Mind is Playing Tricks on Me (Part 2)

To Our Investors and Friends,

The S&P 500 Index (S&P 500) increased 2.22% in June, driven by growth stocks for the first time in many months. Oil increased 11% in the month to end slightly over $73 a barrel, reaching a level not seen since 2018. The 10-year Treasury bond declined 13 basis points to 1.45%, as did the spread between the 2- and 10-year, ending the month at 99 basis points, a 29 basis point contraction. After hibernating since last September, large cap growth finally emerged from its slumber, up 6.3%. The Russell 2000 Growth Index increased 4.7%. On the value side, many stocks gave back some of their recent gains. The Russell 1000 Value Index contracted 1.2%, and the Russell 2000 Value Index fell 0.6%.

The economy’s dramatic change from a nearly complete shutdown to rapid reopening driven by a faster than expected vaccine rollout around the world has turned the market’s attention to inflation. Some market strategists have suggested that “reopening related” inflation could be the beginning of high inflation that was last experienced back in the 1970s (as seen in the chart below). Supporting this is a view that US oil production is now hindered by ESG (Environmental, Social, Governance) considerations and could be followed by greater regulations to stem global warming. Oil was a primary driver of inflation in the 1970s, since it is a major expense in the production of all commodities and the primary fuel for an industrial economy. In addition, the returning labor force is demanding higher wages as they re-enter the labor market. Having discovered new freedoms of the “gig” economy, many workers can demand meaningfully higher wages for traditional low skill jobs. Other market strategists have suggested that these pressures are transitory and due to friction that occurs as supply lines are reactivated and inventory restocked. Over time, such re-opening periods spark technological innovation that dramatically increase productivity and offset inflationary pressures.

We believe that Inflation will likely remain a topic of intense debate and has been the narrative supporting value’s superior performance versus. growth over much of the last year. In “Mind is Playing Tricks on Me” Part 2, we examine the popular myth that growth stocks are hurt by inflation, while value stocks benefit (last month, Part 1 attempted to debunk the idea that we are in a second tech bubble). We calculated the stock returns of both leading technology and industrial companies during the 1970s. The stock returns of our technology cohort through the decade are as follows:  Intel (INTC’s IPO was in 1971): 3,040%; Texas Instruments (TXN): 41%; and Hewlett Packard (HPQ): 130%. The stock returns of our industrial cohort were Caterpillar (CAT): 91%; Honeywell (HON): 102%; and Boeing (BA): 440%. Contrary to popular myth, there was no sector-skewed difference in returns between these two groups. As has been the case for decades, stock performance over any meaningful period is directly tied to revenue and earnings growth. For average companies, mature companies with fewer competitors often are more successful passing on price increases than developing industries with many competitors. This slight edge of the average is no match for superior stock picking.

At Kingsland Growth Advisors, we will continue to search for and own what we believe to be the best growth companies. Investors will love these companies some of the time and favor cyclical companies or dividend stocks at other times. We think these robust business models have the potential to produce strong stock performance for the underlying shares over many years. With a long-term horizon in mind, we believe the current correction in growth stocks affords a good opportunity to buy some of the best companies out there at relatively attractive price levels.

All the best to you,

Arthur K. Weise, CFA

Mind is Playing Tricks on Me (Part 1)

To Our Investors and Friends,

The S&P 500 Index (S&P 500) increased 0.6% in May as value stocks continue to move higher, while many growth companies declined for the month. Oil rose an additional 4.3% in the month to end slightly over $66 a barrel, and is now up 35% for the year. The 10-year treasury bond slightly declined in the month to 1.58%, as did the spread between the 2- and 10-year, ending the month at 144 basis points, a five basis point contraction. Value dominated, especially industrial and commodity businesses that plan to increase pricing in the current inflationary environment, a phenomenon that investors have been eager to embrace, no matter how long or fleeting such pressures remain. As a result, the Russell 2000 Value Index increased 3.1%, the Russell 1000 Value Index grew 2.3%, and growth sank…1.4% for the Russell 1000 Growth Index and 2.9% for the Russell 2000 Growth Index.

