LANDING THE LANDING
Perhaps the most anticipated recession in history, the 2023 recession has yet to officially arrive. It is possible that it will not arrive, and Chairman Powell will engineer the “softish” landing he has been calling for. It is also possible that the Fed has underestimated the damage from the rapid federal funds rate increases of 540 basis points, along with their higher for longer position on rates. . ... READ MORE
The Stock Market: A Beacon of Innovation
Throughout history, the stock market has been a reflection of human innovation. Technological advancements in various sectors, such as medicine, healthcare, transportation, and computing, can be observed through the lens of capital markets. As investors, it is important to recognize that selling out of our portfolios essentially means betting against human innovation—a wager that may prove unwise in the long run. . ... READ MORE
Mid – March Update 2023
Silicon Valley Bank, the nation’s 16th largest bank and a bank that was 40 years old, went under this week. This is remarkable not only because of its size and history but also because credit quality was strong. ... READ MORE
PREVAIL, LEARN, AND ADAPT
We will prevail, learn, and adapt. Again. Just as we always have. As we prepare to turn the page of 2022, let us take the opportunity to look forward to a blank canvas but one that is built on a solid foundation of experience and discipline ... READ MORE
SAYING GOODBYE TO TINA & THE TIDE
November 23, 2022
Since the “Great Recession” in 2008, consumers and investors have been accustomed to easy monetary policy from Central Banks around the world. In order to spur on economic growth, Central Banks kept interest rates at or near zero ... READ MORE
A SHELLEBRATION OF DISCIPLINED INVESTING: NURTURE VERSUS NATURE
There once was a bet between two legendary commodity traders. Back in December 1983, Richard Dennis and William Eckhardt had a one-million-dollar wager on whether trading could be taught or if it was a natural talent ... READ MORE
THE POWER OF PRICING POWER
April 13, 2022
2022 has started with a revaluation of most stocks. Some are calling it a correction, some are calling it a bear market, depending on which areas of the market one is referring to ... READ MORE
It Is Time To Discuss INFLATION…….Again
August 20, 2021
For many years, one of the most common inquiries we have received at Spence Asset Management has been our thoughts on INFLATION. Recently, inflation figures suggest ... READ MORE
Art or Science?
July 27, 2021
Over the decades our asset management firm has lived in the world of micro-economics, which is the study of the economic decisions of individuals and individual companies. Many scholars are wary ... READ MORE
MICRO ANALYSIS DESPITE MICRO ATTENTION SPANS AND MACRO ISSUES
May 12, 2021
The nation’s GDP, or Gross Domestic Product, is an economic statistic that involves an estimate of the annual gross value of domestic output from economic activities. Sixty years ago (1960), the United States economy generated ... READ MORE
ON THE SHOULDERS OF GIANTS
March 5, 2021
Einstein humbly surmised: if he had in fact advanced the base of knowledge on physics, it was because he stood on the shoulders of giants. Everyone assumed Einstein was mostly referring to the most famous physics “giant” of them all ... READ MORE
Holding Cash Reserves is an Integral Component of Our Equity Investment Strategy
January 6, 2021
2020 has been nothing short of extraordinary. Who would have guessed that events like Brexit, Hong Kong protests, the most active hurricane season in Atlantic history, the Black Lives Matter movement, the first commercial space flight ... READ MORE
“SHUTTING OUT” 2020
December 11, 2020
Asset managers who operate in the United States equity markets often compare their annual performance to the S & P 500 Index. This high-profile index tends to be the standard benchmark of the domestic investment industry. Not only do we track performance of our own holdings ... READ MORE
June 29, 2020
In our previous newsletter, we spent some time discussing our inclination over the past few decades to make investments in what we believe to be strong secular trends. We continuously develop and evolve our convictions regarding ... READ MORE
Pace of Change
May 26, 2020
It seems almost ironic that our last newsletter was sent to you on Friday the 13th in March. The topic of that communication is now all too familiar to anyone living on planet earth with even modest access to media and/or a facemask ... READ MORE
Our Approach to Coronavirus
March 13, 2020
As of the writing of this newsletter there were 3,967 deaths caused by Cornonavirus around the world. Of those deaths, 3,120 have been reported in China. According to a study done by Medicine Net, approximately 646,000 people die globally from ... READ MORE
The Most Powerful Force in the Universe “Compound Interest”
February 25, 2020
Albert Einstein once said: “Compound interest is the most powerful force in the universe. It is the eighth wonder of the world. He who understands it, earns it; he who doesn’t ... READ MORE
Observations on International Investing
February 10, 2020
Over the years, clients who have participated in our Focus Equity strategy have come to realize that on the surface, our portfolio does not check all of the typical diversification boxes that many asset allocators prefer. We have never invested for the sake of diversification ... READ MORE
Many Reasons to be Thankful
November 25, 2019
This week we all give thanks. We are thankful for many things; it has been a record-breaking year at Spence Asset Management, our hard-working team is healthy and happy, and our client base is larger and more loyal than ever. We are also thankful for ... READ MORE
Major Price Changes
October 01, 2019
Last week we received news that should reduce the cost of investing for our clients. In addition, thanks to these new efficiencies, we will be able to explore a broader array of sensible investment choices ... READ MORE
LANDING THE LANDING
The media’s current favorite debate is “hard-landing" or a “soft-landing.” As this current leg of our investment journey includes a rate hiking cycle, fortunately, history offers examples of both types of landings to learn from:
The Magnificent Eleven: A History of Monetary Tightenings since 1965.
1. September 1965 – November 1966: During this year-long episode, the U.S. faced inflation concerns amid low unemployment and the escalating Vietnam War. The Federal Reserve, led by William McChesney Martin, initiated a tightening period, although debates persist about whether it constitutes a "soft landing." This period involved a "credit crunch" and a "growth recession." Despite some disagreements, it underscores the intricate interplay of fiscal and monetary policies.
2. July 1967 – August 1969: The U.S. witnessed a significant rise in inflation, peaking at around 6 percent, leading to a two-year tightening cycle by the Federal Reserve. A total rate increase of 540 basis points occurred. Interestingly, fiscal policy was also employed, with President Johnson seeking a tax hike in early 1967, although its passage took time. The combined efforts resulted in slowing GDP growth and eventually a recession in 1970. This episode can be seen as a "softish" landing, which reduced core inflation to approximately 4.5 percent by 1971.
3. February 1972 - July 1974: In this episode, the U.S. faced a unique blend of challenges. President Nixon's wage-and-price controls in 1971 led to surging inflation. Additionally, substantial monetary stimulus in anticipation of the 1972 presidential election and supply shocks further complicated matters. The Federal Reserve responded with a massive rate hike, raising rates by roughly 960 basis points. However, stagflation, characterized by both inflation and recession, persisted. The Fed grappled with policy uncertainty and fluctuating interest rates, resulting in a prolonged and severe recession.
4. January 1977 – April 1980: Following a brief respite from inflation, the U.S. experienced rising food and oil prices in 1978 and 1979, partly due to global events like the Iranian Revolution and Iraq's invasion of Iran. Paul Volcker, leading the Federal Reserve, took decisive action by raising the federal funds rate significantly, ultimately increasing it by 1,300 basis points. This period involved two recessions, with the first in 1980, attributed more to President Carter's credit controls than monetary policy. While the landing was painful, it contributed to lower inflation rates in subsequent years.
5. July 1980–January 1981: Paul Volcker's Fed aggressively raised rates to combat inflation but briefly reversed course due to economic concerns. They then resumed tightening, raising rates by 1,005 basis points in six months. This triggered a severe 16-month recession with a 10.8 percent unemployment rate. The Fed's commitment to tackling inflation eventually succeeded, with inflation declining significantly. Paul Volcker prioritized inflation control over a soft landing.
6. February 1983 – August 1984: Spanning about a year and a half, this episode represented more of a policy recalibration than a tightening, considering the context of recovering from a deep recession and money supply targeting experimentation. Nonetheless, the Federal Reserve consistently raised the federal funds rate, accumulating a 313 basis point increase. During this period, GDP growth was robust, unemployment declined, and inflation remained moderate, around 3–4.5 percent. It marked the early years of the "Great Moderation."
7. March 1988 – April 1989: In early 1988, the U.S. economy appeared healthy, with low unemployment, robust GDP growth, and stable inflation. Under Alan Greenspan's leadership, the Federal Open Market Committee initiated a cautious tightening cycle, raising the federal funds rate by 326 basis points over 13 months. While this cycle had the potential for a soft landing, Saddam Hussein's invasion of Kuwait in 1990 led to a brief recession. Nonetheless, Alan Greenspan's monetary policy was not the primary cause of the less-than-soft landing.
8. December 1993 - April 1995: In 1994, Alan Greenspan led a tightening cycle that is renowned for achieving a perfect soft landing. Beginning in December 1993, the Federal Open Market Committee decided to raise the target federal funds rate seven times over a year. One of the significant hikes was a 75 basis point increase in November 1994. The results were remarkable: inflation remained around 3 percent, unemployment decreased, and real GDP growth stayed above 3 percent. This period marked a rare instance where a soft landing was successfully achieved without external disruptions.
9. January 1999 – July 2000: The late 1990s witnessed robust economic growth, falling unemployment, and low inflation. The Federal Reserve, led by Alan Greenspan, adopted a cautious approach. They maintained the target federal funds rate at 5.25 percent or 5.5 percent for approximately 2½ years and even lowered it to 4.75 percent during the 1998 financial crisis. This tightening cycle resulted in a mild recession known as the "recessionette." Inflation remained in check, fluctuating within the 1.9 to 2.6 percent range.
10. May 2004 – July 2006: The Global Financial Crisis of 2007–2009 stemmed primarily from the housing market bubble and reckless financial practices, rather than the Federal Reserve's monetary policy in 2003–2004. The Fed's rate hikes, totaling 425 basis points, closely aligned with the effective federal funds rate. Several factors, including the timing of the rate hikes and the severity of the financial system's near collapse in 2008, played more substantial roles in causing the Great Recession.
11. November 2015 – January 2019: The last Fed tightening period, spanning over three years, may not be classified as a traditional tightening cycle but rather a gradual normalization of interest rates following years of near-zero rates. Despite a 228 basis point rate increase, the Fed's actions did not cause the subsequent severe recession, which resulted from the COVID-19 pandemic and related factors.
*Source - Blinder, Alan S., 2023. "Landings, Soft and Hard: The Federal
Reserve, 1965–2022".” Journal of Economic Perspectives 37 (1):119.
Today in 2023, what type of landing are we in for? As usual with economic activity, only time will tell.
When it comes to time, investors can spend a lot of it getting bogged down in the macro-economic climate. The market historically has “climbed a wall of worries” and lifted despite social, geopolitical, and economic headwinds. As investors, we cannot afford to ignore macro-economic conditions, however, we also cannot afford to hide out and wait for an all-clear. All clear signals usually do not arrive without the market moving considerably higher beforehand.
Instead of waiting for an all-clear, we keep scouring the universe for companies that can succeed in most economic conditions. One of the ways we look to navigate possible landings ahead is gravitating towards companies that are business to business companies (B2B) instead of directly consumer facing companies. We do this consciously for several reasons:
Not trendy. We don’t have to navigate trends, fashion, or consumer tastes when we invest in B2B companies. Staying ahead of the latest trends is nearly impossible for an investor to do consistently. Instead of focusing on what’s “cool,” businesses are looking for providers of efficiency and growth.
Cost of switching. Most B2B companies have larger customers and switching products or services can be very costly and time consuming. Being offline is expensive, retraining employees is expensive, management reviewing new proposals and contracts is expensive. Switching can be expensive.
Mission critical. Many of the companies we invest in provide mission critical services to their corporate customers that are essential to operating their businesses. Although a company may reduce numbers of users and add-on services during an expense reduction campaign, there would be many other areas of cost cutting before a mission critical product is considered.
Less emotion. Consumers can get emotional, especially when it comes to financial decisions. They can be easily influenced by what their friends and family are buying (or not buying). The media and world events can also quickly play into purchasing decisions. Businesses, on the other hand, usually have management and boards to answer to when contemplating financial decisions which can lead to slower, more deliberate, and thought-out decisions.
Many operating levers to pull. Businesses can innovate through downturns and add new product offerings. We’ve seen companies leverage their physical footprint, expand to adjacent markets, or even vertically integrate their supply chain.
Many financial levers to pull. Corporations have many financial tools in their toolbelt to weather storms. They can cut expenses, issue debt, issue equity, spin off divisions or delay investment. Many businesses have teams constantly evaluating these options.
