Is the Correction Over?

Even though the markets recovered somewhat on Friday, at the end it was another bad week with losses for the leading US market indexes. The S&P 500 shed 7.23% this month and was down more than 10% at some point. Does Friday’s recovery mean the correction is over? We don’t think that anybody actually knows for sure.

We always prefer a longer term view. The volatility within a few days or even weeks is not important. One of the two main benchmarks we use is the S&P 500. It has an average return over the last 10 years of 10.41% and a CAGR of 8.49%. Our US portfolio has outperformed this benchmark since we started this portfolio in January 2017. December 2017 and January 2018 produced excess returns of about 4% on a year-to-year basis. The number of data points is still too small. Perhaps we just got lucky and in future we won’t be able to produce an excess return. Only time will tell if the excess returns are sustainable.

Let’s have a look at how the setbacks in the last two weeks influence valuations. 

For example Apple (AAPL) is now available at a price/earnings (P/E) ratio of 15.94. Forward looking P/E ratio is 12.5. When we look at the average annualized total return for AAPL, its value is 19.72% over the last 5 years. They just announced their biggest quarterly profit of all times. Apple now has an installed base of 1.3 billion mobile devices and they add more each month. While a large portion of their revenue is generated by the iPhone, their service business is growing faster than the iPhone revenue. As a result the share of services is now 9% compared to 6% of revenues. There are indications that Apple Music may overtake Spotify in the US market as the largest music streaming provider. Since Apple started to pay a dividend they have increased their dividend each year. They are sitting on a large pile of cash. Now that they can repatriate that cash into the US at a much lower tax rate, more of it could be appropriated to buying back shares and increasing the dividend. This is not to say that they will actually do that. But there is definitely more wiggle room for it. All taken together, in our view this means that the “For Sale” sign went up on Apple stock. This might be a good buying opportunities either now or until the current correction has bottomed out.

Looking at dividend aristocrats, another group of shares that we really like, the picture in terms of valuations is improving as well. Before the recent market declines most of them had P/E ratios of over 20 or even 30. Some still do. But some now some have become available at P/E’s of less than 10. For example AT&T (Ticker symbol 'T') has a P/E ratio of just 7.74 as of writing. Yes, there are reasons to be cautious in their case. AT&T’s liabilities are at 71.85% of their total liabilities and equity in the latest quarter. Long-term debt is at 34.86%, so any increase of interest rates could impact their bottom line. On the other hand large mobile phone providers like T Mobile USA and Sprint have indicated that they will scale back their discounts throughout this year removing some price pressure. This should help AT&T as well. The pending acquisition of Time Warner is not approved yet and the settlement talks with the Department of Justice (DOJ) fell through in December 2017. The lawsuit continues and the outcome is far from clear. One option that AT&T could consider is a (partial) float of their DirectTV business to generate some cash. The upside for AT&T’s stock is that their dividend yield is a generous 5.33% and they being a dividend aristocrat they have increased their dividend for at least the last 25 years. While some of their decisions are risky, the sheer fact they are willing to make significant changes demonstrates that they are taking concrete steps to secure their future.

So, perhaps, it’s best to take comfort in the knowledge that in general buy-and-hold is a long-term strategy that has worked out for other long-term investors like Warren Buffett, provided you selected quality stock in the first place. Setbacks in the stock markets could be buying opportunities!

Happy investing!

Disclosure: We own shares of Apple and AT&T. We don't have a position in any of the other companies mentioned in this article. We have no plans to change our positions within the first 48 hours after publishing this post.

Worst Week since January 2016 for US Stock Markets

The Dow Jones fell 4.1% in the past week making it the worst week since January 2016. Friday alone, the Dow Jones fell 2.54%, the S&P 500 was lower by 2.12%.

We believe several factors are contributing to the significant change in the market and the correction may not be over just yet:

• P/E ratio very high compared to historical data
• Weak dollar increasing inflation
• Strong wages growth potentially increasing inflation
• Increasing yields, e.g. 10-year treasury yield
• Change in Fed leadership. Powell might change path compared to Yellen.
• Highest employment, lowest unemployment in decades, putting more upward pressure on wages

We’ll look at the P/E ratios in this post.

For quite some time we have been concerned about the P/E ratios of the stocks that are at the top of our list of favorites. Even though the P/E ratio is one of the factors that influences the content and order of our list of favorites, we cannot help but observe that quite a few of them have P/E ratios higher than 15 with some even higher than 30. For example Coca-Cola has a P/E ratio of 43.67 as of market close Friday. To some degree the P/E ratio expresses whether a given stock is seen as a premium stock by the market. For example Coca Cola are a dividend aristocrat. That plus other factor may potentially warrant a high valuation.

