For the 3rd quarter of 2018, ending on September 30th, the average return for TF-managed accounts was 4.61%. For comparison, the S&P returned 7.71%, emerging markets returned 1.52% and the total market returned 3.84%. I provide these measurements as a benchmark of performance, but they are not numbers we should focus too keenly on.
At TF, decisions are made with a long-term orientation. We intend to invest in companies throughout a full market cycle of 3-5 years. We favor high-quality companies, trading below their fair value. The high-quality nature gives us the confidence and reassurance necessary to hold on through any rough patches. We take a conservative approach with valuations, with a strong preference for value opportunities. Undervalued companies usually trade below fair value for a reason. Emotional reactions tend to amplify movements. Trends can continue indefinitely, causing further dips in price. Later, we'll dive deeper into this topic. Regardless, a well-composed portfolio may take time to reach intrinsic value.
We stay true to our investment pillars: namely, a long-term orientation, strict investment standards, time in the market, business-owner perspective, amongst others. Doing so, we seek to outperform the market over the long-term. We acknowledge that we may underperform over certain periods; more so in extended bull markets. This is expected within our investment methodology. Similarly, to undervalued opportunities overextending to the downside, popular high-return stocks can overextend to the upside. Market trends tend to continue in place, requiring significant energy to reverse. While it may seem great for a while, the allure of quick profits at the risk of permanent loss to capital is not something we fancy. At TF, we have no intention to participate in speculative, high flying stocks. Rather, we strive for consistency over time.
The economy continues to grow. Unemployment is at 3.7%; the lowest it has been since 1969. Wages are rising. Interest rates continue to rise. Corporate earnings are growing at 20% y/y. The three major indices have recently hit all-time highs. The longest bull market in financial history continues. This makes investors nervous. The AAII sentiment survey has consistently reported bullish sentiment between 30-45% for weeks. Many investors claim to be holding or building stockpiles of cash. Strength begets strength. We believe any pull back to be controlled and expect the market to march on to new highs.
Regarding increasing interest rates, the 10-year treasury now sits at 3.2%. We do not find this to be a threat to the bull market. In 1996 the 10-year was 5.6% and the S&P rose from 650 to the high of 1,550. Inflation naturally results in increased earnings – as costs increase, companies record higher sales and profits. At some point, bonds can become serious competition to stocks. We are not there yet. There's a silver lining to the FOMC’s, or Fed’s, actions - they work in our favor. They may continue to raise rates, as long as the economy is performing. In case of any serious risks to the economy, we would expect the Fed to hold off on any rate increases.
We believe in time in the market over timing the market. Yet, we are not blind to the macro markets. We actively monitor and track developments. While we believe timing the market is impossible to do consistently, we may make slight adjustments to skew defensive or aggressive. The macroeconomic market, however, is not a primary driver in our decision making process. We make our investments with a business owner's perspective.
Many investors may believe that holding the SP500 provides robust diversification. In reality, the SP500 skews strongly to the large caps in technology, financial, and health care sectors. The top 3 companies in the SP500 -- Apple, Microsoft, and Amazon -- make up over 11% of the entire index. This is likely a surprise to a passive investor who thinks they are well diversified in over 500 companies. The point here is that as long as technology stocks continue to do well, the SP500 will be a tough benchmark for a truly diversified portfolio to compete against. We find many of the top tech companies to range from slightly overvalued to extremely overextended. AMZN trades at 33x cash flow and 137x earnings with growth rates of ~30%. MSFT trades at 20x cashflow and 29x earnings, with growth rates of ~16%. AAPL is the most reasonably valued, trading at 15x cashflow and 20x earnings with growth rates of ~15%.
We select our portfolio companies from various sectors and industries. We look for healthy, stable companies with low/no debt and established and consistent historical growth. We look for companies with strong management, good culture, and a clear plan for the future. Below we highlight some of our notable companies.
Signature Bank (SBNY) and Bank OZK (OZK) are two regional banks. Signature Bank focuses on serving high net worth individuals, leveraging personal connections. They also maintain a large portfolio of commercial real estate loans in NYC. Bank OZK, recently renamed from Bank of the Ozarks, is a rapidly growing regional bank focusing on commercial real estate lending. OZK has over $22B assets under management while SBNY has over $45B. Both of these companies have established track records, averaging 18% growth in operating earnings per share over the last 16 years. Both companies are returning more to shareholders this year. SBNY recently established a dividend, yielding 2%. A couple months later, SBNY announced a $500M share buyback plan, which equates to over 7% of the outstanding shares at today’s price. Bank OZK recently raised their quarterly dividend 5%, continuing their tradition of raising the dividend every quarter over the last 33 quarters. Both of these companies have sold off on fears of a lending peak. We find these fears unwarranted. These businesses fared well in the last recession, producing profits throughout the real estate crisis. We continue accumulating shares aggressively.
Luxoft (LXFT) and Cognizant Technologies (CTSH) are our technology consulting companies. LXFT is an international consulting company headquartered in Switzerland. It provides consulting services to companies from around the world. Their focus is on financial services (custom solutions using artificial intelligence, block chain, etc.), automotive (self-driving cars), and digital enterprise (automate flows, move to the cloud, etc.). LXFT has consistently grown revenue at rates of 20%+. LXFT continues to leverage M&A for growth, most recently acquiring 2 top software consulting firms. CTSH focuses on anything digital. They help companies create a strategy and plan to digitize. They offer digital operations to help your company execute that plan. And they provide digital systems and tools, their strength being in machine learning and artificial intelligence. We believe that both LXFT and CTSH are attractive companies to own in our world - they are high quality companies with consistent results delivering high-demand services.