As a result of rising interest rates, a recession may be just around the corner, or we may see the “Goldilocks” scenario that slows inflation but does not impair growth in the economy. Rather than waiting on the sidelines, we prefer investing in B2B companies that can withstand either scenario. Constantly striving for efficiency, B2B companies free us from the burden of predicting trends, enjoy a high cost of switching, are usually central to the operations of their customers, are usually less emotional and have many levers to pull, both operating and financial. When business is the core customer, the B2B provider can usually expect more stability from their customers and thus, more predictability in the revenue stream. Predictable revenue streams provide the best possible safety belt for whatever landing may be ahead.
Thank you for your business and for “traveling” with us!
The Stock Market: A Beacon of Innovation
Throughout history, the stock market has been a reflection of human innovation. Technological advancements in various sectors, such as medicine, healthcare, transportation, and computing, can be observed through the lens of capital markets. As investors, it is important to recognize that selling out of our portfolios essentially means betting against human innovation—a wager that may prove unwise in the long run.
Waves of Innovation:
The first wave of innovation began in the late 1700s and was driven by waterpower, textiles and iron. At this time, the Philadelphia Stock Exchange was formed, and the Industrial Revolution was in full force. The second wave began in the mid1800s with steam power, rail and steel, propelling further innovation and industrial advancement. Railroad stocks were the most popular investment at that time. The next wave of innovation was primarily electricity, chemicals and the internal-combustion engine arriving in the early 1900s. Tobacco, steel, utilities and rail companies dominated the trading volume as the euphoria of innovation gave way to exuberance. In approximately 1950, the fourth wave of innovation began with the onset of aviation, electronics and petrochemicals. The “Nifty Fifty” became an informal designation of large companies trading on the New York Stock Exchange and included IBM, Coca-Cola, Eastman Kodak, Sears, Proctor & Gamble, and General Electric. The fifth wave of innovation was built on digital networks and software. Investors gobbled up shares of anything with “Dot com” in its name as the internet became a household tool in the 1990s. Cisco, Dell, Lucent, Yahoo, and America Online were some of the decade’s biggest winners. Many argue that we are entering the sixth wave of innovation with artificial intelligence, robots, drones and cleaner technology.
Interestingly, some of the aforementioned companies have become long, enduring stalwarts that make up the corporate landscape today and some have ceased to exist despite their innovative lead during a wave innovation. This is yet another great reminder that not all great innovators are great investments. Not all great products make a great company. We, as consumers, can love a product or an innovation but we must think differently as investors.
Especially when the markets start to get excited by innovation, it is crucial to stay disciplined and go back to core tenets that lead to successful investing. Vigilantly watching how CEOs, as capital allocators, navigate rapid growth becomes even more crucial during an innovation wave. Prioritizing low capital intensity businesses, particularly in inflationary environments, while also ensuring responsible use of debt by companies must continue to remain at the forefront of investment decisions. Additionally, monitoring competitive threats and regulatory challenges is fundamental to owning businesses as the wave brings with it tremendous and rapid change.
Stock Market Performance:
Back to the present day, in 2023, the stock market has witnessed remarkable performance in the face of much uncertainty. Many professionals argue that the stock market is forward looking and it “prices in” adverse events as it may very well have in 2022 with a 20% decline in the S&P 500. Just as the market sees waves of innovation, it is also expected that we see waves of uncertainty. Last year the market was likely pricing in such uncertainties and economic challenges as:
1. The war between Russia and Ukraine
2. Rising interest rates, which inherently slows growth.
3. Rapid inflation in food and labor costs as the economy rebounded from supply chain issues that followed the Covid shutdown.
4. Tensions with China that are leading to a largescale, geographic shift in manufacturing.
5. A banking crisis that led to the demise of three of the country’s larger regional banks.
The market is beginning to accept these adversities and has begun to look ahead again. Despite these adversities still persisting in 2023, we are seeing some pockets of strength. Some sectors are beginning to outperform as the market once again returns to the power of innovation. Sectors that are seeing inflows of capital seeking innovation:
1. Technology: Companies at the forefront of innovation, such as those involved in cloud computing, artificial intelligence, and cybersecurity have
experienced remarkable growth as digital transformation continues to reshape industries. Technology spending for corporations is essential and
unavoidable. Having 2022 to test and challenge novice management teams has allowed some companies to emerge stronger. Managements had to
weather a tough storm and this fire they have walked through has separated “the wheat from the chaff.”
2. Healthcare: The healthcare sector has thrived throughout the pandemic as governments increased funding for research and innovation.
Advancements in pharmaceuticals, biotechnology, and healthcare services continue to propel healthcare investment. Companies focusing on
innovative treatments, therapies, and healthcare solutions have delivered strong returns over the long term.
3. Renewable Energy: With increasing global emphasis on sustainability and clean energy, the renewable energy sector has flourished. Solar, wind, and
other green energy companies have attracted significant capital, driven by growing demand and government initiatives.
4. E-commerce and Digital Services: The shift towards online shopping and digital solutions has been accelerated, leading to substantial gains for
companies operating in e-commerce, digital payment systems, and online marketplaces. The convenience and accessibility offered by these services,
along with Covid lockdowns, have boosted their growth.
5. Electric Vehicles: The growing interest in electric vehicles and the transition to a greener transportation system have driven the performance of
electric vehicle manufacturers and related infrastructure companies. Increased consumer adoption and supportive government policies have
contributed to their success.
6. Global Manufacturing Shift: With supply chain woes fresh in their minds and as tensions with China escalate, manufacturers are scrambling to move
manufacturing closer to home. This is impacting real estate, labor and also leading to strong transportation innovation.
A Bright Future:
We are steadfastly optimistic about the future and the power of human innovation. Waves of uncertainty often create tremendous opportunities to embrace the potential for continued growth and prosperity. And although we are ready to ride the waves of innovation, we will do so with discipline and unwavering focus on what not only makes an amazing product, but what also makes an amazing investment.
As always, we are here to address any questions or concerns you may have. We value our partnership with you and appreciate your trust. We hope you are enjoying your summer and perhaps enjoying some “waves” that are not economic in nature.
Mid – March Update 2023
Silicon Valley Bank, the nation’s 16th largest bank and a bank that was 40 years old, went under this week. This is remarkable not only because of its size and history but also because credit quality was strong. Historically, bank failures were a result of risky lending. Instead, this failure and possibly others were the result of rapid Federal Reserve tightening and rapid spreading of fear.
First and foremost, it is important to understand that the US Treasury has backstopped all deposits at Silicon Valley Bank. Depositors will have full access to their money. Next, it is important to learn from and work to identify the ramifications of these events.
What have we learned? 1) Social media and its power are not to be underestimated. Depositors at Silicon Valley who were closely watching their Twitter account, were not only quickly moving money out of the bank but were also passing along the panic. In 42 hours, the country’s 16th largest bank was run.
2) Trying to make large interest rate calls in one direction or another can result in tremendous pain. Silicon Valley management deployed almost of all their deposits into treasuries and mortgage-backed securities by year end of 2021. They also selected long maturities thinking that the interest rate hikes were almost over, when in reality they were only just beginning. Trying to compensate depositors with 3% when you are earning 1.6% was unsustainable.
3) Never say never. “Black Swan” events can and do happen. Regardless of the pundits who say they knew it was coming, pandemics that shut down the global economy or bank runs with no defaulted loans can happen and blindside investors.
What are the immediate ramifications? 1) Tighter credit in the short run is likely inevitable. All banks, big and small, will be forced to take a breath, review their held to maturity securities, their loans, their deposit concentration, and their geographic/industry concentration. Loans to marginal customers will be delayed. 2) Companies that rely on private debt to operate may also need to delay projects, lay off workers, and rein in spending in the near term. 3) Bank regulation and the cost of bank of regulation will increase. Instead of too big to fail, we may begin to see too small to succeed. 4) The Federal Reserve will need to think more carefully about future interest rate increases.
However, as always, investing is about the long-term prospects of companies and debt issuers, not about the headlines of today. Moments like these are where the Warren Buffetts of the world make their money. The greatest investor in the world, Warren Buffett, released his most recent letter to shareholders as the Chairman and CEO of Berkshire Hathaway. We have quoted Mr. Buffett many times throughout our 30 years in this business as he has had tremendous influence on our investment philosophy. In his recent letter to shareholders, Buffett reminds us that he and Charlie are not stock-pickers but are business-pickers and episodically, it becomes easy to buy pieces of wonderful businesses at wonderful prices. He also reminds investors of his missteps; Berkshire once was a major shareholder of Solomon Brothers which was one of the 5 largest investment banks in the United States and the most profitable firm on Wall Street during the 1980s and 1990s. The company had to be rescued in a buyout by Travelers Group in 1997 after treasury bond trading fraud. Another bad investment was his investment in USAir which filed bankruptcy twice in two years. All investors have investments that were not what they thought were. As Buffett opined: “Capitalism has two sides: The system creates an ever-growing pile of losers while concurrently delivering a gusher of improved goods and services.”
The investment journey is always a bumpy one. The outsized returns seen in the stock market are a reward for enduring tremendous volatility and staying the course. Staying the course isn’t always easy. Large declines in the market including Monday, October 19, 1987, also known as “Black Monday” when the Dow Jones Industrial Average fell 22.65% in a matter of hours was one of history’s most obvious examples of extreme panic. The Energy crisis from 1970-1980 and the resulting petroleum shortages and elevated oil prices also created tremendous challenges for those navigating the markets. More modern events that substantially rattled the markets include the Great Financial Crisis of 2008 where we watched Lehman Brothers and Bear Stearns fall into receivership, as well as the Dot Com Bubble burst of 2002 when we saw many companies cease to exist like MCI Worldcom and Kmart. Each of these events ultimately created tremendous opportunity for the Warren Buffetts of the world to add to their wealth. Likely, we are seeing one of those opportunities unfold now. According to Buffett: “Patience can be learned. Having a long attention span and the ability to concentrate on one thing for a long time is a huge advantage.”
What now? Buffett describes his mandate as, “Our job is to manage Berkshire’s operations and finances in a manner that will achieve an acceptable result over time and that will preserve the company’s unmatched staying power when financial panics or severe worldwide recessions occur”. Similarly, our job is, patience, staying power and level headedness. As we always do, we return to our core philosophies. We check and recheck our assumptions on the companies we own and the companies we would like to own. We get out of sinking boats and swim to those that are seaworthy, as Buffett says. We find managements that are adapting to the world’s new realities. We scour the universe for great businesses with competitive moats that are intact. We remain cognizant of not just credit risk but also interest rate risk, inflation risk and liquidity risk as we diversify issuers and maturities for fixed income investors.
And then we get up and do it all over again tomorrow.
Happy St. Patrick’s Day; we are “lucky” to have you as a client!
PREVAIL, LEARN, AND ADAPT
We will prevail, learn, and adapt. Again. Just as we always have. As we prepare to turn the page of 2022, let us take the opportunity to look forward to a blank canvas but one that is built on a solid foundation of experience and discipline. We want to be clear on what you can expect from us year in and year out, regardless of market behavior and investor sentiment.
Although 2022 has been an irritating and at times, extremely unlovable market, we at Spence Asset Management embrace the opportunities the volatility presents. Although we too have had the unpleasant experience of seeing our portfolios being valued lower than in previous years, along with most asset classes this year, we have been here before; as George W. Bush would say, this isn’t our first rodeo. We have been shareholders of great businesses for quite some time now, 1992 to be exact, and have been able to successfully navigate several economic cycles and historical events including the Asian Contagion, 9/11, the DOT-COM bubble, the Great Financial Crisis, PIGS crisis, and most recently COVID in 2020. This too shall pass, and our clients will prosper in the long run.
Some of history’s greatest businesses have emerged from similar turmoil and we are diligently learning, studying and dissecting these new businesses. We have a strong culture of learning- constant learning. We believe our ability to adapt to these environments goes beyond possessing skill or intelligence. In the same way we screen for great companies that create shareholder value, our firm is constantly searching for ways to deliver value to our clients that goes beyond financial planning, estate planning and portfolio management. Our belief since this firm’s inception is that we have created a cumulative advantage over other firms, and we remain committed to continue doing so. We believe we will continue to strengthen as well as widen a moat around us as our firm looks to the next 30 years through constant learning and learning faster than our competition.
