Winter 2019 Market Commentary
In the fourth quarter, the combination of a US-China trade deal, a resolution of Brexit and sharp declines in interest rates provided strong tailwinds for equities both domestic and international. A record low unemployment rate, declining energy prices and historically low borrowing costs have aided consumer spending and the service sector. Long-term interest rates, as measured by the 30-year Treasury bond, declined from 3.02% at the end of 2018 to 2.39% as of December 31, 2019. Rock bottom interest rates led to a refinancing boom which accounted for 38% of mortgage originations in 2019 (WSJ). Declining rates also helped price-earnings (P/E) multiples expand as operating earnings for the full year 2019 were lackluster. Earnings growth only contributed 8% of the market gain according to Goldman Sachs. The S&P forward P/E expanded from 14 times to 19 times and accounted for 92% of the gain. Corporate share buybacks provided more demand than any other source as individuals were generally net sellers. Some estimate corporate share purchases offset individual sales seven-fold. While increased refinancing could indicate consumers’ confidence in a strong economy, we remain focused on thorough research to be able to navigate a market that may be in a state of euphoria.
Cloud Services at the Front of Digitization
The public cloud service industry has become incredibly important in our rapidly digitizing world. The global cloud industry was estimated to be worth $227.8 billion in 2019 and is expected to reach $266.4 billion in 2020 (Gartner). The cloud market is currently made up of dozens of companies but the two leaders, Amazon and Microsoft, dominate the rest of the market. There are three main types of cloud computing services: Infrastructure as a Service (IaaS), Platform as a Service (PaaS) and Software as a Service (SaaS). IaaS is one of the most important types of cloud services because it provides users online access to servers for storage and networking. PaaS allows customers to use a provider’s servers to develop and host applications without needing to maintain and manage the backend infrastructure. Amazon is the current leader in IaaS and PaaS with a market share of nearly 40% (Synergy Research Group). SaaS is the third type of cloud service and it is how companies like Microsoft provide their users with software such as Microsoft Office. SaaS allows providers to automatically update their applications to ensure that users always have the best experience. Microsoft is the current leader in SaaS with a market share of 17% (Synergy Research Group). More companies are looking to move their data to the cloud due to the greater security and flexibility it provides which is creating healthy growth for the market. From 2019 to 2022 global public cloud service revenue is expected to grow at a compound annual growth rate (CAGR) of 15.89% (Gartner).
One positive aspect of the growth in the cloud industry is just how diverse the market is. Companies specialize in different areas like Amazon with infrastructure, Microsoft with software and Oracle with data security. These specialties provide consumers with greater choice and flexibility in the type of cloud service they need. Many customers will use the cloud services from several providers to build the most efficient and effective solution for their business. Because of this, companies like Amazon and Microsoft can afford to expand and grow without necessarily taking market share from each other. We like these market dynamics as it gives us the ability to invest in different cloud companies with different strengths and priorities in the same market. Keeping an eye on developments in this space will be important as more companies shift from on-premise solutions to cloud solutions.
Technological Innovation is Key
Technological innovation continues to be an important driving force in the market as businesses look for ways to disrupt their industries and improve their operations. Data analytics, cloud computing, artificial intelligence (AI) and 5G connectivity are major disruptors. Oracle is a company that is looking to shake up the cloud market with their autonomous database. Using AI and data analytics, the database can cut down on workloads and server downtimes as it can detect and patch security flaws, as well as perform regular maintenance, autonomously. We dig deep to find new technologies like this that have the potential to change the landscape of an industry so we can be on the forefront of that disruption. Another business we like with a focus on digital innovation is Medtronic. Medtronic has created smart medical devices that can improve the lives of patients such as a closed loop insulin pump that can detect changes in blood sugar levels and automatically administer the correct amount of insulin. Watching developments in technological innovation remains vital to our work as they can have a large impact on the market. The top 5 contributors to the returns of the S&P 500 in 2019 were all technology stocks. Apple and Microsoft led the returns for the S&P 500 and together accounted for 14.8% of the total return in 2019 (CNBC). It is easy to get swept up in the exciting stories of these fast-growing tech stocks, but it is important for us to remain vigilant and prioritize enduring business models and strong fundamentals over exciting stories. 5G connectivity, which boasts incredible speeds and low latency, is another technology that is expected to be a disruptor in the market. 5G technology could have many applications such as allowing for remote surgical operations with essentially no lag time. Self-driving technology could improve by allowing cars to communicate with each other to increase safety. Though there are many potential uses for 5G technology, Cowen predicts that 5G is still in its infancy and won’t be available for mass market adoption until at least 2022. Developments with 5G will be on our radar as more companies begin to adopt the technology.
