Greetings from the Northwest.

During past market cycles I had a chance to read company reports, newspapers, and periodicals. Visit with company executives and their business to business trading partners. Reflect on business and industry segments and then pin it all up on my “wall of worry” and look at it. The process was a little like adding a new chapter to an ongoing story each quarter. Everything must continue to evolve. Well, welcome to the crazy-fast times. It is not as common as it once was to read a book. The tales of far-off lands now arrive as fast as the next news cycle, which is terrifying. It’s hard to find time to reflect on the good or the generous and the joy of a poem. And why would we when we can be entertained and amazed at the silly, greedy, and stupid behavior of so many prancing world leaders?
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Let’s take a moment of our precious time and focus on the real monster in the room. Uncertainty. It has often been said that the “market” likes good news, dislikes bad news and absolutely hates uncertainty. We should add that investors don’t like volatility. Uncertainty creates volatility, which causes investors to become restless. Restless about what? Patrick has been doing some thought-provoking work looking into the comings and goings of recessions. Yes, I’ve said it. Recession. We will have them. Patrick’s work is helping shed light on the recession monster and what we should be doing now… or not.

Equity returns during the quarter were mixed, with large-cap U.S. stocks posting a slight gain of 1.7%, while small-cap U.S. stocks, international developed stocks, and emerging market stocks posted slight losses of -2.3%, -0.79%, -4.75% respectively. Volatility has started to pick back up again, as markets grapple with a combination of trade tensions, changes in monetary policy, and slowing global growth.

During the year we spend a lot of time with our clients discussing what is going on in their lives, the ongoing management of their wealth, and how we view this ever-changing market environment. We learn a great deal from these discussions. Though the economy has been strong over the last few years, in recent months we have observed recessionary fears rising amongst the public and the folks we talk with. It’s easy to see why, as the news chatters regularly about when the next recession will happen. This has largely been driven by the consistent yield curve inversion. As of August 31, 2019, the New York Federal Reserve Bank’s Recession Probability Indicator, based on the yield curve, has moved to a 37% chance of recession within the next 12 months, up from 14.5% a year ago.

In April, I wrote about the lag times after the yield curve inverts and the inconsistent message that an inversion sends (read about it here). However, there are more data points in recent months revealing that the economic recovery is showing signs of stalling. We take evidence as it comes and do not attempt to predict the likelihood of when the next recession will start. At this time, the data we analyze does not point to immediate recession. Where we have been focusing our efforts is in analyzing what the most likely market experience would be if we entered a recession in the near term. Our conclusions are as follows:

• Investor experience is quite different based on how expensive or cheap the stock market is at the time of recession and leading up to it.
• When market valuation is high, top-to-bottom market experience is much more drastic than the market experience only during recession dates.
• If a recession is not right around the corner, equity markets could continue to move higher.
• Unfortunately, the S&P 500 is expensive, increasing the chance of large market declines if market trends change.
• Your portfolios have a much lower valuation (cheaper) than the broad market.
• Historically, cheaper portfolios tend to have far less loss than more expensive portfolios during market declines.

With the market cycle being in the later stages, we do realize that there may come a time to lower equity exposure below what a desired percentage normally is. Over the coming months, we may be reaching out to you and sharing our most recent research and how we might act if the economic or market environment should shift.

On a positive note, as Cairn searches the investment landscape for opportunities, we have continued to find quality companies to invest in that are trading at appropriate prices.

As our reliance on technology continues to advance, cybersecurity is of the utmost importance. We are always keeping an eye out for suspicious activity in your accounts and will call to verify as soon as we see any changes made. Cairn has your back. If you access your accounts online through Schwab Alliance, here are a few helpful tips to improve the security of your accounts:

• Use unique passwords for sensitive websites, like financial institutions. Using the same password for multiple sites can put you at risk of compromised account security.
• Two-step verification adds a layer of security to your login credentials. After entering your login credentials you will receive a single-use six digit password via text message, email, voice call, or by calling Schwab. There are two options for setting up this feature: “Only on untrusted devices” or “Always on login.” You can update your preferences once you are logged in to Schwab Alliance by selecting the “Service” tab, then “Security Center.”

