The recovery from the Financial Crisis of 2007-2009 has been marked by two extraordinary characteristics. The first is that economic growth in the US and throughout the world has been extremely slow. Gross Domestic Product has not grown at a rate above 3% during any year and has averaged 2.1% since the recession ended in the second quarter of 2009. The second characteristic is that the recovery has lasted a very long time. So far, the current expansion has been in effect for almost eight years and is the third longest growth streak since 1930.
One reason for the slow growth/long lasting nature of the recovery is that this recovery follows a major credit contraction. Home values plummeted and banks and other financial institutions pulled back incredible amounts of credit. Banks were fragile and these institutions needed to reduce lending and protect their own balance sheets. The second reason for the slow recovery is that the workforce is growing slowly and there has been no great innovation such as the Internet which has boosted productivity.
During the first few months after the presidential election, interest rates rose significantly and the stock market surged. The conventional wisdom assumed that the Trump administration and the Republican Congress would enact aggressive tax cuts and regulatory reforms that would cause a spike in economic activity and earnings. Beginning in March, the market’s momentum stalled especially after the Congress could not change the Affordable Care Act. The market now appears to discount the likelihood of grand legislative changes. We believe that coming agendas and reforms will be more incremental than sweeping given the checks and balances inherent in our system.
In March, the Federal Reserve also increased short-term interest rates 0.25% for the third time in the last year and one-half. We expect this pattern to continue, but again, at a slow pace given that the economy is not close to over-heating. Savers and fixed income investors are now able to obtain slightly more competitive rates, but yields are not high enough to threaten stock market valuations.
While the US has grown very slowly, the rest of the developed world has stagnated since the Financial Crisis. However, Europe seems as though its malaise is ending. European Union factory activity just touched a six-year high in March. European banks were weaker than ours and their regulators less decisive in clearing bad loans from the books. Since growth on the Continent has picked up, it appears that added demand will help further global expansion.
Given each of these factors, we expect continued growth in the US and the world at a pace similar to the averages since the recession. Earnings growth will also continue as corporations continue to invest, consolidate and cut costs to grow their bottom lines. Stock valuations are higher than they were earlier in the recovery, but are not out of line relative to bond yields which are still historically low.
Even though we believe that the global economy and corporate earnings are not growing quickly in the aggregate, the pace of change within various industries is accelerating. For example, Amazon has irrevocably changed retail in the United States. Every retailer, including behemoths such as Wal-Mart and the large grocery chains, must address the Amazon challenge or literally face rapid extinction.
Clayton Christensen, Harvard Business School professor, coined the term Disruptive Innovation whereby simple applications that serve the lower end of the market rapidly displace competitors throughout the whole market. Christensen’s thesis is that many current solutions in the market are too complicated to meet consumers’ needs and therefore are displaced by simpler/less costly solutions that better address those needs. This process is rampant and influences many of our investment decisions.
We hold every position in client portfolios because we believe that our portfolio of companies is fundamentally more valuable than the prices attached to them by the market. However, our valuation is not stagnant; we are constantly stress testing our investment ideas to make sure that the competitive landscape has not changed. If we believe the underlying market can be disrupted to the detriment of a stock in our portfolio, we will sell that holding immediately to preserve capital. Proceeds from these sales are often redeployed into investments which are more insulated from potential disruption. While we try to limit turnover in accounts to reduce tax and brokerage expenses, vigilant management is necessary to grow and preserve assets in the current environment.
Disruption in Telecommunications and Banking
The investment industry often makes a distinction between “bottom-up” investing versus “macro” investing. We are bottoms-up investors—we search for individual companies with attributes we’ve identified as linked to both competitive advantages as well as relative outperformance over time. We focus most of our research efforts on the individual company, its business, its management— rather than a “top-down” approach where investors form a bias for a particular sector or economic factor and then gain broad exposure to it with less regard for the individual securities chosen.
However, disruption is accelerating in a number of different industries such that old assumptions regarding what looks attractive at the individual company level, must be continually reassessed. One such example is bricks-and-mortar retail such as Macy’s or Best Buy suffering at the hands of an on-line purchasing shift to Amazon. The shift from traditional server-based computing and data storage to cloud is another example where an older and more expensive solution is being rapidly erased.
Within telecom, the advent of the Internet and digital wireless technology has slowly erased the majority of landline (wired) telephone service and has changed the game for Verizon and AT&T. Wifi provides free voice service (Skype, Apple Facetime etc.) and many are content with only a smartphone. Verizon and AT&T long ago saw this writing on the wall, and smartly invested billions in developing networks and brands in wireless voice and data, and then subsequently, in distributing video (Fios, U verse, Dish). For a period of several years, life was good, as wireless subscribers grew and average revenue per user also rose along with wireless data consumption. The companies gained reputations as share leaders and premium quality providers and churn remained low. The growth in wireless masked the decline of the traditional landline telephone business.
