Quarterly Update Second Quarter 2019 - GKV Capital Management
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GKV Capital Management
Quarterly Update
Second Quarter 2019
Second Quarter Review
Beyond Cult Stocks
Looking Ahead
GKV Capital Management
Opening Thoughts
Despite an outlook for slower global economic growth, stock prices worldwide continued
to rise this year with double digit gains through the end of the second quarter. The major
U.S. indices are trading at all-time highs. Meanwhile interest rates have retreated to
2017 levels with the 10-year treasury closing the quarter at 2.0% as central banks look to
add additional stimulus in the face of mounting economic headwinds.
Trade conflicts between the U.S. and its economic partners have begun to take a toll on 2Q19 Data Points
global growth, but clearly investors expect the damage to be short-lived. So far, earnings
expectations for the companies that make up the S&P 500 index have been reduced 4% DJIA YTD 14.0%
from the estimates at the beginning of the year as the imposition of tariffs have disrupt-
ed supply chains. Despite the reduced forecasts, earnings are still expected to rise about S&P 500 YTD 17.4%
8% this year over last.
NASDAQ YTD 20.7%
Central banks have generally shifted back to a more accommodative stance, lowering
interest rates to keep global growth on track. We have grown increasingly troubled that US Bond YTD 6.1%
the economy requires a reduction in interest rates to keep the party going, but for the
moment, investors have cheered the repositioning by bidding up stocks. Fortunately, 10-Year 2.00%
geopolitical crises have been relatively benign and economic metrics have been general- Treasury Yield
ly positive. Low unemployment, low inflation and positive household income numbers S&P 500 LTM 1.91%
give us some measure of confidence that the rally is sustainable for the moment. Dividend Yield
S&P 500 EPS $173.73
Next 12-MTH
We are far from complacent. There is always plenty to worry about. We would like to see
better global growth numbers. Europe and China have been weaker than expected. We S&P 500 P/E 16.9x
would like to see strong enough economic activity that interest rates do move up from
historic lows. While we are at it, we would like to see a calmer political environment as
we start into the new election cycle. Overall, it is hard to complain about much. Certain-
ly, the gains this year, for both stock and bonds, are great. We just hope we don’t see a
repeat of last year.
GKV Capital Management is an independent registered investment advisor.
For more information about us please call (805) 497-2616 or visit gkvcapital.com
Page 2
Second Quarter 2019
Second Quarter Review
The broad stock indices continued to new highs in the sec- al growth. Earnings estimates on June 30th project $173.73
ond quarter of 2019. The gains were impressive given an per share for the combined S&P 500 over the next 12-
outlook for slowing global growth and reduced earnings months. If companies meet these expectations it will repre-
expectations due largely to trade and tariff disruptions. sent 13% growth over the last 12-months. The earnings esti-
These concerns were shrugged off as central bankers world- mate for the next 12-months results in a price-to-earnings
wide repositioned to a more accommodative, low interest ratio of 16.9x for the S&P 500 as of the market close on June
rate stance after hiking rates earlier in the year. Further- 30th of 2,941.76. This valuation level should be viewed as
more, despite the potential economic damage of the broad fully valued by historical standards and assumes continued
trade disputes and weaponization of tariffs as a negotiating positive earnings growth beyond 2020, in our opinion.
tool, the market seems to believe that a trade resolution is
around the corner and little lasting damage will result. Look- For the first six months of the year, the technology sector
ing at the economic data in the U.S., low unemployment, led the market with a gain of 24.8%, followed by industrials,
low inflation and positive household income have all provid- up 24.4%, and consumer services up 21.3%. Somewhat sur-
ed economic tailwinds for U.S. equities for the first six prising is the health care sector with the worst year-to-date
months of 2019. performance up 8.8%. There has been a political overhang
on the health care sector with investor concern that new
The S&P 500 gained ground in the second quarter rising regulation from Washington lawmakers might impair
3.8% for the quarter and ending June up 17.4% for the year. growth.
The Dow Jones Industrial Average also improved ending the
second quarter up 14.0%. The technology sector continued Despite the weakness in GDP growth worldwide, equity
its gains, driving the NASDAQ Composite to end up 20.7% markets around the globe are having a positive 2019. In
for the year through June 30th. In hindsight, the correction in fact, there is not a single developed or emerging market
the fall of 2018 leading to broad losses for U.S. stocks was that is negative in 2019 through June 30th. The MSCI EAFE
overdone and the strong performance to date in 2019 is (Europe, Australasia, Far East) gained 11.8% for the first six
making up for it. While the year-to-date gains are impres- months of 2019. The MSCI Europe index gained 13.2%
sive, the S&P 500 is up 10% over the last 18 months which is through June 30th and the MSCI Emerging Markets Index
a 6.7% annualized return and is an average long-term histor- gained 9.2% for the first two quarters of 2019.
ical performance for equities.
