Fall 2019 Market Commentary
We continue to see corrective price action in many industries since the market highs of January 2018. The global transportation, materials, agriculture and manufacturing industries are a few discounting a recession. Europe, Japan, China and emerging markets have been weak on trade tensions, political uncertainties of Brexit and historic lows in many commodities (many under cost of production). In the US, a continued expansion in labor markets, resilient consumer spending and a stable service sector are positives for the domestic economy. Homebuilder order growth has accelerated with the recent drop in mortgage rates. According to Standard and Poor’s, the spread between the most expensive and least expensive stocks is one of the highest in the past 70 years. Up until recently the most overpriced names have often been outperforming the cheapest. However, we are starting to see many momentum stocks with exciting stories come back to earth as investors are shifting focus back to cash flow and away from “revenue growth at any price.”
Don’t Fight the Fed
According to Evercore ISI in the past three months there have been 40 rate cuts by monetary authorities around the world. In addition, the Fed has been expanding their balance sheet to the tune of $60 billion a month. Back in 1995 and 1998 the Fed was able to prolong an extended US economic expansion with a series of rate cuts, even as Japan, the number two economy, was suffering from a major downturn. Instead of instigating much needed restructuring many countries, especially in Europe, are overly reliant on monetary policy and negative interest rates to stimulate their economies. Globally we are seeing historically low yields (and high prices) with over $13 trillion in negative rates. According to JP Morgan, since 1958 the average yield on US 10-year Treasury notes has been 6.05%. Recently we saw yields drop to 1.45%. As a result, bonds and bond surrogates such as real estate, utilities and consumer staples, have been strong performers so far in 2019. However, on the downside, a 1% increase in rates would lead to a drop of over 20% in 30-year Treasury bond prices. With bonds you have purchasing power risk, as governments love to spend, but also interest rate risk not previously seen in our lifetime. While low rates inflate asset values it hurts the banking industry especially when rates turn negative. The average European bank trades at less than 50% of its book value. US banks trade at very cheap price-earnings ratios as well. In past recessions high and escalating energy prices have often been a major contributor to downturns. This time we have energy gluts in oil and natural gas and declining prices for many alternatives like wind and solar. Battery storage is making huge advances. This continues to act as a tailwind for US consumer spending and the service sector. Low energy prices have negatively impacted many emerging markets that are dependent on oil.
We aggressively research hundreds of companies over the course of the year to stay on the pulse of industry dynamics, supply and demand, etc. We track credit markets and balance sheets. We want to be ready when there is a turn in fundamentals—up or down. We are seeking facts. Since our focus is on maintaining the power of compounded returns, we see diligent research as important in mitigating risk. Since 1989 the Japanese market is down by about half. To passively have held that in an index would have been a disaster. Markets can go sideways or down for years. We have found that the careful purchase of outstanding “high return” businesses with a heart and soul, capable management, with “skin in the game” may be a viable formula for success.
Market Purging Speculative Manias
Historically, easy money has led to numerous speculative manias that have ended badly. The Economist magazine had a letter of correspondence in the 1860s citing easy money back then as the cause of manias. “It is equally beyond doubt, that every speculative mania which has run its course of folly and disaster in this country has derived its original impulse from cheap money.” Fast forward to today, we are witnessing a purging in money losing speculative companies with questionable business models. Overhyped venture capital backed businesses from Japan, China and Silicon Valley are collapsing. WeWork, funded by Japanese firm Softbank was being touted by major brokerage firms to be worth as much as $92 billion a few months ago. The model of transforming rented office space into smaller units has historically been a failure for the past sixty years. It now has been revalued to less than $7 billion. Tilray, a leading Canadian marijuana company has recently declined from $300 to $23 as fundamentals have failed to materialize as promised. There is a surplus of food delivery stocks funded with seemingly “free money.” DoorDash, Postmates, Uber Eats and Grubhub to name a few. Grubhub recently suffered a 43% one-day decline. There is a belief in the venture world that if you are losing money on every transaction that magically increased volume will help. When rates are low the promoters come out in full force. There is an old saying that a fool and his money are invited everywhere. Private equity is another area of excess that many institutions see as “low risk”. Yet the model depends on paying inflated prices for businesses then applying extreme leverage which is risky in a period of record leverage loans. We are watching closely for goodwill write-downs like the $15.4 billion suffered by Kraft Heinz this year when they overpaid for Kraft which torpedoed the stock. By some estimates there is still over $2 trillion in buying power in the private equity industry. Overpaying and overborrowing destroys shareholder value over time. While money is flowing into private markets, we see the inherent volatility and mandated disclosure of public markets as a better bet for long term compounding. Greater transparency underscores the importance of high-grade ethics to endure. Those cutting corners are getting crushed. The proliferation of headline-driven program trading may benefit the serious investor willing to research individual businesses. Material misappraisals take place with headline-driven momentum trading. We are finally seeing a renewed focus on productive assets with strong underlying cash flows as opposed to money losing story-stocks where revenue growth was prized at any price. Valuation is making a comeback in the investment equation.
