2017 4th Qtr. Kildare Asset Mgt.-Kerr Financial Group client review letter

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The following is a copy of the 4th quarter and year end letter sent to clients.  It reviews the markets and the client account’s activity and performance for the 4th quarter of 2017 and year-to-date.

Kerr Financial Group

Kildare Asset Mgt.

Jeffrey J. Kerr, CFA

 

In a year full of extraordinary events, the financial markets were among the top stories of 2017.  This is no small statement.  In a typical year, something like the Trump administration on its own is a topic that contains enough developments to characterize a year as historic.  Yet in addition to the fury and controversy surrounding President Trump, 2017 will also be remembered for the following things – North Korea, revelations of sexual harassment, Hurricanes Harvey, Irma, and Maria, the national anthem at NFL games, Fake news, and Bitcoin.

 

Staying within the markets, stocks had their best year since 2013 while bond yields remained calm for long maturities but rose on short dated issues.  The U.S. dollar had its worst year in a decade.  Both crude oil and gold prices rose in 2017.  But the biggest story of the 2017 markets was the growth and prevalence of passive investing.

 

Passive investing has been an enormous market influence for the past several years as the growth of investor capital devoted to the approach has been historic.  The two leading providers of passive investing products (Vanguard and Blackrock) have had inflows of over $1 trillion during the past two years.

 

Passive investing involves buying exchange traded funds (ETFs) or mutual funds that track an index.     Investors seek to invest in various asset classes via these funds.  For example, the SPDR S&P 500 Trust (symbol SPY) tracks the S&P 500 index. The SPY or its equivalent mutual fund is widely viewed as the equity asset class of a portfolio.  The iShares Barclays Aggregate Bond Fund (symbol AGG) tracks the Barclays Aggregate Bond Index which is a broad bond market index.

 

One example of a passive approach (also referred to as indexing) would be a portfolio of 70% stocks and 30% bonds using the SPY for stocks and AGG for bonds.  Once set, the investor may periodically rebalance the portfolio to keep the desired balance.

 

The goal of passive investing is to achieve market returns over the long term at the lowest possible cost.  As a result, this approach has the advantage of being much simpler as there is minimal upfront research – you are just investing in the chosen index.  Further, there is limited monitoring after investing the money.

 

While there are many appealing parts to this strategy, especially when the markets are moving up, it still exposes the investor to market risk.  This part of the passive investing equation is overlooked.  If the stock market corrects 15%, your portfolio is declining 15%.  This has not happened in a while so it’s easy to forget this possibility.

 

Another important risk is a function of the popularity of passive investing.  With all of the growth in the indexing approach, there are enormous amounts of capital doing the same thing.  This involves owning the same stocks, bonds, and other assets in the same amounts. If, for some reason, there is move to unwind some positions or raise cash, it could cause a wave of selling.  Depending on the circumstances, this could feed on itself and increase system wide risk.

 

There was very limited selling in 2017.  It was one of the calmest and smoothest years ever for the stock market.  There were no 5% corrections and buyers viewed every small dip as an opportunity.  The Dow Jones Industrial Average closed at a record 71 times last year which is the most ever.  Large cap stocks outperformed mid and small caps and growth stocks outperformed value stocks.  Here are 2017’s and the 4th quarter returns for the major averages.

 

4th Qtr. 2017

Dow Jones Industrial Average

10.3%

25.1%

S&P 500

6.1%

19.4%

Nasdaq Composite

6.3%

28.2%

Russell 2000

2.9%

13.1%

Using a size weighted average, here is how the average Kildare Asset Management-Kerr Financial Group client’s account performed. This is calculated after all fees and expenses.

 

Kerr Financial Group

-0.56%

12.82%

The 4th quarter was a challenging one.  Several of our holdings traded flat during the period and a couple even traded lower.  This was especially frustrating because the broad markets were so strong.  Fortunately, this turned out to be a temporary situation as these lagging positions rallied strongly in January.  Nevertheless, 2017’s 4th quarter was disappointing.

 

There was no common reason for this poor performance.  Instead there several distinct developments in the quarter that concurrently pressured different positions to trade lower.  Seacor Marine Holdings is a good example.  The stock (symbol SMHI) began the quarter trading in the mid-$15 per share.  It fell to under $12 in late December.

 

Seacor Marine provides global marine and support transportation services to offshore oil and gas exploration and production wells.  The company offers services that include crew transportation, platform supply, offshore accommodations, maintenance support, standby safety services, anchor handling and mooring capabilities, and liftboats.  The company operates in the Gulf of Mexico, Latin America, the North Sea, West Africa, Southeast Asia, and the Middle East.

 

Seacor Marine was spun off from Seacor Holdings in the second quarter of 2017.  Spinoffs happen for many reasons and often lead to opportunities as well as problems for the newly issued stock.

 

When a division is divested from a corporate owner, its stock often becomes an orphan in the eyes of institutional investors.  Depending on the reason for the separation, Wall Street may have little interest in the standalone company.  This is because there are often undesirable characteristics surrounding the division being let go by the corporate parent.  For example, the spun off company might be in a competitive, low growth industry with shrinking margins.