Along with learning, we believe in the ability to change our beliefs when they are proven wrong or outdated. This takes an enormous amount of humility yet is instrumental; most people cling to what has worked in the past even though the world surrounding them is constantly changing. Blockbuster, Kodak, Enron, and Sears are just a few examples that remind us how important the ability to adapt can be. We are constantly reviewing our assumptions as well as our assumptions that have proven incorrect.
However, sometimes the hardest thing to do is the best thing to do. Jesse Livermore’s “It was never my thinking that made the big money for me, it always was sitting, sitting tight,” is as true today as it ever has been. We apply this philosophy when owning stocks, as we stick with companies that are profitable, whose managements remain focused and disciplined and whose competitive position remains intact. Additionally, we have never, nor will we ever, chase performance (i.e., hot stocks), chase yields (i.e., junk bonds), or chase the latest get rich quickly “new asset class” (i.e., Bitcoin) which is being confirmed yet again as we watch the trial and ramifications unfold for Sam Bankman-Fried and Alameda Research. We believe our willingness to remain patient will continue to build a cumulative advantage for our firm and continue to create value for our clients.
Along with losing their patience, challenging market conditions can quickly cause investors to abandon their disciplines and core philosophies. Although we have adapted and learned a great deal from the various market cycles and have constantly had to recheck our assumptions, we have never abandoned our discipline. No matter the market conditions, we require a strong operating history from our companies as well as a focused, shareholder-friendly management that manages capital prudently. We require a durable competitive advantage and a low capital intensive business with relatively predictable revenue streams. Companies can change, industries can be disrupted, economic cycles can shift, regulations can emerge, but our core discipline will remain steadfast.
Unwavering philosophies are rare as is conviction in those philosophies. According to Morningstar 47% of mutual fund managers DO NOT personally own any of their own fund. Read that last sentence again. This is the equivalent of someone who drives a Rivian recommending their clients buy an F-150 or a Chevy. When we say we understand your frustrations when portfolio values are down, we truly understand, as we own the exact same companies in our personal portfolios. This firm was created to align client interests with advisors’ interests in order to avoid conflicting interests. We remain true to this modus operandi to this day. We eat our own cooking at Spence Asset Management.
Understanding the ingredients of that cooking is crucial to staying patient. We believe once clients understand what they own inside their portfolios and why they do so, they will feel comfortable riding out the storm as well as what to expect going forward. The world is full of smart people but a lot of what used to count as intelligence is now most likely automated and most do not understand how those automated strategies work or what they own inside of them. Along with clear communication of what we own and why, we always take into consideration our clients’ financial picture, their comfortability and their areas of expertise to come to an understanding of their needs and financial goals. We all view life through different lenses and those lenses become a tool in the construction of your portfolio. We do our absolute best to look through those lenses with you.
No matter the lens, we hope that 2023 continues to bring true wealth for all in the form of health, new experiences, fire-side chats with siblings, friends, and parents. We are grateful to have the opportunity to be more than advisors and cherish being able to call you our friends and family.
Thank you again for your trust in our team. We will work hard again in 2023 to continue to earn that trust.
SAYING GOODBYE TO TINA & THE TIDE
November 23, 2022
Since the “Great Recession” in 2008, consumers and investors have been accustomed to easy monetary policy from Central Banks around the world. In order to spur on economic growth, Central Banks kept interest rates at or near zero. This policy provided consumers and investors an opportunity to increase consumption and as well as for investors to borrow at rates of return not seen in 70 years. As the world became addicted to cheap borrowing, Central Banks were unable to change their stance; bad economic conditions meant that this policy would continue and in good economic conditions, Central Banks struggled to take away the “punch bowl” from economies that were enjoying the prosperity. Investors benefitted tremendously as the tide continued to swell. This led to the acronym TINA – There Is No Alternative. The term was coined in the 19th century and has persisted as a justification for political and financial decisions. The phrase is used to suggest that, in a world of bad choices, one must be the least bad. The TINA effect can explain an asset price bubble. That is, prices rise to unrealistic heights due to a lack of reasonable alternatives.
In the past few years, the rising tide swelled to tsunami-like heights and the TINA trade pushed asset prices to unrealistic heights. Consumer demand drove traditional assets like art, collectible cars, single family homes, vacation homes as well as new assets like crypto currency, non-fungible tokens and meme stocks to eye-popping levels. Pandemic-related shutdowns left Central Banks no choice but to stand by, knowing that at some point, the tide would have to go back out. Here are a few traditional and non-traditional assets that rose to unsustainable heights due to a lack of reasonable alternatives over the past few years:
Real Estate - S&P CoreLogic Case-Shiller Home Price index which tracks residential home prices in cities like Boston, Miami, Phoenix, San Diego, and Tampa, amongst others, reported an 18.8% Annual Home Price Gain in 2021. Since 1891, home prices have increased on average 3.2% annually.
Stock Market - The S&P 500 index notched 70 all-time highs in 2021, a record that is second only to 1995. From April to early December of 2021, Tesla, Nvidia, Apple, Microsoft, Google, and Microsoft, accounted for 51% of the S&P 500’s 26.61% return. The S&P has returned a historic annualized average return of 11.88% since its inception in 1957.
Meme Stocks - GameStop shares rose from less than $5 a share to $325 in January of 2021, in less than six months. In January alone, GameStop gained as much as 1,700%. GameStop was part of the “meme stocks,” which refer to shares of a company that have gained a cult-like following online and through social media platforms.
Non-Fungible Tokens - Non-Fungible Tokens or NFTs are like physical collector’s items, except they are in digital form; they can be bought and sold online and represent a digital proof of ownership for any given item. NFTs enable the tokenization of things like art, collectibles, even real estate in digital form. In February of 2021, Everydays: The First 5000 Days, a collage of 5000 digital images created by artist Winkelmann was sold for $69.3 million; the record for the most expensive NFT ever sold.
Crypto - Cryptocurrencies that launched as jokes, such as Dogecoin and Shiba Inu, became major market players, contributing to the tripling of the total cryptocurrency market in 2021. Today, there are almost 21,000 different coins in existence.
In 2022, the lights began getting turned on. Anyone who has overstayed their welcome in speculative assets is being told by the Federal Reserve that they need to sober up. After more than a decade, the Fed’s Zero Interest Rate Policy has come to an end. The tide began to recede. In an attempt to cool down inflation, the Federal Reserve has started to raise its federal funds benchmark rate.
In March of 2022 we witnessed an interest rate hike of .25%, followed by a .75% rate increase in early May, then .75% again in June, and another .75% in September. Expectations are that the Fed will continue this path until they deem inflation is under control. An end to the Fed’s Zero Interest Rate Policy means that investors finally do have an alternative- an alternative that was not available 12 months ago. They no longer must go to the end of the risk spectrum or into complex alternative asset classes in order to achieve a return. At the moment, the bond market seems to present a viable alternative in the form of high-quality fixed income securities with attractive yields. Capital will always flow where it is treated best. Over the last several months, it has flowed out of equities and crypto and toward treasuries.
Like the tide, capital is always on the move to where it is treated best. As Warren Buffet likes to remind investors, when the tide goes out, we get to see who is swimming naked. Clearly, as the tide goes out, naked swimmers such as meme stocks and crypto currencies are giving back gains and sending ripples of pain through the financial system.
The tide going out has created tremendous pain but also tremendous opportunities. These tumultuous markets and rapidly changing economic conditions have greatly tested management teams of public corporations. They face rising debt costs, they face falling demand, they face employment challenges, they face rising input costs, all while facing never before seen pressure on social issues. We are watching closely to see how management teams navigate this storm and ready to cull any management that is not able to evolve.
How do we want to see a management team evolve in this post TINA environment? Again, in the equity markets, capital will always flow to where it is treated best. 1) We need to see some financial discipline. With sales growth slowing, we need to see that a management team can trim their workforce, if needed, and can increase productivity. 2) We need to see responsible use of retained earnings. We need to see acquisitions that make sense to their core business as well as capital investment at levels that are appropriate in order to balance future growth with current uncertainty. 3) We would also like to see conviction in the future of the business from management. That often comes in the form of share repurchases and insider buying. In other words, is management treating our capital best?
2022 has been a challenging year for management teams and investors alike not only because of the Fed’s monetary tightening and concerns of a resulting recession but also adding to the market’s uncertainty are the elections, the war between Russia and Ukraine, commodity costs, China’s shutdown policy due to COVID concerns and supply chain woes. Like management teams that must evolve in these rough waters, the tide going out is giving individual investors an opportunity to evolve as well. As we transition into a new financial regime it is important to revisit your financial plan, your investment objectives, and your asset allocations. We are happy and ready to do so anytime.
But more importantly, we thank you for your trust and your business during a very uncertain year and we wish you and your loved ones a very blessed and healthy holiday season.
A SHELLEBRATION OF DISCIPLINED INVESTING
NURTURE VERSUS NATURE
There once was a bet between two legendary commodity traders. Back in December 1983, Richard Dennis and William Eckhardt had a one-million-dollar wager on whether trading could be taught or if it was a natural talent. The bet would be settled by the group of traders who earned the most profits over a one-year period. The 23 traders they hired for the experiment were men and women, from all over the country, who were accountants, poker players, athletes, teachers, amongst other walks of life. The Wall Street Journal published an article on this experiment in September of 1989. You can find a reprinted page here: https://www.turtletrader.com/images/wsj_turtle_article.pdf. Some of the most renowned Commodity Trading Advisors, known as the “Turtles”, came from this program. (Dennis named the participants in the experiment in reference to the farm-grown turtles that he witnessed during his travels abroad.) These turtles were taught to trade for big profits and demonstrated their ability to learn how to be a successful trader.
Along with proving that having a trading background was not necessary, the conclusions of the experiment were both interesting and plentiful, but the most significant and universal take away from it: the most important element of successful investing is having the unwavering discipline to follow your investment principles above all else. Once taught the discipline, the traders, even without previous experience, were successful, as long as they stuck to it. The investment discipline became the turtle’s shell- always there, always providing the best protection.
Market environments like the one that we are currently facing are the most difficult in which to be unwavering in investment principles. The current market environment has been a challenging one, to say the least. After many years of monetary accommodation, the market is currently trying to correctly price financial assets in the face of monetary tightening. This is evident in every single major asset class: from bonds to stocks, real estate, and new asset classes, like crypto currencies. Even cash is being revalued as each hard-earned dollar buys less at the pump and less at the grocery store.
The revaluation seems to be moving at a turtle’s pace for both equity and fixed income investors. Today’s market seems to be punishing “growth” companies without regard for their business models or profitability, and then rewarding companies tilted towards “value” without regard for historical valuation or the fundamental economics of businesses. It is more tempting than ever to abandon investment principles, to lose patience with asset classes and to “stick our neck out” by investing in capital intensive, commodity businesses that are extremely cyclical but are the only successful investments so far in 2022.
Successful investing isn’t about having the highest returns, it is about having the best returns for the longest periods of time. Some people think of successful investment managers as risk takers, but instead we define them as risk killers. As investment managers, we constantly need to be very critical of what could go wrong. Benjamin Graham stated it best, “The essence of investment management is the management of risks, not the management of returns.”
The best risk management tool available is holding steady to a strong investment philosophy that has been through many market cycles. Like a turtle, one of the oldest creatures still in existence, that carries its shell for immediate risk mitigation, our investment philosophy will provide shelter and protection that will persevere over time. For the last 25 years, we have been managing risk by being steadfast in our investment discipline. Through bubble bursts, through recessions, through housing crises, through dramatic shifts in political power, through epidemics and pandemics, through terrorist attacks and the collapse of financial institutions, we have stayed the course.
We remain in companies with strong competitive moats, with focused, candid and shareholder friendly managements. We hold tight to companies with good long-term growth prospects that possess low capital intensity. Companies with the ability to raise prices without losing market share and companies that can continue to prosper in almost any economic environment, we will stay behind. We will continue to be highly selective in and invest in what we feel are the greatest companies on earth.
As an investor, one of the worst things to do is to blow with the wind and submit to the temptation of changing one’s core investment philosophy. Chasing after what is doing well right now often leads to overpaying for a sub-par company. We will not ever invest in companies only because the market is currently rewarding them but rather, we will stay focused on the long-term financial prospects of the business. Only solid fundamentals will get us to buy and only a change in those fundamentals will get us to sell. Costco co-founder and former CEO, Jim Senegal, said it best, “I think the biggest single thing that causes difficulty in the business world is the short-term view. We become obsessed with it. But it forces bad decisions.”
