Quarterly Letter

January 2019 – Quarterly Letter

By February 4, 2019 No Comments

January 23rd, 2019

The holidays are usually the most wonderful time of year. This year, investors received more than a few lumps of coal. That meltdown was exceptional by historic standards.

We build our stock portfolios with risk management as our prime directive. The best way to reduce risk is to diversify. We generally allocate between 25% and 35% to non-U.S. based companies. This gives us exposure to economies at different phases of the economic cycle, while also reducing our exposure to the U.S. dollar. When fundamental factors drive markets, diversification reduces a portfolio’s volatility while also potentially strengthening returns. When factors external to market fundamentals dominate, diversification is incapable of mitigating the volatility. This was the case during the global credit crisis in 2008, and it has been the case for the last four months.

The current decline in stock prices is unique regarding how evenly the pain has spread. Bear markets that are driven by fundamental market factors, like after the dot-com boom, concentrate their pain in the areas that went up the most during the previous boom. The portfolios that I managed after the dot-com bust were up substantially in 2001 and 2002, while the NASDAQ and the S&P 500 were collapsing. There is no place to hide from this drawdown. Value and growth stocks are suffering equally. This suggests that the impulse for the sell-off is external to the stock market. This is a “flight-to-safety” sell-off. Investors sold stocks across the board, as they were having a hard time quantifying the risks from political errors.

4th Quarter Performance of Key Investment Styles

S&P 500                           -14%

Midcap Stocks                  -15%

Midcap Growth                -18%

Large Growth Stocks        -15%

Small Stocks                     -19%

Non-U.S. Stocks               -13%

I’m not ignoring the mildly ominous clouds on the economic horizon. Earnings estimates for 2019 have come down by about 5%. The government shutdown shaves a modest amount of GDP that increases the longer the shutdown persists. China’s economic slowdown seems to be bottoming, but it’s too early to tell. The uncertainty around Brexit has immediate economic implications as businesses preserve capital that they may need during Great Britain’s transition out of Europe.

Several issues seem to have come to a head all at once. As these issues resolve, one way or another, we will move past them and uncertainty will decrease. As investors refocus on the market fundamentals, they will likely conclude that the economy is not falling into a recession, it is simply slowing a bit from an unsustainable pace.

There are two valuations that are key to successful long-term investing. 1) The intrinsic value of a company is the present value of all future cash flows. This number changes very slowly as the prospects of a company rise or fall. 2) The nominal valuation is the price that the public market assigns to a company. Over time these two distinct valuations are highly correlated, however there are long stretches when nominal value disconnects from intrinsic value.

Volatility is to some degree a constant. The average high to low swing for the market in any given year is fourteen percent. The range between the high and the low in 2018 was about 20%–higher than usual, but nothing extraordinary. Positive returns are also a constant over time. The longer the period, the less likely you will endure a negative return.

In 2018, the growth in the intrinsic value of global equities was greater than what the decline in nominal price reflects. Earnings grew by more than 20%, while stocks declined in price! If earnings grow 7% in 2019, as expected, the market will have a lot of catching up to do.

Earnings expectations will continue to soften a bit, but I expect that we will experience a valuation expansion from the current 15.6 times 2019 earnings, which is the lowest since 2014. If investors value companies in line with what they have been since 2014, the P/E ratio should head up to at least 17.5 times earnings, which we saw as recently as late September.

An S&P 500 that trades at 17.5 times projected 2019 earnings would be worth more than 3,000. By the end of this year, the S&P 500 would be worth 3,342. 


The market price underperformed the fundamentals in 2018, which makes it highly unlikely that the market will lag fundamentals again in 2019. The market is staring down an unusually unpredictable 2019. Over the next three to six months we will get resolution of the following cliffhangers:

·        The pace of interest rate hikes by the Federal Reserve.

·        The trade truce between the U.S. and China is set to expire without some sort of mutual understanding.

·        Great Britain could crash out of the EU without any legal structure to replace its current trade agreements.

·        We will get further clarity on earnings estimates for 2019.

·        The Democrats will take over the House of Representatives and will likely initiate several investigations.

·        The two parties will resolve the government shutdown, but the current stalemate suggests that we will be in for another round of brinkmanship when the current debt ceiling is reached.

Globally, this political uncertainty is a double-edged sword. On the one hand, there are a lot of opportunities for things to go wrong. On the other hand, politicians have disappointed us so much that investor expectations are sufficiently low.

All indications are that the U.S. and China are moving steadily towards a trade deal. The government will likely re-open in a couple of weeks. The economy is slowing, but still showing signs of strength and modest growth. The Federal Reserve is sending signals that it won’t increase rates as aggressively as was previously feared.

Politicians on both sides, and around the world crave attention. Incrementalism does not tend to grab people’s attention as much as controversy. Sometimes, the noise of human progress gets very loud.   Sometimes, it seems like we’re going backwards. Eventually, governments must respect the will of the people, even as the people struggle to figure out what that is.

Even at times when it feels like progress is elusive, major advancements occur on many frontiers. According to the World Bank:

Over the last 25 years, more than a billion people have lifted themselves out of extreme poverty, and the global poverty rate is now lower than it has ever been in recorded history. This is one of the greatest human achievements of our time,”

Any economic weakness in the first quarter should quickly resolve once the government reopens. Federal employees will eventually receive back wages. Once the pent-up demand is released, the economy will snap back. As a recession becomes less and less likely, the valuation of the market should improve.  Since the bottom of the recent run on the market, the S&P 500 is up almost 10 percent in the last month. 3,000 on the S&P 500 seems like a good baseline projection for 2019.

Eric Barden, CFA