We had a very good year in 2021. The markets continue to snap back from the COVID induced bear markets of 2020. Over the last three years our model account is up 30.36%, 20.39% and now 33.3% this year. As you know, those returns have not been linear. It’s not been a smooth ride. We are 100% convinced it won’t be a smooth ride over the next three years. Here are some of our thoughts about what might be next.
We have been big believers in inflation coming back. We wrote about that in our last letter so we don’t have a lot of new things to add. We do want to point out the chart below. We don’t think inflation is transitory as the Federal Reserve initially thought. The chart below points out how big a surge we have had in inflation this year. At our holiday party we noticed that lots of our clients were talking about inflation. This is new and worth noting. The Fed has doubled it’s balance sheet in the last 18 months. If that money starts to circulate through bank loans and housing speculation, we might see some big inflation numbers in the next two years.
When inflation kicks in, interest rates tend to rise. We are shocked that we just reported a 6% inflation rate and the 10-year government bond is yielding only 1.5%. We have not been government bond buyers for our clients in the last 10 years. We still don’t get why owning bonds are a better bet financially than owning stocks or commodities. We reserve the right to change our mind, but when you have inflation at 6%, short-term rates should be way higher than zero. Something has got to give. You can’t expect savers to have a net return of minus 6% after inflation and accept that forever.
We talk a lot about the markets in these letters because they are an area of intense interest to most investors. We want to elaborate a little more on that subject to discuss how we view owning individual stocks versus owning the broad markets (S&P 500, Russell 2000, etc). We view the stocks that we own as if they were corporate bonds. We think it’s easier to value an individual stock that way than it is to value the entire market. We then compare each individual stock to all the asset classes out there (particularly bonds and oil). How do you “make” a stock a bond for analysis purposes? The cash flow that a company earns may or may not be paid out to shareholders through dividends, but its there for the company to decide what to do with. It belongs to the shareholder whether they pay the cash out as a dividend or not. As an example, Lumen has over $3 billion of free cash flow this year. They paid out $1 billion of that money in dividends while also buying back $1 billion in stock. That left them with over a billion bucks to pay down debt. As we type this, the company’s stock is valued at $13 billion. If you take the $3 billion of free cash flow that Lumen produces and divide it by the total value of the stock you get a 23% yield if they paid it all out in a dividend. By doing that you can start the process of comparing a stock to a bond. If you did that with BGC Partners the yield would be 11%. With Berkshire it is around 10%. When you have those types of valuations with interest rates at zero or 1.5% on a 10-year bond, it makes it easier to decide what to own. The risk with owning stocks is that you get the cash flow estimates wrong. If Lumen only had free cash flow of $2 billion, the stock would still be cheap, but it would start to lose its margin of safety. Hence, you want something that pays way above the bond rate to compensate for the uncertainty of owning that stock. You must get the cash flow right over time or the investment is a mistake.
Our two best performing stocks over the last three years have been Tesla and Apple. As those stocks went up a lot, we started paring back the positions. Today the bond equivalent yield on Tesla is 1%. With Apple it’s about 4%. We think the markets “yield” is around 3%. When we first bought Apple’s stock, the yield the way we calculate it was 23%. In 2013 there were a lot of concerns about how viable Apple’s cash flow was going to be. Today there is not. As Apple’s or Tesla’s stock went up, our margin of safety went down, hence we sold some. We continue to hold those stocks in most of our accounts. If Apple and Tesla continue to grow earnings over the next five years, their stocks will do well, but that’s not a certainty. If they don’t, then we have to worry about what interest rates are doing when we compare the stock “bond” yield to the actual 10 year bond rate.
The S&P 500 made new highs in December. Why do some investors worry about breadth? What’s breadth? The S&P 500 is a market cap weighted index. Market cap simply means that Apple’s $3 trillion stock valuation (market cap) dwarfs the 500 th stock’s market cap in that index. Apple represents 6.927% of the index while Under Armour’s stock (number 500 in the index) represents .0086% of the index. If Under Armour’s stock was to go up 10 times in value next week while Apple’s stock only declined around 12%, the effect would be the same on the index. The S&P would be flat. What happens to Apple is more important than anything that happens to Under Armour by a large factor. We want to highlight that phenomenon by showing you two charts. The first chart is the S&P 500. Notice how it has been above its 200-day moving average all year. The second chart is the number of stocks that are in the S&P 500 that are above their 200-day moving average. As you can see, most stocks in the S+P 500 were above their moving averages until June. Now the majority are below it. You can’t tell that the market is “churning” from looking at the S&P chart because it is comfortably above its 200 day average. The reason for the divergence is that stocks like Apple/Google/Microsoft are still trending up and what they do dwarfs the bottom 450 of the S&P 500. This is what the stock market pundits mean by bad “breadth”. Only a few stocks are going up and the rest are not.
We point out these divergences to remind people that the indexes are a great way to see how the markets are doing. That said, because the S&P 500 is influenced by the largest stocks in the group, it can cause for a lot of distortion. Our last chart is of the Value Line composite. This chart does away with market caps and values ever stock as equal. The move in the smallest stock is equal to what Apple’s stock is doing. That index is up only 16% since the first quarter of 2018. If you were throwing a dart at a list of all of the stocks in the United States, this is what you would have most likely made. What is great for us is this is the group we are looking at. If they haven’t gone anywhere in three years, but their earnings have, this make us interested. We hope to find some new ones soon.
Our last stock purchase for clients this quarter was Transocean Drilling (Rig). This stock is a bet that fracking slows down in the U.S. and oil drilling moves offshore. We kept the size of the position to around 1% of your portfolios because this stock has more risk that our usual ones. Rig’s earnings are very sensitive to the price of oil. They price their offshore platforms to customers on what is called a day rate. This rate fluctuates a lot. If oil prices continue to climb, so will this rate. Most of the offshore drilling industry has been in severe financial distress. The largest of the drillers just emerged from bankruptcy. The industry is consolidating. We think there is a good chance Rig and the industry will have pricing power if oil prices stay where they are. If they go up, we should have fun owning this. If prices go down, so will their earnings and we hope we get consolidated. We don’t have as much earnings backing this stock up as we would like, so we kept the position small for now. We will keep you updated
Sincerely,
Mark Brueggemann IAR Kelly Smith IAR Brandon Robinson IAR