 

The spinoff of Seacor Marine Holdings was driven by covenants in a debt deal with the Carlyle Group.  Specifically, Seacor Holdings would have had to re-pay $175 million of convertible notes if Seacor Marine was not divested by December 31, 2017.

 

This is not to say that Seacor Marine was an invaluable gem to keep at all costs.  The industry is a mess.  With the growth of on shore drilling that takes advantage of fracking technology, offshore exploration became uncompetitive.  Consequently, companies servicing offshore drilling have been under severe pressure as business has declined.  Chapter 11 filings have been regular developments.

 

From an operational standpoint, Seacor Marine has weathered the storm – so far.  They have a strong balance sheet and have managed the downturn reasonably well.  Further, they have viewed the current industry landscape as an opportunity to buy some competitors’ assets out of bankruptcy.  Management believes that these transactions represent excellent long term value.  Also, there are signs of improvement as off shore drilling has reduced the cost of exploration and activity has increased as crude oil has rebounded to over $60 per barrel.  If offshore exploration continues to rebound, Seacor Marine could be in a position to make a lot of money.

 

Returning to the 4th quarter’s stock price decline, it appears that SMHI was a victim of tax-loss selling.  This involves investors looking to realize losses toward the end of the year as these losses reduce taxes as a deduction or to offset gains.  Seacor Marines stock was valued at $23 per share at the time of the spinoff.  As the stock price declined throughout the year, it became a strong candidate for selling in December to use the losses to reduce taxes.

 

I suspected that this was the reason for the weak stock price.  While the industry challenges remained, there were no new developments involving the company.  Unfortunately, it is never clear that tax strategies are behind a falling stock price.  I did use this opportunity to add to some positions but these were minor adjustments.  There was no way of being certain that the selling would subside when the calendar turned to 2018.  However, the stock has recovered in January 2018 which increases the probability that the 4th quarter’s price drop was tax related.

 

Reviewing other holdings during the 4th quarter, Dick’s Sporting Goods (symbol DKS and covered in the 3rd quarter letter) closed the year strongly.  Given the company’s financials, the stock price plunge that happened in 2017 might have been overdone.

 

Layne Christensen and Hurco both closed flat for the quarter.  Layne reported quarterly results in the beginning of December which showed continued progress in returning the company to profitability and growth.  However, initially the stock price dropped to the $11 per share area before finishing the year above $12.50.

 

2018 has started out with broad gains and we have participated.  While the 4th quarter was disappointing, client accounts have rebounded and outperformed in January.

 

I think this year will be much different from 2017.  The economy is growing but the Federal Reserve is signaling further monetary tightening.  This will provide some headwinds to the capital markets.  In addition, the markets will be adjusting to tax reform and possibly an infrastructure initiative.  It is possible that last year’s leaders are replaced by new sectors.  And of course, the influence of passive investing might be a greater market risk.  As always, this changing investment background will provide new opportunities.  I will continue to seek out those situations.

 

Please call or email with any questions.  Thank you for your continued confidence and trust.

 

“And now for something completely different….” – Monty Python’s Flying Circus

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Kerr Financial Group

Kildare Asset Mgt.

Jeffrey J. Kerr, CFA

Newsletter

April 2, 2018 – DJIA = 24,103 – S&P 500 = 2,640 – Nasdaq = 7,063

In the 1970’s the British comedy group Monty Python’s Flying Circus produced a half hour long show that was broadcast in England and eventually made it on to U.S. television.  This was the stone age of television when viewers’ only choices were ABC, CBS, NBC and the public stations.  No cable, no ESPN, no CNN, and no FOX.  (How in the world did we know what to think??)  With such small distribution options it was remarkable that it got picked up.  Just the same, putting it on Sunday night at 11:00 on public TV (its show time and channel) was the equivalent of not getting air time.

Despite this obstacle, the troupe developed a cult following with their sketches that included topics such as dead parrots, Spam, and lumberjacks.  Many early episodes began with John Cleese in a black suit seated behind a desk which was in an outlandish place – zoo cage, in shallow water at the edge of the ocean, or suspended in air.  He would open the show by saying, “And now for something completely different”.

The reason behind this nostalgic tangent is that the capital markets, like Mothy Python, are acting “completely different”.  And it’s important that investors recognize this change, try to understand the causes, and make necessary adjustments.

To review where we’ve been, during the past several years, the markets were heavily supported by the Federal Reserve asset purchases (bond buying) and suppressed interest rates.  As traders came to understand this landscape and gained confidence in the fed, the result was a steep decline in volatility and steady increases in assets prices.

This is especially true since the bottom of the February 2016 correction and resulted in record calm during 2017.  Unfortunately, all good things come to an end and 2017’s tranquility has been replaced by its arch enemy – volatility.  This began when U.S. stocks hit an air pocket in the beginning of February and the Dow Jones Industrial Average and the S&P 500 both fell over 10% in ten trading days.   Indexes bounced in back during the second half of February but the sellers returned and stocks lost over 5% two weeks ago and closed near the February lows.

