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October 16, 2019

Common Sense Not Drama

Valuation 50 Q1 Review

The Valuation 50 returned 15.39% in the 1st quarter of 2019, outperforming the SPY by 187 bps. The Valuation 50 outperformed the SPY by 191 bps and 14 bps in January and March respectively, and underperformed by 27 bps in February. (Total returns)

Common Sense Not Drama

With Q1’19 behind us, we were again reminded why most strategies which trade in and out of the market are nothing more than a Siren call luring a portfolio to crash on the rocks of chasing returns. Much better to be Odysseus and put wax plugs into your ears and focus on the long term to avoid buying high and selling low as volatility trashes your sense of normality. After Q4’18, few people had much appetite for equities, thinking only bad news would prevail in the year ahead. Yet, by the end of Q1’19, US equity markets were up double digits.  The Valuation 50 outperformed the SP500 by 187 bps in Q1’19.  Had the strategy underperformed, our discussion would not change, however. During the past 15 years, the Valuation 50 has delivered on its goal of consistently beating the SP500 by 100-200 bps annually.  Since inception, the strategy’s annual returns have outperformed the SP500 approximately 66% of the time, while delivering annualized returns around 130 bps in excess of the SP500.  Recently, one of the largest portfolio consultants asked us, as a team what do we do differently during periods of underperformance such as Q4’18.  For our long-time partners, our answer was not surprising – nothing. The strategy has no trades in Q1’19, as the companies we owned continued to offer solid potential, while providing a reasonable and credible path forward to realize their upside over time. We are confident that over the long-term the process we have created stacks outcomes in our favor, with common sense risk management that avoids excessive specific sector or stock exposure. We don’t claim the process is rocket science, but as the record of most failing money managers show, it is very difficult to implement as successfully and consistently as we have with the Valuation 50.

Looking Backward and Forward

The memories are still fresh the SP500 lost 13.5% of its value in Q4 of 2018, with 9.2% alone in December. Barely did investors have a chance to regroup, the SP500 rose 9.92% in January and closed 19Q1 15.4% higher. In fact, 19Q1 is the best quarterly gain for SP500 in nearly 10 years and its best start to the year since 1998.

We wrote in our last quarterly review that a few things might reverse the negative sentiments in 18Q4, namely, 1) The Fed slows down and pauses; 2) A trade agreement with China is reached; 3) Healthy corporate earnings and revenue growth.

It turned out a more dovish Fed is indeed the best friend to the equity market, at least in the short run. On January 4, Fed Chairman Powell indicated inflation was muted and the central bank would be in no hurry to raise rates. The SP500 rose more than 4% on the day and ended January nearly 10% higher. In late March, the Fed formally trimmed the number of rate increases they foresee in 2019 from two to zero while holding its benchmark funds rate unchanged in a range of 2.25% to 2.5%. The central bank will also complete its balance sheet roll-off program at the end of the September, which will likely leave the Fed balance sheet with at least $3.5 trillion in bonds, down from roughly $4.25 trillion when the program started. The quick change in the direction of the Fed rate policy is striking, which according to the fed, was attributable to reduced expectations in US GDP growth (from 2.3% to 2.1%) and inflation (from 1.9% to 1.8%) and a slightly higher unemployment rate (from 3.5% to 3.7%). The great equity market returns in Q1 suggest investors are less concerned about the reduced GDP growth projection, or at least in the short term, believe the GDP will be fine if the Fed leaves it alone without raising rates too fast.

Separately, great progress has been made on the trade negotiation with China. In fact, since both sides signaled progress in talks in late December, the U.S. and Chinese stocks have both turned around, with China’s Shanghai Index up roughly 30% YTD.

On the corporate earnings front, the picture is not as rosy relative to the Fed and China. 19Q1 earnings estimates for the SP500 have been marked down by 7.2% since December, representing the largest percentage decline in the quarterly bottom-up EPS estimate since Q1 2016 (-9.8%). For the SP500 in 2019, analysts are now projecting earnings growth of 3.7% and revenue growth of 4.9%, down from 7.9% and 5.3% in December.

With projected 2019 EPS at ~$168, the latest SP500 level trades at approximately 17 times forward 12 months EPS, up from 14 times at the end of 2018.

Looking ahead to the current quarter, completion of a trade agreement between the US and China, better growth data from China, and continuously healthy US economic growth could keep the equity market in good shape, as macro and corporate growth estimates could be revised higher. On the other hand, a failure to reach a trade agreement (unlikely in our view though), volatile growth data from China and/or the US, and worsened European economic data whether it is due to a messy Brexit or continued weakness in European manufacturing, would make the market choppy.

While it is important to be keen observers of current events and be able to comprehend their impact, what happened in 18Q4 and 19Q1 again suggests chasing price is a futile exercise and an obsession with near term momentum is a harmful mindset. Instead, it is critical to focus on the long term, have conviction in investment ideas, and rely on intrinsic value as core guidance not price. A recession is going to occur and unemployment will go up, that is part of life. However, a blip in US economic growth has little impact on the fundamental strength or potential of the overall US economy in the long run. It is important to remember that the US economy is among the longest duration entity in the world, and the equity market is an epitome of corporate America. If the US economy is still capable of growing at positive rates in the long term, corporate America will see its value grow and so will the equity market.

It is critical, however, that our assumption remains intact that the best days are ahead for the US. We have always taken it for granted this assumption would hold true, as that has been the case for the past 250 years. Free private enterprises have been the true engine of growth for the US, and the combination of capitalism and principles laid out by the founding fathers have worked spectacularly well in making this young nation the most prosperous country on the earth. With the progressive camp in the democratic party being increasingly bold and outspoken, the 2020 US presidential election promises to have a heated debate over socialism and capitalism. We are getting a taste of those debates hearing the leftist democrats touting economic policies such as: the Green New Deal, Medicare For All, hiking top marginal income tax rate to 70%, among others. Though the progressives argue their policies are inspired by the success of the Nordic countries of Sweden, Finland, and Norway rather than Venezuela or Cuba, their proposals ignore the actual practices of those Nordic countries, which indeed tend to have a big safety net but also have more recently moved in the direction of cutting taxes, reining government benefits and freeing up their economies.

If our capitalism based, free enterprise driven economy can continue to unleash its power, the future will remain bright and the upward bias of the equity market would hold true. As disciplined investors, we are confident our valuation driven strategy will likely lead to consistent outperformance and create wealth for investors. With an average turnover rate of approximately 10% a year, the Valuation 50 has an average holding period of 10 years, which is long enough to cover most economic cycles from bottom to peak or vice versa. We strive to own strong companies in their respective sectors that can survive and thrive under any economic conditions, with attractive valuation as our best defense. We also favor companies with solid balance sheets and ample debt coverage, so they can carry out their corporate strategy under any interest rate environment.

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