SFM 2nd Quarter Update
Equity markets raced higher during the second quarter as the anticipated reopening of the US economy allowed investors to disregard the doomsday scenario prevalent during the first quarter. Stock returns in the US had the highest quarterly increase in over twenty years. It is important to remember that markets are discounting expectations for the future, not what is happening in the short-term within the economy or corporate earnings. In another reversal from the first quarter, non-government bonds rallied off of the March 2020 lows as swift actions by the Federal Reserve helped to alleviate liquidity concerns. With US Treasury bond yields at record lows it was encouraging to see the value of many of your bond holdings rising by more than the underlying annual yield during the quarter.
The most significant driver of investment returns during the quarter relates to the government’s overwhelming market support through fiscal and monetary stimulus. The massive fiscal support supplied by the US Treasury included extended and enhanced unemployment benefits, employer access to low cost/no cost loans, and extensions on tax filing for all. The Federal Reserve’s monetary injection and participation in providing liquidity to the bond markets through open market purchases gave reassurance to investors in both the bond and stock markets. The Fed’s actions effectively created a floor on valuations, which is commonly referred to as the “Fed Put”.
As investors focus on expectations for 2021 and as interest rates fell in response to the weakening economic environment, stocks again looked comparatively attractive. The dividend yield on the S&P 500 topped 2% intra-quarter, while a 10-year US Treasury bond pays a yield of only 0.6% per year. Remember that bond prices move with an inverse relationship to interest rates. So unless US government bond interest rates drop into negative territory, there really is not much further for interest rates to fall. This means that capital appreciation in bonds is limited, creating a headwind for the entire asset class.
The smoothing effect that bonds provide in a volatile equity environment will continue to be an important part of your portfolio, but the growth aspect will likely be realized within the stock and alternative investment portion of your portfolio. “Alternative investments” include things like real estate, precious metals (gold), and structured product investments that give downside protection in case the markets drop, while still participating in the upside. The “income structured products” that we have recently purchased in most of your portfolios offer outsized contingent yields that will only be at risk if the equity markets fall significantly and stay there for an extended time frame.
The performance of our SFM investment strategy was especially highlighted during the stock market crash in March, but also the rebound we have had since. Your individual stocks and also your actively managed stock mutual funds and ETFs outperformed in the first quarter during the market was sell-off, but also outperformed in the second quarter as the stock market strongly rebounded. During the second quarter stocks moved up significantly, with the degree of increase depending on the company size, industry, and geography. We have attached performance for six widely used equity benchmarks, along with three fixed income and one alternative index in the “Reference Benchmark Table” towards the end of this report.
Our investment strategy has always favored steady, consistent growth companies that are not dependent on a strong economy to grow. We have also focused our investment strategy on investing in high-quality companies, with little to no debt (a big help this year), and ultimately strong and durable competitive advantages that lead customers to choose their products and services…causing competitors to struggle to compete. In the second quarter, many of the companies that were negatively impacted by the mandated shutdown of the economy during the first quarter bounced off their lows as investors bought economically sensitive holdings in anticipation of a recovery. The real story, however, was the acceleration of trends that have been driving the market to record highs before the shutdown: the rapid expansion of cloud computing, digitization of data, ecommerce, digital payments, and the growth of business software companies that save firms time and money. These trends benefited many of your largest SFM stock holdings including Microsoft, Amazon, Alphabet (Google), Apple, Visa, Mastercard, Adobe, and Salesforce.com as they all appreciated by at least +20% in just the second quarter alone.
In addition, work-from-home coupled with mandated quarantines aided companies like Home Depot and Sherwin Williams, as idle time shifted to home improvement projects. Many technology firms including Microsoft (and the other 7 tech stocks mentioned above) along with ServiceNow and Intuit also benefitted from the directives as work productivity tools continued to be in high demand. The Chinese technology company Tencent was another strong performer, gaining over +30% during the quarter, as the social media, digital payments, and video game firm experienced huge demand for its online services. With restaurants closed for most of the second quarter, it was beneficial to operate drive-through and take-out, as Dunkin and Yum Brands (owns Pizza Hut, Taco Bell, and KFC) outperformed the broader market in the second quarter. Meanwhile, widely held stock funds such as the Morgan Stanley Large Cap Growth Fund, the Allianz RCM Technology Fund, the Artisan Developing World Fund, and the iShares Expanded Tech- Software Sector ETF all had massive gains during the quarter.
A multitude of healthcare companies are in clinical trials to find an effective vaccine for the COVID-19, with hopes of a successful vaccine within a year and possibly sooner. Most observers believe that we will not be able to resume ordinary activities without one. Negative factors on the economy like double digit unemployment, restaurants operating at well below breakeven and limited air travel will continue to act as a head wind on the economy and second quarter corporate earnings. A return to “normal” is still a way off, as infection rates have spiked in certain states following re-openings, with some hospital systems under strain. In addition to the healthcare landscape we are experiencing a very tumultuous period of social unrest, which will likely be exacerbated by the presidential election in November.
The portfolio design of your investments centers on participating in the ever-changing opportunities within the equity landscape. Things that were one considered “high-tech” like radios, TV’s, autos and cell phones become commodities as technological advances in areas like healthcare, entertainment and communication rendered these products as low-margin and low growth industries. This transition from old to new is known as “creative destruction”. Your investments are focused on companies and industries that we believe will offer the greatest opportunity for growth in the equity markets. Themes like clean energy, genetic/immunology based medical treatments, cloud computing, and the digitalization of our economy are just a few of the investible themes that are in your portfolios today. We continue to look for cutting edge companies that should maintain a dominant market position in very large addressable markets, and are highly profitable or have clear paths to profitability.
Our thoughts are with you and your families as we try and get through the pandemic, and hope you will reach out with questions or concerns if we can help in any way. We appreciate the confidence you place in us and thank you for your continued support.
Sincerely, Glenn, Chis, Sam, Debbie, Janice and Steve