Value Investing

Insights On Current market sentiment, investing strategy, lessons learned and general commentary

Feb 17, 2018, 9:54 pm

I wanted to share the market commentary from a dividend growth investor friend of mine, who manages money. This is not a paid post, and I do not receive any compensation from him. Rather, I have interacted with Joe off and on over the past decade. He is one of those readers who have stuck around for a while, who I regularly discuss dividend investing with. Writing about investing can be a lonely pursuit, so it is definitely helpful to have someone and bounce off ideas.

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I am sharing this market commentary, which he shared privately with his clients, because a lot of his points resonate very well with me. While no two investors are alike, his strategy of finding quality dividend payers for the long term really hits home for me. The letter captures current market sentiment, investing strategy, lessons learned and general commentary. If I ever leave blogging to manage money full time, this is the type of letter I would be sharing with clients.

Without further delay, this is the comment letter from Joe Ferris at Summer Fields Investments LLC: Source Of Letter

Dear Friends,

2017 was a remarkable year in the equity markets. The broader US stock market did not have any negative months in the year, giving it the distinction of being the strongest market, per that metric, in 90 years [1]. Furthermore, there was no correction greater than 3% in the year, which is unusual for equities. The graphic that I included over 6 months ago has proved to be correct, for now, as we have broken out, to the upside, of a long trading channel in the S&P.

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There are a number of reasons for this.

Before the presidential election in November 2016, I thought that the Blue Team would win, and that minimum wage would be gradually raised, inflation would creep up, and goods and services would earn more revenues. This would put a higher floor in our companies’ earnings, spurring the market to pay a higher multiple for our companies’ earnings.

Well, as we all know, the Red Team won, and now, minimum wage is being gradually raised [2], inflation is creeping up, and our company’s goods and services are earning more revenues. It’s funny how that happens.

There is also the matter of the large corporate tax cut, which gives our companies more after-tax profits. The market has been excited by that.

We have seen a number of US companies either attempt (in the case of Pfizer and Allergan) or execute (Medtronic, Johnson Controls, etc) foreign inversions in the past decade, so it makes sense to me that incentives should be provided for US companies to not pack up and run to lower tax regions. However, they should also have more regulations on tax avoidance, and that is indeed happening, with some companies getting rid of their tax shelters [3].

In 2016, many Summer Fields Investments accounts beat the broader market due to us buying selected financials when they were depressed during the summer Brexit vote. 2017 presented a higher hurdle.
The last time we bought Boeing was when they were under investigation by the SEC for accounting irregularities, in the first quarter of 2016, for approximately 114 per share. This presented an opportunity that we always search for- a good company which is going through temporary drama that depressed share value. Since early 2016, Boeing share price has gone up to around 333, a 192% return in the past 2 years. Much of that rise happened since the election. In January 2017, it started at 157, where I thought it was already richly valued, and went up another $199 in 2017, a 126% return in 2017. Boeing is now very overvalued, in my opinion, trading well over historical market multiples. Being that the Dow Jones Index is only 30 companies, Boeing dragged the Dow up very high in 2017, to around 26%. The S&P returned 19.4% for the year.This type of behavior is a characteristic of a more mature phase in the market cycle and in the bull market. There is a lot of global liquidity and people want to put their money to work as they see the market gaining over the past years. Excited investors pile into the winners, and those that already have appreciated a lot attract even more capital. We see this especially in the FAANG stocks- Facebook, Apple, Amazon, Netflix, and Google. It has been tough to compete with that kind of excitement in 2017 on a total return basis. However, all of your accounts have done well in 2017, most comfortably in high double digit territory, and some of you exceeding 20% for the year. All of you, of course, have higher current dividend yields than the richly valued S&P, now yielding around 1.84%. The Dow also similarly yields around 1.99%, also fairly expensive.

In January 2018, many of our companies have joined the market excitement. Abbvie, which many of us own, went up 15%, more than doubling in the past year (unjustifiably, in my opinion- the market is overexcited about short term catalysts in the stock, including Abbvie winning a lawsuit which extends patent protection of Humira for a little longer than anticipated). Target Corp. went up almost 40% in the past few months, and 12% since the beginning of the year. Long term market returns can often be lumpy.

