Q4’2017 Year-end Review and 2018 Preview

2017 was a banner year for US equity markets with the S&P returning 21.83% and the technology sector leading the way. Markets rose steadily through the year, which stands in stark contrast to the four distinct periods experienced during 2016. First and foremost, it is essential to emphasize that years such as this are not repeatable and in effect are the result of pulling returns forward from future years. We explained this reality in our 2013 year-end commentary in a way that is worth repeating:

While we did not see the economy’s traditional metrics of success reach “normalized” levels in 2013, it has been clearly positioned for the long awaited, but elusive escape-speed breakout from the Great Recession.  In many respects, the stock market has now surpassed the real economy in its estimation of improvement.  Given that reality, it is quite possible, almost probable that 2014 will be a better year for the economy than it will be for the stock market.

One reality we all must accept is how great years in the stock market tend to borrow from future returns, rather than enhance them.  Heading into 2013, one could have reasonably expected to earn an annualized return of 6.67%  – on par with the market’s average since 1925 – over the course of the next decade.  The S&P 500 started 2013 at 1426.  Factoring in a 6.67% annualized return the index would be at 2720 at the end of ten years.  Assuming that despite last year’s near 30% return, this 2720 ten year S&P index target does not change, the expected return over the next nine years would be 4.39% annually, instead of 6.67%.[1]

In many respects, 2017 is the year that should have happened in 2016 for stock markets. The path to the underlying drivers of economic strength were all paved in advance of this actuality. That said, there were some unique stories that accompanied the market’s ascent along the way which we will cover below. It would be impossible to talk about 2017 in financial markets without broaching the topics of Bitcoin and tax cuts.

Throughout the year, Bitcoin and its fellow cryptocurrencies performed exceptionally well; however, in the fall, the crypto world seemingly captured the imagination of everyone. This peak in interest corresponded with pronounced strength into Thanksgiving and the imminent launch of Bitcoin futures contracts at the CME. The innovation behind Bitcoin, specifically the blockchain, is fascinating and holds tremendous potential; however, as often happens in markets, what started as a story backed by a solid fundamental thesis has warped into a speculative frenzy the likes of which we have not seen in nearly two decades.

The passage of tax reform towards the end of the year added the final bit of gas to propel markets higher. More interestingly, tax reform helped inject a greater degree of dispersion into financial markets than we have seen since before the crisis period. We think tax reform as a topic has been thoroughly picked over by the mainstream media; however, we would like to add a few incremental points to the conversation that often end up omitted:

  1. Think of industries and the playing field within industries on a sliding scale of competition from perfect competition to monopoly. The closer to perfect competition a given industry is, the less impact tax reform will have on the earnings power of the various businesses. It is only for those businesses who face a smaller degree of competition that tax reform will make a meaningful long-term impact on earnings power and thus valuation.
  2. One exception to the above is the situation of legacy retail competing with Amazon (NASDAQ: AMZN). While the prevailing forces are strong and hard to mitigate (i.e. the secular move of brick-and-mortar retail sales to ecommerce), tax reform is uniquely supportive of the legacy retail sector. Think of it as follows: Amazon manages its income statement to invest all profits in growing its business and as such, realizes little to no reported net income. With almost no net income, Amazon is not a Federal corporate income tax payer. In contrast, despite retail’s woes, the retailers generate considerable earnings and pay a higher tax rate than the average S&P constituent by virtue of having predominantly domestic businesses. Simply put: Amazon gets no benefit from tax reform, while legacy retailers get considerable benefit. This does not mean retailers can change the inevitability of the tide flowing from brick-and-mortar to online; however, it does mean that retailers will have proportionately more resources to dedicate towards competing with Amazon.

Bitcoin and the Superexponential Price-Mediated Feedback Loop

The following is a chart of Bitcoin on a logarithmic scale from the beginning of 2015 through the end of 2017:

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The chart cleanly moves in the up and to the right direction, but there are two additional observations worth making:

  • The Y-axis—it does not move up 1 unit at a time, but instead jumps according to a scale factor a little shy of 2. This is a power law in action, just like the Richter Scale for earthquakes whereby each 1 unit up the scale has 10 times the amplitude of the 1 before it (ie an earthquake that registers 7 on the Richter Scale is 10 times as strong as an earthquake that registers 6).
  • The moving averages—look at the magenta, green and yellow lines following the price higher. These lines have a parabolic arch and are curved instead of straight. A straight line from bottom left to top right on a log chart shows something increasing at an exponential rate. A curved, upward-sloping line on a log chart shows something growing at a superexponential rate.

Very rarely in financial markets do we see something maintain a superexponential arch for so long. These phenomena are rare for a reason and deserve attention when they happen. In addition to being rare, they are also unsustainable. Stated simply and bluntly: this is exactly what bubbles look like. In 2017 one of the best books we read was Scale: The Universal Laws of Growth, Innovation, Sustainability, and the Pace of Life in Organisms, Cities, Economies and Companies by Geoffrey West. West is a theoretical physicist and professor at the Santa Fe Institute who has studied scale and growth in great depth. West’s explanation of the consequences of superexponential growth are incredibly relevant to Bitcoin:

[Superexponential] growth behavior is clearly unsustainable because it requires an unlimited, ever-increasing, and eventually infinite supply of energy and resources at some finite time in the future in order to maintain it. Left unchecked, the theory predicts that it triggers a transition to a phase that leads to stagnation and eventual collapse…

…there has to be a transition from one phase of the system to another having very different characteristics, analogous to the way the condensation of steam to water which subsequently freezes to ice epitomizes transitions between different phases of the same system, each having quite different physical properties….Unfortunately, for cities and socioeconomic systems the phase transition stimulated by the finite time singularity is from superexponential growth to stagnation and collapse, and this could lead to potentially devastating consequences.

….A major innovation effectively resets the clock by changing the conditions under which the system has been operating and growth occurring. Thus, to avoid collapse a new innovation must be initiated that resets the clock, allowing growth to continue and the impending singularity to be avoided.

….to sustain open-ended growth in light of resource limitation requires continuous cycles of paradigm-shifting innovations.[2]

There is a lot to unpack in the preceding excerpt. The most obvious point that carries through the entire section is the unsustainability of superexponential growth. The subtle point that we would like to expound on is the energy needed to drive Bitcoin. Bitcoin requires two essential forms of energy to move upwards:

  1. It needs net inflows of money.
  2. It requires increasing amounts of power to maintain the network.

We won’t go in detail on the power needs necessary to fuel Bitcoin, because the actual energy is the area most ripe for an innovative phase change that can engineer sustainability. This is not the case on the money side in any reasonable timeframe. (If you are interested in reading on the power requirements of the network, Wired offered a great primer in December titled “How much energy does bitcoin mining really use? It’s complicated.”)[3] The higher Bitcoin goes on this superexponential trajectory, the more money it requires to keep driving it. Price moves based on simple supply and demand. With an essentially finite supply, each new dollar coming in is used to cash out an existing holder. In other words, the newest investors in Bitcoin in effect are cashing out the earliest holders of Bitcoin who are intent on holding unless and until it hits a price worth selling at. If this sounds a little like a ponzi scheme it’s because there are very real parallels, though that is likewise the case with any bubble. This is the essence of speculative markets where the intent of the buyer is not to  value the fundamentals underlying the asset, but instead to participate in the Keynesian Beauty Contest in search of a “greater fool” who will eventually pay a higher price.

Bitcoin today is in what Soros calls a price-mediated feedback loop. The newest buyers of Bitcoin are not people with a fundamental understanding of the technology or even a basic theory on what it might be worth. Speculators are merely buying because the price has gone up a lot with the hope that it continues to go up a lot. Elliot went into great detail on this in a blog post titled “The Rise and (Inevitable) Fall of Bitcoin.” [4] We covered a similar phenomenon, though far less extreme in our April 2015 Commentary on ETF Fund Flows.[5] Specifically, we looked at the relationship between fund flows and price in a dozen different sector-based ETFs and noticed something unique and odd in IBB-the biotech ETF. Here was the chart with the accompanying explanation:

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Of the dozen plus ETFs we looked at, this is the only one where price and flow moved upwards in tandem. This is exactly what a price-mediated feedback looks like. The rise in price brings more flow, which drives price higher, thus attracting yet more flow. This is also the explanation for how momentum works and what it looks like in action. While in the past we asserted biotech was not in a bubble based on valuation metrics and the fundamental outlook, this right here is a very concerning development. The longer this persists, the more troubling it will be. While price and flow can keep driving each other higher, when one breaks down, the other too will follow. One of the foremost points we learned from Soros is that when price-mediated feedback loops break, they do not simply find a new equilibrium at the price’s present plateau. Rather, the feedback loop reverses and works in the opposite direction. Note that the move up and down in price and flow are both positive feedback loops—the disequilibrium-seeking forces in markets. As such, these relationships are inherently unstable [emphasis added].[6]

Sure enough, 2 months after the date of publication on our ETF fund flow report (5/11/2015), the biotech sector ETF peaked nearly 13% higher and promptly shed 40% over the next seven months. We are now nearing two years since the bottom of the reflex move lower in IBB and yet the sector has recouped only half of its losses from peak to trough.

Considering the Bitcoin move has been many times more extreme than biotech, we expect a more extreme flush out that will similarly take an extended period to recover from. In fact, the Bitcoin situation is far more akin go the Dot Com bubble in 1999 and to emphasize the point, consider that Priceline first neared $1,000 per share in 1999 and took a whole 14 years to finally get back to those levels. At its worst, Priceline had declined over 99% from peak to trough.

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Priceline may not be a perfect example for what Bitcoin will do from here, but it does offer a good lesson. Cryptotechnology holds tremendous potential, but today the values are premised on speculative fervor rather than fundamental valuation. Speculative fervor is fleeting and when it ends, the price of the asset needs to find a floor and build a foundation where fundamentals can support the valuation. From that floor, to once again begin an ascent, the promise of the speculative fervor needs to be translated into tangible worth.

We are sure that in laying out our perspective in cryptocurrencies, the nuance will be misinterpreted by bulls and bears alike. Let us all remember one key fundamental fact here: there is little actual utility for Bitcoin today aside for international remittances. The initial promise was at least in part premised on Bitcoin as a transaction protocol and the combination of volatility and painfully slow clearing times make that a virtually moot point barring some phase change in the consensus of the Bitcoin community. To that end, the potential fundamental value is even lower today than when the transactional element was core to the thesis. It takes real utility and real value to develop a fundamental valuation to underpin the price of such an asset, not merely the potential for such development. We will continue to learn about the technology underlying Bitcoin and blockchain and explore investment opportunities and their respective merits. This pursuit will be taken with immense patience and caution. In anything with incredible long-term promise, there is far more risk in being too early, during a clearly euphoric phase, than in being a little late. Fear of missing out is not a fear that we at RGA actually feel anywhere in our bones.

Long end of the yield curve debt ceiling move unwind?

The following is a graph of the US Treasury yield curve today vs January 1, 2011:

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Notice that the yield curve is far flatter today than it was in 2011, despite a strong economy and inflation gaining in velocity. This is counter to what one would expect, though there is a sensible narrative: a flattening yield curve today theoretically is an expression that bond investors expect the Federal Reserve Bank will raise interest rates and put the economy into a recession before inflation gets ahead of itself. Many are wondering whether this is the case. We think there is a different view worth exploring. Let’s look at a proxy for Treasuries that will show another angle to underpin our narrative on what we think happened and how this might play out from here:

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The circled area above shows exactly when rates on the long end of the yield curve came down dramatically. Two external shocks happened within the circled space alongside a change in the Federal Reserve’s quantitative easing strategy:

  1. The US debt ceiling crisis
  2. The European sovereign debt crisis entered an especially acute phase.
  3. The Federal Reserve Bank hinted at and then commenced operation Twist

One of the big changes that occurred is European financial institutions, especially in the worst performing economies, started buying more Treasuries to balance their risk profile. Ireland is especially telling. In the beginning of 2011, Ireland was the 16th largest foreign holder of Treasuries. As of today, Ireland is the 4th largest holder, registering a 643% increase in their Treasury holdings.

Over the last six years, in aggregate, the Fed was by far the biggest purchaser of Treasuries as part of its quantitative easing (QE) policy. QE2 ended in the early summer of 2011. The Fed had been purchasing relatively short-dated Treasuries in the beginning of QE, because that is where the majority of issuance and thus liquidity is situated; however, in the Summer of 2011, the Fed introduced and then shortly after commenced “Operation Twist”—a name borrowed from a 1961 Fed initiative applying the same strategy. The stated intent of “Operation Twist” was to pull lower long-term interest rates. Up until 2011, the market’s implied interest rate expectation was decently higher than the Fed’s own expectations. To pull longer-term interest rates lower, the Fed announced it would use the proceeds from maturing short-term Treasuries (3 years or less) owned via QE1 and QE2 into longer-dated Treasuries (6-30 years). Today we can see clearly that the strategy accomplished its objective though it now looks like the effect has outlasted the Fed’s intent.

Today, with Europe healing and with the market now behind the Fed in expecting interest rate normalization, we think the time is right for the 2011 move in the long-end to entirely reverse. Europe’s sovereign yields have normalized and the Fed today is slowly unwinding their book of Treasuries by letting maturing bond proceeds revert to cash. This would be welcome news as equity valuations are near the upper-end of the fair value range and some yield from bonds would be a helpful addition to our portfolios should we decide during the year to move some of our exposure out of equities in anticipation of a more favorable return setup long-term.

