Hall Capital “Market Views” Newsletter January 2019
This is the 35th edition of Market Views from HALL CAPITAL. Our aim is to provide concise views of where we see risk and opportunity for investors.
Perception is Reality
- for investors
To be sure rising interest rates were real and not a perception, but slowing global growth was not due to higher interest rates in the US. There is little doubt that the threat of more ill advised tariffs took its toll on corporate plans to expand globally. Add in Washington chaos and the perception of a friendly investment environment shifted dramatically. Q4 2018 was the first time in US stock market history that the fourth quarter more than erased the positive returns of the previous three quarters. We experienced the worst December performance since 1931.
Now that wealth creation of the stock market has been reversed, consumers may well perceive less wherewithal and cut back on spending - notwithstanding an actual increase in wealth when home prices and other assets are factored in. A perception of less wealth could diminish growth in the US which to date has stood out among the world's largest economies as the most robust.
The fact that perceptions have real consequences for investors is one reason it is so difficult to forecast the stock market over the short term. Psychology will ebb and flow, but over the long term companies produce products and services that create profits and ultimately this wealth will accrue to investors. That is a reality we can count on.
Political Risk vs Recession Risk
- we face both
US stocks are not overvalued now and are within 10% to 15% of pricing in a recession which is hardly a sure thing. And typically a buying opportunity is created after psychology has turned so negative. However, we are hesitate to deploy "dry powder" and add to equities at this time due to increasing political risks. If you thought 2018 was politically tumultuous, you ain't seen nothin' yet.
And while there are no signs of an imminent recession in the US; Europe, Japan and, most importantly, China are slowing markedly. Though we are always concerned about recession risk this long into a recovery, we are more sanguine about the impact of a garden variety recession.
There have been 10 recessions since 1950 in the US. The average length was 11 months. The stock market swooned in every case and usually began its recovery before the recession was over. In all but three recessions the stock market recovered to new highs within a year. Those three cases were: 1. High inflation mid 70's 2. Dot Com Bubble of 2000 and 3. The Financial Crisis of 2008. Due to stronger balance sheets of US banks, we have more reason to believe that the next recession will be "garden variety" as opposed to a crisis.
As to political risks, it is harder to say how they will play out which is why we are taking a wait and see approach. As noted many times, trade wars are dangerous. Hopefully a workable deal with China will be struck before long. While we consider trade as the most important political issue facing investors, there are others. Hence, some caution is in order.
Some caution does not mean piling into bonds. We have recommended a compliment of short to intermediate bonds as "dry powder". However, the risk and returns on long bonds remain uninteresting (except for some special cases of closed end funds trading at discounts of over 15%). We still lean toward equities and alternatives.
Focus List Corrects
- as some excess returns are given back
The Focus List was indeed ahead of itself and gave back much of its excess returns for the year in Q3 but still managed to hold up better than the S&P 500 by the slimmest of margins. The Focus List returned -4.3% for 2018 compared to a -4.4% return for the S&P 500. It would have been easy to do worse. It should be noted that the capitalization weighted index outperformed the median stock within the index, which fell some 9% in the year.
We have maintained that the Focus List, though concentrated, is not more risky than the market. This assertion is driven by two very important characteristics of these "stalwarts": strength of competitive position and strength of balance sheet. These companies are much stronger on both dimensions than the average stock in the S&P 500. To wit: the Debt/Equity for the Focus List is .7x. Perhaps a more relevant measure of financial risk is to look a the total net debt of the Focus List compared to market value. It is a mere .04. To put this in perspective, Apple generates enough cash flow in one year to pay off the entire net debt of the Focus List companies!
As a comparison, consider GE whose debt/equity is 3.7x. Or Ford which is 4.2x. These two companies combined show a debt to market value of 1.7x or 42x that of the Focus List combined ratio!
What about competitive position? I think you would agree there is no comparison to the competitive position of Alphabet (Google) or Walmart to GE and Ford. This is not to say that GE and Ford, or even the average stock in the S&P 500, can't beat the Focus List over a year or so. What I am saying is that should the Focus List perform well, it will do so without taking the risk of an average company and avoiding the disasters of the likes of Eastman Kodak and Sears. The fate of such poorly performing companies begin with slipping competitive positions and end with the consequences of too much debt.
Driven mainly by stalwarts, since inception over eight years ago, the Focus List has averaged a compounded annual return of 15.4% vs 13.4% for the S&P 500.
Some of the data below is shown as Not Meaningful (nm) due to the one time distortions due to the new tax law.
For individual stocks as well as selection strategies, past performance is not necessarily indicative of the future.
Hall Capital Focus List
Follow Up – from our letter one year ago
"Thus, most of the $1.5T tax cut will benefit investors, if not the average worker. In the long term, average workers will need to to see some benefit by new policies not yet enacted or a political backlash could ensue."
- The jury is still out on this. If the "benefit" helps no one, then the backlash will be from all sides.
"Trends are currently positive but obviously the environment could change. Hence, though we are leaning toward opportunity, we would advise some hedges."
- US stocks were up some 9% through Q3 and the environment changed.
NOTE: Now in addition to ALL our quarterly letters, on our website is a tab with just the Follow Ups.
About HALL CAPITAL
HALL CAPITAL, LLC is a registered investment advisor and was formed by Principals from Arcturus Capital in 2010.
For more information, contact Donald Hall 626 578 5700 x101 dhall@hallcapitalmanagement.com
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