2021 Q4 client and investor letter

David MoonUncategorized

January 2022

Dear clients and fellow shareholders:

By almost every broad measure, 2021 was a great year for investors. All major U.S. stock indices increased more than 20 percent, finishing the year at all-time highs. Our stock portfolio performed even better (up approximately 30 percent, excluding cash and bonds), despite not owning the ridiculously priced tech stocks that always seem to grab headlines.

We enjoy those types of returns at least as much as anyone else, but not to the point of ignoring the components that generated those returns. Not all price increases are created equal – and some are more vulnerable to reversal than others. Only half of the market’s return in the past two years is the result of an increase in the earnings of the underlying businesses. (We looked at two years of earnings and stock price increases to avoid using the 2020 shutdown year as a beginning point for comparison.) The other half of the market’s return was due to an increase in the P/E ratio from 24 to 30 – that is, inflation.

Financial asset inflation 

In the same way that $5 trillion in borrowed Treasury stimulus payments is a contributor to an increase in consumer prices, so does an additional $5 trillion in newly created Federal Reserve assets contribute to an increase in the prices of financial assets. If you needed any convincing that the Fed’s unprecedented bond buying program is supporting both bond and stock prices, look at the market’s reaction to any hint that the Fed is about to end or even taper the program. The most recent example came on January 5 when the Fed released the minutes from its December policy meeting, revealing that officials discussed shrinking its $8.7 trillion investment portfolio to combat rising consumer inflation and a tight labor market.

Stock and bond prices immediately reacted. The Nasdaq Composite dropped 3.3 percent, the S&P 500 fell 1.9 percent, the Dow Jones Industrial Average declined 1.1 percent and government bond yields rose to their highest levels since the beginning of the pandemic. (Lest you think that cryptocurrencies offer some type of magic protection against Federal Reserve policy actions, Bitcoin declined 6.5 percent that day.)

The old Wall Street adage, “never fight the Fed,” is clearly applicable when the central bank is flooding the markets with newly created cash. It is also a fair warning for when the Fed begins withdrawing that money from the markets. The problem, however, is one of degree. There is no historic precedent for the Federal Reserve to reduce an investment portfolio of this size.

Consumer price inflation

The causes of rising consumer prices are obvious, although experts can disagree about the relative importance of each factor. Restarting the world’s production is much more difficult and time-consuming than was shutting it down in March 2020.

Manufacturers continue to struggle to meet consumer demand – not just because of the difficulty in returning to 2019 levels of production, but also because of the increased consumer demand resulting from $5 trillion in Covid-related “stimulus” funds and a shift from travel/entertainment to consumer durable and non-durable expenditures. The much-discussed supply chain disruptions are just one of several macro difficulties resulting from trying to reverse the shutdown.

There is often a short-term self-fulfilling prophesy component to group dynamics, which explains why policymakers sometimes (regularly?) resort to virtuous lies in hopes of shaping public actions. If Treasury Secretary Janet Yellen and Fed Chair Jerome Powell actually believed that consumer inflation was transitory, they were likely about the only two relatively informed observers to hold that view. A more generous possible explanation for the year’s worst economic forecast is that Powell and Yellen were trying to prevent a self-fulfilling narrative that higher and persistent inflation was a given – something that would almost certainly fuel inflation expectations and thus potentially worsen the inflation problem.

Whether or not inflation will be persistent largely depends on the actions of the Federal Reserve, Treasury and elected officials. But we can almost guarantee that reported inflation will be higher – at least for the foreseeable future.

Expect higher reported inflation

The November 6.8 percent reported inflation figure is clearly understated, at least as it relates to housing. Housing is the largest single expenditure for most people, so it is logically the largest component of the CPI calculation, comprising a 33 percent weighting of the index.

However, according to any source other than the Bureau of Labor Statistics (BLS), the annual cost of owner-occupied or rental housing has increased much more than 3.5 percent or 3.0 percent, the figures the BLS used to determine the official inflation rate. Even if none of the 1,200 economists working for the BLS have access to The Google, it seems reasonable that they might at least have access to the U.S. Census Bureau reports indicating that rent and median house prices increased 19 percent and 16 percent in the past 12 months.

The BLS observation, calculation or estimation process appears deeply flawed – or, at least, is designed to estimate something other than reality. The BLS housing price methodology is so convoluted that officials can almost make the figure be anything they’d like it to be – at least for a while. As lease terms expire and more home sales are recorded, the housing component of the CPI will drive the official inflation figure higher.

