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Holly LaFon
Holly LaFon
Articles (8315) 

Boyar Asset Management's 4th Quarter Shareholder Letter

'Tesla is a testament to our ability to trust 10-year forecasts from people who can’t get one-year forecasts right.' - Jim Chanos

February 06, 2018 | About:

A Look Back

Our performance for the fourth quarter of 2017 was satisfactory and partially made up for the poor start to the year. Although we are pleased with our results overall, we still trailed the S&P 500 for 2017. The S&P 500’s superior performance has in part been driven by performance chasing individual investors embracing passive investment strategies. In the late 1990s, passive investing represented approximately 10% of U.S. equity assets; however, it now represents roughly 40% (when factor-based investing is included). This momentum has come at a cost to value investors, because most of the money that has flowed into index funds has been used to purchase growth stocks, which have the largest weightings in most of the major indices as well as ETFs. This has contributed to the outperformance of many of the most sizeable index/ETF components (which to a large extent are technology companies) and has become a self-fulfilling prophecy.

As stated in a recent Wall Street Journal article:

Investors who loaded up on U.S. and Asian stock index funds might be surprised to learn just what they own now: technology stocks—a lot of them... Led by Apple Inc., and its peers, the weighting of technology stocks in the S&P 500 index has climbed to 23.8% as of December 26, from 20.8% at the end of 2016, according to S&P Dow Jones Indices. Over the past 10 years, the weighting of the tech sector in the S&P 500 at year-end has averaged 19.6%.

Furthermore, according to an article written in November by Rob Isbitts that appeared on Forbes.com nearly 50% of the S&P 500’s return (through November 6th) had been generated by 17 companies, and more than half of those businesses are technology companies. He noted that the next 33 highest weighted companies contributed another 25% of the S&P 500’s return. So essentially 33 stocks accounted for 75% of the S&P 500s gains.

A Look Ahead

As long as passive funds benefit from positive inflows, they should continue to perform well. That said, what happens when redemptions exceed fund inflows? In 2017, an S&P 500 index fund, run by PNC, experienced withdrawals of $63 million, representing 38% of its assets. Considering that this fund’s mandate is to replicate a market capitalization-weighted index, it had no flexibility in terms of what assets to liquidate. Because Apple represented ~4% of the S&P 500, it had to sell ~4% of its Apple holdings (which have appreciated significantly over the past few years). It was unable to do what any tax-sensitive active asset manager would do consider selling holdings that had gone down in value, thereby mitigating any taxes owed. This lack of flexibility resulted in the fund paying out $4.19 in gains on a per-share basis, on a fund whose NAV was $19 per share, leaving investors with a significant tax bill. Although this may be an extreme example, investors should be aware of the potential consequences of owning a passive investment vehicle.

During our respective investment careers (which, for one of us, has been for almost half a century), we have learned that when a particular investment style has caught the attention of a large group of market participants by capturing outsized gains, investors should exercise extreme caution. For example, during the 1960s and 70s, a group of stocks, affectionately dubbed the “nifty fifty,” were in high demand. Companies like Polaroid and Xerox were considered one-decision stocksin other words, investors could buy them and hold them foreverbecause they would be able to grow earnings regardless of economic conditions. The valuations of these companies soared; in fact, Polaroid was the first major company to command a P/E multiple of 100.

When the U.S. economy entered a severe recession in the early- to mid-1970s, the nifty fifty’s profit growth faltered, and these stocks lost, on average, ~75% of their value. In addition, at the height of the dotcom mania, value-oriented investors were considered to be dinosaurs and underperformed the market for several years. However, they were eventually vindicated when the vast majority of dotcom companies crashed and burned, causing the tech-heavy NASDAQ to lose almost 80% of its value after peaking in March of 2000. In the era following the dotcom implosion, value investing once again regained its luster and handily beat growth stocks for a prolonged period of time. We are confident this will eventually reoccur; we just cannot accurately predict the timing.

Although normally we are bottoms-up stock pickers and do our utmost to ignore macro-economic data when analyzing individual stocks, certain economic factors/indicators exist that give us reasons for both optimism and caution. Some of these are detailed below.

U.S. Consumer Confidence Continues to Strengthen

U.S. consumer confidence is at a 17-year high (as measured by The Conference Board). However, we believe that another leg-up could come during 2018. The potential benefit of increased discretionary income for individuals via lower tax rates, as well as the broader impact of accelerating economic growth in the U.S should serve as positive catalysts for consumer confidence levels in the coming quarters. Further gains in confidence should bode well for the fundamentals of a range of sectors within the economy, such as consumer discretionary and retail. These positive tailwinds should improve the outlook for several companies owned by our clients, such as Kohls, Tapestry (formerly Coach), and Harley Davidson.

Foreign Investors are Piling into U.S. Stocks as Margin Debt Rises to a New Record

After four years of foreign investors pulling money out of U.S. stocks (2013–2016), overseas buyers pumped over $66 billion into these stocks between January and September 2017; almost 40% of these inflows came in September alone. This development is somewhat concerning for the 8+ year bull market because foreign investors have historically proven to be “the last group to the party” in a rising market. (Note that foreign money piled into U.S. stocks in 2000 and 2007 just prior to major selloffs.)

Of equal concern is that margin debt recently reached a record $560 billion (higher than previous bubble peaks). This statistic may, in real terms, understate the leveraged bets being made on a rising stock market, considering that the assets in Rydex bull funds currently outnumber those in Rydex bear funds by almost 30 to 1.

