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“Are Corporations People?” and Other 1st Quarter Musings

In American politics, there is a clear separation between Democrats and Republicans on the subject of whether corporations deserve the same rights as citizens. Where both parties appear to agree lately though is when it comes to extracting big fines from them. The number of billion-dollar fines grew from zero in 2010 to nine in 2016. The 1st few months of the Trump administration saw four settlements of over $1 billion each.

The current President, despite touting his pro-business credentials, was very happy to follow the prior administration’s footsteps saying on Twitter in February that fines and penalties against a bank, Wells Fargo, would be “pursued and, if anything, substantially increased.” So the recent news that the bank got fined $1 billion did not come as a surprise.

This begs a legitimate question: Did Wells Fargo and other corporations commit these crimes or did people? We’ll side with the people did it view. If these behaviors were reprehensible, then the people who committed them should have also paid the price. Here, we make a distinction between restitutions, damages, and compensation on one side, which are disbursed to the victims (including federal programs such as Medicare), and fines and penalties on the other side, which are paid to the US Treasury. Our bone of contention is with the latter.  Shareholders are already penalized multiple times following the actions of management: a first chunk of payouts goes to the victims to compensate them, then millions go to lawyers, accountants and extra staff, and finally profits suffer from the real but unaccounted costs of these distractions on the new management team.

Going back to Wells Fargo’s case, the bank set aside more than $4 billion last year to cover restitution and compensation to victims of its different scandals. Then, two months ago, the Federal Reserve also ordered the bank to contain its balance sheet to its end-of-2017 size until risk controls meet regulators’ approval. In the meantime, its expenses are inflated by tens of millions of dollars paid to lawyers and accountants. Although we are confident that the bank and its stock price will do well going forward, these costs substantially reduce current shareholders’ profits and dividends.

It is also unclear to us how such fines are assessed. Two years ago, Wells Fargo already paid a $185 million penalty related to the same issues. Did the bank commit additional crimes five times more onerous to justify another $1 billion fine? The formula the government used to arrive to these amounts is never mentioned in the media, and consequently appears arbitrary and driven by political or headline-grabbing goals. These amounts clearly exceed the legal costs borne by the regulating agencies.

Finally, while the people who committed these crimes are usually no longer employed by these companies, it remains an open question whether punishment was adequate: they remain wealthy, frequently end up in management or board positions at other companies, and few if any has gone to jail or faced criminal charges. We suspect that a big part of the reason is that it is easier, cheaper and faster for the Justice Department to extract a fine or a penalty from a corporation than to pursue criminal charges against individuals. Not surprisingly, the companies’ directors and managers are also eager to settle to put these matters behind them.

Sadly, when it comes to fines, as far as the government is concerned, rights and responsibilities are not always tied to the same parties: people commit crimes, while corporations and their shareholders pay. This disconnection makes it unlikely that fines will deter future bad corporate behavior. Currently, the gamble for unethical or greedy managers is too often a case of head I win, tail shareholders lose.

1st Quarter Wrap Up
After a year during which the S&P 500, a proxy tracking the 500 US biggest companies, showed positive returns every single month, 2018 started off in similar fashion with an almost 6% increase in January. But then, volatility returned with a vengeance and investors experienced their first market correction of 10% in a long time. The S&P 500 finished the quarter down only 0.8% (including dividends).

This return to a more historical level of volatility was seemingly due to fears of a trade war with China, revelations of Facebook’s data harvesting activities, and expectations of higher inflation. Yet the economy continues to perform nicely, with both businesses and households benefiting from higher levels of income. Although psychology and politics can trigger market panic, we feel that positive economic fundamentals should continue to provide support for stock prices around the world.

While technology and growth stocks generally declined further during the latter part of the correction (and so far in April), they still outperformed value stocks during the quarter thanks to significant outperformance earlier in the year. Both US small companies’ stocks and foreign equities declined slightly, while Emerging Markets stocks registered a gain. Real Estate Investment trusts experienced one of the biggest drops among stock categories, hurt by rising interest rates.

