October 2019 – Quarterly Letter

–  Warren Buffett

The purpose of investment management is to insulate you from uncertainty. We invest your assets to maximize the probability of you achieving your long-term goals. Matching the volatility of your portfolio to its duration reduces the likelihood that you will be forced to sell your assets at an unfavorable valuation. If we want to reduce portfolio volatility, we increase the allocation to fixed income. We also diversify your portfolio based on portfolio factors or strategies like value, growth, quality and defensive.

You might have heard that Schwab has eliminated commissions on online trades.  This is great news, but it might make you wonder how Schwab makes money.  The main factor that determines how much Schwab gets paid for its custodial services is how much cash is in your portfolio. They pay a very low rate of interest on cash, and they invest your cash for a higher rate. The revenue from trading has become so meager that Schwab is no longer profiting from commissions. They’re willing to forego commissions in the hopes that they can attract more assets from investors, as their business model now depends on earning money from reinvesting client cash.

While we love the service that Schwab provides us and our clients, we want to minimize how much cash you hold.  The cash allocation in a portfolio is the least productive asset and a drag on portfolio performance. Over most periods, stocks and fixed income produce a positive return. The longer the investment period, the more likely that the return is positive. Assets that we expect to remain invested for periods of one year or more should go into either fixed income bonds or stocks.

History provides us with plenty of examples of the market deviating from intrinsic value. This deviation goes in both directions. Remarkably, in the current context of both economic and political uncertainty, the market has stayed very calm. We are just a bit higher than the level first reached in early 2018. Economic growth appears to be slowing as we suspected it would, but it has yet turn negative.

The market appears to be a hostage of the ongoing trade negotiations with China. Both parties have a strong interest in reaching agreement. As negotiations drag on, business confidence deteriorates. The consumer side of the economy continues as a strength, with very low unemployment rates leading to marginally faster wage growth for the average American household.

The Brexit crisis continues to inch towards resolution. Central banks around the world are lowering short-term interest rates. Investors’ recent rush into fixed income bonds decreased long-term interest rates, which reduces the cost of major purchases like homes and autos. It usually takes six to nine months for lower interest rates to impact economic growth, but the combination of all these factors suggests that the third “mini-recession” of the last ten years is likely behind us.

Stocks enjoyed a strong rally through the first seven months of the year, gaining back all the ground they gave up during the 4^th quarter of 2018. Since July of this year, stock prices have stalled as earnings estimates came down. It’s hard to know just how much of the decline in earnings estimates is due to trade uncertainty and how much is a result of a generally slowing economy that is now ten years from its most recent recession. At the point that earnings expectations stabilize or even move higher stock prices should pick up.

Stocks will also reflect political uncertainty. Current trade policy is just one way that politics will impact the economic outlook. Elizabeth Warren is a strong advocate of policies to regulate health care and the financial sector. As her prospects rise at the expense of more centrist Democrats, investors will mark down the valuations of companies in those sectors. Candidates Warren and Sanders create the most uncertainty in terms of how industries like health insurance would operate under Medicare for All. Biden and Buttigieg are generally considered to seek incremental change that would intervene less in the ongoing operations of the health care and financial sectors.

As we’ve seen over the last couple of decades, Washington D.C. is very resistant to wholesale changes. Change comes in baby steps.  No matter how much a candidate promises to revolutionize our system and solve all our problems, the reality is that we will be struggling with the same issues for the foreseeable future. The overall S&P 500 is likely to slowly grind higher over the next year as it processes the probability of varying electoral outcomes.

The current market can be broken into three type of stocks, economically sensitive cyclical stocks, high quality growth stocks, and defensive, yield oriented bond substitutes. The cyclical “value stocks” have never been cheaper relative to high-quality growth stocks and defensive bond proxies. The composition of the S&P 500 reflects current investor preferences.

Defensive stocks and high-quality growth stocks dominate the S&P 500, while the weighting of economically sensitive stocks has never been lower. Investors are hoping to ride out the anticipated economic weakness in high yielding stocks and growth stocks. Hedge funds are even hedging their exposure in defensives and growth stocks by shorting value stocks. This has been a very profitable trade over the last ten years, but the eternal challenge of investing well is knowing when an idea becomes too popular and overrated.

My best guess is that a period of surprisingly strong economic growth will put to rest any remaining concerns about a recession within the next year. Increased confidence in the underlying economy will cause investors to reduce their exposure to low volatility, and high yielding stocks.

If economic weakness is temporary, then value stocks and economically sensitive stocks in general are primed for a very strong comeback. The underrepresentation of cyclical industries in the dominant S&P 500 index suggests that the index could go through a period of extended underperformance—like the 2000-2009 period, while out of favor styles like international, small cap and value are poised for an extended period of outperformance.