“Investors are businessmen buying pieces of businesses, not traders buying stocks”-Warren Buffett
Being a fundamental investor in the current macro environment can seem naïve when there are so many unsettling situations around the world. Resurgent Islamic fundamentalists, Russia menacing the Ukraine, China threatening democracy in Hong Kong, and a stagnating European economy; why isn’t the stock market testing new lows? In this quarterly note, we’ll briefly outline the factors that we believe are supporting the equity markets and how we interpret the current environment.
Economic conditions in the United States continue to point towards a moderate recovery. The ISM composite index, a measure of business activity, indicates GDP growth of around 3%. Additionally, consumer income is expanding by 4.3% in nominal terms and 2.8% adjusting for inflation. Unemployment in the latest month declined to 5.9%, its lowest level since the financial crisis. Corporate earnings continue to increase moderately, although revenue growth remains challenging.
Economic recoveries don’t die of old age, but from imbalances that arise over time. In the late 1990’s a massive capital expenditure boom combined with the dot.com bubble eventually resulting in the bust of 2000. Our most recent crisis of 2008 was ignited by a debt-fueled housing bubble that spiraled into a broad financial crisis. Since 2009, stock prices have recovered from their lows, yet capital expenditures remain subdued and spending on consumer durables remains below past highs. New excesses have yet to emerge. When the Fed initiated its quantitative easing programs during the crisis some thought they would create a bubble. However, the Fed is now ending the QE programs as employment and business conditions have strengthened.
Low interest rates lessen the likelihood of a major correction in the equity markets. With the 10 year US Treasury yielding 2.34%, near historic lows, bonds provide little appeal beyond preservation of capital. When a bond is purchased the interest rate coupon remains the same until maturity so if inflation accelerates, it can result in a negative real rate of return. Equities, on the other hand, often pay dividends that can be increased as underlying earnings improve. When interest rates are low equities command a higher valuation, but we believe additional expansion of market multiples is limited. Further advances in the equity markets need to be supported by underlying earnings growth.
In the third quarter we made a few changes to the holdings in client accounts. We reduced our position in Celgene following a period of excellent stock performance. We sold our holdings in Dentsply, Iconix Brands, and PVH Corporation, and we added positions in Amphenol Corporation and Amazon.com. Dentsply was having difficulty generating revenue growth and losing share in the orthodontics market. Iconix Brands had doubled since we purchased it in 2012 and we felt it reflected a fair value for the business. PVH Corporation was sold because we were disappointed in its acquisition of Warnaco and felt it was time to move on. We bought shares in Amphenol, a manufacturer of electronics and connectors, to capitalize on growth in the wireless industry. We established an initial position in Amazon.com because the stock had fallen 18% year-to-date, and we believe the company has the ability to generate significant free cash flow as the online marketplace matures.
We remain fundamental investors, recognizing that the volatility in the equity markets is likely to increase due to global issues. When Warren Buffet was asked whether he considered geopolitical events when evaluating an investment he said no. He continued by saying that when he purchased a company his intent is to hold it through good and bad economic times, and at the end of the day the value of the company would be determined by how it performed throughout the cycle. We concur. We will continue to seek out the best companies we can find in order to generate solid results through good and bad economies and during periods of volatility we will have our shopping list ready.
Thank you for entrusting Ayrshire Capital Management with your money. We look forward to speaking with you over the coming quarter.
JM Sam Nevin, Jr.
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