The economy is dramatically different from a year ago. The second quarter of 2020 was the worst quarter of the COVID-led recession and makes for the easiest comparisons from a growth perspective for a majority of companies, especially travel, brick and mortar retail, and restaurant businesses. In the past week, many retailer’s first quarter reports (ending in April) showed eye-popping same store sales as the recovery charges full speed ahead, boosted by a substantial fiscal stimulus check for lower- and middle-income consumers. We believe the next two quarters will be meaningful in determining what the economy looks like in the future. Some of the changes over the past 12 months might be here to stay while others we will be happy to be rid of. My enthusiasm for flying immediately plummeted last week, the first time I traveled by plane since the pandemic. LaGuardia Airport’s multi-year construction project and long security lines that left us running for our plane was a quick reminder that virtual meetings are a fantastic alternative.

“Mind is Playing Tricks on Me,” an early 90s hit song by the Geto Boys, is a reminder that our minds often alter reality to reflect our desires or fears. When faced with a new situation, our minds often distort reality to help us understand what is happening. In this letter, we are going to answer a question we are often asked: “was last year a growth bubble like the internet bubble over 20 years ago?” We suspect this view is part of the reason why growth has been so violently sold off over the last three months.

We compared the performance of leading stocks from March 1999 through August 2000 (a few months after the peak) to leading stocks from December 2019 through May of 2021 (a few months after the growth peak). We also examined the revenue growth of these same stocks over a 12-month time frame (FY 1999 and FY 2020). Finally, we compared these returns to that of the S&P 500 over the same time frame. The Four Horsemen of 1999 include Oracle, Cisco, EMC, and Sun Microsystems. The 1999 Tech Darlings include Qualcomm, Network Appliance, Broadcom, and JDS Uniphase (bring back memories?). Last year, FANG consisted of Facebook, Amazon, Netflix, and Google (Alphabet), while the 2020 Tech Darlings include Tesla, Peloton, DocuSign, and Zoom Video.

Source: Company reports and William O’Neil’s Panaray database.

So, is it Tech Bubble 2.0? Based on the chart above, it is difficult to come to that conclusion. In fact, stock performance is far more consistent with revenue growth than back in 1999. Twenty years ago, the Four Horsemen returned four times the revenue growth of the S&P 500 and the stocks advanced 17 times as much as the Index. The 1999 Tech Darlings returned 16 times the revenue growth and advanced 67 times the return of the S&P 500. This time around, FANG produced 24% revenue growth versus -2% for the S&P 500 and advanced 66% versus the 30% return of the S&P 500.  The 2020 Tech Darlings produced 126% revenue growth compared to the S&P 500’s -2% return and advanced 374% versus the 30% gain of the S&P 500 over the same time frame. Did the 2020 Tech Darlings get ahead of themselves? Yes. Are they in a bubble? We don’t think so, especially if they can continue to grow into their stock prices (the 1999 Tech Darlings all saw their businesses decline over the subsequent years).

Next month, we plan to examine another popular myth… that inflation is bad for technology companies.

At Kingsland Growth Advisors, we will continue to search for and own what we believe to be the best growth companies. Investors will love these companies some of the time and favor cyclical companies or dividend stocks at other times. We think these robust business models have the potential to produce strong stock performance for the underlying shares over many years. With a long-term horizon in mind, we believe the current pullback in growth stocks affords a rare opportunity to buy some of the best companies out there at relatively attractive price levels.