Despite this expansion of services, Verizon’s and AT&T’s basic “distributor” model never changed— they invested billions in their networks and in their brand in order to ensure they maintained a scale advantage. The problem: technology is making distribution simpler and cheaper. It’s also narrowing the gap in network quality with the smaller national players—Sprint and TMobile. The main point of differentiation today? Answer: Price. For national wireless service, four credible providers exist. Several years ago there were only (truly) two. Everyone is in a race to the bottom on ‘unlimited’ voice/data. Verizon tried to roll its unlimited data offering back recently, but reversed course when others did not follow. AT&T just announced free HBO service as part of its unlimited data package.
Video/TV programming is also being disrupted—as it can now be had on an a la carte basis for $4.99-8.99/month through a host of vendors—Netflix, CBS All Access or Google’s You Tube—rather than through traditional cable at $100+/mo. This change in the way video/TV is consumed has proven a major headache for media distribution businesses that rely on advertising attached to a large package of channels every subscriber must take. Solution? Answer: own the content as well as its distribution. This is where AT&T’s attempted acquisition of Time Warner is headed—but the acquisition says something about the disruption in the distribution model.
Another example of where there is technological disruption towards ‘simpler/cheaper’ is in U.S. banking—except here it’s creating a cushion to offset profit headwinds. Post 2008/2009, US bank profits have been challenged by regulation and tighter availability of credit. The offset has been a sea change in a major area of cost: the bank branch. Rapid growth in mobile and digital banking transactions has reduced the amount of activity that occurs at a physical branch. Many large banks such as Citibank and Capital One are shuttering 12-15% of their branch network over a 2-3 year period. This trend has had a positive impact on cash flow and earnings at a number of our bank holdings. While there will always be some need for banking clients to interact with a live person (1m people a day still walk into a Bank of America branch) the advent of software programs that simulate human interaction through texts and voice (think Amazon’s Alexa or Google Home) will become much more widespread in 2017/2018 as the industry creates solutions that replicate many activities previously conducted in person. As in other industries, innovation is driving cost a lot lower and convenience higher for both provider and customer, but also changing the rules of who wins and who loses.
Smart Beta: Wall Street's New Suite of Products
Large investment banks and financial services companies have also experienced radical changes in their business models due to disruptive changes. As trading commissions depreciate rapidly (most large brokerage firms reduced their commission rates to $7 or less per trade), Wall Street has scrambled to find new profit centers. The latest sales efforts have focused on a relatively new group of Exchange Traded Funds (ETFs) referred to as Smart Beta or Factor-based investing.
At the most basic level, there are two types of investing, passive and active. A passive investment strategy involves buying a product which tracks a specific index, such as the S&P 500. An active investment strategy attempts to out-perform an index by selecting only some of the stocks in the index, stocks that aren’t in the index, and/or weighting the stocks within the index differently. Eagle Ridge uses an active investment strategy.
A hybrid version, called Smart Beta, has become much more popular over the last few years. This type of product uses a set of pre-determined rules to deviate from a straight market cap weighted index. It may have the same companies as the S&P 500, but with slightly different weights. The term beta is used because beta is a measure of risk. A beta of 1.0 when compared to the S&P 500 implies the portfolio will have the same level of risk as the S&P. The portfolio and the S&P 500 will move up and down in concert. A beta greater than 1.0 is more risky, less than 1.0 is less risky.
These products attempt to allocate risk intelligently, thus the “smart” part, by weighting portfolios to investment factors such as value, momentum, quality, volatility and size. Academic studies use these factors to broadly explain investment performance. For example, in some years “value” stocks do well and in others “momentum” stocks do well, and if a portfolio is tilted towards the given factor, it should out-perform the broader index.
Smart beta products, due to their rules based approach, are backward looking. This prevents them from truly replicating our style as our research allows us to be forward focused. If a company’s margins erode, its high returns on capital become low. A product that invests in the top 100 companies in the S&P 500 when ranked by return on capital over the last 12 months will not evaluate whether those margins will continue. Our research would evaluate that possibility and adjust accordingly- in this case, by not buying the stock. The products are also somewhat arbitrary in how they define the factors. For example, measuring momentum based on the last 11 months of performance, instead of 12 or maybe 6.
Certain Smart Beta ETFs can play a role in well-constructed portfolio of stocks and/or funds. However, there is also the potential for these investments to amplify potential risks that may not be present in more traditional investment portfolios. Smart Beta ETFs, as with any strategy that is promoted by Wall Street, require close scrutiny which focuses on the fundamentals such as diversification and risk profile.