The Reemergence of Dispersion

During 2017, while markets rose, dispersion collapsed. The following chart from KKR’s “Outlook for 2018” is insightful:[7]

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Dispersion measures the degree to which stocks correlate with one another. The higher the dispersion, the more uniform the moves across markets. Beginning with the financial crisis and through 2015 correlation between stocks stayed above its long-term average (the horizontal red line in the chart above). At the end of 2016 dispersion started to emerge and then accelerated as 2017 went on. At the end of the year, there was as large a degree of dispersion between stock as there had been over the last 30 years. This is a great development for active investing.

Financial crises tend to inject volatility into markets during which time “all correlations go to 1.” In other words, during financial crises, everything tends to move together. It is notable how long this condition persisted even past what many would regard as the “end” of the Financial Crisis itself. We believe one of the primary forces behind this extended period of little dispersion has been the move towards increased indexation. Many forces have driven indexation, though with this too we can tie to the Financial Crisis itself: as markets recovered from the Crisis, many advisors and people alike concluded that indexation in buy-and-hold fashion is superior to an attempt to actively pick winners and losers. We explored this topic in greater detail in our October 2013 commentary.[8] For our purposes here, the most important point is related to one we made above about Bitcoin: financial markets (and by derivative, financial market participants) tend to take good ideas way beyond their logical extreme.

There were three distinct catalysts that helped dispersion reemerge:

  1. The Presidential election in 2016
  2. The passage of tax reform in 2017
  3. The rise in short-term rates

The first two of these events had traders betting on companies and sectors whose prospects were specifically changed by either actual or expected policy changes. Some of the most distinct winners in both were sectors whose primary business are domestic (in contrast to multinationals) and whose businesses are subject to regulatory oversight. The rise in short-term rates were a big boon to the financial sector and a source of pain for the sectors whose allocations over the prior decade had been driven by yield. Specifically, the worst sectors last year (from worst to best) were the utilities, the REITs and the staples. Each of these were treated as bond-like proxies and with the rise in rates and the expectation for more hikes yet to come, they were on the receiving end of considerable selling pressure.

The issue of dispersion raises an important question: is dispersion increasing a side-effect of markets rising? Stated another way, will dispersion remain high in the next market decline? We are inclined to believe that from here on out, dispersion should be more “normal” than had prevailed in the Financial Crisis and its wake. In the 2000-02 bear market there were abundant opportunities to make money being invested on the long side, so long as one stayed clear of the carnage in technology. In contrast, in 2007-09 everything collapsed together. It is hard to sit in our seat today and say exactly which areas of the market would best withstand the next bear, for there are yet to be obvious areas of overinvestment like the technology sector in 2000 and the financials in 2007 that will lead the way down; however, we have confidence that the nature of the next recession (and let’s not forget, a recession is an inevitability eventually) will be different than the last. To reiterate: the 2007-09 bear market was an actual liquidity crisis where deflation was the risk that imperiled the economy, whereas the next recession will be a normal Fed induced recession when inflation gets too high and the Fed thus raises rates to cool things off. By virtue of this difference in nature, a Fed induced recession will hit sectors and underlying economic fundamentals in a very different way than was evidenced in 2007-09.

If dispersion remains at these high levels, expect our portfolio activity to increase considerably from 2017. While 2016 was one of the most active years ever for us, 2017 was our single least active year yet. Amidst high market valuations, dispersion is the primary force behind uncovering new opportunities. We need not necessarily wait for broader market declines to make moves, but instead can find fertile hunting grounds in either out-of-favor sectors or those sectors on the wrong side of flows and rotation trades.

Everything is now Tech, Tech is now everything:

In the past, we have bemoaned the use of labeling and categorization with respect to industry and sector classification. While a necessary evil, the rise of indexation has led to pronounced mispricings where the categorization does not fit the business reality. These problems have been most acute with the existence of the technology sector. We most recently made this point in our Q2 2017 commentary by asserting that “Investors are realizing that companies either use technology to their advantage or risk obsolescence….The natural endpoint is where people stop thinking of companies as ‘technology’ or ‘retail’ and think about how a particular company is developing technology to entrench their business in the new commercial landscape.”[9] We maintain heavy “technology” exposure as a result of this worldview, yet the overlap with the label has at times led us to experience a higher degree of volatility due to certain exposure and factor unwinds.

In November 2017, the S&P Dow Jones Indices and MSCI announced that they will revise the industry categorizations pertaining to technology companies. The “Telecommunication Services Sector” was relabeled the “Communication Services” and will now “include[s] the existing telecommunication companies, as well as companies selected from the Consumer Discretionary Sector currently classified under the Media Industry Group and the Internet & Direct Marketing Retail Sub-Industry, along with select companies currently classified in the Information Technology Sector.” Further, “online marketplaces…regardless of whether they hold inventory” were moved into the “Internet & Direct Marketing Retail Sub-Industry.”

In effect, the Global Industry Classification Standard (GICS) has moved closer to acknowledging that we live in a world where technology is not a standalone sector, but rather a crucial piece of infrastructure enabling and impacting each and every facet of the economy. We welcome a world where investors think more critically about the underlying drivers of a business separate and apart from the adoption of “technology” generally speaking. For example, while Alphabet (NASDAQ: GOOG) is regarded by most as a technology company, as the company achieves immense scale, its earnings will increasingly be driven by the cyclicality of the advertising industry, Expedia (NASDAQ: EXPE) and Priceline (NASDAQ: PCLN) already are in position where their earnings are subject to the fluctuations in global travel and sentiment and PayPal’s earnings will eventually reflect the flow of payments. These companies maintains considerable runway for secular growth with the share of business moving from offline to online in each respective domain; however, the reality cannot be escaped in analyzing these businesses that they are indeed beholden to their end source of demand rather than some abstraction called technology.

Thematic trade in the financial sector—low valuations, strong fundamental backdrop, yield sensitivity, business cycle, easing regulatory environment, capital cycle in full swing!

We buy each position based on our bottoms-up analysis of a given business. We want to know that a company has a strong management team, excellent or improving unit-economics, reasonable growth prospects embedded in the market’s expectations and a fair price. One of the most useful screening criterion for us to find new investments is the development of a thematic thesis on a given sector or industry. While any given theme is of secondary import in actually allocating to a security, our use of themes as screening criterion are a) thoroughly fleshed out with data and analysis, and b) an explanatory force behind why our positioning tends to cluster around certain sectors. You can think of our overexposure to technology in this way—we have a prevailing thesis that technology is not actually a sector, but rather a collection of companies using technology to do business in a better way and we sought out companies within technology where that distinction was most acute between the price of the stock and our estimation of fair value for the business.

One other sector where we have maintained excess exposure to is the financials. In the most acute phase of the Financial Crisis there were bankruptcies and a frenzy of M&A activity. While such actions have been few and far between lately, globally, the financial sector is far more concentrated than it has been in the recent past. Setting aside the debate about the merits of such a situation from macroprudential considerations, we think this is incredibly supportive of the long-term profitability in our leading financial institutions. With underwriting standards remaining largely rigorous since the crisis, there is further support to the fundamentals underlying banks today. Despite these forces, financials as a sector continue to trade at nearly a four turn forward P/E discount to the S&P 500—a clear reflection of the residual stigma from the crisis period.

Financials stands to benefit from all three forces behind dispersion referenced above more so than any other sector. First, Financials by-and-large were on the receiving end of increased regulatory scrutiny following the financial crisis and that has reversed with the new presidential administration. Second, financials in the US tend to be predominantly domestic businesses taxed at the all-in U.S. rate. With tax reform, financials as a sector stand to receive nearly the full benefit of the change in statutory tax rate for businesses. Third, financial sector earnings are sensitive to the direction of interest rates. The Federal Funds Target Rate started 2017 at 0.50-0.75% and ended the year at 1.25-1.50%. This is a substantial increase that boosts potential growth tremendously at many banks and insurance companies alike.

We expect each of our financial holdings to benefit from the prevailing environment. The Charles Schwab Corp’s (NASDAQ: SCHW) earnings are the most sensitive to interest rates and will continue to grow well into the double digits. Envestnet Corp’s (NYSE: ENV) (technically an Information Technology, not Financial company) earnings are influenced by asset valuations, therefore rising markets will be a powerful tailwind to revenues, with earnings leverage in the coming year. JP Morgan (NYSE: JPM) stands to benefit from easing capital standards which should result in a better Return on Equity and a higher payout ratio, supporting strong dividend growth. The situation in Europe is perhaps even more advantageous on some of these fronts, where ING Groep (NYSE: ING) should be able to pay a considerable special dividend, expunging the excess capital regulators required during the crisis period and leading to a step-change in ROE. Meanwhile our insurers—Markel Corp (NYSE: MKL) and Exor (BIT: EXO)—will benefit from investing the bond portion of their float in higher-yielding securities, while the equity side benefits from alpha-generating investment management continuing to beat the S&P.

What do we own?

2017 was a strong year, with the vast majority of our holdings ending in the green. Of the three laggards below, only one remains a current position and we have increased our allocation to it considerably during 2017—Walgreens Boots Alliance. We covered Walgreens in our Q3 2017 commentary[10] and on January 12th, Elliot gave a detailed presentation on Walgreens at Best Ideas 2018, Hosted by MOI Global.[11] You can find his slides at the following link for our full thesis. Total returns are indicated based on the stock’s performance during our holding period within 2017 and are denominated in the US dollar.

The Leaders:

IAC/InterActiveCorp (NYSE: IAC) +88.73%

Trupanion (NASDAQ: TRUP) +88.6%

PayPal Holdings, Inc. (NASDAQ: PYPL) +86.52%

The Laggards:

Under Armour, Inc. (NYSE: UA) -24.95%

Walgreens Boots Alliance, Inc. (NASDAQ: WBA) -12.25%

AmerisourceBergen (NYSE: ABC) -9.10%

Best books we read in 2017:

The Structure of Everyday Life: Civilization and Capitalism, 15th-18th Century Volume 1 by Fernand Braudel – A far-reaching study of what daily life would look like for an average person in each region of the world covering diet, work, household, possessions and relationships and their respective evolutions across the covered time period.

Scale: The Universal Laws of Growth, Innovation, Sustainability, and the Pace of Life in Organisms, Cities, Economies and Companies by Geoffrey West – Scale offers several powerful mental models with broad applicability across the social sciences.

The Attention Merchants: The Epic Scramble to Get Inside Our Heads by Tim Wu – A fascinating look at the news, media and entertainment industry over the past century and its quest to capture increasingly large swaths of our attention. The historical templates offered in the book for the rise of nascent industries and the detailed color on the tactics used by information predators to capture our attention or insightful.

Merchants of Grain: The Power and Profits of the Five Giant Companies at the Center of the World’s Food Supply by Dan Morgan – The intersection of history at the industry and global level is a captivating perspective on how cornerstone industries become enmeshed in some of the most important geopolitical events of any epoch.

Adaptive Markets: Financial Evolution at the Speed of Thought by Andrew Lo – Lo offers an entirely new economic paradigm incorporating the efficient market theory, behavioral economies and the collective lessons of the financial crisis. The work is ambitious, but accessible and a worthwhile read for anyone interested in finance and how it impacts society and touches our lives.

Thank you for your trust and confidence, and for selecting us to be your advisor of choice.  Please call us directly to discuss this commentary in more detail – we are always happy to address any specific questions you may have.  You can reach Jason or Elliot directly at 516-665-1945.  Alternatively, we’ve included our direct dial numbers with our names, below.

Warm personal regards,

Jason Gilbert, CPA/PFS, CFF, CGMA
Managing Director
O: (516) 665-1940
M: (917) 536-3066
jason@rgaia.com

Elliot Turner, CFA
Managing Director
O: (516) 665-1942
M: (516) 729-5174
elliot@rgaia.com

 

[1] http://www.rgaia.com/december-2013-investment-commentary-our-2014-outlook/

[2] West, Geoffrey. Scale: The Universal Laws of Growth, Innovation, Sustainability, and the Pace of Life in Organisms, Cities, Economies and Companies. Pages 414-416.

[3] http://www.wired.co.uk/article/how-much-energy-does-bitcoin-mining-really-use

[4] http://compoundingmyinterests.com/compounding-the-blog/2013/11/11/the-rise-and-inevitable-fall-of-bitcoin-1.html

[5] http://www.rgaia.com/april-2015-investment-commentary-etf-fund-flows/

[6] Ibid

[7] http://www.kkr.com/global-perspectives/publications/outlook_for_2018_you_can_get_what_you_need#.WlgbCjQabu8.twitter

[8] http://www.rgaia.com/october-2013-investment-commentary-our-actively-passive-investment-strategy/

[9] http://www.rgaia.com/q217-investment-commentary/

[10] http://www.rgaia.com/q317-investment-commentary/

[11] http://www.rgaia.com/walgreens-boots-alliance-owner-operator-run-pharmacy-retail-leader/

Past performance is not necessarily indicative of future results.  The views expressed above are those of RGA Investment Advisors LLC (RGA).  These views are subject to change at any time based on market and other conditions, and RGA disclaims any responsibility to update such views.  Past performance is no guarantee of future results. No forecasts can be guaranteed. These views may not be relied upon as investment advice.   The investment process may change over time. The characteristics set forth above are intended as a general illustration of some of the criteria the team considers in selecting securities for the portfolio. Not all investments meet such criteria.  In the event that a recommendation for the purchase or sale of any security is presented herein, RGA shall furnish to any person upon request a tabular presentation of:
(i) The total number of shares or other units of the security held by RGA or its investment adviser representatives for its own account or for the account of officers, directors, trustees, partners or affiliates of RGA or for discretionary accounts of RGA or its investment adviser representatives, as maintained for clients. (ii) The price or price range at which the securities listed.