• Ensure your contact information is up to date, and let us know if you make any changes to your address, home or mobile phone numbers, or email addresses.
• Should you need to deal with Schwab over the phone, you have the option to activate a verbal password. This would act as the primary authentication Schwab would request before discussing any account information.

I would be happy to further discuss these options if you have any questions or would like to learn more.

Thank you, Patrick and Jesyca.

Come on by and let’s review your equity exposure and/or two-factor authorization. We’ll make sure the coffee is fresh.
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Happy Trails,
​Jim Parr, Principal
Cairn Investment Group, Inc.

Headquartered in New York, NY, Foot Locker is a leading operator of retail apparel and athletic footwear stores. The company offers merchandise under the names of Foot Locker, Lady Foot Locker, Champs Sports, Footaction, Kids Foot Locker, Runners Point, and Sidestep.
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Dick Johnson, who joined the company in 2003, is the CEO and Chairman of the Board.

Founded in 1974, Foot Locker is a leading global athletic retailer operating approximately 3,200 stores in 27 countries. Unlike their competitors, Foot Locker focuses on high end sneakers and athletic footwear with a higher profit margin. Their company strategy is to generate long-term growth by empowering youth culture across communities. They demonstrated this with the opening of their Detroit store where they teamed with local artists, musicians, and athletes on store decoration, design concepts, and apparel offerings geared towards greater community and local youth connection.

Over the next four years, Foot Locker is planning to aggressively invest in mobile and digital interaction technology to improve their adjustability to core customer shopping patterns. They will also revise merchandising and sales strategies with their main suppliers (e.g., Nike and Adidas). For example, in their newest New York City store in Washington Heights, Foot Locker customers can download the NikePlus app for product information and shoe availability—the first time Nike has made available their shopping technology to a third-party store. Customers can also use the Foot Locker app directly to shop for apparel and shoes across all brand offerings, and reserve forthcoming shoes prior to their in-store launch.
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Simultaneously, Foot Locker is shrinking their mall footprint from 80% to 70% of physical stores and increasing their standalone ‘power store’ format. These larger store concepts include design features and apparel offerings that reflect local communities and support the more interactive shopping experience. They include expansion across Asia, where the sneaker culture continues to gain popularity. In 2018 they opened a new power store in Hong Kong, and added digital platforms by partnering with Alibaba’s Tmall.com, which sells to Chinese consumers. These growth initiatives set the company up to deliver strong returns on capital, consistent profits, and dividend growth for shareholders in the coming years.

Foot Locker is trading at very attractive valuation levels. At their current sales and cash flow multiples, they are trading at roughly a 20% discount compared to their historical operating performance. Investor concerns over changing consumer shopping behavior surrounding physical mall locations are putting pressure on their shares. We realize that consumer shopping behavior is changing. Based on our analysis, we feel the market is overly pessimistic regarding the future of Foot Locker. If our analysis is incorrect, we believe there is a large margin of safety built into their current price.
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Risks we will monitor going forward include the company’s transformation from a traditional brick-and-mortal footprint to a digital one promoting local community experience, and Foot Locker’s relationship with their suppliers (e.g., Nike). Weighing both potential rewards and risks, we are optimistic that Foot Locker is a good long-term investment.

​Cairn Investment Group and its affiliates (“Cairn”) produces Company Spotlight reports (“Reports”) for its clients and the general public. The Reports are impersonal and do not provide individualized advice or recommendations for any specific investor or portfolio. Investing involves substantial risk. Cairn makes no guarantee or other promise as to any results that may be obtained from using the Reports. Past performance should not be considered indicative of future performance. No reader should make any investment decision without first conducting his or her own research and due diligence. At various times Cairn may own, buy or sell the securities discussed for purposes of investment or trading. Cairn disclaims any and all liability in the event any information, commentary, analysis, opinions, advice and/or recommendations in the Reports prove to be inaccurate, incomplete or unreliable or result in any investment or other losses.

The Reports commentary, analysis, opinions, advice and recommendations represent the then current views of Cairn, and are subject to change at any time. The information provided in the Reports is obtained from sources the author believes to be reliable. However, the author has not independently verified or otherwise investigated all such information.