Of course, leading into February, the market has been in correction mode. I will address my thoughts on the current state of the markets and my projections for the future later on in this update.

I shared in the last Summer Fields Investments update how Cisco Systems behaved in the Tech Boom and Bust of the late 1990s and how we started buying when they were significantly cheaper, after they initiated a dividend. We have done very well with those purchases, and the aggregate Cisco position in Summer Fields Investments is up over 35%, including dividends paid.

I would like to now share my experience with FAANG, specifically with Apple Inc.

I was familiar with the brand, having been an Apple user since the late 1990s. There were execution fears and issues which the company navigated through in their early days after Steve Jobs returned to the company, and the successful launch of several iPhone cycles cemented their status as the tech darlings, and indeed, market darlings, of the time. In 2010 and 2011, an enormous amount of capital, from hedge funds, to growth investors, to general retail investors, piled into the name. Apple share price went up a lot in that period.

As their product cycles matured, they decided to initiate a dividend in 2012. I took that as a sign that management was confident about their future prospects, and after much analysis, surveying, and testing, I initiated a small position shortly after the dividend initiation announcement. I thought it would be good to put a toe in the water and the valuation, although high, seemed somewhat reasonable for a richly valued growth stock.
In the next year, the stock fell over 40% from the 2012 highs as hedge funds and growth investors fled the name. At that point, I bought with both hands. The stock has since almost tripled, and the annual dividend has been raised by approximately 10.6% per year since then.

There are a lot of lessons in this story. First off all, averaging into positions is always nice, because it is harder to predict what happens in the shorter run. We do this by generally averaging into the market via reinvesting dividends. I also encourage you to invest new cash regularly/monthly for this reason.

Secondly, no publicly traded company is immune to gravity. All companies that I have studied have periods of overvaluation, sometimes extremely so, and sometimes for extended periods – and all companies have periods of undervaluation. There is no company that always rises with no stop. Consolidation occurs, volatility occurs, change in perception occurs- and that is precisely how we capitalize on opportunities that arise.

When the opportunity arises, of course, the question is, what does a person capitalize on. What do we decide to plant in our dividend fields?

Let’s talk a little bit about some of the hot names of the current market cycle. I’ve discussed some of these names in the past and it would be nice to revisit them.

Big Tech had a great run in the past couple of years. Technology typically can always get ahead of itself because it is fertile ground for human imagination. We can’t imagine what will happen in the future and sometimes, when excited, we humans can overpay for potential and possibility. We see this happening in many different companies currently.

Typically, companies on the stock market trade for a multiple of their future earnings, and make various amounts of profit depending on their earnings growth, how good the year is, how much stock they bought back or issued, and so on and so forth. Netflix is hemorrhaging free cash flow, as you can see in the diagram above. They are taking on enormous amounts of debt in order to create new content and shows, and in order to advertise more. Bullish investors in the stock hope that they will ultimately put together something “sticky” enough to retain viewers and make it so that people won’t cancel the service. They might also be able to raise prices higher in the future as they hope to achieve high market share and thus a degree of inelasticity.

The market is valuing the company very highly now for a number of reasons. They have a good position in the market now. They have advanced technology that they have built out over the years. Also, the market currently like SaaS models (software as a service), because they are predictable and an easy-to-value revenue stream, which can be leveraged especially in a low interest rate environment.

Netflix would be a perfect example of a company that hasn’t made much in the way of profits, but has taken advantage of this low rate and low regulatory tech environment to grow their revenues tremendously. The market has rewarded them because their share price has grown too.

However, they will have to pay the piper one day. Disney is coming out with their own SaaS model. Disney has multiple revenue streams including ESPN, theme parks, and tentpole movies. There will be a time when the market will demand profits, and possibly sell stocks that have negative cash flows. I am concerned that these types of high flying growth stocks will be severely hit, much like our old buddy, Cisco, which fell about 90% from the highs in the 2000 Bust.