All the best to you,

Arthur K. Weise, CFA

Investing Lessons from a Pro

To Our Investors and Friends,

The S&P 500 Index (S&P 500) increased 5.2% in the month of April and is off to a robust start to the year. Oil prices rebounded 7.5% in the month to almost $64 from $59. The 10-year treasury bond was relatively flat for the month at 1.65%, as was the spread between the 2- and 10-year, ending the month at a still high 149 basis points. Small cap stocks were relatively flat, while larger companies performed better. The Russell 1000 Growth Index charged ahead 6.8% as technology reasserted itself on strong first quarter earnings results. The Russell 1000 Value Index increased 4.0% in the month, while the small cap Russell 2000 Growth Index was up 2.2% and the Russell 2000 Value Index was up 2.0%.

Cyclical stocks have performed much better than secular growth stocks this year, leading many investors to question whether trends established last year will continue in the future. In search of answers, we decided to revisit a favorite investing book, William O’Neil’s How to Make Money in Stocks, A Winning System in Good Times or Bad. O’Neil studied the traits of the top 600 stock performers from 1950 until 2000 (stocks that achieved gains of hundreds or thousands of percent during their growth runs) and found similar traits among this group. Namely, these companies exhibited a persistence of strong revenue and earnings growth.

The stock market is currently rewarding “recovery” stocks that are exhibiting a sizable bounce from incredibly depressed revenue and earnings levels in 2020. Using William O’Neil’s methodology as a guide, we would argue that it is far more important to examine the recovery from 2019 (the last healthy year) to 2021. If the total number is nicely positive, then the business is truly recovering. If it is still off the 2019 levels, then the market is giving credit for a recovery that may not happen. The next several quarters will help set the stage for what the economy will look like in the future. We will be paying close attention to how potential leaders that revealed themselves last year develop in 2021 and adjust our portfolios accordingly. The next few quarterly results will be crucially important in determining this.

In his book, William O’Neil correctly points out that “industries of the past offer less dazzling possibilities.” He follows with a list of industries, including material companies, transportation companies, energy companies, and department stores. Not surprisingly, these older industries are leading the market this year. We think history will show that such leadership is fleeting, as many of these companies are at the same stock levels that they first achieved decades ago. O’Neil’s industries of the future list include businesses tied to ecommerce and the internet, biotechnology, and software…. the groups that are underperforming this year.  Although it is unclear how long this underperformance will last, we are feel confident that they will return to sustainable leadership before too long. Once they find a better solution, humans tend to stick with it, suggesting that a return to the 2019 way of doing things is highly unlikely.

At Kingsland Growth Advisors, we will continue to search for and own what we believe to be the best growth companies. Investors will love these companies some of the time and favor cyclical companies or dividend stocks at other times. We think these robust business models will produce strong stock performance for the underlying shares over many years. With a long-term horizon in mind, we believe the current pullback in growth stocks affords a rare opportunity to buy some of the best companies out there at relatively attractive price levels.

All the best to you,

Arthur K. Weise, CFA

The Return of the Cyclicals!

To Our Investors and Friends,

The S&P 500 Index (S&P 500) increased 5.8% during the quarter as the market awaits a robust cyclical recovery this year. Oil prices rebounded a robust 25.2% to $61 from $49 at the beginning of the year. The 10-year treasury bond increased 81 basis points (bps) in the quarter to 1.74%, while the spread between the 2- and 10-year substantially widened 71 bps to a rare 151 bps. Expectations for one of the best cyclical recoveries ever led value to decidedly trounce growth. The Russell 2000 Value Index increased 21.2% for the quarter, followed by the Russell 1000 Value Index, which gained 12.2% for the quarter. The Russell 2000 Growth Index increased a more modest 4.9%, while the Russell 1000 Growth Index, which beat large cap value by over 35% in 2020, was up 1.0% in the quarter.