After a downdraft in the markets like we have experienced over the last year and bad decisions have been inevitably made, an investor can feel like a turtle as we slowly rebuild, gradually revalue, and steadily recalibrate. The process can be grueling and can feel like we aren’t making any progress. Staying laser focused on your investment discipline and positioning for the next cycle has never been more crucial. Equally crucial: revisiting your financial plan, your return assumptions, and your asset allocations for the next cycle. But following the herd into cyclical, over-valued, slow growth names without long-term tailwinds will most likely lead to more pain for those investors and leave them like a turtle left on its back. But those greatest companies on earth? We will not abandon our shell.
THE POWER OF PRICING POWER
April 13, 2022
2022 has started with a revaluation of most stocks. Some are calling it a correction, some are calling it a bear market, depending on which areas of the market one is referring to. Whatever you call it, the change in values can be eye popping from one day to the next and can be quite discouraging to investors. We constantly remind our clients that we are not managing accounts (our own included) for day-to-day price fluctuations. As always, we stay focused on the bigger picture and the long-term prospects of our individual companies. We expect these fluctuations, especially after the strong performance years we experienced in 2020 and 2021. These fluctuations contribute to the long-term health of the market and keep speculation in check.
The revaluation was triggered by the anticipation of higher interest rates. Although we have yet to see dramatic valuation corrections move into most other assets, stocks are very similar to any other asset, like a house or a bond. As rates rise, the value of that asset declines. “Growth” companies usually go first in a decline in value during a rising rate environment because the value that a typical acquirer would pay declines in line with the amount of increased borrowing costs on that acquisition. Younger, smaller, fast-growing companies that have seen dramatic rises in their valuation include a take-out premium, or the speculation that these companies are likely to be bought by older, slower growing companies with a great deal of cash. In the initial stages of a downturn in the markets, these companies are valued lower because if they were to be bought now, it would cost the older company more to borrow the funds to acquire the younger company. It is very typical and logical behavior in the stock prices of these companies, although the underlying fundamentals and growth rates of these companies remain unchanged.
We always refer to history when navigating market environments. And, as Mark Twain said, although history does not usually repeat itself, it often rhymes. Looking back to the 1970s when we last experienced a prolonged inflationary environment and the Federal Reserve was forced to take action, we do see a bit of “rhyming.” In 1964, inflation was 1%. In 1974, inflation was 12% and in 1980, inflation reached 14.5%. The most recent CPI reading including food and energy was 8.5%.
The late seventies do have some similarities to our current headwinds. One commonality includes fiscal imbalances. In the late 60s and early 1970s there was legislation that brought about large spending programs across a broad array of social initiatives at a time when the US fiscal situation was already being strained by the Vietnam War. Today, fiscal policy has dumped tremendous amounts of stimulus into the hands of Americans. Both fiscal explosions led to a higher than normal level of spending that is in excess of what the economy could produce. Another similarity between these two periods includes a Federal Reserve that was being too accommodative. In the late 60s and early 1970s, the Federal Reserve was holding interest rates steady instead of adjusting to the rising prices. Leading up to the current period, the Federal Reserve continued to “ease” or institute large buying programs of treasuries to keep rates low. Finally, a common culprit of the inflation in the 1970s was the energy crisis resulting from an Arab oil embargo that began in October 1973 and then the Iranian revolution in 1979. Similarly, unrest in Russia and Ukraine as well as policy changes regarding fracking and oil & gas exploration have led to rising energy costs, although at smaller magnitudes.
However, there are some key differences between the 1970s and the current situation as well. A rarely discussed difference between the two eras is the Bretton Woods system and the anchoring of the US dollar to gold. Bretton Woods was a system formed globally to bring economic stability and promote global trade during World War II which fixed currency exchange rates and linked the US dollar to gold. As the supply of dollar reserves soared abroad and exceeded the US stock of gold, it became clear that the tethering was contributing to inflation. The most notable difference in today’s inflationary environment versus the 1970s is the Covid pandemic. The pandemic led to shutdowns in manufacturing, shipping gluts and severe labor shortages. Another important difference would be the Federal Reserve’s use of public expectations. Today, the Federal Reserve uses communication and expectations as part of their “tools” to manage the economy and achieve their mandate. It took many years of double-digit inflation before the Federal Reserve would begin to take action in 1979. Today, the Fed has begun aggressively “talking” inflation down.
Overall, we believe in both situations, the Federal Reserve has found themselves between a rock and a hard place trying to maintain price stability but also maintain full employment. So, how do we navigate an inflationary environment that is requiring some Federal Reserve action? One of the key advantages of a company that will result in surviving and thriving the resetting of asset prices is pricing power. This is one of the requirements for our holdings in that we scour the stock universe in search of companies that have the ability to raise prices without losing market share. Companies will need to raise prices in order to pay their employees more, matching what other companies are paying their employees in order to retain key personnel. Companies also need to cover higher input costs, higher travel costs, higher energy costs and even higher food costs. As we hunt for companies that can maintain market share, we look for companies that are ingrained in our daily lives, either directly as consumers or indirectly through business-to-business suppliers. We look for companies with high switching costs or very little competitive alternative so that retention of customers is highly likely. Likewise, we like to see products or services that are necessary for their customers, regardless of the economic environment. All of these factors contribute to a company’s ability to raise prices.
Another important tenant in our investment philosophy is a low capital-intensive model. Inflationary environments are when the advantages to these types of companies really shine. A capital intensive model like a manufacturing company will see their costs rise more quickly than a low capital intensive entity like a software company. The manufacturer will have to replace/update expensive machinery at higher prices (and perhaps face delays in receiving the equipment during shortages and shipping challenges). The manufacturer will have to handle higher input costs, higher energy costs as well as higher labor costs. And if the manufacturer is forced to raise prices any faster than its competition, they will lose market share. Again, this takes us back to pricing power. We must stay focused on companies that can pass on price increases without losing market share in any environment.
All economic environments present investing challenges. Staying focused on companies that can weather any economic environment is essential and becomes most challenging in times of extreme volatility. We welcome the volatility and the opportunities it creates. We also welcome the flushing out of companies that are not up to the task. Volatility is the price we pay for the long-term rewards of the stock market. Through the storms, our team is diligently and constantly revisiting our most important tenants, especially the pricing power of each of our holdings as well as those we are considering for investment in the future. Our team is diligently and constantly scrutinizing each company that is in our universe to ensure we stay invested in superior, growing companies that can weather our current storm. And although we don’t believe the current storm is the 1970s repeating themselves, storm rhymes with “norm;” storms are to be expected over the normal course of investing and the opportunities they create are to be assiduously examined.
It Is Time To Discuss INFLATION…….Again
August 20, 2021
For many years, one of the most common inquiries we have received at Spence Asset Management has been our thoughts on INFLATION. Recently, inflation figures suggest a dramatic re-acceleration of the inflation rate that is extremely troublesome. With interest rates near zero and the purchasing power of our currency shedding more than six percent of its buying power in the last twelve months, it is time to revisit this all-important topic.
Some perspective on inflation seems appropriate. Much has been written on the topic of inflation since the printing press was invented in the fifteenth century. Inflation is intricately woven into the fabric of both macro and micro-economic forces. We are reminded of what Dr. Thomas Sowell, one of our all-time favorite economists, says regarding economics and inflation. The first lesson of economics, according to Sowell, is based on the idea of scarcity: “There is never enough of ANYTHING to satisfy all those who want it.” Sowell often paired the first lesson of politics with the first lesson of economics. “The first lesson of politics is to disregard the first lesson of economics.”
Not just scholars have noticed politicians in both political parties disregarding the first lesson of economics. At the end of the day, politicians all along the philosophical spectrum recognize that it is far more palatable to simply print money than to encourage economic growth to alleviate scarcity. Those politicians who do not recognize this fact, are rarely elected let alone re-elected. It is truly a fundamental bi-partisan truth. And the printing of money ultimately leads to inflation, a fundamental economic truth.
Since our profession requires us to face daunting realities rather than delve into the theory of public policy debates, we refer to historians Will and Ariel Durant. The Durant’s were awarded the Pulitzer Prize for General Nonfiction in 1968 and the Presidential Medal of Freedom in 1977. These prolific scholars wrote eleven volumes of The Story of Civilization. This remarkable treatise on human history, which was published between 1935 and 1975, was an epic study of both trends and human tendencies. Near the end of their lives, the Durant’s sought to unify the great body of their historical knowledge and bring vitality to it for contemporary application when they wrote a one-hundred-page masterpiece entitled, The Lessons of History. Having studied fluctuations in prices and those participants who adapted best, the Durant’s concluded: “History is inflationary and money is the last thing a wise man will hoard.”
What did the Durant’s mean by saying “money” is the last thing a wise man will hoard? Is this investment advice? What we believe they meant by this conclusion was that hoarding excess cash is a losing proposition in the long run.
Case in point: consider the hopefully soon to be first time home buyers from a few years ago. Millions of young Americans diligently saved a significant portion of their income for a down payment while earning virtually no interest in their money market savings accounts. Sadly, the price of homes, thanks to the vagaries of inflation, rose much faster than they could save. This lamentable situation continued right through the pandemic. It turns out hoarding cash in an inflationary environment was the worst thing that could be done.
What do we think about inflation right now, and what are we doing about it?
The inflation rate is both cause and an effect. Inflation reduces purchasing power, however, owning assets that mitigate the effects of inflation and actually appreciate at a pace that diminishes the damage to the purchasing power can reduce the effects of inflation on our stored wealth.
Unlike the savers who hoarded cash, those who have owned well-selected stocks and real estate have been somewhat insulated from the gradual acceleration in inflation in recent years.
Ultimately, inflation creates a negative force in the macroeconomic equation for all participants. However, the negative impacts of inflation are not evenly distributed. Investments in bonds, which generally produce fixed rates of return, offer very little, if any, inflation protection. This is especially true in a bizarre near zero interest environment created by policy makers. On the other hand, investments in assets with superior investment characteristics can and do provide satisfactory returns, even in accelerating inflationary environments.
Inflation increases the breakeven figure for purchasing power calculations. Simply put, for investment capital deployment decisions to result in a mitigation of the negative effects of inflation, the returns attributable to the assets owned must rise at least proportionately to the rise in the inflation rate. And purchasing power in the future will suffer when returns on equity diminish and advance at a rate that is less than the future inflation rate. This is why increasing returns on shareholder’s equity are so valuable, all else being held constant.
Understanding the mathematics of inflation is the easy part. Identifying the financial characteristics of companies that can outpace inflation is critical. Characteristics that give us the best chance to prosper during inflationary periods involve many variables.
So, what are the basics? For decades we have structured our thinking around the recognition that, “History is inflationary and money is the last thing a wise man will hoard.” All of the processes we engage in to address this problem could be the subject of a book not a newsletter. So, let’s just mention a few here:
1. We AVOID capital intensive industries where profits must be plowed back into buying increasingly expensive equipment to operate the business that must be continuously modernized at ever higher prices while competitors do the same.
2. Identify companies with the ability to pass on price increases. The more pricing power a company has and the easier it is to raise prices during inflationary environments the better.
Naturally, there are other “boxes” a company must check in order to make the grade. We look at management tendencies, unit volume and revenue growth, profit margins, return on invested expenses, return on shareholder’s equity, consistency, durability of competitive advantages etc. However, in the end, we begin with the idea that “history is inflationary” and we must identify dominant, low capital expenditure companies, with pricing power.
At this moment in history, we have an alarming jump in consumer prices in recent months. Are these numbers likely to continue or will they abate? We really do not know the answer to these questions. What we do know is “history is inflationary” and public policies, regardless of which party is in power, will not address inflation until it becomes a crisis. This is true despite the fact that inflation has been an ongoing reality since civilization first formed. As always, we stay focused on what we can control, refrain from making macro-economic predictions and instead, expend our energies investing in businesses that will be successful over the long run, regardless of inflation levels.
Art or Science?
July 27, 2021
Over the decades our asset management firm has lived in the world of micro-economics, which is the study of the economic decisions of individuals and individual companies. Many scholars are wary, in terms of regarding economics as a “science.” In fact, the imprecise and unpredictable nature of economics is so loathed by some, that long ago economics was dubbed the “dismal” science. Perhaps considering economics an “art” would be more appropriate?
