QUARTERLY LETTERS

Q3 2020 Survival of the Fittest

QUARTERLY RECAP AND OUTLOOK – Q3 2020

SURVIVAL OF THE FITTEST

The market rally that began in March continues its historic run. In stark contrast with what is happening on Main Street, Wall Street has performed exceptionally well, with the S&P 500 posting its best two consecutive quarters in the last 20 years! That incredible performance has not been uniform across all market segments; value stocks in particular have not kept up with growth stocks and lag by over 36% in just the last 9 months – the largest delta since 1979.[1] The economy, while improving from the bottom, is still far from normalized output levels. Not surprisingly, investors have responded by shunning businesses such as banks, energy companies, airlines, and others that similarly rely on an improving economy. Investors have instead paid up for businesses that grow irrespective of the general economy as growth is so hard to come by for many companies.

This lack of growth in the economy and companies has resulted in interest rates stuck at historically low levels with no expectation of them rising in the near future. In fact, at its last meeting, the Federal Reserve signaled it will keep short term rates low for years, and a number of members indicated rates will likely be anchored near zero through 2023. Given the fragile economy, the central bank understands its primary function at this point is to maintain liquidity in the markets. Bonds have generated admirable returns with the long-term decline in interest rates (bond prices go up when interest rates go down and bond prices go down when interest rates go up). Given that the Fed has said it will not take rates below zero, going forward capital gains in bonds will be hard to come by and the total return will likely be limited to the interest payments bonds distribute. Given this backdrop of near-zero rates and scarce growth for corporations, we think equities could remain at historically high valuations with fewer and fewer places to generate real positive yields.

Generally, strong areas of the market do not maintain leadership forever. We expect (and hope) that driven by better virus metrics come next spring and summer, the weaker sectors may find a way to catch up. The airline sector has been decimated with travel down over 67% from last year’s levels. It is interesting to view the transfer of shareholder wealth that occurred over this time. Since the pandemic began, the public equity value of the largest US airlines has dropped by over $50 billion and the two largest US hotel chains have lost $25 billion in value. Zoom Communications has emerged victorious, having gained over $100 billion in value as those business travelers who flew and slept in hotels now conduct meetings from the confines of their own homes! One could argue that net-net, the value merely transferred from the real-life analog world, to the digital. That is one of the reasons the market has done so well, as the largest stocks in the market are now all beneficiaries of the evolution to exponentially more time spent in the digital world.

Only the Strong Survive.

The illustration below appears to credit Charles Darwin with the quote “It is not the strongest species that survives, nor the most intelligent that survives. It is the one that is most adaptable to change.” Although widely attributed to Darwin – and as such is inscribed on the floor of the California Academy of Sciences – the quote is actually from Leon Megginson, a business professor at LSU in 1963. Megginson was a social scientist who believed in the power of change and asserted that businesses that recognize, embrace and adapt to change have a better chance at success in the long term.

Darwin quoteOn an evolutionary level, change happens so slowly that we barely notice it. In practice, think about the transition to smart phones which took years, or the adoption of ride share programs. Most people would agree that these inventions made our lives better (we realize this is a debatable statement), yet these inventions caused other businesses to decline and even fail. When is the last time you bought Kodak film or sent a fax, for example?

Today, the S&P 500 is dominated by technology companies because that is where value has been created. The most successful companies are the ones who not only recognized the coming changes but also those who reacted quickly. Of the top ten companies in the market today, none were in the top ten in 1980 and 1990. Only Microsoft was in the top ten in 2000 and just four were in the top ten in 2010 – Microsoft, Berkshire Hathaway, Google and Apple. A deeper dive into these four companies will likely confirm Megginson’s theory that deliberate and constant reactions to our changing world are essential to long-term success. Like companies themselves, we as investors MUST accept and embrace change because it is constantly occurring.

The same theory applies to us as individuals. From decreasing our reliance on fossil fuels to enacting stricter building codes to combat the effects of a world where natural disasters are more frequent and powerful, embracing change can prove to be key to both short-term and long-term survival. Even on a micro level, so many of us not accustomed to the idea initially shuddered at the thought of having to wear a mask in public. However, to reject the idea leaves many of us vulnerable to the disease so we adapt and don the masks.

The COVID Pandemic has accelerated change that was already occurring at breakneck speed. Some changes will stay with us and others won’t, and all companies are forced to adapt and evolve. [LP4] Those companies that do so will be deemed the most “fit” and survive.

The election, less than a month away, could bring about tremendous change, or things could remain status quo. While we are (thankfully) not in the business of predicting election outcomes, we know that the market, like you, takes great interest in who will win. It is our belief, based on data, that the market’s immediate reaction to the election is a short-term response and over the long term will not be impacted to any great degree by who is in the White House.[2]  Markets have done well under both Republican and Democratic leadership and we expect that the performance over the next decade will prove to be no different.

