As I write this letter, COVID 19 reported case counts have hit daily records in excess of 80,000 and the on again, off again, negotiations on another government stimulus seem to be…off again. More than 11 million Americans find themselves unemployed, and Pfizer announced earnings this morning without any statement as to the efficacy of their vaccine. Yet, the market finds itself only 5.75% from its all time high. One might legitimately wonder about the reasons for the apparent disconnect.
Of course, the Federal Reserve is a big part of the answer. The adjusted monetary base now stands in excess of 25% of GDP, far ahead of even Great Recession levels. With the 10- year Treasury now at a yield of 85 bps., future corporate earnings streams become that much more valuable. The prospect of additional fiscal stimulus will further prime the pump. It is important to note here that this observation is not a value judgement; as long as the economy remains less than robust, there has to be someplace for all that money to go. It is boosting asset prices, especially financial assets, for those lucky enough to own them.
As I wrote in my last quarterly letter, tumultuous times reinforce and accelerate economic disruption already in place. Our portfolios have been positioned for some of these changes since long before COVID 19; for every corporate winner, there is often more than one loser.
The case of Intel (INTC) is illustrative of the speed and depth at which this disruption is occurring. Linear growth in semiconductor chips used in the data center had, for several years, kept demand high. But Intel’s inability to efficiently manufacture a 10 nanometer size chip, while its competitors were already producing 7 nanometer size chips, began to impact Intel’s gross profit margins four quarters ago. Since the tech heyday of the 1990’s, Intel’s stock has always been directly correlated with the direction of its gross margins. Recognizing this, we were fortunate to exit our very profitable (but still underperforming vs. the overall market) position in the stock immediately before the announcement of second quarter earnings in July, before the stock sold off almost 25% on that second, and then third, quarter announcement.
Two other companies, which have been Intel’s chief disruptors, Advanced Micro Devices (AMD) and Nvida (NVDA), have been held in portfolios very successfully, very much outperforming the overall market. An interesting tell all….when Lisa Sui, an MIT engineer, took the helm at AMD, the company had an equity market cap of $2B with $2B in debt. Today, with the announcement of spectacular earnings, AMD also announced the purchase of the chipmaker Xilinx (XLNX), another longtime portfolio holding, for $35B. Xilinx makes a specialized chip called a Field Programmable Gate Array, a programmable chip that will be very important in the early years of the buildout of 5G. Nvida just made an offer to buy ARM Holdings, by any definition the most important chip designer in the world. Virtually every important chip company is, in some way, a client. Nvida’s powerful chips, originally for gaming video applications, will be the basis for the most sophisticated artificial intelligence chips.
While some large companies have found themselves more starkly disrupted by the pandemic, others have much improved their position. We have written previously about the success of WalMart (WMT) and Disney (DIS) in arming and adapting to compete with their disruptors, Amazon and Netflix. Similarly, the lockdowns which have caused the closure of many neighborhood restaurants, with a commensurate effect on their small suppliers, has benefited larger chains and improved prospects for Sysco (SYY). Sysco has actually increased sales $1B and reduced structural expenses some $400B during the COVID period!
As we look toward the election, my guess is that no matter who wins, the election will get most of the credit, or blame, for what happens in the stock market. I would posit a different view. The spread between growth and value has almost never been so large, growth having been the clear beneficiary of the virus and stay at home. Now we face the wonderful prospect of a vaccine and other therapeutics as we look toward Spring, 2021. The market always looks at least 6 months ahead. Prior positioning by money managers usually determines the near/intermediate term performance of the market, and that positioning has been toward growth. Though the prospect of higher capital gains under a Biden presidency will be blamed for any selloff in what have already been hugely profitable growth stocks, I believe their declines on spectacular earnings announcements this quarter simply signal that those earnings may have reached maximum acceleration during COVID 19. They may, in the near term, find themselves a source of funds by other market participants to buy value stocks whose cost reduction efforts both pre and post the virus have yield increased operating leverage as we begin a new economic cycle.
To this point, we have added Dover (DOV), Parker Hannifin (PH), Dow (DOW), Dupont (DD), Oshkosh (OSK), and GM to existing industrial positions in Rockwell Automation (ROK) and Honeywell (HON). We expect some near term weakness in our growth positions, and have done some modest selling in anticipation, but remain convicted of their unique value over the longer term.
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