Policy and Political Leadership – Ignore it at Your Peril
In August, Argentina suffered the second biggest crash of any stock market since 1950. The MERVAL Index plummeted 48% in one trading session. This was the result of elections showing the left-wing populist leader Alberto Fernandez pulling ahead in the polls. Extreme socialism is the enemy of free enterprise. Argentina has defaulted on its government debt eight times since 1816 yet was able to sell 100-year bonds two years ago. Venezuela’s radical social populism has crushed their government debt as inflation exceeded 1.37 million percent in 2018 (Source IMF). This is why we prefer to invest in businesses, not markets. The financial industry likes to put investor money in scalable models which leads to opaque structures and often overcrowding. This can work in up markets but not during long periods of flat to declining markets, which history shows occur over 40% of the time. It can be hard to stay the course in such periods. There are so many ways to lose money, especially if you don’t know what you own.
Healthcare Stocks Lagging but High-Quality Solid Value
Healthcare stocks in general have suffered price-earnings compression from negative macro headlines like “Medicare for All.” We see opportunity in gloom and are focusing on innovative companies and managements utilizing rapid advances in data analytics, compounding knowledge and artificial intelligence to increase the odds of cures for many of the most devastating chronic illnesses. Healthcare is showing some of the best relative earnings for the quarter with strong free cash, yet many companies are trading at steep discounts to the overall market. According to the American Diabetes Association one person develops diabetes every 21 seconds. Over 5.8 million Americans suffers from Alzheimer’s. Biogen has been a leader in diseases of the brain and has a strong position in the fight against Alzheimer’s with their drug aducanumab. Yet, the stock recently traded at a mere nine times earnings. Huge strides are being made in oncology as well through the immune system, with Merck’s Keytruda. Gene therapy is making rapid progress in fighting cystic fibrosis.
Streaming Wars too Much Supply
Over the past few years growth in online streaming has been quickly catching up to traditional cable. Globally streaming subscriptions grew 27% to 613.3 million in 2018 according to the Motion Picture Association of America (MPAA). This growth contrasted with traditional cable subscriptions which decreased by 2% to 556 million in 2018. Streaming growth is expected to continue to outpace cable as the rise of smartphones and tablets have increased the desire for more on-demand content. The streaming market has long been dominated by Netflix, but competition will soon intensify as big players like Disney and Apple enter the streaming space. Competition is bringing an increased focus on investing in quality original content. In 2018 Netflix spent $12.04 billion on content creation and licensing and Wall Street analysts expect content spending could increase to $15 billion in 2019. The Financial Times reported that Apple invested $6 billion into their streaming service. Disney only expects to spend just under $1 billion on original content in 2020. A large company like Disney may have an advantage over Netflix and Apple due to their massive library of brands like Star Wars, Marvel, Pixar and Disney’s own animated films. Disney can simply focus their investments on original shows and movies while competitors like Netflix must also pay licensing fees to fill out their catalog of content with movies and shows from other media companies. From an investor’s view we are monitoring the industry closely but are nervous with the massive spending on content over $30 billion for new shows in 2019 alone. Who has time to watch all that?
Third Quarter 2019 Performance Update
Auxier Focus Fund’s Investor Class returned -0.22% in the third quarter vs. 1.70% for the S&P 500 Index and 1.83% for the DJIA. Stocks in the Fund comprised 94.9% and declined -0.01%. The equity breakdown was 80.5% domestic and 14.4% foreign, with 5% short-term debt instruments. A hypothetical $10,000 investment in the Fund since inception in July 1999 to September 30, 2019 is now worth $40,907 vs. $31,304 for the S&P 500. The equities in the Fund have returned over 570% since inception. This was achieved with an average exposure to the market of less than 79% over the entire period.
Contributors to the quarter: Our outlook on a cross section of portfolio positions with a positive return for the quarter ended 9/30/2019.
