Index Surgery
The Value Fund gained +5.2% (net of fees) for the six-months ended June 30, 2018. During this period the S&P/TSX Total Return Index gained +1.9% and the S&P500 gained +2.6% including dividends (+7.4% measured in Canadian dollars – the Value Fund’s reporting currency).
Notes: All returns and Value Fund details are as of June 30, 2018, based on Class A units and are net of all fees. The Value Fund was launched on November 1, 2011. Prior to January 17, 2014 the Value Fund was managed by Lightwater Partners Ltd. while Mr. McCloskey was employed by that firm.
Currency movements that lowered our returns in both 2016 and 2017 reversed and have helped us so far in 2018. At times these movements will make us look brilliant and at other times foolish. Our view is that neither description is deserved. Currencies generally move within broad ranges and short-term movements are largely noise. We purposely accept this volatility in exchange for forgoing the hedging costs along the way. Our currency strategy remains unchanged and has been written about at length.
Recent Annual Meeting
Thank you to the 40 people that attended our Annual Meeting on June 13. For those who weren’t able to join us, a copy of the presentation along with a video recording of the event is now available on our website.
Portfolio Review
At mid-year, 97% of the portfolio was invested in 22 common stocks (1% Canadian and 96% foreign) and 3% was invested in cash and equivalents.
Our top three contributors year-to-date were all technology stocks: online travel agent Booking Holdings (Nasdaq:BKNG) +16.7%, credit card network Visa (NYSE:V) +16.2% and industry stalwart Cisco Systems (Nasdaq:CSCO) +12.3%.
Our large bet (6.8% weighting) on Express Scripts (Nasdaq:ESRX) is performing according to plan with the stock up +16.4% since we purchased it in April. Our recent writeup of our investment thesis for Express Scripts can be found in Scorecard #21. Our idea was published in Barron’s and was recently ranked as one of the best performing ideas from the View From The Buyside column. In an expensive market, good ideas are hard to find. But they are out there. It just takes a lot of effort to uncover them. We remain bullish on our investment in ESRX as we continue to believe that the announced merger with Cigna (NYSE:CI) will receive regulatory and shareholder approvals and eventually close. Consequently, we expect the stock to gradually move towards the $92.00 deal price (vs. $79.45 today).
Our biggest performance detractors for the first half of the year were diabetes care leader Novo Nordisk A/S (NYSE:NVO) -14.1% and telecom giant AT&T (NYSE:T) -17.4%. Novo Nordisk remains well positioned to benefit from the growing number of people worldwide that are afflicted with the disease. Diabetes is truly a global pandemic. We are sitting on a decent gain on our investment and view the recent pullback as temporary. The future for AT&T is less certain. We inherited the stock as part of the consideration received on the takeover of our prior investment in DirecTV (we took some cash on the deal as well). The media and telecom landscape continues to change rapidly and AT&T is trying to adapt as evidenced by their recent acquisition of Time Warner. We like the 6.1% dividend yield but their balance sheet and industry shifts both make us cautious. We are closely monitoring the company’s progress.
During the first half of 2018 we also initiated a few new positions including Alphabet (Nasdaq:GOOG) – also known as Google. Their dominance in search (>90% market share) is unlikely to be disrupted despite regulatory attempts to punish the company for abusing its market power. When people use the Google search engine, the company has a window into what is on our minds at that precise moment in time. That is a very valuable asset and advertisers are willing to pay to get in front of us at these critical moments. Google’s AdWords is the gatekeeper and the company should continue to monetize its search traffic at high margins for years to come. The company’s “Other Bets” like self-driving cars (Waymo) are less certain but we aren’t counting on them as part of our valuation for the company. If they do pan out it’s gravy. That said, we wouldn’t bet against the company when it comes to innovation. Google has a winning culture underpinned by its top-notch engineering talent and its reliance on data-driven decision making. For those interested in learning more about the company, we recommend the book How Google Works written by former CEO Eric Schmidt and former SVP Products Jonathan Rosenberg.
Finally, during the first half of 2018 we fully exited our positions in Allergan (NYSE:AGN), Corus Entertainment (TSX:CJR.B), Gilead Sciences (Nasdaq:GILD), Pandora A/S (CPSE:PNDORA) and Swatch Group (SWX:UHR).
We finished the period with unrealized gains on our equity investments of approximately $5.8 million. The Value Fund is well positioned as the companies that we own are of high quality and should continue to increase their intrinsic value over time. A snapshot of the entire portfolio at June 30, 2018 can be found on the Schedule of Investment Portfolio on page 5 of the Financial Statements provided to GreensKeeper clients in our 2018 Half-Year Report.