We've invested in few companies in the energy sector. We find today to be an opportune moment for investing in the Permian Basin. Our portfolio companies include Diamondback Energy (FANG), Parsley Energy (PE) and Centennial Resource Development (CDEV). These 3 companies are increasing production at staggering rates, nearly 50% y/y. They currently trade at under 10x cash flows, and are growing cash flow at rates of over 30%. With the price of oil on the rise, we see these companies well positioned to profit in the future. We continue to accumulate on any opportunities.
JD.com (JD) and Alibaba (BABA) are our two Chinese technology companies. Alibaba is the Amazon of China. Growing revenues at 60% y/y, BABA continues expanding its dominance beyond its online marketplace and into supply chain, logistics, artificial intelligence & machine learning, and more. JD is the second largest e-commerce company in China. JD focuses on a high quality experience - fighting fraudulent products and ensuring a top-notch experience. In contrast to a marketplace, JD owns its inventory and delivers directly. Affected by the trade war with China, both of these stocks have dropped significantly - not due to performance, but sentiment. On top of the trade war, JD faces additional pressures due to the CEO being recently accused of sexual harassment. These are two of the worst performers for the year. For now we plan to hold these positions. We are monitoring for a change in sentiment which could shift us to begin accumulating. We expect very positive results over the next 3-5 years.
Celgene (CELG) and Abbvie (ABBV) are our two picks in the healthcare industry. Celgene is a biotechnology company selling over $15B/year of prescription drugs including Revlimid, Pomalyst, Otezla, and Abraxane. Revlimid, its largest drug, produces over $9B of revenue for the company. Certain patents on Revlimid expire in 2022, resulting in uncertainty and driving the share price down. We find Celgene to be a great company, with much potential. Over the last 10 years, Celgene averages 25% growth in earnings per share. They house a robust pipeline, concurrently running over 160 trials. The company believes in the value they create - they plan to purchase over $6B worth of shares this year. Abbvie, a spin-off of Abbott, is the maker of Humira and Imruvica. With consistent growth of 15%, a dividend yield over 4%, and a strong pipeline, we find ABBV to be a company worth holding. We hold our position in ABBV while we continue accumulating CELG.
New additions to the portfolio for the quarter include the semiconductor companies Broadcom (AVGO), Skyworks (SWKS), Applied Materials (AMAT) and Lam Research (LRCX). These have sold off recently due to the expectation of a slowdown in the industry. Consumer spending played an important role historically. PC sales, for example, were driven by consumer spending. As spending slowed, demand for chips slowed. Another amplifier to the cyclicality was the technologies lifecycle. As PCs became common place, demand slowed down. Then the smartphone era began, giving new life to chip producers. These factors have contributed to a cyclical stereotyping of the semiconductor industry. Today, we are at the beginning of a third technological era — big data and artificial intelligence. This shifts the market. Spending, now driven by enterprise customers (building data warehouses, cloud computing centers, etc), is more stable and predictable. Demand is no longer expected to be constant, but exponential. The market for big data and artificial intelligence does not max out at 1 per household or 1 per person, rather grows by the number of things connected to the internet. A single autonomous test vehicle produces 30TB of data per day, in comparison to 100GB/day produced by all 270M Twitter users. All four of these companies carry low/no debt, have cash on hand, stable earnings, and pay a dividend. We plan on accumulating shares over the next year.
We are confident in our portfolio companies. In our last letter, we shared our learnings in refining our approach to investing. We shared how we came to better understand and value a company's balance sheet. Today, we continue to grow and learn.
We've identified two new factors we are trying to better understand and master: volatility and patience. By analyzing our actions, we strive to better train our decision making.
Volatility can be distracting. Volatility seems to lead to unnecessary action and result in a lose-lose for a long-term oriented investor. Let's take FIVE as an example. Five Below (FIVE) is a discount retailer popping up across the country. The unit-level economics of each store are compelling. Their twist is staying on trend - rapid product/opportunity identification, coupled with seamless production and logistics for quick delivery. We began accumulating shares between $60-$70 in January 2018. Just 9 months later, the stock traded at $135. We were no longer comfortable with the valuation. The price rose too much, too fast. We trimmed on the way up. For traders, this is the dream. For long-term oriented investors, it tempts actions - if the stock were to continue increasing, we'd feel regret for selling. If the price were to drop, we'd feel regret for not selling. Compare this situation to a stock that increases slowly and steadily, in unison with fundamentals -- no action required.
The second factor is patience. An undervalued opportunity today can become a much better opportunity tomorrow. An undervalued stock has sold off for a reason - be it rational or not. That selling will likely fuel further selling. The fear-of-missing-out on a quick reversal may compel us to invest. While initiating a small position may be warranted, there is no advantage gained by making multiple purchases in a one-week timeframe. By spreading purchases out over months, we can leverage any further price drops to our advantage. And, if the trend were to reverse, we would be happy to continue purchasing on the way up.
We plan on continuing to share our experience as we continue to grow in our learnings.