MasterCard continued to grow during the quarter driven by the strength of the U.S. economy and as a result management has guided for double-digit revenue growth for 2019. The company’s balance sheet remains solid with manageable debt levels and positive free cash flow generation. The Indian payments market has been growing as the country demonetizes their currency. MasterCard is intending to invest $1B in India to take advantage of a mobile payments market that has grown at a compound annual growth rate (CAGR) of 121% from 2013-2018 (RBC Capital Markets). MasterCard partnered with technology company R3 to develop a new cross-border payment system which aims to allow institutions to make secure real-time payments to each other. In 2018, 77% of the world’s transactions were completed with cash (McKinsey & Company). This number continues to fall as card payments become more widespread which could present further growth opportunities for MasterCard.
PepsiCo Inc. (PEP)
PepsiCo has been performing well over the last quarter and management has guided for 4% organic revenue growth for 2019. The company’s strong cash flow generation has given management the flexibility to invest in the growth of the business and they expect free cash flow of $5 billion for 2019. Increases in daily snacking habits have more than offset declines in the consumption of carbonated beverages. PepsiCo is making strides to be more environmentally conscious with a new target of reducing first-use plastic by 35% across their beverage portfolio by 2025. Management is working to make their business more sustainable to fit in with the shifting priorities of consumers. PepsiCo plans to continue to create new types of products to bolster their portfolio and keep up with changing market trends.
Raytheon Company (RTN)
Raytheon performed well during the quarter, growing both sales and earnings. The company’s performance is supported by a record backlog of $43 billion. Raytheon’s planned all-stock merger with United Technologies’ aerospace division is expected to close in the first half of 2020. This merger is designed to leverage nearly 100 years of experience to bring the company more in line with its competitors like Boeing and Lockheed Martin. Management is confident that the merged company will be a cash flow generating machine. Raytheon is continually creating new, and innovative products such as a new, smaller and cheaper missile that will replace the 30-year-old missile currently used in the F-35 fighter jet.
Medtronic plc (MDT)
During the quarter Medtronic unveiled its new robot assisted surgery platform that they claim is more flexible and cost-effective than other systems currently on the market. This robot is expected to launch internationally in early 2020 and after two years will be brought to the US. This robot aims to compete with Intuitive Surgical’s current robot that has been operating with little to no competition. Medtronic has been improving their expense structure which has led to operating margin expansion. Along with their surgical robot innovations Medtronic also plans to release the next generation of their MiniMed insulin pump in 2020 which aims to reduce finger sticks by 95%.
Microsoft Corporation (MSFT)
Microsoft’s Azure cloud platform continued to be the biggest growth driver for the company during the quarter. Microsoft is currently in second place in the cloud computing market and is growing more than twice as fast as the market leader Amazon (Gartner). The company’s balance sheet remains extremely solid as they have strong earnings and cash flow generation that will easily cover their debt obligations. Microsoft plans to invest their excess cash into creating new products such as Surface tablets and game consoles as well as improving the functionality of their cloud platform to remain competitive in the space. Management reaffirmed their full year 2020 guidance of double-digit revenue growth and expects their cloud platform to be the main driver.
Detractors to the quarter: Our outlook on a cross section of portfolio positions with a negative return for the quarter ended 9/30/2019.
Discovery, Inc. (DISCA)
With the amount of content available today, Discovery has made it a priority to focus on more niche programming in order to compete in the current streaming market. At the end of September Discovery announced the launch of the Food Network Kitchen, a direct-to-consumer product with live streaming and new interactive cooking instructions each week. Food Network Kitchen will also offer over 800 on-demand classes, online shopping and home delivery and plans to be available through all Amazon, iOS and Android devices. A limited version of Food Network Kitchen is intended to be available for free at the end of October while the full suite of products will be available for $6.99 a month or $59.99 a year. Discovery had nearly $600 million in free cash flow this past quarter.
Johnson & Johnson (JNJ)
Johnson & Johnson has been struggling for most of the year due to lawsuits related to their role in the opioid crisis and talcum powder products. In August, a judge in Oklahoma ruled that Johnson & Johnson was responsible for paying for one year of Oklahoma’s costs related to opioid addiction. This came out to $572 million, and although it may seem like a lot, it was viewed as a win for them as it came well short of the 20 years of costs, or $17 billion, that Oklahoma was seeking. The talcum powder lawsuits all allege that Johnson & Johnson’s talcum powder causes ovarian cancer and mesothelioma in women using it for personal hygiene. Johnson & Johnson has maintained that their products do not contain asbestos and that talc is not a known carcinogen. Talc has over 30 years of medical studies showing it is safe for human use. While the negative headlines in the short term are likely to continue to weigh on Johnson & Johnson, their strong pipeline and fundamentals should be enough to carry them through. They currently have over 30 drugs in phase three trials.
