The New Economy is Dealing with COVID-19 Better than the Old

To Our Investors and Friends,

The S&P 500 decreased 20.0% in the first quarter as the COVID-19 pandemic quickly pushed the world economy into recession. Oil prices (WTI) plummeted 66.5% to $20 a barrel as Saudi Arabia and Russia decided to meet falling demand with more supply. The 10-year collapsed 118 basis points during the quarter to end at 0.70%, while the spread between the 2- and 10-year expanded to 47 bps. Demand for treasury bonds is now only exceeded by demand for toilet paper during the current health crisis. Growth’s dominance continued even as the market plummeted. The Russell 1000 Growth fell 14.1% in the quarter, while the Russell 2000 Growth dropped a more severe 25.8%, given that smaller companies are less liquid. Value’s higher energy and financial weights caused this group to fare even worse. The Russell 1000 Value fell 26.7% and the Russell 2000 Value fell 35.7%.

We have long held the view that industrial era businesses are slowly losing share to new companies that are more technologically savvy and less capital intensive. COVID-19 will likely act as a catalyst to an acceleration in growth of the digital economy, at the expense of the brick and mortar economy. As can be seen in the chart below, it is clear that younger businesses fared far better than older ones in the first quarter. Noteworthy, are market leaders Apple, Microsoft, and Amazon (now 26 years old) powered the 26-50 year old cohort to the best performance. The over 100 cohort was helped slightly by a number of industrial era food companies benefitting from pantry hoarding, a phenomenon we believe likely ends as the crisis abates.

Looking back at the 2008-2009 financial crisis, new leadership bottomed early, and then drove the market higher with the birth of the next bull market. Now is the time for investors to adjust their portfolios and get ready to prepare for the next bull market. It will be quite volatile at times, but will be well worth it over the long haul.

All the Best to You,

AKW

Weighing the Effects of the Coronavirus on the Digital Economy

To Our Investors and Friends,

The S&P 500 fell 8.4% in February as the Coronavirus spread globally and now threatens to lead the global economy into recession. Oil prices (WTI) continued their decline from the previous month, down 13% to less than $45 a barrel as canceled air travel routes and the postponement of major conferences and events threaten to curtail oil demand. The 10-year dropped 38 basis points during the month to end at 1.13%, the lowest level ever recorded. The spread between the 2- and 10-year is 27 bps. The effective FED funds rate is 1.58 bps and again is creating an inversed yield curve, which often foretells of recession. All indexes turned sharply negative at the end of the month. The best performing major index, the Russell 1000 Growth, declined 6.8%. The Russell 2000 Growth was down a sharper 7.2%.  Financial and Energy stock declines led to much worse performance for value. Both the Russell 1000 Value and Russell 2000 Value indexes fell 9.7% for the month.

Oftentimes, a crisis can accelerate a trend or create a new one. Two hundred years ago, the eruption of Mount Tambora in Indonesia darkened the sky and led to the year without a summer in 1816, causing a worldwide famine. Without enough to feed them, horses were slaughtered by the thousands. In need of a new form of transportation, the bicycle was invented. More recently, the great recession of 2008 and 2009 forced many to abandon their expensive Starbucks cup of premium coffee in favor of the much more affordable Keurig K-Cup. During the same time, millions of newly unemployed people sought out new fortunes by creating their own businesses. The resulting explosion of entrepreneurs helped launch consumer retail software platforms such as Shopify (SHOP) and ride sharing giant Uber (UBER).

Make no mistake, the Coronavirus is a serious health concern for segments of the population. However, from a business perspective, we think it could accelerate existing trends and create new ones that will continue to advance Fourth Industrial Revolution beneficiary companies at the expense of older companies. Telecommuting and telemedicine are certainly going to see faster growth in the future as individuals are forced to try new alternatives to both work and doctor visits. Migration to the cloud likely accelerates because the data center model will have trouble dealing with this new way of working. In education, online services are being adopted as a supplement and possible replacement for in-class education. Finally, governments are likely to pick up their spending on mass communication systems to help better prepare the public for future outbreaks.  