Again, we hope that you, your friends and family are holding up and doing well, all things considered. Please reach out to us if there is anything we can do to help.

All the best,

Adam Greg Matt

DISCLAIMER: Past performance is not indicative of future results. The securities identified and described do not represent all of the securities purchased, sold or recommended for client accounts. The reader should not assume that an investment in the securities identified was or will be profitable.

RIVERWATER SMID STRATEGY

The SMID strategy had positive returns in the quarter and outperformed its benchmark. Given our style of investing we expect to keep pace with the market when up and protect to the downside when down. We are happy to have done both as the market dropped in the first quarter and then came roaring back in the second and third.

We have done this with no major changes in the portfolio makeup over the last nine months. Which brings us to our continual consideration of when and if we should become more aggressive and oriented to a more “back to normal” environment where people feel comfortable congregating again. We think the earliest normalcy could return is at best next summer, but we need to be cognizant that the market usually figures things out at least six months in advance.

This quarter we bought two new companies and trimmed one position. Charles River Labs grew to an outsized weighting (it is up +75% over the last year) and so we  trimmed our position. We took those proceeds and started a position in Quidel (QDEL).

Quidel is a leader in the development, manufacturing, and marketing of rapid diagnostic testing solutions. Their products aid in the detection of critical diseases and medical conditions, including infectious diseases, cardiovascular diseases, and women’s health, to name a few. Products are sold for use in physician offices, hospitals, clinical laboratories, urgent care clinics, and pharmacies. Quidel has consistently grown revenue at 10% per year historically; today, we believe several opportunities – further expansion of testing beyond influenza, the launch of the new Savannah testing device, and FDA Emergency Use Authorization (EUA) for their COVID test – will accelerate that growth rate over the next several years. The stock is attractively valued as it trades at a below market multiple with above average growth.

We had been following the company and took advantage of an irrational selloff caused by the news of Abbott’s 15-minute test. We were happy to see the CEO follow our buy with an open market purchase and since then the stock recovered most of the loss from the news.

We also took a bold step and added a new position in SVB Financial (SIVB). Banks have been hit hard as interest rates plummeted and credit issues are likely to ramp as businesses deal with widespread closures. Nonetheless, we felt comfortable given SVB’s strong balance sheet and lower reliance on interest income due to a large percentage of earnings coming from fee-based revenues. SVB also has significant exposure to the technology sector which has insulated them from credit issues. Additionally, the stock’s valuation is at the low end of its historical range. Finally, we were attracted to the ESG efforts the bank has taken which we believe are way ahead of their industry competitors. The bank has made it a priority to focus on diversity and inclusion. It has set goals to achieve gender parity by 2030 and has been one of less than ten US banks to be included in the Bloomberg Gender Equality Index.

RIVERWATER LEI STRATEGY

On an absolute basis, our Large strategy had positive returns, and also outperformed its benchmark.  We were not terribly active again in the quarter with just one sale and one trim. Year-to-date we have added only four new positions and three of those were in the month of March amongst the market mayhem. We are running slightly higher levels of cash as we have not yet reinvested the proceeds from the sales of FirstEnergy (FE) and a trim of American Electric Power (AEP).

On July 21, FirstEnergy received subpoenas in connection with an investigation surrounding a utility Bill passed by the Ohio House legislature.  Allegedly, Ohio House Speaker, Rep. Larry Householder, and several politicians were directly tied to First Energy and paid tens of millions of dollars to pass the utility Bill. The alleged bribery case gave us significant concern regarding their governance practices and violated our internal ESG guidelines. Shortly after learning of the subpoena in the morning (all the facts were not yet known), we sold our entire position in First Energy. A press conference was held later in the day and the stock promptly gapped down to levels below where we sold.

On July, 27th, it was alleged that American Electric Power was also involved in the bribery investigation through an AEP, solely sourced, non-profit.  Later the same day, AEP proved to have no involvement in the bribery. During these few hours of uncertainty, we again decided to reduce our exposure and trimmed our position in half.

On a more positive note we had our first takeout of the year as Analog Devices (ADI) announced its intention to acquire Maxim Integrated Products (MXIM). Maxim shareholders will receive .63 shares of ADI for each Maxim share. We started a small position in Maxim close to three years ago and doubled down on it this past March. Thankfully, the takeout price is over 38% higher than what we paid just a few months ago. We are comfortable holding the shares for now but are currently looking into potential replacements.

DISCLAIMER: Past performance is not indicative of future results. The securities identified and described do not represent all of the securities purchased, sold or recommended for client accounts. The reader should not assume that an investment in the securities identified was or will be profitable.