However, long term the average EPS growth needs to be equal or bigger than the P/E ratio. For example if the EPS growth is let’s say 20% and the P/E ratio is 15, then the stock might be worth a closer look. Obviously, if the outlook suggests that EPS growth slows down, then P/E ratios need to go down as well.

US companies had a fantastic run since 2008, with a total return including dividends of between 1.31% (2016) and 32.43% (in 2013) per year based on the S&P 500. For the last 5 years this amounts to a compound annual growth rate (CAGR) of +15.79%. For the last 10 years the CAGR is +8.49%, which includes the year 2008, the year of the Global Financial Crisis (GFC), dragging down the CAGR with a value of -37.22%. The index grew another 21.83% in 2017 including dividends. This indicates that the increase in valuation has accelerated. The graph illustrates this as well. This is not sustainable.

The question is, though: When does it come to an end? Since nobody can look into the future, nobody knows. It’s just a matter of time when the markets have to adjust to what is happening in the real economy. At the moment, despite the 4.1% drop this past week, we believe the market is still overvalued.

What does this mean? We don’t try to get the timing right. Instead we look at the long term picture. The S&P CAGR is 8.49% for the past 10 years, 9.92% for the past 15 years and 7.19% for the past 20 years. And we use a set of rules for managing our positions that are independent of market swings. As long as we manage to beat our benchmarks, the ups and downs of a particular day, month or year don’t matter.

Happy investing!

Disclosure: We own shares in Coca Cola and have no intention to change our position within 48 hours of publication of this post.

January 2018 Results

January was yet another good month for our US portfolio. It ended with +4.31%, making it the 15^th month in a row with a positive result. At a time the portfolio was almost up even more than the 4.31%. However, looking at how things have developed over the last few years it’s clear that this is not sustainable. Eventually the real economy has to catch up to what the markets do. And if that doesn’t happen or does not happen to the degree required, then the markets will have to adjust. A first taste were the two days with triple digit losses of the Dow Jones on 29 January and 30 January.

We believe that there are three main reasons the US markets made so much progress in January. Firstly, the tax reform helped a number of businesses to take a windfall. They opted for either buying back more shares, increasing the dividend or to pay a one-off bonus to their employees. Or a combination of these. Another factor was that some companies reported results that were better even if you exclude the change in the US tax rules. AbbVie (ABBV) is one such example. Finally, because the US dollar weakened compared to some currencies, US shares looked more attractive. For example the EUR was USD 1.2457 on 31 January 2018 compared to USD 1.0755 on 31 January 2018, a change of 15.8%. Taking this into account the increase of the S&P 500 over the same period (+23.91%) is still a very good value but doesn’t really look as impressive anymore.

As always let’s look at how our US portfolio performed compared to its benchmarks. The portfolio is up 27.87% year-to-year. In the same timeframe the S&P 500 is up 23.91%, so our portfolio is ahead by 3.96%. This figure is down from 4.31% last month, mainly because of how Procter & Gamble (PG), Johnson & Johnson (JNJ) and Atlassian (TEAM) performed. For all three we continue to be optimistic long-term.

Let’s look at another two benchmarks. One is the S&P 500 Dividend Aristocrats (SPDAUD) and the other ProShares S&P 500 Dividend Aristocrats ETF (NOBL). Using 31 December 2016 as 100%, our portfolio is 5.83% ahead of SPDAUD (+4.91% in December) and 6.25% ahead of NOBL (+5.18% in December) as of 31 January 2018.

Note that the S&P 500 had an annualized return over the last 10 years of about 6.93%, SPDAUD of 8.89% and NOBL of 13.89% (NOBL since inception 09 Oct 2013). Over the 12 months ending 31 January 2018 our US portfolio beat all three of these by at least 3.96%.

Please be aware that past results do not guarantee future results. Also, keep in mind that perhaps we were just lucky picking the rights stocks when we started this portfolio in January 2017. The early indicators suggest that choosing a good balance between about 70% to 90% of dividend aristocrats and 10% to 30% of hand-picked other stock might yield good results for the increased risk.

Happy investing!

Disclosure: We own shares of ABBV, TEAM, JNJ and PG. We have no plans to change our position in the next 48 hours after publication for any of the financial instruments mentioned in this post. S&P 500, ProShares, etc. are trademarks of their respective owners.

Results for PG, JNJ and ABBV

Three positions in our portfolio experienced significant price changes this week after their results was announced: Procter & Gamble, Johnson and Johnson (JNJ) and AbbVie (ABBV). Let’s look at each of them.