Our search continues for transformational businesses…those companies that offer superior solutions to what currently exists. Such companies generally experience rapid revenue growth that eventually leads to even faster earnings growth, although oftentimes later in the company’s life cycle. There is frequently an unanticipated accelerant to these businesses that allow them to emerge bigger and better than previously thought possible. We hope that the coronavirus is not nearly as bad as currently feared, but nevertheless will use this time for more intensive discovery.

All the Best to You,

AKW

Price Momentum Built with Straw or Brick

To Our Investors and Friends,

The S&P 500 fell .2% in January as a combination of Corona Virus and an impeachment trial spooked the market at the end of the month. Oil prices (WTI) plummeted almost 16% to $52 a barrel as concerns over a slowdown in China dominated the commodity. The 10-year dropped 37 basis points during the quarter to end at 1.51%, a level not seen since last fall. The spread between the 2- and 10-year fell to 18 bps. Large companies performed far better than small. The Russell 1000 Growth led the market, up 2.24% driven by strong tech earnings. This far exceeded the 2.15% decline in the Russell 1000 Value, as financials and industrials gave back some gains earned at the end of last year. In the small cap space, the Russell 2000 Growth fell 1.1% and the Russell 2000 Value dropped 5.4%.

Earnings season has begun and is largely revealing continued strong growth for many new sectors of the economy, led by technology companies such as Microsoft (MSFT) and Apple (AAPL), and continued weakening trends in many industrials – most recently Boeing (BA) and Caterpillar (CAT). Not surprisingly, the stock market is again reflecting these underlying trends.

Over the last decade, the number of quantitative strategies available to investors has exploded. Many of them rely on price momentum as a primary factor in their algorithms from which they base their buy and sell decisions. We are seeing early in 2020 that not all price momentum is the same. In fact, speculative price momentum, in which market price is anticipating a change in trends, drove the performance of industrials and financials in the last few months of 2019. This is price momentum using a fragile material such as straw as its foundation…. quick to construct, and equally quick to fall apart. Price momentum built on fundamentals is using brick as its foundation…it often takes longer to build, but is far more durable as market fears materialize. In fact, Robert Novy-Marx’s paper Fundamentally, Momentum is Fundamental Momentum (https://www.nber.org/papers/w20984) points out that earnings momentum is the primary determinant of stock momentum, and that price momentum strategies absent of earnings momentum give investors high volatility without better performance.

Our search continues for transformational businesses…those companies that offer superior solutions to what currently exists. Such companies generally experience rapid revenue growth that eventually leads to even faster earnings growth, although oftentimes later in the company’s life cycle. Next generation businesses are using a customer-centric approach that leads to predictable, ongoing customer relationships that produce steady revenue and earnings growth over a span of years. In the end, these strong customer relationships are the bricks used to build predicable revenue and earnings streams that lead to higher stock prices over time.

All the Best to You,

AKW

A Decade of Technology Leadership That is Here to Stay

To Our Investors and Friends,

The S&P 500 increased 8.5% in the fourth quarter as concerns surrounding the potential for an economic slowdown dissipated during the quarter. Oil prices (WTI) increased almost 13% to $61 a barrel as economic growth around the world picked up modestly. The 10-year increased 24 basis points during the quarter to end at 1.92%, while the spread between the 2- and 10-year expanded to 34 bps, the widest seen since the beginning of the year. Small caps led the market in the final quarter of the year. For the quarter, the Russell 2000 Growth finished up 11.4%, modestly beating the Russell 1000 Growth up 10.6%. On the value front, the Russell 2000 Value expanded by 8.5% and the Russell 1000 Value returned 7.4%.

Many market participants have spent a lot of time and effort arguing that value should begin to beat growth on a sustained basis. We don’t share this view because we think the difference in performance between the different styles is driven by real, sustainable economic change.

Over the last decade, the Russell 1000 Growth Index increased by 312%, driven by a handful of technology companies now commonly referred to as FAANG – Facebook, Amazon, Apple, Netflix, and Google (now Alphabet) – which all experienced much faster stock appreciation than the index (led by NFLX up over 4000%). The Russell 1000 Value increased a more modest 205%, and the S&P was up 190%. Customer-centric companies are using the tools of the fourth industrial revolution to create better businesses than those they are replacing. This trend is set to continue and is being bolstered by an emerging consumer that is seeking advanced technology to simplify their lives. This technology has an added benefit of keeping inflation at bay as sharing services reduce demand for the asset heavy products produced by the previous industrial revolutions. The chart below highlights how these younger companies have grown materially faster in both revenue and stock appreciation than their older peers.