​This is not a solicitation or offer to buy or sell any securities. Cairn does not receive any compensation from any of the companies featured in the Reports. Any redistribution of the Reports or the information contained therein, without the written consent of Cairn is strictly prohibited.

Greetings from the Northwest.

Our second quarter report is always a little chaotic to produce, since the Fourth of July holiday generally jumps right into the middle of the progress. The distraction of summer, and all that this Fourth brings with it, can cause your diligent advisors to be found yearning for the sizzling BBQ burger or the thirst-quenching relief of an ice-cold beer. This Fourth of July holiday was marked by distinctly cool weather that made the 32nd Waterfront Blues Festival, held along the bank of the Willamette River, quite tolerable in the warming afternoons all 4 days. If the afternoons were filled with blues, the morning of Sunday was exploding with excitement as the U.S. women’s national team took the soccer World Cup for the fourth time!!

Being distracted from the business world for a bit was a nice relief from the growing number of global economic woes filling the airwaves recently. The most significant topic of today may be the announcement that Deutsche Bank is retreating from its global expansion and laying off 18,000 people. Oops.

Closer to home, in the American oil patch, things are slowing down as well. “Hoping for a gusher, driller came up short.” It’s a common refrain heard in so many words about many business ventures these days. There are so many situations in business now that are good, but not quite great:

• The Fed, reversing trend
• Housing starts, ok
• Tariffs, flip on / flip off
• Tax laws shift and slide
• Energy / healthcare / technology

​I’m sounding like a deflated firework and Patrick is itching to report on the current economic trends, so over to Patrick while I go squeeze our lemons into lemonade.

The second quarter witnessed investors tossing tariff risks and economic growth concerns aside to focus on the possibility of the Federal Reserve cutting interest rates in the coming months. After bouts of volatility during the 4th quarter of 2018 and again in May, large company U.S. stocks closed near an all-time high. During this time, investors have experienced quite a change in economic growth expectations and monetary policy implementation. Just one year ago, the U.S. Fed was forecasting 2019 GDP growth to be 2.4% and 2020 growth to be 2.4%. When they released their most recent projections on June 19, those figures dropped to 2.1% and 2.0%, respectively. Looking at corresponding interest rate projections, previous forecasts were calling for a rise in the fed funds rate (short term interest rates) to 3.4% in 2020. The current forecast is predicting that interest rates will fall to 2.1%. What a difference a year makes. This flip-flop in policy has been a large component of falling interest rates across the bond market (prices rise) and the tailwind we have witnessed for U.S. stocks in the short term. As Danielle DiMartino Booth, former Federal Reserve Bank of Dallas Advisor and founder of Quill Intelligence, recently said, “We are having a recession party” when describing how positively the stock market is reacting to much slower growth that could result in easier monetary policy.

As the S&P 500 index (large company stocks) trades close to an all-time high, while small cap and international stocks do not, we like to check underneath the hood to see what is really driving these recent returns. One question I looked at recently was, “Are all stocks carrying their weight and rising together or are just a few winners saving the day?” Examining this allows us to determine the overall health of the equity market. The breadth of participation signals how broad or shallow a market rally can be, which we find useful during the late innings of a cycle. One of the ways we analyze this is to look at the return contribution of the top names of the S&P 500. Recently, I ran comparison of the return contribution of the top 4 (largest) companies during 2013 and the contribution of the top 4 companies over the last 12 months. For the majority of 2013, we witnessed a broad based contribution and participation from U.S. stocks across the board. Which makes it a good comparison point. Here is the story the data tells:

2013:

• The top 4 names (Apple, Exxon, Google, and Microsoft) constituted roughly 12% of the index.
• The return contribution of the 4 names was 11% of the total return of 32.39% for the year. Meaning the return would have been 11% less.

Last 12 months:

• The top 4 names (Microsoft, Apple, Amazon, and Facebook) constituted roughly 13% of the index.
• The return contribution of the 4 names was 22% of the total return of 10.51% for the previous year. Meaning the return would have been 22% less.

