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4th Quarter Review: A Rising Tide Lifts All Boats

Global capital markets appreciated virtually across the board in the 4th quarter, capping off a strong year for investor returns which saw domestic stock indexes once again close near record highs—boosted by U.S. tax reform legislation passed in late December.  Below is a summary of how our model 60/40 portfolio was allocated at year-end, along with recent trailing returns of relevant benchmarks for each asset class (note: your portfolio’s allocation and results may differ—please refer to your Quarterly Portfolio Review Report):

Much of the explanation for this skew comes from the fact that large cap technology stocks were the best-performing S&P 500 sector in 2017—up 38.8% for the year.  In fact, this sector is now home to 7 of the 10 largest public companiesoverall:


Tech giants (as well as multi-national pharma companies) figure to be big beneficiaries of the 2017 Tax Cut and Jobs Act—which not only cuts the corporate tax rate from 35% to 21%, but also levies a one-time repatriation tax on foreign earnings of either 8% or 15.5% (well below the formerly prevailing rate).  For many years, U.S. multinational companies had avoided repatriating the earnings of their overseas subsidiaries, in order to defer the associated taxes (tech and pharma companies were disproportionately represented among this group).  With the passage of the tax bill, this patience has been rewarded.  Recent estimates place the amount of overseas cash on U.S. company balance sheets above $2 trillion.  In fact, in a ranking of cash balances among S&P 500 companies, the top 10 alone account for over one-third of that estimate (Figure 3).  These companies formerly carried a liability on their balance sheet for deferred taxes. Following the passage of the tax bill, that liability is reduced, providing an immediate boost to each firm’s value, all else being equal.

Warren Buffett famously said: “You pay a very high price in the stock market for a cheery consensus.”  The five companies listed above have dominant market shares, and are valued accordingly.

What is less clear is whether they will remain dominant over a long enough period to justify today’s lofty valuations.  Implicitly, such premiums suggest a consensus view that these firms will grow twice as fast as the broader market—even though they are already the largest companies in the world!

Midway through 2017, our sense that U.S. equity valuations were becoming stretched motivated us to shift a greater portion of the portfolio to international stocks (where valuations are more favorable).  For context on this valuation gap: the S&P 500 index finished the year at 18.2x expected 2018 earnings, whereas the MSCI All-Cap World Index (excluding U.S.) and the MSCI Emerging Markets Index traded at 14.3x and 12.5x forward earnings, respectively.

As it happened, international stocks outperformed U.S. equities in 2017, thanks to accelerating global growth and a favorable currency tailwind.  From mid-2011 through late 2016, the U.S. dollar steadily appreciated vs. a basket of major currencies, reflecting higher U.S. GDP growth rates, as well as the prospect of rising U.S. interest rates.  During this time, the strong dollar was a headwind for U.S. holders of overseas assets.  However, that trend reversed in 2017.  The dollar weakened about 6% vs. a basket of other currencies, boosting returns for U.S.-based investors (Figure 4).  Moreover, with U.S. Treasury secretary Steven Mnuchin and Commerce Secretary Wilbur Ross tacitly endorsing a weak-dollar policy in order to boost U.S. exports, this trend appears likely to continue.

On the other hand, REITs, utilities, and other yield-focused equity investments faced a tougher time in 2017 against the backdrop of 3 successive interest rate increases by the Fed.

Speaking of interest rates, the Fed is well on its way to “normalizing” short-term rates (the target overnight rate now stands at 1.25-1.50%), but so far this has had little impact on long-term rates (which are more sensitive to inflation expectations).  The yield on the 10-year U.S. Treasury bond increased by only 5 basis points in 2017.  For perspective, Figure 5 shows how the rising short-term rates have flattened the slope of the yield curve over the last 4 years:

With such a narrow spread between short and long-term rates, bond managers are unable to earn much of a return premium by assuming interest rate risk (i.e. owning longer duration bonds), and often compensate by taking more credit or currency risk instead.  The broad-based Barclays Aggregate Bond index returned only 3.5% in 2017, but investment-grade corporate bonds (6.5%), high-yield bonds (7.5%), convertible debt (13.7%) and global bonds (7.4%) all benefitted from benign credit trends and/or currency tailwinds.

As we’ve mentioned before, we are reluctant to take material credit or currency risk within the fixed income portion of client portfolios, since we believe that the primary objective for this allocation should be capital preservation.  That said, we have gradually increased our allocation to “other” assets (i.e. preferred stocks, merger arbitrage, and closed-end funds), which function as a hybrid between traditional stock and bond categories and allow us to improve the overall risk/return profile of the portfolio.

During the 4th quarter, we slightly increased our allocation to this “other” bucket with the addition of preferred stock in Steel Partners Holdings (SPLP-A).  These preferred shares have a current yield of about 7%.  However, they also have a fixed maturity date (2026) and the parent company has committed to tendering for 20% of the outstanding shares by February of 2020—in each case at a par value of $25 per share.  Therefore, the weighted average “yield-to-maturity” is likely to exceed 8.5% per year—an attractive return in the context of our muted expectations for stocks and very low expectations for bonds.

