First quarter 2021 letter

David MoonClient

April 1, 2021

Dear clients and fellow shareholders:

Only 13 months ago, the U.S. stock market was trading at all-time highs, unemployment was lower than economists once thought was possible, small business formation was at record levels and inflation was running at less than 2% annually.  We had just been introduced to the strangely self-contradictory term “social distancing.”  Most of us didn’t use the word “asymptomatic,” nor had we used “zoom” as a noun. Bernie Sanders appeared on his way to securing the Democratic nomination for president – which was irrelevant – because Donald Trump was a virtual lock for reelection.  And 550,000 Americans had not yet been killed by a new coronavirus disease.

While there were many unpredictable changes over the subsequent year, one thing has come full circle and has returned to its pre-pandemic state: the stock market is at all-time highs.

Not only has the market set new highs since the pandemic’s beginning, but Americans also managed to save a record $2.3 trillion in 2020. We Americans are notorious for many things, but saving money isn’t one of them. However, two (now three) rounds of coronavirus bonus checks, combined with fewer outlets for spending the money, resulted in a massive accumulation of aggregate wealth by the 130 million Americans fortunate enough not to have suffered pandemic-related job losses.

At the other extreme, almost 10 million Americans remain out of work, after peaking at 23.1 million less than a year ago.

In a year of pandemic and lockdown, how was there such a divergence of economic experiences? The New York Times published an article titled “Why Markets Boomed in a Year of Human Misery” that effectively explains the microeconomics of covid and pandemic relief. Rather than mildly plagiarize the newspaper, you can read the article at this link. The title of the Times piece is a bit misleading; there are reasons for the stock market’s performance that the article does not address. But the article does an outstanding job of analyzing those sectors and demographic segments that have suffered/enjoyed wildly divergent economic outcomes during the pandemic.

How high is too high?

Reaching all-time highs does not, by itself, create an overpriced stock market or valuation bubble. Over time, the economy grows, and all market highs are eventually broken.  In 1987 we had a client who refused to put money into stocks because the market was at (then) all-time highs. When the market collapsed in October of that year he was vindicated, but wanted to wait until the Dow Jones Industrial Average fully retreated to its “resistance level” of 1,000. Instead, the Dow finished the year just shy of 2,000, a level to which it has never returned. Similarly, one of these days the Dow will cross 33,000 and never return to that level again.

This, however, probably isn’t that day.

Algebraically, all stock price movement is explained either by earnings (actual or anticipated) and a multiple (P/E) applied to those earnings. Each of those two broad categories are influenced by a practically unlimited number of potential factors, all of which impact either earnings or the earnings multiple. Don’t be frightened or shift your entire retirement plan into bitcoin simply because of looming risks for the stock market; there are always looming risks for the stock market.

Earnings risk – tax code

Possible changes to the tax code fall into the “always looming risks” category, but we need to distinguish between potential changes that would affect us personally, versus those that would influence corporate earnings – and thus the overall level of stock values and prices.

If Congress passes increases in either personal income taxes or estate taxes, it will affect many of our clients, some substantially. But the effect would be very personal and specific to individuals – either themselves or their heirs.  If income tax rates are raised on families earning more than $400,000 or the estate tax exclusion amount is reduced from $23.4 million per married couple, it might have a significant impact on your cash flow, but it wouldn’t likely have any effect on the values of the assets in your investment portfolio.

However, an increase in the corporate tax rate could have significant negative effect on business earnings, especially in industries such as utilities, healthcare and banks. A change in earnings results in a corresponding change in the value of the business producing those earnings. This is true regardless of the cause of the change or its direction.  The corporate rate cut in 2017 produced a $95 billion increase in the 2018 after-tax earnings of the companies in the S&P 500, which resulted in an 18% increase in the index’s underlying value.

What Congress can give, Congress can take away.

A corporate tax increase would result in lower earnings – and lower stock valuations.  Analysts estimate that the current proposal to increase the top corporate rate from 21% to 28% (repealing approximately half of the 2017 cut) would reduce S&P 500 earnings somewhere between 10 and 13 percent.  The math is pretty straightforward: eliminating 10% of a company’s earnings also eliminates 10% of its value.

Valuation risk and interest rates

Given investor fascination with the daily noise of trying to predict the business cycle, elections, quarterly earnings reports, commodities prices and the Fed’s next move, it is easy for some people to overlook what has been the silent benefactor to stock prices over almost four decades: declining interest rates.

