What a difference a few weeks can make! Following one of the sharpest declines in history during the first quarter of 2020, we saw one of the strongest rebounds in the second quarter. As measured by the S&P 500, the market returned -3% for the first half of 2020, despite returning 20.5% in the second quarter. This came on the heels of the 19.6% loss in the first quarter. Because of the returns of a few large cap technology companies, the S&P 500 performed better than the Dow Jones Industrial Average, which returned -8.4% for the first half of 2020. Small and mid-cap stocks, as measured by the Russell 2500, also lagged their larger peers and returned -11% in the first half of 2020.
The Macro Environment
The greatest influence on the financial markets has been the positive investor reaction to the stimulus provided by the Federal Reserve and from relief programs for the coronavirus epidemic. Both monetary and fiscal levers were used, but unemployment remains troubling with more than 17 million Americans out of work. On the monetary side, the Federal Reserve (Fed) and central banks around the world have signaled that interest rates will remain low for a long time as inflation is muted. In varying degrees, central banks are purchasing all forms of debt across the maturity spectrum to manage the yield curve. The Fed’s balance sheet is in excess of $7 trillion and unprecedented liquidity has been pumped into the system. As a result, we do not and will not have a free market but rather a managed market for an extended time. This perceived government safety net coupled with the reopening of the economy and some rebound in employment buoyed investor spirits and the equity markets as well. Concerns about COVID-19 were pushed into the background. Unfortunately, recent data shows that the virus continues to spread and there are daily records of new infections in populous states across the south and west. Other “hot spots” with rising infections include Brazil, Latin America and India. It may be that the optimism of investors is premature and that our economy may be subjected to several fits and starts; company profits and cash flows will be similarly interrupted and volatile. With the market now at extended and unattractive valuation levels and with such an uncertain outlook, we continue to take a cautious and conservative approach to both allocation and issue selection. We expect that better opportunities will emerge in the future and that patience and restraint from “chasing” stocks is required. Currently, we are in a rebounding equity market that has been labeled TINA (There Is No Alternative) and where investor sentiment is dominated by FOMO (Fear Of Missing Out). Such environments historically have not ended well.
This client letter is being written during the celebrations of our country’s birth and declaration of independence. While our country is not perfect and improvement is hopefully in our future, the tenets of freedom, individual rights and justice for all have been the foundation of our great country. As this is our second client letter since we formed Heron Bay Capital Management and we are in the midst of a pandemic, political turmoil and racial tension, it is a good time to review our investment philosophy that provides the foundation of our portfolio construction efforts. We will also review how this is currently being expressed in the strategies at work in your portfolio. Accordingly, this letter may be longer than normal.
Investment Tenet: Valuation
At Heron Bay Capital Management, we pay close attention to valuation and it has served me well for over 40 years. Investment return is a function of the price paid for something, the current price or the level it could be sold at and the income received. I have always been a “value” investor and sought undervalued stocks for purchase and been a seller when the stocks became overvalued. My thinking and discipline have changed over time and become more holistic. Early on, research and personal experience taught me that investing in stocks with low price-to-earnings (P/E) ratio was a fruitful way to capture excess returns due to their reversion to the mean. Low P/E stocks were less expensive due to neglect or some short-term issue that caused them to be out of favor. However, some were cheap for good reason and became a “value trap”. Later, I came to define value as multiple variables on a sector-specific basis with measures of cash flow and free cash flow rising in importance. Now, I look for the right blend of value, profitability, and predictors of cash flow. Profitable companies with astute capital allocation discipline can continue to grow without taking on additional levels of debt or risk. These qualities are underappreciated by the market and make for favorable investments when the company’s internal investments expand earnings in excess of the low expectations for the company.
Investment Tenet: Quality
There are many definitions among investors of the term quality. For the purposes of our investment discipline, a quality company delivers an above average, consistent and ideally growing level of profitability. These are measured by the amount of cash return that is generated by the investment within the company or, stated differently, it is the return on invested capital or operating assets. Companies with these attributes have a competitive advantage that allows them to achieve a higher level of profitability. Some of these companies maintain their competitive advantage by operating in niche markets or in oligopolistic industries. With a long-term view, we can discount this cash flow stream to determine an underlying intrinsic value of the company, which in turn can be compared to the current market price. Alternatively, at the current market price, the internal rate of return (a function of free cash flow yield and free cash flow growth rate) can be compared to other investment opportunities.
The level of debt or financial leverage is critical to evaluating quality. While debt can be an important source of capital for those companies that can generate a return above the cost of the debt, it creates a higher level of risk. As the cost of the debt is constant or perhaps rising, the profitability of a company may not be and is subject to cyclical or secular pressures. Management hubris and short-term thinking encourage “empire building” by using high levels of debt to create growth of less profitable or cyclical businesses. When conditions change, the investor is penalized. By comparison, companies with a conservative capital structure and high levels of debt coverage have a more durable enterprise that is not subjected as much to the risks of rising interest rates or a decline in their revenues (regardless of cause or duration). For us, the characteristics of superior profitability and conservative levels of debt represent a high quality, long term investment opportunity and are not a speculation about short-term growth.
