As the chart below indicates, capital markets during the 3rd quarter were mixed. Globally, markets were rattled in September by the potential collapse of Chinese property giant Evergrande. Emerging markets and US Small Cap stocks were down, while commodities were up. The US Bond market was unchanged as well.
Twelve months' returns paint a very different picture though: shares of US Small Cap stocks were up almost 60%, commodities increased over 40%, and all other equity categories delivered returns above 18%. US Bonds, on the other end, had negative returns, including the interest received.
On average, our balanced portfolios lagged a similarly blended benchmark during the quarter but continue to outperform year-to-date and for the past 12 months. Our stock segments were the reason as most underperformed during the quarter. The only exception was the Emerging Market category where the fund’s lower exposure to Chinese stocks helped performance.
On the bond side, our fund selection continued to do well: with rates rising, our focus on shorter maturities and more defensive options (including inflation-indexed bonds) kept returns in positive territory while the US bond benchmark is now down 1.6% year-to-date.
Finally, our Other Assets category also contributed positively to our portfolios’ relative performance during the quarter. Most of the underlying investments were intended to provide better returns than the overall bond market during a time of rising rates. They have delivered accordingly so far, both during the 3rd quarter and over the past 12 months. We are becoming more selective though as some are no longer priced as attractively as a year or two ago.
Markets have performed exceptionally well since bottoming out in March 2020, but we urge caution. Not that we claim to have a crystal ball, but history shows that equities typically return between 7% to 12% over rolling 20-year periods. Coming off one-year returns ranging from 20% to 60%, our natural inclination is to temper our clients' expectations. We would not be surprised to see the stock allocation within our portfolios average between 3% and 5% for the next few years.
We also expect that the US Bond market will continue to face headwinds. Looking at the rear-view mirror to bond returns can be misleading because we just lived through 4 decades of declining interest rates—and ever-rising bond prices. No one is currently forecasting a return to double-digit interest rates.
Somewhat concerning though, the annual rate of consumer price inflation rose by a tenth of a point in September in America, to 5.4%—higher than economists had forecast. Dearer food and shelter accounted for more than half of the month-on-month increase of 0.4%.
Even if future inflation falls back in the 2.5% to 3.5% range, the yield from US Treasuries could increase another 1% to 2% from today's levels (see chart below). The Federal Reserve has already announced that it will stop buying bonds and supporting low rates after it meets in November. We expect a continuation of flat to slightly negative returns from US Treasuries and other high-quality bonds in the near future.
So, what should investors do today? As we've discussed during our meetings with you, our current recommendations remain articulated around three strategies:
- Maintain an overall proportion of stocks towards the higher end of your target allocation range to help keep returns ahead of inflation and maintain the purchasing power of your assets.
- Favor bond portfolios with defensive characteristics (actively managed or low duration) to mitigate the impact from rising rates without sacrificing quality.
- Keep allocating to alternative asset classes that provide higher risk-adjusted yields, historically uncorrelated returns to bonds or stocks, or both.
Implementing 1. & 3. will likely lead to higher overall volatility. Unfortunately, we feel that this is a trade-off that today's investors have no choice but to accept. To a certain extent, it is not necessarily all that bad: with short-term volatility comes opportunity. We will take advantage of what markets will bring by rebalancing as appropriate and staying focused on the long term.
Large Cap Value Portfolio Review
(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.)
As growths stocks generally fared better than value names and larger companies performed the strongest, the LCV portfolio underperformed the S&P 500 Index's 0.6% return during the quarter. The calendar year ending September 30, 2021, is still very much a value story, with the portfolio leading the 30.0% gain for the same index. After five years of pervasive value underperformance, the past year (essentially since the first vaccine was approved) has been more rewarding for value investors despite a reversal during the summer.
The most significant contributors to performance during the quarter were Amerco/U-Haul (+10%), Bank of America (+4%), and Nutrien (+7%). Amerco was also our 3rd best performer for the year (+43%), behind Wells Fargo (+55%)—yes, that Wells Fargo—and Johnson Controls (+47%). Despite their recent strong stock price performance, we still maintain sizable positions in all these companies because their shares remain attractive.
The most significant detractors during the quarter were Anheuser-Busch (-22%), Qurate (-22%), and Micro Focus (-27%). For the full year, Anheuser Busch (-19%), Novartis (-10.6%), and Bayer (-5.9%) are our worst performers. All these investments also remain in your portfolio as their shares continue to sell at significant discounts to our estimates of their intrinsic values.
We added to our holdings in Anheuser Busch and Howard Hughes this quarter as their share price pulled back to attractive price-to-value levels.
