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April 2021 Investment Commentary & Letter to Clients

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April 2021 Investment Commentary & Letter to Clients Investment Commentary & Letter to Clients April 2021 liveoakprivatewealth.com 1741 Tiburon Drive Wilmington, NC 28403 | P: (844) 469.5679 First Quarter Letter March 31, 2021 “The idea of projecting out extremely high growth rates for very, very long periods of time has caused investors to lose very, very large sums of money.” - Warren Buffett What a difference a year makes! In just 12 months, investors’ focus has shifted from the “fear of loss” to the “fear of missing out,” often referred to as FOMO. Let’s be honest, a year ago, nobody expected the markets to rip higher in the face of the pandemic, business shutdowns and uncertainty related to the November elections. Last year’s bear market was the shortest in history, lasting just 33 days. According to Yardeni Research, the median age of bear markets (going back to the 1920s) was 302 days. Over the years, we have discussed the dangers of market timing. To successfully time the markets, one has to be correct not only on when to exit the markets, but also must be correct on when to re-enter the markets. This is quite difficult to navigate, particularly when human emotions become involved. In the past quarter, all 11 economic sectors showed market gains with cyclicals leading the way. Market leaders during the first quarter were energy (+29.3%), financials (+15.4%) and industrials (11.0%). Market laggards were utilities (+1.9%) technology (+1.7%) and staples (+0.5%). As can be seen in the chart below, returns for the last 12 months are staggering, led by the small and mid-cap indexes. Bonds fell in the most recent quarter as the 10-year treasury yield increased by 83 basis points, driving long-term treasury bond prices down (-13.3%) and investment-grade corporate bond prices down by (-4.5%). During the quarter, there was a large rotation from growth to value and from large caps to small caps. Additionally, the Russell 1000 Value Index outpaced the Russell 1000 Growth Index by 10.4%, the biggest rotation to value since 2001. We believe this move can be attributed to expectations of a strong earnings rebound in the more cyclical (value) areas of the markets. During the most recent quarter and year, the S&P 500 equal-weight index has outperformed the S&P 500 Index by 5.4%, and 15.7%, respectively. This represents a distinct reversal in market internals, with the average stock actually faring better than the market capitalization-based S&P 500 Index. Market Statistics as of March 31, 2021 Index 2021 Trailing 12 months 1st Quarter Ending March 31, 2021 DJIA 8.3% 53.8% S&P 500 6.2% 56.4% S&P 500 (equal weight) 11.5% 71.6% S&P Mid Cap 13.5% 83.5% Russell 1000/Growth .9% 62.7% Russell 1000/Value 11.3% 56.1% Russell 2000 12.7% 94.8% NASDAQ Comp. 3.0% 73.4% As a sign of things getting better and just cause for the strength this quarter, during the first quarter, analysts increased earnings estimates for companies in the S&P 500. The Q1 bottom-up earnings per share estimate (which is an aggregation of the median Q1 estimates for all 500 companies in the index) increased by 6.0% ($39.86 from $37.61) during the quarter! This is a significant increase and is in contrast with the more typical estimate decreases. Looking at the last five years (20 quarters), the bottom-up EPS estimate has recorded an average decline of 4.2% during the quarter. Analysts have not only increased EPS estimates for the first quarter, but also the full year. The 2021 aggregation of the median estimates increased 5.0% to $175.75.1 It appears analysts were too pessimistic in their downward revisions to EPS estimates during the first half of last year. This, of course, was at the height of the virus shutdown. Late last year, analysts started raising estimates as overall economic activity started picking up. Rising commodity prices and interest rate increases appear to have played a role in the upward revision as well. Companies themselves are telegraphing more confidence as well in issuing positive EPS guidance for 2021. Portfolio Strategy Discussion Live Oak Private Wealth Growth Strategy COMMENTARY & THOUGHTS The internal framework surrounding our growth strategy relates to investing in growing companies at a reasonable price (GARP). We rely on checklists that are geared towards certain traits we are looking for in a successful investment. First on the checklist is the company must possess what we consider a competitive edge or structural advantage that is fueling the growth. It doesn’t have to be a rapidly growing early-stage business, but one that clearly has a runway for growth and is moving down the runway. Second is the price or value. We require a degree of cheapness in the company’s shares relative to its estimated growth. It is most important to not overestimate this growth or extrapolate it too far. Third on the list is our perception of quality. Much consideration is given to the financial health of the company’s balance sheet, the capital allocation skills and hopefully, aligned interests with management. Growth investing has captured the majority of attention and return over the last several years, especially in many technology businesses. What we consider our reasonable price discipline keeps us out of many high-flying, popular growth companies like Tesla or the many Software as a Service (SaaS) stocks, and SPACs. Many of these very popular growth stocks have been immensely profitable to those who speculated on these shares. Why don’t we own these popular and, so far, very lucrative stocks? Most importantly, because we are disciplined in what we pay for the expected or assumed growth in a company’s earnings. We remember the last time valuations for expected growth were priced at extreme levels, the year 2000. The math behind what 1 Source: Factset 3 you pay and what you end up getting does not work if the growth doesn’t continue exponentially. In 2000, many technology stocks were riding the dot.com wave of the internet. One such example was Sun Microsystems, which might be a worthy comparison to Tesla or the many SaaS stocks today. There is a famous quote by the CEO of Sun Microsystems, originally given to Businessweek in March 2002, just under two years after the dot.com bubble burst. This quote is now stored at Bloomberg since Businessweek was acquired by Bloomberg. In March of 2002, after Sun Microsystems had lost about 90% of its value, Scott McNealy, Sun Microsystems CEO, said these words: “…two years ago, we were selling at 10 times revenue when we were at $64. At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?” 10 times sales is a high price to pay for any business; perhaps only justifiable in companies with really high margins and incredible growth, but stocks trading at 10 times sales is just as often an indicator of market over ebullience. Ah...now 20 times revenues is the new 10 times revenues. Here is a small example of market darlings trading at 20 or more times trailing revenue. There are many more. Company Market Cap Multiple of Revenues Tesla $696 billion 25 x revenue Nvidia $332 billion 22 x revenue Shopify $137 billion 54 x revenue Source: Standard and Poors This growth end of the market is euphoric. A feature of late-stage bull markets and euphoria is the low-quality new issue market. There is a stage in the market cycle when masses of people trip over themselves to buy newly created shares at prices disconnected from reality. Wall Street salesmen will happily satisfy this demand. We have seen examples of this this quarter with low-quality new issues and there is some real garbage coming to market at dizzying valuations. First Quarter Portfolio Activity We made no changes to the GARP model portfolio during the first quarter. Trading activity was very light and only involved minor tweaks to a few positions. We missed our annual pilgrimage to Columbia University in New York this year for their investment conference. Fortunately, we participated virtually and came away feeling good about our portfolio positioning. We also participated virtually in the SHOOK Top Advisor Summit where we listened to many of the world’s top investment professionals debate various facets of the markets today. The balance of the quarter saw us attending many portfolio company presentations virtually and listening to a lot of conference calls. We felt content with our portfolio based on the most recent financial updates from management, even though several of our positions are fully valued, to say the least. Clearly you will see our “growthier” positions were weaker as their higher PE multiples were compressed by the change in interest rates this quarter.
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