Q3’17 Investment Commentary

One of our biggest mistakes was not investing in Amazon shortly after reading Josh Tarasoff’s 2012 VALUEx presentation, instantly recognizing the appeal and dismissing a potential purchase on account of the stock being “too expensive.”[1][2] We will forever hold ourselves accountable for this mistake, while simultaneously self-reflecting on what we can do to avoid this mistake in the future and figure out where and how value does accrue in commerce today. In considering Amazon today, especially the stock, we all need to recognize that the perception pendulum has swung from perhaps “neutral” to exceedingly bullish. The fear of Amazon is so acute across various sectors that merely the whisper of Amazon’s encroachment in a given vertical moves market caps billions of dollars in a matter of seconds. As such, it is imperative that every investment manager and corporate manager recognize where and how their business does and might compete with Amazon in the future and consider what can be done to entrench any advantage that may exist as of today. Further, all stakeholders need to consider what their markets might look like over the course of five to ten years down the line since this is the playing field upon which Amazon’s shareholders afford it the right to compete.

In reflecting on our experience (or lack thereof) with Amazon, we think one of the company’s biggest successes is how they have changed consumer behavior and made buying online easy. With Prime, consumers know that whatever they may want can be bought and received within two days—Amazon has literally become the “Everything Store.” While Amazon was the first to drive this change in behavior, and has been the primary beneficiary thus far, they did something else at the same time: they opened the door to other different mediums for transactions and opened consumer minds to exploring more online consumption opportunities. Changing behavior from offline to online was the seminal achievement of Prime. Incumbents and upstarts alike cannot at this point displace Amazon; however, in the right situations, they can defend their own turf or forge new paths for themselves. If it sounds like we are anti-Amazon, let us clarify: we are not. We are Prime members, habitually ordering a variety of products from Amazon, but we are also bargain hunters. As bargain hunters we both scour for the best combination of quality and price when in the market for a product purchase, and we look for situations in markets where there is a disconnect between sentiment and reality. There is no larger disconnect in our assessment of the market today than the implicit inevitability of Amazon’s dominance across a host of domains. When Amazon sneezes interest, the target sector immediately catches a bad cold. It has reached a point where even if Amazon does fulfill its rhetorical predestiny, there is ample room for others to succeed. In fact, we see several unique niches being carved out or already dominated by competitors whose servings meet a balancing of demands between quality, price and convenience.

While Amazon has been conscious of vast potential future profit pools and willing to forego short-term profits for long-term potential, its scale and many simultaneous efforts will leave room for competitors to carve out enough of their own scale within niches to create their own offering premised on something other than mere convenience. We see the following opportunities for companies differentiate their offerings from the acknowledged leader:

  • Higher touch, service and education element
  • Smart curation in areas where selection matters
  • Trade away the convenience of fast shipping for even lower prices
  • Immediacy that next day is not enough for
  • Low volume, high price
  • Quality that inspires passion and a direct brand relationship
  • Unbiased openness

Acquiring customers isn’t necessarily easy, but cheap capital has afforded these nascent startups the opportunity to offer meaningful subsidization of everyday products. We initially mocked the idea of Jet when the company was featured in the Wall Street Journal for its negative gross margins–in other words, the more product Jet sold at the time, the more money they lost.[3] At the same time, we were cognizant that Marc Lore is a force to be reckoned with and he had a sensible idea for incentivizing optimized shipping structures while kicking back the savings to customers. Immediately upon the Walmart acquisition it struck us that perhaps Jet, Lore and the VCs involved knew of Walmart’s interest and merely needed to prove concept in order to bring about a swift acquisition and meaty IRR.

This Amazon prelude offers the opportunity to visit one of our best (PayPal) and one of our worst performers (Walgreen’s) so far this year.

1 – Amazon’s share of e-commerce = PayPal’s opportunity

One of our theses behind PayPal has been how significantly the company stands to benefit for online consumption outside of the Amazon ecosystem.[4] To that end, their growth in Total Payment Volume (TPV) is a great proxy for the growth in online sales-ex Amazon.

Capture1

As the chart above and PayPal’s stock’s price clearly indicates: e-commerce outside of Amazon has been vitally strong this year.[5] Stated differently: there are beneficiaries other than Amazon of this sweeping change in consumer behavior, though this is not a story we often hear. Amazon created the “1-click” buy button, but PayPal has made the login-free “One Touch” buy button ubiquitous on every non-Amazon shopping experience and in virtually all important mobile apps. In fact, offering this as an “open-source” payment stack has been one of the key drivers of the explosion in innovative apps. For retail, it has been a key tool to foster improving shopping cart conversion rates. For consumers, PayPal has been a secure, easy payment platform that facilitates less sharing of sensitive financial information, ultimately creating fewer points of failure for credit card of identity theft.

PayPal itself is a key player behind behavioral change in commerce as well: PayPal was early to pointing out how the lines between a point-of-sale transaction and an online transaction are blurring. An oft-repeated example is how someone can buy goods online at Home Depot and pick up in-store. This is happening with increasing frequency. Similarly, in the past, when you ordered Chinese food from the local restaurant, this was registered as a “POS” payment, but now the same transaction made on Grubhub is recorded as “online.” As consumer behavior continues to evolve, the variety of offerings catering to this new demand is growing.

Amazon has not hid its ambitions of capturing more payment share, yet merchants need to think hard about whether they truly want to share key data with a company that could inevitably turn into a competitor.[6] While Amazon claims merchant data is anonymized, Amazon has not been shy about competing directly with companies who were customers of Amazon platforms. PayPal is the only truly open, unbiased end-to-end solution for e-commerce and we think it has a long runway for future success.

Walgreen’s: delivering on better outcomes at a lower cost

While PayPal is a new ecommerce company of similar vintage to Amazon, Walgreen’s is an old-world, century old stalwart. In further contrast to PayPal, Walgreen’s stock has been our weakest holding thus far this year. Given the weakness in Walgreen’s stock, one would assume from the look of things that Amazon is already competing with the company and inflicting considerable damage. That assumption would be wrong. Evidence of the zealotry behind the Amazon fear is all over Walgreen’s stock. Starting with Amazon’s acquisition of Whole Foods in mid-June, there have been three further instances of Amazon-related headlines leading to 5% or greater drops in Walgreen’s stock.

It has reached the point where outside of the financial crisis and the company’s dispute with Express Scripts (during which we commenced our position), Walgreen’s has never seen such lush free cash flow yields:

Capture2

Meanwhile, in Walgreen’s own business they continue to take share from other pharmacies (CVS included) on prescriptions and have finally completed a complex and drawn out regulatory process for the acquisition of a large swatch of Rite-Aid stores. The delay in completing this acquisition was no-doubt a sore point for Stefano Pessina in pursuing his typically aggressive M&A strategy, though it has not hindered Pessina’s fostering of new partnerships to position the company for success in an evolving healthcare landscape (look no further than the creation of a strategic alliance with Prime Therapeutics for a new kind of PBM).[7]

Amazon’s ability to compete on a longer timeframe than competitors has been a crucial source of advantage and thus for Walgreen’s, Pessina himself is a key competitive advantage the company has that others have not. In many respects, Pessina should be the next chapter in William Thorndike’s acclaimed “The Outsiders” exploring CEOs with non-traditional backgrounds who built incredibly successful businesses and wealth for themselves and their shareholders. Pessina is a self-made billionaire who after having finished his academic career in nuclear engineering took over his family’s small pharmaceutical wholesaler. At the small family business, Pessina commenced a string of acquisitions—both vertical and horizontal in nature—ultimately building the most formidable global pharmaceutical organization. Pessina’s vision and large ownership stake insulate him from the short-term pressures that so many of Amazon’s competitors have succumbed to.

Importantly, there are no signs in any financial performance to-date that Walgreen’s is in fact vulnerable; however, from the outside, the company’s US-heavy retail footprint appears primed to lose business to Amazon. Pharmacies in the US are a complex, highly regulated business with multifaceted relationships. In most cases, the person purchasing a drug at the pharmacy counter is not the person paying for it—that would be the PBM. Deals with PBMs can be complex (as was evidenced by the past Walgreen’s/Express Scripts problems) and competitive. Even were Amazon to make inroads in pharmaceuticals, the shape of the competitive market needs to be contextualized: Walgreen’s retail foot-print has already withstood competition from “convenience” and “price sensitive” mail order business driven by PBMs. Global scale at Walgreen’s is a crucial driver of a cost advantage that has led to the capture of share from peers. This has been aided by the company’s growing stake in AmerisourceBergen.  Moreover, Walgreen’s has key profit-pools that are largely immune to Amazon’s foray into pharmaceuticals including, but not limited to same-day needs, vaccinations, a European wholesale and distribution business, and a thriving portfolio of proprietary cosmetics mainly sold in Europe.

With all this said, it’s worth concluding by pointing out it remains uncertain if, or even how Amazon will try to compete in this industry. If they do, there will be losers, but Walgreen’s will be fighting from a strong, defensible position. Alternatively, should Amazon opt not to compete, it would be but one more indication that Walgreen’s is a truly special business.

What do we own:

The Leaders:

Envestnet, Inc (NYSE: ENV) +30.40%

GrubHub Inc. (NASDAQ: GRUB) +20.78%

PayPal Holdings, Inc. (NASDAQ: PYPL) +19.86%

The Laggards:

AmerisourceBergen Corp (NYSE: ABC) -12.06%

Twitter, Inc. (NYSE: TWTR) -5.60%

The Howard Hughes Corp (NYSE: HHC) -4.00%

Thank you for your trust and confidence, and for selecting us to be your advisor of choice.  Please call us directly to discuss this commentary in more detail – we are always happy to address any specific questions you may have.  You can reach Jason or Elliot directly at 516-665-1945.  Alternatively, we’ve included our direct dial numbers with our names, below.

Warm personal regards,

Jason Gilbert, CPA/PFS, CFF, CGMA
Managing Director
O: (516) 665-1940
M: (917) 536-3066
jason@rgaia.com

Elliot Turner, CFA
Managing Director
O: (516) 665-1942
M: (516) 729-5174
elliot@rgaia.com

[1] https://twitter.com/ElliotTurn/status/297072766518177792

[2] https://www.scribd.com/document/98208572/ValueXVail-2012-Josh-Tarasoff

[3] https://www.wsj.com/articles/jet-com-runs-into-turbulence-with-retailers-1438899476

[4] For our fuller PYPL thesis, check out the presentation from 2015 http://www.rgaia.com/ebay-paypal-split-analysis-buy-two-moats-for-the-price-of-one/

[5] http://files.shareholder.com/downloads/AMDA-4BS3R8/5421520140x0x960247/15B1F272-F94C-4743-84BB-A36C509F557C/Investor_Update_Third_Quarter_2017.pdf

[6] https://www.cnbc.com/video/2017/10/23/amazon-pay-vp-on-amazons-push-into-payments.html

[7] http://news.walgreens.com/press-releases/general-news/walgreens-and-prime-therapeutics-agree-to-form-strategic-alliance-includes-retail-pharmacy-network-agreement-and-combines-companies-central-specialty-pharmacy-and-mail-service-businesses.htm

 

Past performance is not necessarily indicative of future results.  The views expressed above are those of RGA Investment Advisors LLC (RGA).  These views are subject to change at any time based on market and other conditions, and RGA disclaims any responsibility to update such views.  Past performance is no guarantee of future results. No forecasts can be guaranteed. These views may not be relied upon as investment advice.   The investment process may change over time. The characteristics set forth above are intended as a general illustration of some of the criteria the team considers in selecting securities for the portfolio. Not all investments meet such criteria.  In the event that a recommendation for the purchase or sale of any security is presented herein, RGA shall furnish to any person upon request a tabular presentation of:
(i) The total number of shares or other units of the security held by RGA or its investment adviser representatives for its own account or for the account of officers, directors, trustees, partners or affiliates of RGA or for discretionary accounts of RGA or its investment adviser representatives, as maintained for clients. (ii) The price or price range at which the securities listed.

Q2’17 Investment Commentary

The technology sector come into focus in the second quarter of 2017. At the same time, the end of the “Trump Trade” we spoke about in our first quarter commentary continued, with cyclicals lagging the rest of the market. As investors aggressively shifted portfolios towards technology, they also moved money away from anything remotely related to the mall-based retail economy at an accelerating pace.

In January 2016 we highlighted the shift in our portfolio towards technology-based platforms that were solving old problems in new ways, with the following common traits:[1]

  • Two-sided networks—these companies all unite sellers of goods or services with consumers, at a scale that is on the one hand, large and defensible, and on the other, very lucrative.
  • Capital lean—these networks require very little incremental capital investment. There is little CAPEX needed for either maintenance or growth. Most of the actual investment flows through the operating line (R&D in some cases, marketing in others), thus actually suppressing what we believe to be the true long-term earnings power of each of these businesses.
  • High margin businesses—despite investment flowing through the operating line, these companies generate substantial operating profit margins and/or have the capacity to ramp these margins as the businesses further scales top line growth. Further, each incremental customer who buys or a good or is serviced on these platforms has very little incremental cost to the platform itself. As such, revenue growth has two effects: 1) the ramp of growth itself; and, 2) an upward pull on margins.

We listed the companies and summed up the opportunity as follows: “Collectively, we think of them as dominant business and commerce platforms for the future, with proven business models, robust cash flows and large growth runways.” Since that time, we have only added more exposure to this uniquely modern style of company. These positions have paid off nicely and due to the large growth runways, have ample opportunity to continue to do so.

