2019 Q3 Client Letter

Dear Clients:

We’re again pleased to report client equity portfolios continued to experience solid performance through the first three quarters of 2019, which also marked the first time since 1997 when the S&P 500 had a total return greater than 20% in the first nine months of the year. While we’re grateful this year finally broke a streak of 21 straight years without a 20%+ total return for the S&P 500 through the first nine months of the year, we’re even more encouraged the relative performance pendulum began to swing strongly from “growth” towards “value” in September, a trend we hope continues.

As we stated in our Interim Update on September 16, 2019, we always advise ignoring the stock market’s short-term wiggles and focusing primarily on the long-term. Ben Graham, who was Warren Buffett’s business school professor and mentor, famously said, “though the stock market functions as a voting machine in the short run, it acts as a weighing machine in the long run.” What this means is fear and greed play important roles when votes are being cast, but fundamentals are what matter and eventually determine stock prices.

As you’re well aware, the past five years in particular have been extraordinarily difficult for active, “value” investors like us. We believe to produce better-than-average long-term results, you need to own a portfolio that’s different than the average. We evaluate companies as if we’re buying the entire business. We look for stocks our analysis says trade at a reasonable discount to what that business is worth and have a future catalyst in sight to narrow that gap.

While we firmly believe that strategy is sound, it has certainly not been rewarding recently. We’ve been frustrated stocks we buy at cheap valuations (i.e. could double in price and still be attractive) have struggled while stocks with absurdly high valuations (i.e. not profitable anytime soon and could be cut in half and still be overpriced) have soared. However, as shown in the table below, a shift in fortunes may have begun in September, as the S&P 500 Value index dominated the S&P 500 Growth index in September, leading to a solid outperformance by “value” in the third quarter.

One good month/quarter for “value” obviously doesn’t necessarily mean a good turn in fortune for “value” has begun and planning a parade is certainly premature. There have been false starts for “value” before. Still, a shrimp cocktail looks like a feast to a starving man and we’re starting to see some cracks in the “growth at any price” fan base and a long-overdue return to sanity by investors.

Trouble in “FAANG”-land could mark a top for the mindless, passive indexing fad. Shares of Facebook, Apple, Amazon, Netflix and Alphabet (parent of Google), together the FAANG stocks, have enjoyed tremendous momentum of the upward variety. Their ever-increasing prices have led to continually higher capitalization-weights in indices like the S&P 500 (these five stocks are 1% of the stocks in the S&P 500, but account for a whopping 20% of the capitalization weight), which has in turn led to a constant flow of buying as the mindless, passive indexers deploy their increasing volume of inflows from investors attracted by the performance and misleadingly “free” cost of index funds. It’s no coincidence Morningstar reported as of the end of August, passive index funds had overtaken actively-managed, stock-picking funds in assets for the first time, $4.27 trillion vs. $4.25 trillion. Further, in the past decade, passive index funds added $1.36 trillion in net flows, while actively-managed funds shed $1.32 trillion.

As we all know, trees don’t grow to the sky and some issues have arisen that threaten to interrupt this fairy tale. Technology giants like Facebook and Google are targets of increased governmental regulation, as lawmakers worry about abuses that accompany these companies’ growing power. The roster of companies seeking to eat some of Netflix’s streaming lunch grows by the day. The upshot is Facebook ended the third quarter of 2019 down 18.1% from its high (7/25/18), Apple down 3.5% (10/3/18), Amazon down 14.9% (9/4/18), Netflix down 36.1% (7/9/18) and Google down 5.8% (4/29/19).

It’s an interesting coincidence the very stocks that have powered the performance of index funds are stumbling just as index funds have surpassed actively-managed funds in assets. It will be equally interesting indeed to see what happens if/when the capital that has flowed into passively-“managed” funds heads for the exit and mindless buying turns into mindless selling, leading to even more mindless selling. At that point, “sell to whom?” will be the trillion dollar question. We’ll bring the popcorn!

It’s true they don’t ring a bell at market tops (or bottoms), but we’re pretty sure the “Unicorns” (privately-held technology companies, typically losing tons of money, but valued at $1 billion or more) are trying to tell us sanity is returning, which is positive for the health of the overall market and will hopefully benefit investors who focus on valuations and ignore the hype, like us.

