During the third quarter, the stock market, as measured by the S&P 500 Index (S&P 500), posted a modest 1.70% gain, while the U.S. economy enjoyed a continuation of the recovery begun in 2009. Both achievements were remarkable, not so much for their extent, but because they happened in the face of some very serious uncertainties, including rising tensions in the Middle East, the U.S./China trade war, Brexit and Hong Kong unrest. All this uncertainty led to disruption and likely postponement of capital spending decisions, resulting in slowing global economic growth.
Adding to these headwinds was slower growth in China, a number of developing economies, and Europe. In fact, Germany may already be in recession. Despite growing uncertainty and slower international growth, the U.S. economy continued to expand, and the stock market inched ahead.
In response to the various risks to economic growth, the Federal Reserve (the Fed) cut rates another 25 basis points (0.25%) in an effort to keep the expansion alive — the second rate cut since the current round of easing began in July. Anemic inflation, hovering below the Fed’s 2% target, has given the Fed room to cut rates. In a nutshell, we would describe the third quarter as “lots of headlines,” but not much real change in the U.S. economy.
Our focus remains on industry leading or dominant companies enjoying robust tailwinds and facing the prospects of rising or, better yet, accelerating earnings and cash flow growth. While we believe buying leading companies in structurally advantaged industries can be a rewarding investment strategy, there are two important additional considerations: 1) the sustainability of a company’s competitive position and 2) a company’s valuation. In this age of rapid disruption, we are especially conscious of the first issue. Just consider Kodak, a once dominant company that is now virtually non-existent due to the replacement of physical film with electronic bits. Regarding the second issue, shares of Coca-Cola, the most dominant beverage company on the planet, have compounded at only 3.8% annually vs. 6.6% for the S&P 500 since June 30, 1998. The price one pays matters. As we have argued before, one of the reasons we are focusing on dominant companies is that we feel we are moving toward more of a “winner take all” economy. There are several reasons for this evolution. In some industries, scale economies come into play. In others, network effects dominate. In most, the ability to fund technological infrastructure capital projects enables leading companies to drive down their operating costs faster than their lesser competitors can, thus becoming more profitable and more capable of serving customers with either better service, lower prices, or both. Here are some examples:
Amazon has become an awesome force in retail due to its unrivaled scale, forcing many smaller retailers into oblivion.
The universal banks (Bank of America, JPMorgan Chase, Citigroup and Wells Fargo) are spending billions on technology, making it increasingly difficult for smaller banks to remain competitive. Much of this technology enables compliance with growing regulatory burdens, further protecting the large banks from smaller competitors.
The cost to develop new planes is enormous. As a result, Airbus and Boeing have emerged as an effective duopoly in aircraft manufacturing.
Google rules the roost. Extremely well capitalized players have tried repeatedly to gain a foothold in internet search but have failed to replicate the Google algorithm, which benefits from a virtuous cycle whereby the more users search on Google the better the search results, attracting more users, improving search results and so forth.
Facebook dominates. People want to use the social media platform with the broadest participation, leaving little room for secondary players.
The cloud is dominated by Amazon, Microsoft and more recently, Google. Network effects and economies of scale limit the risk of new entrants.
Cloud computing requires data centers. A few large operators dominate the data center business because of network effects and scale benefits. This industry continues to consolidate.
Waste Management, Republic Services and Waste Connections now comprise roughly 60% of the North American market due to the strategic value of diminishing landfill capacity.
Crown Castle, American Tower and SBA Communications control nearly the entire U.S. cellphone tower market, leaving little opportunity for new players to arise. Regulatory issues have preserved this oligopolistic market structure.
After decades of consolidation, seven companies comprise nearly the entire North American rail industry. Any change in industry structure would almost certainly result in further consolidation.
Comcast and Charter Communications are by far the largest cable players today after years of consolidation, dwarfing competitors. While technology disintermediation is a persistent risk to the cable industry, scale has proven a winning formula for managing significant fixed costs.
The U.S. wireless market has consolidated to only four major players, as subscale operators all went out of business or were consumed by the current incumbents. Depending on regulatory actions, this industry may consolidate to only three players.
While certainly not exhaustive, this list gives a sense of how consolidated many sectors of the economy have become. Of course, the question has to be asked: Has this trend towards dominant players in consolidated industries raised the risk of regulatory action? This is a question we constantly wrestle with. We think the companies we have selected carry the least regulatory risk. Obviously the technology industry has attracted the most scrutiny recently, so we continue to spend significant time evaluating this issue. The vast majority of our technology investments are not under antitrust investigation and likely will not be in the future, so we feel comfortable with those companies. Google is most directly in the crosshairs, but we believe their largely free-to-consumer services, and their willingness to work with regulators (and occasionally accept manageable financial penalties) combine to ameliorate the antitrust issue, especially at current valuations.
We would also note that antitrust scrutiny has affected many industries we have been involved in over time, indicating the level of dominance and quality many of the companies in these sectors enjoy. And while not something to be trifled with, regulatory risk often creates a great buying opportunity: Just think back to Microsoft, which was nearly broken up in the early 2000s but whose shares appreciated by roughly 600% since the Department of Justice settlement in November 2001 vs. about 300% for the S&P 500.
In summary, given the market uncertainty and where we are in the current economic cycle, we feel it prudent to more heavily invest in dominant businesses enjoying structural growth. As always, please let us know if you have any questions or feedback.
Past performance is no guarantee of future results. Index performance is not indicative of fund performance. To obtain fund performance call (866) 236-0050 or visit osterweis.com.
This commentary contains the current opinions of the author as of the date above, which are subject to change at any time. This commentary has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.
The S&P 500 Index is an unmanaged index that is widely regarded as the standard for measuring large-cap U.S. stock market performance. One cannot invest directly in an index.
A basis point (bp) is a unit that is equal to 1/100th of 1%.
Earnings growth is not a measure of the Fund’s future performance.
Cash flow measures the cash generating capability of a company by adding non-cash charges (e.g. depreciation) and interest expense to pretax income.
Free cash flow represents the cash that a company is able to generate after laying out the money required to maintain and expand the company’s asset base. Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value.
As of 9/30/19, the Osterweis Fund held Kodak (0.0%), Coca-Cola (0.0%), Amazon (0.0%), Bank of America (0.0%), JPMorgan Chase (0.0%), Citigroup (0.0%), Wells Fargo (0.0%), Airbus (0.0%), Boeing (2.5%), Google (Alphabet) (5.4%), Facebook (0.0%), Microsoft (4.5%), Waste Management (0.0%), Republic Services (0.0%), Waste Connections (3.4%), Crown Castle (2.2%), American Tower (0.0%), SBA Communications (0.0%), Comcast (0.0%) and Charter Communications (3.8%).
Holdings and sector allocations may change at any time due to ongoing portfolio management. References to specific investments should not be construed as a recommendation to buy or sell the securities by the Osterweis Fund or Osterweis Capital Management.
© Osterweis Capital Management
© Osterweis Capital Management
Read more commentaries by Osterweis Capital Management