Revenue and stock appreciation of the top 250 S&P 500 companies over 10 years

We don’t expect FAANG to dominate the indexes’ performance over the next decade but believe that a new crop of technology leaders will follow in the footsteps of these established companies. New tools such as artificial intelligence, nanotechnology, and big data analytics are being used to reshape our world. Our effort is focused on identifying and owning these companies that we believe will drive returns over the Roaring ‘20s.

All the Best to You,

AKW

The Challenges that Come with Being Disrupted

To Our Investors and Friends,

The S&P 500 increased 3.4% in the month of November as concerns of an economic slowdown dissipated, and investors began to focus on a stronger 2020. Oil prices (WTI) increased almost 2% to $55 a barrel. The 10-year increased modestly to 1.78%, while the spread between the 2 and 10-year remained at a more recent norm of 17 bps. The Russell 2000 Growth took the lead this month, increasing 5.9%. The Russell 1000 Growth finished up 4.4%. The Russell 1000 Value expanded by 3.1% and the Russell 2000 Value returned 2.3%. 

Older companies are being forced to change their business models to adjust to their newer, cooler competitors. Disruption usually impacts businesses when a cheaper, simpler, and faster model is introduced to the marketplace, challenging the status quo. The challenges became apparent for two companies this month as they introduced their answer to these disruptive forces. Disney (DIS) introduced the Disney+ service to compete with Netflix (NFLX), and Ford (F) introduced the Mustang Mach E, an all-electric version of their Mustang Muscle Car, to compete with Tesla (TSLA).

Bob Iger once said that if someone is going to “eat their digital lunch, it might as well be them.” Disney+ was launched this month as a response to Netflix’s popular VOD service. The new service has a similar layout and functionality with some obvious shortfalls. The content consists of a library of animated and live-action films and television shows from Disney’s more than 90 years in the entertainment business. Still, the content is just a fraction of Netflix’s offering, and a large amount of it appears dated and irrelevant to today’s global consumer. The most relevant content, Disney’s most recent releases, are not on the service until they complete their DVD windows for consumer purchase at retail. And here is where the problem begins. In the end, Disney must compete with itself in order to move forward. Old content monetization methods such as movies at theaters and for purchase or rent options are all under fire, without which Disney is a much smaller and less profitable company. I don’t know what impact Disney+’s service will have on Netflix, if any, but I do know that it will be very harmful to Disney’s legacy business as consumers realize they no longer need to buy the same content multiple times.

Ford’s Mustang 2021 Mach E (Tesla purposely doesn’t have model years) will be available for purchase in about a year. It has a familiar touchscreen console in the middle of the dash, and is similar to the Tesla in both range and acceleration. Unlike the Tesla, it produces a sound reminiscent of a roaring engine. What is missing, however, is wireless updates and autonomous features that really put the Tesla in a class by itself. The biggest challenge Ford will face is that the dealer network, which serves as Ford’s entire distribution channel, is going to be left wanting. Electric vehicles do not require oil changes and require minimal maintenance. Dealers make almost all of their money through both service and financing. It is likely they will either need to be heavily incented to sell the electric vehicles, or will simply steer the consumer to those vehicles that will maintain their profits.

We believe these types of challenges will pressure both the revenue and profits of old blue chip companies while the challengers are growing their revenue and profits with scale. In the end, few of the old guard will thrive, and many will not survive. We welcome you to join us on the path of discovery of the next generation blue chip companies, those using the tools of the Fourth Industrial Revolution to disrupt the old industrial base.

All the Best to You,

AKW

A Decade of Growth has Changed the Economy

To Our Investors and Friends,

The S&P 500 increased 2.0% in the month of October, heavily influenced by a handful of mega cap stocks including Apple (+11.1%) and Facebook (+7.6%). This continues a trend that has been in place for the last decade. Oil prices (WTI) remained flat at $54 a barrel. The10-year remained within a fairly tight range, closing 1bp higher for the month to 1.69%, while the spread between the 2 and 10-year widened to a more recent norm of 17 bps. The Russell 1000 Growth continued to lead the market, up 2.8%, driven by large cap tech noted above. The Russell 2000 Growth was up about 2.4% as semis rebounded strongly. The Russell 2000 Value returned a similar 2.4% driven by utilities, REITS, and financials. The Russell 1000 Value rebounded the least, up a less robust 1.4%.

