Shaker Navigates Record Setting Markets
The investment results for Shaker’s Fundamental Growth strategy were positive for the second quarter and the first six months of the year, and outperformed the broad market by more than 10% year to date. Despite this outperformance, at no time was it easy. The market set records in terms of moves to the downside as well as upside, and the S&P 500 remains down 3.1% for the year. The COVID-19 pandemic has increased fear and uncertainty, and has dramatically impacted our daily lives. It caused the quickest economic collapse in US history, and a record increase in the number of workers filing claims for unemployment. Nearly as quickly, the economy began to stabilize and recover in May and June as lockdowns ended and business activity resumed. However, economic activity remains well below pre-COVID-19 levels and there is a great deal of uncertainty as to the future course of this recovery.
This has been an extremely difficult period of time to manage investments. The S&P 500 was down 33.8% from February 19th through March 23rd, and up 45.1% from March 23rd until June 8th. The percentage change in many individual companies was much greater. This volatility left many investors frustrated and confused, as it is much easier to invest during longer periods of more consistent trends. There was nothing long term about this rapid move down and then up in stock prices.
What caused the turnaround in the market from the lows of March 23rd? Unemployment is still at levels not seen since the great depression, and we have never seen this sharp of a decline in the economy as measured by GDP. This divergence between the performance of the stock market and the economy is, at first glance, quite perplexing. However, a deeper review of the facts can help us to understand the markets’ response.
First – The Federal Reserve has provided large amounts of cash to the economy. Bank deposits have increased significantly in the last four months and fixed income yields have declined to almost nothing (and many are negative around the world). Furthermore, there has been less demand for that cash as consumers are not traveling, eating out, or going to concerts or sporting events. The excess liquidity has increased demand for financial assets as the money has to go somewhere. The discount rate used to value the future cash flows of public companies was very low at the beginning of 2020, and declined further this year. With the abundant supply of cash available to invest in financial markets, stock prices can move higher if expectations for the future look better.
Second – In tandem with monetary policy, there has been unprecedented fiscal stimulus to support the economy. Aggregate Personal Income has actually increased in the United States during the pandemic even as compensation sharply declined due to the increase in unemployment. The government intervention via increases in transfer payments and loans to businesses has acted as a stabilizer to consumer spending and thus far prevented an even worse economic collapse. Concerns remain, however, as many of these support programs are set to expire in the coming months.
Third – While fear and uncertainty around the impact of COVID-19 remains high, the worst case scenarios envisioned in March that were priced into financial assets were not realized. Treatment protocols have improved, and we have a better understanding as to what methods can effectively reduce the spread of the virus. The global lockdown ended, and it is more likely that future responses that reduce economic activity will be more localized and regionalized. Many countries in Europe and Asia have demonstrated a willingness to follow guidelines to effectively “squash the curve” that will better facilitate economies that operate as close as possible to full potential. America seems to be following a different path in terms of virus control, and questions remain as to what extent that will inhibit the economic recovery or increase the risk of a second downturn.
Fourth – The stock market tends to track the directional rate of change in the economy. In other words, it is not the level of economic activity but the rate at which it is improving or slowing down that drives the stock market. The economy hit bottom in April and has been improving since then. Investors look to the future, not the past or the present. As long as leading indicators are improving, the stock market will likely move higher. We will have to worry more when indicators like the ISM Manufacturing and Non-Manufacturing Indices quit going higher.
While the broad large-cap equity indices were approaching 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 have been led by what are commonly perceived to be the “safer” growth 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. Large-cap Tech has clearly been leading this market higher.
Year to date, the strategy’s 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.
In addition, Growth companies continue to outperform Value companies that tend to be slower long-term growers and more economically sensitive. We have often discussed our expectations that in a slower growth world economy with a lower discount rate, faster growing companies would be more valuable relative to their peers, and we are seeing that occur. COVID-19 has accelerated these trends as many high growth companies provide a technology or innovation that will work anywhere, and they are now gaining market share even faster from more traditional businesses that are more dependent on in-person economic activity.
The impact of these two trends on our performance is especially evident in the relative performance of some of our financially classified stocks. PayPal Holdings (PYPL), a leading edge payments processor with a focus on e-commerce, has a market cap of $200 billion and is up 61% for the year. In contrast, our two traditional bank stocks are down: Citizens Financial Group (CFG) has a market cap of $10 billion and is down 36%, and Axos Financial (AX) has a market cap of $1.4 billion and is down 27%. Fortunately, we are diversified. Banks only account for 33% of our financial sector investments. PayPal and Visa (V) are two of our three largest holdings in this sector. We continue to hold the banks because the market has proven throughout history that no trend lasts forever and at some point value stocks will return to favor. The banks we hold are cheap on a price-to-book ratio, they are the best run companies we can find in the industry, and we can quickly invest a lot of money in them and others when they do start to outperform.
The most significant individual contributors to your results in the second quarter were Livongo (LVGO), The Trade Desk (TTD), Dexcom (DXCM), Paypal Holdings (PYPL), Paylocity (PCTY), Globant (GLOB), Paycom (PAYC), LGI Homes (LGIH), Amazon.com (AMZN), and SYNNEX Corp. (SNX). There were no notable detractors to our returns in the second quarter.
