Quarterly Update June 2019 - GKV Capital

GKV Capital Management

Quarterly Update

Second Quarter 2019

Second Quarter Review Beyond Cult Stocks Looking Ahead

GKV Capital Management

Opening Thoughts

Despite an outlook for slower global economic growth, stock prices worldwide continued to rise this year with double digit gains through the end of the second quarter. The major U.S. indices are trading at all-time highs. Meanwhile interest rates have retreated to 2017 levels with the 10-year treasury closing the quarter at 2.0% as central banks look to add additional stimulus in the face of mounting economic headwinds.

Trade conflicts between the U.S. and its economic partners have begun to take a toll on global growth, but clearly investors expect the damage to be short-lived. So far, earnings expectations for the companies that make up the S&P 500 index have been reduced 4% from the estimates at the beginning of the year as the imposition of tariffs have disrupted supply chains. Despite the reduced forecasts, earnings are still expected to rise about 8% this year over last.

Central banks have generally shifted back to a more accommodative stance, lowering interest rates to keep global growth on track. We have grown increasingly troubled that the economy requires a reduction in interest rates to keep the party going, but for the moment, investors have cheered the repositioning by bidding up stocks. Fortunately, geopolitical crises have been relatively benign and economic metrics have been generally positive. Low unemployment, low inflation and positive household income numbers give us some measure of confidence that the rally is sustainable for the moment.

We are far from complacent. There is always plenty to worry about. We would like to see better global growth numbers. Europe and China have been weaker than expected. We would like to see strong enough economic activity that interest rates do move up from historic lows. While we are at it, we would like to see a calmer political environment as we start into the new election cycle. Overall, it is hard to complain about much. Certainly, the gains this year, for both stock and bonds, are great. We just hope we don't see a repeat of last year.

2Q19 Data Points

DJIA YTD

14.0%

S&P 500 YTD 17.4%

NASDAQ YTD 20.7%

US Bond YTD 6.1%

10-Year

2.00%

Treasury Yield

S&P 500 LTM 1.91% Dividend Yield

S&P 500 EPS $173.73 Next 12-MTH

S&P 500 P/E 16.9x

GKV Capital Management is an independent registered investment advisor. For more information about us please call (805) 497-2616 or visit

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Second Quarter 2019

Second Quarter Review

The broad stock indices continued to new highs in the sec-

al growth. Earnings estimates on June 30th project $173.73

ond quarter of 2019. The gains were impressive given an

per share for the combined S&P 500 over the next 12-

outlook for slowing global growth and reduced earnings

months. If companies meet these expectations it will repre-

expectations due largely to trade and tariff disruptions.

sent 13% growth over the last 12-months. The earnings esti-

These concerns were shrugged off as central bankers world-

mate for the next 12-months results in a price-to-earnings

wide repositioned to a more accommodative, low interest rate stance after hiking rates earlier in the year. Further-

ratio of 16.9x for the S&P 500 as of the market close on June 30th of 2,941.76. This valuation level should be viewed as

more, despite the potential economic damage of the broad

fully valued by historical standards and assumes continued

trade disputes and weaponization of tariffs as a negotiating

positive earnings growth beyond 2020, in our opinion.

tool, the market seems to believe that a trade resolution is

around the corner and little lasting damage will result. Look-

For the first six months of the year, the technology sector

ing at the economic data in the U.S., low unemployment,

led the market with a gain of 24.8%, followed by industrials,

low inflation and positive household income have all provid-

up 24.4%, and consumer services up 21.3%. Somewhat sur-

ed economic tailwinds for U.S. equities for the first six

prising is the health care sector with the worst year-to-date

months of 2019.

performance up 8.8%. There has been a political overhang

on the health care sector with investor concern that new

The S&P 500 gained ground in the second quarter rising

regulation from Washington lawmakers might impair

3.8% for the quarter and ending June up 17.4% for the year.

growth.