Global economic growth projections continue to be reduced
After starting the year with an expectation of rising interest due to low energy prices and potential fallout from trade
rates, slowing economic growth drove rates lower as capital tariffs. In the April update of the International Monetary
poured into the relative safety of fixed
income. The 10-year Treasury returned to YTD Performance by Industry Sector
the lows of 2017, ending the second
quarter at 2.0%. The market is now antic-
ipating the possibility of multiple rate
cuts from the Federal Reserve in the face
of slower economic growth. Relatively
positive economic fundamentals, unem-
ployment and inflation, further economic
stimulus in the form of lower rates could
very well prolong the current expansion.
In our view, the market is discounting a
positive scenario.
Corporate profit expectations have mod-
erated somewhat this year due to trade
conflict and slower than anticipated glob-
Page 3 Dow Jones LLC, June 30, 2019
GKV Capital Management
Firmwide Asset Allocation
Fund’s global forecast, world GDP growth expectations
were reduced by 0.2% to 3.3% in 2019, representing slower
growth over the 3.6% estimate for 2018. Growth has mod-
erated for the U.S. as well, coming off a better than ex-
pected 2.9% in 2018 due partly to corporate tax cuts. The
forecast for 2019 is 2.3% with a further decline to 1.9% in
2020.
The U.S. labor markets remain healthy as the unemploy-
ment rate ended the second quarter at 3.6% from 4.0% on
January 1st. Inflation remains low by historical standards
ending May 31st at 1.8%, down from 1.9% at the beginning June 30, 2019
of the year. At the end of June, the 10-year treasury yield
declined back down to 2.0% from 2.7% at the end of 2018.
Per capita disposable income is up 3.3% year-over-year and continue to moderate our exposure to interest rate risk by
personal consumption is up 4.2%. Consumption and retail reducing the duration of our portfolio with the return of
sales are being driven in part by increases in household rates to current low levels. The U.S. aggregate bond index is
debt which increased 3.5%. While the increase is not of up 6.1% for the first six months of 2019 due to the decline in
immediate concern, a long-term trend of rising household interest rates this year.
debt relative to wage growth is unsustainable. Improving
data from the Institute for Supply Management’s economic While we manage each client’s portfolio separately to meet
indices continued to indicate an expanding economy. their specific needs, the snapshot of our asset allocation
firmwide can provide some visibility into our current con-
The decline in interest rates has had a positive impact on servative posture in the market. We ended the June quarter
bond holdings. With falling interest rates, existing bond with significant cash reserves of 16% of total assets under
positions are priced to reflect the current lower yields now management. We have become increasingly concerned that
available to new bond investments. A bond paying a 4% the slowing growth outlook coupled with earning reductions
coupon for the next 10 years is worth more than a bond may have an impact on equity performance this year and we
paying 3% for the next 10 years. Our fixed income portfolio are reluctant to give up the gains of the first half of the year.
continues to be reduced through the maturity of issues and Across all accounts our fixed income positions totaled 35%
selective profit-taking but it remains a significant percent- of assets under management on June 30th. Equities totaled
age of assets under management for our clients. We will 47% of assets under management on June 30th.
Expected Returns—Major Index Historical Performance
Page 4 Performance Data for periods ended December 31, 2018
Annualized monthly standard deviation
Bond Index is Barclays US Agg TR USDSecond Quarter 2019
Beyond Cult Stocks
“I can calculate the movement of the stars, but not the madness of men.”
- Sir Issac Newton (1642-1727)
In early 1720 Sir Isaac Newton owned shares in the South selection. We try to avoid speculation particularly when suc-
Sea Company. Newton, who co-invented calculus and cess is contingent on growing popularity of the investment
revolutionized physics with his three laws of motion was rather than business metrics such as sales growth and profita-
undeniably brilliant. That year in England, the stock of the bility. There is a material difference between speculating and
South Sea Company soared as investors became excited investing. Speculation is short-term investment with the ex-
about its trading monopoly with South America. Rampant pectation that prices will move higher resulting in capital
insider trading and the purchase of shares with company gains. In other words, the investor is betting that a future buy-
funds sent the stock soaring. Newton sold his initial in- er will want the asset at a higher price. It doesn’t matter
vestment for tidy 100% profit of approximately whether the asset is gold, a comic book, Cabbage Patch doll,
$1,000,000 in the current currency equivalent. The stock crypto currency or a hot stock. Limited supply and increasing
continued to rise more than 600% as the year progressed desirability for the investment matters most to the speculator.