​In essence, 2013 was a year where there was broad participation with many names of the index carrying the weight. Over the last 12 months you cannot say the same thing. A little more than 10% of the index is making up almost a quarter of the return. This indicates that the largest, and most popular, names have been carrying the load and the majority of companies have not been keeping up. I will leave it to you what you draw from this observation, but just a hint: It’s not sustainable in the long run.

Cairn’s approach is not just following the crowd by investing more and more dollars into overly expensive companies. Our process of uncovering suitable investments is disciplined and consistent. As we stated in our September 2018 letter:

​As the chart below illustrates, your portfolios trade at a significant discount to the S&P 500 by many different valuation metrics.

Lastly, here is just a small subset of the companies we own across portfolios we manage. We thought it would be of interest.
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• Cerner Corp (CERN): We have been investors in Cerner for over a year. Cerner is a medical technology company that develops and markets Electronic Medical Record (EMR) software for health care facilities, clinics, and government institutions. They have consistent revenue from long-term contracts that make profits and growth stable over time. The growing number of institutions converting to EMR systems, to make client care more efficient, provides Cerner a solid base for continued growth.
• Genesee & Wyoming Inc (GWR): We have been investors in Genesee & Wyoming for many years. GWR is a short-line railroad company operating freight railroads along the Pacific and Atlantic coasts. Fortunately and unfortunately, on July 1st GWR has agreed to be acquired by Brookfield Asset Management for $112 per share, so we will not be investors much longer.
• Flowers Foods Inc (FLO): We have been investors in Flowers Foods for over 2 years. Flowers is a bread company. They produce and market their bread, nationwide, under many different labels. The most notable name (especially up here in the Northwest) is Dave’s Killer Bread. They also produce Wonder Bread and Nature’s Own. Their continued focus on organic offerings makes them a compelling consumer company.
• Polaris Foreign Value Fund (QFVIX/QFVOX): This is not an individual company but an actively managed mutual fund that invests in companies outside the U.S. We have owned a position in this fund for almost a year and chose them to represent foreign exposure in select portfolios. Polaris’ investment philosophy and process are very similar to our own, making them a nice complement to our individual equity investments. One interesting fact is that they recently hired a new analyst who was a former Navy Seal. The reason for this addition was not for his mathematical skills in company analysis, but for his skills in being able to analyze people and their behavioral quirks. They believe this will be useful in management and analyst meetings.

As we head toward the second half of the year, we will continue to look for opportunities, realizing that risk management remains paramount as we reach the late stage of both this economic and market cycle.

If you’re interested in reading more about individual companies that we’ve researched, check out the Company Spotlights or give us a call and Jim, Tim or I will be happy to provide more information.

Thank you, Patrick.

As I’m fond of saying at the close of our quarterly letters, swing on by for a cup-o-joe. The coffee pot is always on.
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I’d like to add a personal note to all, about how thrilling it is to see our children grow. This event found me walking daughter Lindsey down the outdoor aisle in Wyoming as she accepted Aaron’s hand.

Happy Trails,
Jim Parr, Principal
Cairn Investment Group, Inc.

Cognizant Technology Solutions, a global IT services company, partners with clients worldwide to provide technology solutions to transform and modernize digital needs. Headquartered in Teaneck, NJ, Cognizant operates under four segments: financial services; healthcare; products and resources (retail, manufacturing, travel, energy); and communications, media, and technology.
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Cognizant’s new CEO, Brian Humphries, recently joined the company from Vodafone Business, where he also served as CEO.

Cognizant Technology Solutions focuses on transforming the current and ongoing digital needs of their clients. Their global consulting team works closely with clients to develop digital platforms and solutions to increase operational efficiencies, while securing and modernizing their businesses. Due to the integrated nature of their IT work, Cognizant rapidly becomes engrained in client operations, making the costs of switching to a competitor high, and facilitating enduring client relationships.

Over the last five years, Cognizant led the industry in revenue growth, averaging over 12% compared to single digit growth for primary competitors Accenture and Infosys. This high growth combined with solid client relationships expedited their becoming a large player in the global IT services and consulting arena.

Cognizant Technology Solutions is trading at a large discount compared to their historical operating performance. Investor concerns over the recent CEO leadership change, and slower near-term growth in their two largest segments (financial services and healthcare), weighed on shares. We feel this is a short-term issue and presents an opportunity as the company has proven to operate at a high level, producing consistent growth over the long-term. Even with modest growth assumptions over the next business cycle, the company is trading at roughly a 20% discount to our fair value calculation. If our assumptions are incorrect, we believe this provides a margin of safety.