U.S. Margin Debt

Interest Rates

The Fed has indicated that it is set to raise interest rates three times in 2018. Additionally, it is already in the process of shrinking its balance sheet after pumping trillions of dollars into the financial system to help combat the global financial crisis. Although we believe that both are prudent long-term policy decisions, the Fed needs to be extraordinarily careful in implementing them. If it raises rates too quickly, this could have significant negative consequences for the economy. Our fear is that if the economy continues to improve, the Fed will implement additional rate hikes to combat inflation, potentially derailing the economic expansion. Although the situation is not completely analogous (as rates were much higher then), the Fed should be mindful of what happened in 1994, when a rise in rates caused a horrific corporate bond rout.

Presidential Election Cycle

While we take statistics about stock market performance and the presidential election cycle with a large grain of salt, what has occurred in the past is at least worth noting. If history is any guide, 2018 should be a rollercoaster ride in terms of stock market performance. In 9 of the past 14 midterm election years, bear markets either began or were already in progress. Since 1913, the Dow Jones Industrial Average has dropped by an average of 20.4% from its post-election year high to its subsequent low in the following midterm year, and since 1914, it has gained 47.4%, on average, from its midterm-year low to its subsequent high the following year. With the Dow trading near all-time highs, history tells us that 2018 could bring a bear market (or a significant market correction) followed by a relatively quick recovery, creating a tremendous opportunity for opportunistic investors who are brave enough to “buy the dip.” However, because the current administration has deviated so significantly from prior presidencies in so many ways, past performance may not be indicative of future results in this instance.

*Note: These Presidential Election Cycle statistics were provided with permission by Jeffrey Hirsch of the Stock Trader’s Almanac. The 2018 edition can be found at www.stocktradersalmanac.com.

Could we be Experiencing a Market Melt-Up?

We believe the chances are better than average that the stock market is currently experiencing a market melt-up, which could culminate in a major decline in 2018. We have been calling for a correction for well over a year, and obviously we have been wrong/early. However, the longer the market advances without a meaningful decline, the greater the likelihood that the loss will be of a significantly higher magnitude. Remember, market corrections are an integral part of the investment process, and without them an investor could not capture future outsized gains. Having cash during these periods allows an individual to take advantage of the bargain basement prices that occur at such times; this should also make up for the underperformance resulting from holding an asset that demonstrates little or no return for a number of years (i.e. cash). As we have frequently noted, if we had not had cash in 2008 and 2009, we could not have taken advantage of the once-in-a-generation opportunities that arose then.

Amazon Antitrust Action?

One of the companies that helped lead the S&P 500 to record highs in 2017 was Amazon. However, could there be an antitrust case on the horizon? Although Amazon does not fit the traditional definition of a monopoly—its overall share of total U.S. retail sales is relatively small at ~5% (excluding food)—its market share of online sales is ~44%, according to eMarketer.

With current antitrust doctrine focusing mainly on consumer prices as evidence of sound competition, it does not appear that Amazon should have a legal problem because the company has caused the prices of most goods to decrease. Although Amazon probably does not have a bona fide legal issue, it certainly is faced with a significant political problem. It is no secret that President Trump is no fan of Amazon founder Jeff Bezos. In a 2016 speech, Trump stated, “If I become President—oh, do they have problems. They’re going to have such problems.” In a television interview, meanwhile, he said: “He (Bezos) thinks I’ll go after him for antitrust . . . because he’s got a huge antitrust problem, because he is controlling so much—Amazon is controlling so much— of what they are doing.”

It appears that Trump believes Bezos to be using the Washington Post (which he controls independently of Amazon) to protect the online retailer from both IRS and antitrust scrutiny. Amazon has a clear history of engaging in anticompetitive behavior. For example, after initially expressing a desire to buy Quidsi (the owners of Diapers.com as well as other online retailers) and being rebuffed, Amazon lowered the price of diapers so significantly that, by some estimates, it lost $100 million in three months on diapers alone.

This put so much pressure on Quidsi that it had no choice but to sell itself to Amazon. Not surprisingly, after purchasing Quidsi, Amazon stopped discounting the items over which it had competed with Quidsi. This is only one of many examples of Amazon using aggressive pricing to destroy its competitors as well as scare away new entrants.

Will the Trump administration convince the Justice Department to pursue Amazon? At least one well-known investor thinks so, with Doug Kass of Seabreeze Partners stating:

I am shorting Amazon (NASDAQ:AMZN) today because I have learned that there are currently early discussions and due diligence being considered in the legislative chambers in Washington, D.C., with regard to possible antitrust opposition to Amazon’s business practices, pricing strategy and expansion announcements already made (as well as being aimed at expansion strategies being considered in the future).

If I am correct, word of this could lower Amazon’s shares by 10% overnight. And if expansion or pricing prohibitions are attacked for antitrust reasons (or for other reasons), a far more severe market impact is possible.

Some will argue that because Amazon’s stock price increased ~58% in 2017, the market considers the threat of government action to be remote. However, it is worth remembering how tight the deal spread was for the Time Warner/AT&T combination (another merger Trump vowed to oppose) before, apparently out of nowhere, the Justice Department sued to block it for what many view as politically motivated reasons.

Should you have any questions, we are always available.

Best regards,

Mark A. Boyar

Jonathan I. Boyar


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