[1] https://markets.businessinsider.com/news/stocks/stock-market-outlook-growth-driving-market-value-bounce-bofa-strategy-2020-10-1029646337#

[2] https://www.cnn.com/2020/09/23/investing/stock-market-election-trump-biden/index.html

Q42020 An Unimaginable Year in Review and 2021 Outlook

YEAR END RECAP AND OUTLOOK – Q4 2020

An Unimaginable Year

As we review 2020 and position for the future, it goes without saying that the past year was exceptional and unpredictable. Who in their right mind could have imagined a global pandemic, racial injustice protests, the worst economic decline in history and a contentious election that resulted in an insurrectionist storming of the US Capitol? No one.

Nor would anyone in a million years have guessed at the depths of the bear market in late March that global stock markets would have performed like they have. In March, the virus was ripping through New York, Italy and China and taking the global economy down with it. Fear was rampant given the unknowns; fear of contracting the virus, fear of losing one’s livelihood and fear of losing savings. The US Federal Reserve and central banks around the world came to the rescue and with swift action gave confidence to market participants. They have not looked back since March 23rd, the market’s nadir.

With professional sporting leagues and most casinos shut for months, many new investors flocked to the sport of buying stocks to keep themselves occupied. We have not seen this many newcomers to the market since 1999. And these newcomers have had a tremendous influence on the market.[1]

Party Like it’s 1999

The stock market run in 1999 and early 2000 centered on technology stocks and, more specifically, internet stocks. New technologies (plus greed) excited the imagination and investors ran wild as they paid insane prices for companies. Everyday investors were able to get in on the fun like never before as online brokerage firms democratized investing by slashing fees to trade stocks to $29.99 from hundreds if not thousands of dollars as commissions had been up to 1% of value for a one-way trade.[2]

The NASDAQ ran up 100% from August 1999 through March 2000, but as we all know every party must end. On March 10th, the bell rang. It then took 15 years for the NASDAQ to get back to its old all-time-high!

Today, Robinhood has become the new tool to facilitate ease of trading and technology stocks have reemerged as the driving force of the market’s returns. FAANG +M is a much used acronym that represents Facebook, Apple, Amazon, Netflix, Google and Microsoft.

These six companies were all major beneficiaries of the lockdown and saw their stocks all reach all-time highs. If you take these six stocks out of the S&P 500 return in 2020, the benchmark would lose a third of its gains. Since 2013, if these stocks were removed the market would lose over a quarter of its performance. The concern is that if a market’s performance is driven by fewer and fewer names the bull market is long is the tooth.[3]

Similar to the turn of the century, excesses exist in certain areas of the market like cryptocurrencies, but we do not believe the overall market is close to the bubble levels of late 1999 early 2000.

We’ll say it, too: “Don’t Fight the Fed”

Don’t fight the fed is a simplistic saying, but there is much truth in it. Cue Metallica singing, and nothing else matters here. When liquidity is easy, stocks go up. When liquidity is drained, markets end up going down as seen in the chart below. Financial conditions have NEVER been this easy and so stocks have gone up.

Financial Conditions vs S&P 500Interest rates are at generational lows (Globally there is over $18T of negative yielding debt today), the Fed continues to buy bonds (trying to keep rates low) and while stocks are hitting all-time highs, as the saying goes “There Is No Alternative” (TINA) to stocks.

It’s hard to argue with TINA as over the long-term stocks have produced phenomenal gains. Going forward we are sure to see market drops, but as you can see in the chart below,[4] those drops over the long-term just appear as blips. It seems much much worse while they are actually occurring as fear dominates.

S&P 500 Since 1928Companies have and will continue to adjust, adapt and forge ahead like they (and for that matter all of us) have with the pandemic.

Investors have been drawn to growth stocks and, like they did in 1999, have left value stocks for dead. Growth outperformed value by its largest margin in history in 2020. We don’t think this is sustainable. With an improving economy and a hopeful return to a new normal once the vaccines are fully rolled out, cyclical stocks should be positioned to rebound. This would benefit value over growth as a broader economic recovery lifts companies leveraged to it.

Our forecast for the year ahead is that it will be hard to forecast what will happen.[5] Last year we guessed that the market would see single digit returns as valuations were stretched and the market would need earnings growth to go higher. We got it totally wrong! Earnings were down, but investors were willing to pay higher prices for each dollar of earnings (P/Es) and so the S&P 500 was actually up. The difficulty in predicting the short-term is best displayed by 2020. That is why a diversified portfolio with a long-term focus is the most prudent way to invest.

Again, we hope that you, your friends and family are holding up and doing well, all things considered. While 2021 has started off like an extension of 2020 we hope and believe things will get better!

