Letter to Investors: Third Quarter 2016

Dear Partner,

This is the first in a series of quarterly letters to Three Nine Financial investors.  The purpose of these letters is to keep you informed of what’s going on with your portfolio and to provide the “why” behind some of our investment decisions.

First, we want to cover some housekeeping items before diving in.

  1. The letters will focus on the TNF Equity Strategy, where we take an active investment approach buying and selling individual stocks.  We don’t discuss bonds in much detail because we take a passive approach to fixed income investing.

  2. We officially launched the TNF Equity Strategy on July 11, 2016.  Therefore, any data you see in this letter is based on the period from July 11 - Sept 30.

  3. Although we’re providing quarterly performance information in these letters, we do not manage the portfolios for quarterly performance.  Instead, we focus on long-term results.  That means there will be times where we underperform in a quarter, and times when we outperform.  Don’t put too much weight in any one-quarter’s performance (good or bad).  Something I’ve learned from being in this business for almost a decade is that things can change quickly.  Those that survive all of the vicissitudes of the market are the ones who have a long-term orientation.

  4. We will not use these letters to guess at what the market will do going forward.  We don’t believe we can be successful over long periods using a “market-timing” approach.  Instead, the letters will focus on our investment portfolio and the major factors driving the performance of the companies we own.  

Now that the housekeeping information is out of the way, let’s quickly review our investment approach.  Here are the three pillars of our investment philosophy:

1.  Long-term Ownership
When we evaluate the buying or selling of any stock, we do so from the perspective of a long-term business owner.  We look to invest in enduring companies that trade at a discount to their fair value.  Because of our long-term orientation, we are able to take advantage of the short-termism that has invaded Wall Street, and keep trading costs and portfolio turnover low. 

2.  Concentrated Diversification
We coined the term “concentrated diversification” to highlight the fact that diversification is valuable, but too much diversification can be counter-productive.  At any point in time, our portfolio will have 20 to 30 stocks in it.  Investing in 20 to 30 stocks allows us to be more familiar with the companies we are buying, and take larger positions in the ones we feel most conviction about.  Academic research has shown that holding a portfolio of just 20 stocks helps diversify away company-specific risk.  

3.  People Over Profits
We look to invest in companies that are doing well by doing good.  We want to own businesses that treat all stakeholders well and not just shareholders.  The best companies are those that put people ahead of profits.

Our investment philosophy as outlined above, instructs every decision we make when managing your portfolio.  So let's dig into the performance info for the third quarter of 2016. 

The portfolio gained 4.9%* from July 11 until the end of the quarter.  The S&P 500 gained 1.5% for the same period.  We’re pleased to report outperformance of 3.4% for the quarter.  However, a quarter is just an arbitrary point in time, so don’t read too much into one quarter; instead, stay focused on long-term results.

Our outperformance was driven by three of our companies that were up by over 20% in the quarter: TD Ameritrade (AMTD), Hollysys Automation Tech (HOLI), and Ixia (XXIA).  While we still like TD Ameritrade, the stock is close to our price target, so we are considering trimming it back.  

On the other hand, a major detractor was Magellan Health (MGLN), down just over 20% for the quarter.  An earnings miss and the loss of a major customer (not Magellan’s fault) were the two main reasons for the downward stock move.  However, the company maintained full year guidance, and we think the lower price presents a buying opportunity.  Magellan is a differentiated health insurance provider that generates strong cash flows, so we’re considering increasing our position.

As mentioned in the housekeeping section, we do not prognosticate on the future of the overall stock market or the US economy in these letters.  Nevertheless, we do want to review the current state of the stock market, and how we manage your portfolio through market cycles.  

We feel that equities (and fixed income) are currently overvalued relative to historical valuation levels.  By almost any measure (P/E, Shiller P/E, Total Market Cap/GDP, etc.) the stock market looks pricey.  But with low (and even negative) interest rates on fixed income investments, there aren’t many alternatives for investors.  

Which means, even though the stock market doesn’t look cheap, it could stay this way for a long time and even command a higher valuation before it stumbles.  When will it normalize?  What will trigger a sell-off?  The Fed raising interest rates?  The presidential election?  Terrorist attacks?  In our experience, there is no way to successfully predict (repeatedly) the short-term movements of the stock market.  Therefore, we don’t waste any time trying.

Instead, we focus on investing in companies that are trading at a discount to their fair value.  This approach should provide some protection of your portfolio during a market downturn in two ways:

  1. We’re buying companies at low multiples, so the potential downside is likely lower.  

  2. In periods where the market is overvalued, there will naturally be fewer “bargain-priced” stocks, so we’ll hold more cash in the portfolio.  

A quick side note: we do keep some cash on hand to have extra dry powder to take advantage of investment opportunities when they present themselves.

We’re grateful to partner with you to steward your resources for maximum Kingdom impact.  Our first quarter (Q3 2016) performance is a great start, but (at the risk of beating a dead horse) investing is a long-term endeavor.  We would be wise to keep that in mind as stewards of God’s resources.

“The one principle that surrounds everything else is that of stewardship; that we are the managers of everything that God has given us.” 
-Larry Burkett 

Sincerely,

Ben Malick, CFA
Portfolio Manager

 

 

*Performance is net of fees and is representative of a single client account that started on July 11, 2016.

The information contained herein reflects the opinions and projections of Three Nine Financial (TNF) as of the date of publication, which are subject to change without notice at any time subsequent to the date of issue.  TNF does not represent that any opinion or projection will be realized.  All information provided is for informational purposes only and should not be deemed as investment advice or a recommendation to purchase or sell any specific security.  TNF has an economic interest in the price movement of the securities discussed in this presentation, but TNF’s economic interest is subject to change without notice.  While the information presented herein is believed to be reliable, no representation or warranty is made concerning the accuracy of any data presented.

Past performance is not indicative of future results.  Actual returns may differ from the returns presented.  Reference to an index does not imply that the funds will achieve returns, volatility or other results similar to the index.  The total returns for the index do not reflect the deduction of any fees or expenses which would reduce returns.

Positions reflected in this letter do not represent all the positions held, purchased, or sold, and in the aggregate, the information may represent a small percentage of activity.  The information presented is intended to provide insight into the noteworthy events, in the sole opinion of TNF, affecting the portfolio.