As the year began, most investors found themselves still shaken by the dramatic market rout that had occurred in the final quarter of 2018. Many expected yet another leg downward, given the sudden hyperawareness to a long list of potential issues weighing on markets. There was a lack of clarity around the path of Federal Reserve policy going forward, especially after the violent reaction to the central bank’s December hike, a factor many pointed to as the primary culprit for the volatility encountered that month. At the same time, it seemed many investors appeared to be taking a more conscious inventory of the looming threats to global growth, which appeared to be increasing both in quantity and potential magnitude. Whether it was the consequences of increasingly antagonistic U.S. trade policy, the potential for a slowdown in Chinese growth, or political dysfunction on both sides of the Atlantic, there was undoubtedly plenty to be apprehensive about as we entered 2019.
Yet as we have seen all too often late in this expansion, it took very little for concerns to be assuaged. In January, the Federal Reserve communicated that it would put further rate hikes on hold for the time being, and later in the first quarter unveiled a plan to end quantitative tightening. Such moves neutralized any concerns of a more hawkish Fed, with markets beginning to price in a rate cut at some point this year. Further reassurance came out of Frankfurt, where Mario Draghi announced that the ECB would not be raising rates until 2020 at the earliest and would be offering further low-cost financing to banks within the Eurozone. At the same time, those concerned about slowing Chinese growth were encouraged by news of accelerated fiscal and monetary stimulus while data suggested signs of stabilization in the world’s second largest economy. Altogether this synchronized global pledge of increasingly accommodative policy created the backdrop for what was an impressive market recovery in the early part of this year.
As matter of fact, by April, many of the world’s equity indices had posted double digit returns, with the S&P 500 marking yet another all-time high towards the end of the month. In many ways, this made sense given the U.S. continuing to post stronger-than-expected Q1 economic numbers and earnings generally meeting or beating consensus expectations. Other markets, both developed and emerging, saw a similar pattern emerge, with economic data and news flow providing a more moderate, but nevertheless supportive backdrop.
While the recovery in Q1 and into Q2 was noticeably swift, we did have the opportunity to initiate several new positions in suitable client portfolios where we have investment discretion, holdings which we feel will benefit not only from this late cycle environment, but have the ability to compound capital over the long term. Early in the year, we took a position in Delphi Technologies plc, a key OEM supplier to both light and commercial vehicle manufacturers. Several years ago, the company spun off its sensor and electronics business to focus solely on propulsion technologies. In our eyes, though the market has been quite enthusiastic about the “SpinCo”, it has misunderstood the value of the propulsion portfolio at Delphi, categorizing it solely as a business focused on internal combustion engine technology. However, we see a great deal of potential when it comes to the increasing electrification of vehicle propulsion, and its comprehensive portfolio offering allows for opportunities to take increasing advantage of this transition. While we recognize that this move will require significant changes at Delphi, we believe the company’s new CEO has the domain expertise and operational acumen to execute on the business transition here. What’s more, the misunderstood components of this business, combined with the weakness we’ve seen in the automotive market as of late, allowed us to purchase shares in Delphi at a valuation we feel provides a more than adequate margin of safety to account for the relative uncertainties present at the moment.
Another of our new positions also seeks to take advantage of the transition from internal combustion engines to electric vehicles, albeit in a different manner. Albemarle is a specialty chemical manufacturer that, since its 2015 purchase of Rockwood Holdings, has become the world’s largest producer of lithium. With the proliferation of electric vehicles expected to drive significant increases in demand for lithium in the coming decades, we believe that the scale of Albemarle’s operations offer a significant advantage in this space. However, lingering fears of oversupply in the lithium market have likely created an overhang on the shares of Albemarle and its competitors as of late. As we performed due diligence on the business, this was one of our major concerns, with the advantages afforded by scale still leaving us owners of what was ultimately a commodity business. Further research allowed us to understand that not all lithium is created equal, and that Albemarle enjoys a low-cost position in no small part due to the fact that its mining assets enjoy a quality advantage when compared to competitors. This means that not only is the company able to produce large amounts of lithium, but the costs at which it can offer battery-quality lithium are significantly lower. As we came to understand the nuances of this business, we were able to build greater conviction around Albemarle. Here too, valuation certainly added to our comfort level as well, as did the backstop provided by the company’s legacy specialty chemicals businesses. We continue to add to this position, taking advantage of what we see to be an unwarranted discount by the market given the quality of the assets involved, and the long-term growth prospects of the lithium business.
Although we are glad that that this year has provided us the opportunity to make some new investments, especially after having bemoaned the dearth of compelling opportunities for quite some time, the fact remains that we still find this to generally be an uncertain and frothy environment. As “long only” investors, this can create its own set of challenges: consider the case of Qualcomm, a long time holding, where a disparate set of events have caused several double-digit percentage moves (both upward and downward) in recent months. While such gyrations can at times be confounding and even frustrating, the silver lining is that they are often the precursor to the types of idiosyncratic opportunities we have described, with share prices occasionally becoming quite divorced from even the most conservative estimates of intrinsic value. Naturally, it is our intention to continue to seek out such situations, while at the same time leveraging these dramatic movements to reposition client portfolios when prudent.
