Fourth Quarter 2016 Commentaries

 

The year 2016 began so ominously. Yet it ended with euphoria and optimism. In the first month and half, the S&P 500 swiftly dropped nearly 10%. So it seemed that the long running bull market was in danger. Yet the recovery was equally swift. By quarter end, stock had turned in a positive return. From there, the market climbed steadily, then accelerated towards the last two months with the surprising election of Donald Trump as the president. For the year, S&P 500 advanced 11.96%.

For 15 consecutive years from 1991 through 2005, the Legg Mason Value Trust mutual fund’s return beat the S&P 500. That made its portfolio manager Bill Miller a legend in the investment management industry. Though no one is really looking, I had my own little streak running before 2016. After over a decade as a mutual fund manager, I founded Evla Hills in 2007. For the first 8 complete calendar years from 2008 through 2015, our equity portfolio had also beaten the S&P 500 consecutively. Alas, 2016 was a struggle for our stocks from the very beginning as our portfolio returns lagged significantly. Stocks’ speedy recovery coming after the January sell off was a big surprise. Our portfolio had been conservatively positioned and did not benefit from the market rally in late February and March. Our strong weighting of health care stocks also hurt our returns. Many years of drug price inflation had finally caught the attention of politicians and regulators. The resulting political risk and a likely peaking of price inflation made healthcare one of the worst sectors in the S&P 500.

After a miraculous streak, the Legg Mason Value trust would under-perform the S&P 500 5 out of the 6 subsequent years. Success bred capital inflow and soon Mr. Miller was managing tens of billions of dollars. With such size, the investable universe of stocks became much smaller and the fund’s chance of beating S&P 500 also diminished. Despite an unsatisfactory year, we are optimistic that we will deliver market beating returns in the future years. Our philosophy of picking unvalued stocks with improving business prospects is sound and proven. Our asset size remains in the tens of millions allowing us the luxury of investing in opportunities that don’t make sense for a larger fund.

For 2016, S&P 500 earnings will likely grow less than 1%. Thus, market valuation has become stretched after a strong year. Yet fundamentals are also improving. For 2017, analysts are calling for an earnings growth by S&P 500 companies of about 12%. Even after discounting for the usual over optimism of equity analysts, mid to high single digit earnings growth is certainly achievable. Countering this positive factor is the rise of interest rate. In the December statement after raising rates by 0.25%, the Fed stated a likelihood of another 3 hikes in 2017. If this were to come to fruition, I believe the current higher than historical price to earnings multiple on the S&P 500 will not be sustainable and may result in a year of single digit negative return. If the economy should prove to be not as robust and Fed is constrained to raise interest rate only one time, then I believe the earnings growth will give us another year of positive return. With balanced risk and reward, we will continue to position our portfolio on the risk averse side and seek opportunistic situations to garner better return and focus our attention on picking great individual stocks.

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