The US bond market was lower as well with long-dated issues suffering the most: from the start to the end of the quarter, the yield on the 10-year U.S. Treasury rose to 2.7% from 2.5%, and the Bloomberg Barclays U.S. Aggregate Index, a proxy for US bond performance, lost 1.5%—its first negative quarterly return in over a year. Foreign bonds bucked the trend and rose thanks to dollar weakness and easing policies by the European and Japanese central banks.

How Did Your Portfolio Do?
10 out of 12 asset classes experienced a decline and our average client’s balanced portfolio (i.e. made up of stocks and bonds) declined slightly during the 1st quarter. Exceptions were Emerging Market equities and Foreign Bonds categories, which both rose in low single digits.

Our investment selection outperformed on average in 8 out of these 12 categories during the quarter, and 6 out of 12 during the last 12 months (your own portfolio results may differ – please refer to your Quarterly Portfolio Review Report). The table below shows how a model 60/40 balanced portfolio is allocated, and for each asset category, the benchmark returns through March 31, 2018:

How Is Your Portfolio Positioned?
As the Federal Reserve maintains its policy of slow and steady tightening of monetary conditions, we continue to anticipate higher interest rates across the maturity spectrum. As we discussed before, for the past couple of years, we made two tactical decisions to protect your portfolio in that scenario: The first was, within the US bond category, to allocate about 60% to 70% to more defensive, actively managed bond funds, rather than a broad market index. The second was to reduce the overall fixed income allocation in your portfolio, and progressively substitute investments in preferred stocks, merger arbitrage funds, and other less traditional asset classes (called “Other Assets” in your reports). Our goal was to find investments that had the potential to outperform bond market indexes in a rising rate environment while exhibiting less volatility than stocks.

Both moves have paid off so far, as returns from these investments have outperformed the US bond market benchmark over the past 18 to 24 months. Although we’re not ready for a victory lap yet, it is our expectation that they will continue to do so for the foreseeable future.

Another tactical move which we highlighted a year ago was, within the stock portfolio, to increase your portfolio’s allocation to foreign and emerging market stocks. The reason behind this decision was that we viewed foreign markets as more attractively valued, which in our opinion, increases the odds of better long-term returns going forward.

Candidly, we do not claim to have a crystal ball and such tactical moves are always measured and incremental. Our core belief remains that your portfolio, within the constraints and objectives of your personal situation, should always be diversified among a broad set of asset classes as markets have a long history of surprising investors.

Finally, it is important to remind our investors that our portfolios are consistently positioned with a ‘value’ bias. Whether we look for investments in stocks or bonds, US or foreign stocks, large or small companies, we focus on identifying investment ideas where there is a discount between price and value and gravitate towards fund categories that are cheaper than the alternatives. Today, in the US, value stocks trade at attractive levels, especially in comparison to growth stocks. This is also true in international markets, and even truer in emerging markets. We believe that over the long-term, value strategies are bound to outperform, while possibly insulating or protecting our clients’ portfolios from the next inevitable market turbulences along the way.

Review of Bristlecone’s Large Cap Value (LCV) Equity Portfolio
(Not all clients of Bristlecone are invested in our Large Cap Value Equity portfolio strategy depending on the size of the overall portfolio, and the client’s objectives and constraints)
During the 1st quarter, the average LCV portfolio declined slightly more than the broader market, yet delivered good absolute returns (in the low teens) for the past 12 months. Not surprisingly, the biggest contributors to performance were technology names: Cisco Systems (CSCO +13.2%), Keysight Technologies (KEYS +26.0%), Intel Corp (INTC +13.5%), Hewlett Packard Enterprise (HPE +22.6%), and Dynegy Inc. (DYN +14.1%). Detractors were mostly companies potentially affected by trade tariffs: Wells Fargo (WFC -13.0%), Valmont (VMI -11.6%), Agco Corp (AGCO -9.0%), Amerco (UHAL -8.6%), and Cemex S.A. (-11.8%).