Since 1983 the S&P 500 has increased 2,300 percent. Increases in earnings only explain half of that 8.90% annual increase. The other half of the increase is due to a doubling of the S&P 500 P/E multiple from 12.4 to 25.3.

A P/E ratio is simply the algebraic reciprocal of an earnings yield – and like all yields, it reflects the cost of money. As the cost of money declines, the return on monetary assets increases. For common stocks, the cost of money is reflected in the earnings multiple investors collectively choose to assign to a company’s earnings.  For example, HCA’s P/E of 17 means that investors currently believe that each dollar of HCA earnings is worth $17.  At the other end of the scale is Tesla, which investors collectively value as worth $984 for each dollar of its 2020 earnings.  Collectively, investors currently believe that a dollar’s worth of S&P 500 earnings is worth $25, up from only $12 in 1983.

For most of our adult lives (and – for some of our clients – for all of their adult lives), we have become effectively numb to the day-to-day prospect of higher rates. With one exception, the few incidents of rate increases since 1983 have been both brief and quickly forgotten.  Intellectually we know that rates can’t decline indefinitely, although the emergence of negative interest rates in certain markets tempts us to believe that if rates ever increase it will be so far into the future as to be personally irrelevant to us.

Not only have declining interest rates helped propel 40 years of stock returns, but they have also more recently resulted in a massive shift of wealth from savers to borrowers (including everyone from leveraged home buyers to leveraged private equity firms.)  The current rate on a 30-year fixed rate conventional mortgage is only one percentage point greater than the average inflation rate over the past 30 years and a mere quarter of a point greater than the current inflation rate.

The real cost of a 30-year fixed mortgage has fallen from 8.2% in 1983 to only 0.25% today. (Real cost is the difference between the loan’s annual percentage rate and the then-current inflation rate.)  After adjusting for inflation and interest rates, monthly mortgage payments are now well below where they were in the late 1980s. In Denmark, rates on adjustable-rate home mortgages are actually negative, requiring banks to make monthly interest payments to borrowers. (Lest you get too excited at the prospect of negative rate mortgages coming to America, you should know that banks in parts of Europe now charge customers for holding their checking and savings account deposits.)

Pricing risk, not panicking

As depressing or scary as the preceding three pages may be, we are mindful that investing is never without risk of some type. Some periods may seem more risky than others, but it is often times of perceived low investment risk that lull investors into false sense of security. Just because something hasn’t occurred recently doesn’t mean that it can’t.  (Higher interest rates come to mind.)  Being mindful of exaggerated risks to business earnings and stock valuations simply informs the types of investments we find suitably priced for the always-present unknowns that we can never avoid.

To that end, we made some changes to our stock portfolio this quarter.

First American Financial (FAF)

We recently purchased shares of title insurer First American Financial.  First American is a leader in the title insurance and settlement services industry with 760 offices and 25% of the U.S. market share in the title business.  The title insurance and services segment provides title insurance, closing and escrow services and related services domestically and internationally in connection with residential and commercial real estate transactions.

At 11 times earnings, FAF trades at a discount both to its historic norm and the overall market.

The company’s revenue is generated in roughly equal amounts from two models: direct and agent.  Under the direct model, the policy is issued by a title insurer, the search is performed by or on behalf of the title insurer, and the premium is collected and retained by the title insurer.  Under the agency model, the search is performed by or on behalf of the agent; the agent then collects and retains a portion of the premium. The agent remits the remainder of the premium to the title insurer as compensation for the insurer bearing the risk of loss in the event a claim is made under the policy and for other services the insurer may provide.  Although there are thousands of title firms, these smaller companies do not have the actual capacity to issue insurance, and thus are not competitors.  For instance, a local Knoxville company such as Tennessee Valley Title writes First American policies.

First American is a particularly good business because it collects a royalty on real estate transactions through an essential service that represents a tiny portion of the underlying transaction cost.  On average, the company collects roughly $2,500 per order for its title services.  The service is split between purchase and refinance transactions, with the purchase fee per file roughly twice the cost of a refinance.  Commercial transactions, though representing a much smaller portion of the volume, generate revenue closer to $8,000 per order.

The title insurance offering should be considered more of a fee-based financial service rather than traditional insurance.  While the service offering is technically insurance, title insurance is not a very balance sheet intensive business compared to that of property or casualty insurance.  Loss ratios typically average in the mid-single digits vs. 50-60% in more traditional P&C lines.  The business is more of a process and diligence business than a typical insurance company.

