Fall 2020 Market Commentary
The unprecedented events of 2020 have led many companies and industries to have wildly varying performance in the market. The pandemic has created a clear digital divide. The essential businesses who have digitized aggressively and kept strong balance sheets have adapted and outperformed year to date. However, this past quarter, after meeting firsthand with many CEOs, we are starting to see undervalued businesses that are more cyclical in nature outperform for the first time in many years. Smaller companies are starting to perform better as well. We try to stay on the pulse of businesses to catch the turn up in fundamentals. Inventory levels are very low and will need to be rebuilt. Manufacturing numbers out of China and the US are the best in two years. In the US, housing and autos have a positive multiplier effect. Record low mortgage rates are fueling a refinance boom and strong housing numbers, especially in suburban markets. Cheap gas and diesel prices are contributing to surging sales of trucks and SUVs. Used car prices are up over 12% for the year. The stock market is excited about the total addressable market for electric vehicles, but there are still over 278 million cars on the road that operate on gasoline or diesel. Boat, RV and bike sales have all seen shortages as people spend more time outdoors. The transportation sector, outside of airlines, has been recovering. FedEx and UPS have been able to take advantage of an increase in e-commerce as more people migrate to online purchases. Because of this change in consumer behavior, FedEx and UPS have seen their stock grow over 70% and 45% respectively this quarter. Other strong performers during the quarter were smaller companies like FirstService Corporation, Celanese Corporation and Lincoln Educational Services, gaining 31%, 25% and 40% respectively. I met the FirstService chief financial officer in 2003. They were a very small property management firm with a ton of energy and integrity. It has been the best performing stock in the Fund since inception. That is why we like companies that are family owned or founder run, because management tends to care more about the business and its reputation over the long term, not a quick-hit lottery ticket. On the downside, the energy, aerospace, travel and service sectors have been pummeled. In-person conferences and global travel have suffered. Goods have been outperforming services, especially where groups are involved. Spending on goods was up 6.7% versus spending on services, -7.7% for the quarter. Commercial real estate and the proliferation of collateralized mortgage obligations are suffering, forcing dramatically higher banking reserves. This and low net interest margins are hitting banks' income statements hard.
Digital Ad Growth
We are seeing an accelerated move to digital ads due to COVID-19. Companies like Snap, Pinterest, Facebook, Alphabet, Alibaba and Amazon with advanced data analytics are transforming the industry. The Interactive Advertising Bureau (IAB) expects digital ad spending to increase by 6% in 2020 despite virus-related headwinds. The IAB also estimates that traditional media advertising will decline by 30% this year indicating that companies are prioritizing digital ads as many consumers are spending so much more time at home. Alphabet's YouTube is enjoying digital ad growth greater than 31%.
Housing
The housing market has also been performing well amid the pandemic. According to Bankrate and Freddie Mac, the 30-year fixed-rate mortgage fell to an all-time low of 2.86%. Demographically, there are over 90 million millennials in the US which represents the potential for strong multiyear demand. The "work from anywhere" trend is helping people move out of cities into suburban, highly aesthetic and low-tax locations. The pandemic and remote technology have increased the demand for space and living areas with yards. The National Association of Realtors (NAR) found that completed housing transactions in September rose to 6.54 million on a seasonally adjusted annual rate, up 20.9% from September 2019. The highest in 15 years. Home remodeling has been strong with a surge in mortgage refinancing. A downside is the cost to maintain many of these houses and the potential for higher property taxes in areas where municipalities are enduring record revenue shortfalls.