We are struck by how much the economy has changed over the last decade. Since the end of the financial crisis, the youngest companies in the S&P 500, many harnessing the power of intelligent tools of the fourth industrial revolution, have grown from a mere .6% of GDP to over 3%. As indicated in the chart below, more mature companies like Microsoft and Apple (which drove the gains in the market this month), have helped the 26 to 50-year old cohort of companies grow from approximately 5% of GDP to approximately 8% of GDP. Over this same period, companies over 100 years old (many financials and the leaders of the second industrial revolution), are losing their economic relevance within the economy. According to our analysis of S&P 500 members, these companies have seen their contribution to GDP fall from 27% to 22% since the financial crisis.  

We believe that the economic trends that have been in place for the last decade remain firm, and will only expand from here. We believe that the stock market has only begun to recognize the changes brought about by digitization of the economy, and that these young growth companies can become considerably larger. We will continue our efforts to invest in the beneficiaries of the Fourth Industrial Revolution, those companies that we believe can become the country’s next generation blue chip companies. This group can be volatile at times, as has been demonstrated in the last few months, but should drive meaningful returns over time. We welcome you to join us on this journey of discovery.

All the Best to You,

AKW

The Problem with the IPO market

To Our Investors and Friends,

The S&P 500 increased 1.2% in the third quarter, slightly lower than the record high seen in July. Oil prices (WTI) dropped over 7% to $54 a barrel as global growth continues to slow, despite an attack on Saudi oil facilities a few weeks ago. The10-year fell to a quarter low of 1.47%, before rebounding to close the month at 1.68%. In the US, the spread between the 2- and 10-year is a mere 0.05%. This resulted in a predictable continuation of trends in the large cap Russell indexes - the Russell 1000 Growth index increased 1.5%, and compared favorably to the Russell 1000 Value’s 1.4% increase. The small cap space behaved much more unpredictably as this year’s best performing stocks were sold off in September, while the worst performing stocks rebounded strongly. The net result was the Russell 2000 Growth index fell 4.2% in the quarter, while the Russell 2000 Value index fell a more modest 0.5% in the quarter.

September was full of surprises that went well beyond the headlines regarding the escalating China trade war and impending impeachment inquiry. Most notable was the IPO market itself, which went from inviting to hostile very quickly.

Over the last decade, IPO investing has changed from an orderly process of transferring ownership from private hands into public hands to something considerably more chaotic. After the financial crisis, many long-term investors sought better risk adjusted returns through allocating more capital to the private markets. The result was an explosion in money slated to both private equity and venture capital. Traditional pubic investors in IPOs, meanwhile, are dramatically shrinking as assets move from active managers to passive managers. It gets more complicated, because many large active managers exhaust their demand for IPOs by buying shares in the private marketplace before the companies go public.  Passive investment vehicles largely do not invest in new issues for a period of time after the IPO. Who is left? The fast-acting hedge fund community that judges each investment on incredibly short-term criteria.

The changing dynamics of a larger private market transferring ownership to a smaller, more short-term public market can lead to much greater volatility. IPOs now have fluctuating initial offering price ranges, insatiable initial demand, and then massive stock volatility immediately following the offering. The last few weeks have been characterized by IPOs that immediately trade off in the public markets. Peloton (PTON) and Smile Direct Club (SDC) reversed course very quickly once going public. WeWork decided to postpone their IPO as the $47 billion private valuation was whole heartedly rejected by the public markets.

We believe the best way to approach this new world is with caution and patience. There is no reason to rush in when the investor base is so fleeting. A patient, well-informed investor should be able to translate short-term rapid market dislocations into better long-term returns. For those that have a long-term time horizon, we welcome you to join us on this journey.