In early October, technical issues struck Facebook, one of our investments, when it suffered an outage that kept it offline for 6 hours. However, it went from bad to worse the next day, with a former employee's US Senate testimony accusing the firm of endangering democracy and teenagers' mental health. Some pundits made comparisons with the tobacco industry’s woes.
Although shares have performed well so far this year and since we purchased them almost two years ago, they have lagged other tech giants since approximately September, when the allegations were first raised in a series of articles in the Wall Street Journal and on 60 Minutes. We provide our take on these recent developments and a review of our reasons to continue to own the stock.
First, we feel that these revelations omitted important facts. Reports that Instagram, Facebook's photo-sharing app, makes one in five (American) teenagers feel worse about themselves are a concern. Overlooked were the findings that Instagram makes twice as many feel better. Additionally, experts remain divided on the impact of social media on mental health.
Other complaints are really criticisms of the broader internet. The question of how to regulate content goes beyond Facebook and also affects Twitter, Snapchat, YouTube, or TikTok. Yet, the company has gone further than other social media giants in trying to settle free-speech issues and minimizing harm with its oversight board. As Ben Thompson at Stratechery noted: "TikTok's algorithm is far more addictive than Facebook's and dangerous for minors, and YouTube has played perhaps the leading role in the spread of anti-vaccine information, but it is Facebook that gets all of the blame."
Potentially more damaging to our investment case is the claim that Facebook has concealed a decline in usage amongst young users. We feel that this was already known (especially to parents with teenage children), yet the reality is more nuanced. Third-party sources show that US teenagers continue to spend more time on Instagram than on any other platform.
Next, politicians threaten to break the company up, but the antitrust case appears flawed to us. For instance, the Justice Department's claim that Facebook is a monopoly rests on defining its market so as to exclude most social networks. During the outage, users flocked to other apps like Telegram, TikTok, and Twitter, demonstrating the nonsense of this assertion. The reality is that, in 2021, Facebook — even with Instagram and WhatsApp — faces more competition than ever before.
Does any of this matter for our investment case?
So far, downloads of Facebook apps remain strong, particularly overseas. As we mentioned before, there is no evidence of reduced engagement on Facebook, Instagram, or WhatsApp. This past week's service outage was a reminder of Facebook's competitive position. As the New York Times noted, the outage demonstrated to small advertisers the value of its platforms in driving purchases. With no access to Facebook ads, many niche businesses did suffer a drop in sales.
We expect that Facebook will continue to spend on content-moderation, potentially pressuring profitability. Facebook's operating margins—now about 40%—have never recovered from their pre–Cambridge Analytica peak of 60%. Rather than a threat, we feel that potential new regulations are far more likely to hinder new startups.
Finally, we are not expecting these issues to go away quickly. If anything, we would not be surprised to see more bad press in the near term, and the pressure from public opinion to investigate will remain high. The question that we face, as investors, is whether bad news is already largely discounted or not. We believe it to be the case. Shares are inexpensive in relation to what we estimate the company is worth, even using more conservative assumptions for profitability and growth. Facebook has continued to post impressive results for both revenue and active users of its traditional platforms. In the meantime, the company keeps progressing with new initiatives—payments, virtual reality, and e-commerce—and maintains attractive monetization optionality around services like Messenger and WhatsApp.
Tax & Policy Updates
It now seems likely that we will see new tax legislation passed before the end of the year. While a lot of details are still up in the air, odds are that some of the following proposals will become law:
- Estate and gift taxes: The personal exemption might be reduced from today's $11.7 million per person to roughly half of that. Estate tax rates would remain unchanged and take effect next year.
- Income taxes: The top marginal rate could increase to 39.6% for single filers with taxable income over $400,000, or $450,000 for married couples filing jointly.
- Capital gains taxes: The new top rate could likewise increase from 20% to 25% for the same high-income taxpayers. This change, however, could be retroactive to September 13th to prevent a loss of tax revenues from a surge in stock sales at the current, lower 20% rate.
- Roth IRAs: The elimination of the "backdoor" Roth IRA conversion also seems likely with after-tax contributions to IRAs or company retirement plans no longer eligible for Roth conversion. A new cap could also be in place based on the taxpayer's existing Roth IRA value.
These changes may present some planning opportunities to some of our clients. Depending on your current marginal income tax bracket, Roth conversions, selling appreciated assets, or accelerating income to 2021 might make sense rather than facing higher rates next year. Individuals or families who may face an estate/gift tax burden under the reduced personal exemption next year might also consider making lifetime gifts to reduce the size of their estate. Finally, if your home value has appreciated significantly and you are thinking about selling in the next year or two, now could be a good time, assuming you already have some other place you can move to.
We encourage you to consider how these possible changes might impact your financial plans and to consult with us and your tax professional to discuss an appropriate course of action if necessary.
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.
This content is developed from sources believed to be providing accurate information, and it may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.