While growth in intrinsic value has been an important driver for return in these stocks, most of the return has come from multiple appreciation. In other words, Mr. Market has warmed to these kinds of stocks and is willing to pay more for the same amount of earnings as he did just a mere year and a half ago. At the same time, Mr. Market has been punishing anything with even a passing connection to retail. While retail earnings have hardly been robust, and pockets of retail have been downright terrible, they have not been uniformly bad. The vast majority of the punishment in retail has been the flip-side of the technology sector: while earnings deterioration has hurt, Mr. Market is viewing the sector with increased concern. This is evidenced in the proliferation of references to “change at an accelerating rate” in retail, while in actuality the rates themselves have been fairly constant:

snip

[2]

Instead of an accelerating rate, what we are witnessing is the compounding effect of a consistent rate of change ultimately leading to increasingly large dollar volumes at stake in the shift in value from traditional retail to “technology.” Investors are realizing that companies either use technology to their advantage or risk obsolescence; however, they are not scrutinizing whether certain retailers are constructively deploying technology to that end. The natural endpoint is where people stop thinking of companies as “technology” or “retail” and think about how a particular company is developing technology to entrench their business in the new commercial landscape.  We have pursued a deep dive into the retail sector and its related companies. We entered this study with a few biases:

  • No company can rest on its laurels of having a “strong brand.”
  • Companies that are natively vertical, with a differentiated, high-quality product have an inherent advantage.
  • The world where big box stores could compete on a combination of location, well-curated products and generally (though not universally) low prices is entirely over.
  • Distribution and convenience are important challenges online, but can be overcome with some combination of low prices, premium quality and exceptional service.

It would be appropriate and well suited at this time to thank our terrific 2017 Summer Analysts, Ryan King, Joshua Herman, and Robert Palmer for their intellectual curiosity and diligent analysis. Each contributed tremendous value to our research efforts. Because of them, we can enter the second half of the year with a deep understanding of retail replete with an extensive watchlist of promising investment opportunities.

Not a Fully Furnished Yet, but Getting Started in Retail:

We have yet to get aggressive in the affected areas of retail, but we did commence our positioning in the space. Valuations are cheap, but the risk of being wrong (or early) is perilous.  Moreover, since nearly all these companies are priced quantitatively at valuations predictive of outsized gains, ultimately being right on investments in this space comes down to qualitatively determining the companies best positioned to succeed. As Buffett apparently said, “my greatest investments weren’t mathematical, they were unique qualitative insights.”[3] We are quite confident that will hold especially true here.

We did take a starter position during the second quarter that has subsequently been increased to a more substantial size in one retailer whose characteristics embody what we are looking for: Williams-Sonoma (NYSE: WSM). Williams-Sonoma is unquestionably cheap, trading at a mere 5.5x 2018 consensus enterprise value to EBITDA. In the depths of the crisis, the company traded at 4x forward EBITDA, but outside of the November 2008-January 2009 period, the company has traded in a range between 5.5x and 11x EBITDA. While many associate the company with its namesake brand, William-Sonoma’s largest driver of earnings is Pottery Barn. As of next year, Williams-Sonoma the store will be the third largest source of revenues behind Pottery Barn and the fledgling West Elm brand. As evidenced by the valuation, investors right now are lumping this company in with “mall-based retailers” considering all its closest comparables are just that.

Upon closer inspection, it becomes apparent that Williams-Sonoma is a different company than meets the eye. While the brand is often associated with its mall-based footprint, nearly 52% of its revenues are generated online, with over 72% of its operating income earned via the web despite furniture’s status as an especially under-penetrated area online (only 10% of US furniture sales happen through the online channel). We suspect this is so because many people still like shopping for furniture in a way such that they can see and feel the quality and comfort of what they are buying. Stores thus provide a natural showroom. Moreover, William-Sonoma’s furniture brands use stores as a springboard for a high-touch retail offering that other natively online retailers (like Wayfair) cannot compete with. Specifically, the stores create a national footprint of designers who are positioned to help customers plan their layout and present and future purchases to furnish their homes.

Clearly Williams-Sonoma is doing something different here with the extent of their online success. We think the in-store designers help by tying people into the aesthete and driving future sales that may not be captured at the store level. Many strong brands making high quality goods, but formerly sold through the standard retail channel can enhance their business by expanding their “Direct-to-consumer” (DTC) offering. But, (we learned this the hard way in Under Armour) DTC comes with several problems that are short-run operational problems and long-term valuation ones. Here are a few of issues with DTC:

  • Lower margins
  • Requires greater working capital, specifically inventory to handle high rates of return
  • Ramped capital investment to handle new distribution and foster greater convenience for customers.

The company’s history in the mail-order catalogue business is an advantage in how it afforded management the opportunity to leverage the catalogue’s lessons learned and distribution footprint immediately into a distribution advantage online. This is as much related to the company’s physical capability to handle a large volume of online orders as it is about the company’s culture being geared towards driving sales irrespective of channel, with processes in place to fulfill customer needs and orders. Beyond that, management has proved adept in understanding changing tastes and trends, having built West Elm from scratch starting in 2003 to a $1b run-rate brand, all amidst the backdrop of this larger shift from retail to technology that we prefaced this company feature with. West Elm benefits greatly from leveraging Pottery Barn’s existing distribution infrastructure and lessons learned in capturing customer mindshare online.

All of the unique brands at Williams-Sonoma the company offer high quality products that the brand stands behind. Pottery Barn and West Elm in particular are natively vertical, with differentiated aesthetes in furniture. We think this is important, because people who buy into a particular aesthete, expectant of a certain level of quality and comfort, will be increasingly likely to make additional purchases from the same brand.

What do we own:

The Leaders:

Trupanion, Inc. (NASDAQ: TRUP) +57.38%

IAC/InterActiveCorp (NASDAQ: IAC) +40.04%

GrubHub, Inc. (NASDAQ: GRUB) +32.56%

The Laggards:

Cisco Systems, Inc. (NASDAQ: CSCO) -6.60%

Walgreens Boots Alliance (NASDAQ: WBA) -5.30%

Markel Corporation (NYSE: MKL) 0.00%

For those of you who have enjoyed reviewing our investment presentations in the past, we have a special treat for you. Elliot Turner was again honored to present at the 2017 Value Conferences Wide Moat Investing Summit. He presented IMAX at the inaugural event four years ago followed by eBay/PayPal in 2015, and Envestnet in 2016.  At the Wide Moat Investing Summit, recognized value-investors presented some of their best investment ideas. Elliot presented on Twitter and his slides can be accessed here[4].

Thank you for your trust and confidence, and for selecting us to be your advisor of choice.  Please call us directly to discuss this commentary in more detail – we are always happy to address any specific questions you may have.  You can reach Jason or Elliot directly at 516-665-1945.  Alternatively, we’ve included our direct dial numbers with our names, below.

Warm personal regards,

Jason Gilbert, CPA/PFS, CFF, CGMA
Managing Director
O: (516) 665-1940
M: (917) 536-3066
jason@rgaia.com

Elliot Turner, CFA
Managing Director
O: (516) 665-1942
M: (516) 729-5174
elliot@rgaia.com

[1] http://www.rgaia.com/robust-networks-for-the-long-term/

[2] http://dashofinsight.com/weighing-the-week-ahead-is-a-market-friendly-policy-agenda-in-peril/

[3] https://twitter.com/ElliotTurn/status/664475437679190016

[4] http://www.rgaia.com/twitter-presentation/

Past performance is not necessarily indicative of future results.  The views expressed above are those of RGA Investment Advisors LLC (RGA).  These views are subject to change at any time based on market and other conditions, and RGA disclaims any responsibility to update such views.  Past performance is no guarantee of future results. No forecasts can be guaranteed. These views may not be relied upon as investment advice.   The investment process may change over time. The characteristics set forth above are intended as a general illustration of some of the criteria the team considers in selecting securities for the portfolio. Not all investments meet such criteria.  In the event that a recommendation for the purchase or sale of any security is presented herein, RGA shall furnish to any person upon request a tabular presentation of:
(i) The total number of shares or other units of the security held by RGA or its investment adviser representatives for its own account or for the account of officers, directors, trustees, partners or affiliates of RGA or for discretionary accounts of RGA or its investment adviser representatives, as maintained for clients. (ii) The price or price range at which the securities listed.

Twitter Slides from the Wide Moat Investing Summit

Elliot Turner was honored to present at the 2017 Value Conferences Wide Moat Investing Summit. He presented IMAX at the inaugural event four years ago followed by eBay/PayPal in 2015, and Envestnet in 2016.  At the Wide Moat Investing Summit, recognized value-investors presented some of their best investment ideas. Elliot presented on Twitter.  We are excited to share his slides here:

Q1’17 Investment Commentary

Many of the themes from the end of 2016 persisted into the early first quarter of 2017. Around the second week of February, the so-called “Trump Trade” reached its crescendo with many of the politically driven ascents fully faded into the end of the quarter. The market’s overall levels largely held up with a shift in strength towards technology and some of the other “high quality” laggards of late last year at the expense of cyclicals.

Underlying economic strength continued into the quarter and helped push the acceleration of expectations for the first Federal Reserve rate hike of 2017. Coming into the year, markets expected less than a 50/50 chance of a March hike, but during a spate of voting member talks in the month of February, these expectations shifted to near certainty. This coincided with the Trump trade’s inflection point.

We took advantage of the strength in cyclicals to shed some positions where we felt the pendulum swing in sentiment did not correspond to a shift in fundamentals—we sold both our auto manufacturer and car dealer (while maintaining our entire exposure to the financial sector). Below, we expand on two other notable portfolio changes during the quarter.

In which we realized our mistake quickly, though not soon enough:

In our 2016 year-end commentary we shared our thesis on Under Armour (NYSE: UA). [1] Shortly after publishing our thoughts, the company issued a trifecta of bad news when their earnings missed the mark, they abandoned what had been issued as longer-term guidance only three months prior, and their CFO resigned. Any one of these may have been indicative of a short-term problem, but together they compounded the woes. While our quick about-face may appear surprising, we think it is essential to remain flexible in our views despite our long-term bias and believe it is important to learn the right lessons from our mistakes. One of the foremost mistakes with UA was our under-appreciation for how much this company on the apparel side resembles a “fashion” company more so than a pure sports play. These quotes from their Q4 2016 conference call make this point stark:

  • “We need to become more fashionable with the products that we have out there. And one of the things we found is that some of the core basics were some of the challenges that we saw, is that we are counting on core basics as we have in years past to do more work for us. But the consumer today frankly has more options, and frankly most of those options are from good brands that we compete with, that are heavily discounting as well.” – Kevin Plank[2]
  • “So what you’ll see is that I don’t think it’s one shift of abandoning one for the other. Obviously, with things like the investment we’re making in UAS (31:30) in sport lifestyle in general, but we need to become more fashion. The consumer wants it all. They want product that looks great, that wears great, that you can wear at night with a pair of jeans, but that also does perform for them. But the performance has just become a bit of a given information. And so I think you’ll see us continue to react to that, and hopefully I think you’ll see us continue to lead in that.”[3]

We cannot help but ask, what is the company’s edge if “performance just become a bit of a given.”

Further, was growth demand-pull or supply-push? That is, did the company grow because consumers kept buying more and more, or because UA kept putting out more and more product. Obviously to some extent there is a symbiotic relationship between the two, but in hindsight it appears certain that the growth emphasis from leadership despite the reset in expectations during the Fall was a sign that the growth had inflected from a balance between the two to a more dominant supply-push. Supply-push is far less certain because it comes with increasing the capital base of the business ahead of the top line and requires growing inventory to the point where if something goes wrong, it will go very wrong. This is evident in the gross margin miss and the inventory build.

While Plank deserves admiration and is a worthy subject to study for how successfully he built UA, there was a warning sign that we did not consider until after-the-fact. Plank had been touting UA’s “26 straight quarters of 20% or more YoY top line growth.” This is a great accomplishment, but it is also an overt risk. When a streak becomes too important a corporate imperative, the incentive to continue the streak can outweigh the incentive to do the right thing because no one wants to be responsible for it ending.

UA’s goal in hindsight seems like it was kept up with pulling growth forward (creating way too much product and discounting heavily. Further, Q3 guidance for 2017 was shaped far too much by attempting to maintain the “above 20%” as an important threshold, instead of being realistic about what already was acknowledge as slowing but robust growth. Accounts receivable was a tell we should have noticed. Whereas inventory only grew 11.9% vs sales growth of 22.1% year-over-year in Q3 of 2017, receivables grew 29.5%. This inventory was sold through the channel to wholesalers who had not paid for the product. This helped boost sales and reach growth targets, when in fact it should have been a big red flag.

  • “a larger increase in accounts receivable of $53.7 million in the current period compared to the prior period, due to the timing of shipments driven by current period sales being more heavily weighted to the end of the period.”[4]

Perhaps the key takeaway here is as simple as the “capital cycle.” We were first introduced to this idea in “Capital Account: A Fund Manager Reports on a Turbulent Decade.”[5] The book featured the letters of Marathon Asset Management and its focus on the capital investment cycle at both the micro and macro levels and the impact it would have on valuations. We no longer own any other investments in companies which are simultaneously sacrificing margin & investing in capex at such a voluminous rate. We do have some investments in which out-year margins will be greater due to the investment that flows through; however, these businesses are very capital light and the investment through margin should be long-lived. UA is basically the reverse.

