The following is a copy of the 1st quarter letter sent to clients. It reviews the markets and the client account’s activity and performance for the 1st quarter of 2018.
Kerr Financial Group
Kildare Asset Mgt.
Jeffrey J. Kerr, CFA
Fads and popular trends are common in many parts of our lives such as fashion, food, and pop culture. They become widely and intensely followed and just as they seem to have established a permanent part of our lives, they often completely disappear. For those who lived through them, who can forget (as hard we try) leisure suits, mullet haircuts, and pet rocks.
This same human emotion that plays a role in fads is also an important part of the markets. As a result, there is a long history of popular investing approaches that assembled cult followings. The Dutch Tulip mania took place in 1630’s and the South Sea Bubble followed in the 1700’s. Some recent examples include the Nifty Fifty in the late 1960’s, portfolio insurance in the 1980’s, the Dot.Com bubble in the late 1990’s, and house flipping in the 2000’s. To be sure, all were profitable strategies for a time. But, as their popularity grew, there were fewer and fewer buyers to push the trade higher and ultimately they ended in tears.
In hindsight it’s easy to distinguish between a successful strategy and a fleeting fad. However, in the midst of a bull market, nothing looks like a fad that is about to end. Instead, investors convince themselves that the popular trend is a successful new investment approach and explain away any appearance of shortcomings.
During the past couple of years, passive investing has assembled a following that rivals the historic stock market bubbles. While passive investing can be an appropriate and reasonable approach, its popularity has grown so much that it is causing distortions in the markets.
First, a review of the passive investing or indexing. Repeating the description used in last year’s 4th quarter letter, passive investing involves buying exchange traded funds (ETFs) or mutual funds that track an index. Investors buy 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.
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 as you looking for market returns, positive as well as negative.
Passive investing’s appeal and popularity is reflected in the capital flows into the investment products that follow the strategy. The two leading providers of passive investing products (Vanguard and Blackrock) have had inflows of over $1 trillion during the past two years. And there are many other companies that have seen spikes in the inflows into their passive products.
As indexing and passive investing grew in popularity the stock market experienced record low levels of volatility. This was especially evident in 2017 as the year passed without experiencing a 5% correction and stocks had a smooth gradual journey higher.
Perhaps 2018’s 1st quarter witnessed a peak in this steady move from lower left to upper right. One of the 1st quarter’s noteworthy developments was a return volatility across the markets something that hasn’t been seen in years.
The stock market started the year by continuing 2017’s rally. The major indexes climbed into late January setting daily record highs along the way. However, stocks reversed direction and quickly lost 10% in two week. Equities recovered a portion of the losses but then retreated in March and retested the February lows as the quarter ended.
As stocks were dealing with their turmoil, bonds were also struggling. The yield on the 10-year Treasury note rose in January and February climbing from 2.46% to 2.95%. Its yield ended the quarter at 2.74%. As a reminder, bond prices move inversely to interest rates which meant that as rates rose, bond prices fell.
Importantly, 2017’s 1st quarter marked the first time in years that stocks and bonds both declined. The recent pattern has been that if one asset drops the other rose. This was helped by the passive/indexing strategy as institutional investors constructed portfolios with a mix of stocks and bonds that performed well. Once again this has become somewhat crowded trade which may explain the increased volatility as there was some unwinding in February.
At the end of the quarter, most of the averages were lower. The Nasdaq had a positive quarter but there was narrow leadership as a small number of large companies drove the index. Here is how the major averages performed in the 1st quarter.
|Dow Jones Industrial Average||-2.5%|
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 – Kildare Asset Management
Despite the market challenges, your account performed well. We had several positions that were immune to the tumult together with the use of hedges to reduce exposure and overall market risk.
First, we had another takeover. Layne Christensen (symbol is LAYN) becomes our third position to be bought out in the last year. Fortress Investment Group and Parkway Properties were both acquired in 2017. This demonstrates that the effort to buy the stocks of undervalued and out of favor companies can be a successful approach.
LAYN will be bought by Granite Construction (symbol GVA). Granite is a $3 billion construction company. They have divisions that focus on water projects and will try to blend Layne’s expertise with these efforts.
I’m somewhat disappointed at the price of the deal. LAYN had been making significant strides toward profitability and their mining and energy divisions appeared ready for strong growth. If they were successful in producing strong profitable growth, the stock could have risen into the $20’s (Granite’s offer was a stock deal that valued Layne around $18 per share. Granite’s stock has declined since the announcement so Layne’s price is trading lower).
There was some criticism of the deal. Cetus Capital filed a letter with the SEC that questioned the negotiation process as well as the valuation and suggested that Layne’s board did not fulfill its duties. Nevertheless, the deal likely gets shareholder approval. In full disclosure, I voted client shares against the deal.
Another reason for the good 1st quarter’s performance was a Seacor Marine Holdings (SMHI). As you may recall, Seacor Marine was a big reason for 2017’s disappointing 4th quarter performance. SMHI was a spinoff from Seacor Holdings. They provide global marine and support transportation services to offshore oil and gas exploration and production wells.
SMHI’s stock price began the year at $12.15 and rallied to $19.00 by the end of March. I had suggested in the 4th quarter letter that SMHI’s weak stock price could be a function of tax loss selling in late 2017. This may have been the case as the stock moved higher through 2018 despite the overall market’s weakness.
Of course, higher crude oil prices obviously help Seacor Marine’s business. Higher prices should result in increased exploration (both onshore and offshore) which will increase the demand for SMHI’s services. The industry was devastated during the past few years as crude prices collapsed. Some competitors filed bankruptcy. Seacor Marine is well positioned for a return of offshore exploration if crude prices remain firm.
Dick’s Sporting Goods’ stock price had a strong 1st quarter. DKS began the year below $30 per share and closed the quarter above $35 per share. As everyone knows, online shopping is a headwind for a business with physical stores. Despite this, DKS financial performance remained stable. Dick’s Sporting Goods’ revenues exceed $8 billion (and are growing), they remain profitable, they have a strong balance sheet, and they had a dividend yield over 3%. In hindsight, investors overlooked the positives and got too pessimistic during 2017.
During the first quarter, I used various hedging strategies to manage risk. Specifically, I used inverse mutual funds and options (for those clients who have that capability). These positions move in the opposite direction of the market and provided a way to reduce risk as the market fell. The timing of these approaches is challenging but it I executed it well and it contributed to performance in the 1st quarter.
The 1st quarter marked the return of volatility in the capital markets. It’s possible that it was a temporary situation and that the markets return to the calm environment we saw in 2017. I am not expecting this.
I think there are several changes in capital markets that will shift traders and institutional investor’s viewpoints. First, the Federal Reserve will continue to raise interest rates. This hasn’t happened in almost 10 years. I think there will be an adjustment process for businesses and the markets.
Secondly, the U.S. dollar has strengthened in 2018. This could have far reaching impacts on emerging markets and international trade. The emerging markets need dollars to conduct trade and, if the dollar is higher in foreign exchange trading, it is a higher cost to those economies. Also, a higher dollar make U.S. companies goods and services more expensive for foreign customers.
I think 2018 will be a challenging year for the markets. Higher interest rates and a stronger U.S. dollar are changes to the international markets that will require adjustments. I don’t expect these changes to be priced into the markets in a smooth seamless process. I’m not sure that we will have a repeat of the 1st quarter’s turmoil, but I think that the markets could have some additional indigestion. Of course, if this happens, there will be opportunities. I hope to be able to recognize these opportunities and take advantage of them.
Please call with any questions. Thank you for your business.