Current Portfolio Positioning
Our discipline of holding high quality companies that are attractively valued has resulted in concentrations in certain sectors that deviate meaningfully from popular benchmarks. These benchmarks and the passive strategies that represent them hold many more stocks and include many that are riskier or less attractively valued than we care to own. Our investments represent only those companies with the attributes we seek and are attractive in the long-term. Health Care represents the largest sector overweight in our equity portfolios compared to an index weighting. This sector benefits from an aging population that spends more on health care. The large cap biotech, pharmaceutical and private health care insurance companies all are beneficiaries. Our investments represent only those companies that have the desirable investment characteristics described above and where we understand the business model. Further, many have an above average dividend yield.
Over the quarter, we added to existing positions and added some new stocks during the panic phase of the equity market. These included a manufacturing company, defense and aerospace companies as well as energy companies. We reduced our exposure to banks and interest sensitive stocks and have little or no exposure to REITS, utilities or commodity companies as they do not currently meet the criteria of investment in our discipline. We remain cautious about investing in consumer stocks and most other cyclically sensitive stocks as most appear expensive and subject to the economic swings that are probable due to continued measures to contain the coronavirus.
Many clients have an income need or have a conservative asset allocation due to their unique risk tolerance. For these clients, we have maintained an exposure to bonds or municipal bonds. We have concentrated on high quality, short- to medium-term maturities with a high probability of being called in the next 3 years. These were very attractively priced at the time of purchase. The crisis environment that typified March and April gave us a great opportunity to make attractive investments in closed end funds (CEF’s) and some preferred stocks in the financial sector. Each became attractively valued and offered significant yield advantages as the prices were falling due to investor panic at the time. These investments should provide a stable flow of income for those who desire it.
Mega Cap Technology or FAANG plus Microsoft
Much has been written over the past 3 years about the success, growth, and stock performance of the FAANG stocks represented by Facebook, Amazon, Apple, Netflix and Google and more recently Microsoft. They are very popular and their combined market capitalizations represent an unprecedented concentration in the popular indices and passive strategies as capital continues to flow to these “winners” regardless of valuation. We have been holders of Apple, Microsoft and Google as these were purchased when their valuations were much more attractive. We have never owned Facebook, Netflix or Amazon as they have not met our criteria of quality or attractive valuation. As a group however, these stocks have advanced 26.3% as the market has declined. While these companies continue to execute well on their business models, they are coming under increased scrutiny of their business practices, privacy policies and antitrust behaviors all of which represent increasing risks to their future growth. By contrast, their valuations have become increasingly stretched and we have been reducing our exposure to the companies we own. Not since the dot.com era have we seen such concentration of capital and flows by less price sensitive buyers to such a narrow group. As we all know, it did not end well and it guides us to a more cautious and conservative portfolio structure that emphasizes less expensive, quality companies. We remain over-weighted to technology in most long-term oriented portfolios as there are many investment opportunities in attractively valued quality companies.
It is our hope that during this uncertain and distressing time that you and your family remain healthy and safe. If you have any questions about your portfolio and the strategies we have employed or if you have changes in your personal circumstances, please call. As things open up and as we can safely meet, it is our desire to have a meeting, taking the necessary precautions. Alternatively, we can have a traditional phone or video call.
Heron Bay Capital Management, LLC (“HBCM") is a registered investment advisor. Advisory services are only offered to clients or prospective clients where HBCM and its representatives are properly licensed or exempt from licensure. For current HBCM information, please visit the Investment Adviser Public Disclosure website at www.adviserinfo.sec.gov by searching with HBCM’s CRD #305537.
No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. All investments include a risk of loss that clients should be prepared to bear. The principal risks of HBCM strategies are disclosed in the publicly available Form ADV Part 2A. Risk associated with equity investing include stock values which may fluctuate in response to the activities of individual companies and general market and economic conditions.
The model performance shown was created by HBCM utilizing Portfolio Attribution within Factset for each investment portfolio listed. The model performance shown is not indicative of future performance, which could differ substantially. It does not reflect actual account performance for any specific client or a composite performance for a group of clients. Model results represent what an investor’s returns might have been, had they been invested in the exact investments using the exact same allocation for the exact same time period for the model portfolio reflected. This does not reflect the impact that material economic and market factors may have had on decision making. The results shown were achieved by means of a mathematical formula.
Actual returns will be reduced by investment advisory fees and other expenses that may be incurred in the management of the account. The collection of fees produces a compounding effect on the total rate of return net of management fees. The applicable fees are described in Part II of the Form ADV.
Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income. You cannot invest directly in an Index.
All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.