Since last September, the Russell 2000 Value index is up 61%, 28% higher than the Russell 2000 Growth Index over the same time frame. What could possibly justify such a rapid recovery, and the strongest performance versus the growth index in more than 20 years? A cyclical recovery unlike anything we have ever experienced, at least that is what the market is expecting.  As can be seen in the following chart, the top end of the value index is expected to trounce the top end of the growth index this year from a revenue and earnings perspective. After one of the worst economic declines in years, the economy is set up for a meteoric recovery in 2021. In fact, the top 25 companies in the Russell 2000 Value Index are expected to experience a 63% revenue gain and an 87% increase in earnings in 2021. This compares favorably to the top 25 companies in the Russell 2000 Growth Index’s more modest 29% increase in revenues and 80% increase in earnings.

Source: Factset.  As of March 31, 2021.

Why is there such a difference between growth and value stocks? After a horrendous 2020, market leading material companies such as US Steel, Alcoa, and Cleveland Cliffs, which top the value index, are expected to experience an unusually strong recovery in 2021. In fact, analysts increased their earnings expectations of this cohort of the top 25 index holdings, including material, energy, casino, and travel companies by 55% in just the last few months. No wonder the market is selling technology favorites…their steady growth doesn’t hold a candle to the cyclical growth of traditional favorites (at least early in 2021).

At Kingsland Growth Advisors, we will continue to search for and own what we believe to be the best growth companies. Investors will love these companies some of the time and favor cyclical companies or dividend stocks at other times. We think these robust business models will produce strong stock performance for the underlying shares over many years. With a long-term horizon in mind, we believe the current pullback in growth stocks affords a rare opportunity to buy some of the best companies out there at relatively attractive price levels.

All the best to you,

Arthur K. Weise, CFA

The Psychological Impact of COVID-19

To Our Investors and Friends,

The S&P 500 Index (S&P 500) increased 2.6% during the month of February as the market anticipated an economic recovery on the horizon. Fears of a slow oil production ramp-up during this anticipated recovery drove oil prices up a steep 17.8% this month, to end at almost $62 per barrel. The 10-year treasury bond increased 33 basis points (bps) in the month to 1.44 bps, while the spread between the 2- and 10-year widened 30 bps to 130 bps. As would be expected, the anticipation of a rapid economic recovery drove value to significantly outperform growth and small cap to outperform large cap. The Russell 2000 Value Index increased 9.4% for the month, followed by the Russell 1000 Value Index, which gained 6.0% for the month. The Russell 2000 Growth Index increased a more modest 3.3%, while the Russell 1000 Growth Index, which beat large cap value by over 35% in 2020, was flat for the month.

Since the onset of COVID-19 about one year ago, humanity has dramatically changed how we live and work. This has caused people an unusual amount of stress and anxiety, often leading to erratic and sometimes horrific behavior. As explained in Nicholas Christakis’s Apollo’s Arrow, The Profound and Enduring Impact of Coronavirus, stay-at-home orders and a change in daily life has caused people around the world feelings of considerable loss, often leading to depression. “The damaging psychological impact of plague has been known for a long time…the corruption of the mind was much more dangerous during an epidemic than the …air that we breathe around us.” In an attempt to regain control of their lives, many blame others for the disease, instead of the faceless virus itself. We attribute this blame game in part for the attack on the Capitol in early January, and even the erratic trading of GameStop (GME) over the last month as the little guy pushed back against Wall Street (Gamestock anyone?).

Christakis believes that the economy will continue to be impacted by the “clinical, psychological, social and economic shock of the pandemic…perhaps through 2024,” or well after herd immunity is reached and COVID-19 is behind us. The long-lasting psychological impact of the disease will create uncertainty that makes us especially cautious about the market’s assumption that the world is going to quickly return to the pre-2020 economy. We don’t buy it, and instead expect many of the strengths and weaknesses revealed by COVID-19 will inalterably shape our future. The psychological impact of COVID-19 could far outlast the virus which is why we are especially interested in healthcare companies that focus on mental health, an area that we believe will be important to consumers and corporations alike. If we ever want to fully recover from this pandemic, we must compassionately embrace those with depression and anxiety, healing the wounds caused by COVID-19.  