Risks that we will monitor going forward include growth in the overall IT consulting market, and Cognizant’s current upper management transition.
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Weighing both potential rewards and risks, we are optimistic that Cognizant is a good long-term investment.

​Cairn Investment Group and its affiliates (“Cairn”) produces Company Spotlight reports (“Reports”) for its clients and the general public. The Reports are impersonal and do not provide individualized advice or recommendations for any specific investor or portfolio. Investing involves substantial risk. Cairn makes no guarantee or other promise as to any results that may be obtained from using the Reports. Past performance should not be considered indicative of future performance. No reader should make any investment decision without first conducting his or her own research and due diligence. At various times Cairn may own, buy or sell the securities discussed for purposes of investment or trading. Cairn disclaims any and all liability in the event any information, commentary, analysis, opinions, advice and/or recommendations in the Reports prove to be inaccurate, incomplete or unreliable or result in any investment or other losses.

The Reports commentary, analysis, opinions, advice and recommendations represent the then current views of Cairn, and are subject to change at any time. The information provided in the Reports is obtained from sources the author believes to be reliable. However, the author has not independently verified or otherwise investigated all such information.

​This is not a solicitation or offer to buy or sell any securities. Cairn does not receive any compensation from any of the companies featured in the Reports. Any redistribution of the Reports or the information contained therein, without the written consent of Cairn is strictly prohibited.

​Headquartered in Cambridge, MA, Biogen is a biopharmaceutical company that specializes in the discovery and development of drugs for people suffering from neurological and autoimmune diseases. Their core business is a portfolio of medicines to treat multiple sclerosis (MS) and spinal muscular atrophy. Their CEO since 2017, Michel Vounatsos, was previously with Merck for 20 years.

According to NeurologyToday, neurological diseases are the leading cause of disability worldwide. Founded in 1978, Biogen rapidly became a global leader in developing medicines to treat serious neurological diseases. They have the largest portfolio of treatment options for MS, and an estimated 35% of MS patients globally use Biogen medicines. Their core MS medicine business coupled with continuous development of drugs for other neurological diseases including dementia provides them with robust growth potential moving forward. Within the next few years, the company intends to expand their neurological portfolio to better address neuromuscular diseases, strokes, and movement disorders. Biogen’s disciplined capital allocation framework and high research and development spending (19% of revenue) provides the potential for consistent growth. 

Biogen is trading at a large discount compared to their historical operating performance. Investor concerns caused the price move in March of 2019 after the company abandoned a late stage Alzheimer’s drug. While disappointing, and given the current price, we feel we are buying their still-expanding core MS business for free, and benefitting from future growth potential on their remaining portfolio. Even with modest growth assumptions over the next business cycle, the company is trading at a 20-30% discount to fair value. If our assumptions turn out to be incorrect, we believe this provides a margin of safety.
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Risks that we intend to monitor going forward involve regulation of drug prices and pipeline development. Weighing both potential rewards and risks, we are optimistic that Biogen is a good long-term investment.

Headquartered in Calabasas Hills, CA, The Cheesecake Factory is involved in the restaurant and baking industry. David Overton, CEO and Chairman of the Board, founded the company with his parents in 1978. Today they own and operate over 200 upscale yet casual dining restaurants in 36 states and Puerto Rico under the names ‘The Cheesecake Factory,’ ‘Grand Lux Café,’ ‘RockSugar Southeast Asian Kitchen,’ and ‘Social Monk Asian Kitchen.’

With strong brand recognition and customer loyalty, The Cheesecake Factory is a leader in the upscale, casual, and eclectic dining space. In 2018, their sales surpassed US$2.3 billion. Though mature, the company’s core Cheesecake Factory brand offers consistent sales growth and cash flows which they supplement by diversifying their restaurant portfolio across dining concepts. Fueling growth outside of their core brand, expansion plans involve healthy but fast casual dining opportunities via the brand Flower Child, which features locally sourced ingredients for vegetarian and vegan customers, and Social Monk, which is a modern Asian kitchen experience. They additionally hold a minority stake in North Italia, which focuses on upscale, made-from-scratch Italian cuisine in a modern urban atmosphere. The Cheesecake Factory plans to acquire the entire brand in late 2019 and open six new North Italia restaurants per year over the next few years (there 
are currently 23 locations).

