LBW Commentary Q1 2019
How LBW Sees It
Last quarter we addressed our concern about the potential for more volatility entering into 2019. We witnessed volatility - it just happened to be positive, not negative. For example, in Q1 of 2019, the S&P 500 TR was up 13.65%, the Russell 3000® increased by 14%, while the MSCI World ex USA returned 10.60%. A stark contrast from the almost 20% correction we witnessed in the back half of 2018. What in the world happened?
In the back half of 2018, there were multiple events at play driving the markets lower. Rumors were flying about the next recession, the current administration's policies, trade wars, etc. However, the one piece of news that ruled them all was the Federal Reserve (“Fed”), their policy adjustments, and their outlook going forward on the economy. As economic data was released, it showed the U.S. continued to be on solid footing. However, as we have stated multiple times, the good news was actually bad news. The strong economic outlook meant it was time for the Fed to start tightening the U.S. monetary policy by increasing the federal funds rate and aggressively selling bonds to the open market. The thought of losing the easy money the economy has been accustomed to over the past decade led markets to fear for the next recession. And even though the Great Recession happened over 10 years ago, its lingering impact pushed the markets to the edge of a bear market.
Going into Q1 the Fed’s projections for the U.S. economy began to slow. The Fed stated, “In the medium term, real GDP growth in 2019 was forecast to be at a rate above the staff’s estimate of potential output growth, step down to the growth rate of potential output next year and then slow further to a pace below potential output growth in 2021.” Furthering this view of the economy slowing in the near future, the Fed decided to hold the federal funds rate at their target level of 2.25% to 2.5% and not increase it for the time being. This news jump-started the markets and it began to push asset prices out of their slump. In addition, company earnings were once again strong, the administration seemed to be getting the trade war with China moving in a positive direction, and the government shut down eventually ended. All of these factors changed market sentiment driving the markets close to the levels we saw prior to the downswing discussed earlier. Furthermore, many of the larger Wall Street institutions are promoting a neutral allocation position. Said differently, they don’t feel one should be overweight or underweight in any one part of the world, but should still be fully invested. One may conclude that even the big boys aren’t sure where the next win will be, but they sure won’t miss out on the ride.
Going forward, we anticipate continued volatility in the markets. The U.S. has been on an upward trajectory for some time and we are most likely in the late stages of a business cycle. However, we are not going to place our bets on trying to anticipate if we are or are not entering into a recession in the coming months or even years. Instead, we will focus on the businesses we follow and do our best to buy them at prices where we feel we have a sufficient margin of safety. As we always state, we will take into consideration macro factors; however, we will not allow them to dictate how we invest. The volatility we anticipate in the coming months or years will allow us to find opportunities which are currently hidden due to elevated prices. We will welcome the opportunity and fall back on our due diligence and research to grab securities we have wanted for some time.
Nathaniel’s Beautiful Mind
We Don’t Understand
We get asked all the time about certain companies such as Netflix, Amazon, and Google. We have nothing against them – they are outstanding companies if one were to review their stock price returns and company results. That said, we don’t own any of them because we either don’t understand them or we don’t know what they’re going to look like ten years from now.
We don't buy the market, we buy individual companies. We believe that buying a stock is buying ownership in a company – it's not a piece of paper to trade whenever the mood suits you. We have a framework and we stick to it. We utilize the four filters we've talked about so often (we don't stick to them stringently; they're meant to be flexible). These filters are:
Understand what the company does
The company must have a sustainable competitive advantage also known as a "moat"
Management must show evidence of intelligent capital allocation and trustworthiness
Buy at a discount (we like to say buy with a "Margin of Safety")
The first filter is perhaps the most important. We often ask our clients if they would invest in something they don't understand. They always answer with "no," and we feel the same way. The second filter kind of works in tandem with the first. Understanding if the company has a moat or not really isn't that difficult. We can figure that out from a host of metrics, principally Return on Invested Capital and Incremental Returns on Invested Capital. The hard part is if we can figure out if there will be a moat in ten years or not. If we can determine that the moat will be there, even if it shrinks or increases as company moats tend to do as time goes on, that's when you can move past the filter (again, the filters are not set in stone). The reason for this is as follows: even if you have a deteriorating moat, if it's not deteriorating too fast, will still be present in ten years or more, and the price is right, you may have a good investment on your hands.
We apply our framework in ways that may be different from other investors. This is principally due to all investors having different circles of competence. Our circle of competence lies in companies that are categorized within the industries of media, telecom, and software and typically have an owner-operator at the helm or a controlling shareholder behind the scenes pulling the strings. If we come across companies outside of these circles, we typically pass on them because we will either be unable to understand what they do or we won’t know what their moat will look like ten years from now. One of the most important qualities an investor should have is understanding where the perimeter of their competence lies and not trespassing across it.
It’s not that we’ve stopped learning and refuse to adapt to new companies and industries. Rather, we’re continually expanding our circle of competence. Sometimes it may take a while to wrap our heads around a new concept. It is only when a company passes our process will we consider investing in it, and we will do so at an appropriate discount because the risk of permanent capital loss is too real of a risk to jeopardize losing our clients’ savings.
 LBW Wealth Management, sourced from: http://us.spindices.com/indices/equity/sp-500
 LBW Wealth Management, sourced from: https://www.ftse.com/Analytics/Factsheets/temp/7994c0fc-90fe-471e-8168-a22bf7f2a922.pdf
 LBW Wealth Management, sourced from: https://www.msci.com/documents/10199/99459e68-5e21-4888-ace6-72a3ffe9b1ab