Seven Canyons Strategic Income Quarterly Commentary
WASIX earned a 2.84% return for the quarter ended June 30. This was on target, finishing between the 3.78% return of our ACWI (MSCI All Cap World Index) stock benchmark and the 2.82% return of our Barclay’s aggregate bond benchmark. The annualized return for the quarter was near 12%, above our high single digit return goal. While the quarterly results met out objective, as always, one quarter is too short a period to provide meaningful insight into how WASIX is doing.
Even one year doesn’t provide much insight, especially for a buy and hold investor like WASIX. Our best ideas are the ones we can hold for years. So a single year’s results don’t say much about the long term prospects of a company or, for that matter, of our portfolio. That said, our performance lagged over the past year. During the year ended June 30 WASIX earned 3.27%, falling short of the 5.74% return of our stock benchmark, the 7.87% return of our bond benchmark and our high single digit return goal.
The best understanding of how a portfolio manager is doing is gained by assessing performance over an entire market cycle. This provides information about how the manager does during both good and bad times. In general, three years is long enough to capture these effects. But the last three years don’t provide a window into performance during bad times, as they start at a low point in the market and end on a high point. Nevertheless, as these reports always present three year performance, we will stick with that period as representative of a market cycle. During the past three years WASIX’ annualized performance was 8.08%, spot on our high single digit return goal. Returns also fell between the 11.62% return of our stock benchmark and the 2.31% return of our bond benchmark.
Given that the trends driving the market have been so similar over the past quarter, year, and three years (and longer), I’m going to discuss our results for these three periods together. Since 2012 the market has been driven by two primary factors. The first is the gradual acceptance that interest rates will remain lower for longer. The second is the piling on effects of automated trading, including index investing. Both of these factors tend to make “rich” stocks get richer. The market’s acceptance that interest rates will remain lower for longer has the most favorable impact on rapidly growing companies. This is because lower rates may make future growth more valuable causing prices (and market cap) of these already rich companies to rise. Index investors may buy disproportionately more of these larger market cap companies which tends to make their prices rise further. Not surprisingly, these same trends make “poor” stocks get poorer. Because WASIX owns a mix of rich and poor stocks, we have tended to lag behind the market.
The impact of these trends has been evident in WASIX’ performance over the past quarter, year, and three years. The two leading contributors to our returns over each of these periods have been Mastercard (MA) and Visa (V). These two stocks have been poster children of the rich get richer phenomenon. Their multiples have doubled as the market has incorporated lower rates and the role of automated trading has risen. In addition to MA and V, other market leaders have included AAPL, AMZN, and FB. WASIX did own AAPL but sold it too soon. While both AMZN and FB are great companies, they do not pay a dividend and so aren’t candidates to be owned by WASIX. As always we seek to own companies which have both the ability and the willingness to pay a growing stream of dividends.
Assuming the current market trends will continue, why doesn’t WASIX only own rich stocks? Why own any poor stocks? There are two answers. One is that trees don’t grow to the sky. At some point, rapidly growing rich companies will cease growing. For example, I sold AAPL because the majority of people worldwide already own a phone. There are relatively few new phone buyers left. Further, replacement demand for AAPL’s phones has been dampened by the lack of innovative features. As a result, AAPL’s sales have declined for the past two quarters.
The second rationale for not buying only rich stocks is that WASIX is a buy and hold “GARP” investor. While we do want to own companies which will grow their earnings, we want to buy Growth At a Reasonable Price (GARP). Although we still own both MA and V, at more than 40x their P/E multiples are stretched. This is a stark contrast to the 10x multiples of the poor retail drug chains we own, including CVS (CVS) and Walgreens (WBA).
The rationale for owning some poor stocks is similar to the rationale for not only owning rich stocks. Today’s trends won’t always continue. Some rich stocks will become poor. Some poor stocks will become rich. Investing must be based on assessing future prospects. A skillful portfolio manager will be able to anticipate future trends. Additionally, while future earnings growth plays the primary role in stock selection, valuation plays a lesser but still important role. Cheap poor stocks have a built-in advantage compared with expensive rich stocks.
To date, our holding of poor retail drug chains CVS and WBA has been a mistake. They have been a drag on performance for the past quarter, year, and three years. But I continue to own them because I believe they are growing their ability to serve as front line health care responders. Most people have their most frequent contact with health care providers at their local drugstore. A growing number of drugstores are expanding their services by offering “minute clinics” where a doctor or nurse can treat minor illness or injury. Walgreens is innovating further by providing in-store lab services enabling a person to have blood drawn, tested, and results returned right at the drugstore. CVS is focusing on gaining a more holistic view of the customers it serves by acquiring Aetna. Though positive contributions are coming more slowly than expected, I continue to own these poor stocks with the belief that they will make a solid contribution to WASIX’ future returns.
During the quarter the median dividend growth of the companies we own was a strong 11%. I believe that the quarterly dividend growth of our companies is even more important than their price growth. This is because prices fluctuate in response to ephemeral factors, while steadier dividends reflect how a company is actually doing.
Our portfolio didn’t change much this past quarter. I did sell Jetpak as further analysis of its prospects led me to question its future growth prospects. The biggest change I made was to increase our cash to nearly 10% in response to the current unusual fiscal and monetary policies. Never before have we had a tax cut at this stage of an economic expansion. Never before have we had easy money at this stage of an economic expansion. So far the market has responded positively to these policies. But I believe caution is always the best policy, so WASIX held above normal “dry powder” to enable us to exploit buying opportunities that may arise.
OUTLOOK: As I noted in my Chairman’s message, I am expecting a slowdown as fear of trade wars creates turmoil in the global supply chain. I do not, however, expect a recession. Nevertheless, I have added slightly more than normal dry powder to the portfolio. This will allow us to take advantage of any price disruptions that occur.
ACWI (MSCI All Cap World Index) is a market capitalization weighted index designed to provide a broad measure of equity-market performance throughout the world. The MSCI ACWIis maintained by Morgan Stanley Capital International (MSCI) and is comprised ofstocks from 23 developed countries and 24 emerging markets
Barclay’s aggregate bond benchmark is a broad- based benchmarkthat measures the investment grade, U.S. dollar-denominated, fixed-rate taxable bondmarket
Price-to-earnings (PE) is the ratio for valuing a company that measures its current share price relative to its per-share earnings.
All investing involves risk. Investments in securities of foreign companies involve additional risks, including less liquidity, currency-rate fluctuations, political and economic instability and differences in financial reporting standards and securities market regulation. Investing in small and micro-cap funds will be more volatile and loss of principal could be greater than investing in large cap or more diversified funds.
Dividends are not guaranteed and a company’s future ability to pay dividends may be limited. A company currently paying dividends may cease paying dividends at any time.
Past performance is not indicative of future performance and current performance may be lower or higher than the data quoted. For the most recent month-end performance data, visit www.sevencanyonsadvisors.com. Investment returns and principal value will fluctuate and shares, when redeemed, may be worth more or less than their original cost.
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