Corning Inc. (GLW)
The company that made the glass for Thomas Edison’s first lightbulb has gone through dozens of transformations over its 168-year history and is currently going through another one. As Corning’s revenue from TV manufacturers and wireless carriers shrinks it has been forced to come up with an alternative source of revenue to make up for their declining sales in other sectors. Luckily for Corning their product Gorilla Glass has been making up for their losses in other sectors as it is a key product in smart phones, tablets and smart screens in cars. As the demand for strong, shatterproof glass in phones, tablets and cars continues to grow, Gorilla Glass has Corning well positioned to take advantage. Apple recently announced a $250 million investment in Corning from their Advanced Manufacturing Fund.
Anthem Inc. (ANTM)
The health insurance industry has been down on talks of Medicare-for-All in the Democratic Primary overriding the otherwise positive results from Anthem. Both Sen. Warren and Sen. Sanders have healthcare proposals that would either eliminate or severely cut down the role of private health insurance providers at an estimated cost in excess of $30 trillion. Health insurance stocks have gone down as the odds that one of these senators is elected goes up. Although it is possible, and starting to become more likely, that one of these senators is nominated as the democratic nominee they would still have to win the general election before attempting to get a bill through Congress, which seems unlikely given Majority Leader Mitch McConnell has said multiple times that he would never allow a Medicare-for-All style bill through the Senate. While the threat of these healthcare plans is not nothing, it remains incredibly unlikely that the health insurance industry is going to be legislated out of existence.
UnitedHealth Group (UNH)
UnitedHealth Group is experiencing the same problems as Anthem with the negative sentiment in the industry overriding its positive results. Total revenues were up 8% while net earnings grew 15%. UnitedHealth is a leader in data analytics and enjoys significant scale and cost advantages due to its powerful network effect. It maintains a solid balance sheet and over $17 billion in cash.
Transparency of the internet is underscoring the great importance of ethics in leadership as many companies cutting corners are suffering the consequences. We are still finding opportunities during market weakness to add high quality businesses with strong free cash flows that have fallen out of favor as investors have gravitated to revenue momentum names. There appears to be the start of a reversion to the mean which should favor our disciplined approach to capital allocation. We aim to add value for our investors with our years of cumulative knowledge and hard study of successful enduring businesses. Research and rational reasoning are so critical and necessary in reducing risks and in pursuing compounded returns. We adhere to the Ben Franklin adage, “An investment in knowledge pays the best interest.”
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Before investing you should carefully consider the Fund’s investment objectives, risks, charges and expenses. This and other information is in the prospectus, a copy of which may be obtained by calling (877) 328-9437 or visiting the Fund’s website. Please read the prospectus carefully before you invest.
Fund returns (i) assume the reinvestment of all dividends and capital gain distributions and (ii) would have been lower during the period if certain fees and expenses had not been waived. Performance shown is for the Fund’s Investor Class shares; returns for other share classes will vary. Performance for Investor Class shares for periods prior to December 10, 2004 reflects performance of the applicable share class of Auxier Focus Fund, a series of Unified Series Trust (the “Predecessor Fund”). Prior to January 3, 2003, the Predecessor Fund was a series of Ameriprime Funds. The performance of the Fund’s Investor Class shares for the period prior to December 10, 2004 reflects the expenses of the Predecessor Fund.
The Fund may invest in value and/or growth stocks. Investments in value stocks are subject to risk that their intrinsic value may never be realized and investments in growth stocks may be susceptible to rapid price swings, especially during periods of economic uncertainty. In addition, the Fund may invest in mid-sized companies which generally carry greater risk than is customarily associated with larger companies. Moreover, if the Fund’s portfolio is overweighted in a sector, any negative development affecting that sector will have a greater impact on the Fund than a fund that is not overweighted in that sector. An increase in interest rates typically causes a fall in the value of a debt security (Fixed-Income Securities Risk) with corresponding changes to the Fund’s value.
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The S&P 500 Index is a broad-based, unmanaged measurement of changes in stock market conditions based on 500 widely held common stocks. The Dow Jones Utility Average is a price weighted index designed to represent the stock performance of large, well-known U.S. companies within the utilities industry. The S&P MERVAL Index, Argentina’s flagship index, seeks to measure the performance of the largest, most liquid stocks trading on the Bolsas y Mercados Argentinos Exchange (BYMA) classified as domestic stocks. The constituents of the index must meet minimum size and liquidity requirements. One cannot invest directly in an index or average.
The views in this shareholder letter were those of the Fund Manager as of the letter’s publication date and may not reflect his views on the date this letter is first distributed or anytime thereafter. These views are intended to assist readers in understanding the Fund’s investment methodology and do not constitute investment advice.