Through all of this, our focus on the digital economy and how it is changing our world remains steadfast. COVID-19 has been the event that has led to mass discovery of what is new and great about the digital world, and what is not working in the brick-and-mortar economy. We think the emerging leaders in the digital space are going to be the next FAANG (Facebook, Amazon, Apple, Netflix, and Google) of the bull market that began March of 2020 – a bull market that we think will create a next generation roaring 20s. This current market correction doesn’t mark the end of COVID-19, but the beginning of something new.

All the best to you,

Arthur K. Weise, CFA

Good Capitalism

To Our Investors and Friends,

The S&P 500 Index (S&P 500) fell 1.1% in the first month of 2021. Oil advanced 7.6% this month to end at over $52 a barrel on the view that demand should improve throughout the year. The 10-year treasury bond increased 18 basis points (bps) in the month to 1.11 bps, while the spread between the 2 and 10-year widened 20 bps to 100 bps. Small cap stocks continued to lead the market higher, a trend that began late last year. The Russell 2000 Value Index advanced 5.3% for the month while the Russell 2000 Growth Index increased 4.8%. Large cap stocks began the year in decline. The Russell 1000 Growth Index decreased 0.7% for the month, and the Russell 1000 Value Index declined 0.9%.

According to Yuval Noah Harari, author of Sapiens, A Brief History of Humankind, Adam Smith’s groundbreaking book, The Wealth of Nations, presented a much better alternative to the economy run by the aristocrats of their day. Capitalists were incentivized by profit to build factories that would provide jobs to workers and cheaper goods to society in a way that benefited everyone. Greater profit meant more money to build, create jobs, and lower prices for all. This virtuous cycle was far better than the wasteful spending of aristocrats that went to finance ornate palaces, ostentatious clothing, and elaborate parties that provided little benefit to the rest of society. For over 200 years, the incentive structure created by capitalism has been the driving force behind economic growth that brought significant numbers of the world’s population out of poverty. In the United States, this virtuous cycle remained present up until the early 1970s, as all levels of society grew their standards of living at a relatively similar rate.

Among many things clearly revealed by COVID-19 is the vast growing disparity between the top and bottom earners in our country. In fact, a recent Washington Post article, “The Covid-19 Recession is the Most Unequal in Modern U.S. History” reveals that the top 25% of workers by income experienced a slight increase in compensation since the onset of COVID-19, and the bottom 25% of workers experienced a 30% decrease over the same time frame, exacerbated by unemployment ranks that grew at eight times the rate of the top 25% of earners. Unlike the economy of 50 years ago, many large corporate leaders have spent much of the last 20 years shedding the lower paying jobs of the many to provide greater income to the few. We believe this has dramatically weakened the foundation of some of America’s oldest blue-chip companies, and like the aristocrats of centuries ago, has opened an opportunity for an economic system that is better for all...which we call “Good Capitalism”.   

Like the early capitalist that created virtuous cycles for society, we believe many leading digital economy companies are doing so now. Shopify (SHOP), Square (SQ), and Etsy (ETSY), among many, are using the tools of the fourth industrial revolution to build businesses that benefit consumers, their workers, and shareholders alike. We believe that these virtuous cycles will continue to drive their businesses forward as many older businesses suffer from the inequities of their own making. We acknowledge that this is aspirational and that inequities won’t disappear overnight, but we think as investors, a greater balance is required for sustainable economic growth.

We saw this past month that current imbalances can lead to unpredictable events – thousands of small investors banded together to topple formidable hedge funds through massive, short squeezes. Technology is a tool that can disrupt current norms and we expect more of these black swans in the future. As good capitalism becomes more dominant, we expect a more sustainable balance in our economy, the environment, and our democratic system.

All the best to you,

Arthur K. Weise, CFA

The views expressed are those of Kingsland Growth Advisors and are not intended as investment advice or recommendation.  For informational purposes only.

