Client Letter 3Q 2019
This was a pretty volatile quarter we just went through. The broad stock market managed to eke out a new all-time high in late July before plunging 6% in just over a week. This plunge was driven by two things – a reaction to the Federal Reserve indicating that more future rate cuts were not a sure thing and a surprise increase in tariffs on Chinese goods.
Our current economy is still growing albeit very slowly at this point. We are already on a downward track as GDP growth – the measure of all output in our economy – has fallen from just over 3% in the first quarter to just over 2% in the second quarter and is expected to fall below 2% in the third quarter of the year. Mind you, a slowing economy does not necessarily mean “recession”, but when you throw additional, unplanned tariffs onto an economy that is already slowing you are setting the stage to make things worse rather than better for the economy. For there to be a recession we would need to go backwards with negative growth instead of just slowing growth.
All of this uncertainty has led to a market that is trapped in a range with a lot of volatility. Investors find themselves responding to tweets and headlines with no clear direction. Everyone is hoping for a trade resolution, and no one is seriously expecting a trade resolution. What is an investor to do then? If you hold stocks and stock mutual funds you risk losses should trade talks completely break down. If you don’t hold stocks and stock mutual fund you risk losing out on serious gains should we somehow end up with a trade deal. Neither prospect is satisfying. In the end, the best thing seems to be to ‘stay the course’.
Over the past quarter many of the stocks and mutual funds we have in client accounts did reasonably well. The Janus Henderson Balanced (ticker: JABAX) was up 2.60% for the quarter while the Janus Henderson Multi-Sector Income, the core bond fund we are using, was up 1.73% for the period. Among stocks – and we are still buying some individual stocks when the opportunity is right – Seaspan Corp (ticker: SSW) was up 9.70% for the quarter, Dick’s Sporting Goods (ticker: DKS) gained 18.32%, while our star holding Meritage Homes Corp. (ticker: MTH) gained a stellar 37.03% for the three months.
Not all came up roses, though. We did have several holdings that detracted from performance. The biggest losses for the quarter were from Compania Cervecerias Unidas (ticker: CCU), a Chilean brewer which fell about 21.5% before we sold at the end of August, while Warrior Met Coal (ticker: HCC) was off 17.87% when we sold it at the beginning of August. The worst performer was a specialty mutual fund that we hold in a few client accounts. The AdvisorShares Trust Pure Cannabis ETF (ticker: YOLO) fell 35.58% for the quarter. While the cannabis space would seem to be one that offers up a lot of promise we are probably much too early here. We are likely to exit this position sooner rather than later though it is one that we will keep on our radar.
Overall, I am moderately pleased with how the quarter turned out. I am still “tweaking” client account allocations and constantly looking to improve upon our holdings. Most of the changes that I have made or will make are largely adjustments to current holdings – adding to or subtracting from in order to adjust the amount of risk in a portfolio. While I am generally satisfied with our current lineup of funds and securities, I am always researching new ideas and funds. If I find a fund that offers better returns with similar levels of risk or similar returns with less risk, I am likely to make a change to our holdings.
Speaking of securities, in my last quarterly report I indicated that I was primarily moving to mutual funds across client accounts. This seemed to worry a few clients who were afraid I was going to sell every individual stock holding and move everything into mutual funds. Let me clarify this for you. If we currently have good, solid stock holdings there is no need to sell them. Second, while I am primarily moving to mutual funds this does not mean that I am giving up completely on individual securities. We have continued to do well with individual stock picks. There are two key reasons that I will add mutual funds to client accounts. One is to gain exposure to areas that are more difficult to access or research, and the other is to invest excess cash in order to earn a more reasonable return and hopefully improve long-term performance.
We did add new positions to client accounts this past quarter. We added a position in Manulife Financial Corp (ticker: MFC), and we wanted to add a position in tech company Sanmina Corp (ticker: SANM) but chose to use an option strategy instead. We obligated ourselves to purchase shares of Sanmina at $29 per share – about $2 below where the stock was priced when we entered our strategy. In exchange for taking on this obligation, we collected a premium. This premium paid us almost 1.5% on the amount of money we are risking over the 39 days until the option expires. This is a very nice return for such a short time period, so we win no matter what. We either buy the stock for a lower price or we keep this “interest” on the money we are risking. We also added a very special situation in a few smaller client accounts. We purchased shares of Parker Drilling (ticker: PKD) across a few accounts largely because the special situation limited us to buying fewer than 100 shares per account. The company is wanting to de-list from the stock exchange. In order to do so they are buying out shareholders who own less than 100 shares (what is known in the business as an “odd lot”) and will offer $30 per share to these shareholders. We paid around $21 per share and now we await the time to sell the shares back to the company and collect our profits.
As I write this letter, the U.S. and China have come to a trade agreement. From all indications, the agreement is relatively weak. China is agreeing to ramp up their purchases of agricultural products and the U.S. will not raise tariffs in October as planned. The biggest and most important elements that need to be addressed such intellectual property rights seem to be off the table for the moment. Markets have reacted positively to this news of a “trade deal”, but the key thing to keep in mind is that tariffs are still in place and no real progress has been made on the biggest trade issues. I remain a bit skeptical of the efficacy and success of this trade deal especially given that there is no timeline to end the current tariffs. There is only a tentative agreement not to increase tariffs in mid-October as originally planned. Further, there was no mention made of the tariffs that are scheduled to be implemented in December.
Given the weak trade deal and the continued weakness in sentiment I am still in the camp that says a recession is possible next year. It is certainly not guaranteed, and I do not wish for it, but I am prepared for it to happen. In the interim I am keeping clients invested in stocks even with the sometimes-increased volatility that can drive us all nuts. Should we continue to get partial trade deals that resolve some of the bigger issues, markets will continue higher. Should we instead inch towards a recession markets will fall. If that happens, I will adjust portfolios by cutting back on stock holdings and increasing bond investments. We can probably expect a lot of froth in the markets but little in the way of major gains or losses. This is completely frustrating, but it can create some opportunities. Much like the Sanmina Corp. trade I mentioned above, I will be strategically using options a bit more. The strategies, though, will lean to the conservative side. For example, I sold options against our shares of Dick’s Sporting Goods that obligated us to sell shares at a set price and we collected a premium for that. In fact, I have done this on four separate occasions, and we have collected about 3.68% of the price we originally paid for our DKS shares in premiums. Normally, I am not fond of these types of trades as it can limit the amount of profits we could potentially collect. However, I am convinced that we likely have more downside risk than upside potential, so these transactions have a better chance of being profitable for us. You are likely to see more transactions like this to boost cash and improve performance a bit.
As always, we truly appreciate the trust you have placed in us, and the opportunity you have given us to manage a portion of your assets. If you have any questions or need to discuss any issues, please feel free to give us a call.
Alan R. Myers, CFA
President / Senior Portfolio Manager
Aerie Capital Management, LLC
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