Bubble Watch
With the suppression of interest rates the past few years, a momentum strategy rooted in "growth at any price" has prevailed. Bubbles have historically started during periods of easy money and exciting technological developments. Eventually price levels get too far detached from cash flows, leading to crashes. Railroads in the 1830s, airplanes, cars and radios in the 1920s and the internet in the late 1990s are examples. Recently bitcoin and marijuana stocks soared the past few years then plummeted over 80%. Today, electric vehicles and enterprise software with IPOs like Snowflake priced over 100 times sales are experiencing excessive exuberance. This speculative activity can change overnight if inflation and interest rates were to reverse course. Over the long term, price and value are important despite generally being deemphasized today. Overpriced momentum strategies tend to revert to the mean. The two big sins of investing I have witnessed over the decades that have consistently destroyed shareholder value have been CEOs overpaying in times of euphoria and adding more risk with borrowed money. There is a famous saying in the airline industry: "There are old pilots and bold pilots but no old, bold pilots." Investing is similar. To endure over the long term it takes a committed, rational research effort to avoid permanent capital losses. Ego, emotion and "winging it" combine to blow up many portfolios and take investors out of the game. We have found humility and flexibility to be necessary character traits in order to survive the incredible competitive challenges that most businesses face. In the current environment, the focus of the market has been on revenue growth, almost to the exclusion of all other investment yardsticks. Many losing companies have had tremendous returns based on exciting stories with little underlying cash flow. We have experienced these kinds of markets before. Disney, for example, was extremely popular in 1973 and the stock traded up to a price-earnings ratio of 81. Their revenue had grown 3.3 times over the prior seven years, yet in the 12 years from 1973 to 1985 the stock had a negative return despite sales growing five-fold. Popular, highly valued, "high expectation" stocks can torpedo a portfolio when they disappoint. Over the very long term it is difficult to maintain even a 13% growth rate. So high valuations tend to revert to the mean. Historically, index funds purchased at over 20-times earnings have had a negative return over the following ten years. Socialism is inflationary and inflation is the enemy of high price-to-earnings stocks. We continue to focus on doing deep dives into undervalued companies with strong or improving fundamentals that we believe have the potential to achieve "double-play" returns where improving fundamentals lead to expanding valuations.
COVID-19 Developments
Many companies are still feeling the impact of pandemic-related shutdowns while the race to find a treatment or vaccine for COVID-19 continues. Companies like Abbott Laboratories, Thermo Fisher Scientific, Quest and LabCorp are working to improve testing to help prevent future contact with the virus while others, like Pfizer, Merck and Johnson & Johnson, are working on vaccines. Merck may be best positioned to scale a vaccine, with decades of experience in mass producing vital vaccines. A recent study from the American Society of Hematology found that T-cells taken from the blood of recovered COVID-19 patients could be used to protect others from infection, as the cells maintain the ability to target the key proteins of the virus. T-cells are a critical part of the immune system that attack infected cells and pathogens. The cures for cancer are coming through the immune system and CAR T-cell therapies are growing in importance not only in cancer, but in vaccines for viruses like the flu and COVID-19. We also see mineral deficiencies as a major contributor to many diseases. The cattle industry learned early on that in order to keep vet bills low, mineral supplementation was a necessity. Low vitamin D levels have been found in over 90% of COVID-19 deaths. It appears that the best way to protect people is to focus on strategies and diets that will bolster individual immune systems. However, with cases rising in certain areas, some states and countries are weighing the possibility of additional COVID-19 lockdowns to help slow the spread of the virus, which could lengthen the recovery time for industries like energy, travel and entertainment. We continue to monitor these vulnerable industries closely during this time and remain focused on finding those select companies that have been able to find success.
Discounts on Managed Care Companies
Managed care companies like Anthem and UnitedHealth have historically seen discounts in election years as the healthcare industry is a common point of contention between candidates and uncertainty over the future of the industry is high. In the past four elections we have been a buyer of quality healthcare names that were bargains due to negative headlines. According to UBS, discounts relative to the S&P 500 peak around elections and then improve in the months afterwards as politics fade and the industry acclimates to any changes made. UBS has found that managed-care stocks have rallied 21% in the six months after the last 7 presidential elections. These stocks were up 44% a year after the last 7 elections, higher than the gains of the S&P 500. Post-election, companies like Anthem and UnitedHealth could see some positive tailwinds. The repeal of an Affordable Care Act tax on health plans in 2021 could save health insurers an estimated $15 billion annually. According to AARP, 10,000 people in the US turn 65 every day which would boost enrollment in Medicare plans. Election cycles provide unique opportunities to add strong, diversified companies that are trading at a discount relative to the market and have the potential to run.