Tesla is worth mentioning. I give Elon Musk a tremendous amount of credit for advancing alternative energy in the public sphere, and pushing other companies to be competitive in that regard. However, as it stands now, the company is a black hole of unprofitability, running on a lot of hype, hope, and cash deposits for cars that may or may not be ready far into the future. The market seems excited that they delivered approximately 103,000 vehicles in 2017. Ford produced 6.4 million cars in 2016. Ford is worth 42 billion dollars, and Tesla is worth 58 billion. Financial legend Jim Chanos, the person who discovered accounting irregularities in Enron which ended up helping to bring the company down, is short Tesla stock, which means he is betting that the stock goes down. This is not a stock I would buy for a dividend growth investment. However, I would not short this company as they are on the forefront of innovation. It is just that the cash flow statements of the company do not inspire me to invest in this business, until I see more mature operations.

Facebook is a similar tale with different details. Big Technology companies were allowed to get away with a lot in the previous decade as the United States was very permissive in not demanding technology companies be liable for much at all, so that they could grow unencumbered. We are currently seeing more regulation enter the space, as government entities push for more accountability especially around full disclosure of campaign funding [4]. When a stock is rising and has momentum, it is a terribly exciting time. But there may come a time, especially in the age of trade tariffs and reaction to globalization, when more limits are imposed on Big Tech than are currently priced into the markets [5]. That time may come sooner than later [6].

There also seems to be a bit of public backlash around social media, where thought leaders are questioning the utility of its addictive and potentially vacuous nature. Furthermore, if these large companies such as Facebook are indeed a platform, and not a media company, as they have historically claimed, they might then have to be classified and regulated as a utility. Facebook is currently trying to serve many masters, and is struggling with its identity. It must be addictive to be able to charge top dollar for advertising, but it must also be appealing enough for people to stay on it and feel good about it and themselves for the long run. There is also the issue of incentive, where Mark Zuckerberg, Facebook’s founder, has 60% of the voting power. He may not feel the need to pay himself dividends if he owns over $70 billion of equity in FB. There has also been drama in the past where he wanted to retain voting majority control of the company even if he sold more than a majority of his shares, and this was ultimately vetoed after shareholder revolt. This does not reflect well on current corporate culture. I could be wrong, and if Facebook decides to pay a dividend I will reconsider. Even then, I would wait for a track record, and a cheaper valuation before buying.

I can write many more paragraphs in continued analysis, but suffice it to say, I prefer investing in more mature companies that have a good track records, solid fundamentals, and recurring cash flows and a corporate culture that is favorable to shareholders. An investor must always be vigilant, but over the long term, history has shown that the odds of success are better with companies that have the discipline and corporate culture of paying regular dividends for an extended period of time [7].

Before I close the book on FAANG in this email I should also mention Amazon. Amazon is a remarkable business that has managed to stretch itself quite far into the world and in commerce in general. US retail revenues were around $5 trillion in 2017, and about 4% of that total was transacted through Amazon in 2017, an impressive number. They have a similar SaaS style valuation where Prime subscriptions are valued highly by the market, and they also indeed offer software as a service in their AWS (Amazon Web Services). They have also been effective at trying to circle many businesses’ wagons in various ways. We see them undertake many business initiatives, some of them great, and some of them silly. They are not afraid to take risks.

They are becoming a more and more impressive business as time goes on. Even more recently, it seems that they have beat Apple to the punch when it comes to home-based speakers. While I thought that they failed at electronics because they did a terrible job at trying to get their Amazon phone to the public, they actually rallied their resources afterward to supply cheaply made home speakers to the public. We will see how it plays out as the technology is still nascent. While we wait, I am comforted that of the 5 trillion dollars of retail business revenues achieved in the US, approximately $4.8 trillion of it was not transacted via Amazon. Somehow I think that diversified investors might be able to profit from even a small percentage of that bounty.