All the Best to You,

AKW

A Volatile Market is Driven by More than Recession Fears

To Our Investors and Friends,

The S&P 500 fell 1.8% in the month of August, off a record high in July. Oil prices (WTI) dropped 6% to $55 a barrel as global growth slows, and supply remains robust. The most significant change in the markets came from the bond market, where the yield curve continued to fall. The 10-year govt bond dropped to 1.5% from 2.1% one month ago. We believe this is being driven by pressures on rates throughout the globe, driven in part by a slowing economy worldwide. One meaningful example, the German 10-year, dropped to negative .7% from negative .4% a month ago. In the US, the spread between the 2- and 10-year is now essentially 0.0%. This is a very bad scenario for bank profits, but has not caused a lack of credit availability, and therefore may not be a precursor to a recession.  The Russell 1000 Growth index fell 0.8% and the Russell 2000 Growth index fell 4.3% in the month, both continuing to beat the bank heavy Value indexes by approximately 2% and 1% respectively.

Globalization, aging demographics across the world, and a changing economy driven by the introduction of new ways of communicating and transacting are all playing a part in influencing global markets. All markets will eventually reflect the new economic realities driven by these forces. Volatility in markets is being influenced by another major change… technology is reshaping both the participants in markets and how markets are correlated worldwide. 

After the financial crisis, financial institutions began to dramatically reduce their ranks. Algorithms first assisted and then replaced thousands of human traders at an unprecedented rate, and continues at a rapid pace more than 10 years after the financial crisis ended. These new computer programs are vastly simpler than their human counterparts. New information triggers trading to buy or sell underlying assets, with little regard for the longevity of the decision or whether the market already reflects the new information. The end result is rapid one-way directional trading. We have witnessed individual shares move much more dramatically than in the past on less meaningful fundamental information. A single-day 10-20% stock move is now commonly a 20-40% single-day stock move.  As you can imagine, exaggerated moves lead to a less efficient market, and therefore a growing opportunity for long-term investors.

We believe that the best way to approach rapidly vacillating markets is with a long-term approach. A patient, well-informed investor should be able to translate short-term rapid market dislocations into better long-term returns. Our research efforts extend well beyond what is occurring, focusing more on why it is occurring. We believe this should allow us to take advantage of market opportunities while many are simply reacting to the latest tweet.  For those that have a long-term time horizon, we welcome you to join us on this journey.

All the Best to You,

AKW

A Golden Age of Superior Customer Solutions

To Our Investors and Friends,

The S&P 500 advanced to a record high in July, finishing up 1.3% after a sell off on the last day. Oil prices (WTI) remained at the same $58.50 level. The 10-year Treasury Bond moved up modestly 3 bps to 2.04%. The spread between the 2- and 10-year narrowed to 17 bps. On the last day of the month, the Fed lowered rates by 25 bps, acknowledging that their previous moves may have been too aggressive.  The Russell 1000 Growth index expanded 2.3% and the Russell 2000 Growth index grew .9% in the month, both continuing to beat their respective Value indexes by about 1% each.

The market has been volatile since the start of the year, which we think is, in part, due to an underlying shift in the economy. Shifts like this can lead to significant change. There have been many Golden Ages throughout history, but one of the most notable took place in Spain after Christopher Columbus returned from the New World. In his book Secrets of Sand Hill Road, Scott Kupor describes Queen Isabella of Spain as one of the first venture capitalists. She provided capital in the form of money, ships, supplies, and a crew to Columbus to do something very risky that most would not have attempted. In return, she wanted all trade from the New World to go through Seville, Spain as well as a cut of the profits. The Golden Era that followed lasted for more than a hundred years, only ending after the river to Seville began to silt up and could no longer accommodate ocean vessels.

Although there are huge differences between this first venture capitalist and today’s VC community, there are certainly some similarities. Several hundred years ago, Europeans used technology to change the course of history. Today, new companies are using innovative technologies and creativity to devise better customer solutions. These solutions attract new customers, who both happily abandon their previous solution and tell all of their friends about the better solution. Like the spice traders failed efforts to hold onto their trade routes, the product-centric businesses of the industrial revolution are struggling to hold onto their customers.