How much higher? If the BLS had used a more plausible housing inflation rate of 15 percent, (rather than the bizarre 3.0 to 3.5 percent figures it actually used), reported inflation in the past year would have been 12.9 percent, almost eclipsing the all-time high of 13.5 percent in 1979.

Implications

Unlike the spike in yields during the inflation of the late 1970s, interest rates have yet to react to the declining purchasing power of the dollar. The Fed’s bond purchases have done more to decrease interest rates. than the Treasury’s stimulus spending has caused rates to increase. (The Fed’s bond purchases have also resulted in higher price-to-earnings ratios, since the reciprocal of a P/E is E/P, which is simply an earnings yield – that is, a type of interest rate.)

As inflation approaches seven percent, the Federal Reserve’s multi-trillion bond buying program has kept 10-year Treasury yields hovering around 1.5 percent. Historically, 10-year Treasuries have traded at a 200-basis point premium to the annualized consumer price index. If interest rates were to adjust to that historical norm, the yield on 10-year Treasury would be approaching nine percent.

It is not pleasant to think how most stocks would respond with rates at nine percent.

The easiest path to high stock returns over the past several years has been to buy the most speculative, least profitable companies and ride the wave of retail euphoria. However, certain signs are beginning to suggest that this route may be leading investors off a cliff. As interest rates inevitably follow inflation upward, the negative implications for future cash flows fall disproportionately on the very companies the market has bid up the most (money-losing “story stocks” whose profits are expected many years in the future). Some investors are beginning to take notice. As Bloomberg recently highlighted, despite a market still hovering near all-time highs, more than 40 percent of Nasdaq stocks are down 50 percent or more from their one-year peaks.

At present, it appears that investors collectively believe at least one of the following:

  1. They can identify the point at which interest rates are about to rise and will liquidate stocks (particularly overpriced ones) before rates begin to increase.
  2. Interest rates and prices no longer have any bearing on valuations.
  3. Interest rates aren’t going to increase.

We know Number 1 and 2 are incorrect. And we highly doubt that Number 3 will happen.

Higher interest rates can affect stock investments in two primary ways, neither of which are positive, at least not in the short-term. Higher rates result in a greater cost of capital, which is reflected in lower P/E ratios. When money is cheap and alternatives are unattractive, investors are willing to pay a higher price for a dollar’s worth of corporate earnings. The reverse happens as interest rates increase. Investors are willing to pay less for a dollar’s worth of earnings.

Higher rates also result in increased interest expense for businesses forced to borrow or refinance maturing debt. Increased interest expense results in lower net income. Lower net income, combined with lower P/E ratios, will make clear the difference between speculating and investing.

We can’t insulate ourselves from the immediate emotional market reaction to higher interest rates, but we can avoid businesses that are priced such that they are especially vulnerable to an overall contraction in market P/E ratios. And we can avoid businesses whose earnings will suffer from higher rates because they rely on constantly borrowed funds for operations.

With those goals in mind, there were a few late-year changes we made in our stock portfolio.

Purchase of GoDaddy

We recently purchased shares in GoDaddy (GDDY), a leading online software provider that helps small and medium businesses create, manage and market an online presence. We view GoDaddy as an overlooked compounder with a business model that benefits from the continuing shift to the digital online economy.

GoDaddy’s business produces high recurring revenue, high margins and strong free cash flow. It also requires relatively little capital to grow. Free cash flow is growing in the high teens and its already attractive margins continue to increase. The business is also recession resistant, given the predictable, highly recurring nature of revenues. (More than 85 percent of its revenue is considered recurring.) Despite its attractive financial profile, the shares trade at 13 times free cash flow, a large discount to a majority of its software peers.

The company recognizes this discount, as it repurchased seven percent of its outstanding shares in the past two years.

The most high-profile of GoDaddy’s business segments is domain registration – a market it dominates. Its 37 percent market share of .com domain registration is equal to that of the next ten largest companies combined. Godaddy’s size gives it a low-cost competitive advantage and enables it to pass on low prices to customers. As the leading domain registrar, the company can cross-sell all sorts of web services, including web hosting, marketing, online stores and other applications. The company’s combination of size and brand strength allows it to be a one-stop shop for small and medium businesses looking to manage an online presence.

Since its 2015 initial public offering (IPO), GoDaddy has demonstrated its ability to grow organically in a reliable fashion – 17 percent annual revenue growth, driven by 9 percent growth in customers and 7 percent growth in average revenue per unit. More impressively, GoDaddy grew free cash faster than revenues (25 percent annually), as it expanded margins by 600 basis points, even as it invested in new product developments and marketing.

