Shaker's Fundamental Growth Finished 2019 on a High Note
The fourth quarter of 2019 was very good for the Fundamental Growth Strategy and for US equity markets as both rose high single digits on a percentage basis. Market price-to-earnings multiples rose as investors showed a strong interest in buying US equities driven in large part by:
1) A significant expansion of the Fed’s balance sheet that drove an expansion in the US money supply. This expansion reversed the trend of the prior year and a half when the Fed reduced the size of its balance sheet. That period saw weaker, more volatile equity market returns.
2) Companies’ future earnings being discounted at lower rates due to lower interest rate expectations, low inflation expectations, and easing monetary policy by central banks across the globe. Investors expect interest rates to be “lower for longer.”
3) Investor anticipation of improving US GDP growth in 2020 based upon the typical lagged stimulus effect of lower interest rates on economic activity.
4) Expectations of reduced risk from tariffs and trade wars as the US government reached a “Phase One” agreement with China and Congress passed the United States-Mexico-Canada Agreement.
The following is a summary of returns for the Fundamental Growth and selected major indexes for the fourth quarter, last twelve months, and current market cycle beginning 12/31/06:
| 3 Months Ending 12/31/19 | 12 Months Ending 12/31/19 | Annualized Return Since 12/31/06 | |
|---|---|---|---|
| Shaker Fundamental Growth* | 9.87% | 36.57% | 8.94% |
| S&P 500 Index | 9.07% | 31.49% | 8.81% |
| Broad All Cap Index | 9.10% | 31.02% | 8.76% |
| *returns are preliminary and net of 1% management fee and expenses | |||
Discussion of Fourth Quarter Performance and Positions
Multiple stock positions had significant positive impacts on performance in the fourth quarter and for the full year. Our largest winners were:
1) Paycom (PAYC) and Paylocity (PCTY). Both companies are cloud-based providers of software for payroll and other human capital management activities to small- and medium-sized businesses.
2) The Trade Desk (TTD) – a self-service, cloud-based platform that helps ad buyers optimize their purchases of digital advertising.
3) Synnex Corp (SNX) – a distributor of IT equipment and software which also provides outsourced business services.
4) Dexcom (DXCM) – the premier provider of Continuous Glucose Monitoring (CGM) devices to diabetics.
Three other stocks that contributed significantly in Q4 were Axos Financial (AX), a branchless bank, Globant SA (GLOB), a technology software and services company and Zebra Technologies (ZBRA), a leading manufacturer and designer of ID and data capture products to support supply chains.
Other major contributors to the fund’s annual performance include:
1) CoStar Group (CSGP) – the dominant provider of information to commercial real estate professionals and the apartment rental industry.
2) Insulet Corp (PODD) – a provider of insulin pumps to diabetics.
3) PayPal (PYPL), Visa (V), and Worldpay (WP, which was acquired by Fidelity National Information Services, FIS) – all companies involved in various aspects of the electronic transfer of financial information.
4) Alphabet Inc. (GOOGL)
5) LGI Homes (LGIH) – a builder of homes targeted at the entry level buyer.
Given the strong equity markets in the fourth quarter and for the full year, there were very few losing investments to mention. Our largest detractors on the long side during 2019 were Stamps.com (STMP) and Abiomed (ABMD), both of which were sold earlier in the year. We had significantly reduced our investment in ABMD in 2018 at a large profit.
During the fourth quarter we added Livongo (LVGO), which provides a software-based platform and patient coaches to help patients modify behavior to better manage chronic health conditions such as Type 2 diabetes and hypertension
During the fourth quarter we exited our long positions in Arista Networks (ANET), D. R. Horton (DHI), and iRythm Technologies (IRTC). We also reduced our position in Insulet (PODD) and LGI Homes. We remain very positive on PODD but just did some slight rebalancing due to significant price appreciation during the year.
Investment Outlook for 2020
The investment environment starting 2020 is markedly different than in 2019. At the beginning of 2019, investor psychology was quite negative following a double-digit sell-off in the equity markets in late 2018. This change in investor sentiment can be clearly seen in the forward price-to-earnings ratio of stocks, or Forward P/E—the amount investors are willing to pay for each dollar of earnings companies are expected to generate (based on analyst consensus estimates) over the next-twelve-months. In early 2019, the Forward P/E for the S&P 500 was 15x, a sharp 24% decline from the Forward P/E of 19x at the beginning of 2018. This lower forward P/E reflected fears of increased recession risk driven by trade wars and tightening monetary policy from the Federal Reserve. Twelve months later, as we start 2020, those fears seem to have abated. Investor psychology is back to more positive and potentially exuberant levels, despite limited earnings growth to support the equity market returns of 2019. The Forward P/E for the S&P 500 is back to where we started 2018 at 19x.
Given the current elevated P/E levels, should investors be concerned and expect weak equity market returns over the next twelve months? Investor sentiment and high P/E ratios certainly are key components on our “cautionary signs” list. But there are other signals that suggest investors should remain bullish. The stimulus that caused P/E expansion in 2019 should support better economic and earnings growth in 2020. Credit is widely available and relatively cheap for businesses to support expansion or support returns to shareholders through dividends and stock buybacks.