It is enlightening to pause and consider how the both the terms “art” and “science” have been historically construed. We tend to think of the term, “art” as being quite abstract and centered in free-wheeling creativeness. Alternatively, the term, “science” is thought of as a concept steeped in facts and empirically verifiable data. The perception is strong that “science” requires a study of only things that are measurable. Ultimately, the seemingly generalized terms of “art” and “science” reside at opposite ends of the conceptual spectrum regarding human knowledge. Consider our perceptions of modern art versus modern science as an illustration of this point; modern science continues to produce astonishing and indisputable advancements in living standards, while modern art’s advancements or lack thereof, are endlessly debatable.
Still, at universities all around the world, Colleges of Arts and Sciences tend to be quartered under one roof. At first glance this seems odd. Or does it?
When asked to explain our successes in the area of portfolio management, we have often suggested our methods can best be defined as the result of the application of both art and science. The dissection of balance sheets, income statements, and cash flow statements reflects the most scientific aspects of what we do. After all, balance sheets….are….well…..they are required to “balance” mathematically. Alternatively, forming well-informed opinions regarding the existence of and particularly the durability of competitive advantages of a business is mostly an art form.
With art, it is often said that “beauty” is in the eyes of the “beHOLDER.” In equity investing, which is long range process, the beauty (and success) of a given business model and the skills of the management team running it, is determined by the collective decisions of present and future “shareHOLDERS.” Whereas current profits and current rates of return for investors are quantifiable, FUTURE profits and FUTURE rates of return on shareholder’s equity are notoriously difficult to forecast.
The biggest problem associated with forecasting investment results is the number of potential variables that can and do come into play. While graphs and charts depicting the impact of the forces of supply and demand are relatively easy to produce, identifying and quantifying all of the most critical factors associated with possible investment outcomes can be almost infinite and often times not measurable. Art or Science?
We embrace both the artistic and scientific requirements necessary for successful portfolio management. Much like the nature of energy as well as the nature of information transmission, the fields of finance and investments are bound by fundamental truths. Like the laws of gravity and general relativity, the need for capital expenditures, the existence of pricing powers, and the addressable market sizes govern investment considerations. The potential for unseen variables, (pandemics, political revolutions, and natural disasters) can modify even our most basic assumptions simply because they are always possible.
In the end, the fields of both art and science continue to evolve. The future figures to always be vague and difficult to define. While the fundamental truths contained in “laws” of some areas of science, such as Thermodynamics, remain fixed, the advances in human knowledge can best be described as a never-ending expansion. History teaches us that the need for accurate information in human processes has always been crucial. On the other hand, the evolution of tools used for improving information technologies, are continuously pushing the limits of scientific frontiers. Anticipating the impacts of developments on the scientific frontiers and how they will affect global economics and particularly micro-economics is likely to remain at best, a blend of art and science.
Time, the evolution of tools and the arrival of unforeseen factors continues to march onward. As the month of August 2021 rapidly approaches, we remain eternally vigilant about the fundamentally complex nature of the investment landscape, and we are eternally grateful for your trust in our efforts.
Micro analysiS despite micro attention spans and macro issues
May 12, 2021
The nation’s GDP, or Gross Domestic Product, is an economic statistic that involves an estimate of the annual gross value of domestic output from economic activities. Sixty years ago (1960) the United States economy generated GDP of around $543 billion. In last year’s pandemic afflicted economy, U.S. GDP was approximately $21 trillion. Doing the simple math, essentially, the U.S. economy is 40 times larger than it was sixty years ago.
One would expect the benchmark United States stock market index, the S & P 500, which was created in 1957, to also have grown in value by roughly 40 times since 1960. However, the index numbers do not quite reflect a one-for-one correlation with GDP numbers. At the beginning of 1960, the S & P 500 Index stood at 58.03. By the end of 2020, the index had grown in value to 3,756.07. So, while the U.S. economy grew 40-fold over the last 60 years, the S & P 500 grew 65-fold during the same time frame.
There are many factors involved in explaining why the S & P 500 value grew faster than U.S. GDP. The primary reason is that the S & P 500 is not a static index. The component companies in the S & P 500 have changed dramatically over the last sixty years. No longer part of the U.S. corporate landscape are companies such as Trans World Airlines, Pan Am, Woolworth, Sears & Roebuck, Compaq Computer, Lincoln Savings and Loan, Lehman Brothers, and Eastman Kodak. Dozens of other former corporate powerhouses have long ago seen their finest days. Companies that once dominated their segment of the U.S. economy and perhaps the global economy, have sought re-organization protection under U.S. bankruptcy laws causing shareholder investments to be virtually wiped out. Think of General Motors, Chrysler, K-Mart and many others.
Companies rise to greatness then fall to obsolescence, yet the earth continues to spin. Today, we are in the midst of 1st quarter 2021 earnings reporting season. Four times each year, companies we hold shares of report quarterly results and conduct question and answer sessions during their conference calls. Companies release mountains of information regarding the most relevant aspects of their operations. Combing through relevant information provided by our management teams each quarter represents a cornerstone of our expertise. When we are considering a new idea, we also delve into previous conference calls looking for relevant data, in addition to pouring over financials and scouring the competition.
When we are explaining our approach to vetting and selecting common stocks for investment, we often summarize these activities by saying that we, “spend the vast majority of our energies at the micro level.” What this basic statement means is that we focus on a wide variety of factors and how they affect individual companies, rather than more general factors that tend to have an influence on the broader economy.
To illustrate the reasons why we direct our energies to the micro level, let us briefly explore a few important facts regarding the S & P 500. First of all, as we move forward in 2021, some of the largest companies in the S & P 500 simply did not exist back in 1960. Microsoft, Apple, Google, Amazon, and Intuitive Surgical are some examples of newer members to the index. Each of these profoundly successful companies were founded long after the inception of the S & P 500 Index back in 1957. Staying focused on the individual companies and not on an industry or an index keeps us focused on the most relevant companies of our generation.
Next, as evident in the first quarter of 2021, several of the companies whose shares are held in our Focus investment accounts have already reported stellar results that have exceeded our expectations but have not yet been rewarded for those phenomenal results. What does this mean to us? For starters, it is quite a misnomer to think that companies reporting significantly larger shares of the $21 trillion U.S. GDP pie will immediately see their share prices rewarded with increases in value immediately after results are reported. Markets move about day-to-day, month-to-month, quarter-to-quarter, and even year-to-year, based on the whims of the masses as well as various underlying economic conditions. Market prices of shares of individual companies routinely move both ahead of (or behind) the fundamental realities of their underlying businesses. Assuming that there will be an immediate reflection of successful competitive results requires the embracing of a myth. Additionally, expecting immediate reflection of a declining competitive position in share prices, is also a myth. There are too many distractions available for those seeking guidance from media sources. It is logical given these realities that the markets are constantly producing false signals.
Despite these false signals however, as sure as night follows day, over the long run, the shares of once leading companies that begin to fail in their respective micro-level competitions, like the K-Marts and the Sears, will eventually become mired in subpar share value performance or even bankruptcy. Alternatively, as day follows night, the shares of companies that can and do sustain above-average operating progress, will significantly reward patient investors as they grab a larger share of the $21 trillion U.S. GDP pie.
Thus, we devote our finite energies at the micro level because we are very uncomfortable relying on rises in global or domestic GDP or worse yet, false market signals to carry us to success. Companies like TWA, Eastman Kodak, and K-Mart operated during eras when both U.S. and global GDP was rising. And the markets gave off many false signals regarding their eventual competitive destination. However, the quarterly and annual results over time of those companies did not.
The key to our continued long-term success will be to work diligently to process relevant information properly at the micro level, not just quarterly but daily. This means continuing our efforts to identify and hold shares of companies with favorable financial characteristics and competitive advantages who continue to deliver results regardless of the direction of GDP; we must accurately forecast that their advantages are durable in an ever-changing competitive landscape.
Finally, once we do make a decision to commit capital for investment, we understand that we must continuously monitor our assessments of their favorable attributes every business day in case the validity of our assumptions shows flaws over time. With only 94 companies still in the S&P that were in the original S&P, a company’s fundamentals can and often do break down over time.
With these distinct processes in mind, we are content with gathering facts during earnings seasons without seeking the fickle affirmations (or lack thereof) provided by financial markets. Financial markets, heavily influenced by the news media, and now social media, often behave like children. Childishness involves limited perspective and short attention spans. These tendencies serve as forces that are counter-productive to astute analysis and profitable investment decision-making.
ON THE SHOULDERS OF GIANTS
March 5, 2021
Einstein humbly surmised: if he had in fact advanced the base of knowledge on physics, it was because he stood on the shoulders of giants. Everyone assumed Einstein was mostly referring to the most famous physics “giant” of them all, Sir Isaac Newton. However, it has become clear that “Invariant Theory” developed in 1841 by mathematician George Boole contributed more so to the development of Einstein’s General Relativity Theory. George Boole dealt with important recurring problems of analysis that continue to this very day.
Invariant Theory is the study of orbits of groups. Given one set of variables, an” invariant” does not change. But in another set of variables, it takes on a different value that then remains unchanged within that set of variables. The theory explains the change in algebraic expressions that change in a specified way under linear changes of variables.
Successful equity investing is most certainly NOT rocket science or the proper application of Invariant Theory. However, like Invariant Theory, an investment will likely behave in a certain manner given a certain set of variables or within the “orbit” of, say, rising GDP, falling interest rates, and a low inflationary environment. But jolt the investment into an entirely new set of variables, like a global pandemic for example, and its behavior is likely very different. And, like Invariant Theory, there are layers of abstract thought required to navigate the maze of information supplied by all forms of media regarding the financial “markets.” As Einstein did, we stand on the shoulders of the giants who have successfully navigated the financial markets over time in order to assess our current set of variables and find investments that will prosper in almost any set of variables.
Each year in late February, we log on to the Berkshire Hathaway website and read the latest observations from two of those said giants: Warren Buffett and Charlie Munger. A significant portion of what we have learned over the years has come from reading the deepest thoughts of both Buffett and Munger regarding investments.
Like Buffett and Munger, we see our roles as equity managers not as stock market experts, but primarily as business analysts. While active traders and the media personalities tend to think of shares of stocks as poker chips, we see them as a collection of carefully selected businesses of which we own a portion. Of course, we do not oversee or in any way control the operations of these companies. However, we do benefit from long-term prosperity they generate.
The “orbits” or the variables that surround the financial markets have shifted tremendously throughout history. Through wars, medical advancement, inflationary environments, political instability, terrorist attacks, technological advances, and recessions, businesses have prospered. Buffett and Munger have always focused mainly on the potential of their businesses, not on the set of variables they are operating within or on trying to predict what the next set of variables may be.
Quite often the factors that make businesses not just successful, but great investments, can seem buried beneath the surface. In our day-to-day efforts, which are out of our client’s field of view, we spend our time furiously digging. We mine income statements, cash flow statements, and balance sheet data. We plow through conference calls which are conducted by the management teams running the businesses we own shares of. We drill into the competitors of companies we are considering, their financials, their managements and their communications as well. Our goal, like that of Buffett and Munger, is to unearth insights regarding the status and trends associated with a company’s competitive advantages.
Even when we can identify companies with competitive strengths today, often we will see these strengths erode sooner rather than later. Some of the most heated debates in our investment discussions are over the question of “durability” when it comes to competitive strengths. How will these competitive advantages hold up when the variables shift to a new orbit?
And the variables do indeed continue to shift. We have moved into the orbit of “stay at home.” We have moved into the orbit of a new administration. We have moved into the orbit of tremendous stimulus being injected into our financial system. The competitive advantage digging persists.
The variables will continue to shift. For clients just getting started with Spence Asset Management in our Focus Equity Program as well as those who have been in the program for decades, the future is unknown. The future is muddy, and it has always been that way. Rest assured that our “shovels” are not resting. We appreciate your business, your loyalty, your patience, and your friendship.
Holding Cash Reserves is an Integral Component of Our Equity Investment Strategy
January 6, 2021
Asset managers who operate in the United States equity markets often compare their annual performance to the S & P 500 Index. This high-profile index tends to be the standard benchmark of the domestic investment industry. Not only do we track performance of our own holdings, we also compare our overall performance relative to the S & P 500.
It is important to recognize a few important aspects of the S & P 500 Index. When used as a benchmark, the index represents near complete exposure to the ups and downs of the shares of the largest 500 companies in the U.S. stock market including many companies that are far past their primes. Also, there is no cash reserve or money market reserve fund that is factored into performance of the S & P 500 Index. It represents a 100% commitment to stocks. With these two important facts in mind, we refer to Warren Buffet’s words in his 2014 letters to Berkshire Hathaway shareholders that is particularly noteworthy to this discussion. Buffett said, "We always maintain at least $20 billion — and usually far more — in cash equivalents."
