As 2019 began, many investors found themselves reeling from December’s intense market rout, which capped off the worst year for U.S. equities since 2008. Many began to wonder whether this would be a year marked by even greater losses, one in which the post-crisis bull market finally met its end. At that time, fear was undoubtedly the primary emotion gripping the markets. Yet in the 12 months that ensued, the S&P 500 returned 31.5% on a total return basis, hitting new highs along the way. Meanwhile, global equity and fixed income markets, both developed and emerging, also posted impressive returns. Volatility was generally quite muted, and a combination of solid U.S. economic data, accommodative Federal Reserve policy and hope for an improving outlook for global growth all did their part to drive markets higher. While there were a few points where fear crept back into market sentiment, such periods were brief, and recoveries were generally swift. By and large, this was a year where risk assets of all kinds were able to exceed expectations.
The tone for the year was set quite early, as markets began a markedly rapid recovery from the painful correction of late 2018. Central bank assurances both from the Federal Reserve and ECB aided in this recovery, as did encouraging news out of China, where signs of stabilization dispelled concerns about a “hard landing” in the world’s second largest economy. In April, the S&P 500 set its first of several record highs this year, as economic data and earnings numbers further reinforced a constructive backdrop. An otherwise quiet summer was bookended by two periods of heightened volatility, the first coming in May and the second in August. Both were driven by heightened tensions in the Sino-U.S. trade war, as the prospect of increased tariffs weighed on industries levered to global growth. Yet as quickly as markets were roiled by these developments, they staged an even quicker recovery as fears dissipated. Though a concrete resolution remained elusive, stable economic data and Fed rate cuts in both July and September likely both played a part in stabilizing markets.
Undoubtedly, the primary story dominating the headlines for the remainder of the year came out of Washington, as House Democrats formally began an impeachment inquiry into President Trump over alleged improprieties in his dealings with Ukraine. While this story has provided plenty of fodder for political pundits, members of congress and journalists, it has had little impact on the markets. How this plays out is anyone’s guess, but it will certainly be a story continuing to command attention in 2020.
While political turmoil may have done little to move markets in the final quarter of the year, there were several other developments that explained the period’s impressive gains. Most notably, the announcement, at least in principle, of a “Phase 1” trade deal between the U.S. and China afforded increased confidence in markets around the world. A de-escalation of tensions and tariff regimes between the two nations bodes well for global growth and reduces uncertainty on the part of investors, corporates and consumers. Other factors likely also contributed to the more sanguine backdrop, as the Federal Reserve lowered rates yet again in October, while increased commodity prices, especially for energy, bolstered many emerging market economies. Finally, a victory by the Conservative Party in December’s general election in the UK removed a great deal of the uncertainty surrounding Brexit, providing a clearer outlook not only for Britain, but many of its trading partners on the Continent. Overall, the final months of 2019 offered plenty of reasons to enter the new year with optimism.
Indeed, despite a rocky start and a few speed bumps along the way, this was an impressive year for risk assets. While we certainly think that there have been reasons for optimism, 2019 was also a year where we saw signs that the excesses we have warned about for some time now remain unrecognized and uncorrected. To wit, consider many of the high-profile IPOs that occurred this year: despite a great deal of buzz and valuations frequently measured in the billions of dollars, their public market performance frequently left much to be desired. The fact is, when these companies released their financials and strategic plans to public markets, the reaction was typically negative. We believe that this is justified, and there remain a great many companies, both public and private, commanding heroic valuations with long and uncertain paths to sustainable profitability. Perhaps nowhere was this more evident than the case of WeWork, a highly unprofitable lessor of short-term office space which stated its mission was to “elevate the world’s consciousness”. After WeWork filed prospectus to go public in August, and details of the company were brought under the sharp, bright light of public markets disclosure, it faced serious questions about everything from quality of governance to the fundamental soundness of its business model. Ultimately, these questions forced WeWork to shelve its IPO, force out its founder/CEO Adam Neumann and accept what amounted to a “rescue package”, one which dramatically deflated the company’s valuation from $47 billion down to $5 billion in a matter of months. This series of events led many to question the logic of WeWork investors like SoftBank, who have pumped significant sums into private markets in recent years, frequently in the name of “growth at any cost”. As a result, we believe that other high-flying “unicorns”, whether still private or already public, may face increased scrutiny going forward. The fact of the matter is, it can be quite easy for many “visionary” founders (and, for that matter, their investors) to claim value is being created as new funding rounds produce higher valuations, gaining widespread recognition on the back of rapid but unprofitable growth. While we see some of these businesses eventually living up to the high expectations set for them, a great many will also fall victim to the laws of “economic gravity”. Ultimately, a business must be able to, at least somewhat consistently, generate a profit for shareholders, and do so without further financing and/or unsustainable customer subsidies. Though the WeWork affair provided a cautionary tale, demonstrating how detached from economic reality many firms and investors had become, we believe there remain significant excesses in private and public markets that ultimately need to be rectified. While it is tough to say when this will occur, any softness in the economy could likely precipitate such a “moment of reckoning”. Investors who have thrown caution to the wind, underwriting questionable business models at obscene valuations all for “fear of missing out” on the next great company, would likely be well served to consider the risks that lie ahead.