Large Cap Value Portfolio Update
(Not all clients of Bristlecone are invested in our Large Cap Value Equity portfolio strategy—depending on the size of the portfolio, and the client’s objectives and constraints)

Our average Large Cap Value account saw good absolute returns both in Q4 and in 2017, but in each case under-performed the S&P 500 index by a small margin.  However, given the especially wide performance disparity between growth and value stocks in 2017, as well as the higher-than-normal level of cash we maintained for most of 2017, we are not altogether displeased with this result.  For context, the Russell 1000 Value index achieved a total return of only 13.7% last year.  Measured against its large cap value peer group, the portfolio outperformed significantly.

Our trading activity in Q4 was restrained, as the nearly 9-year-old bull market has left fewer stocks trading at a material discount to fair value.  We made one addition to the LCV portfolio, initiating a small position in Expedia (EXPE).  We owned this stock several years ago, and it has remained on our radar ever since.  In the years since we last owned Expedia, its industry segment (Online Travel Agency – OTA) has experienced explosive growth, now claiming around 50% of travel-related spending.  Coincident with this growth, the industry consolidated globally around a handful of major players, strengthening the market power of these incumbents.  In the U.S., the OTA market is effectively a duopoly between Expedia and Priceline (PCLN), each of which owns many well-recognized subsidiary brands.  Both companies benefit from pronounced economies of scale and entrenched network effects which would be difficult for upstarts to replicate.

Recently, EXPE announced Q3 earnings which disappointed Wall St due to certain one-time charges pertaining to acquisitions.  Our view is that the negative impact of these accounting charges is transitory, whereas the competitive moat Expedia builds through consolidation of former competitors is likely to be powerful and enduring.  An overnight 20% drop in Expedia’s stock price following the earnings report offered an attractive entry point.

Our other trade during the 4th quarter was to sell our position in New York REIT (NYRT), a concession that our original investment thesis no longer held water.  As you may recall, we purchased NYRT as a “special situation” investment early in 2017, shortly after the company commenced a plan of liquidation which sought to close the gap between the stock’s trading price and the firm’s per-share Net Asset Value (NAV).  We anticipated a short holding period, limited downside, and potentially a double-digit annualized return (in the best-case scenario).  Unfortunately, the market for high-end commercial properties in New York City softened during 2017, and several of NYRT’s buildings sold for less than management had estimated.  More critically, management revised their plan to sell the single largest property in NYRT’s portfolio (arguably the source of most of the unrealized value), instead deferring that sale for four years while they partnered with two other NYC-area REITs to re-finance, renovate, and re-lease the building at (hopefully) higher average rents.

While that plan may yet come to fruition, it is far from assured, and in any event, is not the investment case we had initially contemplated.  Moreover, per the terms of the liquidation agreement, NYRT will be de-listed from the New York Stock Exchange at the end of March.  Holders of the stock after that date will have their shares exchanged for non-traded “liquidation trust” units, which will not be marketable or redeemable until NYRT’s final property is sold.  Anticipating that the company will effectively become an illiquid micro-cap stock levered to a single Manhattan office building, we no longer consider it an appropriate investment for the Large Cap Value portfolio.  Accordingly, we made the decision to sell in mid-December, so that taxable clients could at least utilize the capital loss to offset other gains on their 2017 tax returns.  Our initial appraisal relied too much on management’s estimates and similar transactions’ multiples which turned out to be optimistic.

As always, we encourage your comments and feedback, and appreciate your continued trust in our services.

One of Bristlecone Value Partners’ principles is to communicate frequently, openly and honestly. We believe that our clients benefit from understanding our investment philosophy and process. Our views and opinions regarding investment prospects are "forward looking statements," which may or may not be accurate over the long term. While we believe we have a reasonable basis for our appraisals, and we have confidence in our opinions, actual results may differ materially from those we anticipate. Information provided in this blog should not be considered as a recommendation to purchase or sell any particular security. You can identify forward looking statements by words like "believe," "expect," "anticipate," or similar expressions when discussing particular portfolio holdings. We cannot assure future results and achievements. You should not place undue reliance on forward looking statements, which speak only as of the date of the blog entry. We disclaim any obligation to update or alter any forward-looking statements, whether as a result of new information, future events, or otherwise. Our comments are intended to reflect trading activity in a mature, unrestricted portfolio and might not be representative of actual activity in all portfolios. Portfolio holdings are subject to change without notice. Current and future performance may be lower or higher than the performance quoted in this blog.

References to indexes and benchmarks are hypothetical illustrations of aggregate returns and do not reflect the performance of any actual investment. Investors cannot invest in an index and returns do not reflect the deduction of advisory fees or other trading expenses. There can be no assurance that current investments will be profitable. Actual realized returns will depend on, among other factors, the value of assets and market conditions at the time of disposition, any related transaction costs, and the timing of the purchase.

Economic factors, market conditions, and investment strategies will affect the performance of any portfolio and there can be no assurance that a portfolio will match or outperform any particular index or benchmark. Past Performance is not indicative of future results. All investment strategies have the potential for profit or loss; changes in investment strategies, contributions or withdrawals may materially alter the performance and results of a portfolio. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be suitable or profitable for a client's investment portfolio.