Even with concerns about elevated P/E ratios, investors should keep in mind that there is little correlation between P/E ratios and returns over a forward one-year horizon. For longer-term investors, there is more correlation between elevated forward P/E ratios and lower forward ten year average annual returns. This long-term implication should not be a major surprise. The S&P 500 has returned 13.5% annually over the last ten years after starting near the lows of the Great Recession. Over the next ten years investors should expect lower average equity returns, albeit still positive and better than alternative asset classes like fixed income.
Looking at P/E’s alone ignores other factors such as interest rates, inflation, and future earnings expectations. Equity Risk Premium (ERP) is similar to P/E but a more advanced concept that tries to take these other factors into account and bring greater comparability to relative market valuations over different time periods and conditions.
The ERP provides an estimate of required equity market returns above the risk-free interest rate (typically estimated as the 10-year Treasury Yield), that investors should “demand” in exchange for taking on the risk of investing in the equity markets rather than the safety of Treasury Bonds. As with P/E’s, the Equity Risk Premium has limited predictive power for short-term, year-to-year returns for the market, but can be very helpful over longer time horizons such as five or ten years. Historical data shows a high correlation between the ERP and long-term forward equity market returns. In general, a high equity risk premium is associated with better future long-term (five- or ten-year) investment return expectations and a very low market ERP is a potential danger sign for future longer-term investment returns. The following graph (1961 – 2019) compares the implied ERP of the S&P 500 to the actual average annual returns of the S&P 500 over the following ten years. This span encompassed periods of rising inflation and interest rates as well as declining inflation and interest rates.
At the beginning of 2020, the ERP of the S&P 500 was in the upper half of its range over the last 60 years and was not signaling a dangerously overvalued market based upon existing conditions. While some market observers highlight the dangers of today’s elevated P/E levels, an analysis based on levels of the ERP quantifies how the equity markets can remain quite attractive when one adjusts for low interest rates, low inflation, and growth expectations. These factors are not taken into account by P/E ratios alone. While we do not expect a repeat of the 13.5% annual returns over the last ten years, we confidently assert that equity markets will likely achieve substantially better average returns over the next ten years than the current 1.8% yield of a 10-Year Treasury bond.
With that in mind, we are focused on stock selection, which we believe is our core competency as a means to add value and generate superior investment returns for our clients. We hold a diversified portfolio of stocks. Our largest long holdings in your account are as follows:
Technology
Paycom Software Inc. (PAYC)
Synnex Corp (SNX)
Producer Durables
Costar Group (CSGP)
Paylocity Holding Corp. (PCTY)
Consumer Discretionary
The Trade Desk Inc. (TTD)
Health Care
Dexcom Inc. (DXCM)
Insulet Corp (PODD)
Financial Services
Axos Financial Inc. (AX)
PayPal Holdings, Inc. (PYPL)
We look forward to updating you further as the year progresses.
Sincerely,
The Shaker Investment Team
General Disclosures:
The information contained in these materials is as of 12/31/2019. This document is confidential and for the sole use of the intended original recipient. It is not intended as investment advice or recommendation, nor is it an offer to sell or a solicitation of an offer to buy any interest in any fund or product.
Risk:
An investment in any of our strategies is speculative and involves a high degree of risk, including potential loss of principal. There is no guarantee that the investment objective will be achieved, or that the investment strategies will be profitable. Investments in smaller companies may be riskier, less liquid, more volatile and more vulnerable to economic, market and industry changes than investments in larger, more established companies.
Performance:
Past performance is not indicative of future results. Returns in the current year are preliminary. The strategy’s overall return is a composite of clients’ separately managed account returns. Some clients’ investment returns were more or less than the overall strategy return. Not all our client’s returns surpassed the benchmark. The index return information herein has been obtained from public sources and we do not guarantee its accuracy. The following disclosures applies to information mentioned in this document:
1. Gross returns are net of expenses.
2. Net returns are net of expenses and a 0.25% quarterly (1% annual) management fee for the corresponding period.
3. Inception date for the Fundamental Growth Strategy is 10/01/1991.
4. The benchmark for the Fundamental Growth Strategy is the Dow Jones US Total Market Index, a broad All Cap index. However, the strategy is more concentrated and contains a higher percentage of growth stocks than the benchmark.
5. Risk metrics are estimated using monthly returns net of fees for the last 3 years, unless otherwise noted.
6. Sector allocations may not add up to 100% because of rounding.
Recommendations:
The specific securities identified and described in this report do not represent all of the securities purchased, sold or recommended for clients. It should not be assumed that investments in the securities identified and discussed will be profitable in the future. Holdings and sector weightings in any strategy are subject to change and should not be considered investment advice or a recommendation to buy or sell a particular security. Actual holdings may vary by client. A list of the stocks selected for any of our strategies during the trailing twelve months is available upon request.