher.   We think the internet-fueled business transformations ultimately drive the bull market forward, but it may take some time for investors to renew their confidence in this, given the ongoing concerns mentioned earlier.  We are using this time to build positions in new, smaller businesses with great potential, that are replacements for some of our long-time winners. 

All the Best to You,

AKW

Market Sinks in October on Trade War Fears

INTRO:

I am launching our first monthly investment letter after the worst month the market has seen all year. The purpose of this letter is to provide some insight into my thought process on stocks, the market, and the economy. I will also spend more time discussing data than speculating on an uncertain future. Market speculation is rampant, and a focus on facts over fiction is more important than ever.

I have a long term view, but will always look to use market fear and greed as opportunities to add alpha to portfolios…by either harvesting profits for winners that no longer offer as much alpha going forward, or adding to positions when indiscriminate selling provides discounted prices.

October 2018 Investment Letter

To Our Investors and Observers,

The S&P 500 sank 6.9% over the month, and would have been closer to 10% had it not been for a market rally over the last two days of the month. Oil prices didn’t recover, and fell 13% for the month. The 10 year Treasury Bond, the best proxy for interest rate impacts on the economy, moved up 10 basis points to 3.15%. Our favorite growth proxies, the Russell 1000 Growth and Russell 2000 Growth indexes, fell 8.9% and 12.7% respectively. This performance was the worst the market has experienced since the summer of 2011.

There are many reasons why this may be happening. The market has become fearful over interest rate increases (which appear minor to me), the prospects for slower growth or recession brought on by a trade war, and fears surrounding the political future of the country. One of these concerns will be resolved on Tuesday of next week, and most likely will lead to a relief rally. The trade tariffs started impacting companies at the end of September, and despite modest changes to earnings guidance (so far), industrial companies like Caterpillar, United Technologies, and 3M sold off on fears that tariffs could significantly impact profits in the future.

Not every stock performed poorly last month. Tesla (TSLA), the leading manufacturer of electric vehicles and our favorite auto manufacturer, was up 27% for the month. Against many Wall Street views to the contrary, the company produced a record amount of vehicles, revenue, profit, and cash flow! Tesla will remain controversial, especially given its mercurial leader. Still, I am impressed with the results….and will look for more of the same in the future.

There were a few other stocks that moved up during the month, but were predominately defensive consumer staple businesses like Coca Cola Company (KO) and Procter and Gamble (PG). For the sake of future economic prosperity, let’s hope Washington and the White House settle this trade war quickly.

As the market declined, I added to positions that I think are undiscovered. Conversations with other investors (that were generally unaware of these businesses) suggest I may be on the right path. I believe undiscovered revenue and earnings power is the fuel to higher stock prices….I think it generally reveals itself during earnings season, and often leads to out sized moves in stocks. As we move through November, the elections and earnings season will end, and hope surrounding 2019 should begin to help stabilize and then advance the market. Although I don’t know if the worst is over, I think we are making our way through this phase of the market.

All the Best to You,

AKW