Shaker Fundamental Growth 3rd Quarter Update
During the third quarter, investment returns for your account continued to exceed the returns of broad U.S. equity market indices. We achieved these results due to alpha generated from individual stock selection as well as sector positioning. We are especially proud of the fact that the composite Fundamental Growth strategy had a net return of 3.53% in a quarter when the major market indices were flat to down.
The following is a summary of returns for the Shaker Fundamental Growth strategy and selected major indices for the third quarter, year to date, and average annual returns for the last five years and since January 1, 2007, which encompasses a full market cycle:
Multiple stocks had a positive impact on performance in the third quarter led by:
Paylocity (PCTY) – a cloud-based provider of software for payroll and other human capital management activities to small- and medium-sized businesses
Paycom (PAYC) – a cloud-based provider of software for payroll and other human capital management activities to small- and medium-sized businesses
Dexcom (DXCM) – the premier provider of Continuous Glucose Monitoring (CGM) devices to diabetics
WESCO (WCC) – a distributor of electrical products and other industrial maintenance, repair, and operating supplies as well as a provider of integrated supply services and logistics
Axos Financial (AX) – a branchless bank
During the third quarter, individual position returns were mixed, consistent with the broader market indices. After a strong “risk-on” first quarter for the market that was led by small cap value stocks, in the second and third quarter investors rotated to more stable, larger capitalization companies. Returns were broadly positive in the second quarter despite this more defensive shift. In the third quarter, this trend continued albeit returns were less robust as large caps were flat and small caps declined more than 4%. Moving past the “peak” earnings growth of the second quarter, high valuations, and expectations of reduced monetary and fiscal stimulus are potential culprits that may have weighed on investor sentiment.
Several of the top performers, such as PCTY, PAYC, and DXCM, were names that underperformed earlier in the year but have more recently benefited from the shift in the market environment to favor companies with more stable, robust growth that should continue for the foreseeable future.
Investment Outlook
Despite a choppier third quarter for stocks, the market continues to be driven higher by record cash in our economy, elevated Manufacturing and Service PMIs, and improved profitability of public companies. To put it into perspective, the S&P 500 Index has returned more than 30% in the last year and has averaged 16.63% per year over the last ten years. Such high returns are unusual.
However, the conditions that led to those returns are likely to change in the next 12-24 months as we enter an economic environment that is likely to be a little less favorable to investment returns. There are several major risks that we believe investors must pay close attention to as we move forward:
Fiscal and monetary stimulus by the Federal Government and Federal Reserve has been very supportive for the last eighteen months as well as the last thirteen years. The deficit spending by the Federal Government has provided stimulus to the economy, and the Federal Reserve has massively increased the money supply to drive rates lower and to keep them low. Interest rates on the 10-year Treasury bond have declined from 5% in 2007 to 1.6% currently. Short-term rates have been zero for the last eighteen months. Low rates and excess money and savings has caused stock P/E ratios to expand, and it has inflated asset values in other areas like real estate, art, and cryptocurrencies. As a result of COVID-19 and this stimulus in demand, we are faced with significant labor shortages, supply chain bottlenecks, long lead times and rising prices. Consequently, the Federal Reserve is widely expected to begin the process of reducing (tapering) the amount of additional money it adds to the economy in November. They have been adding $120 billion to the economy each month and consensus is that they will reduce this incremental stimulus to zero by the summer of 2022.
However, the tapering won’t reduce the amount of excess cash that currently exists. ServisFirst Bancshares (SFBS) has 30% of its assets in cash and deposits held at the Federal Reserve or other banks. All of this is earning zero or close to zero interest. Similarly, JP Morgan held 28% of its assets in cash and deposits. Historically, cash at banks is in the single digits as a percentage of assets. This excess cash waiting to be put to work could mean tapering alone may not have much of an impact to slow demand and reduce inflation.
Inflation is caused by the excess of demand over supply, and too much inflation hurts economic growth because it reduces consumer’s real incomes and purchasing power. Caution is warranted as inflation and inflation expectations are at their highest levels since July 31, 2008. We are not forecasting a repeat of the recession that occurred in 2008. But we do expect that economic growth will slow but remain positive in 2022, with the risk that growth could slow further if the Federal Reserve decides to tighten monetary policy more than is currently expected to combat persistent high inflation.
The big unknown is the labor supply. Relative to before the coronavirus disrupted our daily lives, more than three million workers are no longer looking for work. Reasons for the decline in the labor force include early retirements, childcare needs, continued health fears, and that simply more time is needed due to the typical frictions in the labor market. If sufficient numbers do not reenter the workforce and start to fill the open positions, it will be very difficult to increase output of goods and services or solve the supply shortages without a greater reduction in demand.
The factors discussed above could cause inflation and interest rates to rise more than currently expected. Typically, rising interest rates impact demand with a lag of about 12-18 months. Thus, the rate rises in the 10-year Treasury yield already this year should cause some slowing in growth in the economy in 2022. Further increases in inflation could cause rates to rise and growth to slow even more than currently expected. Longer term, declines in birth rates over the last 40-50 years in the United States and the rest of the developed world will likely cause economic growth to be slower over the next twenty years than it has been for the last fifty years.
We still expect growth in revenues and profits. We just think that the growth rate will be slower and that future earnings could be discounted at a higher rate if inflation and interest rates are higher than currently expected.
Our investment approach remains focused on individual stock selection. We evaluate risks and opportunities in order to better understand the future operating environment facing each company that we evaluate as an investment. We own stocks that we believe offer attractive combinations of predictable growth and value. While we continue to find new companies in which to invest, our concerns about the economy and the heightened uncertainty have led us to add to the number of different positions in the Fundamental Growth Strategy and decrease the exposure we have in any one stock. This increased diversification should help us to adjust more quickly to whatever happens.
We look forward to updating you on the full year in January.
Sincerely,
The Shaker Investment Team
General Disclosures:
The information contained in these materials is as of 09/30/2021. 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.