Index Surgery
We have previously mentioned in passing a few of the shortcomings of the major stock market indexes but some recent market events justify dissecting them further.
Going back to first principles, the first stock market index was introduced in 1896 by Charles H. Dow as a barometer of how the equity markets were performing. Mr. Dow’s eponymous index is still in existence today, however its small number of constituent stocks (30) and calculation based on price weighing(1) vs. market capitalization make the Dow Jones Industrial Average (DJIA) a less-reliable gauge of how the broader markets are faring.
A more widely followed index is the S&P500 whose constituents comprise the 500 largest companies listed on the major US stock markets as measured by market capitalization. While this is arguably a better measuring stick for the US equity markets than the DJIA, the S&P500 Index has its own shortcomings.
For example, as a company’s shares rise in price and the valuation becomes more expensive, its weighting in the S&P500 Index increases. Index investors end up owning more and more of expensive companies and less and less of cheaper ones. Amazon (Nasdaq:AMZN) alone accounted for 33.4% of the S&P500’s gains through June 30, 2018 (see table below). As we previously wrote in the Globe and Mail, while Amazon is a gift to consumers, we have no interest in owning the stock at its current valuation. We are of the same opinion for another top index contributor and market darling: Salesforce.com (NYSE:CRM). With the company trading at a valuation of 65x forward earnings (232x trailing), we just don’t get it and will take a pass. Best to leave pricey stocks like this to others who think that we are missing something.
Having a growing portion of your portfolio invested in expensive stocks is the exact opposite of what we would argue is our more rational value investing approach. As stocks decline in price, they actually become more attractive (and less risky). Overvalued companies can also sell off quickly when market sentiment changes. For example, Facebook (NYSE:FB) issued results last week that were below expectations and the stock sold off (17.2%) in one day. Given the company’s size – and hence large index weighting – it accounted for almost all (86%) of the S&P500 Index’s decline for the day.
(1) Price-weighted indices like the Dow Jones Industrial Average (DJIA) are calculated such that higher-priced stocks have a greater index weighting than lower-priced ones, even if the lower-priced stock is in a company with a market capitalization that is larger than the higher-priced stock.
Markets have been rising for some time so passive index investors tend to become complacent and forget about the risks that they are taking. As we wrote in Scorecard #19:
“… there are a lot of poor-quality companies out there that we prefer to avoid. For example, at its peak valuation, Valeant Pharmaceuticals (TSX:VRX) accounted for 6.1% of Canada’s S&P/TSX Composite Index. Shades of Nortel circa 2000. Again, we prefer to mitigate investment risk by owning high-quality businesses at undervalued prices and avoid the rest.”
The foregoing observations should not be taken to mean that market indices aren’t useful to investors. Index levels and their movements are useful barometers of broader market conditions. Our main point is that investors need to dig beneath the headline numbers to understand what is really going on before reading too much into them. Which leads us to one final observation about indexes.
The massive fund flows into passive index investments strike us as herding behavior that has yet to be tested by a market panic. Markets occasionally do extraordinary and unexpected things on short notice and we humans are emotional creatures after all. Panic selling of stocks will likely induce index redemptions which will in turn force certain index funds to sell stocks in order to fund them thereby creating a negative feedback loop. We have no desire to be market Cassandras, but this setup vaguely reminds us of the portfolio insurance phenomenon of the 1980s that played a role in the 1987 market crash. We think that the next major market correction, whenever it comes, will deliver a few unpleasant surprises to passive index investors. Caveat emptor.
GreensKeeper’s view on Cryptocurrencies:
“Speculative assets like Bitcoin attract capital, aggressive promoters and then fraudsters. We prefer to simply stay away.”
Annual Meeting
June 13, 2018
A Different Approach
In a world of extremely low interest rates and an overvalued Canadian real estate market, we believe that equities remain an attractive asset class for Canadians. However, market valuations remain elevated – which is why we don’t own the market.
Instead, we seek to invest in high-quality but undervalued companies with solid balance sheets. In the present environment we are very focused on risk mitigation and capital preservation when selecting our investments. We walk our talk at GreensKeeper and believe in aligning interests which is why I have over 70% of my family’s net worth and 100% of our investible assets invested directly alongside GreensKeeper’s clients. In short, we are different.
If you are interested in learning more over coffee at our Oakville office or downtown Toronto, feel free to give me a call.
July 30, 2018
Michael McCloskey
President & Founder