and Newton bought back into the company. As it became Actual business performance is a secondary consideration.
apparent there was no realistic prospect for trading
profits in South America, the stock crashed back to earth Speculation can be successful but as Newton quipped, it is
fostering a global liquidity crisis at the time. For Newton, frequently difficult to calculate the madness of people. In eval-
his large profit turned to a huge loss of £20,000 or more uating any investment opportunity, we look to the fundamen-
than $3,000,000. tals of the underlying asset. We evaluate what the expected
earnings or income the asset will generate, what the transac-
Every so often a new idea, a new product or a new busi- tion and carrying costs will be, and what an estimated resale
ness model captures the imagination of the broad in- value will be. The value of a company’s stock should reflect
vesting public. New ideas and promising new companies the likely future earnings of the company and as sales and
come along infrequently. As is the case with any supply earnings grow the shares will appreciate accordingly. A com-
and demand imbalance, investors clamoring for a new pany that is expected to earn $1.00 per share next year should
opportunity invariably bid the limited number of shares to be worth more than a company that is expected to earn $0.50.
heights that often cannot be supported by the reality of Accordingly, a company expecting to double its earnings the
the business fundamentals. The fantastic new opportunity next few years should be worth considerably more than the
may really exist and with talented management many company that is no longer growing.
companies do realize fantastic growth. With investment
pouring in, the question every investor must consider is As professional investors, we enjoy handicapping the growth
whether the growth can ever be enough to justify the expectations of the latest hot stock and through fundamental
value being placed on a popular new company. When the analysis, we look at just how carried away the market can get.
fervor for an investment becomes totally detached from Usually, the excitement around the latest cult stock is for a
any rational fundamental metrics we like to think of the good reason. It can be a great new idea or new product cate-
opportunity as having reached cult status. Obviously, cult gory. A new technology or new business model that promises
investments are not a new phenomenon. The practice of tremendous growth. These are all good reasons to invest. The
trading for profit is as old as civilization itself, and the problem arises when the speculation exceeds even the most
more irrational the trade the greater volatility and greater optimistic outlook.
opportunity for gain for astute practitioners at the ex-
pense of the naive. Usually a cult stock is driven by unbridled optimism for an ex-
citing new product or business model. GoPro is a good recent
Traders seek to profit from fluctuations in supply and de- example. The company’s portable video cameras created a
mand while investors look for long-term appreciation. At new product category as sports enthusiasts around the world
GKV Capital, we are professional investors rather than sought to capture their exploits on camera. GoPro stock closed
traders. We bring rigor and analysis to our investment it’s first day of trading on July 7, 2014 at $43.96. Three months
Page 5GKV Capital Management
later the stock had more than doubled to close just under Tesla, from an investor perspective, is that Tesla and Ford cur-
$94.00. As cell phone cameras continued to improve, de- rently have the same market value of $39 billion. At the end of
mand for GoPro’s cameras declined sending the stock down the day, both companies sell cars and they should ultimately
more than 90% to $4.13 by the end of 2018. The perfor- have similar profit margins. To justify the premium value cur-
mance of the stock was ultimately tied to the company’s rently placed on Tesla’s stock the company needs to continue
earnings hitting $1.07 per share in 2014 and declining to a to double sales the next few years. While that may be possi-
loss of $0.78 by 2018. Rapid growth was replaced by signifi- ble, there are plenty of risks to such an assumption. That isn’t
cant losses. At the high, the company’s total valuation hit to say that Tesla won’t be successful, we are fans of the com-
$11.6 billion which would be fine if only sales had continued pany, but it must be really successful to justify the current
to double a few more years. stock price which is already down 40% from the 2018 high.