Fourth Quarter 2019 Performance Update
Auxier Focus Fund’s Investor Class returned 8.28% in the fourth quarter vs. 9.07% for the S&P 500 Index, 6.67% for the DJIA and 5.12% for the Lipper Balanced Fund Index. Stocks in the Fund comprised 96.3% and returned 8.93%. The equity breakdown was 82.6% domestic and 13.7% foreign, with 3.7% short-term debt instruments. For the full year 2019 the Fund returned 20.20%, DJIA 25.34%, S&P 500 31.49% and the Lipper Balanced Fund Index 19.44%. A hypothetical $10,000 investment in the Fund since inception in July 1999 to December 31, 2019 is now worth $44,294 vs. $34,144 for the S&P 500. The equities in the Fund had a cumulative return of 501.26% since inception and the Fund as a whole had a cumulative return of 342.93%. 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 12/31/2019.
UnitedHealth Group (UNH, Financial)
During 2019 UnitedHealth stock was heavily impacted by discourse around the 2020 presidential elections. Several candidates support a single-payer healthcare system that could have a negative effect on companies like UnitedHealth. During the quarter healthcare stocks moved higher as talk of a single-payer system died down. The business side of UnitedHealth performed well during the most recent quarter as revenue and earnings per share grew 6.7% and 13.3%, respectively. Management has provided guidance for high single digit revenue growth and cash flow generation of over $19 billion in 2020. Positive cash flow generation has allowed the company to maintain a steady dividend yield even as their stock price has risen.
Bank of America Corporation (BAC, Financial)
The company has been growing their reach by adapting to the shift towards digital banking and transactions. 100% of Bank of America’s 16,626 ATMs are contactless enabled to allow customers the convenience of only needing to use their phones. The company’s digital payment partner, Zelle, continues to grow, ending the most recent quarter with 8.9 million active users and 80.8 million transactions. Management hopes that their continued investment in digital technology will appeal to a wider range of consumers, specifically the younger generation. The Fed voted in December to keep interest rates steady, which after several rate reductions, is seen as a positive development for the banking industry.
Anthem, Inc. (ANTM, Financial)
Like UnitedHealth, Anthem has been affected by the primary debates, but the recent change in expectations of a single-payer healthcare system has boosted the stock price over the last quarter. Future price movements for Anthem may continue to be impacted by ongoing election year debates. Anthem’s membership base stood at nearly 41 million members as of October 2019, an increase of 2.7% over October of last year. Both revenue and earnings increased by double digits during the quarter due to membership growth and premium rate increases. The company has been consistent with returning capital to their shareholders returning over 50% of their net income through share repurchases and dividends.
Mastercard (MA, Financial)
The strength of the U.S. economy continued to drive growth in the top and bottom lines for Mastercard. Gross dollar volume for the most recent quarter was up over 10%. Management runs an asset-light business which gives the company the flexibility to acquire new companies and technologies to grow their reach. The company recently acquired the cybersecurity firm RiskRecon as growth in digital transactions will require more secure systems. Even as digital payments continue to grow, cash is still the most widely used form of payment in the world which signifies the massive potential for growth for Mastercard as consumers continue to move away from using cash. In the US, digital transactions have been growing at nearly twice the GDP growth rate (McKinsey & Company). Digital wallets like Apple Pay have made electronic payments more convenient and secure which could benefit companies like Mastercard if fewer consumers feel the need to carry around a physical wallet full of cash.
Microsoft Corporation (MSFT, Financial)
In the most recent quarter, Microsoft saw their revenue and earnings increase by 14% and 21% respectively. This growth was led by the strength of their Azure cloud which grew by 59%. Management has been investing in their cloud AI platform and their investments are starting to pay off as Azure AI is used by more than 85% of the Fortune 100 companies. In October, Microsoft won the contract for the Pentagon’s Joint Enterprise Defense Infrastructure (JEDI) service. The contract is valued at $10 billion over the next 10 years. As part of the contract, Microsoft will provide cloud-based enterprise services to the Department of Defense. This contract win is another positive step in improving Microsoft’s competative edge in the cloud services industry. The company plans to continue to invest in their digital and cloud services and management still expects double digit revenue and operating income growth for the full-year 2020.
Alphabet Inc. (GOOG, Financial)
Even as one of the largest companies in the world, Alphabet has continued to innovate with new services and technologies which has led to consistent growth. Alphabet operates with low levels of debt and positive cash flow. In November, Alphabet purchased fitness and health company Fitbit for $2.1 billion. Alphabet currently develops the software that other smartwatch makers use, but this acquisition will allow them to compete with companies like Apple on the hardware side . This purchase also gives Alphabet access to valuable user data that they will be able to use to improve their other products and services. Alphabet made advances in AI with their BERT program. This AI can recognize more subtle patterns in language which will allow Alphabet to provide better search results. Cloud services grew 38.5% in the most recent quarter and Alphabet plans to continue to focus on the rapidly growing industry. The company announced a 10-year partnership with Mayo Clinic to provide advanced cloud computing and data analytics to help improve their healthcare outcomes. In December, the company announced that Sundar Pichai would be taking over as CEO following the decision of co-founder Larry Page to step down from the role. Pichai is focused on bringing more transparency to the company which could help ease user’s concerns over Alphabet’s use of data.