 

RIVERWATER SMID STRATEGY

Small caps had a banner fourth quarter (The best quarter on record for the Russell 2000 and the second best since the 1960’s) and ended the year up nicely. It’s crazy to think that Apple had a larger market cap than the entire small cap space as represented by the Russell 2000 earlier this year.

The Riverwater SMID strategy underperformed in the strong upswing in the fourth quarter but did end up outperforming by a significant margin for the entire year, driven by strong downside protection at the depths of the selloff in February and March and some opportunistic purchases after the selloff.

Our friends at Furey Research have looked into forward year returns after strong quarters and found that one and two-year returns have averaged over 20% and, in every instance, have been positive. Past performance is no guarantee of future returns and no two markets are alike, but we are hopeful small caps can begin to reclaim performance leadership.

During the quarter we bought four new companies and sold three. We sold Principal Financial Group, FLIR Systems and Financial Institutions to invest in companies that we felt have better longer-term prospects. There was nothing inherently wrong with any of the companies we sold, but over the long-term we feel more confident in the new additions.

StoneX Group (SNEX) is a diversified global brokerage and financial services firm providing services across asset classes and markets around the world. It has carved out a niche in servicing mid-tier clients that are underserved by large multinational investment banks. SNEX will continue to benefit from an increase in trading and volatility and could see further upside if interest rates continue to rise. The company was founded by its current CEO who along with a seasoned management team has grown the book value of equity over the last 10 years by 20.7% per year. We have been engaged in dialogue with management about improving their ESG reporting.

Farmer Mac (AGM) is a stockholder-owned, federally chartered corporation that combines private capital and public sponsorship to serve the farm sector. Farmer Mac is a unique company with a large moat because Congress has charged it with the mission of providing a secondary market for a variety of loans made to borrowers in rural America. Farmers came under pressure during the boycott of US farming products by China and then from the pandemic. This provided an opportunity to purchase a high-quality asset at a reasonable price. In the short-term farmers have not only received aid from the Government but there has been an increase in crop prices. In the long-term farming will only become more important as populations increase. AGM has consistently earned mid to high teens return in equity over the years, and with the strength of the farming sector can continue to earn strong returns into the foreseeable future. We have spoken with management and the board to give them input on ESG issues and the issuance of their first sustainability report.

We purchased Valvoline (VVV), a brand that has been around since the mid 1800’s and servicing automobiles since the Model T. In 2017, Valvoline was spun out from Ashland and is still in the early stages of executing its long-term objectives. We are excited about Valvoline for many reasons, including: strong brand recognition, a long-term plan of growing their retail locations servicing internal combustion engines (ICE) as well as electric vehicles (EV), a strong international presence and a thoughtful approach to ESG strategies and recycling. Additionally, they have an excellent training program which creates high employee satisfaction and happy customers. If you get a chance, stop by and check out their services. We’d enjoy hearing your feedback!

Lastly, we purchased Atkore International (ATKR), a supplier of electrical and mechanical products for commercial, industrial and construction markets. Since its IPO in 2016, Atkore continues to increase their value proposition as their products form the critical infrastructure from the original power source to the final outlet. We are encouraged by their focus on quality, leadership in their respective markets such as data centers and renewable energy and their steady gains in revenue and margins.

Q4 2020 SMID FACTSHEET

RIVERWATER LEI STRATEGY

On an absolute basis, our Large strategy had positive returns, but did underperform our benchmark in the quarter.  For the year we were essentially in-line with the Russell 1000 Value Index. We were not terribly active again in the quarter with just one trim of Chevron (CVX) and two additions to existing holdings, Carrier Global (CARR) and Otis Worldwide (OTIS).

Year-to-date we have added only six new positions and three of those were in the month of March amongst the market mayhem. Over the course of the year total portfolio turnover came in at just under 10%, meaning at the current rate we would hold on to positions in the portfolio for over ten years. We invest for the long-run and we strive to emulate Warren Buffett who has said his favorite holding period is forever.

We still have slightly elevated cash levels at just over 5% and expect to have one or two new names added in the first quarter.

Q4 2020 LEI FACTSHEET

[1] https://www.cnbc.com/2020/05/12/young-investors-pile-into-stocks-seeing-generational-buying-momentinstead-of-risk.html

[2] https://www.businessinsider.com/historical-trading-commissions-2014-3

[3] https://www.yardeni.com/pub/faangms.pdf

[4] https://www.macrotrends.net/2324/sp-500-historical-chart-data

[5] We still take a guess that the broad market will be up 8-12%, driven NOT by higher P/E ratios, but rather by higher earnings because of a rebounding economy.

DISCLAIMER: Past performance is not indicative of future results. The securities identified and described do not represent all of the securities purchased, sold or recommended for client accounts. The reader should not assume that an investment in the securities identified was or will be profitable.