Companies with premium valuations can grow into their The recent initial public offering of Beyond Meat is what got
lofty expectations and even exceed them. Although Amazon us thinking lately about cult stocks. The company began trad-
could never have been considered a speculative cult stock, ing on May 2nd with an initial price of $46.00. It closed the first
the early expectations were high. The company went public day of trading up 43%. In just two months the stock has hit a
with the argument that the online business model would high of $169.96 for a 269% return. Beyond Meat is one of sev-
lower expenses and make the company more profitable. eral new alternative meat companies producing plant-based
The higher profits never materialized, Amazon’s net margins protein alternatives to meat products. This is a lot more than
are similar to Walmart’s but the absolutely fantastic rate of veggie burgers, however. The demand for Beyond Meat and
sales growth greatly exceeded expectations and the stock its principal competitor Impossible Foods is growing at a fan-
has soared along with its sales growth. tastic rate. The taste has improved dramatically from the
bland veggie burger with food critics claiming that Burger
Similarly, Netflix has revolutionized the delivery of content King’s Impossible Whopper tastes better than the real thing.
in the entertainment industry. The company has realized Beyond Burger is available in grocery stores, when they can
fantastic subscriber growth but as that growth has begun to keep them in stock while Impossible Foods alternative meats
slow, Netflix has expanded its value proposition to the crea- are only available in restaurants, for the moment.
tion of entertainment content. It remains to be seen wheth-
er the company can leverage its leading position in Internet So, should you buy the stock? Only if you want to speculate.
content delivery to monetize the creation of content. In- The current price of $152 could double or get cut in half.
creasingly, Netflix will be competing with industry heavy- There are no earnings to speak of as the company is spending
weights such as Disney. With a current market value of $159 to get its products distributed as widely as possible to capture
billion, Netflix is valued at more than half of the considera- market share. Revenue has grown rapidly and is likely to con-
bly larger Disney at $251 billion. With nearly $60 billion in tinue to do so at least in the short-term. Total sales in 2018
revenue for 2018, Disney’s sales are four times larger than were $97 million up nearly 300% from $38 million in 2017.
Netflix. The key for Netflix stock to move higher will be Beyond Meat is currently at an $11 billion market capitaliza-
growth which is slowing as the numbers get bigger. Netflix tion which is more than one-third the price of food giant Tyson
revenue increased 35% in 2018 over 2017. At that rate it will Foods at $30 billion. Yes, Beyond Meat is growing rapidly and
take Netflix another three years for revenue to reach 60% of far more exciting, but consider that Tyson’s 2018 revenue was
Disney’s. Netflix is a great company; it is possible, but by no $40 billion, a mere 412 times that of Beyond Meat. We view
means certain. The risks are significant. Beyond Meat in a similar vein to Tesla. A company with an
extremely innovative new product in a stodgy mature industry
Tesla is another interesting example. Although the stock is that’s ripe to be shaken up. It will be difficult for the estab-
well off the December 2018 highs of $366, the company still lished food companies to create competitive products but
enjoys a premium valuation. The company has done an im- given enough time, like electric cars, they will. We are hopeful
pressive job in a highly competitive and capital-intensive Beyond Meat can continue to grow rapidly and love to watch
industry of bringing a better product to market. Tesla is successful new companies but as an investment, Beyond Meat
struggling to manufacture its cars fast enough and cannot is beyond reach.
keep up with demand. Revenue growth has tripled from
2016 to 2018 from $7 billion to $21.5 billion. Consider Ford
Motor over the same period increased revenue only 6%, but
the numbers are much larger. In 2018 Ford revenues were
more than 7 times Tesla at $160 billion. The problem with
Page 6Second Quarter 2019
Looking Ahead
The question on every investor’s mind should always be pricing in rate reductions this year. Earnings are growing, albe-
“where do we go from here?” With the major indexes all it at a slower rate, employment numbers are positive, house-
at new highs the question seems to take on a greater ur- hold income is growing and although debt continues to rise,
gency. It is a mistake to make investment decisions based the increase is not alarming. Inflation is virtually nonexistent
on whether the market or a stock is at a recent high or and persistent low interest rates add economic stimulus. The
low. There will always be new highs and the potential for geopolitical environment is relatively benign. The scenario is
new lows. It is important to understand what expecta- what many on Wall Street refer to as a Goldilocks economy.
tions are priced in and what events are likely to occur to Grow too fast, the economy overheats, and inflation takes off.
change those expectations. For example, if investors ex- Grow too slow and risk falling into a recession. The current
pect that earnings this year will be $100 but actual results expansion has been “just right” and as a result is noteworthy
will be $80, then you should expect the value of the mar- in its duration.
ket to decline 20% as the result becomes apparent.
