A Market Dichotomy: Risk On in the Face of Rising Risks

Q4 2020 Quarterly Commentary – January 1, 2021

Domestic equity markets, as measured by the Dow Jones Industrial Average, S&P 500 and Nasdaq Composite indexes returned 7.3%, 16.3% and 43.6%, respectively, including dividends in 2020. Foreign markets also rose, with the MSCI EAFE index (developed economies) and MSCI Emerging Markets index returning 7.8% and 18.3%, respectively. Two-year and ten-year Treasury note yields declined by 145 basis points and 99 basis points, respectively, to 0.13% and 0.93% at December 31, 2020, powering the Bloomberg Barclays Aggregate Bond index to a 7.5% return for the year. If one did not know about the Covid-19 pandemic or of the resulting economic, political and societal crosscurrents during the year, one might think that 2020 was a normal one. But we all know that 2020 was an extraordinary year for investors by any measure.

The range between the S&P 500’s low on March 23rd of 2237.40 and high on December 31st of 3756.07 was 1518.67 points, implying an intra-year rise in that index of 67.9%. The Nasdaq Comp’s rise over this same period was 87.9%. These indexes are market-capitalization-weighted, meaning that the highest-valued companies carry the most weight when measuring changes in the index. Investors flocked to these large-cap companies in droves during the year, in part because many benefitted from dislocations caused by the pandemic, but also because investors, and Summitry, believe these companies are well-positioned to maintain and grow their profitability in a post-Covid-19 economy. The five largest components of the S&P 500 (Apple, Microsoft, Amazon, Alphabet and Facebook) returned an average of 52.7% during 2020. The remaining 495 companies, on average, returned 12.0% over the same period. At the close of 2020, investors valued these five enterprises at a multiple of 38x estimates of forward earnings. This is a sign of great faith in the future of these companies by both institutional and retail investors. We’ve noted the dramatic jump in retail trading volume during 2020 as a percentage of the total, facilitated by trading apps like Robinhood and free commissions at traditional brokerages like Schwab and Fidelity. Retail investors have tended in past to be less valuation-sensitive than institutional investors, and as the year approached its end seemed to be throwing caution to the wind. The valuations of publicly traded companies are determined by the latest transaction, and it doesn’t matter if this trade was for 10 shares or 100,000 shares.

Risks of “Risk-On”

The resurgence of retail trading is something to watch closely because in our experience it leads, eventually, to the same unpleasant end. Our founder Michael Golub used to remark, “In the stock market, there’s one thing you can hang your hat on. Individual investors will always behave in an extreme manner at the end of a market cycle.” The dotcom bubble of the late 1990s was as pure an example of this as we have seen in our careers involving the stock market. Widespread speculation in U.S. housing in the mid-2000s is another excellent illustration of the animal spirits that rage among individual investors, and of the aftermath. Unfortunately, the reversal of speculative bubbles is felt broadly, not only by those engaging in the risky behavior. But the adverse impact can be mitigated for those who follow a disciplined approach and investing only in securities (and real estate, and other financial assets) whose value can be justified by their own fundamentals. While there’s no escaping market volatility even when exercising great care, we believe investors who follow that discipline can avoid the permanent losses of capital that typically befall to the speculators and can position themselves for the next market recovery.

While it’s not that difficult to notice the growing market speculation, no one can predict the market’s direction in the coming months or years. Recall that Federal Reserve Chairman Greenspan made his comment about “irrational exuberance” in December 1996, more than three years prior to the dotcom-fueled market’s peak. Since markets offer a rapid feedback loop, speculative behavior in rising markets is self-reinforcing and is not easily exhausted. Famed investor George Soros wrote books about this phenomenon, which he called “market reflexivity,” and his fund profited immensely from the feedback loop in the period leading up to the dotcom crash.

Instead of riding a speculative tsunami or getting caught in its way,  we prefer to avoid it by doubling down on our approach of owning competitively advantaged businesses at reasonable prices. This approach worked for the firm through a number of challenging periods, including the Global Financial Crisis of 2008-2009 and the Covid-19 crisis of 2020. By investing in individual securities whose merits and risks can be evaluated, as opposed to investing in swathes of markets through ETFs, whose merits and risks are hard to quantify, we hope to protect you from adverse outcomes. We do this armed with the knowledge that fundamentals matter, and that securities prices ultimately reflect the intrinsic worth of the asset they represent.