The Cheesecake Factory is trading at attractive valuation levels. At their current sales and cash flow multiples, they are trading at a 20% discount compared to their historical operating performance. Investor concerns over rising wage costs and core brand growth are putting short-term pressure on shares. Based on conservative growth assumptions that The Cheesecake Factory will grow cash flows in tandem with broad economic growth, shares should be valued at close to $65, not the mid $40’s. These growth rate assumptions are much lower than their historical operating performance. If our assumptions turn out to be incorrect, we believe this supplies a margin of safety.
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Risks that we will monitor going forward involve growth rates of new concept restaurants and wage inflation pressures. Weighing both potential rewards and risks, we are optimistic that The Cheesecake Factory is a good long-term investment. 

​Cairn Investment Group and its affiliates (“Cairn”) produces Company Spotlight reports (“Reports”) for its clients and the general public. The Reports are impersonal and do not provide individualized advice or recommendations for any specific investor or portfolio. Investing involves substantial risk. Cairn makes no guarantee or other promise as to any results that may be obtained from using the Reports. Past performance should not be considered indicative of future performance. No reader should make any investment decision without first conducting his or her own research and due diligence. At various times Cairn may own, buy or sell the securities discussed for purposes of investment or trading. Cairn disclaims any and all liability in the event any information, commentary, analysis, opinions, advice and/or recommendations in the Reports prove to be inaccurate, incomplete or unreliable or result in any investment or other losses.

The Reports commentary, analysis, opinions, advice and recommendations represent the then current views of Cairn, and are subject to change at any time. The information provided in the Reports is obtained from sources the author believes to be reliable. However, the author has not independently verified or otherwise investigated all such information.

​This is not a solicitation or offer to buy or sell any securities. Cairn does not receive any compensation from any of the companies featured in the Reports. Any redistribution of the Reports or the information contained therein, without the written consent of Cairn is strictly prohibited.

How to absorb all of this noise, and move on? I like a bit of quiet time with the Wall Street Journal and a cup of coffee on the weekends. This particular end-of-the-first-quarter newspaper even had a few pink cherry blossoms stuck to it as I pulled it out of our paper box. How beautiful, the scents of spring blossoms, fresh pressed coffee, and printer’s ink not quite dry on the sunrise edition.

And then the crazy stuff begins. Parliament rejected… The FBI has embarked… Trump again threatened… The Justice Department… Emails in a lawsuit… U.S. and Chinese trade… The Red Cross said… The Vatican issued… Lyft shares jumped… and then the clincher… U.S. stocks notched their biggest quarterly gains in nearly a decade, lifted by bets that central banks would hold interest rates at low levels as global growth slows.

Patrick, what does it all mean?

With the markets regularly acting like a kid bouncing on a pogo stick, you are forgiven if you are wondering what will happen next. In the third quarter of 2018, U.S. stocks (measured by the S&P 500) rose 7.71%, followed by the fourth quarter decline of -13.52%. And just when pundits were calling for continued declines, the S&P 500 rebounded 13.65% during the first quarter. Predicting short-term market movements is usually an exercise in futility, which is why we spend our time looking at long-term valuations on which we base our expectations. While the decline that happened during the fourth quarter made the broad market “cheaper,” it did not move the needle very much, from a long-term perspective. So while we were able to invest in some new companies, at cheaper prices, we still view the broad market as rather expensive.

The topic du jour over the last few weeks has been the Treasury yield curve and the inversion of the 3-month/10-year U.S. Treasury yield. On March 22 the shorter yield was higher than the longer yield, thus inverted. Inversion of the yield curve has predicted the previous nine U.S. recessions with few false signals, so you can see why this news has become so prevalent. News articles and TV pundits will confidently make predictions about the timing ​of the next downturn, but, like many events in both finance and economics, inversion of the yield curve is not always a direct cause and effect relationship regarding stock market returns, or an accurate predictor of when a recession will emerge. The chart below graphs the yield spread versus the one-year future return of the S&P 500 Index.