A Year of Disruption

To Our Investors and Friends,

The S&P 500 Index (S&P 500) increased 11.7% in the last quarter of 2020, enabling a 16.3% annual gain in a highly tumultuous year. Oil advanced 21% in the quarter to end at over $48 a barrel on the view that demand should improve in 2021. This move reduced oil’s drop for the year to approximately $12 a barrel, or 21% lower than at the end of 2019. The 10-year increased 24 basis points (bps) in the quarter to 93 bps, while the spread between the 2- and 10-year widened a similar 24 bps to 80 bps. We can thank the Federal Reserve’s early monetary stimulus at the beginning of the crisis for the significant increase in the stock market last year and for the noteworthy recoveries in interest-sensitive sectors like housing and autos. Small cap stocks roared ahead in the last quarter of the year, helping this part of the market to catch up to larger companies that posted better returns for much of the year. The Russell 2000 Value Index advanced 33.4% for the quarter while the Russell 2000 Growth Index increased 29.6%. This year-end move helped the Russell 2000 Growth Index to post a 34.6% increase for the year and the Russell 2000 Value Index to post a much more modest 4.6% annual gain. Large cap stocks performed less robustly for the last quarter of the year. The Russell 1000 Growth Index gained a more modest 11.4% for the quarter, finishing the year up 38.5% and the Russell 1000 Value Index advanced 16.3% in the quarter, edging into positive territory (up 2.8%) for the full year.

We have highlighted the stark differences between the digital economy and the industrial economy since the founding of Kingsland Growth Advisors a little more than two years ago. COVID-19 acted as a catalyst to accelerate the digital economy in a way that most could not have anticipated, including us. We think that the strength of the digital age companies will build upon itself, and the weakness of the brick-and-mortar economy and will diminish the importance of many companies in the future. This reshuffling of the economy is ultimately being driven by business transformation enabled by the intelligent tools of the fourth industrial revolution, including artificial intelligence, big data, internet of things (the network of physical objects connected to the internet), robotics, genetics, and other innovations that are shaping how we live and work. Although it is way too early to tell, it is possible that this is the beginning of a new “Roaring 20s” that mimics the changes to the economy that occurred 100 years ago with the widescale acceptance of automobiles, radio, telephone, and electricity that all drove the second industrial revolution.

As can be seen in the following chart, the performance of the members of the S&P 500 revealed the difference between old and new. The youngest cohort experienced tremendous growth after the additions of dynamic businesses like Tesla (TSLA) and ETSY (ETSY) to the S&P 500 late in the year. In fact, the average company in this 25-and-under cohort appreciated 55% in 2020. The 26- to 50-year-old cohort S&P 500 stocks grew a robust 18% in 2020. Of note, Amazon (AMZN) turned 26 this year. Older companies were either only slightly higher or flat for the year as the constituents lost relative ground to their younger peers. At the end of the year, 13% of the S&P 500 weight were companies 25 years or younger; 33% companies between 26 and 50 years old; 23% are 50 to 100 years old, and 31% of the Index weight consists of businesses over 100 years old. The 50-and-under crowd grew from 38% to 46% of the Index weight in 2020, an 8% shift in weight from just one year ago.  What does this mean? Even after the Index added a number of next generation companies last year, the S&P 500 still primarily consists of old economy companies, which likely will continue to provide modest returns in the future.

Chart source:  www.slickcharts.com.

Kingsland Growth Advisors believes that the digital economy is just beginning to transform the overall economy. Even after a robust year for growth stocks, we believe ample opportunity remains for capital appreciation of these new and next-generation blue chip stocks in the future. We will try to continue to position our portfolios for growth and explore new opportunities that will lead the economy of the current decade and beyond.

