Review and Outlook
The third quarter was a challenging one. Concerns arose that growth in China was significantly slowing. The Chinese devalued their currency by 2%, which fueled the fire. Emerging market equities and currencies declined, and their economies entered recession. Fears were stoked that developed economies would suffer in conjunction. The U.S. market experienced its first correction in four years.
The tenor of the small cap market changed. Psychology turned negative. The down draft in prices spread from companies with big foreign exposures to engulf many of the sectors that had been the leaders for the previous year. Biotechnology, pharmaceuticals and high multiple technology stocks rolled over. Health Care stocks got spooked by comments by politicians that drug cost inflation needed to be better controlled. Investors sold “winners” to protect gains. Concern about a possible interest rate hike contributed to the weak market.
In all this negativity, there are some positive observations. If rates stay low, that would be good for stocks. The U.S. dollar was rising in anticipation of higher domestic interest rates, which was hurting our economy and reducing reported earnings of companies with international operations. This, too, is on hold. Investment sentiment quickly became negative. . . this is good for stocks. Stock multiples have contracted to a point where they seemed reasonable, even cheap in many cases, against our expectations of future earnings.
We believe earnings will be the key to the market and it is what we are most focused on. It has been a market where struggling companies that miss earnings expectations have been blasted, no questions asked, and the stocks have gone down more and stayed down longer than in normal market environments. Many performing companies have become market darlings, trading up to hefty valuation levels we feel uncomfortable with. Many of these companies are not yet profitable and trade at revenue multiples or other concoctions, which do not hold up well in corrections.
We are hoping to invest somewhere in the middle. We seek to invest in businesses that are able to show significant organic revenue growth (usually 5-20%), which can increase margins so profits are growing faster than revenues, that can supplement this with accretive acquisitions, debt repayment or share repurchase, so that per share earnings grow even faster; and where trading multiples can (ideally) expand or stay around present levels.
Going forward, the bull case for stocks is that the economy will continue to expand at a modest, yet self-sustaining rate. Monetary policy will be friendly, meaning when rates do rise that it will be gradual and will not choke off growth. We think stock valuations will remain reasonable and inexpensive relative to low levels of interest rates and inflation. The bear case is that a recession is in the offing or the market will be gripped by contagion. The bull case seems more likely to us, and we are generally positive about the U.S. economy and underlying fundamentals. But we are hearing of weakening conditions from some of our portfolio companies so we are watching carefully.
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Quarterly Attribution Analysis
The Quarterly Attribution Analysis for period ending September 30, 2015 is not yet available
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