Equities bounced last week but are still around 8% below the records reached in late January.  Looking at the first quarter, the Dow and S&P 500 posted their first losing quarter in two years while the Nasdaq was up.  Here is the 1st quarter performance for the major averages.

2018
Dow Jones Industrial Average -2.5%
S&P 500 -1.2%
Nasdaq Composite +2.3%
Russell 2000 -0.4%

Nobody expects the Spanish Inquisition and few expected the stock markets’ tumultuous 1st quarter.  It’s unclear whether there was a specific cause behind the fall or whether stocks were simply overdue for a correction.   Of course, it’s likely a combination of both.  Some of reasons offered for the selling include rising federal deficits, chaos in Washington, trade wars, geo-political tensions, and central bank tightening.

At a minimum, there are some important changes in the financial landscape and this could have had a large influence on the markets.  First, interest rates have risen.  Last month the Fed raised the overnight interest rate to 1.75%.  It was the 5th rate hike since President Trump was elected.  More importantly, investors are pricing in several more rate increases in 2018.

Other interest rates have moved higher too.  LIBOR (London Inter-Bank Offered Rate), which is another short-term rate, is at the highest level since 2006.  Below is a chart of 3-month Libor (the Libor interest rate for 3 month borrowings) which covers the past 10 years and shows the recent jump.

 

There is no honor among thieves and, as the chart shows, apparently very little among bankers in times of financial stress.  3-month LIBOR spiked almost 100% amidst the failures of Lehman Brothers and Bear Stearns as it was every man and woman for themselves.  After the dust settled and the Fed got done fiddling as Rome burned, counterparty risk collapsed as central banks flooded the markets with money.

As can be seen, 3-month LIBOR scrapped along a floor of 20 to 40 basis points for 6 ½ years.  It rose above 50 basis points in 2015 and jumped from 1.2% to 2.2% during 2017.  This may appear to be a somewhat insignificant move but to economies that have become hooked on low rates and monetary easing, this is a big deal.  One of the ripples in this interest rate pond is that adjustable rate loans become more expensive for borrowers some of which probably can’t afford higher expenses.  Given that the Security Industry and Financial Markets Association reports that corporate debt is at all-time highs ($8.83 trillion), rising interest rates are a problem.

As noted, interest rates have been moving higher for over a year.  A more recent change is a new Federal Reserve chairman as Jerome Powell replaced Janet Yellen.  The new sheriff in town comes with a new view.  According to recent congressional testimony, Fed Chairman Jerome Powell said the stock market isn’t the Fed’s focus.  According to The Wall Street Journal, Mr. Powell told the House of Representatives that “We don’t manage the stock market” and “I think the general thing is that the stock market is not the economy”.  He admitted that the markets are important but not central to the organization’s decisions.  (The Wall Street Journal, February 27, 2018).

While the markets are aware of the Federal Reserve’s “dual mandate” (price stability and employment growth), traders have long believed that they also kept close watch on the financial markets especially the stock market.  If stocks approached any level of panic, Wall Street expected the Fed to step in any way possible to support prices.  This has some history as it dates back to Alan Greenspan (the Greenspan Put) and continued with Ben Bernanke and Janet Yellen.  If Jerome Powell views the stock market as less important than prior Fed heads, this represents a material change and might be contributing to the recent declines.

In addition to higher interest rates and less Fed coddling, inflation could be a third head on the market’s adversarial monster.  After years of deflation and falling prices, there are signs that the U.S. economy could be facing a pick-up in inflation.  This will be a tectonic shift in the markets’ landscape and something that many investors have never faced.

Some of the obvious impacts of inflation include higher interest rates and reduced profit growth due to higher costs.  It could lead to a situation of nowhere to hide in the financial markets.  Low or no profit growth would compress valuations and stocks would fall.  At the same time, higher interest rates would result on losses in the bond market.  The 60/40 or 70/30 mix of stocks and bonds strategy that became popular in the past several years of would suffer.  Add some leverage to this equation, as is the case with many hedge funds, and the pain could become intolerable.

Of course, these developments are not certain to happen.  The capital markets have several reasons for confidence.  Lower corporate taxes should drive earnings growth, the Trump administration has rolled back a great number of President Obama’s regulations, and business and consumer optimism is high.  On this final point, there is much expectation on corporate investment as a result of reduced taxes and repatriation of offshore capital.  This could be a powerful economic wave if it happens.

The volatility of February and March has been a surprise.  The important question is whether it is part of “normal” correction and a great buying opportunity or a function of a changing backdrop to the markets and the start of a larger decline.  This latter option would qualify as something “completely different” and would suggest further downside risk.

It would seem that investors are well aware of the bullish argument and that much of the positives are priced in.  The damages from higher rates and increased inflation are less know and could cause further disruptions as the markets adjust to their likelihood.  Caution might be the best investment approach until the answer becomes clear.