Q3 20 Letter to Shareholders
The Frank Value Fund Institutional Class returned 9.22% YTD as of 9/30/2020 compared to 4.09% for the S&P 500 TR Index and -12.84% for the Russell Midcap Value Index. The fund is delivering superior returns with significantly less volatility than the market averages. Please see the end of this letter for more performance information.
In the third quarter, the US stock market continued its rally back toward February 2020 levels. The media narrative claims the rally is caused by a full recovery in the US economy and “back to normal.” Instead, our research shows it is the opposite. Stock prices are strong, but the economy is damaged, with long-term growth expectations decreasing. The rising tide of stocks is purely the result of flows from strategies that conduct no fundamental research, and these strategies are allocating money in a market-capitalization-weighted, momentum fashion to the best performing stocks. While it gives us pause to watch loss-making companies rally, and high-quality growth trade at valuations unseen since the 1990s tech-bubble, we are finding ways to invest without compromising our principles. As a result, we believe the amount of fiscal and monetary intervention to keep markets essentially flat in 2020 is extremely positive for the Frank Value Fund portfolio. The stats below illuminate our case.
|Category||Feb 2020||September 2020||% Change|
|Fed Balance Sheet||$4.1 trillion||$7.1 trillion||+73%|
|Gold price per ounce||$1570||$1900||+21%|
|Continued Jobless Claims||1.7 million||11.8 million||+594%|
|Real US GDP Annualized||$19.2 trillion||$17.3 trillion||-9.9%|
|US Government Spending||$7.5 trillion||$10.9 trillion||+45%|
|US Government Debt||$23 trillion||$26 trillion||+13%|
|Fed Funds Rate||1.5%||0.09%||N/A|
This year, the Federal Reserve has slashed its overnight rate to 0% and has grown its balance sheet by 73% or $3 trillion. The US government increased its annualized spending by 45% or $3 trillion in just seven months. At some point, the mind numbs to the large percentages, and it is unable to comprehend the sheer size of words like “trillion dollars.” These are the largest institutions in the world! Increases of this magnitude would be stunning for entities 90% smaller than the US. The authorities are intervening as aggressively as possible, yet stocks are roughly flat, and continued jobless claims are still over 11 million. Recall at the height of the Global Financial Crisis in 2008, continuing jobless claims were 6.5 million. US GDP is nearly $2 trillion below February 2020 levels. According to the Congressional Budget Office, by the end of 2021, US GDP will still be 2% below Q4 2019 levels. The bottom line? Government intervention, quantitative easing, and widespread debt have a diminishing effect on growth and jobs. We are clearly at the point where every new dollar of debt has little effect on the real economy, and authorities have reached hard limits, like 0% interest rates, that restrict their options.
Will the reality of diminishing returns stop government officials from intervening in the economy? Absolutely not! Therefore, the Frank Value Fund continues to be positioned in various stocks, bonds, metals, and gold miners that all benefit from reckless monetary and fiscal intervention. Also in the above chart, you can see gold prices have increased over 20% since February 2020, and our research indicates there is significantly more upside as the world moves towards negative interest rates. The economy will have a slow claw back to its Q1 2020 high watermark, but government intervention and precious metals are already in a bull market.
Markets are completely mispriced for slower growth, even though this appears to be the most likely outcome. Data from the Internal Revenue Service showed 265 million W-2 forms used to report wages from employers in 2019. In the pre-COVID, 2019 projections, the IRS estimated this number to be 266 million in 2027. Instead, after the recent shocks to the economy, the 2020 projections now estimate 255 million W-2 forms in 2027. The IRS is projecting 11 million fewer wage-reporting filings seven years from today than they had projected in 2019. The economy has permanently lost jobs, and as mentioned above, the Congressional Budget Office is forecasting 2022 Real GDP to be roughly flat from 2019. Further, the CBO projects a low 2% growth rate in 2022 and beyond. Historically, the CBO has been much too bullish in its GDP forecasts. Long-term slow growth means earnings will disappoint. Why is growth so limited in a dynamic, technologically advanced economy like the US? Government intervention has created a debt problem. More debt means slower growth. Scores of companies, individuals, state and local municipalities, and even pension funds, (with their obligations) are focused more on avoiding defaults than spending for growth. Think about being behind on your mortgage. You will scramble, sell assets, and maybe even borrow money from elsewhere (at a higher rate) to make sure you keep your house. You may fend off the bank, but you have been unable to focus on growth and may be in a weakened position by the forced sale of other assets and more restrictive borrowing. Again, debt slows growth. Slow growth means valuations should be a lot lower.