It’s very hard not to write off the big investments of the past year given how badly the company missed on both top line and margins, and what the outlook into next year is like for both as well as free cash flow. On the plus side, the company is lowering CAPEX spend, but this seems more out of necessity and leads us to wonder why it didn’t happen sooner. This does not strike us as a “capacity to suffer” (Tom Russo’s definition) problem right now.[6] This more realistically strikes us as a company struggling to find its identity in crossing the chasm from a passionate, profitable niche (performance gear for the active athlete) into mass market appeal. In the process, the UA is wavering between “performance” and “fashion” and “growth” and “operations” with none really emerging a clear-cut winner for the brand’s identity. Plank talks a lot about the identity, but if “performance is taken as a given” then we wonder what that identity looks like at the end of the day.

High quality at a depressed price:

During the quarter we commenced a position in Arcadis (AMS: ARCAD). Arcadis is a global design and consultancy firm with specialties in infrastructure, water, environmental remediation and architecture. They work on vital pieces of infrastructure that touch our lives daily: levees, tunneling for subways and water pipes, dams, desalination plants, help municipalities manage flood plains and construct plans, etc. The company’s 20,000 plus employees work on 30,000 projects annually around the globe.

The unique specialty and capabilities in water put this on our radar. If you casually followed some of the post-Sandy reconstruction in New York and the discussion of broader coastal protection, it is likely you have come across this name.[7] As we often do, we noted Arcadis’ contribution to the reconstruction efforts and put them on a long-term watch list. Over the past year, between a spate of poorly timed (and executed) emerging market acquisitions, an investigation by Brazilian authorities of corruption in the procurement of construction contracts (notably Arcadis is a design, not construction firm) and evolving needs of the formerly very profitable US environmental remediation business, the stock took a beating. Nonetheless, free cash flow remained high. Heading into the new year, the company “parted ways” (aka fired) its CEO Neil McArthur and hinted at a renewed emphasis on operations over growth. To that end, Arcadis hired Peter Oosterveer, the long-time COO of Fluor Corp (NYSE: FLR) who has the right experience and exposure to help streamline operations and restore profitability accordingly.[8]

Arcadis’ main input cost is labor capital. The company is not necessarily unique in this respect; however, they are unique in their ownership structure. The single largest owner of shares is an aggregated pool of employee holdings—representing 17.2% of the outstanding shares. There is very little physical capital deployed in the company. As such, capital expenditures are very low and most investment flows through in the form of labor expenses. The company has a shared common knowledge base that is “housed” in its DNA that gets deployed to each project along the way. This knowledge and expertise is something that other companies would have difficulty to replicate both in its scale, its vintage, and its specialty.

Returns on capital are very high at Arcadis (30% ROIC ex-goodwill and acquired intangibles). With goodwill and intangibles the numbers are inferior now—hovering around 8%, due to the sluggish performance of some of the more recent, larger transactions and the downturn in the Emerging Markets business.ROIC ex-goodwill is the best way to judge this company, because when you include goodwill, you are making a judgment on management in addition to the actual business. Looking exclusive of goodwill gives a clearer picture on the cash generation capacity of the business as it stands today. This is particularly relevant here as the company transitions from an acquisitive to an operations-focused CEO. Oosterveer comes in with a clean slate and will be unencumbered by the returns generated on goodwill (ie by the strategic decisions of previous management). Cash generation is very lush, and supports both the interest expense in its presently over-levered state, as well as a dividend payout of 30-40% of net income. CAPEX has been, and will continue to be low. Since there is little physical capital deployed in the business, fixed costs in the long run are very low; however, they are high in the short run due to certain institutional imperatives and the uncertainty with respect to how quickly cyclical forces will resolve themselves. When the company has clarity (as it does in Brazil) that the problems run deeper than merely cyclical ones, they can right-size the cost base and restore margins fairly quickly. This helps make cyclical margin problems shorter-term in nature, even if revenues don’t come back quickly enough. While the company is a cyclical, the infrastructure needs they service are secular. To that end, it is the funding cycles, not necessarily end demand which are cyclical. Working capital does eat up some capital, though that is proportionate to the revenue base at any given time. There are nearer-term problems right now as some oil and gas companies and countries exposed to oil and gas pricing have stalled on payments. These problems will be watched closely, though we believe they should be resolved in the not-too-distant future.

As a company that deploys labor, it’s important to mention that most of the projects are staffed locally—projects are staffed with people who are located in the same country as the project itself. The Hyder division brought in global outsourcing centers in India and the Philippines that are used for some elements of design and architecture, though this is mainly for UK-based projects. Only 3% of US-based projects are staffed with outsourced talent. This was particularly helpful in thinking about what may happen to the company were the US to adopt a border adjustment tax.

Further adding to our intrigue in Arcadis is the contribution the company can have to the portfolio’s correlations–in particular, flooding events are bad for the economy and especially so for insurance/reinsurance, to which we have exposure by way of Markel (NYSE: MKL) and Exor N.V (MILEXO.MI). If a flood event hurt the reinsurance sector, it is likely that Arcadis would move strongly in the opposite direction (for context, Arcadis rose 5.6% the day Sandy made landfall and enjoyed an especially strong year). At the time of our purchase, we picked up shares for just north of a 10% cash flow yield based on our 2017 estimate. Should multiples remain constant, then we would expect to earn this double-digit cash flow yield over time. This estimate assumes no margin improvement. If margins improve in 2018 (and the company has taken action to effect that outcome), alongside any basic recovery in cyclically weak areas of infrastructure demand, there is the potential for powerfully strong performance. One thing is clear with Arcadis: there will continue to be immense need for the crucial services they provide in making our world more livable, especially in the face of climate change.

What do we own?

The Leaders:

The Priceline Group (NASDAQ: PCLN) +21.41%

Exor N.V. (MI: EXO) +20.00%

Arcadis N.V. (AMS: ARCAD) +15.86%

The Laggards:

Under Armour, Inc. (NYSE: UA) -24.95%

GrubHub Inc. (NASDAQ: GRUB) -12.57%

Envestnet, Inc. (NYSE: ENV) -8.37%

Thank you for your trust and confidence, and for selecting us to be your advisor of choice.  Please call us directly to discuss this commentary in more detail – we are always happy to address any specific questions you may have.  You can reach Jason or Elliot directly at 516-665-1945.  Alternatively, we’ve included our direct dial numbers with our names, below.

Warm personal regards and all the best for a healthy, happy and prosperous 2017,

Jason Gilbert, CPA/PFS, CFF, CGMA
Managing Director
O: (516) 665-1940
M: (917) 536-3066
jason@rgaia.com

Elliot Turner, CFA
Managing Director
O: (516) 665-1942
M: (516) 729-5174
elliot@rgaia.com

[1] http://www.rgaia.com/2016-year-end/

[2] https://seekingalpha.com/article/4041127-armour-ua-q4-2016-results-earnings-call-transcript?part=single

[3] https://seekingalpha.com/article/4041127-armour-ua-q4-2016-results-earnings-call-transcript?part=single

[4] https://www.sec.gov/Archives/edgar/data/1336917/000133691716000113/ua-9302016x10q.htm

[5] https://www.amazon.com/Capital-Account-Manager-Turbulent-1993-2002/dp/1587991802

[7] http://www.pbs.org/newshour/rundown/engineers-draw-barriers-to-protect-new-york-from-another-sandy/

[8] http://www.enr.com/articles/41625-fluors-retired-coo-will-become-ceo-of-arcadis

Past performance is not necessarily indicative of future results.  The views expressed above are those of RGA Investment Advisors LLC (RGA).  These views are subject to change at any time based on market and other conditions, and RGA disclaims any responsibility to update such views.  Past performance is no guarantee of future results. No forecasts can be guaranteed. These views may not be relied upon as investment advice.   The investment process may change over time. The characteristics set forth above are intended as a general illustration of some of the criteria the team considers in selecting securities for the portfolio. Not all investments meet such criteria.  In the event that a recommendation for the purchase or sale of any security is presented herein, RGA shall furnish to any person upon request a tabular presentation of:
(i) The total number of shares or other units of the security held by RGA or its investment adviser representatives for its own account or for the account of officers, directors, trustees, partners or affiliates of RGA or for discretionary accounts of RGA or its investment adviser representatives, as maintained for clients. (ii) The price or price range at which the securities listed.

2016 Year-end Investment Commentary

The calendar turning is an arbitrary metric-point from which to measure and assess the recent past and what it portends for the future. It is a moment when we can take a step back and think about our goals and specific paths to achieving them. At key moments during the year, we contemplate what our year-end commentary would look like were the year to end at that very moment. In 2016, there were four distinct periods in which the narrative forged a decisive break from what preceded it:

  1. The Meltdown: January ended with the S&P down 5%. It was down 10% about halfway through the month. The only worse Januaries were in 1990 and 2009. The infamous “January Barometer” which holds “as January goes, so does the market” had many investors trembling. During this time, markets were trading in lockstep with crude oil.[1]
  2. The Snapback: February was similarly volatile, with the S&P and Russell finishing within spitting distance of UNCH (unchanged), after a 6.52% and 9.05% respective drawdown. The 1st quarter finished up for the S&P after a strong March. Energy, mining and industrials led the way up.
  3. The slow grind: This act lasted from the beginning of April through the day before election day. For the first part, markets slowly churned with an upward bias, only to be interrupted by an interlude dubbed “Brexit.” The second half of this act saw the slow upward grind give way to a slow downward grind. While this downward phase will make history books as the “longest losing streak since 1980,” the market fell just shy of 5% altogether.[2]
  4. The PostElection Frenzy-This was the outcome and reaction that no one predicted. Even the most enthusiastic Trump supporters did not expect a market rally upon a Trump victory. What overnight on Election Day seemed like a market catastrophe turned into a surge led by financial stocks, industrials and energy stocks. This strength persisted through year-end, with the tech sector the notable laggard.

While this summary focuses on equity markets, the action in bond markets was equally noteworthy. Coming into the year, consensus was that we were at the start of a rate hike cycle and that rates would rise as the curve steepened throughout the year. Instead, in the first half, rates collapsed and the yield curve flattened. We felt this was “flat wrong.”[3] By the end of the year, rates ended up higher, though the yield curve only steepened slightly. The path was volatile, to say the least.

1

Trading Politics

The year’s political developments deserve further discussion, as they greatly influenced market action throughout 2016. Brexit was the first political landmine for markets during the year. This landmine left little collateral damage on global markets, with the recovery in US indices taking nary more than a few days. It remains to be seen whether the United Kingdom will actually “leave” the European Union, as the political processes were not prepared in advance, and the outcome was hardly popular across all demographic profiles. Notably, the younger voters (under 24) voted in favor of “Remain” by a 75% to 25% margin. [4]

2

In a backwards-looking assessment of 2016, it is easy to forget that what looks like a strong year for equity markets, the pockmarks were severe, with serious questions raised at the time.  At the time, prominent news sites and analysts alike dubbed Brexist “a Lehman Moment” implying that the consequences would be as severe for markets and economies as was the failure of Lehman Brothers in September of 2008.[5] We emphatically argued otherwise and were largely met by deaf ears for a few days until markets quickly repaired themselves and traders grasped how unclear the consequences would be. Our most poignant paragraph from the time is worth repeating today:

The invocation of Lehman here strikes us as a case of “recency bias”—a form of post-traumatic stress disorder that the humans who operate markets exhibit in the aftermath of extreme events. The cleanest definition for the recency bias is that it “is the phenomenon of a person most easily remembering something that has happened recently, compared to remembering something that may have occurred a while back.”[1] Ultimately it is easier to recall recent events, especially when a high level of emotion is involved. Ye the more emotion is involved, the harder it is to cleanly recall a sequence of events with a factual level of detail. This is why every time the markets have had a rough patch since the Great Financial Crisis, some investors wonder whether it will be the next acute phase of troubles. A reality that we often cite in these instances is that it is far safer to fly in an airplane shortly after a crash happens, than just before. This is true because those who are stakeholders in the security of flying are on higher alert for any potential problems in the aftermath of disaster. The same is true in financial markets, with one of the clearest signs today being the very safe capital ratios in the financial sector. If you will recall, the troubles at banks were the transmission mechanism through which problems in markets became a real economic calamity, and while we are never immune from problems in markets, they are far less likely to spread and become really deep when in such good shape.

The U.S. Election has some similarities to Brexit. Ultimately we had what can be called a “populist” vote led by backlash against “elites” with a mandate to protect national interests in an increasingly complex and global economy. The market recovery post-U.S. election was even quicker than following Brexit. While it looks like markets have uniformly surged, the moves have been far more nuanced. The most cyclical sectors have seen the biggest boost, while the most yield sensitive have declined. Technology (in the middle) has done little, if anything. Importantly, most of the forces that have driven this “Trump Trade” were in place well before the election itself.

The cyclical sectors like energy, materials and mining, and industrials had led the way since the market’s strong March. Some of the narrative attribution, suggesting that a major tax reform, a $1 trillion stimulus and a more lax regulatory environment seem overbuilt excuses for an extension of what has been a multi-month rally. There is little evidence that such a stimulus can and will be passed anytime soon. Tax reform might happen sooner, though the consequences are uncertain when considered alongside potential trade tariffs.

The most real rally in any sector since the election is in the financials. We say “real” in this case, because the shift in the yield curve will be consequential for earnings. Bank net interest margins bottomed in Q1 of 2015 and had been trending up, albeit modestly so through 2016.