Since Buffett and his business partner, Charles Munger, are arguably the most successful investors in human history, we must ask ourselves this question: Why would an intelligent investor hold cash when the returns on cash are so negligible? Before we elaborate on our thoughts regarding cash reserves, we need to go back to Buffett one more time. Buffett said the following when explaining why he is well reserved with cash at all times: "Cash, is to a business as oxygen is to an individual. Never thought about when it is present, the only thing in mind when it is absent. When bills come due, only cash is legal tender. Don't leave home without it."
Naturally, we understand and occasionally have the “itch” to put every dime of our liquid cash in our managed fOCUS accounts to work to “maximize” our returns. However, in the particularly tricky and unpredictable macroeconomic environment as well as the volatile geo-political environment of the 21st century, we have found important comforts and solace in always maintaining reserves for the inevitable downturns in stock prices. While we will always keep our primary focus on the companies we own, the uncertainty of a pandemic, an election or federal reserve movements may cause us to increase our cash position. Similarly, a sizeable sell off may induce us putting some of the cash position to work.
While we want our holdings to perform at a high level, we want purchasing power on hand when opportunities present themselves. By embracing an opportunistic mindset 365 days a year, particularly when it comes to market declines, we are happy to have a bit of hard reserves earning a pittance. Having low earning reserves is the cost of retaining the flexibility to pounce when we see fit or meet a sudden and surprising demand for liquid funds.
Additionally, there are many industry segments of the S&P 500 that we have no intention of investing in. We prefer to concentrate in what we feel are the best companies of the entire stock market, regardless of industry. Accordingly, we much prefer processes that involve extreme patience, intense selectivity, and the occasional trimming of existing positions, to the more conventional and one-size fits all full investment approach of indexing with an absence of any reserves. This concentration can lead to higher volatility, which can be somewhat muted by cash reserves.
You can label this part of our overall strategy: market downturn insurance, rainy day liquidity funds, or even a dependable funding source for unanticipated opportunities. No matter what it might be called, it has been part of our strategy for many years and will continue to be so for the foreseeable future.
Best wishes to all for a safe, happy, healthy, and prosperous 2021!
“SHUTTING OUT” 2020
December 11, 2020
2020 has been nothing short of extraordinary. Who would have guessed that events like Brexit, Hong Kong protests, the most active hurricane season in Atlantic history, the Black Lives Matter movement, the first commercial space flight and the most area burned in wildfires would not make the “front page.” Nobody could have predicted how every life would change this year, how schools would sit empty, how funerals, graduations and weddings would be cancelled, how masks would become the year’s most important fashion accessory, how travel would come to a standstill and how “Zoom” would become a daily verb.
As we all pine for a world that returns to normal filled with travel, family celebrations and school, we also yearn for the return of sports. Lately, the great baseball pitcher Nolan Ryan has come to mind. Ryan is 72 now. He was in a word, “phenomenal.” Ryan is the all-time leader in pitching no-hitters with seven. He threw three more no-hitters than any other pitcher. Ryan also threw the most one-hitters. He had twelve one hitters along with Bob Feller. Astonishingly, Nolan Ryan also pitched 18 two-hitters during his storied career. Then of course there are his strikeout totals. Ryan struck out more batters than any pitcher in baseball history. He has more than 800 strikeouts ahead of his closest rival in that important statistic.
With back-to-back extraordinary performance years in the investment business, we have been feeling a bit like an investment version of Nolan Ryan. However, we have been around long enough to know that investing is NOT a game of perfection. It is a game of percentages. And investing can be extremely humbling. Nolan Ryan was also the losing pitcher of record 292 times, which is third all-time. Oddly, Nolan Ryan never pitched a perfect game, nor did he ever win a Cy Young Award. Cy Young, the man for which the greatest seasonal honor is named for, is the all-time leader in LOSSES and WINS. To illustrate the essence of humiliation that can go with glory, Cy Young lost 315 games.
Seasoned investment professionals must expect similar peaks and valleys that Nolan Ryan and Cy Young encountered. But the greatest causes of failure for a talented athlete are often distractions and diversions. Why was a pitcher like Nolan Ryan so successful? It is because his preparation never changed. He refused to allow himself to get distracted or diverted. During his remarkable 27-year career, he had a few off years. However, he never let the arbitrarily determined length of any season affect his basically fundamental approach to his job or damage his hard-earned confidence.
As 2020 comes to a close and we reflect, it was a year where diversions and distractions were outsized. There were the extraordinary impeachment proceedings in January. There was the onset of Covid-19 in February followed by the worldwide effects of the virus. There were lockdowns, quarantines, vaccine tests, and extraordinary measures taken by Congress and the courts to determine the usefulness and constitutionality of emergency procedures. The Federal Reserve Board became active in ways beyond comprehension along with central banks in Europe and Asia. Then, we had a presidential election and the acrimonious disputes over voter fraud that followed. And as we go to bat in 2021, very little has been resolved. Divided power or a complete change of power in Washington is in the cards. The rollout of the vaccine and its timeline remains unknown as our economy limps along. 2020 threw a curve ball unlike any we have ever seen.
Pandemics, political turmoil and toilet paper shortages: our view does not change, nor does our preparation processes. Having back-to-back years with extraordinary results changes nothing. A calendar year is merely a snapshot of a long process based on the time it takes the earth to circle the sun one time. While we are pleased with the performance of our investments so far in 2020, like Nolan Ryan, we reset our expectations every day, every month, every quarter, and every year. We live in the micro-world of business analysis where we cover the bases of correct identification of competitive advantages, secular trends, clean balance sheets, promising income and cash flow statements, and talented management teams.
Similar to Nolan Ryan’s preparations, we maintain a commitment to our own fitness including mental flexibility, strength of analysis, constructive attitudes, and ceaseless patience. We must rely on our experience regardless of whether our last outing was a no-hitter or a far less productive outing. Perhaps more than any other power pitcher in history, Nolan Ryan understood that his major league career was a marathon and not a sprint. Accordingly, his preparations remained disciplined and fundamental. And his commitment to excellence was steadfast regardless of looming diversions and distractions.
It is hard to imagine that 2021 could bring more diversions and distractions than 2020. However, we take nothing for granted. We do our level best to be surprised by nothing. When we step up to the plate each day, we are prepared to be humbled either by setbacks in 2021 or encounter more extraordinary success.
As 2020 winds down we are sadly reminded of some of the long-time clients and good friends we lost to the great inevitable. They will be dearly missed and always remembered. Yet, we are also thankful for the new friends/clients we made this year despite what took place with the virus. Most of all, we are grateful for the confidence and trust you have shown in our team. We want to wish you and your family all the best and a safe, healthy, and happy holiday season, knowing full well that these are never things that we should ever take for granted.
June 29, 2020
In our previous newsletter, we spent some time discussing our inclination over the past few decades to make investments in what we believe to be strong secular trends. We continuously develop and evolve our convictions regarding secular trends. Entering 2020, we already had commitments to what we believed were investable trends that were in place long prior to the Coronavirus outbreak. We also suggested in our last communication that many of the trends we were committed to appeared to be accelerating. This is particularly true of the aggregate demand for remote inter-connectivity, cloud-based computing, and improved mission critical data management. The outbreak of Coronavirus has made these areas of interest more urgent priorities for consumers, governments, and businesses alike.
Coronavirus pandemic or not, in managing your money, we have three central challenges. Nobody gets these challenges right 100% of the time, but we need to get it right more than we get it wrong. In 2020 these challenges have become even more imperative but also much more difficult:
1. Decipher between what is temporary and what is permanent
2. Decipher between what is noise and what is relevant
3. Decipher between luck and discipline
Is it Temporary?
It is important to understand we have identified many successful investments over the years by identifying and avoiding “popular” but “temporary” phenomenon. Trendy has never been our game and likely never will be. Trying to identify the next great dating app or the “must have” shoes for teenagers next year could not be further from our wheelhouse.
However, “temporary” can also be a friend to investors. From February 2020 until the third week of March, the markets under-delivered. This was due to widespread fear and panic. Back in March, we offered reminders that the widespread fear and panic we were seeing, was in fact, a long-term investor’s best friend and would likely subside. Temporary created opportunity.
One of the great ironies of successful investing is that while fear and panic produces incredible investment opportunities, exuberance and unbridled optimism regarding any market segment does diminish performance opportunities in the short run and can also be transient. Here is where we find ourselves today. Some might say 2020 has been a little “too good.” So, while we are pleased with our 2020 results thus far, we are tempering our near-term expectations for the time being.
Is it Noise?
The media can also be a friend to an investor bringing notice to companies whose stocks are performing well, encouraging even further price appreciation. But often what the media brings to the investment community is a whole lot of noise.
We find it easier to comprehend the “impact” of the whims of the news media rather than predict them. Media reporting on secular trend accelerations have not been lost on the reporters and anchors in the financial news media over the last three months. Accordingly, as we watch this odd period in history unfold, we are reminded of the remarkable proliferation in financial news broadcasts during the last few decades. News networks dedicated to covering the financial markets now broadcast information to consumer/investors practically 24 hours a day, seven days each week. If one is interested in information regarding financial markets, the ad-driven TV vendor choices include CNBC, Fox Business Channel, Bloomberg, and Cheddar. There is simply more financial information and so-called analysis available on television now, than ever before. When taking into consideration the mountains of information available on the internet and from subscription-based publications, investors are literally swimming in a sea of sometimes relevant, but mostly irrelevant, information. Deciphering noise from relevance has never been more onerous.
Considering all the positive media interpretations regarding areas of the markets where we have made significant commitments, we have no plans to alter our methods simply because many of our companies have become “popular” with the media. We expect this to occur from time to time, however, it rarely happens as rapidly as it has in 2020. As we look ahead to the third and fourth quarters of 2020, we are inclined to be somewhat more cautious about the short run.
Is it luck?
The stock market, over time, does an excellent job of humbling even the most brilliant investors. It is easy to extrapolate short- term success infinitely and attribute a few surprising pops in a stock price to investing prowess. However, short-term success often draws investors away from their core discipline and philosophy which can ultimately be very costly. As Warren Buffett often says, “Once the tide goes back out, you see who is swimming naked.” When market volatility subsides and investors return to watching the fundamentals of sectors and individual companies, those who abandoned their discipline will be greatly impacted. Those who got lucky will be suddenly feeling very unlucky.
Therefore, when it is most difficult to stick to your core philosophy is when it is most important to do so. It can be tempting to wade into dot com companies with no revenue, no profits, no competitive moat, and a very green management team when everyone else is. It can be mouthwatering to see energy companies and cruise companies trading for pennies on the dollar. But these are the times it is most crucial to stick to the investing tenets that have brought us success for 20 years, not for 20 days.
Is it realistic?
We have one additional challenge when it comes to managing your money and that is managing your expectations. Sometimes, when we are in the right companies for the long run and there is an abrupt recognition by the media of the trends these companies address, our investment performance rewards can come extraordinarily fast. This has been the case since the third week of March 2020. We find ourselves in an enviable position. While in the aggregate, the financial markets have experienced extraordinary turmoil in 2020, we are grateful that our mature Focus Equity accounts have, by and large, bucked strong overall market headwinds and registered exceptional results. And with this reality, we feel it is important to recognize that grossly out-sized short-term performance rewards are quite unsustainable.
Since we understand the fickle nature of the “short run,” our methods will continue to center around our core beliefs regarding long-term secular trends. We are laser-focused on identifying companies benefitting from secular trends that are investable. We do so while understanding the short-term whims of the markets constantly provide psychological obstacles. Because fickle markets can either over-deliver or under-deliver performance for our accounts, we remain committed to psychologically girding ourselves against reacting to what is temporary and what is noise. Despite unprecedented times, we will remain steadfast in our discipline. But in the short run, be prepared for a volatile ride. And, as always, we are honored to be on the ride with you.
Pace of Change
May 26, 2020
It seems almost ironic that our last newsletter was sent to you on Friday the 13th in March. The topic of that communication is now all too familiar to anyone living on planet earth with even modest access to media and/or a facemask.
No doubt the pandemic has dominated not just the attention of the media and the politicians, but also day-to-day life for all of us. Events have transpired in ways that seemed hard to imagine on New Year’s Day, which seems like a very long time ago.
In times of uncertainty and market volatility, we try to place even more emphasis on being both students and teachers of relevant points in the ever-lengthening time span involving “recorded” history. This time, however, we want to go back farther in time than we usually do.