To that end, we find it interesting that 2019 was a year in which conversations about the economic cycle became more frequent. Looking at data for the year, we continued to see falling unemployment, rising wages and buoyant consumer confidence, all of which suggested that the economic expansion remains on firm footing. At the same time, auto sales, manufacturing PMIs and global GDP numbers suggested, at the very least, that the rate of growth in the global economy may be slowing. This somewhat dissonant picture was further obscured by an inversion of the U.S. yield curve in the middle of 2019. Typically, the term structure of interest rates is such that the longer one borrows, the higher the rate due to the risk of uncertainty. However, in the situation we encountered for a portion of this year, the yield on short term U.S. government bonds was higher than the yield on longer term obligations. While a recession does not always follow an inversion of the yield curve, this is quite frequently the case, making increased discussion of such an event understandable. In our eyes, the current state of the economy remains, for now, distinctly “late cycle”: growth remains quite robust but could easily be derailed if market participants begin to lose faith in the future. The longer the “boom” period lasts, the greater the deterioration in underwriting standards, and the harder the repricing of asset values. This final step, when economic fundamentals again dictate value, can frequently be quick and painful- ask investors in WeWork! To be clear, we are by no means implying the economy is anywhere near the precarity of a business that began its IPO filing with a cover page dedication to “the energy of ‘we’”. However, we do believe the fact pattern here is representative of how “boom and bust” cycles work. What’s more, the notion that WeWork’s fantastic rise and fall was able to even occur suggests to us many investors have (and remain) complacent.
As such, despite solid economic conditions, we continued to position ourselves defensively for much of 2019. While we maintained what we felt to be a prudent level of exposure to risk assets, we also opted to allocate a portion of client portfolios to investment grade credit and short-term government bonds. These assets enjoyed several tailwinds, from tightening credit spreads to a falling Fed Funds rate, which reduced the perceived opportunity costs one would expect from holding bonds in a year where equity markets posted such impressive returns. In addition to providing a modicum of safety in the event conditions deteriorate, these assets also provide “dry powder” for when compelling opportunities come to the fore.
We have noted the dearth of such opportunities for some time now, the result of an ever-frothy environment. Nevertheless, we did add several new positions to client portfolios in the latter half of this year, mainly the result of uncovering misunderstood businesses with impressive economic moats. Consider TPI Composites, a producer of blades for the wind turbine industry. TPI began its life as a producer of high-performance boats, but roughly twenty years ago shifted its focus to the wind power business, leveraging decades of knowledge in composite engineering. In many major markets throughout the world, the levelized cost of energy from wind power is starting to become competitive with that of fossil fuels, making wind projects economically attractive even absent government subsidies. A significant portion of these cost declines have been the result of technological advances in blade technology, and the ability to produce larger, lighter blades is increasingly valued by wind turbine OEMs like Vestas, GE and Siemens Gamesa. As these OEMs frequently compete on cost, outsourcing blade production has been an increasingly attractive proposition, and TPI’s ability to produce custom, quality turbine blades has allowed the company to likely gain increased market share in recent years. While there is a strong case to be made for TPI to continue to maintain this position as a market leader for some time to come, we believe its impressive returns on capital are obscured by certain aspects of its “made to order” business model, rendering it misunderstood (and undervalued) by markets. We also feel TPI Composites’ size has left it under the radar of larger investors for now but believe that top and bottom line growth will change that in the coming years.