3

Simply based on the yield curve action, this bottoming in the bank net interest margin will accelerate in 2017. Moreover, while in other areas, the rollback of regulation will be a more complex process, in financials, the administrative rollback of some of the more onerous provisions of Dodd-Frank are easiest. Lastly, and most consequentially, financials started this rally with such outlandishly cheap fundamental valuations that the entire move has taken the sector from substantially undervalued to modestly undervalued. In other words, financials are still cheap. While banks may appear “overextended” on charts in the short-run:

4

There is ample room for acceleration in the longer-term charts.

5

What happens with rising rates?:

For several years, we have pointed out how improving household balance sheets created a solid foundation for economic growth.  Last year, we expanded on this argument with a look at how two forces—rising real wages and falling energy prices—were improving the income statement of households in a way that had not been seen in decades. This is not a narrative we see presented often, but the combination of strong balance sheets and improving income statements creates a compelling case why this post-financial crisis recession should continue despite its age.

The balance sheet improvement was enabled by falling interesting rates—households refinanced more expensive debt into cheaper, fixed rate debt that will keep debt burdens benign for the masses for the foreseeable future. Though this also beg a question we have been asked by many since the Federal Reserve Bank raised interest rates in December 2016: “will rising interest rates will hurt the economy?”. We have oft-stated that this dilemma of accepting rising rates versus hurting the economy is a false one. Our view is that rising rates are a reflection of real economic strength and improvement in underlying fundamentals, rather than an actual damper on the economy. This is not always and forever our view, and to that end, we have emphasized that the next recession will come from the Fed tightening rather than any lingering deflation fears. As of today, think of rising rates as a reflection of an improving economy rather than a lid on anything overheating. As the following chart nicely shows, when rates are below 5% and rising, this tends to be very bullish for the economy:[6]

6

Biggest mistake:

We made more than one mistake this past year; however, numerically what is our biggest mistake does not appear obvious when looking at your account statements. You may have noticed that the best performing stock in the S&P 500 last year was a familiar name: NVIDIA Corporation (NASDAQ: NVDA). We owned this position for a while and earned a decent gain. This gain happens to be a pittance compared to what could have been had we simply held on to the position. For years, Wall Street’s narrative on the stock focused on the declining demand for PC’s and the failure of NVIDIA’s Tegra processor to gain traction in the phone and tablet market. Seemingly overnight that narrative shifted to the surging demand for the company’s server chips. This error of omission reinforces several valuable lessons that we already should have learned, in particular, the value of patience and independent thinking. It also reinforces how seemingly random the search for “catalysts” in company selection actually is. The company’s fundamentals–mainly a pristine balance sheet with gobs of cash & a high margin product with rapid demand cycles–remained essentially unchanged, but the narrative shifted entirely.

This is but one reason we focus on the qualitative and quantitative elements of a company without spending too much time thinking about catalysts. Known catalysts in theory are incorporated into the market’s pricing of a stock, and the unknown by definition cannot be neatly anticipated. Meanwhile, quality companies who generate cash at worst increase in value proportionate to retained earnings and growth, while their multiple changes with the whims of the market’s narrative.

Most valuable lesson:

IMAX (NYSE: IMAX) has been a long-term core position for us, but during the fourth quarter we sold the stock. We have some fears that this could be another NVIDIA for us, though we think there is a legitimate reason behind this sale, and in that reason lies a valuable lesson. Since 2012, IMAX has grown revenues by 32%, with gross profit rising 43% and exhibiting some of the earnings leverage we expected. Unfortunately, net income grew a mere 5.9% and the ROE dropped from near 20% and growing to the low double digits. How is it that a company could grow the top line and gross margin so nicely with none of it flowing through to net income? There are other possible answers, but here the answer is so clearly bad management that we felt compelled to sell and further memorialize our learning here. We would accept the contention that the company hasn’t exactly grown their top line and market share as quickly as we would have liked, yet the results still should have been better and to that again, we fault management.

When we pitched IMAX in the 2013 ValueConferences Wide-Moat Summit[7], we cited management in two of our risk factors for the company, with the most relevant here having been the following: “Little clarity on management’s track record with allocating actual cash flow.” If there is one area where management excels, it is in compensating themselves. We always felt management was promotional and well compensated, but attributed this in part to the “Hollywood” attachment to the commercial film business. When CEO Richard Gelfond was rewarded a special bonus for overseeing an IPO of the company’s Chinese division, we were simply disgusted. In 2014, Gelfond made $10.58 million in total compensation, which surged to $14.5 million in 2015. The stock did ok during this timeframe (rising 23%), but as a proportion of net income, these are some huge numbers that hurt the value in many ways:

  1. The proceeds should have gone to the company’s coffers
  2. The company is valued by the market on a multiple of earnings and this excessive compensation subtracted from it proportionately (for example: the company has traded around a 30x P/E for much of this timeframe. Were Gelfond paid a more modest $5 million instead, the stock would be worth nearly 15% more on a P/E basis, forgetting about the accrued earnings)
  3. Most of the compensation is in the form of RSUs, secondarily in stock options. While the RSUs take time to vest, both forms are dilutive of shareholders. Worse yet, Gelfond habitually sells nearly all his vested shares as they vest.

We also have questions and concerns about the company’s investments happening in the form of ramped operating expense. Our concerns are both in terms of how much they cost, and how they are structured.  IMAX entered into a joint venture to develop and sell in-home private theaters to high net worth individuals.[8] The idea seemingly makes sense as a natural extension of IMAX’ core mission; however, it was structured as a joint venture with a Chinese company. This makes little sense, for IMAX brings the technology and the media to the partnership, while the Chinese company brings little. That this happened at a time when IMAX was looking to IPO its Chinese division entirely is further suspect. Why wouldn’t the company develop this on its own, or with more established Western companies where concerns of governance and the ability to move around cash and other assets is unquestioned?

The second big investment is even worse, for we cannot see how it is a natural extension of the IMAX brand. IMAX is developing a spin-class concept called the IMAXShift, which uses the company’s immersive screens to create the backdrop for the class.[9] The company spent the better part of a decade trying to move beyond niche uses and gain acceptance as a format in the entertainment industry only to now invest some of the proceeds from that success in half-baked, uncertain ideas with limited upside. We would be less irritated by these investments were the company clearer on its US-based growth path and what it can do to squeeze out competition from other premium large format competitors. The company was in the pole position by a wide margin. That margin is smaller now, though still present; yet, the company has not communicated any broader plan about growing its share of US theater spend.

Over the course of our holding period, we have tried to reach out to investor relations and management with phone calls and letters to discuss some of our questions. For one reason or another, we have been unable to have a constructive conversation with anyone at the company regarding first, our interest, second, our concerns. We find this surprising in light of our publicly bullish stance. We feel better positioned on the sidelines now.

New Buys:

In the quarter we made three new buys: one a small cap that we will introduce once we complete purchasing our position; second, a position in Expedia, Inc (NASDAQ: EXPE);  third, a position in Under Armour (NYSE: UA). These purchases were spread both before and after the election. We point this out to highlight how little the election actually impacted our fundamental analysis. While we do have concerns about some shifts in policies, we try to account for this in consideration of each position’s business.

Getting Longer the OTAs:

You may have noticed that with the Expedia purchase, we now own the two largest online travel agencies (OTAs). We think there is a solid basis for owning both at this juncture. We view these two positions as one larger wager on the proliferation of the experiential over consumption spending habits of millennials and a growing interest in travel, generally speaking. However, we also think there are considerable differences that make the risk/reward profiles of the two unique from each other.

While both businesses book hotels, airlines, rental cars and to a lesser extent, activities, the main driver of profitability is from the hotel business. Priceline (NASDAQ: PCLN) primarily uses what’s called the “agency model” while Expedia operates a “merchant model.” The agency model means that when a customer books a hotel on one of Priceline’s properties, the transaction is between the customer and the hotel, with Priceline as the intermediary taking a cut. In the merchant model, the customer’s transaction is with Expedia itself, with Expedia in charge of booking the room and handling the payment. The merchant model generates commissions per each room booked; however, the agency model has less risk associated to it, is more easily scaled and has higher long-term margins on the whole (in contrast to a per room margin).

How these two companies evolved to operate with different models is best explained with their respective geographies. Priceline’s major value driver is Booking.com which mostly caters to the European market. While the hotel chains do have a presence in Europe, the continent’s hotel industry is far more fragmented, with a more abundant supply of boutique, individually owned accommodations. In contrast, Expedia mostly caters to the U.S. hotel market, where boutiques are still present, though far less so than in Europe. Hotel chains operate the majority of properties (whether via franchise or direct ownership). Hotel chains prefer the merchant model to the agency model, because the agencies take a cut off the top without taking any of the business risk associated to it. Further, in the merchant models, the chains can use their scale and commensurate leverage to negotiate deals that are unique to their own interests and needs. This difference in business model and thus geography is an important component to our rationale for owning both.

In the beginning of the year, Priceline was as cheap as it has been outside of the Icelandic volcano eruption and Great Financial Crisis, despite an outstandingly consistent business with a solid growth runway. Expedia, on the other hand, was cheap, but not exceedingly so. Priceline was trading at only a slight valuation premium to Expedia despite the agency model’s superior margin profile. Since that time, Priceline’s stock has outperformed Expedia by nearly 30%, creating a substantial valuation gap that we think is unjustified. Expedia’s problems can be summed up by one word–the company needed some “digestion.” The stock had appreciated substantially in 2015 and needed to digest the upmove and the company had made a series of substantial acquisitions that needed some digestion operationally. The two main acquisitions were Orbitz and HomeAway, both of which we really like. Orbitz expands Expedia’s flight-booking capabilities and offers the opportunity to add Expedia’s lush hotel inventory to the offering on Orbitz itself. HomeAdvisor greatly scales the supply of “rooms” available on the Expedia platform, by bringing both HomeAdvisor itself and VRBO into the fray. This also mitigates the risk presented by Airbnb to the hotel industry.

With the U.S. hotel industry dominated by chains, one of the primary concerns that impacts Expedia more than Priceline is the hotel industries quest to capture more bookings for itself. HomeAway helps diversify away from this risk. Expedia has also taken smart steps in forging deals with some chains in order to turn this risk into an opportunity. A great example of this is Expedia’s recent deal with Marriott whereby Expedia would provide the technological infrastructure for Marriott’s own booking website while offering the flights, rental cars and entertainment add-ons to those customers who want to book on Marriott[10]). Similarly, Expedia signed a deal with Red Lion Hotels to incorporate Red Lion’s reward program into the booking process for those who secure Red Lion reservations on the Expedia website.

At this point, Expedia is trading at 10x next year’s consensus EBITDA, which we think is conservative. The stock is priced for low single digit growth, yet we think there will be a period of double digit growth on the horizon. Management has a great track record of making accretive acquisitions and driving shareholder value. John Malone, through Liberty Media is the controlling shareholder and board member, and his outstanding long-term record of value creation is an important influence on the company’s culture and values. Together, we think our positions in Expedia and Priceline give us great exposure to an important secular trend (experiential spending), at valuations on the cheap side of fair, with outstanding management teams to ensure shareholders are rewarded.

Athleisure is a Lifestyle, not a Trend

This is but one reason we purchased shares in Under Armour. Under Armour is not per se a cheap stock, but it is high quality with as lush a growth runway as any stock we follow. This past year was a rough one for the stock on the heels of slowing growth, compressing margins and a share class split that raised questions about corporate governance. The share class split is actually a key reason why we felt the time was right in creating an opportunity for us. A picture tells the story neatly.

7

Under Armour had done traditional splits in the past; however, this time, the company opted to do something out of the tech company playbook. Instead of a traditional split, Under Armour split its shares into two classes: the A shares, which would have voting rights, and the C shares which would not. This was an effort for Kevin Plank to keep voting control if he sold his controlling shareholdings down to a level beneath what would afford the voting rights to do so. To some in Wall Street, the optics of this are not ideal, yet to us, we feel a position in Under Armour with or without voting rights is a co-investment as a junior partner alongside Kevin Plank (Founder and CEO of Under Armour)-a smart hustler who built the company from the ground up. When the share split first happened, there was a little more than a 3% spread between the A shares and the C shares. Within a few months this spread jumped into the double digits. After Under Armour’s take-down of long-term guidance in October, the spread surged to more than 20%.  We think there were structural and technical reasons behind the extremity of this spread.

  1. The stock had a large short-interest on account of its excessive valuation coming into the year. After the split, this short interest situated itself in the far more liquid A shares, which at that point were trading with the UA symbol.
  2. Kevin Plank filed a 10b5-1 selling plan that would have him selling C shares, but not A shares.
  3. Baillie Gifford and other large institutions with a mandate to own voting shares sold off their entire C share position to buy A shares (Baillie has carried an 8+% position here).
  4. Lack of awareness-since the UA symbol associated with the stock defaulted to the A shares following the original split, most traders and all analysts focused their attention on those shares and essentially ignored the existence of the C.

One consequence of the widening spread was that the C shares got to our long identified buy price well in advance of the A shares, at which point we established half of our position. This was a nice learning lesson, for in the future we will respect the fact that when everyone on Wall Street values a company according to one share class, a second share class reaching even Wall Street’s undervalued metrics would not trigger enthusiasm. Shortly after completing our position, the company announced a change in symbols that would give the “C” shares the traditional UA symbol, and the A shares, the new UAA badge. As a result, the liquidity profile of the respective shares switched overnight and the combination of the company’s messaging that closing the gap would be a priority and taking this optical though meaningful step towards that end elicited the desired response (at least in part). As shareholders of the “inferior” class, we liked this. As market observers, we found this one of the more interesting experiments in the “price anchoring” bias of traders we have ever seen.