The Dow Jones Industrial Average also improved ending the

second quarter up 14.0%. The technology sector continued

Despite the weakness in GDP growth worldwide, equity

its gains, driving the NASDAQ Composite to end up 20.7% for the year through June 30th. In hindsight, the correction in

markets around the globe are having a positive 2019. In fact, there is not a single developed or emerging market

the fall of 2018 leading to broad losses for U.S. stocks was

that is negative in 2019 through June 30th. The MSCI EAFE

overdone and the strong performance to date in 2019 is

(Europe, Australasia, Far East) gained 11.8% for the first six

making up for it. While the year-to-date gains are impres-

months of 2019. The MSCI Europe index gained 13.2%

sive, the S&P 500 is up 10% over the last 18 months which is

through June 30th and the MSCI Emerging Markets Index

a 6.7% annualized return and is an average long-term histor-

gained 9.2% for the first two quarters of 2019.

ical performance for equities.

Global economic growth projections continue to be reduced

After starting the year with an expectation of rising interest

due to low energy prices and potential fallout from trade

rates, slowing economic growth drove rates lower as capital

tariffs. In the April update of the International Monetary

poured into the relative safety of fixed income. The 10-year Treasury returned to

YTD Performance by Industry Sector

the lows of 2017, ending the second

quarter at 2.0%. The market is now antic-

ipating the possibility of multiple rate

cuts from the Federal Reserve in the face

of slower economic growth. Relatively

positive economic fundamentals, unem-

ployment and inflation, further economic

stimulus in the form of lower rates could

very well prolong the current expansion.

In our view, the market is discounting a

positive scenario.

Corporate profit expectations have moderated somewhat this year due to trade conflict and slower than anticipated glob-

Page 3

Dow Jones LLC, June 30, 2019

GKV Capital Management

Fund's global forecast, world GDP growth expectations were reduced by 0.2% to 3.3% in 2019, representing slower growth over the 3.6% estimate for 2018. Growth has moderated for the U.S. as well, coming off a better than expected 2.9% in 2018 due partly to corporate tax cuts. The forecast for 2019 is 2.3% with a further decline to 1.9% in 2020.

The U.S. labor markets remain healthy as the unemployment rate ended the second quarter at 3.6% from 4.0% on January 1st. Inflation remains low by historical standards ending May 31st at 1.8%, down from 1.9% at the beginning of the year. At the end of June, the 10-year treasury yield declined back down to 2.0% from 2.7% at the end of 2018. Per capita disposable income is up 3.3% year-over-year and personal consumption is up 4.2%. Consumption and retail sales are being driven in part by increases in household debt which increased 3.5%. While the increase is not of immediate concern, a long-term trend of rising household debt relative to wage growth is unsustainable. Improving data from the Institute for Supply Management's economic indices continued to indicate an expanding economy.

The decline in interest rates has had a positive impact on bond holdings. With falling interest rates, existing bond positions are priced to reflect the current lower yields now available to new bond investments. A bond paying a 4% coupon for the next 10 years is worth more than a bond paying 3% for the next 10 years. Our fixed income portfolio continues to be reduced through the maturity of issues and selective profit-taking but it remains a significant percentage of assets under management for our clients. We will

Firmwide Asset Allocation

June 30, 2019

continue to moderate our exposure to interest rate risk by reducing the duration of our portfolio with the return of rates to current low levels. The U.S. aggregate bond index is up 6.1% for the first six months of 2019 due to the decline in interest rates this year.

While we manage each client's portfolio separately to meet their specific needs, the snapshot of our asset allocation firmwide can provide some visibility into our current conservative posture in the market. We ended the June quarter with significant cash reserves of 16% of total assets under management. We have become increasingly concerned that the slowing growth outlook coupled with earning reductions may have an impact on equity performance this year and we are reluctant to give up the gains of the first half of the year. Across all accounts our fixed income positions totaled 35% of assets under management on June 30th. Equities totaled 47% of assets under management on June 30th.