Pandemic-Related Insurance Losses
An industry that could see a benefit from the pandemic would be the insurance industry. Pandemic-related claims have seen a spike and Lloyd's estimates that total losses for the industry could reach $107 billion for 2020. This would be the largest loss on record for insurers due to a single event. The result of these losses is leading to a drop in capital levels and we are seeing prices on policy renewals spiking broadly. This improvement in pricing will greatly benefit insurers like Travelers, Chubb and Berkshire Hathaway. Insurance brokers like Aon and Marsh & McLennan should see an improvement as they thrive in what is known as a "hard market" for pricing.
Imminent Threat to Oil and Gas Overblown?
The global slowdown in air travel and the move to alternative energies have contributed to a supply glut in oil and fuel. Most oil stocks have dropped by over 50% this year. The shale industry is facing over $300 billion in asset write-downs. According to the Energy Information Administration (EIA), global consumption of oil reached 101.4 million barrels per day in 2019 and they currently expect consumption to fall by 8.6 million barrels per day for 2020. COVID-19 has greatly impacted transportation in the US, whether that be for entertainment or simply commuting to work. Transportation is a very important area for the industry as it was responsible for 68% of petroleum consumption in the US in 2019, according to data from the EIA. Shutdowns have changed how businesses operate, with many employees working remotely. Research from freelancing platform Upwork found that reduced commuting has saved Americans $90 billion since the start of the pandemic. While travel is still below pre-COVID-19 levels, it could slowly improve as shutdowns continue to be lifted. Increased e-commerce activity could help increase demand for oil from freight shipping and offset some of the lost demand from personal travel. Freight shipping has already seen a boost this year with online sales in the US growing 30.1% in the first 6 months of 2020 according to US Department of Commerce data. Deloitte is expecting holiday e-commerce sales to grow by 25%-35% for 2020 compared to growth of 14.7% in 2019. We continue to watch the industry carefully and, while the pandemic has greatly impacted global demand for oil and gas, we see a path to recovery as consumers begin to travel and commute to work again. Since gas powered vehicles make up most of the demand for oil, the rise of electric vehicles could threaten the oil and gas industry. Many auto manufacturers have begun to release plans to fully electrify their fleet in the future. Volkswagen has said that they will no longer develop gas or diesel-powered cars after 2026. Many countries have plans to ban sales of new gasoline cars by 2030-2040. Recently, California governor Gavin Newsom signed an order that would ban the sale of new gas cars and trucks by 2035. Other states could follow suit. Moves like these do present a possible threat to oil and gas demand but there are several factors which indicate that the world may not be ready yet for a transition away from traditional energy sources. Electric vehicles in California make up about 5% of the total fleet, more than any other state, and they are already facing rolling blackouts as energy supply cannot meet demand. To transition to fully electric by 2035, California will face challenges of even more blackouts. According to the EIA, natural gas was the largest source of US electricity in 2019 at 38%. Until renewable sources of energy become more widespread and consistent, the role of fossil fuels such as natural gas will continue to be vital, especially if the country is moving towards electric vehicles. As electric vehicles continue to grow, the demand for fossil fuels will need to increase to support the increase in electricity consumption. Even with the rapid growth of electric vehicles, they still represent an incredibly small portion of total vehicles on the road in the US. According to the Bureau of Transportation Statistics, there were over 1 million electric vehicles on the road in the US in 2018, representing less than 1% of total vehicles. Another positive for the industry is that low gas and diesel prices could increase demand for gas-powered vehicles as lower fuel costs are a big reason for consumers to switch to EVs. Renewed COVID-19 fears could keep the price of transportation fuels low until uncertainty subsides. Even if sales of gas-powered cars are eventually phased out, there will still be many on the road for years after that. Consumer Reports found that the average life expectancy of a new vehicle is around eight years, or 15 years for a well-built and well-maintained vehicle, which could lead to steady demand for oil and gas even years after gas-powered cars are phased out.