There is also a lesson of perception in there, because if an alien visited earth and read the news in the past year, he would probably think 20%+ of retail revenues were transacted through Amazon in 2017. But no, it was only 4%. In fact, many of your portfolios took advantage of all of the fear and hype. The day that Amazon announced that they were purchasing Whole Foods, Target Corporation was sold down to $49 per share, and early that morning I was holding my nose, gritting my teeth, and initiating and adding to positions with whomever had the liquidity at that particular moment. Target makes between $3 – 5 billion in free cash flow per year and pays out $1.3 billion in dividends, using the rest for investing in the business and repurchasing shares. They own their own real estate, unlike Amazon which leases much of their infrastructure. Even though the media was making it out to be devastation and catastrophe, I would buy a situation like that all day long, especially at 11 – 12 times earnings. Now, Target has gone back up to almost 73 per share. That is a classic value investing move, and I am proud of how we handled that. With smaller companies struggling and closing, and a good emphasis on brands that their customers enjoy, Target should get even more business, and I hope they pay us dividends for years to come.

I’ll end my FAANG tirade with this. As we know, it is all about incentives. I am not a hater, I am a value investor and fairly agnostic to value. If Jeff Bezos decides he doesn’t want to sell a billion dollars worth of his own stock annually any more to fund his rocket ship hobby [8] and initiates a dividend, and the stock gets cheap relative to earnings, I’ll happily buy for all of you. As of now, it is only a moonshot in the most liquid of Summer Fields Investments accounts, albeit an expensive company, led by a most remarkable business mind and quantitative finance visionary. However, they have margins between “slim” and “none”, heavily subsidized money-losing retail operations, and NYU business professors yelling at them for antitrust violations and acting in bad faith [9].

It will be fascinating to see how the US and EU ultimately decide to deal with Big Data and Big Tech. Ultimately, if data is the new oil, as many say, it might be regulated as such. If privacy is a competitive advantage, as some economists maintain, it might be anticompetitive if only a few companies possess huge troves of data about billions of people. They may have to democratize this data in the future, causing less profits to them, but spreading the competitive advantages out for the betterment of progress in our capitalist society.

A few Summer Fields Investments related matters:

1) As we know, lower fees improve portfolio returns. I think that after I hit around $12 million in assets under management I’ll bring down my annual fee even further. Although my fees are already attractive compared to other RIAs, I have been inspired by Vanguard Funds lowering their costs as their assets under management get larger. So, keep those referrals coming. I want to be a continuously more attractive place for you to invest and to keep investing into. Lower fees will keep things that way.

2) There is a good chance I will be moving somewhere outside of California when my wife Lori finds a job. I already have clients in 4 states and my location won’t be a significant impact on my business. I’ll come visit California from time to time and we can communicate by FaceTime or Skype if we need to.

3) I am interested in creating a non-profit business entity in order to channel my passion for dividends into an organization that is purely charitable. No management fees, no fancy dancing. It would be a labor of love. It will probably be structured as a 501(C)3 (federally tax exempt non-profit organization) and the dividends will, by law, have to be distributed to 501(C)3 institutions like food banks and other causes. I plan on recruiting some of you to the board of Summer Fields Endowments and we can give a little charity, feed the hungry, and help the world with dividends. You may contribute for charitable purposes and/or for the tax write-off when it is established. I’ll keep you posted.

This has been a remarkable couple of years in the equity markets. I am very pleased with how accounts are being built out over time. I am also proud of some of the decisions we made through the year, including investing into some technology companies that have infrastructural advantages, and to harvest some of the outsized gains we saw for the benefit of those retiring sooner than later.
In the frothiest markets in late 2017 and early 2018, I was taking advantage of some the massive capital gains with selected retirement accounts, especially for those who are retiring soon or already retired. As the market gave us these extreme gifts, it wasn’t a stretch for me to decide to take advantage of some of these gains and reinvest into more yield-producing stocks for the benefit of portfolio income, especially for those retiring sooner. This is part of evolving with the needs, goals, and time frames of every client portfolio in its own way.We are now in a correction period. The market has accepted that the easy money from Central Bank easing over the past years is coming to an end. It wasn’t a surprise that on the first day of the new Fed chair’s job, the market took its most substantial tumble. The market is now finding its footing in a new regime where interest rates are slightly rising, although they are still very low historically. I expect the market to

