Second Quarter Update - Fundamental Growth
The second quarter and the entire first half of 2019 was a very good start to the year for the Shaker Fundamental Growth Strategy and the entire US Stock Market. The investment results for the accounst were positive - in line with market indices in the second quarter and outperformed for the first six months of the year. Equity investors broadly continue to benefit from rising equity markets that have bounced back after a difficult fourth quarter of 2018. Late last year investors were concerned that risks related to overtightening of monetary policy by the Federal Reserve combined with continued trade war escalations could push the economy into a recession. In 2019, concerns with those risks have declined and in June the S&P 500 reached a new all-time high.
While the broad large-cap equity indices achieve new records, the internals of the equity markets still suggest some reticence among investors as they indicate more of a “risk-off” skew rather than “risk-on” bullishness. The equity markets are being led by what are commonly perceived to be the “safer” segments of the market – larger capitalization companies rather than smaller companies, and companies characterized by more stable growth in their results rather than the more economically-sensitive value names. This is understandable as economic growth and public companies’ earnings growth has slowed in 2019 from the more robust rates of the prior two years.
During the quarter, your accounts performance was negatively impacted by the underperformance of smaller capitalization stocks as compared to larger capitalization stocks. As you know, the combination of the amount of our assets under management and our extensive research capabilities allows us to invest in almost any size of company. Thus, we generally have a portfolio-weighted average market capitalization that is smaller than that of the US stock market. Currently, assets are split 60% above $10 Billion in market cap and 40% below $10 Billion in market capitalization. Our second quarter results reflect this tilt – our gains outperformed the US Small Cap Equity Index but slightly lagged those of the large cap indices.
Growth companies continue to outperform value / slower growth companies. We have often discussed our expectations that in a slower growth world economy, faster growing companies would be more valuable relative to their peers, and we are seeing that occur. Furthermore, the more economically sensitive value stocks have been more impacted by the cyclical slowdown in terms of slower economic growth in 2019 due to the lagged effects of Fed rate hikes in 2017-2018, along with tariffs and trade tensions.
However, among these more valuable growth companies, individual stock prices can get ahead of fundamentals even if the market as a whole appears to be fairly valued. We are being careful in our evaluations of the growth opportunities and quality of the companies that we choose as investments in the fund. In addition, as prices and valuations rise, we have been trying to limit the relative size of any one company or sector within our exposure via sales of more heavily weighted investments.
Since we have deferred gains over the years, our sales this year have generated significant realized gains again, but only half as much as in the first half of 2018. We recommend that our clients with taxable accounts should continue to pay attention to the amount of capital gains generated throughout the year and how it might affect taxes due.
The following is a summary of returns for selected major indexes for the second quarter, year-to-date, and average annual returns since January 01, 2007:
|3 Months Ending 6/30/19||12 Months Ending 6/30/19||Annualized Returns since 01/01/2007|
|Shaker Fundamental Growth*||4.54%||22.98%||8.40%|
|S&P 500 Index||4.30%||18.54%||8.28%|
|US Small Cap Equity Index||2.10%||16.98%||7.12%|
|US Large Cap Equity Index||4.10%||18.71%||8.27%|
*returns are preliminary and net of expenses and 1% management fee.
Note that we have chosen to show annualized returns since January 1, 2007, as this time period includes both a recession and an expansion and is more representative of performance over an entire economic cycle.
Predicting future near-term investment returns is always challenging as there are many conflicting factors that could affect the economy and stock market returns. Currently, the US economy is growing, but at a slower rate than growth in recent quarters. This growth slowdown coincides with elevated recession risk – it is never perfectly clear in the moment if economic growth will remain positive during the slowdown, such as in 2015-2016, or enter the more dire negative growth / recession phase. The indicators we watch most closely to predict these trends are mixed. Of particular concern is the message from treasury markets in which the yield curve (the spread between long-term bond rates and shorter-term bill rates) has inverted, which historically has often preceded recessions. But, no indicator is perfectly accurate, and there are numerous indicators that signal more stable growth and that a reacceleration will occur in 2020: consumer spending remains solid, employment is stable and growing, inflation is low, and it appears the Fed will soon be cutting interest rates in order to reaccelerate growth.
The expansion is now ten years old, but economic expansions do not end due to old age. Economic expansions end because of a buildup of one or more excesses that eventually correct. Examples include excesses in inflation, inventories, or debt. This expansion has been slower, and slower growth usually is much more manageable and typically does not trigger the types of severe excesses experienced in the past. Central Banks would like more inflation, not less. Inventories and consumer debt also appear to be under control. U.S. economic volatility has been low for the past decade – perhaps that is sustainable and will continue as the most volatile segments such as manufacturing and real estate construction are a smaller share of employment than in decades prior. The majority of our economy is now service related. Unemployment is very low, the stock market is trending higher, and longer term interest rates are too low to cause a significant reallocation of assets from equities to fixed income investments. We are not guaranteeing that this expansion will go on for a few more years, but we can’t say that it won’t either. We are open to multiple possible outcomes.
Consequently, we remain focused on the outlook for individual companies. We are currently finding companies with good growth prospects selling at reasonable valuations in almost every sector. We are data dependent and will try to adjust to whatever conditions the economy and the stock market deliver.
We are always happy to discuss in detail any of our investments with you.
We look forward to updating you in October.
The Shaker Investments Team