A Slowing U.S. Economy and Trouble Spots Internationally Separate the Good Companies From the Great Ones.
“It’s far better to own a significant portion of the Hope diamond than 100% of a rhinestone.”
—Warren Buffett, 1994 Annual Letter to Berkshire Hathaway Shareholders
For this latest quarterly message, we focus on a long-held Wasatch investment philosophy: Genuinely great companies are—as Warren Buffett wrote in 1994—“rare gems” that prevail regardless of political climates, economic conditions or market events. The same, of course, can be said of the world’s leading investors.
Twenty-five years ago, in his annual letter to Berkshire Hathaway shareholders, Buffett wrote: “If we identify businesses similar to those we have purchased in the past, external surprises will have little effect on our long-term results.”
Buffett, who notched 30 years at Berkshire’s helm in 1994, cited a more than 23% compounded average annual return provided to shareholders since 1964—along with the “major shocks” he witnessed over the preceding three decades. The dissolution of the Soviet Union, the resignation of a U.S. president, the inordinate escalation of the Vietnam War and “Black Monday” (the one-day decline in the Dow Jones Industrial Average of -22.6%) were just some of the examples that Buffett relayed to his readers. Today, we know that not a single one of those episodes—or any global challenges that followed—made the slightest dent in Buffett’s investment principles. As he wrote in his 1994 shareholder letter, “nor did they render unsound the negotiated purchases of fine businesses at sensible prices.”
“GROW OR GO”
Buffett’s fundamental, bottom-up approach to identifying and deploying capital to best-in-class companies with disciplined management teams has been written about by a litany of journalists and stock-market commentators. Few, however, have undertaken an extensive quantitative study of corporate growth and survivorship that spans decades. Two researchers with consulting giant McKinsey & Company, Patrick Viguerie and Sven Smit, did just that in 2008, publishing, along with former McKinsey colleague Mehrdad Baghai, the Wiley business bestseller, The Granularity of Growth.
In 2015, Smit revisited the book’s central thesis with another McKinsey colleague, Yuval Atsmon, to determine if the book’s findings still held true. Smit and Atsmon built a brand-new proprietary database to track company fundamentals across S&P 500 Index constituents over the 30-year period from 1983 to 2013. The duo published their findings in a McKinsey research report entitled Why It’s Still a World of ‘Grow or Go.’ The report found:
- For the three-decade period, nearly 60% of the S&P 500 companies that lagged their peers—in terms of growth and profit margins—were acquired. It was “grow or go,” and the majority of S&P 500 constituents were gone.
- More than 75% of the S&P 500 constituents that generated top-line growth and maintained or improved margins outperformed the Index over the period.
- 56% of the companies that grew slowly but also aggressively distributed cash to shareholders outperformed the Index.
- Companies with deteriorating margins underperformed, even if these companies were still growing at a significant clip. Just 27% of this last group outperformed the Index.
What Smit and Atsmon concluded in 2015 after revisiting the core tenets of The Granularity of Growth was that “outperforming the competition remains possible in all industries, even in sluggish economic times.” They added that high-performing companies “continually seek the kind of growth that generates real and sustainable value.”
Consistent with the principles described by Buffett and the McKinsey researchers, we’d like to emphasize the following points:
- We’re repeatedly faced with challenges. Although just three months—and certainly not 30 years—the first quarter of 2019 presented its share of “shocks,” including the longest federal government shutdown in U.S. history, the continuation of the U.S.-China trade tensions and the U.K.’s wrangling over how to exit from the European Union.
- Financial markets rebounded from sharp fourth-quarter declines, which we believe were intensified by year-end tax-loss selling and significant mutual-fund outflows. Despite the recent strong stock-market performance, we believe global economic growth is slowing.
- While we’re on the lookout for potential challenges, having a large universe to pick from means we can always find high-quality, long-duration growth companies around the world and across market capitalizations.
Now that we’ve presented the broad themes for this quarterly message, let’s move on to the economic and market conditions that we’ve experienced recently.
ECONOMY
In terms of economic news, we begin with the United States, the world’s largest economy. Real gross domestic product (GDP) in the fourth quarter of 2018 rose at an annual rate of 2.2%, which was down from an earlier estimate of 2.6%. Like the financial markets, recently released indicators support the view that the U.S. economy has rebounded somewhat in 2019—although we believe the probabilities suggest slower growth lies ahead.
The release of January’s retail-sales report (published by the U.S. Department of Commerce) was, like most government activities in early 2019, delayed by the longest federal-government shutdown in U.S. history—which ran 35 days from December 22nd until January 25th. Finally released on March 11th, the report downwardly revised December’s percentage decline from -1.2% to -1.6%, further accentuating the worst month for retail sales since the global financial crisis. After this downward revision, however, better news followed when it was reported that U.S. retail sales for January 2019 rebounded from December 2018 and posted a significant 2.3% year-over-year increase.
The U.S. Consumer Price Index also edged up recently, but a temporary drop in energy prices helped to hold down the Index on a year-over-year basis. With core inflation running at about a 2.1% annualized pace, the underlying trend remains in line with the Federal Reserve’s target of 2.0%.
In early March, the Institute for Supply Management (ISM) delivered one of its more noteworthy reports—with a striking divergence. ISM’s nonmanufacturing index, otherwise known as America’s service economy, posted a 3.0% increase month-over-month in February 2019. Simultaneously, ISM’s core manufacturing index fell -2.4% during the same period. While the strength of U.S. services—the country’s largest economic grouping—suggests the potential for a Fed rate hike in the second half of 2019, the state of U.S. manufacturing, exacerbated by the absence of a U.S. trade deal with China, supports the exact opposite. As a result of mixed signals like these, policy recommendations from economists are all over the board.