The Neolithic Age predates much of recorded human history. It began roughly 12,000 years ago when human beings first began to engage in agriculture. The Neolithic Age marked the end of the Paleolithic Age when hunting and gathering dominated the sustenance activities of our species. Methods in agriculture and other basic areas of life improved during the Neolithic era. However, most noteworthy from our modern perspective is the fact that the advances in agriculture were extremely slow…..hence the reality that most scientists believe the Neolithic Age lasted approximately 11,750 years.
The Industrial Revolution marked the end of the Neolithic Age. And with it the Industrial Revolution changed the pace of technological advances in ways that would seem unfathomable to people as recently as the 17th century. So fast have things changed over the last years, that if the poorest Americans only had the day-to-day niceties of Britain’s King James in 1620, they would be considered third world citizens. Simply put, kings and queens from 400 years ago had very few of the qualities of life we now routinely refer to as necessities. Steel magnate Andrew Carnegie properly characterized progress in our living standards during the Industrial Revolution as “a process of turning luxuries into necessities.”
With the onset of the Digital Age, which is still considered by most economic historians as part of the Industrial Revolution, the pace of change has been continuously accelerating and necessities now include internet access. There are virtually no industries today that are not deeply impacted by the advancements in digital technologies.
Most important to this discussion is the fact that since the beginning of the Industrial Revolution, there have been bell-weather global events that truly turbo-charged the pace of change. Many of these events were horrific wars involving widespread global military conflicts. Other events involve scientific discoveries by geniuses such as James Clerk Maxwell, Albert Einstein, Neils Bohr, and Alan Turing.
Of course, many others contributed to the shared wisdom of our species, developing cures for a wide range of diseases that used to be fatal. The result has been longer life expectancies and higher living standards. And oh yes, incredible wealth creation along with it.
We view the current event in human history (the pandemic) as another astonishing bell-weather global event. The consequences of this event will trigger rapid changes in human behavior, many of which are just beginning to emerge.
A close look at our equity portfolio reflects what we believed were important trends that were underway BEFORE this global pandemic. Never shy about familiarizing ourselves with advancing technologies, we have made many technology-related investments for which we continue to have high hopes. If we were/are correct about the implications, which we have reason to believe we will be, the companies in our portfolio should benefit from a sudden acceleration in trends that were already in place.
These accelerations include millions more workers engaged in their efforts via remote digital technology with more flexible schedules, more use of remote technology for medical monitoring and basic health care, more demand for advanced data base software, more online purchases that reflects the benefits of social distancing, at-home digital fitness, food delivery, gaming, biotech innovation and of course more electronic financial transactions versus the use of physical currencies.
The applications for technology to facilitate these changes might well be breathtaking. And as sure as night follows day, increased competition will come to all digital products and services as the Industrial Revolution continues to evolve into an even more digitally focused future.
Accordingly, eternal vigilance will be required by professional investors who hope to capture some of the economic benefits associated with these accelerating trends. Most surely there will be new winners as well as new losers as the competitive landscape evolves, just as it always has.
As we emerge from this crisis, we want to thank everyone for supporting our efforts. We feel almost sheepish in that our business has continued to thrive and prosper, while so many others with hard working people on their teams, have suffered and struggled, through no fault of their own.
We vow to remain eternally vigilant and grateful for the abundance we enjoy as we emerge from the darkest days of the pandemic.
Our Approach to Coronavirus
March 13, 2020
As of the writing of this newsletter there were 3,967 deaths caused by Cornonavirus around the world. Of those deaths, 3,120 have been reported in China. According to a study done by Medicine Net, approximately 646,000 people die globally from flu and flu-like symptoms each year. Another study found that approximately 3,700 people are killed EVERY DAY in world-wide traffic accidents. Still, Coronavirus is different in that we already know about the dangers of the flu, particularly dangers to the elderly. We also know that we take a risk every time we get in an automobile to go somewhere.
Only a fool wouldn’t be somewhat frightened by the unknown risks and threat of Coronavirus. Fortunately, there is plenty of good information out there about precautions that can be taken. Reduced travel and events will slow the transmission. And also, with the advances in medical technology, armies of scientists are working around the clock in labs in many locations to develop treatment solutions to the risks this virus presents. Just as has been the case with Smallpox, Polio, Measles, Mumps, Diptheria, Whooping Cough, Rotavirus, Asian Flu, Ebola, H1N1, Swine Flu, Zikavirus, and Bird Flu, we feel confident that medical science will prevail over Cornonavirus.
Although it is easy to get swallowed in the negative news and panic, let’s approach this situation like our favorite Prussian mathematician Carl Jacobi, (1804-1851). Jacobi loved to solve problems by “inverting,” meaning he looked at problems from opposite points of view to make sure he was not missing something. Since the dangers of Cornonavirus are obvious to everyone, let’s consider what sort of opportunities might present themselves as a result of this latest market panic.
Perhaps the best way to approach a frightening panic is to review what legendary investor Warren Buffett has said on many occasions:
"The years ahead will occasionally deliver major market declines -- even panics -- that will affect virtually all stocks. No one can tell you when these traumas will occur.”
While what Buffett says above is all well and good, what about all the fear out there? When will it end? When will the market stop going down? When will it ever start to advance again?
Again, let’s turn to Buffett who said on many occasions, “Widespread fear is your friend as an investor because it serves up bargain purchases.”
For decades we have come to work each business day with the understanding that there is no reliable way to predict overall stock market movements. Instead, we focus only on individual companies. Accordingly, our approach to investing is to think about the portions of outstanding businesses we own in the same way we would when buying a house. We buy a house only if we understand it, like it, and would be content to own it in the absence of any market in which to buy or sell it. We buy stock in a business if we understand it, like it and would be content to be an owner in it if there were no market to sell its shares.
On this mission to find outstanding businesses, decades of experience in this rough game have taught us that the most important quality we can possess is an all-weather temperament. Though market declines and nasty looking monthly statements are not as fun as rising market experiences, we are always ready for them and you should be too. We are mentally prepared to not panic during downward moves in stock prices. Instead we commit to bargain-hunting for additional shares when our favorite companies go on sale.
Market crashes and steep market corrections should be thought of as buying opportunities, not as reasons to panic or despair because the statements are not as pretty. And although we cannot foresee how long this “buying opportunity” will last, we are looking for great investments for the next 10 years, not the next 10 days. We feel very confident in asserting that some of the most outstanding investment opportunities of this decade will be presenting themselves as a result of this current Cornonavirus panic.
Over the long haul, successful investing is often counter-intuitive. As equity investors, this current climate of fear is our best friend. The best companies with outstanding managements, top market share and solid financials are 20% cheaper this week. Only a climate of severe fear means everything is on sale in the equity markets, including all of the biggest winners of the future.
The Most Powerful Force in the Universe “Compound Interest”
February 25, 2020
Albert Einstein once said: “Compound interest is the most powerful force in the universe. It is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”
Perhaps when applied to the human condition, the most difficult aspect of harnessing the compound interest force is that money must be set aside for investment; it MUST BE LEFT ALONE. Or put another way, money cannot have the immediate pleasure of being spent and exposed the beneficial force of compounding simultaneously.
An easy way to understand the basic math of compound interest is to know that given a seven percent rate of return, account values will roughly double every ten years. Again, the most important factor is that the money is left alone to grow. Likewise, taking advantage of retirement plan tax laws is important because money that is in a retirement account is shielded from taxes. Essentially tax-sheltered accounts are balances that are more likely to be LEFT ALONE.
The math farther out on the time horizon is also simple. If funds are left alone for 20 years and compounding at 7%, the account values roughly quadruple. If the same funds are left alone for thirty years at 7%, the account value will increase roughly eight-fold…….and so on.
Many pension funds increase their return expectations to enhance the force of compounding and meet their obligations. The results are even more impressive when we use higher rates of return in the assumptions. A $10,000 account left alone for 30 years and compounding at 9% grows to $132,676.78 versus $76,122.55 at 7% and $32,433.98 at 4%. However, with the lower interest rates we have now experienced for an extended length of time and will likely continue to experience, we must lower our long-term return expectations. With treasury returns below 2%, we are more likely to see equity returns lower than their historical annualized returns. LOWER RETURN EXPECTATIONS MAKE THE FORCE OF COMPOUNDING EVEN MORE IMPORTANT.
Now let’s assume the investor takes an annual withdrawal from her account of $1,000. At a 7% rate of return, the investor is left with $5,855.07 after 10 years instead of the $19,671.51 she would have had without withdrawals. And even if the investor stops taking withdrawals after that 10th year and leaves the money to compound, she will have $22,657.26 after 30 years instead of $76,122.55 without any withdrawals. The annual “splurge” that the investor withdrew from the account early on greatly cost her in the long run.
And when we talk with our youngest investors, we always like to demonstrate the power of compounding by showing them the outcome if they start saving for retirement now versus the outcome if they wait 10 years. A 22 year-old college graduate starting their job and putting away $200 per month and earning a 7% rate of return will have $594,663.59 at 65 years old. However, if they wait 10 years to start until they are 32 years old: $285,440.22. Time is a young investor’s greatest asset when it comes to compounding.
These simple illustrations show why Einstein said that compound interest is the most powerful force in the universe and the eighth wonder of the world.
Let’s finish the compound interest theme with a real-world example. We will use our investment experience in shares of Mastercard, which is easily the best investment we have made in our careers in our equity accounts. Our initial investment decision on Mastercard shares was made in August of 2006 (for accounts with available cash and an aggressive investment objective). Much analysis and discussion led to the decision. But when it came down to it, we liked the financial characteristics and future prospects of Mastercard. We were thinking that Mastercard shares could produce a decent compound rate of return.
Since August of 2006, Mastercard has grown annual revenues at a rate of over 13%. Much more importantly, on a per share basis, Mastercard has grown its net income per share at a lofty rate of 29.98% since August of 2006.
The results for investors who put $5,000 in Mastercard shares in August of 2006 and left the investment alone for fourteen years are staggering, simply because they reflect the effects of higher compounding rates. A $5,000 investment made in 2006 and left alone in Mastercard shares for fourteen years have increased 56-fold to approximately $283,863.63 in value today. The annual compound rate of return for Mastercard shares of 29.2% since August 2006 almost mirrors the growth rate of Mastercard’s earnings per share growth of just under 30%.
No doubt the Mastercard investment results since 2006 represent a rare “holy grail” outcome. And, unfortunately, we trimmed this position in our accounts instead of letting the force of compounding take full effect. Even with trimming, Mastercard has been an outlier investment result and such “home runs” are very few and far between. Still, this provides an amazing illustration of why we continue to search for companies that exhibit similar characteristics and why we think about longer holding periods instead of quick trades.
The most important takeaways from this compound interest discussion are these:
1) Compound interest is, in a financial sense, precisely what Einstein said it was: the most powerful force in the universe and the eighth wonder of the world.
2) The real power of compound interest is realized over time, not in the short run.
3) When money is removed from an account and spent, the force of compounding is cut short and not allowed to take full effect, the implied costs to the end balance multiply geometrically over time.
There are many ways to view what an investor might have done with Mastercard in 2006. For those who decided to withdraw $2,000 from their account to purchase a big screen television just before we bought Mastercard shares would have enjoyed that big screen television while there would only be $3,000 left to invest in Mastercard. Fourteen years later the balance in the account would be lower by more than $113,000 and the big screen TV would have long ago been rendered obsolete.
The Mastercard example, though radical, is real. The implications of compounding, even at lower rates of return, are still inescapable. While spending is admittedly more fun than investing in the short run, eschewing the powerful force of compound interest produces enormous opportunity costs in the long run.
Observations on International Investing
February 10, 2020
Over the years, clients who have participated in our Focus Equity strategy have come to realize that on the surface, our portfolio does not check all of the typical diversification boxes that many asset allocators prefer. We have never invested for the sake of diversification across industries or across geographies. In our investment meetings, you won’t hear the committee say that we need to find a utility or an industrial stock because we don’t have one. You won’t find our analysts scouring lists of companies based in Germany for more European exposure and you won’t find us settling for subpar performance from one of our holdings because it diversifies us away from technology. We don’t own companies in our equity portfolios because of their market sector or because of their geographic footprint.
