Quarterly Letter

July 2020 – Quarterly Letter

By August 2, 2020 No Comments
July 30, 2020

It seems like the pandemic is as much a threat today as it has ever been, but the market appears willing to believe that we will get it under control without any major long-term economic impact. We have seen one of the strongest periods in market history over the last four months. After rallying 45% off its low on March 23rd, the S&P 500 is basically where it was at the beginning of the year.

Not all areas are recovering equally. Microsoft, Amazon, Apple, Google, Facebook, and Tesla now account for almost half of the Nasdaq 100, and about 25% of the S&P 500. Investors believe large growth stocks have some defensive qualities. Amazon continues to grow and gain market share despite economic weakness. Facebook and Google are nearly a duopoly when it comes to fast growing digital marketing. Adobe is the dominant provider of software utilized by digital creators. All these companies should continue to grow to some degree, regardless of the economic environment. The question is whether investors are paying too much for future growth.

The valuations of the largest growth stocks are trading at a premium to the rest of the market. This is not unusual as investors generally assign higher valuations to higher growth companies. What is unusual is the size of the premium. Valuations for large growth stocks are higher relative to the rest of the market than at any point in history. The only other time valuations were this high relatively speaking was at the height of the dot-com bubble in 2000. In the ten years that followed, growth stocks collapsed, and the S&P 500 lagged almost every other equity market in the world.

The spread between value stocks and the market is now at unprecedented levels.  The NASDAQ 100 is up almost ten percent since the market peaked on February 19th. The economically sensitive value benchmarks are down about 20% over the same time frame. Value style portfolios tend to overweight sectors like financials, energy, and industrials.

Regions around the world are also developing either growth or value attributes. The U.S. market is very heavily weighted towards growth and technology stocks, while Europe and Japan are heavily weighted towards the value sectors like financials and industrials.

Our portfolios have a heavy allocation to the top performing growth and technology stocks. I am not going to sell those companies that have seen the most success over the last few years unless something changes with their growth potential. I am willing to hold companies like Amazon and Adobe that trade at premium valuations, as their growth rates are substantially higher than the market.

The disparity between growth and value stocks is unprecedented, but the valuations of large growth stocks today seems more justifiable than what was occurring in the late ‘90s. Today, the growth companies have excess earnings growth to support the high valuations. Small, value and international stocks have not led the market since the period of 2000-2009.

Historically, we have always seen reversion to the mean. After stocks have had an unusually great 10 or 20 years, they typically turn in subpar results over the next 10 or 20, and after bad 10- to 20-year stretches, the next 10 to 20 tend to be above average. — James O’Shaughnessy

It is impossible to predict what the catalyst will be, but at some point, growth stocks and the S&P 500 will lag relative to value, small and international stocks. It is imperative that we fight the urge to concentrate all the portfolio into the areas that have led the market over the last decade. Prudent risk management dictates that we maintain some exposure in the underperforming sectors as we do not know when the tide will turn. In my experience, once we hit the tipping point, the reversals are fast and furious.

One potential catalyst could be a reversal in the strength of the dollar. Coming out of the financial crisis of a decade ago, the U.S. Federal Reserve was quick to respond. The U.S. economy recovered much quicker than the European Union, which struggled to find a coherent policy response. Europe was also dealing with the Greek currency crisis that presented an existential threat to the European Union.

Now, the situation is reversed. The U.S. is struggling to reopen its economy, while Europe is almost all the way back to business as usual. If the U.S. struggles persist, it is highly likely that the European currencies will appreciate relative to the dollar as they attract more investment capital.

U.S. dollar weakness has historically coincided with international stock and value stock outperformance, with emerging markets being the biggest beneficiary. Stephen Roach, the former Morgan Stanley Asia chairman, recently told MarketWatch that the dollar may sharply deteriorate from current levels. “I do think it’s something that happens sooner rather than later,” he said. In fact, Roach predicts a 35% drop in the dollar against other currencies. The combination of lower valuations and potentially higher earnings growth is a potent one.

We have a heavy allocation to the market leading growth stocks, but we also maintain exposure in sectors like financials and industrials that have lagged. We own very resilient companies in this sector, like Citigroup and Union Pacific that will certainly benefit when investors increase their exposure to these sectors. We continue to maintain at least a twenty-five percent allocation to international stocks.

The portfolio is like a three-legged stool among growth, value and international. It is this balance that allows us to do well in various market environments. We much prefer a track record of consistent performance instead of extreme outperformance one year and extreme underperformance the next.

Eric Barden, CFA