The Procter & Gamble Company (PG) announced quarterly results on Tuesday, 23 January 2018. Revenues grew for their 2^nd fiscal quarter, earnings increased by about 10% year-to-year and beat market expectations. Still, the stock price took a hit. Monday’s close was USD 91.88 and the price dropped to USD 89.02 at close of market on Tuesday, a change of -3.11%. Why is the stock price down while earnings beat expectations? Does it matter? To answer the first question, we believe that expectation were too high. In particular the slow revenue growth of about 2% in the period is still perceived as underwhelming as it barely keeps up with inflation if that. Also, margins continue to be under pressure in particular in their razor blade business (Gilette) where they compete with offerings like Dollar Shave Club. The baby diaper business (Pampers) was subject to aggressive price cutting as well to keep market share. We believe that PG needs to continue keeping their costs under control to be able to further reduce prices where otherwise the price difference to competitors would become too big. As to the second question, does it matter? We believe that PG has demonstrated for a long time that it is able to continuously improve revenue and earnings. They have increased their dividends every year for 61 years. We believe 2018 will not be different. Therefore the one day drop on 23 January is likely to be only “noise in the signal” and the currently somewhat lower prices might be an opportunity to add shares. We are keeping in mind, though that the P/E ratio of 22.6 is still very ambitious. As a long-term investor we don’t see a reason at the moment to change our position.

On 23 January, Johnson & Johnson (JNJ) was another company that reported their quarterly results. Here, too, earnings estimates were beaten and the stock took a hit: from USD 148.14 to USD 141.86, or -4.24%. Revenues for the quarter were up by about 11.5% (year to year) and earnings per share (EPS) were up by 10.1% (year to year). For fiscal 2018 the guidance is for sales growth to be between 5.4% and 6.4% and EPS growth between 9.6% and 12.3%. It appears that during the earnings call it became clear that organic growth would only be 2.5% to 3.5% which means that the remainder would need to come from acquisitions. This was interpreted as negative and caused the fall in stock price. JNJ has increased their dividend for 55 years in a row and we believe it will continue to do so in 2018 as well. With an expected EPS growth of about 10% there should be enough wiggle room for that.

Then on 26 Jan, before market open, AbbVie INC (ABBV) reported quarterly results. It was yet another strong quarter beating estimates for EPS and revenue. Earnings grew by about 23% year over year while revenues increased by about 13%. For 2018 AbbVie expects their effective tax rate to be about 9% as they repatriate overseas earnings at a lower tax cost. This will make it even easier to increase dividends and buy back shares. As a result the guidance for EPS for 2018 was increased from USD 6.37 to USD 6.57 to USD 7.33 to USD 7.43. The markets seemed to like this news and the stock price increased by 13.67% on Friday, 26 Jan.

We remain positive on all three: PG, JNJ and ABBV. However, we highlighted the swings – minus 3.11%, minus 4.24%, plus 13.67% - to demonstrate that within just a week, prices can fluctuate wildly, even for more conservative shares. Increasing diversification and taking a long-term view are two factors that help mitigate wild swings.

Disclosure: We own shares in PG, JNJ and ABBV. We have no plans to change our position within the next 48 hours from publication.

Atlassian Remains Promising Investment

In a different life we have been using products of Atlassian Corporation Plc (TEAM) for many years. When they went IPO in December 2015 we jumped at the opportunity to own shares of them.

Initially we didn’t get the timing right (who does?). We bought some shares at USD 30.79 in December 2015 only to see the price drop over the subsequent months. So in June 2016 we bought more at a price of USD 24.90 to improve the average costs per share. This worked out nicely and in August 2016 we sold just enough shares so that the amount equaled what we paid for our second buy. As a result we had an unrealized gain (+111% as of writing).

We continue to be very positive about Atlassian. Their most recent quarterly results, published after market on 18 January 2018. Revenues for the quarter were up by 43% year-over-year. Free cash flow improved by over 50%. The earnings per share (EPS) were heavily influenced by the tax reform in the US. Because of a write-down of their deferred tax assets they took a one-time charge of USD 47.3 million for the quarter. This charge is non-cash. Without one-off charges their EPS would have been USD 0.13 compared to USD 0.09 in the same quarter one year ago.

Despite these very good results, the market didn’t like them and as a result next day, on 19 January, the share price declined by 5.29%. We believe this is exaggerated. Long term we believe that TEAM’s share price will continue to improve along with their revenues and earnings.

We still use their products. And we still like them and are happy to recommend them. It appears as if other companies agree. TEAM’s long-term liabilities are USD 8 million. Capital expenditures in the quarter were USD 4.5 million. The free cash flow was USD 72.3 million which easily covers both. Stock holders equity is 69.6% of Total liabilities and equities. This ratio is very healthy.

