The following is a copy of the 2nd quarter letter sent to clients. It reviews the markets and the client account’s activity and performance for the 2nd quarter and year to date 2018.
Kerr Financial Group
Kildare Asset Mgt.
Jeffrey J. Kerr, CFA
The capital markets rarely travel in a straight line. While bull markets can last for years, they normally have multiple pullbacks within them. And these corrections can be material with magnitudes of more than 10% and can last several months. Determining changes in direction of these various time frames is critical for managing risk.
2018 provides clear examples of significant short term moves not disrupting the longer trend. The stock market started the year by continuing 2017’s rally which was an abnormally smooth steady climb that set records for its lack of volatility. The major indexes climbed into late January setting daily record highs along the way. Then stocks reversed direction and quickly lost 10% in two weeks.
The stock market stabilized in late February and recovered during the second quarter. However the quarter included a couple of quick drops – one in April and another in June. Yet, despite this volatility, the multi-year bull market marches on.
The advance that ended in late January was accompanied by extreme bullishness. As a reminder, sentiment indicators are normally viewed as contrarian or suggestive of a move in the opposite direction of the signal. In this case, a high level of optimism could be a sign of a top and then a decline. This is because investors who are bullish have already done their buying and may not have much dry powder left. This is especially so at extreme levels and it worked in January
Given the rebound from February’s lows, investors are scouring through the countless statistics for a clue on the strength and potential longevity of the second quarter’s rebound. While such things as GDP and employment data point to a strong economy and higher corporate earnings, there is a couple of breadth indicators that might cause some worry.
Stock market leadership by the FANG stocks (Facebook, Amazon, Apple, Netflix, and Google) has been one constant throughout 2018. These stocks have driven the Nasdaq Composite and Nasdaq 100 indexes which have outperformed. In the first six months, Netflix has more than doubled and Amazon is up around 50%. The 5 largest components of the Nasdaq 100 accounted for over 60% of the first 6 months gains.
This is very narrow leadership which could be troublesome. The higher number of stocks participating in an advance usually translates into stronger and more sustainable rallies. There is nothing preventing a broadening to take place but it typically happens after a bottom such as the one in February.
TPW Investment Management conduct concentration studies and they posted some findings in late June. Since 2000, when the top 5 stocks’ performance represent less than 25% of the yearly attribution (widespread participation), the S&P 500 average annual return was 19.6%. When the top 5 represent over 25% (more narrow leadership), the average annual return for the S&P 500 was only 1.96%. In late June, the attribution of the top 5 S&P 500 names accounted for 52% of the year-to-date returns.[i]
Obviously this indicator suggests challenges ahead. On the other hand, data from 2000 may not be a large enough sample to be useful especially given that in contained an outlier (the housing meltdown and the financial crisis).
Nevertheless, it does highlight a concern that needs to be watched. As The Wall Street Journal included in its review of the 2nd quarter, “The one-directional nature of the stock rally has left investors increasingly worried that a market whose gains have been heavily dependent on technology stocks could reverse sharply in the second half of the year.”[ii]
The FANG’s out performance in the second quarter is clearly shown by the Nasdaq Composite’s doubling of the S&P 500’s return – 6.33% vs. 2.93%. The Dow Jones Industrial Average was up less than 1% and showed a year-to-date loss on June 30th. Here are the details of the major averages for the 2nd quarter and the first 6 months of 2018.
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.
2nd Qtr 2018
Kerr Financial Group – Kildare Asset Management
It was a jittery three months for the capital markets. Tariff threats and potential trade wars that would pressure global growth were a constant investor fear. The Federal Reserve raised interest rates in June and forecast more hikes. International turmoil continued with concerns over Turkey, Italy, and Russia. The dollar strengthened in foreign exchange trading which resulted in intense stress in the emerging markets. To be sure, all markets have things to worry about but these represent an imposing collection.
As a result of these economic and international obstacles, I focused attention to managing risk in your accounts. Primarily, this was done through mutual funds that move in the opposite direction of the S&P 500. While this position helps reduce overall market risks to your account, it does not eliminate them.
This mutual fund was a slight drag on account performance in 2nd quarter and this has continued in the 3rd quarter as the stocks moved higher. However, I believe including this in the strategy is an important piece of controlling risk during this chaotic timeframe.
There are other positions that underperformed in the quarter. Athene Holding Ltd and FGL Holdings are similar companies as their main business is annuity underwriting. Athene declined 8.3% and FGL declined 9.3% in the 2nd quarter. Both stocks were pressured by a flattening yield curve.
One key to successful underwriting is the spread between the yield offered in the annuity and the yield earned by investing the premiums. During the second quarter the 10-year Treasury yield (a benchmark used to estimate insurance investment earnings) declined from a May peak over 3.1% to under 2.9% at the end of June. Investors chose to sell first without waiting to see if the declining yields actually hurt earnings.
Athene had two other strikes against it. One part of the business didn’t produce as much growth as expected. Secondly, company management told analysts on the first quarter earnings conference call that they were not planning to use cash to buy back stock. Instead they see the better use of capital in growing the business and see many opportunities to do this. Disappointing growth and not buying back undervalued stock are two things that puts you in the Wall Street dog house. So entered Athene Holdings.
FGL Holdings has different blemishes. FGL did an IPO to raise capital to buy the FGL business. It was an underperforming annuity business. The two main parties behind the takeover (William Foley – CEO of Fidelity National Financial which has been a long time successful client holding and owner of the Las Vegas Golden Knights hockey team that made the Stanley Cup finals combined with The Blackstone Group to turnaround FGL) have proven track record in developing these kinds of operations.
This new management team is focused on getting an A.M Best rating upgrade to “A” (the highest rating). This is the result of a strengthening of the balance sheet through more capital and better investment positioning. This decision is expected later this year. Brokers and insurance agents are reluctant to sell less than “A” rated products so this could greatly expand their sales channel.
Both companies are trading at low price-to-earnings multiples and have strong balance sheets. Both have unique initiatives that could transform them into bigger and more profitable organizations. I think patience will be rewarded.
SMHI, which was performed well in the 1st quarter, helped in the 2nd quarter as well. They provide global marine and support transportation services to offshore oil and gas exploration and production wells. The stock was up over 21% from April through June.
Graham Corporation is a position that was added at the beginning of the 2ndquarter. The company engineers and builds the interworking chemical plants and refineries. This is a small company at about $275 million of market capitalization and $100 million of revenues. Graham has a very strong balance sheet with over $7.50 per share in cash and no long term debt. This is a cyclical business that is tied to industrial capital expenditures. The company suffered with the collapse of crude oil prices but are rebuilding sales and its backlog. In addition to rebounding sales, Graham wants to grow through acquisitions. The stock was up 20% during the quarter.
Understanding and recognizing risk is important to successful investing. 2018’s second quarter provided a good example as the capital markets had to sift through many complex developments that could turn into significant headwinds. While large cap technology stocks outperformed, the rest of the stock market traded more defensively. This could remain the theme of the second half of the year. It will be important to balance risk management while spotting the opportunities as they arise.
Once again, thank you for your continued trust. Please contact me with any questions.
Jeffrey J. Kerr, CFA
Kerr Financial Group
Kildare Asset Mgt.
45 Lewis Street – Lackawanna RR Station
Binghamton, NY 13901
[ii] The Wall Street Journal, June 30, 2018