All the best to you,

Arthur K. Weise, CFA

The Ignorance Tax

To Our Investors and Friends,

The S&P 500 increased 10.8% during the month of November, as news of effective COVID vaccines and an orderly US election created significant enthusiasm for a better 2021 and beyond. Oil blasted higher, up 26.7% in the month to over $45 a barrel on a view that increased demand was just months away. The 10-year fell a modest 4 bps in the month to .84%, while the spread between the 2- and 10-year contracted 6 bps to 68 bps. For the second month in a row, small cap value dominated the market. The Russell 2000 Value Index increased 19.3% in the month, helped by an enthusiasm for cyclical stocks. The Russell 2000 Growth Index gained 17.6%. Large cap indexes did a decent job of keeping up. The Russell 1000 Value Index gained 13.5% and the tech heavy Russell 1000 Growth Index moved up 10.2%.

Reflecting on all the changes we have had to live through in 2020, I am surprised by how so many investors are preparing their portfolios for a return to the world we knew. I think there will be many who pay a high ignorance tax in the years ahead. The Ignorance Tax is a concept we are all familiar with if we are honest with ourselves. A few months ago, my failed Do-It-Yourself efforts to repair a broken dishwasher resulted in me inadvertently destroying the appliance. I paid a few hundred dollars in an ignorance tax…the price paid to replace a dishwasher that was functioning well enough before I got my hands on it.

It is not just the not-so-handy that have been paying an ignorance tax this year. Ego, emotion, and bias are leading many to make poorly informed decisions that are costing them small fortunes, their jobs, and even their lives. The age of COVID is transforming the world incredibly quickly, and many of us are paying a high ignorance tax in our refusal to accept these changes as our new reality. Our very reaction to COVID – many refusing to change their day to day lives – is the most obvious sign of a resistance to accept this brave new world.

In Ludwig and Hess’s Humility is the New Smart, the authors suggest that we need to take our time responding to the onslaught of new data in order to make better decisions. The old way of reacting quickly based on pre-conceived bias or ego will prove even more costly in the era of the fourth industrial revolution. This has been especially true in 2020. COVID is forcing a change in how we work, engage with friends and family, and even vote in elections. Ignoring these changes now and in the future will certainly result in a high Ignorance Tax in the years ahead. The simple assumption that the world will return to normal, the way it was in 2019, at any point in the future ignores all the new data supporting the many changes that have already taken place in our economy. We will spend our time understanding this transformation so that we can capitalize on the future that is yet to come.

All the Best to You,

AKW

And the Winner is…the Digital Economy

To Our Investors and Friends,

The S&P 500 declined 2.8% during the month of October, as a global increase in COVID cases threatened to dampen the recovery, and election jitters impacted investor enthusiasm for stocks. Oil plummeted 11% in the month to less than $36 a barrel as lockdowns in Europe reduced demand. The 10-year increased a robust 19 bps in the month to .88%, while the spread between the 2- and 10-year widened 18 bps to 74 bps. For the first time in a long time, small cap value dominated the market. The Russell 2000 Value Index increased 3.6% in the month, helped by an improved outlook for banks. The Russell 2000 Growth Index gained a more modest .8%. Large cap indexes declined this month. The Russell 1000 Value Index declined 1.3% and the tech heavy Russell 1000 Growth Index dropped 3.4%, likely driven by profit taking ahead of the election.

There is considerable anxiety surrounding this election cycle. The health crisis and economic crisis has done nothing but increase concern surrounding the outcome of the election. We believe the economy and the stock market are poised to move higher over the next four years, no matter what the outcome this week. COVID has revealed the power of the digital economy to support and eventually largely replace the old economy of the brick and mortar world.

Last week, Microsoft’s CEO Satya Nadella stated simply, “The next decade of economic performance for every business will be defined by the speed of their digital transformation.” This economic change is a force that even our politicians cannot prevent, no matter how much their constituents want them to. It empowers corporations to do business where they can maximize their results. Corporations are no longer tied to a city, state, or country to move their operations forward. In fact, a growing number of California-based technology companies are allowing their employees to work wherever they want on a permanent basis. This freedom will certainly help them attract and retain the best employees, thereby accelerating business development and growth of their companies. Those companies tied to a brick and mortar footprint will simply be at a growing disadvantage.

