Similar to the first quarter of the year, equity and balanced accounts outperformed their benchmarks for the three months ended June 30, 2017. Stock selection drove excess return across accounts.
An e-commerce and internet infrastructure company based in China was the largest contributor. It has been a strong stock for us this year and delivered additional gains in June after its management guided to accelerated (+45%) revenue growth for this fiscal year. We view this as world class performance given that its revenue base is over $23 billion. We see plenty more to come as Chinese e-commerce remains underpenetrated, management increasingly brings more sophisticated strategies to lever data capabilities, and several of its businesses mature from their current incubation phase. For readers with an affinity for analogies, the Chinese company can be viewed as a younger version of the leading U.S. internet retailer with a few significant differences. The younger company operates largely in a faster growing economy that is structurally not on as sound of footing as more developed markets. Also, it is relatively asset light (think third party retailing like 3P) and enjoys an easier runway because traditional retailers there are less entrenched.
A semiconductor company, also added significant value. Typically, we are leery of chip stocks because their inventory cycles are difficult to time which can create dramatic stock volatility. (And, keeping this in mind, we have limited the position size for this investment.) However, our holding offers opportunities well beyond its historic core competency of designing graphic processing units for high-end gaming. The company is now the leader in many applications such as artificial intelligence, autonomous driving, and virtual reality that are in their infancy and are likely to represent total addressable markets lying somewhere between big and “huge.” To paraphrase an old general, this firm is there “the firstest with the mostest.” The most developed of these disruptive technologies are deep learning tools for artificial intelligence in the data center setting (think AWS, Azure, etc.).
Not all of the portfolio was milk and honey during the quarter. Our overweight in the energy sector proved to be wrong. Although OPEC extended production cuts beyond expectations, investors focused on the implications of rising domestic production. More impactful to our performance one of our holdings announced disappointing drilling results and experienced an explosion near one of its wells. This is part of the nature of exploration and production companies but it occurred as the industry was under tremendous pressure. We eliminated the position and the overweight in the group as a result. Overall, though, the portfolio performed well compared to a zippy market.
The market’s buoyancy despite slow economic growth and geopolitical upsets has confounded many pundits. Part of the explanation is found in a theory named the Marshallian K. (No, we don’t make this stuff up.) It postulates that aggressively accommodative central bank policy grows money supply faster than nominal GDP growth which creates “excess” money. The money has to go somewhere, namely into assets such as stocks, bonds, real estate and others. This eventually ends through slower growth in money supply, faster GDP expansion (not a bad scenario for equities), or a combination of the two. The recent catalyst bringing the end of accommodative policy into question was investors’ hawkish interpretation of the European Central Bank President’s June 27th comments. We believe that the verbiage was somewhat ambiguous and premature but already we had been thinking about the “normalization” of policy (as mentioned in our fourth quarter 2016 letter). Our sense is that the gradual withdrawal of monetary stimulus will impact the internals of the equity market more than the level. Bonds could be a different story, and we have constructed the fixed portion of portfolios with this in mind. We take this all with a grain of salt since no one has ever lived through a cycle like this.
Our concentration in bank stocks fits the normalization thematic. Rising rates should bolster net interest margins and, in turn, earnings. While waiting for this to play out, banks have made progress on controlling their cost bases and recently made return of capital announcements (buybacks and dividends) that were significant and in one case bordered on dramatic (9% share reduction in a year). Additionally, the regulatory pendulum appears to be swinging favorably for the group based on recent appointments by the new administration.
We would not be surprised to see some more market volatility in the third quarter as first half levels were historically low and summer seasonality amplifies trading moves. However, looking beyond a few months, we remain sanguine. Economies are synchronously growing across the globe with inflation tame. Domestically, although the pace varies monthly, employment is expanding, corporate profits progressing and interest rates are benign. More importantly, the construct of the portfolio continues to be focused on individual stocks with a pragmatic approach to sector allocation. Key concentrations (not mentioned above) include railroads undergoing organizational transformation, HMOs successfully redeploying free cash flow, and select internet-based franchises. Sectors dependent on falling rates remain underweighted. Balanced accounts approach maximum equity commitment.
Second quarter earnings releases begin this week so we will put down our pen now and start listening to conference calls. Enjoy your summer.