When we examine the data, a few things become clear. First, taking a look at the previous three recessions, the average time from yield curve inversion to recession was twelve months, with the longest being twenty-two months in 2007. Second, future one-year market returns were inconsistent with no discernable pattern. When the yield curve inverted in 1989, rolling one-year returns post-inversion were positive and continued that trend through the recession that followed. In 1998, there was a false signal during the Asian Currency Crisis. No recession followed and market returns were positive as the tech bubble took hold. After the inversion in 2000, market returns were negative approximately 16-20% and would continue that trend through the recession. Most recently, in 2006, rolling one-year returns were positive for almost a year before turning decidedly negative as the housing bubble burst. A hard look at the data is always needed to see what historical outcomes have unfolded. Does it signal that caution should be warranted? Yes, especially when combined with other market data points. We have been in that camp for some time now as market valuations remain elevated. Does it signal that the twelve-year economic expansion is getting long in the tooth? Yes, but that is what should be expected after a twelve-year economic recovery. To quote famed value investor Howard Marks when discussing cycles, “We may never know where we’re going, but we’d better have a good idea where we are… and act accordingly.”

We will not try to guess when the next recession or bear market will start, but we do have a good idea of where we are in this cycle and our research has us acting conservatively.
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Please feel free to email or call with any questions regarding these topics and how we are managing through them. Thank you!

Thank you, Patrick.

These are exciting times, made more comfortable by having a plan and sticking to it. Maybe we will change Patrick’s name to “Col. John Hannibal Smith” the leader of the renegade commando squad “A-Team”… or not?

Please take me up on my standing offer of swinging in for coffee. The pot is always on.

Happy Trails,
​Jim Parr, Principal
Cairn Investment Group, Inc.

Headquartered outside of Chicago in Deerfield, Illinois, Walgreens is one of the largest pharmacies in the United States, with nearly 9,600 locations in all 50 states, Puerto Rico, and the US Virgin Islands. Founded in 1901, Walgreens has three arms: retail US pharmacy, retail international pharmacy, and wholesale pharmaceuticals.

Walgreens CEO, Gregory Wasson, is serving his tenth year.

The Walgreens Company purchased United Kingdom-based Alliance Boots (pharmacy and distribution services) in 2014, becoming the Walgreens Boots Alliance Inc. This acquisition cemented their position as a global leader in retail pharmacy, health, and wellness services. In the US and US territories, Walgreens operates nearly 9,600 pharmacy locations that focus on prescription drug fulfillment and sale of household goods. In 2017, Walgreens filled around 20% of prescription drugs in the US, accounting for around 70% of their revenue.
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Due to the large disparity in revenue between pharmacy and retail household goods, Walgreens is partnering with other companies such as Kroger to expand their grocery offerings, and United Health Group’s MedExpress to introduce clinical services at their locations. These initiatives are expected to increase top line sales, and counterbalance their more mature pharmacy business. Large cash generation allows Walgreens to reward shareholders through dividend increases and strategic share buybacks. 

Walgreens is trading at very attractive valuation levels. At their current sales and cash flow multiples, they are trading at roughly a 30% discount compared to their historical operating performance. Investor concerns over Amazon entering the health care space is putting short-term pressure on Walgreen shares. Based on conservative growth assumptions that Walgreens will grow cash flows at 3% in the near future, Walgreens should be valued at close to $88, not the low $60s. These growth rate assumptions are much lower than their historical operating performance. If our assumptions turn out to be incorrect, we believe this provides a margin of safety.
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Risks that we will monitor going forward surround the ever-changing landscape of health care services and the continued results from Walgreens’ growth initiatives. Weighing both potential rewards and risks, we are optimistic that Walgreens Boots Alliance is a good long-term investment. 

Greetings from the Northwest.

The News: Lower inflation has reduced the Fed’s sense of urgency to prevent economic overheating.

The Result: The Fed may slow the rate increase pace… I think.