Long-Term Thinking a True Competitive Advantage
Staying in the market during volatile times is one of the hardest things for investors to do. Like Peter Lynch used to say, in the stock market "the key organ here isn't the brain, it's the stomach." Over the longterm, markets tend to be resilient, but recency bias may lead many investors to sell low when stock prices go down or bad economic conditions arise. An internal study by Fidelity, which looked at their customers' top returns between 2003 and 2013, showed that the best investors were either dead or had forgotten about their accounts. These types of accounts did not sell in uncertain times or downturns and instead allowed the power of compounding returns to work over the course of many years. Investors who panic and sell low can risk losing out on gains when the market rebounds. Below is a chart from Natixis Portfolio Research & Consulting Group showing the returns of the US stock market (S&P 500 TR) after the 10 worst months between 1985 and 2019.
Investors who sold after volatile times missed out on these market rebounds. Many investors do not have long-term time horizons and therefore could be missing out on gains from recoveries. Reuters analysis of New York Stock Exchange data showed that the average holding period for US stocks was just five and a half months in June. The average holding period has been falling for many decades. In 1999, the average was 14 months and in 1990 it was over 2 years. While long-term strategies may not be as widespread as they once were, we still believe holding stocks for the long term even through uncertain and volatile times provides the best opportunity to take advantage of potential rebounds.
Third Quarter 2020 Performance Update
Auxier Focus Fund's Investor Class returned 5.64% in the third quarter vs. 8.93% for the cap-weighted S&P 500 Index and 8.22% for the DJIA. The equal-weight S&P 500 returned 6.75%. Small stocks as measured by the Russell 2000 were up 4.93%. Emerging markets as measured by the MSCI Emerging Markets Index were up 9.56%. Stocks in the Fund comprised 97% of the portfolio. The equity breakdown was 85.7% domestic and 11.3% foreign, with 3.0% in cash and short-term debt instruments. A hypothetical $10,000 investment in the Fund since inception in July 1999 to September 30, 2020 is now worth $41,938 vs. $36,047 for the S&P 500. The equities in the Fund (entire portfolio, not share class specific) have had a cumulative return of 601% since inception and the Fund as a whole has had a cumulative return of 319.37% vs. 260.47% for the S&P. This was achieved with an average exposure to the market of less than 80% over the entire period.
Contributors to the quarter: Our outlook on a cross section of positions with a positive impact on the portfolio for the quarter ended 9/30/2020.
Mastercard Inc. (MA, Financial)
Cross-border volumes fell about 50% at the start of the pandemic and volumes have only slightly improved since then due to travel and entertainment spending remaining below 2019 levels. Cross-border volumes are important for Mastercard due to the higher fees they realize on these transactions. In other areas though Mastercard has seen some positive developments. Consumer spending in the US has begun to recover as the Commerce Department showed that spending increased 1.5% in July and 1% in August. Another positive development during the year is that due to concerns over hygiene and cleanliness, the use of contactless credit cards and mobile payments has increased. A study by Forrester Research found that 67% of retailers they surveyed accept contactless payment and since January, contactless payments have increased for 69% of retailers. Growth in digital payments means a continued shift away from cash which could benefit Mastercard in the long term.
