A Look at Stralem’s “Participation with Protection” Strategy

What are your thoughts on the U.S. equity market right now? Are we overdue for a major correction?

The history of markets supports that the passage of time weighs on the business cycle. But, aided by the combination of ZIRP and now significant tax cuts, this Teflon market continues to defy history and we do not see significant changes to the earnings trajectory. However, while both U.S. economic growth and corporate earnings growth are strong and stable, there are two economic developments that represent paradigm shifts and may cause increased market volatility and the need (finally) for downside protection in portfolios: global central banks reversing monetary stimulus, and the increased likelihood of protracted and damaging trade wars. These two developments can be game-changers as the meme of “synchronized” global growth fades.

Where are you finding investment opportunities? What areas are you avoiding?

While we only invest in S&P500 listed companies, our portfolio has always been heavily ex-U.S. centric. With this in mind, there have been three secular constants over the past (nearly) two decades that remain in effect today: demographics, the rise of middle-class purchasing power and the evolution in technologies.

The trade tit-for-tat has thus far increased volatility but not come home to roost on the revenue line and that is to be expected from multinational companies with global supply chains and localized production. But we are warry of companies with products that fall under the aegis of “replacement”, meaning items the Chinese can switch out even if lower quality. For now, “irreplaceable” items include technology hardware/infrastructure, pharmaceuticals/biotechnology, logistics, and specific consumer products.

Can you give us current examples of both “up-market” and “down market” investments in your portfolio?

Up-market companies are fast growing with significant markets share – they are the sexy side of the portfolio. They include: 1) Adobe, the software and service company that supplies market leading tools for digital content creation. It's suite of products are considered a de facto industry standard, which has created a huge barrier to entry. And its transition to software as a service model has led to 85% of its revenue occurring from recurring sources – making the revenue in profits even more stable and recurring, and enabling an even higher valuation. 2) Thermo-Fisher Scientific, the life sciences, tools, and services company that offers end-to-end solutions in hardware and software across the high-end biotech research labs in the U.S., and increasingly in China. Their growth is fueled by end-market growth, but also through a repeatable formula of bolt on acquisitions. As science continues to advance, it's clear that the need for ongoing high efficacy investment is going to be critical to the advancement of discovery in complex hard to treat diseases; and 3) Visa, the globally dominant electronic payments processing network. Visa is riding the secular global shift from cash and checks to plastic and mobile payments. They are at the forefront of developing standards for secure digital payments and own substantial IP in the blockchain.

Down-market companies are slow growing but with significant cash generation and the wherewithal to increase dividends at a higher rate than inflation (thus protecting purchasing power of the account). In a down market, when there's uncertainty, when there's volatility, that’s when you want to get paid to be an investor. They are the comfort food side of the portfolio – an anchor to windward if you will. A good example is Dominion Resources. Its strength lies in its utility to its end user, which are really the federal government installations along the Potomac River and the Dulles technology corridors where upwards of 70% of global internet traffic goes through their territory. This is where you're going to find the cloud computing of Amazon and Apple and all the other big networks. Dominion is a diversified utility and it provides an increased regulated customer base, which we love, and high growth natural gas distribution infrastructure complete with an international export facility. It has the balance sheet to support a dividend, which is expected to grow at 8% per annum through 2020 on just a 70% payout ratio. Further, it's got regulated rate base growth of 6.5% per annum – that's a multiple of GDP in excess of two times. Another classic option is eminently unexciting P&C insurer, Chubb. They are the best-in-class commercial insurer and a disciplined underwriter, with cost levers at its disposal and opportunities for growth. Like a tortoise, they are slow and steady and do not exhibit the kinds of expectations that would lead to a lot of dispersion. It's not cocktail talk. It's not sexy, but it has pricing power which in this environment is very attractive to us as investors.

Despite the resurgent growth of the U.S. economy, wage growth has not kept pace. What is the reason for that and how does that affect your longer term view of the prospects for inflation?

As we have seen with the volumes of opinion surrounding this conundrum, there is no obvious reason for wage growth to remain stuck in low gear. It is undeniable that we are in the depths of a part time economy, a sub-set of the service economy that drives so much GDP. The participation rate is at multi-decade low and there is far more slack than is acknowledged. As such (and excluding the highest value add technology and engineering industries), we do not see wage inflation as a head wind to the economy.

The threat of an all-out trade war has escalated in the last few weeks, with the imposition of tariffs by the U.S. and the E.U. How do you expect that to unfold and what will be its impact on the economy and the companies you own?

It is admittedly very hard to game the U.S. president’s intent beyond providing for his voter base. But it is without question going to be paid for by the consumer, which is where your prior question on inflation comes. The cost of every item – from large automobiles to tiny Christmas lights – is heading higher. So whereas we don’t see wide-spread demand driven (wage) inflation, we do see cost-push inflation coming soon to a store near you. The larger companies will be able to sustain lower margins for longer while the smaller companies will be quick to pass operating costs through. There is some irony here as the larger companies are on the firing line of tariffs but the smaller companies will feel it first.

You are heavily invested in the technology sector. The dominance of companies like Amazon, Google and Apple has raised the prospects of an anti-trust regulatory backlash. Are such fears justified? Does that scenario play into any of your investment theses?

We have has conversations with clients suggesting Amazon might be the second coming of Standard Oil. With the extreme political environment, we will undoubtedly see increased calls for a break-up if the current polarization continues unabated. This level of speculation however plays no role in our thesis.

What are your concerns about rising interest rates and how they might affect companies and the market?

After a decade of ZIRP and the gross misallocation of capital by government and businesses, rising interest rates are welcome…and they are a game-changer. Every adjustable rate loan, all the government and corporate debt servicing….this is the reason to have built in, long-only, unlevered positions in the portfolio. Like the financial crisis, everything was fine until a whale surfaced (Lehman and AIG). We won’t see it until some entity cries wolf. Then sit back and watch the counter-parties – once again – prove the fallacy of master netting agreements.

U.S. equity investors have been well-served for most of the post-crisis period by owning a low-cost, market-capitalization-weighted index fund as opposed to an actively managed fund such as yours. Will index funds continue to prevail over active management?

Ask me again when this market breaks! Passive investors have had it easy: low rates, massive earnings accretion, and no volatility. However, we have written extensively to our clients about the weak points in market architecture and fragility. The market already broke once when the volatility linked ETFs blew up earlier this year. And that was in one narrow, esoteric, non-retail product. Time will tell but when times are not so easy, why would you want to own an entire index?

We have no doubt passive investing is here to stay, but we would be surprised if the market for active managers disappeared entirely. As is evidenced by our client base, it remains clear that our way of investing – trying to participate without getting overly extended – has a role and will likely grow more appealing if/when indexes reprice. Further, as investors of our own capital, one tends to have a built in conservativeness that you might not have if you were just investing other people's money, and that continues to hold great appeal.

History has shown us that owning a portfolio of carefully selected stocks that either have room to grow or that have limited downside within a structure that seeks to both grow and preserve capital is among the best ways to build long-term wealth. At this time, in this market, in this economic cycle, we see participation with protection as the prudent investment strategy to navigate an increasingly unpredictable period.

Read more articles by Robert Huebscher