Regarding China, the world’s second-largest economy, early data indicate continued deceleration in 2019. Nevertheless, China’s February retail sales rose more than 8% year-over-year, which was in line with forecasts. What’s more important to us, however, is that the selection of high-quality Chinese companies has doubled in the past three years. And we continue to devote significant on-the-ground due diligence in an effort to identify the emerging leaders in various industries. This research includes a focus on the A-share market, which consists of approximately 1,400 companies incorporated in mainland China.
We turn now to Japan, the world’s third-largest economy and home to what we believe is one of the most exciting small-cap markets globally. Despite being supported by easy monetary policy, many macroeconomic indicators such as GDP growth are uninspiring. However, there are positive factors—such as Japan’s unemployment rate sitting at a multi-decade low and second only to Singapore (among developed countries) in terms of putting citizens to work. Japan’s jobs-to-applicant ratio remains stubbornly high at 1.63 as the country faces a labor shortage. Not surprisingly, we’re seeing some wage inflation in Japan, which can act as a tailwind for the domestic consumer. The tight labor market is also creating opportunities for companies that look to enable businesses to become more efficient and improve productivity.
Wrapping up this quarter’s review of developed nations, we land next on the United Kingdom, which remains in upheaval over Brexit. Prime Minister Theresa May is now faced with exiting the European Union (EU) without any deal whatsoever. In March, she requested a three-month extension from the European Council, attempting to secure a stay in the EU until June 30th. With British Parliament having rejected Mrs. May’s Brexit plan on March 29th for the third time, the EU bloc’s other 27 governments must all agree to postpone the U.K.’s departure. The uncertainty of Brexit has been clouding the British economy and markets since the referendum in 2016, and this haze is likely to persist until we know the outcome.
Among emerging markets, we see attractive company valuations coupled with bureaucratic reforms and stimulative government initiatives. In addition, investor sentiment has improved due to low inflation and reduced concerns over monetary policies in developed nations. These factors have also enhanced the prospects for emerging-market currency valuations. Moreover, country balance sheets have strengthened, as have international fund flows into emerging markets.
Beyond China, which is discussed above, we believe Latin America may offer good investment opportunities because the region’s political situation (although still highly imperfect) has become somewhat more stable, and the economic recovery seems to be getting back on track. In Brazil, we saw signs of improving consumer sentiment, and we think the country will make progress regarding deficit reduction and reining in corruption.
As for India, pro-business priorities and structural government-policy changes that have been implemented over the past several years should pay economic dividends beyond the next decade. These priorities and policy changes—along with attractive demographics and a still rapidly growing economy—help make the country one of our most-fertile grounds for finding promising emerging-market investments.
MARKETS
We recently heard a great adage about investing: “The stock market is the only market where people head for the exit when things go on sale.” And considering what followed 2018’s stock-market rout, heading for the exit certainly wasn’t a wise move. As long-term investors, we prefer to use overall market weakness as an opportunity to increase our positions in exceptional businesses.
During the first quarter of 2019, the U.S. large-cap S&P 500® Index advanced 13.65%. The technology-heavy Nasdaq Composite Index gained 16.81%. The Russell 2000® Index of small caps rose 14.58%. And growth-oriented small caps performed extremely well, with the Russell 2000 Growth Index up 17.14%. Value-oriented small caps in the Russell 2000 Value Index were up 11.93%, as value stocks—including those across larger market capitalizations—generally trailed growth stocks. The outperformance of growth stocks relative to value names was a continuation of a trend we’ve seen for a number of years.
For the most part, international stocks also performed very well but generally lagged those in the U.S. The MSCI World ex USA Index rose 10.45% and the MSCI Emerging Markets Index gained 9.92% for the first quarter.
Intermediate- and long-term bond yields fell during the quarter as the inversion of the yield curve signaled subdued inflationary expectations. Because bond prices move in the opposite direction of yields, bond indexes posted positive returns. The Bloomberg Barclays US Aggregate Bond Index increased 2.94%. And the Bloomberg Barclays US 20+ Year Treasury Bond Index was up a solid 4.73%. One of the best-performing bond indexes was the ICE BofAML US High Yield Index, which gained 7.40%. We believe the strong showing by high-yield bonds was yet another indication of increased risk appetite among investors.
While we don’t generally focus on commodities in our messages, it’s interesting to note that the Morningstar Long-Only Commodity Index rose 10.40% during the first quarter. Moreover, Brent crude oil was up about 25%.
RISKS AND DISCLOSURES
Mutual-fund investing involves risks, and the loss of principal is possible. Investing in small-cap and micro-cap funds will be more volatile, and the loss of principal could be greater, than investing in large-cap or more diversified funds. Investing in foreign securities, especially in frontier and emerging markets, entails special risks, such as unstable currencies, highly volatile securities markets, and political and social instability, which are described in more detail in the prospectus.
An investor should consider investment objectives, risks, charges and expenses carefully before investing. To obtain a prospectus, containing this and other information, visit www.WasatchFunds.com or call 800.551.1700. Please read the prospectus carefully before investing.
Wasatch Advisors is the investment advisor to Wasatch Funds.
Wasatch Funds are distributed by ALPS Distributors, Inc. (ADI). ADI is not affiliated with Wasatch Advisors, Inc.
Information in this document regarding market or economic trends, or the factors influencing historical or future performance, reflects the opinions of management as of the date of this document. These statements should not be relied upon for any other purpose. Past performance is no guarantee of future results, and there is no guarantee that the market forecasts discussed will be realized.
© 2019 Wasatch Funds. All rights reserved. Wasatch Funds are distributed by ALPS Distributors, Inc. WAS004953 Exp: 7/30/2019
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