During the first six months of the year, there was a greater mix of contributors and detractors. The most significant individual contributors to your results were Livongo (LVGO), Dexcom (DXCM), The Trade Desk (TTD), PayPal Holdings (PYPL), Amazon.com (AMZN), Globant (GLOB), and Tandem Diabetes Care (TNDM). The most significant detractors were Axos Financial (AX), Citizens Financial Group (CFG), and Intuitive Surgical (ISRG). ISRG has been particularly painful. It was sold at a lower price due to our concerns that results would continue to be hurt by a reduction in surgical procedures due to Covid-19. The stock market has chosen to ignore that risk and the stock price has recently hit a new high.
One name we would like to highlight is Livongo (LVGO), which was added to the portfolio in 2019 and was our best performer for the quarter and year to date. LVGO helps insurers, self-insured companies, and other payee partners to manage the costs and outcomes of their insured populations with long-term health problems. To date, these are primarily individuals with diabetes and/or hypertension. They employ a combination of data monitoring, artificial intelligence and human intervention to improve patient outcomes. They focus on healthcare as opposed to sick care. In doing so they are also lowering the costs to treat these patients. LVGO’s IPO was July 25, 2019 at $28 per share. The stock hit a high of $45.68 on July 31st, 2019, and then proceeded to drift off to a low of $15.12 on October 2nd. We started to buy it on October 7th and added to the position in early January. Our average cost is in the low-$20s per share. The stock has recently risen to above $100 per share. Our most recent transactions have been partial sells to keep the weighting in our portfolio to a reasonable level. Thus far, this has been a great investment. We think that the company is early on in its growth, but we will manage the size of the position to keep it within our risk parameters.
The following is a summary of returns for the Shaker Fundamental Growth strategy and selected major indexes for the second quarter, year to date, and average annual returns since January 01, 2007:
| 3 Months Ending 06/30/20 | Year to Date Ending 06/30/2020 | Annualized Returns Since 01/01/2007 | |
|---|---|---|---|
| Shaker Fundamental Growth* | 35.85% | 7.98% | 9.21% |
| S&P 500 Index | 20.54% | -3.08% | 8.22% |
| Total Market Index | 22.03% | -3.48% | 8.14% |
| *Returns are preliminary and net of 1% management fee and expenses | |||
Note that we have chosen to show annualized returns since January 1, 2007, as this time period includes recessions and expansions and is more representative of performance over an entire economic cycle.
Investment Outlook
The investment outlook is highly unclear as the US economy is a hostage of the COVID-19 pandemic. There are so many activities that we did one year ago that are either no longer possible or that many consumers choose not to do because we fear that we will contract the virus. If we were a more disciplined populace, we would probably have more success at minimizing the effects of the virus on our daily lives, but that does not appear to be the path that we will follow. Rather we will wait and hope for a vaccine. The Federal Reserve and other government programs are helping to offset some of the negative effects of the shutdown, and that is why we are seeing record results from some companies and crushing declines in revenues at others. Unfortunately, the longer it takes to vaccinate everyone, the harder it will be to recover from the negative economic consequences.
The 2nd quarter earnings season is just getting started, but, as stated in the prior paragraph, we expect wider ranges in company results than we have ever seen. For example, Livongo (LVGO), pre-announced that they will see revenue growth of more than 25% sequentially and 100% year-over-year. Many software-focused and e-commerce businesses are expected to achieve record results. In contrast, Airlines, Cruise Companies, Hotels and Restaurants are all seeing devastating declines in results that are weakening balance sheets. Banks are seeing hits to earnings as they take increased provisions for loan losses, but, thus far, such reserves have not turned into losses and hurt their ability to compete longer term.
We do feel confident in the near-term fundamental outlook for the companies we hold as our investments. In addition, there still is a lot of cash on the sidelines, economic growth is on an upswing, and, historically, strong investment return quarters like in Q2 (up 15% or more) are followed by a quarter of positive returns that are on average one-half the returns of the prior quarter. We continue to closely monitor the risks, as COVID-19 may cause another slowdown in activity and elections tend to increase financial market volatility. We have been very careful in our investments to try to own companies that have both good short-term as well as long-term prospects. This investment strategy has been working more often than not but we have certainly experienced wild swings as the market switches back and forth from “risk-on” to “risk-off”.
We currently hold about forty different positions in our account plus about 5% cash. Our top-14 holdings are 55% of our average account’s net market value. However, they are a significantly smaller part of the net cost of our investments as there are significant unrealized gains. In terms of sector exposure, our positioning closely tracks the weightings of the overall market index, with a 6% overweight in Producer Durables and Healthcare and a 6% underweight in Technology as the only notable variations.
There are many questions and few answers regarding the next twelve months. The virus, the economy, and the election are just a few that come to mind. We are very 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 or any other questions that you may have.
We look forward to updating you in October.
Sincerely,
The Shaker Investment Management Team
General Disclosures:
The information contained in these materials is as of 06/30/202. 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.