Still, at a minimum, several times each year we will get questions from clients or prospective clients about our views on “international investing.” It is a fair question; it is a smaller world these days, and there is unquestionably a great inter-connection between domestic businesses and businesses abroad. So, here is why our equity portfolio does not match up with the standard asset allocation pie chart that has a noticeable slice labeled as “International”:
First, our preference and our priority is for certain types of business models that tend to transcend any particular border boundary. We greatly prefer a low capital spending requirement for our growing businesses. We look for companies that are capable of generating high rates of return on shareholder’s equity. And we surely favor shareholder-oriented management teams, operating in industries they can dominate now and for the foreseeable future.
Next, when we look for companies to invest in, we are mindful of the countless barriers to success. These risks, regardless of geography, fall into many categories including competitive risks, cyclical risks, interest rate risks, and technological risks. However, the additional risks that arise for international investments include: poor sovereign governance, substandard accounting mandates, poor relations with governing bodies, and ever-changing rules, being just a few. The list of barriers to success is almost endless, and there is no jurisdiction anywhere, that is close to perfect in this regard. However, the greatest risk to international investments that can be avoided is the risk of unstable currencies. The U.S. dollar is the world’s reserve currency. And the dollar looks to continue in this role for the foreseeable future. The vast majority of nations prefer this reality, and so do we as investors. It creates distinct advantages too numerous to delve into.
Finally, it is narrow minded to assume that strong domestic performance automatically will translate to strong international performance. Successful global companies usually have painstakingly incorporated cultural, geographic and demographic differences into their international strategy. These companies often have a local presence in various geographies to ensure success which also adds to cost. In addition, it is important to understand that, although international sales can offer large volume growth opportunities, international pricing is often substantially less than in the United States which can make a company’s international operations a lower margin endeavor.
All of this being said, it is a complete misnomer to think that our Focus Equity strategy ignores the amazing opportunities to do business overseas. At least quarterly, we review our portfolio to determine approximately how much of the total revenue our companies bring in that comes from outside the United States and the growth of that revenue. We do so despite the fact that every single name we own is headquartered here in America. Within our Focus Equity portfolio of companies, the average percentage of revenue derived from international sales was approximately 39.03%. The “weighted average,” which is a slightly different measure, was even higher at 40.84%. Simply put, our exposure to overseas business opportunities is quite substantial.
It is important to emphasize again, that we do not begin our search for solid equity investments by looking for overseas exposure and/or opportunities. Our search begins with sophisticated screens that tend to identify business dominators with the most beneficial financial characteristics for shareholders. If a company fits these descriptions, we will neither add extra credit for international revenues nor will we subtract credit as we vet the idea more deeply.
This approach has served us well and we expect to continue it for the foreseeable future.
Many Reasons to be Thankful
November 25, 2019
This week we all give thanks. We are thankful for many things; it has been a record-breaking year at Spence Asset Management, our hard-working team is healthy and happy, and our client base is larger and more loyal than ever. We are also thankful for a conversation we had recently with one of our longest standing clients. This client made an astute observation that was very thought-provoking. He said: "You've changed."
When pressed to elaborate on how he felt we had changed, he said he was referring to our willingness over the last decade or more to buy stakes in companies that are not yet reporting operating profits based on Generally Accepted Accounting Principles (GAAP).
Almost immediately, the name Amazon came up in the conversation. Amazon provides an excellent example of a company that, for many years, was too busy taking market share and growing revenues, to worry about reporting bottom line earnings to investors.
We wished we had bought shares of Amazon many years ago. We couldn’t even begin to count how many times the company has been part of a heated argument at our bi-weekly investment meetings. We passed on Amazon for several reasons: after taking a close look at Amazon’s fundamental business and financial statements after the turn of the century, there were two primary reasons why we missed Amazon’s huge share price run. First, we believe, and still do, that retailing is a very difficult business in which to compete. In retail, management must be smart every single day. Empty shopping malls all over the nation suggest it has not been easy to survive in retail and to stay out in front of consumer trends. Running a retail operation remains, perhaps, the most complex management challenge we know of and when tough management conditions interact repeatedly with retail management teams, it is the tough management conditions that tend to prevail.
Second, Amazon shares always looked wildly expensive to us. Sometimes truly dynamic companies that “look” wildly expensive turn out to be big winners. Others will flounder when it turns out they were not truly dynamic after all. We are reminded of a couple of conversations we had with our favorite finance professor more than a decade ago. We pointed to Mastercard (and later Visa) as examples of dynamically superior businesses that we preferred to own. He passed on Mastercard and then passed again on Visa. When asked many years later if he had ever bought a stake in Mastercard or Visa, his response was, "No, I could never get past the high valuation. The price to earnings ratios just always looked too high for me."
Of course, both Mastercard and Visa shares have been sensational performers. We believe for many reasons that both companies have been dynamic since going public. We recall the income statement on Mastercard was a bit “muddy” back in 2006. The company was showing very little, if any, GAAP earnings per share at the time we purchased an initial stake for clients. As Mastercard emerged from its process of consolidating from private ownership by a consortium of banks to a public company, there were simply too many unique expenses offsetting reported income. We chose to ignore those expenses as being irrelevant to the larger picture. We thought Mastercard had the chance to be extraordinarily dynamic.
Although Mastercard has been a success, we have honed and modified our list of reasons for passing on companies to reflect what we have learned from both our successes and our failures. Over the last decade or so, we have decided that under certain circumstances, when we think we have a dynamic business with huge micro or macro-economic tailwinds as well as a talented management team, we will not pass simply because the shares “look expensive.” Instead, we will remain open to making an investment if sufficiently compelling factors are present that can help us see past the current shortfalls on an income statement. Specifically, if an income statement suggests that a dynamic company COULD BE PROFITABLE immediately, if management felt compelled to report net income right now but instead management chooses to invest aggressively to take additional market share in a growing market, we won’t disqualify it from consideration.
When considering investments, there are certain fundamental truths always at work when it comes to astute analysis of income statements. There are simply no short cuts. A one size fits all mindset simply won’t work as well as an adaptive mindset will. We remind ourselves regularly that NOT all earnings per share are created "equally,” and not all expense types are "equal" either. With mature companies, where management is required to make heavy capital expenditures, these outlays are not made with pre-tax dollars, and usually they do not assist the company with taking market share. Instead, they are required to simply hold a position in the marketplace. Generally speaking, spending heavily to hold your position does not produce superior returns.
Alternatively, exciting companies with disruptive products and services, can and do produce phenomenal residual values under certain circumstances. A good example of this is the Software as a Service or SaaS industry. As the digital age has proceeded virtually non-stop, we have made ourselves very familiar with the unique aspects of subscription-based software companies, particularly the nuances in accounting rules associated with the industry. Some of these admittedly complex rules have literally changed the calculus of profitability.
As we move to the second decade of the 21st Century, dynamic SaaS companies have the potential to be far more profitable than they appear at first or even second glance. This is true because truly exceptional subscription-based software companies are not only growing their customer bases, but are building truly valuable assets on their balance sheets. One of these assets is called a “deferred revenue balance.” The growth in deferred revenue, which can sometimes increase by a significant percentage every year, essentially builds revenues that will be recognized without substantial additional costs in the future. This is a classic example of engaging in a short-term sacrifice for long term gain; the balance of which is the ultimate challenge for today’s CEO as well as the ultimate reward for a successful investor.
And with that all being said, successful investing also involves admitting your failures and revisiting your “Amazons” frequently, no matter how heated the disagreement becomes. We continue to closely monitor the evolution of Amazon, its financial statements and its challenges along with many other dynamic companies. We are thankful that the digital age and the advent of 24 hour per day financial news broadcasts that have produced mountains of data and raw information through which investors must sift. It is in addressing the sifting process where proper conclusions must be drawn, and in that we are afforded the opportunity to enjoy the enormous abundance that dynamic companies can provide for patient shareholders.
Best wishes from our families to your family for a safe, happy, and healthy holiday season, and a prosperous second decade of the 21st Century.
Major Price Changes
October 01, 2019
Last week we received news that should reduce the cost of investing for our clients. In addition, thanks to these new efficiencies, we will be able to explore a broader array of sensible investment choices.
Charles Schwab, Inc. the stock brokerage custodian firm we chose to custody with long ago, has decided to slash equity-trading commissions to zero. This move by Schwab continues a trend in the industry of reducing transaction costs that has been ongoing for several decades.
Schwab continues to be an ultra-competitive stock brokerage firm. The company is very well capitalized and large. It provides custody services for $3.7 trillion in client assets.
Here is a brief history of Schwab’s role in the pricing wars in the brokerage industry:
1971: The firm became a broker/dealer.
1975: The SEC mandates negotiated commissions for all securities and Schwab opened a discount brokerage branch in Sacramento, California.
1996: Web trading on Schwab.com became available.
2006: Schwab introduced flat commissions of $12.95, down from a top tier of $19.95
2010: Schwab cut equity commissions to $8.95 from $12.95
2013: Schwab launched ETF OneSource, featuring commission-free ETF trades.
2017: Schwab cut equity commissions to $4.95 from $8.95.
2019: In early October, Schwab eliminated commissions for equity trades ETFs, and options.
Though we were surprised that the pricing on equity trades has now gone all the way to zero at Schwab (only for clients taking electronic delivery of confirmations and statements), this decision by Schwab is much more complex than it might seem. As is often the case with an announcement that something we used to pay for is now “free,” there is much more to this story than meets the eye in financial news media reports. One of the most basic principles we learned in our Economics courses is the acronym TINSTAAFL which stands for: There Is No Such Thing As A Free Lunch. In other words, Schwab is able to make up for this loss of transaction fees from other revenue sources.
Some background seems in order. When we left the traditional stock brokerage industry decades ago, we did so because we knew we could better serve our clients by performing the tedious task of negotiating with the brokerage industry on our client’s behalf, instead of straddling the competing interests of our clients and our brokerage firm. We have never for a moment regretted the decision to leave the traditional brokerage business, go independent and sit only on the client’s side of the table. Accordingly, since 1992, we have not been employees of any brokerage firm including Charles Schwab Inc.
Instead, our firm functions as the entity that coordinates processes at Schwab on behalf of our clients. We chose Charles Schwab long ago to be our custodian for many reasons. Those reasons continue to be affirmed and validated.
Still, the responsibility for navigating the ever-changing brokerage landscape including strategies Schwab employs to generate income from client accounts are ours. Many things we do daily as a matter of routine, are tedious details that may not be clear to most clients who have countless other things in their lives to keep track of.
There are other trends in place in addition to a reduction in trading costs that are related to falling trading costs. When trading costs fell from $8.95 to $4.95 in 2017, virtually all stock brokerage firms turned towards less transparent strategies to generate higher levels of net interest income on customer cash. While the trading cost reduction helped all of us save money on trades, the new and much less publicized rules related to managing cash require time consuming manual processes to earn market rates of return on cash. It is important to understand that at many traditional brokerage firms, most processes that help clients earn market rates of return on cash are either prohibited or frowned upon. While the headlines point out that pricing on stock trades is coming down, the financial news media is NOT doing much reporting on how much less convenient it is for customers to use money-market funds in brokerage sweep accounts. The reality is the stock brokerage industry, including Schwab, has eliminated money markets for sweep purposes. This means unless you or your non-brokerage money manager (Spence Asset Management, Inc.) is willing to take on the inconvenience of manual processing, the brokerage houses and not the customers, will earn the lion’s share of the market rate of interest on cash.
Another less transparent aspect of many stock brokerage firm’s revenue strategies is known as collecting “payment for order flow.” This revenue stream comes to brokerage firms when they sell their customer’s stock orders to market makers. Often market makers have ties to high frequency trading operations whose sole purpose is to take advantage of the information contained in purchased order flow. It is certainly an open debate as to whether this practice represents a conflict of interest. Conflicts of interest seem to continue to be the bugaboo facing all investors as they navigate the complex landscape known as stock brokerage firm profit strategies.
Again, as a matter of daily routine at Spence Asset Management, Inc. we assume the role of doing our very best to navigate the complex obstacles associated with obtaining “best price execution” on trades that are now “free.” We continue to be convinced that Schwab’s platform offers the strongest suites of tools and software packages in the Registered Investment Advisor industry as well as superior client service. And we are very happy that the trends in the stock brokerage game we identified in 1992 that caused us to alter our approach, seem to be continuing unabated.
With all of these trends in place, we believe it is very good news that Charles Schwab Inc. continues to choose to be a pricing leader in their industry. Their move to slash trading costs to zero affirms our confidence in choosing Schwab to provide custodial services for our clients and reminds us to be ever vigilant in understanding how our custodian is deriving its revenue.
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