I experienced this customer struggle first hand coming back from Seville a few weeks ago. Traveling on a major airline back to the US, the final leg of the trip was cancelled due to poor weather. Originally scheduled to arrive in New York by 6 pm Thursday, the airline rescheduled me to arrive at 10 pm the following day. Only three hours by car from home, I first inquired at a number of rental car firms about renting a car. Seeing the opportunity to capitalize on the weather, the rate doubled from $200 to $400 while I was waiting for confirmation. Disappointed, I was able to find an Uber driver happy to drive me in stormy weather the three hours home for $300. This is a clear example of the superior customer-centric solution taking business away from the inferior product-centric model that seeks to maximize profit at the expense of the customer. Guess who I am calling first the next time I am in a similar situation?

As we spend more time cultivating our growth strategies, we have begun to specifically seek out customer-centric businesses. It is no surprise that some of the best emerging business missions are centered around helping customers succeed. Shopify (SHOP) reported their results on the first of August, and spent a significant amount of time discussing how they are developing tools with the sole purpose of making their customers more successful. Don’t you wish all companies ran their operations with a similar mindset? It helps explain the wild success they and other customer- focused businesses are having.

All the Best to You,

AKW

An Increasingly Customer-Centric World

To Our Investors and Friends,

The S&P 500 finished the second quarter up 3.8%, ending close to an all-time high as the trend towards global easing continued. Oil prices (WTI) fell 2.8% over the same time frame to approximately $58.50, as signs of a global slowdown increased in the face of trade tensions. The 10-year Treasury Bond continued to slide in the quarter to 2.01%, a 41 bp drop from the end of last quarter. The spread between the 2- and 10-year widened to 26 bps, and the short end of the yield curve has become even more severely inverted.  Throughout the quarter, the stock market lurched in an 8% range as trade fears and signs of an economic slowdown were offset by anticipation of rate cuts and a continuation of easy monetary policies.  The Russell 1000 Growth index expanded 4.6% and the Russell 2000 Growth index grew 2.8% in the quarter, both continuing to beat their respective Value indexes by about 1% each.

We believe a next generation of businesses is emerging that is making great use of the tools provided by the Fourth Industrial Revolution, such as Artificial Intelligence, the Internet of Things, and Next Generation Data Analytics, driven by the combination of expansive data sets and low-cost computational processing. These leading companies have new business models that are customer centric, instead of the product-centric business models of the previous industrial revolutions. Subscription-based models are often success-based revenue models – the value of the customer relationship grows as the customer benefits from the subscription-based technology. This close relationship between a business and its customer refocuses research and development efforts to be driven by customer feedback and need, instead of speculation. In the end, decision making is data driven and vastly more efficient than the guess work of the past.

We think that the more the economy is driven by customer-centric businesses, the less cyclical and capital-intensive the economy becomes. Stability and predictability replace the speculative behavior of the past and should ultimately lead to stronger businesses that the market values more. When a business moves from a single transaction with the customer to an ongoing relationship, the investor’s focus should move from unit economics to annual recurring revenue and customer relationship longevity. Leading businesses that are helping their customers succeed start the year with 90-95% of the previous year’s revenue and build from there, driving both high and predictable revenue growth rates.

Our previous studies have suggested that new businesses, those less than 25 years since their founding, are much more customer centric than ones that have existed for much longer. Our portfolio has an average age of about 22 to 23 years, but primarily consists of businesses that are between 10-20 years old. We will continue to focus on this part of the market and expect that high and predictable revenue growth will lead to larger businesses and stocks over time.

Kingsland Growth Advisor’s lead strategy, the Long-Term Growth strategy, continues to build on a successful start. The strategy seeks to identify and own the next generation blue chip companies, those businesses that have the ability to grow 500-1000% over the next ten years.  The stock selection process we employ to successfully identify such companies is the result of 25 years of growth investing in the best opportunities available to the public markets. The strategy is up 41.4% YTD and compares favorably to the Russell 2000 Small Cap Growth index, which expanded 20.4% over the same time frame. Over the last year, the strategy is up 26.0% vs a decline of 40 bps for the Russell 2000 Growth Index. This strong beginning suggests to us that our focus on customer-centric business models may be a good focus. If our observations on the changing economy prove accurate, we would expect we can continue to deliver on our goal of meaningful capital appreciation. We welcome you to contact us to learn more about how we search for great growth companies that will emerge from the Fourth Industrial Revolution.

All the Best to You,

AKW