Detractors to the quarter: Our outlook on a cross section of portfolio positions with a negative return for the quarter ended 12/31/2019.
The Travelers Companies Inc. (TRV, Financial)
The Travelers Companies took a hit in October when they released their third quarter results. Travelers has been particularly hurt by asbestos related claims as well as unfavorable general liability and commercial auto reserves. Due to these challenges we are seeing a favorable trend in pricing. Despite these headwinds, Travelers increased their net written premiums by 7% due to growth from all three of their business segments. Management is focused on cutting costs in order to return capital to their shareholders. In the first nine months of 2019, Travelers returned $1.8 billion to shareholders through dividends and share repurchases.
American International Group (AIG, Financial)
Much like Travelers, AIG has had to work against a tough macro environment for insurance companies. However, they have managed to post positive results with total premiums and deposits increasing over 10%. AIG also managed to return to profitability after difficult results in 2018 due to high catastrophe losses from the 14 separate natural disasters that caused over a billion dollars in damages (NOAA). Premiums tend to rise after natural disasters and AIG is well positioned to take advantage with higher margins. In November, AIG announced that they were selling a 77% ownership stake in Fortitude Group to The Carlyle Group and T&D Holdings for approximately $1.8 billion in order to streamline their business.
Molson Coors Brewing Co. (TAP, Financial)
In 2018 alone, the volume of beer consumed in the United States declined by 1.6% with most of the decline coming in below premium brands such as Keystone Light and Coors Light (IWSR). With this trend not expected to slow anytime soon Molson Coors Brewing is working to transform into a total beverage company by diversifying into other beverages. Their two main goals in their diversification have been in growing their premium brands such as Blue Moon and Peroni and expanding into beverages beyond beer such as seltzers, wines, hard coffees, and THC and CBD non-alcoholic beverages. According to BDS Analytics and Arcview Market Research, the US CBD market is expected to grow from $1.9 billion in 2018 to over $20 billion by 2024 for a CAGR of 49%. With its size and distribution experience, Molson Coors could scale their operations faster and more efficiently than smaller businesses. Molson Coors is expecting $1.4 billion in free cash flow in 2019 as they reduce costs and work to make their company more efficient.
Oracle Corporation (ORCL, Financial)
As part of their ongoing restructuring, Oracle has continued to shift more of their business to their cloud services and license support unit which now accounts for 71% of their revenue. While they are operating on a smaller scale than market leaders Amazon and Microsoft, they recently announced an initiative to allow their software to work with Microsoft’s in order to compete better against Amazon. Oracle is leading the field in autonomous databases and that fast-growing unit could provide a revenue tailwind in the future. Management has expressed interest in small acquisitions to improve their services, however, in a high market environment they have attempted to avoid overpaying for acquisitions and have instead spent their cash on stock buybacks. In 2019 they had a buyback yield of 14.77%.
Unilever plc (UL, Financial)
As Unilever is struggling to find growth opportunities in their developed markets in Europe and North America, their focus has shifted to emerging markets in Southeast Asia and South America. While underlying sales declined slightly in their developed markets, 5.1% growth in their emerging markets helped to boost the company to 2.9% underlying sales growth overall. Unilever CEO, Alan Jope, has worked to enhance their E-commerce capabilities since taking over at the start of 2019. Jope has also encouraged their divisions to work on increasing their local footprint with the 70-20-10 strategy. This attempts to combat the erosion large-cap consumer companies have experienced from smaller, local retailers who can more easily tailor their strategy to the market they are in. Unilever had strong free cash flow generation of €6.1 billion in 2019.
Yum! Brands, Inc. (YUM, Financial)
Yum! Brands has taken a hit on tough competition for Pizza Hut. They have struggled to keep up with Dominoes’ prices and delivery speed and have been slow to adapt to new fast-casual pizza chains such as Blaze, Mod and Pieology. Their $200 million investment in Grubhub has fared poorly. However, KFC and Taco Bell both had same-store sales growth of over 3% as well as operating margin expansion. Yum! Brands’ diversity in fast food affords them a greater stability should one of their three brands falter. They had over $700 million in free cash flow in the quarter and are projecting greater than 100% free cash flow conversion in 2020.
In Closing
We have recently traveled to eight states on research and business meetings and have seen the rapid adoption and application of technology first-hand along with the effect that market competition has on efficiency. Increased competition between Uber and Lyft is improving the service of cabs and rental cars while Airbnb is disrupting the hotel industry. A smart phone in every pocket along with low gas prices are leading to more travel as young and old seek out meaningful experiences. Airports and restaurants are busy. The exponential doubling of knowledge is accelerating the cures for chronic diseases and advances in data analytics. We remain focused on analyzing sustainable, enduring businesses with growing sales, cash flows and earnings. We are looking for high ethics and management teams that are using technology to stay relevant in a rapidly digitizing world. Data analytics, AI, enterprise software, cloud services and mobile applications are rapidly disrupting entire industries. We want to make sure we are on the right side of the digital transition.
We appreciate your trust.
Jeff Auxier (Trades, Portfolio)
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.
