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Unsustainable Leadership

By Justin McNichols, CFA
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Investing in U.S. equities has been frustrating for most investors over the past few years.  After an above average 2014, U.S. stocks have been generally flat for the last 18 months.  Although the recent flat market action has been frustrating, two other characteristics of the domestic equities market have been even more exasperating.  These characteristics are first, a market led by only a few industries or sectors, and second, a market alternatingly led by low quality companies then obscenely expensive companies.  To show what we mean, let’s review the last two years of domestic equities.

2014 was a solid, above average performance year for the S&P 500.  However, markets were led by a very narrow group of low quality and high valuation stocks.  In 2014, the top performing sector was utilities, (up 25%), a sector with 5% earnings long-term growth, very high debt, and a Price/Earnings ratio near 20.  The top two performing industries were airlines (massive debt and   extreme cyclicality) and biotechs (exorbitant valuation).  A manager with a discipline that focuses on high quality, balance sheets and valuation most likely owned none of these.

Next in 2015, returns were negative for the year with seven days remaining.  Thanks to a quick end of year rally and dividends, the S&P 500 posted a 1% return.  2015 was similarly frustrating for any manager with a valuation or quality discipline.  The ten largest companies, sporting an average P/E of over 50, were generally the most successful investments.  In fact, excluding these ten companies, the remaining S&P 490 was down about 4% for 2015.  The result was a year when many of the most famous equity managers and hedge funds posted returns of negative 10%, 20%, and even 30% when valuation no longer mattered.

Since the investment characteristics of reasonable valuation, strong balance sheets and high quality growing businesses are rarely out of favor for long, 2016 was supposed to be the year when normalcy returned, and having an actual discipline would provide performance upside.  Once again, when the volatile first quarter of 2016 ended, only the slowest growing, high valuation and low quality sectors performed well.  The combination of utilities, telecom services, and consumer staples, which as a trio grow earnings at 6%, trade at a P/E above 21, and have a debt-to-capital ratio of over 50%, were cumulatively up 10% for the first quarter. This essentially means the rest of the S&P 500 was down 2%.

Additionally, investing in small companies since the end of 2013 actually exposed investors to an even worse experience than owning large caps.  At the end of 2013, the consensus was nearly unanimous that small-cap stocks would outperform.  The rest of the world was weakening economically, and the probability of a stronger dollar was increasing.  Small-caps were an obvious choice since the majority of their revenue was derived from the U.S., meaning they did not have to worry as much about weak non-U.S. economies or a strong dollar.  Yet, investors who piled into small-caps at the end of 2013 have earned a return of approximately 0% over the last two and one-quarter years (nine quarters).

As a firm that has always used a methodical discipline focused on buying higher quality companies, with strong balance sheets; trading below average historic valuations, watching highly levered, slow growing companies trading at record valuations lead the market is certainly frustrating.  Clients who joined our firm over the last few years due to our strong long-term track record, disciplined approach and performance in flat to down markets, are probably frustrated as well with our recent slight underperformance in the domestic equities asset class.  However, fundamentals, quality and valuation eventually matter in the long-term.  This means inevitably utilities, telecom and consumer staples won’t trade at P/Es above 20 for long, and the GoPro, Yelp, FitBit, Shake Shack, Valeant-types find their true (far lower) valuation.

Until rationality returns, one variable never changes: OPCM’s commitment to owning high quality companies, with strong balance sheets, trading at valuations that provide lower risk and provide an attractive risk/reward profile.


Justin McNichols, CFA

Justin McNichols, CFA

Justin is the Chief Investment Officer for OPCM, and has over 25 years of experience. Justin is a member of the OPCM Investment Management Team, and became a principal of the firm in 2000. Justin is a member of CFA Society San Francisco and CFA Institute. Justin received a Bachelor of Arts degree in Economics in three years and a M.B.A. in Finance from the University of California at Irvine. Additionally, he is a CFA Charterholder.
The opinions expressed herein are strictly those of Osborne Partners Capital Management, LLC ("OPCM") as of the date of the material and is subject to change. None of the data presented herein constitutes a recommendation or solicitation to invest in any particular investment strategy and should not be relied upon in making an investment decision. There is no guarantee that the investment strategies presented herein will work under all market conditions and investors should evaluate their ability to invest for the long-term. Each investor should select asset classes for investment based on his/her own goals, time horizon and risk tolerance. The information contained in this report is for informational purposes only and should not be deemed investment advice. Although information has been obtained from and is based upon sources OPCM believes to be reliable, we do not guarantee its accuracy and the information may be incomplete or condensed. Past performance is not indicative of future results. Inherent in any investment is the possibility of loss.