consolidate and digest some of the last year’s gains here. We should see a little more weakness, until all earnings come in for the quarter and get analyzed by the market. The market needs proof that real earnings are rising, and I suspect the market will get its proof. Earnings are indeed being revised up. This should lead the next leg of the bull market up.The work now is to stay in the boat and let it rock about in the storms, while reinvesting dividends and investing new cash. After the storms pass, the boat should take us where we need to go. Our businesses are designed to give shareholders returns exceeding inflation, and good current income. This volatility is sector rotation, consolidation, profit taking, and noise.

Further into the future, I have good news and I have slightly disappointing news. The good news is, Elliot Wave market analysis predicts higher highs in the future [10]. Jeff Saut from Raymond James maintains that we are in a strong bull market with years ahead of it [11]. Jeremy Grantham thinks there is a possibility of another 20-30% or more upside to the equity markets [12].

The more disappointing news is that the next powerful wave in the bull market cycle is probably the last one in the cycle, according to some Elliott Wave analysts. So we can expect higher highs than we have seen before, possibly significant ones, before the next bear market. How long or how intense the ensuing bull wave, or the next bear market is, no one knows. I would like to think that due to the sharp bear markets we have had in 2000 and in 2008, we are in for an easier period in equities. This supposition can also be supported by the fact that almost 100 million millennials are getting married and starting their own families, buying their own houses and SUVs, increasing their consumption, and possibly contributing to an economic boom much like the baby boomers did before them. Of course, the particulars will be different, but the theme may be the same. There is also the issue of underfunded pensions. Pensions may sell their bonds and invest more into equities in the coming years as inflation and pension liabilities grow.

What I can tell you, though, is that bear markets usually last a significantly shorter amount of time than bull markets. The average length of a bear market is 14 months, and the average length of a bull market is 48 months [13].

Being that equities have outperformed most all other asset classes in the past 120+ years, I am very confident and happy to keep invested in them through many market cycles. In fact, it is my fervent wish to work with, and invest with you all through multiple market cycles, through the ups and the downs. I am incentivized to grow your assets with you, and to make you want to be friends with me in decades to come, not just ride the current waves of hype in any particular sector or industry that is hot right now.

To briefly address Bitcoin, everyone I admire in finance is skeptical of its long term utility. Warren Buffett, Charlie Munger, Seth Klarman, Byron Wien, John Bogle (Vanguard founder) and more have all either expressed skepticism or outright suggested that people avoid it altogether.
From a perspective of historical pragmatism, there have been many technology booms in the past that attracted an enormous amount of capital, which indeed helped to spur the technology to ultimate widespread adoption, but many of the original investments in the sector were unprofitable. This is to imply that the underlying technology of Bitcoin, the “blockchain” (which IBM currently has an excellent corporate position in [14]) might be used ubiquitously in the future, but there is no guarantee that Bitcoin will be used along with it.
Caveat Emptor; buyer beware. A large portion of outstanding Bitcoins are controlled by a small group of people, and it is in their interest to hype it worldwide so that as many people as possible buy it, thereby inflating the value of their holdings.

I have one more thing to comment on, and that is the S&P index. We all know that indexing is very popular nowadays. It is easy to be happy with market indices when they are doing well. However, we should not forget about the “lost decade” of 2000-2010, when both the S&P and the Dow returned approximately 1% per year in that time frame.

But I have an even better one for you. 2017 has been a milestone for Japan. The Japanese Nikkei index has finally touched the high it achieved THIRTY YEARS AGO. You read this correctly. The annualized rate of return of the Japanese Nikkei index has averaged 1% per year since 1988 [15]. This is very poor, indeed. Japan went into a crazy bubble through the latter part of the 1980s, going up many tens of percent per year for nearly a half a decade. The Yen was strong, their businesses were strong, and there was a lot of hype around their equity markets. That highly extended overvaluation proved to be a long term negative for a Japanese index investor who wanted to live on his funds by selling stock every year in hopes that his stock would appreciate.