GoDaddy is trading near its all-time low free cash multiple and at its lowest P/E relative to the S&P 500 since becoming a public company. We expect cash flow to continue to increase and for the shares to revert to a more appropriate multiple of 16. And even if the shares never trade near market multiples, we own a business whose value is increasing 15 percent annually, based on earnings and cash flow growth.

At present, we estimate that the shares are worth $100 per share.

Purchase of Fiserv

Fiserv (FISV) is one of the world’s leading third-party payment processors. You have likely never heard of the company, but it serves as a key backbone to the banking and payments industry – facilitating payments and the movement of money for businesses and financial institutions around the world. Through its various joint ventures, Fiserv serves as the processor for roughly half of the top 10 U.S. merchant banks (known as acquirers), which control more than 75 percent of annual credit, charge and debit card volume. Additionally, the company owns the fast-growing Clover point-of-sale system, one of two market leaders (along with Square) in this segment.

Fiserv also operates something called a payment network rail. Payment rails are the backbone to all digital transfers of money and are some of the best businesses in the world, producing high-margin royalties on people spending money. The two most well-known payment rails are VISA and Mastercard, pure play payment rail companies that trade at more than 30 times earnings. Fiserv, meanwhile, trades at a mid-teens multiple and offers similar exposure to the growth of the payment networks.

Although Fiserv is often viewed as less sexy than pure plays such as Visa or Mastercard, the equity at current prices provides one of the most attractive ways to benefit from the secular trends occurring in electronic payments. The company’s financial algorithm of high single-digit revenue growth, combined with operating margin expansion and share repurchase has allowed Fiserv to compound its earnings at 16 percent annually over the last four years. Next year, the company should earn roughly $6.40 per share, leaving the equity trading at around 16 times forward earnings.

With the potential to compound earnings at high-teens for the next five years, a mid-teens P/E represents excellent value, especially when compared to comps in the payments industry. Despite having to manage through a global pandemic, both the amount and pace of synergy realization from its 2019 acquisition of First Data are exceeding initial forecasts and should continue to drive operating margin improvement over the next several years.

There is also significant incremental value from its Clover subsidiary that is not currently being captured in Fiserv’s valuation. Over time, we expect the market to assign credit to Fiserv for this value, as the embedded growth potential of Clover will become increasingly obvious.

We believe the company is one of the most recession-resistant plays in the financial space, having generated 34 consecutive years of double-digit EPS growth. If we assume the shares trade at a more reasonable multiple of 20 times earnings, Fiserv’s is worth closer to $150 per share, or 45 percent higher than the current share price.

Liquidation of Alibaba

We recently liquidated our position in Alibaba (BABA). It was a rare short-term holding period for us, producing a painful 40 percent loss over the seven months we owned it. (The stock has continued to trade lower since our sale in November.)

We made our initial purchase in April 2021 following a Chinese government regulatory crackdown on internet companies that triggered the worst sell-off for Chinese stocks since 2018. Part of our initial thesis was that those regulatory moves would not materially impact Alibaba over the longer-term. Over the course of the year, the incremental evidence began to suggest otherwise. While we continue to view Alibaba as a great business, we are not at all comfortable with subcontracting our capital to the Chinese government to treat as its own. These and other changes, combined with the change in tone in the way the Beijing government seems to view Western investors, were enough to make us take our losses.

SK Telecom distribution

You may have noticed that in late December, the share price of SK Telecom (SKM) dropped about $19 a share, from $48 to about $29. The market value of our investment did not decline 40 percent. That $19 share price decline reflected a $19.25 cash distribution (akin to a special dividend) we received from the company, related to SKM spinning off its subsidiary SK Square. Since we own SKM via its American Depository Receipts (ADRs) and the company has not registered ADRs for the new spinoff, we received the $19.25 cash distribution in lieu of shares in the new company.

Money market fund change

We also changed our preferred cash management/money market fund in the fourth quarter. Pre-pandemic, we used the Schwab Value Advantage Money Market Fund, as it had the best yield among Schwab’s taxable money market funds. Because of concerns about potential redemption limits in the Value Advantage fund, in March 2020 we switched to a fund that did not have the authority to limit redemptions (the Schwab Treasury Money Market Fund.) This fund had a lower yield, but at the time it was impossible to rule out the possibility that a liquidity crunch or panic might cause Schwab to invoke the redemption limit provisions.

We continued to use the Treasury fund until last month.

The yields on both the Value Advantage and the Treasury money market funds are now essentially equal to that of the most liquid cash option, Schwab cash. Since there is no longer a yield benefit of owning either of those funds, we have switched Schwab cash.

We hope that you and your family are having a great, safe and healthy start to 2022. Please let any of us at MCM know if you have questions or if there is anything we can do for you.