Venture capital/private equity firms invest in private companies at an early-stage, with hopes they will be able to cashout at a big profit when the private company goes public through an initial public offering (“IPO”). These investment firms succeeded in generating high returns (in founder/CEO –led firms like Amazon and Facebook) that weren’t necessarily correlated to what was happening in the stock market, which was catnip to university endowments and other giant institutional investors, who responded by flooding the private market with $2 trillion of capital over the past decade. Indeed, the number of private equity firms has risen from about 1,000 in 2000 to over 7,000 today. During the same period, private equity assets under management have exploded from about $500 billion to $5.8 trillion.

With this tsunami of cheap/free capital chasing too few good deals, the result is predictable. When investors compete to give their capital to private companies, you get standards that are lowered at the same time valuations are raised, a toxic combination. In other words, you get (former) shared office space wunderkind WeWork, which may prove to be the “canary in the coal mine” that kills the hopes of other Unicorns who are long on captivating stories of how they’re going to “disrupt” and dominate the world, but short on realistic plans for how they’re going to make money doing it.

In its first or “A” round of financing in April 2009, WeWork was valued at $97 million. Fast forward 10-years to January 2019, when its “G” or 7th round of financing valued the company at $47 billion, which illustrates how in a private financing with a relative handful of investors, the price is set by the most enthusiastic backer, without the public market discipline of short-sellers who can cast negative “votes” on a company’s valuation.

WeWork’s IPO bombed and has been shelved. Potential investors not only refused to give the company a valuation in excess of the $47 billion it last sold shares at privately, they balked at $20 billion and even $15 billion (WeWork’s valuation at its “E” or 5th financing in 2015). In other words, public investors still wouldn’t touch WeWork at a discount of two-thirds from what the private equity “Masters of the Universe” paid “way back” in January.

Turnoffs were many, including the fact the company that lost $690 million on revenue of $1.5 billion in the first half of 2019 and had no reasonable path to profitability, “risk factors” in the Prospectus for the IPO ran to 32-pages and revelation founder/(former) CEO Adam Neumann sold the rights to the word “We” to the company for $6 million.

Trust us, while this moment of clarity is clearly bad for WeWork (and Uber, Lyft, Peloton, etc.), it is healthy for the overall market and should be a great sign for us that fundamentals and valuation are once again becoming important for setting stock prices and separating attractive investments from the speculative flyers. We think the tide is indeed going out for those companies operating with a “land grab” mentality of growing without heeding cost/ profitability and will prove to have been “swimming naked.” It appears blind faith is on the way out and fundamental analysis is on the way in!

Summary

We’re invested alongside you and are happy stocks had a strong first 9-months of 2019 and “value” stocks showed some long-overdue relative strength in September. According to Bespoke Investment Group, when the S&P 500 is up 20% through the third quarter, the fourth quarter is also up 86% of the time (by an average of 3.4% and median of 5.6%). That said, October is down 59% of the time (by an average of -1.2% and median of -0.9%). U.S. stocks have indeed stumbled hard out of the starting gate in the fourth quarter on the rekindling of fears of a weakening economy that shook stocks in August. It’s impossible to predict the timing or depth of recessions, but we’re keeping our eyes and ears wide open

KM Privacy Policy Notice

Under Securities and Exchange Commission Regulation S-P, KM is required to deliver its Privacy Policy Notice to each client prior to the establishment of an account and updates annually. We are delivering our 2019 annual update to each client account with this letter. In addition, given the increasing importance of protecting clients’ personal information, we have implemented a policy whereby KM personnel will not release any information about a client’s account without specific authorization from the client. If you would like KM to release information about your account to your CPA or other service provider, please contact Director of Client Service Matt Kirr (matt@kirrmar.com), Associate Director of Client Service Zach Greiner (zach@kirrmar.com) or Associate Director of Client Service Maggie Kamman (maggie@ kirrmar.com) by e-mail or at 812-376-9444 or 800-808-9444.

Regards,
Kirr, Marbach & Company, LLC

Past performance is not a guarantee of future results.
The S&P 500 Index is an unmanaged, capitalization-weighted index generally representative of the U.S. market for large capitalization stocks. This index cannot be invested in directly.
The S&P 500 Value Index is an unmanaged, capitalization-weighted index that measures the performance of the value segment of the U.S. market for large-capitalization stocks. This index is a subset of the S&P 500 Index and cannot be invested in directly.
The S&P 500 Growth Index is an unmanaged, capitalization-weighted index that measures the performance of the growth segment of the U.S. market for large-capitalization stocks. This index is a subset of the S&P 500 Index and cannot be invested in directly.