That said, as we study the macro investment landscape, there are other signs that give us pause. In both public and private markets, we are beginning to see instances of broken business models. Valuations, in the aggregate, still appear quite stretched, and the risks we see being underwritten continue to leave us unsettled. The first half of this year saw several initial public offerings that, despite their fanfare, lack a clear path to profitability for the foreseeable future, something we really haven’t seen for 20 years. Speculative issues have not been confined solely to equity markets, with fixed income investors seeing their share of questionable deals coming to market. Credit continues to be extended to “disruptive” businesses at rates once reserved for AAA-rated corporates, even as signs of future distress become more apparent. Sovereign debt investors, long unfazed by low, zero or even negative rates, now have new ways to reach for yield, thanks to the issuance of 100-year bonds by several governments, including Austria and Argentina. Austria, which first issued these bonds two years ago, was recently able to sell a new tranche of its 2117 debt at a yield of 1.171%. That investors were willing to snap up this tranche so vigorously suggests to us that, no matter where one looks, there are ever-present signs of “irrational exuberance”.
Given this environment, we have continued to position client portfolios in a defensive manner. We will be the first to admit that this has not necessarily been the most gratifying decision in the near term, especially given the trajectory of equity indices year to date. As we have seen in the past, markets can, and often do, remain irrational for quite some time. However, we feel that ultimately, we will be rewarded for our patience. Though markets recovered quickly from the rout at the end of 2018, the risks posed by slowing global growth, trade tensions and geopolitics remain quite real. While the environment, at least on the surface, remains sanguine, we have noticed cracks in the façade of what has devolved into a market increasingly divorced from fundamentals. Despite a robust IPO market, the lackluster performance of some of the more high-profile companies going public this year seems to suggest investors are becoming more attuned to the structural (and often cyclical) challenges these business models face. Elsewhere, an inverted yield curve and increasing cash balances held by institutional investors may reflect increasing caution by some market participants. Several significant US trading partners, most notably China, Germany and Mexico, are seeing economic conditions deteriorate. While it may take time, we believe there are signs the environment may be beginning to shift.
As we have said many times in the past, at its core, Drum Hill Capital is a value investor. While that term has come to have many different connotations, we believe quite simply that it means purchasing businesses at a discount to their long-term intrinsic values. Regardless of what may come to pass in the near-term, we have spent a good deal of time this year looking carefully at what history can tell us about times like these with respect to our long-term value bias. While we (and others) have discussed this notion recently, it certainly appears that this environment is quite reminiscent of that of the mid to late 1990s, a period marked by robust economic data, a strong bull market and a fascination with nascent technology firms of all stripes. This was also a period marked by an increased propensity on the part of investors to ignore fundamental issues like valuation or the long-term economics of a business, instead focusing on the potential for outsized future growth. At that time, as is the case now, growth equities were decidedly in vogue, with many questioning the ongoing viability of value-oriented investing strategies altogether. Using the Russell 1000 Value Index and the Russell 1000 Growth Index as proxies, we compared how both strategies performed in the late 1990s and beyond:
Source: Bloomberg
As one can see, growth began to significantly outperform value in the final, heady years of the decade (1). However, with the burst of the Tech Bubble, all this growth outperformance was given back in a matter of roughly 6 months (2). Following this “round trip” journey, growth entered a multi-year period of significant underperformance (3), with value again leading the equity markets of the early to mid-2000s. We feel what transpired during this period is quite instructive, especially given that we have yet again entered a period in which growth has outperformed for a sustained period beginning around 2015. While this outperformance may not be as extreme as that seen during the late 1990s, given the other parallels we see between that environment and today, we cannot help but wonder if we are close to entering yet another period where value investing again leads the way. (Note: If you are interested in learning more about these observations, especially in the context of current portfolio positioning, feel free to reach out and we would be happy to provide you with a more detailed presentation we recently put together on this topic.)
Admittedly, we have been discussing the myriad risks that threaten this bull market for quite some time, emphasizing the need for caution in the face of increasingly strange behavior on the part of investors around the globe. Regardless of what the environment looks like going forward, it is our intention to invest capital only when we feel there is adequate compensation for risk, and absent such opportunities, seek to maintain a reasonable level of “dry powder”. While we believe that this will ultimately be to the benefit of all our clients, we encourage each of you to review your investment policy statement and ensure that it is congruent with your risk tolerance. Should you feel changes are necessary, or simply want to further discuss our positioning and views on the market, we encourage you to reach out- a conversation is always welcome.
As always, we thank you for your support and trust, and wish you all the best for the second half of this year.