Though Corning's business continues to be down compared to last year, the company has seen sequential growth in sales, earnings and free cash flow. Corning recently introduced their new Gorilla Glass Victus, which can survive higher drops and is twice as scratch-resistant as their previous version. Gorilla Glass is the most common glass used in smartphones. With the growth of 5G connectivity and wireless charging, the use of glass on smartphones is expected to become more widespread as glass casings do not interfere with 5G or wireless charging signals like metal casings do. As 5G connectivity becomes the standard, demand for Corning's optical fiber could see a boost. For 5G technology to work and be consistent, a tighter mesh of radio antennas is needed compared to 3G or 4G connectivity which requires more fiber to be deployed. Higher demand for optical fiber could provide a boost to Corning's biggest revenue generating segment. Management expects that the sequential improvement they have seen amid the pandemic will keep them on track to be cash flow positive for the full year.
FedEx Corporation (FDX, Financial)
FedEx has been able to take advantage of increased e-commerce activity in 2020 as people have spent more time shopping at home. During the quarter, FedEx reported pricing improvement in both its freight and ground shipping units. FedEx air freight has also been able to capitalize on less competition as commercial airlines have drastically cut flights. On the company's most recent earnings call, management stated that the company is preparing for a peak like no other this holiday season as the pandemic continues to push more people to shop online. Before the pandemic, FedEx predicted the US would hit 100 million packages a day by 2026 and now they predict it will reach that number by 2023. FedEx could also benefit from a potential COVID-19 vaccine as the company manages 90 cold storage facilities and has experience in shipping temperature-sensitive products.
Medtronic plc (MDT, Financial)
During the quarter, Medtronic faced headwinds from the pandemic as patients continued to defer elective procedures, though management has seen sequential improvement as procedure volumes have begun to recover, especially in international markets. Even amid uncertainties surrounding the virus, Medtronic remains committed to returning at least 50% of their free cash flow to shareholders through dividends and repurchases. Medtronic has been incredibly consistent with their dividend and has increased the annual payment for 43 consecutive years. Medtronic continues to invest in new products to bolster their portfolio and this year they have already had over 130 regulatory approvals globally. Medtronic has been investing in a digital future with a focus on AI-driven surgical planning, robot-assisted surgeries and data analytics. Management believes their investment in these areas will lead to more effective surgeries and products as well as reduced costs.
United Parcel Service Inc. (UPS, Financial)
Like FedEx, UPS has seen a substantial increase in shipping volumes due to COVID-19 as people have been spending time at home. The company has seen a surge in residential shipments, healthcare-related shipments and strong demand from Asia. Holiday shopping, specifically online shopping, is expected to grow, which could help UPS reach record levels of revenue for 2020. Management is planning to hire 100,000 additional workers for the holiday season to help meet demand after already hiring 39,000 people in its second quarter. Through the pandemic, UPS has been able to maintain a steady balance sheet with increasing cash flow generation.
Abbott Laboratories (ABT, Financial)
Abbott Laboratories has been one of the most high-profile medical companies during 2020 thanks to their research on COVID-19 and their successful diagnostic tests. Abbott has released six different tests for COVID-19; four identify active infections and two are intended to identify past infection. Abbott has now sold over 40 million tests worldwide. The company has announced a new test called BinaxNOW which promises to deliver results in 15 minutes for as little as $5 per test. This test requires no special lab equipment, and its low cost could prove vital to widespread global testing as typical lab tests require special hardware and could cost over $100 per test. Aside from the strong performance of the diagnostics business, the rest of Abbott's segments continue to be impacted by deferred procedures. Even with sales contracting due to the coronavirus, Abbott remains profitable with positive cash flow generation which should help the company remain flexible until the market stabilizes.
Detractors to the quarter: Our outlook on a cross section of positions with a negative impact on the portfolio for the quarter ended 9/30/2020.
Bank of New York Mellon Corp. (BK, Financial)
Bank of New York Mellon has been hurt by the Fed's zero rate policies which compresses their net interest margin. With $35 trillion in assets the bank will do much better as the economy recovers and interest rates rise. It sells at one of the lowest valuations in over twenty years.