What do we own?

In the early-year selloff we picked up and/or added to some quality companies for the long-term. Our overseas holdings had good price returns; however, the Dollar’s strength relative to the euro was once again a drag on our total returns. Our holdings in the pharmaceutical sector hurt considerably during the year and in the process, our lush returns experienced over the prior two years in that space were handed back to Mr. Market.  Below are our three best and three worst positions during the year. We no longer own one of the leaders and two of the laggards. Total returns are indicated based on the stock’s performance during our holding period within 2016 and are denominated in the US dollar.

The Leaders:

Johnson Outdoors Inc. (NASDAQ: JOUT) +91.0%

GrubHub Inc. (NASDAQ: GRUB) +77.8%

JPMorgan Chase & Co. (NYSE: JPM) +54.7

The Laggards:

Vertex Pharmaceuticals Inc. (NASDAQ: VRTX) -39.0%

Teva Pharmaceutical Industries Limited (NYSE: TEVA) -35.5%

IMAX Corp (NYSE: IMAX) -22.6%

Best books we read in 2016

  • Tubes: A Journey to the Center of the Internet by Andrew Blum- fascinating book for anyone interested in how physical structure that enables the Internet works. This is great for anyone with casual interest and those looking for an investment angle to Internet infrastructure.
  • Algorithms to Live By: The computer Science of Human Decisions by Brian Christian and Tom Griffiths- an outstanding self-actualization and efficiency book. The book takes a mathematical approach to finding optimized structures through which to make decisions about everyday life problems.
  • The Snowball: Warren Buffett and the Business of Life –by Alice Schroeder A thorough biography of Buffett the investor and individual that sheds new light on what makes Buffett so unique.
  • Wages of Destruction: The Making and Breaking of the Nazi Economy by Adam Tooze – A detailed history of the Nazi Germany economy from the economic backdrop behind Hitler’s ascension to power, to the industrial prowess of the wartime industries, to the collapse.
  • Shoe Dog: A Memoir by the Creator of Nike by Phil Knight- Phil Knight’s personal memoir’s of how he ended up founding Nike and leading it to tremendous success. Knight is an amazing storyteller, with a prolific memory for the finest details, and an enlightened world view. Anyone could learn a lot from reading Knight’s telling of Nike’s history.

Thank you for your trust and confidence, and for selecting us to be your advisor of choice.  Please call us directly to discuss this commentary in more detail – we are always happy to address any specific questions you may have.  You can reach Jason or Elliot directly at 516-665-1945.  Alternatively, we’ve included our direct dial numbers with our names, below.

Warm personal regards and all the best for a healthy, happy and prosperous 2017,

Jason Gilbert, CPA/PFS, CFF, CGMA
Managing Director
O: (516) 665-1940
M: (917) 536-3066
jason@rgaia.com

Elliot Turner, CFA
Managing Director
O: (516) 665-1942
M: (516) 729-5174
elliot@rgaia.com

 

[1] http://www.rgaia.com/robust-networks-for-the-long-term/ chart from in here

[2] http://www.marketwatch.com/story/dow-futures-frozen-in-place-with-all-eyes-on-jobs-report-election-homestretch-2016-11-04

[3] http://www.rgaia.com/the-yield-curve-is-flat-wrong/

[4] Vote stat and following graph from http://www.politico.eu/article/britains-youth-voted-remain-leave-eu-brexit-referendum-stats/

[5] https://www.bloomberg.com/view/articles/2016-07-04/brexit-is-a-lehman-moment-for-european-banks

[6] https://am.jpmorgan.com/us/en/asset-management/gim/adv/insights/guide-to-the-markets/viewer

[7] http://www.rgaia.com/slide-deck-from-valueconferences-wide-moat-investing-summit-2013/

[8] http://www.imax.com/zh-hans/content/imax%C2%AE-corporation-and-tcl-launch-imax-private-theatre-palais%E2%84%A2-china

[9] http://www.imax.com/content/imax-pilot-immersive-indoor-cycling-studio-concept

[10] https://skift.com/2016/09/06/expedia-is-now-helping-marriott-sell-hotels-on-the-chains-website/

Past performance is not necessarily indicative of future results.  The views expressed above are those of RGA Investment Advisors LLC (RGA).  These views are subject to change at any time based on market and other conditions, and RGA disclaims any responsibility to update such views.  Past performance is no guarantee of future results. No forecasts can be guaranteed. These views may not be relied upon as investment advice.   The investment process may change over time. The characteristics set forth above are intended as a general illustration of some of the criteria the team considers in selecting securities for the portfolio. Not all investments meet such criteria.  In the event that a recommendation for the purchase or sale of any security is presented herein, RGA shall furnish to any person upon request a tabular presentation of:
(i) The total number of shares or other units of the security held by RGA or its investment adviser representatives for its own account or for the account of officers, directors, trustees, partners or affiliates of RGA or for discretionary accounts of RGA or its investment adviser representatives, as maintained for clients. (ii) The price or price range at which the securities listed.

Q3’16 Investment Commentary: On the Matter of Correlations

The third quarter was a strong one, with the S&P rising 3.26% and the Russell 2000 tacking on 8.03%. After several consecutive years of summertime volatility, the summer of 2016 saw an historic volatility compression. This certainly was not a summer to “Sell in May and Go Away” (while we are here invoking that line, it’s important to caveat that even were it a successful strategy—and it’s not—it runs entirely contra to our philosophy of finding and investing in high quality businesses).

All sectors were not equally strong, however, with notable weakness in the yield-sensitive areas.  In our May Commentary we told investors to have their “staple remover ready” and the point applies similarly to Utilities and REITs.[1] These three sectors (just last month the REITs officially became a sector of their own) share one very important trait in common: they have each become proxies or replacements for investors in the quest for yield amidst seven years of Zero Interest Rate Policy (ZIRP).

From our vantage point, some of these trends towards dividend investing involve conflation of several themes that have become popular in recent years:

  • Quality investing—what has become synonymous with the search for companies with consistently high ROICs and mid-single digits growth
  • Dividend—the increasing popularity for anything and everything with yield[2]
  • Low beta/volatility—people have gotten frustrated with the whipsaw moves in markets and have been isolating companies that are more immune than others.

When someone not steeped in the financial lexicon is overwhelmed with certain themes, it becomes all too easy for confusion to take over. It also becomes too easy to take what are good ideas with a solid foundation to an extreme far beyond reason.

The strength in these sectors over the past few years has been driven by allocators targeting certain levels of yield for portfolios and not by investors analyzing businesses and determining a fair worth.  This is an important distinction. Additional drivers have been a preference on the part of investors for lower volatility and a movement towards passive (from active) types of management. In the modern incarnation of passive management, portfolio managers seek to capture factor exposures in desired proportions generally via ETFs.

During the last quarter, there was an important change in the yield sensitive names that we think has gone largely unnoticed but will be meaningful going forward.  Since equities are long duration assets, and the short-term rates are set directly by the Federal Reserve Bank, we decided to use TLT as a proxy for long-term rates.  We first looked at the average daily returns and standard deviations of the S&P, TLT and the yield sensitive sectors over the past three, six and twelve months:

1

There are two important takeaways from this chart:

  • All but one sector—XLU (Utilities)—has a lower volatility (standard deviation) over the past three months than over the past year. This is a distinct change in character for the Utilities, a sector that generally is not very volatile.
  • The average daily return over the last three months in every yield sensitive area (Treasuries itself, and Utilities, Staples and REITs) has turned negative, while the S&P remains positive, on average, every day.

This was the first step in calculating the betas of yield sensitive areas compared to each the S&P and Treasuries. Here are those betas[3]:

2

Note that the betas of XLU (Utilities), XLP (Staples) and IYR (REITs) are greater with respect to TLT than they are with respect to the S&P. Further, in our timeframe comparison, these betas have actually lessened as time has gone on—the betas of these sectors verse the S&P are less over the past three months than over the past twelve months. In fact, the Utilities sector is slightly negative against the S&P over the past three months meaning that for each unit the S&P went up, the Utilities actually went down.

There is an extremely important takeaway here worth emphasizing:

If you are buying these sectors today, you are making an explicit wager on the direction of long-term interest rates.

While some may think they are engaging in some kind of investment, diversification or capture of yield, in reality they are wagering on the direction of interest rates. Yes, to an extent there will be some yield capture along the way, but one problem with low rates is how the sensitive the principal (your invested dollars) is to the change in yields. If it is yield you seek, we are afraid to tell you that this market does not offer much of it. If instead you are looking to make an explicit wager on interest rates, there are far better ways to do it than through these vehicles. Needless to say, we feel many investors are in these places right now for all of the wrong reasons.

You may have noticed that all this while, we have spoken about the “yield sensitive areas” without touching on XLF (the financials)—the other sector in our grids above. We are saving this for our conversation below.

Portfolio Update:

After an active first half of the year for portfolio activity, the second half has had a slow start. We made one notable portfolio change—we purchased shares in The Charles Schwab Corporation (NYSE: SCHW).  We love when a confluence of themes we believe in come together in one company, with a reasonable valuation.[4] Our business, our investment in Envestnet (NYSE: ENV), and now our investment in Schwab (NYSE: SCHW) all are at least partly premised on the big transition from a commission-based to fiduciary, fee-based wealth and asset management industry. Registered Investment Advisors continue to grow at the expense of the brokerage wirehouses, reporting double-digit annualized growth for over a decade.

At first glance, the online and discount brokers are typically associated with cheap commissions for retail clients. Yet at Schwab, this is a small and diminishing part of the story.  As recently as 2011, trading revenues accounted for more than 20% of the company’s total top line. Today, trading accounts for about 14% of revenues.  Net interest revenues have been the primary beneficiary in terms of total revenue share—rising from 37% to 40% of net revenues. Notably, net interest revenues have grown in share despite the persistence of the Fed’s zero interest rate policy and the corresponding waiver of money market fund management fees.

Despite the money market fee waiver headwind, Schwab has exhibited consistent operating leverage throughout the post-crisis period. Each year has seen an average of a 1% operating margin increase, with 2016 seeing an accelerating on the heels the December 2015 rate hike—the first since getting down to 0% in late 2008.

This growth is impressive and stems from the company’s consistent ability to provide value-added services to retail and institutional clients, fostering consistent double-digit asset growth and mid-single digit account growth.  A great example of this is the traction Schwab continues to make in its robo-advisor offering (what Schwab calls “Intelligent Portfolios). Assets now exceed $10b, with many of the clients coming from outside of Schwab’s existing clientele. Moreover, asset growth in this segment contributes to further growth in the company’s ETF offerings—an area where the company has become an increasingly formidable force alongside the likes of BlackRock and Vanguard. Per Bloomberg, “Five years ago, Schwab wasn’t even in the top 10 of ETF managers by assets. Now it’s ranked fifth, with $54 billion in its 21 ETFs.”[5] These are nice examples of a virtuous cycle at work, driving significant growth at the company. They are also evidence of steps Schwab has taken through the years to shift their business from trading, to areas that are growing in need and will continue to do so over time. In its illustrious history of driving value for small and retail clients, Schwab has exhibited an exceptional track record of anticipating and driving, rather than reacting to industry trends.

In the past year, the financial sector has traded inversely correlated to the direction of rates. This has been increasingly so in the past 3 months. Stated another way: as rates have gone up (down), financial stocks have gone up (down). Thus in some respects, a purchase of a financial stock seems like a bet that rates will go up. Further yet, over the past year, financials have appeared to be a levered bet (i.e. high beta) on the direction of the S&P. This relationship has been breaking down over the past three months and we think this change is both notable and enduring.  With respect to the Great Financial Crisis, we have often evoked the idea that it is safer to fly after a crash than before, because everyone in a position of accountability is on their highest alert for potential problems. The disdain for financials as a sector (as evidenced by their market low valuations and high volatilities) is an example of the market fighting the past battle instead of looking forward. The system itself is far more resilient and robust today than before the Crisis, yet people seem more worried now. This is a problem of perception.

We paid 26 times trailing earnings, though if interest rates normalize this would be more like a 15 times multiple. What we like about Schwab in particular is the evidence that the company has driven great results irrespective of the rate direction. Upside in rates, will lead to meaningful upside in the stock; however, a rate move notwithstanding, the company continues to drive immense value with its diverse offerings.  We are hardly the first to note this relationship between Schwab’s future earnings and the trajectory of rates. These moves have in fact been driving the stock over the past year. Where we think our perception is unique is with respect to the underlying diversity in quality and growth that Schwab has exhibited and how those forces will drive the business.

The stock has spent most of the past 20 years trading with a mid-20s multiple. If that stays constant (and rates never normalize), we think we will earn a double digit percent long-term return on the heels of strong account growth, robust asset growth and consistent operating leverage. Should the stock’s multiple regress to the market’s multiple (~17x) then we would still be looking at mid-single digit returns over eight to ten years.  If rates do return to levels above 1% on the Fed Funds over the next decade, upside and IRRs would be comfortably in the double digits, even with multiple compression.  As a result, there is the potential for something special here without taking on very much downside risk.

Housekeeping:

You may have noticed that we did not issue a monthly commentary over the past few months. In our internal talks and talks with many of you, we realized that the frequency of commentaries was creating two problems—one specific to us, and one for you, our clients. For us, we have been writing these commentaries for so long now that we have run out of unique general philosophical bits to share without getting overly redundant. For you, the frequency and lengths of some of our narrative resulted in a lower than expected read-count. Quarterly commentaries provide a solution to both: we can go in-depth on a well thought out topic without overwhelming your inbox.