The return of a more volatile market environment provided us with opportunities and our trading activity increased from prior quarters. We reduced your investment in Cisco Systems, a manufacturer of networking equipment. The company continues to report solid results thanks to demand from data centers customers and will benefit from the recent change in the US tax code. However, we view the shares as fairly valued and consequently decided to halve the size of our commitment following a sharp increase in the stock price during the 1st quarter. So far, Cisco has been a successful investment, greatly outperforming the broader market since we bought it in November 2008 at the height of the financial crisis. The complete history has yet to be written though, as we retain a small position.

During the quarter, we finally put some of your cash to work: we added to your investments in Adient, a manufacturer of car seats, in Expedia, the online travel agency, and in Johnson Controls, a manufacturer of HVAC and fire and safety equipment (which merged with long-time portfolio holding Tyco in 2016). We also initiated a new investment in GCI Liberty, a cable company, and Micro Focus Intl., a British software firm.

With the last 2 names, the truth is that you had recently received a small number of shares as a spin off from other holdings or because of a merger. After researching these companies on a stand-alone basis, we decided to make them a more significant part of your portfolio.

Each of these 5 companies benefit from strong competitive positions, low or no debt on their balance sheet, capable management, and attractive valuations brought about by what we view as short-term issues (or in the case of GCI Liberty, complexity).

Adient, GCI Liberty and Microfocus also share some additional characteristics that we highlighted last year as an area of focus: ideas that are more complex, trade on a foreign exchange, or in the case of Adient don’t have a long history as an independent company. Consequently, they are less covered by Wall Street analysts, not yet part of the big stock market indices, and more likely to represent an attractive opportunity. Let’s take a more detailed look at one of them:

GCI Liberty
This business was originally spun off from Liberty Interactive and is part of John Malone’s Liberty media holdings. As you know, we’ve been familiar with Mr. Malone and his management team for decades going back to his original cable venture Tele-Communications (TCI), and more recently as a shareholder in Liberty Media companies. It has served us well as Mr. Malone has accumulated a remarkable track record as a capital allocator.

GCI Liberty is an investment in 2 cable companies, General Communications, the dominant cable provider in Alaska, and Charter Communications, the 2nd largest cable company in the US. This is a case where, in our opinion, the whole trades at a significant discount to the sum of its assets because it is complex, not part of an index and, for now at least, underfollowed by analysts.

We also believe that the cable business is changing, not widely understood, and becoming more attractive because it is increasingly focused on internet high-speed connectivity. Broadband providers frequently benefit from an economic moat protecting their business because it is expensive for competitors to enter their markets due to the high cost of building an alternative.  We think that incumbents such as Charter have a long period of attractive and growing cash generation ahead of them.

What Will the Future Bring?
After earning good absolute returns in 2017, we feel cautious and expect subdued returns for your portfolio in the short to intermediate term. It is also very possible that we could hit a few bumps along the way. We just don’t know. What we do know though is that these are no reason to panic. We will be there to provide perspective and guidance, make any adjustments that might be necessary as your life circumstances changes, and help you stay on track with your long-term financial plans.

Thank you for your continued trust in our services.

Disclosure Brochure Offer
Securities laws require Bristlecone to make available every year to clients the latest version of our disclosure brochure (Form ADV Part 2A). This form contains important information about our firm, such as services, business practices, potential conflicts of interest, a summary of our Disaster Recovery Plan, and Privacy Policy.

If you receive your 1st quarter statement by mail, a copy is included for your convenience. If you elected to receive your statements through our online portal, the disclosure brochure is available for download on our website by clicking here, but we’ll be happy to mail you a copy free of charge (call 877-806-4141 or email clientservices@bristlecone-vp.com)

You may also find additional information about our firm at our website, and through the Investment Adviser Public Disclosure system at www.adviserinfo.sec.gov. We are also required to adopt a code of ethics and provide a copy of which to clients upon request.

Please contact us immediately if you have had any changes in your investment objectives or financial circumstances. Any changes could impact how we manage your portfolio and will become part of your client file. You should also contact us at any time during the year if your investment goals and/or financial circumstances change. Should you hold equity securities in your portfolio, you will be responsible for the voting of proxies with regard to those investments. We typically do not vote client proxies unless specifically requested.

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.