It has been a year for the record books. A market which started the year on an optimistic note, had an unprecedented rapid decline, the likes of which we had never seen before. From February 20, 2020 until March 23, 2020 the market as measured by the S&P 500 dropped 34%. Quick action by the Federal Reserve (Fed) and the Government in terms of massive monetary and fiscal stimulus caused an equally dramatic but bifurcated recovery, which is not apparent looking at the price action of the indices. Companies that benefit from working from home gained immensely while the real economy companies (restaurants, industrials, travel, banks) have in many cases, continued to hit new lows. Some refer to this as a “K” shaped recovery.
Since the “Great Recession”, the Fed has had a very active hand in the economy and continues to provide high levels of liquidity to the system in support of the economic recovery. By expanding its balance sheet and employing other tools, the Fed has engineered very low interest rates. Their policies are paralleled by those of other central banks which have also engineered low or negative interest rates in a global effort to support growth. Their stated policies suggest that interest rates, particularly short-term rates will remain low for a long time (years). High interest rates act like gravity on asset prices. The reverse is true for low rates. By creating a situation where there is no alternative (TINA) the central banks have created a powerful updraft in equity prices.
Currently, inflation is low and likely to remain stubbornly below the Fed’s targeted level of 2% for a number of reasons. The Fed has indicated a willingness to tolerate a rising level of inflation above 2% for some period, implying that they would not raising rates due to short-term inflationary readings. This is a change in Fed policy that signals low rates for a while (years). The currently low level of inflation and interest rates are supportive of the currently high valuation levels of equities, corporate and municipal bonds and homes. Rising inflation and interest rates will have an opposite effect.
Fiscal policy remains stimulative as we accept high levels of deficit spending to combat the effects of the pandemic and its tragic impact on lives and livelihoods. If current programs are reduced or not extended, they will produce a drag on the economy. We remain hopeful for a long-term infrastructure “investment” that should enhance employment, economic growth, productivity and our global competitiveness. Much depends on the election outcome and political environment.
Economic Growth: We are currently recovering from the sharp downturn in the second quarter caused by the shutdowns related to the coronavirus. Its impact on lives and livelihoods has been substantial and will be felt for a long time. The initial sharp recovery seems to be slowing but remains positive. Corporate earnings are similarly recovering albeit from very low levels. There are and will be “winners” and “losers” based on a myriad of factors in the market. This creates a good environment for active management focusing on long-term “winners”.
Valuation: Domestic equities and bonds are not cheap. Low interest rates generally support higher equity prices and the TINA (There Is No Alternative) and FOMO (Fear of Missing Out) effects have created an increased demand for equities as investors have been forced to accept more risk in pursuit of an acceptable rate of return. This bubbling market has created a “frothy” environment with a high level of retail investor participation. There has also been a narrowing of the market that has chased recent “winners” like Tesla, the FAANG stocks (Facebook, Amazon, Apple, Netflix, Google), and other large tech companies. These have been aggressively purchased by price insensitive buyers and as a result, these businesses appear overbought, over-owned and over-priced. At current valuation levels, the long-term markets for equities and bonds are at risk from rising interest rates and potential economic and earnings impacts of a “second wave” of coronavirus infections and shutdowns. Within the markets that appear fully valued, as active managers we remain focused on individual common stocks, preferred stocks and closed end funds (CEFs) that represent attractive valuations relative to their growth, profitability and financial strength.
The Current Investing Environment: Within our security selection and portfolio management disciplines is an assessment of risk and consideration of the current investment environment. This market is reminiscent of 1999, when there was a record bifurcation between growth and value companies. While we cannot predict the future, such a bifurcation bodes well for the future of value-oriented portfolios. Value -as measured by academics and Morningstar- outperformed in the years following the dot com crash.
In summary, this is a very complex environment and we expect to see continued volatility with downside risk that may express itself as changes occur.
Heron Bay Investing Philosophy:
At Heron Bay, our investment philosophy derives from our desire to be rational stewards of family wealth. We believe that key tenets for growing wealth in the long-term are: Plan for the long-term, learn continuously, develop an accurate world view, wait patiently for the right opportunities and act decisively when they appear.
Every equity investment represents ownership of a fractional share of an underlying business. When investing, what we are really selecting is a business and management team to partner with – hopefully for the long-term. High quality businesses of the sort we prefer tend to make money in good and bad times and have a low probability of permanent capital loss. What then, should be the attributes to look for in such a business?
Predictability: Is the business understandable and predictable? While all businesses are subject to forces beyond their control, to what degree does this business and industry control their outcome? (Eg., government regulations, commodity prices, interest rates, etc., may largely be out of control).
Market/Economics: Is there a long runway ahead for above normal growth, or does the competitive landscape cause rapid change? How are the economics of the business - i.e., does the business generate good returns on the amount invested? Is their competitive position weakening or growing? Can they raise prices in excess of inflation and still grow their customer base?
Valuation: Is the management of high character and skill as evidenced by their actions? Are we buying our stake at a discount to compensate for unforeseen risks or errors? Being absolute return oriented, every investment we make should pass our threshold of minimum acceptable return. We are content to do nothing even if good businesses are offered to us at too high a price. Once invested, we diligently monitor the business for signs of deterioration or exuberant valuation and take appropriate action.
To summarize, we are looking to buy competitively advantaged businesses, with long runways for growth, run by high integrity skilled managers at good prices. The goal of the above exercise is to compound your capital at the highest possible rate, while avoiding catastrophic loss. We use a disciplined process deeply rooted in independent, fundamental research. This involves both bottom-up research and the use of fundamentals-based screening tools to generate investment ideas. Since we go where the best opportunities lie, by design our discipline will likely lead to a portfolio that differs widely from an index. We feel this approach gives us the best chance for outperforming over the long-term. In the long-term as Ben Graham said, markets are “weighing machines” and therefore should reflect fundamentals and not just short-term market sentiment. In disciplined portfolio management, we acknowledge that the price of long-term performance can be short-term underperformance, especially in exuberant markets (like the current one). As long as our portfolio companies grow Intrinsic values steadily, we accept the underperformance caused due to temporary and irrational market prices.
In the coming letters we hope to shed some light on what makes our research process distinctive and how we guard against narratives and biases.
Heron Bay Organizational Update
As we complete our third quarter of operation, we are very grateful for the trust and confidence of our clients and we are committed to providing our best advice and investment management. To that end, we operate in a team environment and a culture where we honor dissent and discussion. This enables us to have the best investment solutions for you and to identify and evaluate potential risks early. We recognize that as stewards of your wealth, protection of capital is most important as we avoid permanent loss or impairment of your capital. To add depth to our team we focus on adding talented professionals and capacity in order that you are well served. Towards that end, we are pleased to announce that Chetan (“Chet”) Rastogi has joined our team as a Portfolio Manager and brings a keen analytical mind and business experience in addition to his investment experience. Chet has Bachelor’s and Master’s degrees in Engineering from the Indian Institute of Technology and The Ohio State University. His varied career spans engineering research and management for GM, starting and bootstrapping an engineering and manufacturing firm, and as Manager of Quantitative Research for a Multibillion Institutional Portfolio Management firm in Michigan.
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.