Expected Returns--Major Index Historical Performance

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Performance Data for periods ended December 31, 2018 Annualized monthly standard deviation Bond Index is Barclays US Agg TR USD

Second Quarter 2019

Beyond Cult Stocks

"I can calculate the movement of the stars, but not the madness of men." - Sir Issac Newton (1642-1727)

In early 1720 Sir Isaac Newton owned shares in the South Sea Company. Newton, who co-invented calculus and revolutionized physics with his three laws of motion was undeniably brilliant. That year in England, the stock of the South Sea Company soared as investors became excited about its trading monopoly with South America. Rampant insider trading and the purchase of shares with company funds sent the stock soaring. Newton sold his initial investment for tidy 100% profit of approximately $1,000,000 in the current currency equivalent. The stock continued to rise more than 600% as the year progressed and Newton bought back into the company. As it became apparent there was no realistic prospect for trading profits in South America, the stock crashed back to earth fostering a global liquidity crisis at the time. For Newton, his large profit turned to a huge loss of ?20,000 or more than $3,000,000.

Every so often a new idea, a new product or a new business model captures the imagination of the broad investing public. New ideas and promising new companies come along infrequently. As is the case with any supply and demand imbalance, investors clamoring for a new opportunity invariably bid the limited number of shares to heights that often cannot be supported by the reality of the business fundamentals. The fantastic new opportunity may really exist and with talented management many companies do realize fantastic growth. With investment pouring in, the question every investor must consider is whether the growth can ever be enough to justify the value being placed on a popular new company. When the fervor for an investment becomes totally detached from any rational fundamental metrics we like to think of the opportunity as having reached cult status. Obviously, cult investments are not a new phenomenon. The practice of trading for profit is as old as civilization itself, and the more irrational the trade the greater volatility and greater opportunity for gain for astute practitioners at the expense of the naive.

Traders seek to profit from fluctuations in supply and demand while investors look for long-term appreciation. At GKV Capital, we are professional investors rather than traders. We bring rigor and analysis to our investment

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selection. We try to avoid speculation particularly when success is contingent on growing popularity of the investment rather than business metrics such as sales growth and profitability. There is a material difference between speculating and investing. Speculation is short-term investment with the expectation that prices will move higher resulting in capital gains. In other words, the investor is betting that a future buyer will want the asset at a higher price. It doesn't matter whether the asset is gold, a comic book, Cabbage Patch doll, crypto currency or a hot stock. Limited supply and increasing desirability for the investment matters most to the speculator. Actual business performance is a secondary consideration.

Speculation can be successful but as Newton quipped, it is frequently difficult to calculate the madness of people. In evaluating any investment opportunity, we look to the fundamentals of the underlying asset. We evaluate what the expected earnings or income the asset will generate, what the transaction and carrying costs will be, and what an estimated resale value will be. The value of a company's stock should reflect the likely future earnings of the company and as sales and earnings grow the shares will appreciate accordingly. A company that is expected to earn $1.00 per share next year should be worth more than a company that is expected to earn $0.50. Accordingly, a company expecting to double its earnings the next few years should be worth considerably more than the company that is no longer growing.

As professional investors, we enjoy handicapping the growth expectations of the latest hot stock and through fundamental analysis, we look at just how carried away the market can get. Usually, the excitement around the latest cult stock is for a good reason. It can be a great new idea or new product category. A new technology or new business model that promises tremendous growth. These are all good reasons to invest. The problem arises when the speculation exceeds even the most optimistic outlook.

Usually a cult stock is driven by unbridled optimism for an exciting new product or business model. GoPro is a good recent example. The company's portable video cameras created a new product category as sports enthusiasts around the world sought to capture their exploits on camera. GoPro stock closed it's first day of trading on July 7, 2014 at $43.96. Three months

GKV Capital Management

later the stock had more than doubled to close just under $94.00. As cell phone cameras continued to improve, demand for GoPro's cameras declined sending the stock down more than 90% to $4.13 by the end of 2018. The performance of the stock was ultimately tied to the company's earnings hitting $1.07 per share in 2014 and declining to a loss of $0.78 by 2018. Rapid growth was replaced by significant losses. At the high, the company's total valuation hit $11.6 billion which would be fine if only sales had continued to double a few more years.

