“You can observe a lot by just watching”-Yogi Berra
Markets hate uncertainty and we got a pretty good dose of it in the third quarter. Concern surrounding slowing growth in China came to a head in August when the Chinese authorities devalued the yuan in an attempt to keep GDP expanding near its 7% target. Developing economies, many of which are highly sensitive to commodity prices, have slowed. Closer to home the US economy remains in a lethargic GDP range of 2-3%. The Federal Reserve deferred raising interest rates at its last meeting as global and domestic stock markets stumbled. In the media, market prognosticators are simultaneously predicting a steeper market decline and a solid rebound. With all the noise we feel it is an excellent time to cut through the confusion and remind clients what drives our investment strategy.
We believe the core foundation of value creation is owning companies that are generating free cash flow, run by excellent management teams that are demonstrating the ability to reinvest cash in ways that enhance return on invested capital. Looking at the most recent quarter, earnings of companies owned in client portfolios increased by an average of 9% which compares favorably to the -2% earnings of the S&P 500 composite members. Return on equity is stable but growth is scarce. Reported revenue growth is weaker than actual unit volume gains due to difficult currency exchange headwinds. As we move into 2016, the negative currency translation pressure will lessen.
At the beginning of the year we expressed our concern that further near term gains in equity markets would be challenging. Our reasoning was that equity markets had advanced over the last few years toward the higher end of historic multiples. Further market increases would be more dependent on corporate earnings growth rather than multiple expansion. That has proven to be the case. Our objective is to identify companies that can grow though different market cycles so that market corrections provide investment opportunities, not anxiety. As we write this note, projected earnings suggest a forward market multiple of 15.4x in 2016 and 14.1x in 2017. We believe if we get the corporate earnings outlook correct then our client portfolios will persevere.
The extended period of low interest rates leaves investors with few options to find attractive returns in the fixed income market. Bonds offer the promise of a return of capital upon maturity but not much in the way of return on capital. The ten year Treasury is yielding 2.1% which remains at the lower end of its historic range, while the five year Treasury yields 1.4% and a one year Treasury note yields 0.24%. At these levels, bonds provide little appeal to investors beyond serving as a safe harbor during periods of equity market volatility.
There are structural issues that cause concern longer term. Foremost is the amount of government and individual debt outstanding globally. We believe US economic growth will remain slower than its historic pace for the foreseeable future due, in part, to the headwinds created by poor retirement planning by aging Americans. The blame lies with the overleveraged consumer as well as with the financial institutions that facilitated poor behavior. Many municipalities and states have limited financial flexibility due to the obligations residing on their balance sheets. Europe has lived in this malaise for decades and our nation is now infected. One only has to think of Detroit, Chicago, and Puerto Rico to glimpse what lies ahead unless bipartisan leadership begins to work collaboratively to address fiscal issues. Internationally, nations like Argentina, Venezuela, Greece, and Spain illustrate that it is not only American politicians that have “kicked the can” down the road. We hope that over the next decade we will see more politicians emerge who are willing and capable of addressing fiscal issues in a balanced, thoughtful manner.
During the quarter few changes were made to client portfolios. (We took the late, great, Yogi’s advice.) Late in July we eliminated our holdings in United Technologies and Sigma Aldrich. We sold United Technologies as we became more wary of the slowing building cycle in China and in other developing markets. We eliminated our position in Sigma Aldrich because the company is being acquired by Merck AG. For longer term clients, Sigma Aldrich represented a wonderful investment that returned 6 times our original investment. We’ll miss its dependable performance.
Thank you for entrusting Ayrshire Capital Management with the management of your money. We are working hard to be good stewards of your funds and we look forward to speaking with you in the coming quarter.
JM Sam Nevin, Jr.
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