While their IFRS result for the quarter is still negative we believe that their success story will continue. We don’t expect the switch to a new CFO will have a negative impact.

Bottom line: We believe that TEAM continues to be a very good investment opportunity and therefore we will hold on to this position long term. We may consider selling some of the position if their share in our portfolio becomes too large.

TEAM as of 20 Jan 2018: USD 53.07

Disclosure: We own shares of TEAM. We have no plans to change this position in the next 48 hours.

Keeping Costs Low

It’s quiet at the moment in our portfolio, and that’s how we like it. Only the brokers benefit from buying and selling, in other words frequent trading. We prefer to keep our money instead of making others rich.

Even with low cost brokers you incur maybe USD 3.00 of transaction fees. If you trade too often this adds up. We endeavor to keep our cost at no more than 0.04% of assets value. Vanguard charges this amount for their S&P 500 index fund (VTI). In 2017, our costs were greater than 0.04% of assets as we had restricted our portfolio at the beginning of the year. For 2018 we are planning a ratio of better than 0.04% given available information.

There is no need to throw money at funds who charge you a management fee of 1% or more of assets. Even if they can prove they beat the index, e.g. S&P 500, every year for 10 years or more, there is absolutely no guarantee they will do so in the future. Also, when you look at their performance, always make sure you compare it after all fees, charges and tax.

Our last trades wer in December 2017 when we sold some Apple shares (AAPL) and added Genuine Parts (GPC) instead. We sold Apple as it had a very good run over the last year, so we realized some of the gains. We kept some of the Apple stock as we continue to be optimistic about the company.

We added GPC for several reasons. Firstly, they have increased their dividend each year for over 25 years. With the additional value the number of holdings increased to 29 positions further reducing the risk associate with any particular stock. Of those that we have on our buying list GPC was the cheapest one in terms of price/earnings (P/E) ratio.

Mental note: Pick stocks that you intend to keep for a very long time as in “forever”, in other words: You have no intention of ever selling the entire position. At best you may sell some to realize a gain or by more to get a better average cost per share. Then sit back and wait. 

Happy investing!

Disclosure: We own shares of AAPL and GPC.

“A Rising Tide Lifts All The Boats”

“A Rising Tide Lifts All The Boats” – With US stock markets smashing one record after the other this saying most certainly applied to a lot of investments this year. Therefore we won’t point out the performance of our portfolio which is about +23.7% in the twelve months ending 31 Dec 2017. We believe that it is more important to highlight how well our portfolio performed compared to relevant benchmarks. But let’s start at the beginning.

We’ve been investing in the US stock market for many years. Results back then were mixed, so we decided to do something about it with the objective to reduce risk and volatility while improving performance. As a first step we sought a set of principles in support of this. The result was a very most substantial change in the structure of our portfolio. Our portfolio now features a majority of value stocks “spiced up” with a small number of high growth companies.

Our aim was to achieve a performance that would be as close to the S&P 500 as possible. We picked the S&P 500 because we believe it is a good representation of the overall US stock market. Also, historic data suggest that the long-term compound annual growth rate is about 8.5%. With +19.42% the S&P 500 had an excellent run in 2017.

As a result this means that for this time frame our portfolio has tracked 4.31% ahead of the S&P 500 at 31 Dec 2017. We do not expect this to be the norm as there is obviously the possibility that we just got lucky with our choice of companies. In other years our selection might have fared worse. The following graph compares the performance of our portfolio compared to the S&P 500 and selected ETFs, indexed with 31 December 2016 being 100%.

Based our research we know that historically the value stocks in our portfolio have performed better than the S&P 500 by about 2 percentage points. Combined with the small number of growth stocks, we believe that our portfolio should be performing at least in line with the S&P 500 in the future as well. Obviously, past returns are not guarantee for future returns.

At the same time we keep the costs low. Firstly we are working with a broker who charges us very low fees. More importantly, we avoid feeds altogether by using a buy-and-hold strategy. We rarely sell shares. The turn-over in the portfolio is low. We believe that frequent selling and selling only enriches the broker. We do not attempt to time the market.

We believe that everybody is entitled to a decent investment result, even though, on average, all market participants as an aggregate will have a result that is identical to the market performance (minus trading costs!). As our portfolio started to match the S&P 500 performance we began considering how we could make our approach available to a wider audience. This blog is the first step towards it. Stay tuned for more to come.

Happy investing!

Note: While the quote “A rising tide lifts all the boats” is frequently attributed to John F. Kennedy, his speech writer Ted Sorensen revealed that he got it from the regional chamber of commerce, the New England Council. Source