Talbot Financial – 1Q 2019 Review

The financial markets posted a striking start to the year with the S&P 500 Total Return Index (“Index”) rising 13.6% during the first quarter of 2019. The primary driver of the first quarter rally was the recognition that central banks are more likely to hold interest rates low for an extended period. Perhaps the biggest shift occurred in the U.S., where the Federal Reserve (“Fed”) modified its stance to rate neutrality.

The first quarter Index return of 13.6% marked the strongest quarterly return since the third quarter of 2009. All 11 S&P industry sectors had positive returns for the quarter. The largest gains were in the Technology, Industrials and Consumer Discretionary sectors at 19.9%, 17.2% and 14.7%, respectively. The lowest sector returns during the quarter were in Healthcare and Financials at 6.7% and 8.6%, respectively.

Following such a robust start to the year, we have three observations as we analyze the current state of the economy and the financial markets. First, the shift in the Fed’s stance on interest rates was logical. The Fed has the dual mandate of managing employment and controlling inflation. High employment tends to lead to inflation, so the Fed was raising short-term interest rates to stay ahead of inflation. Ultimately, the Fed recognized that with no tangible evidence of inflation on the horizon, additional rate increases were no longer necessary.

Our second observation relates to the concern of a looming recession. Historically, the last six recessions occurred only after the majority of leading recessionary indicators flashed red lights. We monitor these key indicators , and only the flattening shape of the yield curve is indicating a potential impending recession. Our third and final observation is U.S. based companies are reporting excellent financial results. For example, in the aggregate in 2018 the approximately 500 companies comprising the Index grew revenues at 10%, operating profit at 14%, and earnings per share (EPS) at 23%, as compared to 2017. In fact, the Wall Street Journal reported net margins hit an all-time high of 10.7% during the fourth quarter of 2018. Tax cuts drove some of the year-over-year growth and gains in margins; however, solid economic underpinnings, expense management and increased productivity were also significant drivers.

Our view is the most powerful driver of the enhanced business productivity is the shift to cloud computing, commonly referred to as the Cloud. Simply defined, the Cloud refers to software and services that are run on the internet, not locally on a personal computer, server or a mainframe.

When a business or an enterprise moves to the Cloud, it is transferring its information technology (“IT”) platform from a traditional “on-premises” vertical approach to any of three broadly defined Cloud verticals: Infrastructure, Platform and Software. Each vertical has a different level of complexity and management responsibility. The following chart summarizes the different verticals:

  • On-Premises: The traditional model by which all hardware, software, data are on-site. An internal IT department manages all aspects of the IT platform.
  • Infrastructure as a Service (IaaS): In an IaaS model, the infrastructure - servers, storage, networking, etc. – is moved to a third-party provider. This independent provider then hosts and manages the platform, accessed through the internet.
  • Platform as a Service (PaaS): In addition to the underlying infrastructure, the third-party Cloud provider hosts and manages the operating system and other software for the user. This platform typically provides additional services to help developers create new software more quickly and efficiently.
  • Software as a Service (SaaS): SaaS is where the third-party provider hosts and manages the entire infrastructure, software and applications for the end-user. The entire IT suite is run on the provider’s infrastructure.

At Talbot Financial, our investment portfolios include sizeable positions in companies with significant direct and indirect exposure to the Cloud. Examples of companies with direct exposure include Amazon, Adobe, Cisco, Alphabet (Google), Facebook, Intel, Intuit, Salesforce and Microsoft. Companies with indirect exposure, i.e., leveraging the cloud to improve efficiencies, include Johnson & Johnson, Boeing, Chevon and JP Morgan. We believe that most, and likely all, companies owned in client portfolios are benefitting from the Cloud in one form or another.

We want to expand on Microsoft (Ticker Symbol: MSFT) as an example of a company benefiting from the Cloud as it is one of our largest positions. In short, MSFT’s position within the entire Cloud ecosystem is second to none. First, within the on-premises approach referenced above, MSFT has a dominant share in operating systems (Windows), office productivity software (Office) and server software. This installed base provides MSFT a massive and semi-captive audience to sell its Cloud services. If the business/enterprise wants to continue with the on-premises approach, MSFT continues to capture the revenues.

On the other hand, if the business/enterprise wants to move some, or all, of its IT services into the private or public Cloud, then MSFT also captures the revenues. Either way, MSFT maintains the revenue stream. Importantly, many of MSFT’s products are ubiquitous across platforms; and therefore; easy to transition to the various Cloud verticals listed above. This is an enormous competitive advantage for MSFT.

Secondly, MSFT can and likely will continue to gain market share. Within the IaaS Cloud vertical, MSFT is one of two dominant players, Amazon Web Services (“AWS”) being the other. AWS has greater market share, but the evidence suggests MSFT is catching up. Within the PaaS Cloud vertical, MSFT is one of three dominant players, with ServiceNow and Salesforce being the other two. Lastly, MSFT’s Office 365 package is the predominant SaaS Cloud vertical offering. In 2018, Office 365 had almost $15 billion in revenues.

In summary, we believe MSFT is the only Cloud participant with dominant positions in all three cloud verticals. That said, we own positions in many other leading companies in the Cloud as we firmly believe the innovations from these companies rival the sustainable changes brought about from the Industrial Revolution.

Please find attached your first quarter 2019 portfolio review to supplement the monthly accounts statements available through Schwab. The report provides a performance summary of your portfolio compared to our benchmark S&P 500 Total Return Index and lists the portfolio holdings by industry sector.

As always, we are always excited to hear from you. Please do not hesitate to call us with any questions.

Talbot Financial, LLC