Companies with premium valuations can grow into their lofty expectations and even exceed them. Although Amazon could never have been considered a speculative cult stock, the early expectations were high. The company went public with the argument that the online business model would lower expenses and make the company more profitable. The higher profits never materialized, Amazon's net margins are similar to Walmart's but the absolutely fantastic rate of sales growth greatly exceeded expectations and the stock has soared along with its sales growth.

Similarly, Netflix has revolutionized the delivery of content in the entertainment industry. The company has realized fantastic subscriber growth but as that growth has begun to slow, Netflix has expanded its value proposition to the creation of entertainment content. It remains to be seen whether the company can leverage its leading position in Internet content delivery to monetize the creation of content. Increasingly, Netflix will be competing with industry heavyweights such as Disney. With a current market value of $159 billion, Netflix is valued at more than half of the considerably larger Disney at $251 billion. With nearly $60 billion in revenue for 2018, Disney's sales are four times larger than Netflix. The key for Netflix stock to move higher will be growth which is slowing as the numbers get bigger. Netflix revenue increased 35% in 2018 over 2017. At that rate it will take Netflix another three years for revenue to reach 60% of Disney's. Netflix is a great company; it is possible, but by no means certain. The risks are significant.

Tesla is another interesting example. Although the stock is well off the December 2018 highs of $366, the company still enjoys a premium valuation. The company has done an impressive job in a highly competitive and capital-intensive industry of bringing a better product to market. Tesla is struggling to manufacture its cars fast enough and cannot keep up with demand. Revenue growth has tripled from 2016 to 2018 from $7 billion to $21.5 billion. Consider Ford Motor over the same period increased revenue only 6%, but the numbers are much larger. In 2018 Ford revenues were more than 7 times Tesla at $160 billion. The problem with

Page 6

Tesla, from an investor perspective, is that Tesla and Ford currently have the same market value of $39 billion. At the end of the day, both companies sell cars and they should ultimately have similar profit margins. To justify the premium value currently placed on Tesla's stock the company needs to continue to double sales the next few years. While that may be possible, there are plenty of risks to such an assumption. That isn't to say that Tesla won't be successful, we are fans of the company, but it must be really successful to justify the current stock price which is already down 40% from the 2018 high.

The recent initial public offering of Beyond Meat is what got us thinking lately about cult stocks. The company began trading on May 2nd with an initial price of $46.00. It closed the first day of trading up 43%. In just two months the stock has hit a high of $169.96 for a 269% return. Beyond Meat is one of several new alternative meat companies producing plant-based protein alternatives to meat products. This is a lot more than veggie burgers, however. The demand for Beyond Meat and its principal competitor Impossible Foods is growing at a fantastic rate. The taste has improved dramatically from the bland veggie burger with food critics claiming that Burger King's Impossible Whopper tastes better than the real thing. Beyond Burger is available in grocery stores, when they can keep them in stock while Impossible Foods alternative meats are only available in restaurants, for the moment.

So, should you buy the stock? Only if you want to speculate. The current price of $152 could double or get cut in half. There are no earnings to speak of as the company is spending to get its products distributed as widely as possible to capture market share. Revenue has grown rapidly and is likely to continue to do so at least in the short-term. Total sales in 2018 were $97 million up nearly 300% from $38 million in 2017. Beyond Meat is currently at an $11 billion market capitalization which is more than one-third the price of food giant Tyson Foods at $30 billion. Yes, Beyond Meat is growing rapidly and far more exciting, but consider that Tyson's 2018 revenue was $40 billion, a mere 412 times that of Beyond Meat. We view Beyond Meat in a similar vein to Tesla. A company with an extremely innovative new product in a stodgy mature industry that's ripe to be shaken up. It will be difficult for the established food companies to create competitive products but given enough time, like electric cars, they will. We are hopeful Beyond Meat can continue to grow rapidly and love to watch successful new companies but as an investment, Beyond Meat is beyond reach.

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