May 2018 Result: 1.35% Active Return TTM

The results for May 2018 again yielded in a return better than the S&P 500 in the trailing 12 months (TTM). The active return of our US portfolio was 1.35%. While this is still a good result – we beat both of our two benchmarks - the active return has been decreasing since February. We believe this is mainly caused by the fact that our US portfolio contains to a large degree of dividend aristocrats. With most investors buying dividend aristocrats for their dividends, when the actual interest rates increase dividend aristocrats tend to under-perform the broader market.

This effect is further amplified with the strong job report on Friday, 01 June 2018 for the US labor market. US businesses created 223,000 new nonfarm jobs and the rate of unemployment decreased to an 18-year low at 3.8%. At the same time pressure to increase wages suggests that businesses increasingly compete to keep existing and attract new employees. This upward pressure may require the Federal Reserve to move faster and more substantially in order to keep inflation at bay.

The increases in interest rates are reflected in different ways. The yield on 10-year treasury notes has increased to about 2.9%, the highest since December 2013. The yield on 3-month treasury bills is at about 1.89%, the highest since the GFC in 2008/2009. We can also see this in the dividend yield of our US portfolio which is at about 2.29%. This, too, is the highest since Dec 2013.

We expect our portfolio to not perform as well as the S&P 500 until the interest rates stops increasing. When that will be and by how much the interest rates will be answered in the future. Regardless of this we believe that the dividend aristocrats in our portfolio will continue to increase their dividends by about 5% to 8% per year. This should put some safety cushion under their market value. The other positions in our portfolio represent companies with very strong positions in their respective markets and a fantastic growth trajectory in each case. In combination, we believe that our US portfolio will continue to do well in the long run.

Happy investing!

April 2018 Result: 2.41% Active Return TTM

April 2018 was yet another month where our US portfolio performed better than the S&P 500 in the trailing twelve month period (TTM). This time it was 2.41% which is noticeable lower than for the 12-month periods ending in Dec 2017 and Jan, Feb and March 2018. With raising interest rates dividend aristocrat behave a little bit more bond-like, that is as the interest rates go up the share prices will have some downward pressure. As a result the dividend yield for the dividend aristocrats tends to move somewhat in parallel with the yield on interest-free investments like for example the 3-months US treasury bills in the secondary market. Our US portfolio has allocated about 80% of its funds to dividend aristocrats at the moment.

We have previously discussed the rising interest rates. We continue to believe that these represent the biggest threat to gains in the share market for the time being. Unless the US Federal Reserve indicates that interest rates have reached the desired level, we believe the rising interest rates will continue to put downward pressure on share prices.

Taking a much longer timeframe such as 10 years or more, history tells us that interest rates fall and rise. After each rise there was a fall in the past. After each fall there was a rise. At the moment we are in a longer period where interest rates are trending up. At some point this will come to a halt. Nobody knows yet when that will be as it would require to predict the future.

If you buy shares with the intention to keep them indefinitely the current share prices doesn’t really matter at all. All that matters is what you think the earnings are doing which in turn feed dividend payments. Companies like Stanley Black & Decker (SWK) have paid dividends for 140 years and have increased their dividend each year for 50 consecutive years. It looks as if at least for SWK the ups and downs of the interest rate over the last 50 years didn’t really matter when it came to increasing the dividend. It just was more each year. We don’t expect this to change any time soon for SWK but also for a few more positions we have in our US portfolio.

Obviously we like a higher active return over a lower. Still, we are happy with 2.41% over the S&P 500 over the last 12 months. We are also prepared that until the interest rates in the US stop rising our portfolio may not return as much as in scenarios where the interest rates are flat or even falling. We’ll see. We cannot predict the future either.

Happy investing!

March 2018 Results: 4.09% Active Return TTM

The US stock markets had a negative quarter with declines of -2.49% for the Dow Jones and -1.22% for the S&P 500. The NASDAQ was hit in February and March as well but was able to hold on to year-to-date gains of +2.32%. The NASDAQ benefitted from a 7.36% gain in January.

How did the Optarix US portfolio do in this time frame? Year-to-date it’s down by -1.17% so did better than Dow Jones and more importantly better than our benchmark the S&P 500. Compared to end of March 2018, the S&P 500 is up +11.77% while the Optarix portfolio is up +15.86% given our portfolio and active return of +4.09% over the trailing twelve months (TTM). The S&P 500 gained about 7.89% per years over the last decade. If our active return would have been 4% of that time period, our portfolio would have made about +11.9% per year, and that would have been after tax.