To that end, we plan on approaching these with a different format than in the past.  Each will start with a general overview of something timely or relevant in markets, or a philosophical concept that we would like to delve into (often we anticipate an overlap between both). Next, we will do an update on the latest actions within your portfolios, and if there are none, we will focus on notable stock moves or news within the quarter.

Thank you for your trust and confidence, and for selecting us to be your advisor of choice.  Please call us directly to discuss this commentary in more detail – we are always happy to address any specific questions you may have.  You can reach Jason or Elliot directly at 516-665-1945.  Alternatively, we’ve included our direct dial numbers with our names, below.

Warm personal regards,

Jason Gilbert, CPA/PFS, CFF, CGMA
Managing Director
O: (516) 665-1940
M: (917) 536-3066
jason@rgaia.com

Elliot Turner, CFA
Managing Director
O: (516) 665-1942
M: (516) 729-5174
elliot@rgaia.com

[1] http://www.rgaia.com/may2016/

[2] Dividend investing got so extreme that in the MLPs in particular, investors were looking purely at screened “dividend yield” and ignoring dividend coverage. Dividend coverage is the extent to which net income (actual earnings) affords the company an opportunity to pay a dividend. Throughout this entire sector, coverage ratios were negative; meaning, dividends either had to be paid with balance sheet cash, increased indebtedness, or raising new equity (or some combination of the 3). It took worsening fundamentals for investors to painfully realize that what seemed like a dividend, was not actually a yield, but rather their very own invested capital returned at the expense of increased risk on the corporate level.

[3] In case you were wondering, there was one more step along the way: calculating the correlations between the various securities. We have not included that look here as the same general points are captured by the betas.

[4] Several of these themes were recently covered by Elliot in a presentation at the ValueConferences Wide Moat Investing Summit. http://www.rgaia.com/envestnet/

[5] http://www.bloomberg.com/news/articles/2016-10-06/schwab-s-etfs-are-gobbling-up-a-2-4-trillion-market?utm_content=business&utm_campaign=socialflow-organic&utm_source=twitter&utm_medium=social&cmpid%3D=socialflow-twitter-business

Past performance is not necessarily indicative of future results.  The views expressed above are those of RGA Investment Advisors LLC (RGA).  These views are subject to change at any time based on market and other conditions, and RGA disclaims any responsibility to update such views.  Past performance is no guarantee of future results. No forecasts can be guaranteed. These views may not be relied upon as investment advice.   The investment process may change over time. The characteristics set forth above are intended as a general illustration of some of the criteria the team considers in selecting securities for the portfolio. Not all investments meet such criteria.  In the event that a recommendation for the purchase or sale of any security is presented herein, RGA shall furnish to any person upon request a tabular presentation of:
(i) The total number of shares or other units of the security held by RGA or its investment adviser representatives for its own account or for the account of officers, directors, trustees, partners or affiliates of RGA or for discretionary accounts of RGA or its investment adviser representatives, as maintained for clients. (ii) The price or price range at which the securities listed.

An Envestnet for the Long Run

Elliot Turner was honored to present at the 2016 Value Conferences Wide Moat Investing Summit. He presented IMAX at the inaugural event three years ago followed by eBay/PayPal in 2015. At this fourth annual event, recognized value-investors presented some of their best investment ideas. Elliot presented on Envestnet.  We are excited to share his slides here:

June 2016 Investment Commentary: Brexit is No Lehman

As of last week, the story for this quarter was going to be different. We were going to highlight the more orderly recovery in stocks taking place after a chaotic first quarter. On Wednesday, the 22nd of June, the S&P closed within spitting distance of all-time highs. That narrative suddenly evaporated the night of Thursday June 23rd as votes were counted in the United Kingdom on whether to “leave” or “remain” in the European Union. In a flash, the British Pound went from its highest level of the year to its lowest level in thirty years:

1

What followed was one of the harshest days of selling in global markets, with our S&P falling 3.59% on that Friday, alone. The weekend did little to curb the selling pressure as market commentators wondered aloud whether this was a “Lehman moment.” Since Lehman’s failure marks the most cataclysmic event in financial markets since the Great Depression, we think it is important to address head-on this fearful reprise and bring a dose of reality to the conjecture, as the differences between Lehman and “Brexit” are far more consequential than any perceived similarities.

Mr. Market’s PTSD:

The invocation of Lehman here strikes us as a case of “recency bias”—a form of post-traumatic stress disorder that the humans who operate markets exhibit in the aftermath of extreme events. The cleanest definition for the recency bias is that it “is the phenomenon of a person most easily remembering something that has happened recently, compared to remembering something that may have occurred a while back.”[1] Ultimately it is easier to recall recent events, especially when a high level of emotion is involved. Ye the more emotion is involved, the harder it is to cleanly recall a sequence of events with a factual level of detail. This is why every time the markets have had a rough patch since the Great Financial Crisis, some investors wonder whether it will be the next acute phase of troubles. A reality that we often cite in these instances is that it is far safer to fly in an airplane shortly after a crash happens, than just before. This is true because those who are stakeholders in the security of flying are on higher alert for any potential problems in the aftermath of disaster. The same is true in financial markets, with one of the clearest signs today being the very safe capital ratios in the financial sector. If you will recall, the troubles at banks were the transmission mechanism through which problems in markets became a real economic calamity, and while we are never immune from problems in markets, they are far less likely to spread and become really deep when in such good shape.

The reason we are calling out the market’s recency bias is that a far more apt historical analogy does in fact exists and the set of circumstances around it are very similar to what is happening today. We will visit this example shortly, but it is important to first point out that without question, markets were taken aback and surprised by the vote. Herein lies the one similarity to Lehman—market commentators did not expect the powers-that-be to let Lehman fail. Yet, too much of the rhetoric focuses on the binary question of “whether the markets were wrong about the Brexit vote?” Markets do not think in terms of yes or no. Instead, they handicap likely probabilities, and clearly the expectation was too high that the Remain vote would win.

Moreover, we think labeling this a “Lehman moment” relies on the wrong paradigm for understanding Lehman’s failure. On the five year anniversary of Lehman’s collapse, we wrote our commentary suggesting that investors “beware of mistaking a symptom for the cause.”[2] Lehman certainly exacerbated problems, but the key feature of Lehman is that it was caused by really deep, underlying stresses in our financial system. According to the Federal Reserve Bank of New York’s own internal documents, released nearly three years after Lehman’s failure, the Fed essentially says that the bank run began around August 20th, 2008, nearly four full weeks before Lehman filed for bankruptcy.[3] This was the first bank run our country experienced since the Great Depression. Clearly Lehman was not the causal event, it was a symptom.

So how does this relate to Brexit? Beyond merely contemplating frightening events, it doesn’t relate in the slightest. As discussed earlier, it is far easier to contemplate horrible possibilities than to weight likely ones. Lehman had some obvious and immediate contagion effects. For example, within days of Lehman’s bankruptcy, one of the largest utilities in the country was on the brink of filing its own bankruptcy due to counterparty risk with Lehman.[4] Meanwhile, days after the Brexit referendum we remain unsure whether the UK will even exit the EU. From here, there will be no next step until at least October when a new Prime Minister is selected in the UK. Only then will we know if a two year (or longer) process for departure will in fact commence. While the uncertainty is challenging for markets to grapple with, the imminent prospects of financial stresses that could bring down companies and impact how the average American lives their life with regard to spending and investment is essentially non-existent. Importantly, despite the plunge in bank stock share prices since the vote, there are no real signs of stress in financing channels. In fact, credit indicators remain mostly constructive and are far more benign than they were a few short months ago.

If Not Lehman, Then What?

Recall that the recency bias lends more weight to recent events than to something that happened further back in time. There is truly a historically relevant comparison that we have hardly seen mentioned in the press at all following the Brexit vote. Many of you are probably aware that whereas countries like France, Germany and Italy use the euro as their currency, the United Kingdom uses the Pound. This is so despite all countries being members of the EU. As history would have it, the UK was supposed to be part of the euro currency until what is today referred to as “Black Wednesday” (Wednesday, September 16, 1992)— also known as the day George Soros “Broke the Bank of England.”[5] This event similarly happened at a crucial juncture on the pathway to European integration.

It is worth sharing the “aftermath” section from Wikipedia here in its entirety:[6]

Other ERM countries such as Italy, whose currencies had breached their bands during the day, returned to the system with broadened bands or with adjusted central parities. Even in this relaxed form, ERM-I proved vulnerable, and ten months later the rules were relaxed further to the point of imposing very little constraint on the domestic monetary policies of member states.

The effect of the high German interest rates, and high British interest rates, had arguably put Britain into recession as large numbers of businesses failed and the housing market crashed. Some commentators, following Norman Tebbit, took to referring to ERM as an “Eternal Recession Mechanism” after the UK fell into recession during the early 1990s. Whilst many people in the UK recall ‘Black Wednesday’ as a national disaster, some conservatives claim that the forced ejection from the ERM was a “Golden Wednesday” or “White Wednesday”, the day that paved the way for an economic revival, with the Conservatives handing Tony Blair’s New Labour a much stronger economy in 1997 than had existed in 1992 as the new economic policy swiftly devised in the aftermath of Black Wednesday led to re-establishment of economic growth with falling unemployment and inflation (the latter having already begun falling before Black Wednesday).

The economic performance after 1992 did little to repair the reputation of the Conservatives. Instead, the government’s image had been damaged to the extent that the electorate were more inclined to believe opposition arguments of the time – that the economic recovery ought to be credited to external factors, as opposed to good government policies. The Conservatives had recently won the 1992 general election, and the Gallup poll for September showed a 2.5% Conservative lead. By the October poll, following Black Wednesday, their share of the intended vote in the poll had plunged from 43% to 29%, while Labour jumped into a lead which they held almost continuously (except for several brief periods such as during the 2000 Fuel Protests) for the next 14 years, during which time they won three consecutive general elections under the leadership of Tony Blair (who became party leader in 1994 following the death of his predecessor John Smith).

Note that speculators quickly went on to attack Italy’s currency (then the lira) on the assumption that other similarly frustrated and vulnerable countries would be at risk of similarly troubling attacks in currency markets. This history is rhyming today as traders drive down global markets on speculation that yet again, Italy and other weak countries in the EU might host their own referendums to leave the EU, creating a troubling spiral of events. After Black Wednesday, the UK quickly fell into recession and took years to recover. This too will be the UK’s economic destiny today, and in our estimation, is the most likely consequence—a harsh reality for those in the UK, but not so much for us here in the United States.

The S&P chart from the beginning of 1992 to that same date one year later paints an interesting picture:

2

The S&P had been range-bound for months leading up to Black Wednesday. It dropped 4.3% over the next two weeks (once upon a time markets moved a little slower than they do today); recovered to 52-week highs within two months; and, one year later was up 9.4% from that of Black Wednesday. There is no reason to suspect that the S&P move from here on out will be similar. We are merely highlighting the aftermath to show that a traumatic political event out of the UK, with significant economic ramifications need not change the trajectory for the US economy or the US stock market. The biggest consequences today, as they were then, will be local and political, and while there could be some negative ripples that follow-through, we think it is imprudent to position based off of what these ripples might entail.

In sum: as of today, it remains unclear when, or even if, the UK will actually leave the EU, it is unlikely that there are any enduring economic consequences for us here in the U.S., and there are no imminent follow-on events that would tell us otherwise.

Thank you for your trust and confidence, and for selecting us to be your advisor of choice.  Please call us directly to discuss this commentary in more detail – we are always happy to address any specific questions you may have.  You can reach Jason or Elliot directly at 516-665-1945.  Alternatively, we’ve included our direct dial numbers with our names, below.

Warm personal regards,

Jason Gilbert, CPA/PFS, CFF, CGMA
Managing Director
O: (516) 665-1940
M: (917) 536-3066
jason@rgaia.com

Elliot Turner, CFA
Managing Director
O: (516) 665-1942
M: (516) 729-5174
elliot@rgaia.com

[1] http://www.davemanuel.com/investor-dictionary/recency-bias/

[2] http://www.rgaia.com/september-2013-investment-commentary-beware-of-mistaking-a-symptom-for-the-cause/

[3] http://www.nytimes.com/2011/04/03/business/03gret.html

[4] http://blogs.wsj.com/deals/2008/10/21/constellation-and-then-we-came-to-the-crisis/

[5] https://en.wikipedia.org/wiki/Black_Wednesday and http://www.investopedia.com/ask/answers/08/george-soros-bank-of-england.asp

[6] https://en.wikipedia.org/wiki/Black_Wednesday

Past performance is not necessarily indicative of future results.  The views expressed above are those of RGA Investment Advisors LLC (RGA).  These views are subject to change at any time based on market and other conditions, and RGA disclaims any responsibility to update such views.  Past performance is no guarantee of future results. No forecasts can be guaranteed. These views may not be relied upon as investment advice.   The investment process may change over time. The characteristics set forth above are intended as a general illustration of some of the criteria the team considers in selecting securities for the portfolio. Not all investments meet such criteria.  In the event that a recommendation for the purchase or sale of any security is presented herein, RGA shall furnish to any person upon request a tabular presentation of:
(i) The total number of shares or other units of the security held by RGA or its investment adviser representatives for its own account or for the account of officers, directors, trustees, partners or affiliates of RGA or for discretionary accounts of RGA or its investment adviser representatives, as maintained for clients. (ii) The price or price range at which the securities listed.