We entered the year with optimism. We believed a combination of government stimulus and an effective vaccine rollout would support an already strengthening economy and would engender increasing confidence in still-wary investors. Many seemed to be on the fence, awaiting the outcome of the Georgia Senate races and wondering how they would impact the balance of power in Washington. While politics has never been more interesting, we try hard not to let hyperbole about current events affect our decision-making. We dared to believe our portfolio holdings would be front and center when others got the urge to go shopping.
That is more or less how the quarter turned out. Election drama faded and indications of the strongest US and global economic recovery in almost fifty years were clearly evident - job creation, rising home and car sales, airlines adding flights and so on. The stock market continued upward. Bank of America analysts report that equity funds brought in $576 billion in the five months from November through March – more than the $452 billion attracted over the previous twelve years combined. Attention shifted to industrial, financial, and other cyclical stocks that rose significantly while large tech stocks were spurned for a change – Amazon and Apple were off 5% and 8%, respectively.
Since the market bottomed in March 2020, investors’ willingness to take risk has increased in stages – spreading from the “safe” tech giants to other growth stocks and finally to the entire stock universe, including foreign and value shares. The change in market leadership has been welcomed by investors who have been willing to own stocks that looked considerably cheaper than the popular large tech darlings. We thought that the improving economy would provide a proportionately larger boost to the expected future earnings of financial and industrial companies than it would for Amazon or Apple, whose growth is less tied to the health of the economy.
Not at all anticipated was a rapid spillover of excitement and confidence into strikingly speculative assets. Witness GameStop (GME), a struggling mall-based retailer of new and used video games whose share price was suffering as the use of these products no longer necessitated a trip to a store. With bankruptcy looming, hedge funds bet against the company’s future by selling shares they didn’t yet own under the assumption they would eventually cover by purchasing shares for pennies. The narrative began to change late last year with the suggestion that the company might be transformed into a preferred online retailer of games and other digital goods. A loose confederation of individual traders (and undoubtedly some institutional ones) used social media to encourage the purchase of GameStop as a way to stick it to the hedge funds. Shares of GameStop soared from $40 to $480 over the span of five trading days in January, fueled by hedge funds who reluctantly paid up to cover their short positions and suffered sizeable losses.
In another sign of exuberance, Special Purpose Acquisition Corporations (SPACs), which are used as an alternative route to bring private companies public, have raised more in the first few months of 2021 ($100bn) than they did in all of 2020 ($80bn). A little background first – SPACs raise funds via public markets and in two years or less merge with a private company, allowing the target company to bypass the lengthy and expensive process of a traditional IPO. SPACs are typically issued at $10 a share, and that $10 goes into a trust where it sits until a SPAC lands a deal. When nothing happens, investors get that $10 back, which occurred often until recently.
In a hot market, the expediency of SPACs became very attractive. We may have seen the peak of the SPAC frenzy – already some deals appear suspect, targeting start-ups that are years away from financial viability. In general, SPACs are great for those running the SPAC and terrible for the investors (like many Wall Street products). Upfront fees typically add up to 3% - 5% of deal value. As a deal closes, additional shares, known as the “promote,” are created for the SPAC manager. While the specifics vary, the manager receives about 20% of the SPAC shares. Thus about 25% of investors’ capital is directly or indirectly going to the SPAC manager, a heavy burden on future returns. After rising as much as 20% by the middle of February, an ETF that tracks SPAC performance (SPAK) ended the quarter down 8%.
Outlook & Strategy
After an epic twelve-month run, it is natural to worry about giving back gains. The GameStop saga and the SPAC boom are both indicative of froth in the stock market. They are also reminders that stock prices often diverge from fundamental value. The most popular (and expensive) stocks and sectors are still software and related technology stocks, along with “green” industries such as renewable energy and electric vehicles. Our inability to reconcile share prices with likely business prospects for most of these companies means we must look to invest in other places.
There are macro risks to monitor, including geopolitical tensions with China and a potential inflation spike, as we detailed in our message last quarter. It is fair to say that first quarter market activity reflects much of the recovery that appears to be at hand. However, the factors underlying our optimism are still in place. More stimulus appears to be on the way, especially if some version of the Biden administration’s infrastructure spending plan makes it through congress. The Federal Reserve is sticking to its promise to keep short-term interest rates near zero. Consumers are shifting their focus from disinfecting wipes to plane tickets.
To repeat our mantra – we are “staying the course” – focused on what should work over next one to three years rather than just reacting to what is happening at the moment. When others lose interest in doing basic analysis and instead shoot for the stars, we emphasize patience and redouble our value-seeking efforts.
We eagerly await a return to the daily interactions that define normal life and are looking forward to a day soon when clients are once again a regular presence in the office. Wherever you are, we wish you good health and we welcome any questions you have about your portfolio or this commentary.