What about inflation? Most financial writing about government spending and low interest rates leads the reader to believe rampant inflation is imminent. Our view is nuanced. First, as mentioned above, we believe the immensity of debt is deflationary or negative for growth. The below ten-year chart shows federal debt exploding to the upside relative to the size of the economy. Corporate debt is on a similar path, and even with low interest rates, all this debt adds up and requires cash flows to service. Worrying about your debt means you cut spending, and spending declines are deflationary. Deflation ignites an insolvency cycle where debts are unpaid because customers cut spending, pressuring cash flows, which cause more debts to be unpaid and so on.
What happens if some of these debts are unpaid? Just as in March, when the Federal Reserve may have illegally intervened in the corporate bond market, cries for the Fed to save the day will arise. What if public demands the Fed to abandon its charter of lending and instead directly spend its balance sheet to bail out everyone? That would be incredibly inflationary, and in that scenario as well, you would want to own the Frank Value Fund. We are prepared for both deflation from bad debt and inflation from the Fed or Modern Monetary Theory. Our investment strategy has always focused on businesses that are hard to replicate, have high marginal returns on capital, and perhaps most importantly, hold pricing power over their products. If Pandora’s box of inflation opens in US, the Frank Value Fund is invested in businesses that will fend off this painful environment. We expect in both deflation and then inflation, multiples on US stocks will contract materially, offering us opportunities to invest your capital at attractive long-term returns.
Stocks will continue to march higher from passive flows, not from news of more government stimulus or whoever wins the White House, as the media would have you believe. Stocks are moving purely on investment flows into passive strategies. Passive flows continued to be positive even in the March declines, and as indexing has gained several more points of market share in the aftermath, active managers have never had less influence on stock valuations in history. As passive strategies surpass 50% of all professionally managed money in the US, market fragility increases. This means two things. First, there is less supply of actively held stock for passive to buy. This increases volatility because passive must buy when there are flows from customers, and passive managers will raise their bids until they receive stock. This explains the penny-stock-like run in Apple from $100 to $140 and back to $100 in August and September on a stock split. In this time, Apple market capitalization increased over $600 billion and then declined $600 billion. That dollar move in Apple is greater than the entire market caps of all but 6 companies in the S&P 500! Of course, the fundamentals of the world’s largest and most-followed company did not change drastically this summer. Instead, the extinction of holders focusing on fundamentals is causing more volatility. We expect volatility to remain elevated and increase as evidenced by the VIX trading today in the 20s compared to the low double-digits in February. Second, when passive exceeds 50% market share, it is likely these strategies will eventually suffer net outflows from demographics or the law of large numbers. Passive strategies have never had to contend with sustained outflows. This sets the terrible machine into reverse. Passive managers must meet redemptions buy offering to sell, without regards to fundamentals, and at any price necessary to attract a bid. Active managers do not have anywhere near the amount of cash to meet these ask prices, which will cause extreme downside volatility. This will be the generational opportunity the Frank Value Fund hopes to exploit.
We believe the collapse of passive is a certainty, but the timing is impossible to predict. However, zero interest rates, retiring baby-boomers, increased layoffs of 401k holders, and deflationary conditions are all catalysts for passive outflows. We expect a return to historical valuations, currently over 185% Market Cap / GDP, to a level below 100%. We are shocked less debate and writing is devoted to this topic because it will be the financial planning debacle of a lifetime! Any investor aged 50 and above with significant exposure to passive will have to cut retirement spending rates by painful amounts. We believe investors will be much better served by shifting their equity exposure into the Frank Value Fund. Even if you believe we have a 10% chance of being right, why not hedge and sell some of your passive vehicles? For more information, charts, and specific stock examples, please see free on our website Slaughterhouse 500 and Slaughterhouse Slide Deck. The Frank Value Fund is at the forefront of “passive avoidance” and we are both positioned and prepared to navigate this violent transition.
Frank Value Fund Lead Portfolio Manager