CVS Health Corp. (CVS, Financial)
COVID-19 has led to lower than expected revenues for CVS as they had fewer new therapy prescriptions due to a drop in physical meetings. However, earnings were up over 50%, primarily due to reduced costs from deferrals of elective procedures and other discretionary utilizations in the Health Care Benefits Segment. While COVID-19 has led to a lot of disruption in the industry, CEO Larry Merlo is using this disruption to accelerate their transformation into a much more integrated healthcare company. He said they are excited about the opportunity to demonstrate "the ability to deliver care to consumers in the community, in the home and in the palm of their hand." In the first six months of the year, CVS had over $10 billion in cash from operations, up over 40% year-over-year. CVS is also incredibly cheap, trading at under eight times earnings with free cash flow in excess of $9 billion.
Fears of increased regulation and negative political headlines have hurt all health insurers and Cigna is especially cheap. The stock trades at a very low valuation with double-digit sales and earnings growth and a single digit P/E ratio. From 2014-2019 Cigna's earnings compounded over 16% and the company generates free cash flow in excess of $9 billion annually. That is a free cash flow yield in excess of 13%. Cigna expects earnings to reach $20-$21 per share by 2021. The company maintains a 97% customer retention rate and management expects 10%-15% customer growth over the next 5 years.
Kroger has been a major beneficiary of the pandemic as more people continue to cook and eat at home. In their most recent quarter, Kroger reported sales ex-fuel grew 13.9% year-over-year and repeated 2020 EPS guidance of $3.20-$3.30. Their only headwind has been fuel, which has been hurt by low prices for oil and a decrease in demand as people have cut back on driving. Despite the positive trends through the year, Kroger stock is still cheap, trading at around a 10 times P/E ratio. Management has invested heavily in digital sales which doubled in the quarter. In September, Kroger's board authorized a $1 billion share repurchase program.
Microsoft Corp. (MSFT, Financial)
Microsoft hit all-time highs in August before a market correction in tech took hold in September. While it slightly trailed the market in the third quarter, Microsoft has thrived through the work-from-home movement brought on by COVID-19 and has maintained consistent revenue and earnings growth through the pandemic. Daily active users on their Teams collaboration software has more than tripled since the beginning of the year. Quarterly revenue growth for their Azure cloud has remained over 40% due to strong demand as more businesses transition to digital operations. It has invested heavily in gaming with its Xbox systems as well as more recent investments in cloud gaming with xCloud. At the end of September, Microsoft agreed to purchase ZeniMax Media, parent company of Bethesda Softworks, for $7.5 billion. Gaming is one of the fastest growing forms of entertainment and is expected to reach nearly $160 billion in 2020 according to Reuters. In addition, the Microsoft Office product line has seen strong demand this year as more businesses and schools switch to remote work. Microsoft has over $136 billion in cash, equivalents and short-term investments.
The Travelers Companies (TRV, Financial)
While the net effects of COVID-19 on The Travelers Companies have been modest, they have had significant setbacks from higher-than-expected catastrophe losses. Hurricane Laura alone caused between $8-$12 billion in wind and storm surge losses in Louisiana and Texas. As large storms and fires become more frequent, catastrophe losses will go up. While this is tough on Travelers' bottom line in the short term, the price increases on policy renewals are broad and significant. Travelers has been in business for over 165 years and has been one of the most disciplined underwriters over the past decade. The stock is historically very cheap on a P/E and price-to-book.
In Closing
We believe the potential for government-driven shutdowns in response to the COVID-19 pandemic are far riskier than the virus itself. The lockdowns are a wildcard and disproportionately hurt the poor and schoolchildren. It creates a "winner-take-all" environment where technology driven platform companies grow even stronger. Another risk we monitor is the move to extreme statism and socialism. That can lead to a downward revaluation of financial assets as higher inflation leads to P/E compression. After dozens of meetings with CEOs in numerous industries over the past three months we are finally seeing fundamentals turning positive for many of the businesses we own. We are astounded at the pace of private sector innovation in healthcare and are optimistic that the COVID related problems will be resolved over the next several months.
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.