The graph shows the active returns for the twelve months periods ending in Dec 2017, Jan 2018, Feb 2018 and Mar 2018. On average the active return was +4.36%. Any data we have from periods before Dec 2017 is not meaningful as our investment strategy change from about mid of 2016 to Feb 2017.

Of course, past results are never a guarantee for future results. Perhaps we were just lucky with our particular investment style. On the other hand we believe that our reasoning is plausible and this has so far been confirmed by the data. We typically invest about 80% to 90% in companies that have a track record of delivering increasing earnings per share (EPS) and/or increasing dividends, and combine that with 10% to 20% growth stocks that we believe have a proven business model with substantial growth. Frequently this will be well-established high-tech companies.

Obviously we look at other factors as well. For example we believe that if a company pays dividends, the payout ratio should not be too high. We prefer companies with a payout ratio of less than 50%. We also look at figures like the debt level and free cash flow. Typically we review our position in companies as soon as they become the target of an acquisition. With a buyer in the picture we think this brings with it a lot of speculation around the stock price. Sometimes it is just a rumor that doesn’t materialize. At other times the deal will fall through. We certainly will always do some research about the potential acquirer. Fundamentally, we are more interested in long-term potential than short term trading gains. Generally we follow a buy-and-hold strategy.

We have mentioned in earlier posts that we believe the increasing interest rates in the US represent a risk to the stock market. We continue to believe that the climbing interest rates will put at least a damper on stock prices. Perhaps what happened in the first quarter of 2018 was just an early taste of how much more negative things in the next quarters. We believe that the stock market is still a bit overvalued, so are not holding our breath that we’ll see another 20% or so gain in the S&P 500 in 2018. We are happy to be proven wrong, though.

Happy Investing!

US Interest Rates Are Rising

Over many years investing in shares benefitted from falling and low interest rates. The yield on 3-Month Treasury Bonds was between 0% and 0.2% from January 2010 to about September 2015. From then it started to increase moderately, then faster. As of market close on 02 March 2018 this number is 1.63%. This still appears to be a small number but the diagram shows how this actually does indicate a sharp rise in short term interest rates. The yield on 3-Month Treasury Bills is often used as the reference for the yield of a risk-free investment. There is a general opinion that the likelihood of the US government to default is close to zero for a three-month time frame.

Another metric worth monitoring is the yield on 10 Years US Treasury Notes. These have been falling until about March 2016. Since then they have been moving up as well with the latest number being 2.862% (as of market close 02 March 2018).

Why is this important? Yields increase as the price for bonds and bills decrease. For investors it means that as the yield on investments with a lower risk increases, they either pull out money from investments with higher risks or they need the investments with higher risks to create a higher return. Shares are generally considered to be an investment option with a higher risk than T-bills or government bonds. Given that the US share markets have enjoyed gains of almost 20% in 2017, their valuations have now reached lofty levels. Rising interest rates will put pressure on shares prices as gradually more investors will tend to sell shares and invest in lower risk assets.

So far, some companies have been able to stem the tide somewhat in that they have raised dividends and share buybacks. Both are ways to return money to shareholders. The total return, being the combination of share price increases plus dividend payments and other distributions (e.g. stock splits), improves. However, this works only so far. Some of the dividends are special one-off dividends. And even though the tax reform in the US helps companies to reduce their tax bill, the amount of interest they have to pay increases. The low interest rates over many years was a big incentive to take on more debt in the balance sheets. As the interest rates increase, this can backfire and offset the gains from reduced tax payments.

Also, some companies experienced windfall profits as they need set aside less reserves for future tax obligations. Some have opted to give their employees a pay increase which also increases the cost base.

And then there is the Federal Reserve. It is expected that they will continue to increase the interest this year. Most commentators seem to expect three or four increases in 2018. We don’t know yet by how much. In any case they have several reasons to increase the interest rates. Inflation is picking up and this is driven by several factors including the low rate of unemployment in the US driving wages up and also the weak dollar that drives up prices on everything that needs to be imported. And that is even before tariffs are imposed, tariffs currently known (steel and aluminium) and potential future ones. Even the “most American” of cars consists of at least 50% parts that are imported.

Inflation, the weak dollar and tariffs are potential topics for future posts, so we won’t go into further details here. Suffice to say, interest rates are more likely to continue to rise than they are to stay flat, let alone fall. And this is likely to be a factor for the time being that puts a downward pressure on the US share markets.

We believe, though, that our Optarix US Portfolio is in a good position to do as well as its benchmarks if not better. Stay tuned and observe how all of this will play out. It’s exciting times!

Happy investing!