If nothing transpires to derail this current fundamental eco-
Through the third quarter of 2018, the S&P 500 was up nomic backdrop, we can expect the market to continue to
9%. Corporate tax cuts and positive economic growth cre- march higher along with earnings. The S&P 500 is trading at
ated an earnings windfall. Corporate earnings surged 22% 16.9x times next twelve-month earnings. From a historical
in 2018 over 2017. Anticipating continued economic standpoint, given historically low interest rates, this is a rea-
strength, the Federal Reserve continued to raise interest sonable valuation for the broad market, in our opinion. The
rates throughout 2018. With escalating trade disputes, risk is that earnings may have to be adjusted lower due to a
higher interest rates, and slower global growth, the out- continued slowdown in economic growth. Such a slowdown
look for earnings growth in 2019 began to be questioned. could be due to continued escalations in trade tensions or
As a result, the market corrected violently in the fourth geopolitical conflict or simply a negative shift in consumer
quarter. Gains were wiped out and the S&P 500 ended sentiment. We simply are unsure whether the recent down-
the year with a 6% loss. The overly bullish sentiment in ward revision for earnings growth from 12% to 8% was
early 2018 gave way to an overly pessimistic view by the enough. If further downward revisions are necessary, we may
end of 2019. Of course, we now have the benefit of hind- find the market moving sideways or even correcting depend-
sight but the expectations relative to the actual outcome ing on the severity of any reductions.
illustrates our point.
On the other hand, the relatively quiet Goldilocks expansion
Strength in stocks this year can be attributed to several can continue. If the 8% earnings growth for 2019 is met, then
factors. The selloff last fall was overdone. Earnings growth we have greater confidence in the 2020 expectation of 12%
estimates have been reduced from 12% to 8% for 2019, growth. If these results come to pass, we would anticipate
but this revision did not justify the magnitude of the cor- higher equities over the next 18 months despite being at all-
rection last fall. Importantly, the Federal Reserve has re- time highs.
vised its position on interest rates and the market is now
S&P 500 Earnings and Index Valuation
2013 2014 2015 2016 2017 2018 2019E 2020E
S&P 500 EPS $107.30 $113.01 $100.45 $106.26 $124.52 $151.60 $164.18 $184.02
EPS y/y growth 11% 5% -11% 6% 17% 22% 8% 12%
S&P 500 Index 1848 2059 2044 2239 2673 2507 2942*
Index y/y return 30% 11% -1% 10% 19% -6% 17% YTD
Trailing P/E 17.2x 18.2x 20.3x 21.1x 21.5x 16.5x 17.9x
Forward P/E 16.4x 20.5x 19.2x 18.0x 17.6x 15.2x 16.0x
Page 7
* S&P Dow Jones Consensus EstimatesIndependent Investment Advisory
GKV Capital Management is an independent investment advisory
firm registered with the Securities and Exchange Commission since
1975. We provide portfolio management services for our clients
which include individuals, families, charitable trusts, corporations
and retirement plans. We are in independent, fee-only advisor. We
don not receive commissions and we do not sell any financial prod-
ucts. We have a fiduciary responsibility to put our clients’ interest
Southern California first.
299 W Hillcrest Dr.
Suite 119 Client accounts are separately managed and tailored to meet the spe-
Thousand Oaks, CA 91360 cific needs, including risk tolerance, investment objectives, and tax
Northern California consequences, of each client. Client assets are held at an unaffiliated
1350 Treat Boulevard brokerage firm.
Suite 260
Walnut Creek, CA 94597 With extensive expertise in security analysis, we make direct in-
Phone: 805-497-2616
vestments on behalf of our clients buying individual securities. This
www.gkvcapital.com eliminates costly mutual fund fees and increases the flexibility to
E-mail: greg@gkvcapital.com manage volatility. We actively allocate capital to take advantage of
investment opportunities altering exposure to individual companies,
industry sectors, and asset classes in anticipation of the changing
investment and economic environment.
We are transparent in all facets of our asset management practice
and believe it is important for our clients know what they own,
why, what their performance is, and what they are paying in fees.
We build comprehensive portfolios for our clients with a goal of re-
ducing volatility and producing prudent growth. We protect and
build wealth at GKV Capital.
GKV Capital Management
Build Your Wealth to Fund Your Passions
GKV Capital Management is a registered investment advisor with the SEC under the 1940 act. This newsletter provides general investment information and is not
intended to provide specific financial, investment, legal, or tax advice. Any discussion of individual securities should not be taken as a recommendation for any reader
to buy or sell such securities. You should consult with your own advisor and/or do your own research before acting on any of our opinions, which we change without
notice. The data provided in this newsletter is believed to be reliable, but are not guaranteed as to accuracy or completeness. The value of the securities mentioned
herein may fall or rise and are not insured by any government or private company.
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