Now, there are clear difference between Japan and the USA. The US has a far broader and more diversified economy, and better demographics than Japan. But the idea stands. There is risk holding just a market index. That is why it is important to buy attractively valued, dividend producing stocks. It should protect portfolios from sequence of returns dangers like that. Furthermore, depending on the dividends and not capital appreciation to monetize the investments removes some of that risk as well. Therefore, I am extremely passionate about my dividend growth stocks. As my colleague Dividend Growth Investor who writes an eponymously named blog recently put it, “Should I invest in dividend stocks or in growth stocks? How about dividend growth stocks? You get the best of both worlds – growing dividend income and solid total returns”.

I should also reiterate that I am a value agnostic, and in that spirit, I have recently been investing in international dividend paying equities that have more attractive valuations relative to some US companies as well. We will buy high quality, dividend paying, attractively valued companies where we can get them.

Thank you for the privilege of allowing me to invest on your behalf, and to be of service in this important area. I am personally all in equities, having been invested in them successfully for 20 years. I expect the next 20, and the 20 after them, will also be quite successful, and certainly choppy and eventful, as is the nature of equity investing. I have been through the Asian currency crisis in the 1990s, the tech bust early in the century, 2008 recession, Fukushima nuclear reactor meltdown, earnings recession of 2015, energy and market dip in Q1 2016, and the current volatility. Volatility is part and parcel of equity investing. It is like the weather or a bad mood, we can’t avoid those things, we can only get through them, or in the case of equities, attempt to actually take advantage of the downturn to buy companies at cheap prices. Volatility is inherently part of nature, and to try to suppress it for long periods of time can actually be dangerous and cause more trouble in the future. Consolidations and pullbacks are necessary to let off steam in the case of bubbles, and to form bases for further growth.

While the market is currently scared of inflation, I am not. Our companies possess the pricing and earnings power to navigate through, and probably handily beat inflation over the longer term.
I am excited about the investment opportunities that this year might continue to provide us. As Warren Buffett is fond of pointing out, America still has exceptionally fertile ground and rule of law that is conducive to investment. By regularly investing into these volatile capital markets, we can take advantage and average into good dividend paying companies for the long run.Sincerely,

Joe

P.S. Some actionable things for you to do if you are motivated.

1) Vote for Qualcomm management via either your proxy mailers or through your email from interactive Brokers asking you to vote for Qualcomm. Broadcom is trying to acquire them. While you, the investors, win whatever ends up happening, I’d prefer Qualcomm remain a stand alone company.

2) Buy online when you can from Target.com.

[1] https://seekingalpha.com/article/4134832-stock-market-1st-90-years

[2] https://www.usatoday.com/story/money/2018/01/11/list-companies-paid-bonuses-boosted-pay-since-tax-bill-passed/1023848001/

[3] http://www.bbc.com/news/business-42324485

[4]https://www.reuters.com/article/us-facebook-politics/seattle-says-facebook-is-violating-city-campaign-finance-law-idUSKBN1FP2MB

[5]https://www.marketwatch.com/story/tax-overhaul-is-a-credit-negative-for-tech-sector-sp-says-2018-02-08

[6] https://discovery.economist.com/features/21735021-dominance-google-facebook-and-amazon-bad-consumers-and-competition-how-tame-161596116

[7] https://www.thebalance.com/why-dividend-stocks-outperform-non-dividend-stocks-357353

[8] https://techcrunch.com/2017/04/06/amazons-jeff-bezos-sells-1b-in-stock-annually-to-fund-space-company-blue-origin/

[9] https://www.youtube.com/watch?v=3baKe4B3eyI

[10] https://caldaro.wordpress.com/2018/02/10/weekend-update-640/

[11] https://seekingalpha.com/article/4135923-investment-strategy-curve