We refer you to the discussion in our Q3-2020 commentary concerning our September sale of Apple stock from client accounts. Apple is among the biggest drivers of the stock market’s 2020 rise. Our knowledge of the value drivers of this business, including device sales and service offerings, and our assessment of likely future growth of these lines of business led us to conclude that the market valuation of the company at the time of our sale exceeded Apple’s intrinsic value by a wide margin. We concluded the risks of continuing to own AAPL common stock outweighed the opportunity for future gain. Looking back three months since our sale, we are still confident with our decision. Deep research drives conviction. There is a reasonable chance we may own AAPL again in the future, but only when we see an alignment between intrinsic value and stock price.

Debt and Inflation

We are frequently asked our opinion of the mounting risks posed by federal stimulus fueled by government debt. The Federal government at the time of this writing has issued roughly $27 trillion in funded debt, which is held by individuals, corporations, the Federal Reserve system, and foreign, state and local governments. The ratio of this level of indebtedness to America’s roughly $21 trillion of Gross Domestic Product is the highest in this country’s history, surpassing the level reached at the end of WWII. This ratio will likely continue higher in 2021 given the cost of the federal government’s actions against Covid-19. We hope for responsible decisions in Washington in the wake of Covid, but worry about the growing interest among policy makers in economic philosophies like Modern Monetary Theory (“MMT”). Thus far the markets haven’t registered any negative consequences of reckless spending in Washington, further fueling profligacy (in its own positive feedback loop), but we fear that a day of reckoning is inevitable if those in power can’t contain spending. At the extreme, the fallout could be the loss of the dollar as the world’s reserve currency, an inflationary spiral, higher taxes, cuts in entitlement spending, and other unhappy outcomes. But the risk, even if remote, exists, so we position your wealth in investments that offer some protection from inflation. We believe stocks of companies that have strong competitive advantages and that sell a product or service in high demand are among the best hedges against this risk.

Q4 Portfolio Changes

Please keep in mind, these commentaries should not be construed as a recommendation to buy or sell the securities discussed. Such decisions are made only within the context of the market environment as we perceive it at the time of the decisions and the structure of the diversified portfolio of which the securities are a component. ***

During the quarter we exited our position in Cognizant.

Cognizant

Cognizant is a leading provider of IT outsourcing and system integration services. The company has a dominant position within healthcare and banking and most of the company’s revenue come from these two industry verticals.

We first bought the shares in 2016 because we thought the company benefitted from high customer switching costs and barriers to entry. Cognizant’s expertise within healthcare and banking made it a differentiated provider in the space, shielding the business from competition. We expected demand for Cognizant’s services to continue growing as customers upgrade and modernize their IT systems.

A recent change in management led the company in a new direction. Our research showed that the new management intends to expand into more competitive areas in which Cognizant is less differentiated than peers and doesn’t have the same competitive advantages as in the legacy businesses. With the shares trading around our fair value estimate, the shift in the investment thesis prompted us to take a cautious stance and exit the position.

Welcome

In December, we welcomed Gina McGhee to Summitry, where she serves as a Financial Advisor Assistant to two of the firm’s Senior Financial Advisors, Cynthia Duncan and Sherry Williams. Gina, a Bay Area native and current resident of Pacifica, is a graduate of St. Mary’s College, where she earned a Bachelor of Arts degree in Cultural Anthropology, with a minor in French. After completing her education, she served as an Associate at the San Francisco law offices of de la Pena & Holiday, and as the Assistant to the Executive Vice President of Student Affairs at Academy of Art University in San Francisco. Most of us have not yet met Gina in person, but only by video. When Covid-19 is finally in the rearview mirror, we hope Gina will introduce us to her three little dogs and offer us a demonstration of traditional Irish dance. Gina is the 2017 Silver World Medal Holder from the World Irish Dance Championships in Dublin, Ireland. We are delighted to have her.

We look forward to speaking with you, and if you would like to come in for a visit, please drop us a note or give us a call.