Policy changes can impact business at the margin, but if any company needs government policy to survive, it has already lost. We don’t invest in these old relics dependent on political favoritisms for survival. We focus on the future, and will continue to search for the very best businesses the market has to offer and look to own their shares as long as their opportunities are poised to drive the growth of their businesses. We encourage our investors to take advantage of any dislocation in the market over the next week or so to add to these industry leaders. Their future is bright, and if market depression over political outcomes provides an opportunity to buy their shares at lower levels, we will be there to do so.

All the Best to You,

AKW

Staying on the Sidelines of the Speculative SPAC Craze

To Our Investors and Friends,

The S&P 500 increased 8.5% during the third quarter, as the bull market widened to include industrial stocks along with technology stocks on the view that earnings should accelerate as we get through the COVID crisis. Oil increased 2.4% to end the quarter at over $40 a barrel, a less robust gain on expectations for a slower demand recovery. The 10-year increased a modest 3 bps in the quarter, to .69%, while the spread between the 2- and 10-year widened 6 bps to 56 bps. Growth’s dominance continued. The Russell 1000 Growth increased 13.2% for the quarter, helped by strong performance from mega-cap technology companies. The Russell 1000 Value gained 5.6%, as financials lagged, and energy stocks plummeted. In small cap indexes, similar trends were realized as the Russell 2000 Growth expanded 7.2% and the Russell 2000 Value gained 2.6%.

This has been a year of considerable turmoil driven by the worst pandemic the world has seen in 100 years, the worst economic crisis in 90 years, and the worst social crisis since the 1960s. Possibly the greatest surprise has been the quick reversal of one of the most violent market routs in history…causing a 35% decline over a mere 23 days from mid-February to the end of March. The new bull market is being led by new leadership, which is firmly held by the fourth industrial revolution beneficiaries, those using intelligent tools to provide better solutions for their customers. Enthusiasm for these next generation businesses has spilled over into many areas, some of which are highly speculative…. especially the SPACs.

SPACs (Special Purpose Acquisition Companies) are blank check companies. Management raises money in the market with the purpose of acquiring and making public a private company. Management is incented with a large ownership stake in the SPAC, often 20%, and usually must make the investment within a predetermined time frame. Failure to make the investment, or get shareholders to approve of the investment, results in a return of capital as the SPAC is dissolved. Shareholders have the right to approve or disapprove of the investment and can sell their shares at any time, making such an investment more liquid than private equity or venture capital.

As can be seen in the Chart below, the new bull market has ushered in a speculative SPAC frenzy that has resulted in more than $80 billion in capital raised over the last year. There are now over 140 publicly traded SPACs, of which 65 became public after the market’s March bottom.

Source: William O’Neil database.

We think the SPAC craze is indicative of the public’s desire to get in on new companies early in their development. We are avoiding them, however, because they fail to meet our investment criteria. SPACs are likely the most speculative investments out there, because the SPAC investor has only a rough idea of what management intends to invest in and is completely dependent on that decision to make a return. The company that is receiving the investment is getting a very large amount of money early in its lifecycle, which heightens the prospects that bad decision-making squanders it away. This compares to venture capital investments that typically have multiple funding rounds that provide growth capital to companies over time.

We will continue to search for the very best businesses the market has to offer and look to own their shares as long as their opportunities are poised to drive the growth of their businesses. Unlike SPAC investments, these founder led businesses have been fully vetted by existing customers and public investors, dramatically reducing the chance that negative surprises present themselves like we recently witnessed with the most famous of recent SPAC investments, Nikola (NKLA).

All the Best to You,

AKW