I hope everyone had a delightful Christmas yesterday. I’ve just celebrated the second Christmas after nearly two years of writing this blog. I’ve very much enjoyed getting my thoughts out there and feel that the process has improved my investing. I’m hoping that work quietens down a bit next year, as while I still have lots of ideas for stuff to write about, it’s been pretty tough to keep the momentum going recently.
I’m writing this post off the back of the worst week since 2008 for the US stock market. So much for the Santa Rally. This year we have a Krampus Crash and it seems with my focus on high growth momentum stocks and exposure to US tech that I’ve been on the naughty list.
A US Government Shutdown was added to the long list of news currently spooking the markets. However, last Wednesday’s Fed statement seems to have been the main culprit precipating the large falls. On the face of it this may seem a little counterintuitive, as the Fed was bullish about the strength of the US economy. Consequently it was happy to proceed with its planned interest rate hike and signalled two more for 2019. The stock market’s negative reaction to this suggests that it disagrees with the Fed’s assessment of US economic prospects and believes it to be committing a policy error by raising interest rates too much too fast. Trump’s tweets criticising the Fed on Christmas Eve has reinforced this narrative.
So who is right – the stock market or the Fed? On one hand, while the stock market has tended to be a pretty decent leading indicator of recession, it is prone to overreact to fairly trivial uncertainties. On the other, correctly anticipating what may be coming round the corner is an inherently difficult challenge for monetary policy technicians – monetary policy mistakes are easily made. I wouldn’t have said a US recession seemed imminent, but the market’s reaction is giving me second thoughts, particularly as negative market sentiment can affect business and consumer sentiment in the real world. The longer negative sentiment persists the more likely it is to become self-fulfilling. The stock market and economy is a reflexive system – this means you need to be prepared to adapt your views to account for what others believe. It’s not enough to be objectively ‘correct’.
So what lies ahead? We are clearly in a bear market and more falls seem likely. However, the bottom could come at any point and the rebound could be sudden. It seems foolish to sell out and raise cash during a period of panic, but I do plan to rotate my portfolio to some extent towards more defensive businesses (particularly consumer defensives and healthcare). This should provide greater resilience against the risk of recession.
To this end I made two trades on Christmas Eve, buying back Craneware and a new position in Diageo.
Craneware provides IT payment systems for US hospitals. It is a long-standing favourite that I’ve held previously. I had regretted selling out before it went on its recent run but thanks to the current bear market now have a chance to buy back again for a similar price.
Craneware is one of the highest quality shares on my watchlist:
- Business economics: Craneware is a capital-light and highly profitable business. It has decent operating margins consistently in the high twenties. Its returns on capital have been steadily increasing in recent years and are now at 36%.
- Track record: Craneware has a solid and consistent track record of growing revenues and profits. Accordingly its share price has steadily grown over time.
- Competitive advantage: Craneware is a relatively small business but the market is fairly nascent and Craneware has a growing market share. It has a very strong competitive advantage from ‘sticky’ customers who would face substantial cost and disruption to switch to an alternative provider. Consequently its customers are on long contracts and Craneware has high revenue visibility.
- Growth prospects: These are excellent. Craneware operates in a defensive market that is growing strongly. There is a relatively high degree of certainty that Craneware has many years of profitable growth ahead of it.
The share price has fallen significantly from the highs of earlier this year, though is still in a long term uptrend. Trading momentum is excellent. The valuation is not cheap but for such a high quality business I think it is warranted.
I’m a bit of a whisky nut so have a soft spot for Diageo, a £70bn business that owns many premium alcoholic spirits brands and many distilleries.
- Business economics: Diageo is a profitable and cash generative business making very healthy operating margins. Its returns on capital have been decent but not stellar (around 15% for the past few years). Diageo has faced criticism for some of the capital allocation decisions it has made (i.e. the brands it has bought and sold) in recent years and management may well have made a few missteps. However, fundamentally it is profitable and I think has the potential to be highly profitable.
- Track record: Diageo has been around for donkey’s years and over the very long term has an excellent track record of remarkably steady and consistent growth, massively outperforming the market in a large part due to its defensive characteristics. Over the last few years the track record has been a little more patchy but right now things seem to be going well.
- Competitive advantage: I’d say Diageo’s competitive advantage was pretty rock solid. Alcoholic drinks brands tend to confer strong pricing power, as consumers develop strong preferences and habits about what they like and don’t like. Diageo has probably the best portfolio of high quality spirits brands in the world and much of its focus is on curating this portfolio to ensure it remains relevant to changes in preferences. Its scale and distribution network give it an advantage over smaller competitors. There is a risk that it invests in some of the wrong brands or makes other strategic mistakes but it’s hard to see things going seriously wrong over the long term.
- Growth prospects: given its size, Diageo is not going to achieve stellar growth. However, many of Diageo’s brands are growing steadily and continuing to spread around the world. Most importantly the markets are highly defensive and can continue to grow through recession. This is a huge advantage over the longer term and warrants a high valuation premium.
Relative to the rest of the stock market at the moment, the share price momentum is excellent. This is not unequivocally a good thing, as it can make sense to be more contrarian in a bear market and buy shares that have fallen unjustifiably in anticipation of a rebound. However, the bear market may have quite a bit further to run so I’m keen to rotate some of my portfolio to more defensive positions. Diageo’s current valuation seems very reasonable to me.