Earlier in the year, we also initiated a position in GrafTech International, one of the leading manufacturers of graphite electrodes used in the production of electric arc furnace (EAF) steel. The company has a distinct resource-based competitive advantage due to a unique vertical integration model, one that allows it to internally produce needle coke, the key input for the manufacture of its electrodes, whereas its competitors must purchase needle coke on the open market. (Interestingly, needle coke is increasingly being used in EV batteries, which has led to a marked increase in the cost base for GrafTech’s competitors- though we don’t see this as another electrification “play” per se, it is interesting how far the impact of electrification reaches!) GrafTech’s steady, low cost supply of inputs has allowed it to offer steel producers long-term contracts to purchase its electrodes, which, given the mission-critical nature of these electrodes (a steel mill cannot run without electrodes), has allowed them to secure a significant proportion of business for several years to come. Even if the global economic cycle were to turn, the “take-or-pay” nature of these contracts provides GrafTech with a degree of visibility and stability with regard to its business. While limited free float likely has kept many institutional investors on the sidelines (and valuations staggeringly low), we feel the company’s business model will allow it to continue to return a significant amount of capital to shareholders in the coming years.
We believe that opportunities like this are in many ways representative of those we intend to pursue in 2020 and beyond. Regardless of whether market overexuberance persists, an increasing portion of the larger publicly traded companies are owned by passive investment vehicles, “closet” indexers, and active managers whose size constrains their opportunity set. Absent a change in this set of circumstances, we believe it makes sense to spend more time in less efficient corners of the equity market. This means seeking out smaller, lesser known businesses which, despite meaningful growth prospects, for one reason or another fall outside the purview of larger institutional investors. We have found several such businesses here in the U.S., but actually believe the opportunity set in other developed markets may well be wider, one of the reasons we launched a European Equity Strategy this year. We believe there are some truly impressive small and medium sized businesses in this region trading at markedly lower valuations than their U.S. counterparts, even though obtaining access to quality information and transacting in European markets have both become markedly easier in recent years. If you are interested in learning more about the strategy, we certainly encourage you to get in touch. Whether they are based in Parma, Ohio or Parma, Italy, we feel there are structural advantages to increasing one’s allocation to high-quality small and mid-cap companies. Though such investments, regardless of their domicile, require a good deal more diligence on our part, we feel they offer our clients a far greater opportunity to earn an acceptable risk-adjusted return over the long term. While a significant portion of client portfolios have and will remain in large-cap U.S. equities, we believe our work here will add value.
As we begin this new year and new decade, we have certainly given thought to what we expect to be in store. Having read a fair number of prognostications from market pundits of various perspectives, persuasions and professions over the years, we see this, in many ways, as an exercise in futility. The fact is, no one can predict the future, especially in the very short term. Reviewing many such attempts for 2020, we find it quite telling that few if any included a scenario which involved a significant uptick in tensions in the Middle East. However, the absence of such a prediction certainly did nothing to prevent just that from occurring in the early days of the year!
As such, we feel our time is best spent attempting to think about what is going to be important not over three, six or twelve months, but rather three, six or twelve years. Looking to some of the thought pieces we have produced lately, you likely can develop a good sense of some of the trends we believe to be important: innovation in mobility and logistics, the digitization of manufacturing and the possibilities unlocked by the rollout of 5G wireless technology. In this year and beyond, it is our intention to better understand the implications of these trends, and identify high-quality opportunities levered to their development. We cannot predict if or when a recession will strike, who will win the 2020 U.S. presidential election, or where the S&P 500 will end up for the year, and we have no intention of trying. What we will do is continue to keep a close eye on the global economic environment, remaining cognizant of major risks (whether rising or abating), and considering your specific situation and risk tolerance, allocate your portfolio accordingly, only underwriting those investments which we feel are fundamentally sound. As we have recently noted, investing in this way seems to have gone out of style as of late, but for those investors who measure their horizons in years and decades as opposed to months and quarters, we believe this methodology works quite well.
With that being said, if you have questions about our methodology, specific portfolio holdings, or your positioning going into 2020, do not hesitate to reach out. Even if you simply wish to have a conversation regarding our views on the current environment and where we believe opportunities lie for the long term, we welcome the discussions.
As always, we greatly appreciate your support and trust, and wish you all the best in the coming year.