Title insurance profits are driven by notional volumes of mortgage originations across both residential and commercial buildings, including both purchase and refinance transactions.  Last year saw a particularly robust market in the refinance sector (up 100% to 6.7 million loans), due to record low interest rates.  However, the revenue impact of the increased refinance volume was largely offset by the muted volume in the commercial space, which represents a far larger dollar value in terms of revenue per transaction.

First American Financial earned $6.16 per share in an extraordinary 2020.  After adjusting for 2020’s higher-than-average origination volume, normalized earnings are closer to $5 per share, suggesting our purchase price was made at roughly 11 times earnings.

Science Applications International Corp. (SAIC)

SAIC is a large, pure-play service provider to the U.S. government.  The company’s engineers and scientists work to solve complex technical problems in national/homeland security, energy, space, telecommunications, health care and logistics.  The U.S. government accounts for over 80% of revenue, with the U.S. military being a very significant contributor.  The company does not build hardware or develop technology, rather it works as contract labor to advise, install and integrate high-tech solutions.  SAIC refers to itself as a “technology integrator”, with its core function that of providing engineering and technical services to customers, including the Army and the Navy.

SAIC collaborates with competitors to bid on large contracts, while competing with them in other situations. Competitors include the engineering and technical services divisions of large defense contractors (General Dynamics, Northrop Grumman and Raytheon), contractors focused on technical and IT services (Booz Allen Hamilton, CACI International and Leidos Holdings), diversified companies that also provide U.S. government IT services (Accenture and IBM) and contractors that offer supply chain management and other logistics services (Agility Logistics Corporation and SupplyCore).

Contracts are typically awarded on a multiyear basis (ranging from three to ten years) with the bulk in the five-year category.  Renewal rates are 90% and contracts rarely cancel, creating an inherently predictable, sticky business.  While EBITDA margins are about 8-9%, the business requires very little in research and development and capital expenditures, leaving the majority of operating profits to be converted into free cash flow.  For this fiscal year, SAIC projects free cash flow between $430 and $470 million, roughly 10% of its market cap.  At current prices, SAIC is trading at 12 times forward earnings per share, versus peers that trade closer to 17 times.

American International Group (AIG)

Earlier this year, we sold our multi-year holding in American International Group.  AIG is a well-known global property and casualty (P&C) insurer paired with a U.S.-dominated life and retirement business.  At the time of our purchase, AIG was trading at a significant discount to its book value, improving its operating results, and repurchasing significant shares.  Unfortunately, after the death of the company’s legendary CEO Bob Benmosche, operating improvement stalled and the company’s goal of generating a consistent, double-digit return on equity never came to fruition.

While the results of the P&C business are inherently lumpy, AIG’s significant and repeated charges to it reserves have severely hampered returns and brought into question the credibility of its loss reserves.  AIG increased prior year reserves by $3.6 billion in the fourth quarter of 2015. Then followed that up with a fourth quarter 2016 reserve charge of $5.6 billion. This charge was announced in February 2017, one month after disclosing a large reserve risk transfer transaction with Berkshire Hathaway.   Record U.S. hurricane and wildfire losses of $4.2 billion in 2017 and $2.9 billion in 2018 also impaired results.  Decent results over certain periods and the trading price of AIG’s substantially discounted shares initially left us with the view that management’s progress may lead to brighter days ahead.  We were wrong.  Following last year’s continued underperformance in the P&C business, repeated reserve strengthening, and promises of still to come higher returns, we decided to redeploy capital into other opportunities.

An addition to the team

We are pleased to introduce our new Client Services Manager, Lisa Koscielny. Prior to coming to Knoxville, Lisa spent more than 15 years in New York working in the financial services industry, most recently as the Senior Director for Business Development and Investor Relations for a $3 billion value-oriented hedge fund. In that role she was responsible for all client service, communications and reporting for more than 75 of the firm’s largest investors. In addition to working for an investment management firm, Lisa spent three years on the other side of the table, researching and selecting third-party managers as Managing Director for a fund-of-funds advisory firm.

Lisa earned her MBA from Dartmouth’s Tuck School of Business and a B.S. in Information and Decision Systems (with University Honors) at Carnegie Mellon University. While at Carnegie Mellon, she was a regional Rhodes Scholar finalist and a member of the school’s first women’s varsity soccer team. Fluent in Polish, Lisa is the author of the book Journal of Exile, a look at her family’s quest for survival during the mass deportation of Poles to Siberia in the 1940s.

We (and you) are fortunate that Lisa has family in Knoxville and decided to flee the boredom of New York City for the bright lights and excitement of East Tennessee.

Moon Capital Management, April 1, 2021