The news, and yes, the fake news, is flying through the airwaves at an amazing pace. As someone who attempts to keep track of the investment world, I would vote for a breather so we can look objectively at both the good and the bad economic news.

The current U.S. economic expansion has already had a long life. That doesn’t mean it will end now. Periods of growth don’t end just because of old age; they generally end when something goes wrong, such as unchecked inflation, or a bubble in housing prices, or a central bank pushes interest rates up too fast. Patrick is going to cover more of the economics of today in his comments.
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In general, but not always, our investors’ portfolios performed quite well. Relative returns versus the market can be measured in many different ways; volatility, income flow, relative expensiveness, liquidity, and environmental and social objectives are just some variables. The 4th quarter of 2018 has been tough. But our portfolios are up to the task. Generally, we hold a group of companies that have lower price/earnings, lower price/sales, lower price/cash flows and higher dividends than the S&P 500. Patrick touched on this in our September letter. Please give your reports a good read, and then give us a call. Tim, Patrick, and I are available.

Optimism about the economy, and more specifically about equities, clearly faded during the 4th quarter as stocks experienced a U-turn from the exuberance that they had felt during most of the year. The S&P 500 Index closed down -13.52% for the quarter and -4.38% for the year, after posting impressive gains through the first nine months. International stocks fared slightly better during the quarter, only retreating -12.86% for developed stocks and -7.63% for emerging market stocks. High quality bonds and cash were safe havens during the quarter as investors flocked to safety during December. We have spent many quarters talking about the risks in equity markets and how we manage those risks through patience, not paying a premium for growth, and waiting for compelling value investments to come to us. As volatility increased during the quarter, we sent out an email in December describing our investment process. Our viewpoint and process have not changed over the last few weeks.

One of the primary areas of financial markets that we feel need to improve, in order for investors to feel comfortable taking increased risk again, are the credit markets (i.e., corporate bonds). During this current market cycle, many companies used the low interest rate environment to issue billions of dollars in debt (bonds) to fund share (stock) repurchases and dividends. In essence this was a large, debt for equity swap, and that changed the dynamics of how companies are now capitalized. This generally has no effect on the financial markets, as long as interest rates remain low and profitability for companies remains high so the debt can be serviced. Concerns over the level of corporate debt start to arise when the interest rate environment and maturity schedule start to change. The Federal Reserve has continued down the path of raising short-term rates, which sends a ripple effect through the rest of the bond market as rates across all risk spectrums adjust accordingly. When rising interest rates combine with slowing corporate profits, which we are witnessing due to higher wage and input costs, and large volumes of maturities need to be rolled over at higher rates, the bond market starts to become more volatile. The chart below shows the upcoming maturity schedule for U.S. corporate bonds (both investment-grade and high-yield).

As the chart illustrates, there are large amounts of corporate debt that will need to be refinanced in the coming years at potentially higher interest rates than when the original debt was issued. This should not have a heightened effect for companies that have low leverage and high profits, but will be much more worrisome for companies that already have bloated balance sheets and a lower ability to fund operations internally. When you have excessive valuations in broad U.S. stocks, combined with rising interest rates and economic growth that is showing signs of slowing down, markets can become skittish. Needless to say, highly indebted companies will have some big decisions to make as a large volume of maturities start to take place.

Another reason we bring up the corporate debt topic is that the amount of debt and financial leverage a company has is an important part of our analysis when considering an investment. It’s not just the amount of debt that is important; it’s the ability to service the debt with consistency of cash flows and profits while also having the ability to repay that debt without having to issue additional stock. The low interest rate environment of the previous ten years has truly created some interesting times for corporate America as senior management make decisions on how to navigate the next market cycle.
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Please feel free to drop me a line if you have any follow-up questions or concerns as we navigate through this choppy market environment.

Thank you, Patrick.

The coffee pot is stocked with a new grind of Nossa Familia Coffee medium roast. Seven scoops in a #4 filter make a great 12-cup pot. We are always excited to have investors stop by for a visit at our world headquarters.

​Happy Trails,
Jim Parr, Principal
Cairn Investment Group, Inc.

Greetings from the Northwest. 

The unexpected has become the expected, the bizarre has become commonplace, and the unpredictable is where we are. As investors our goal is to purchase equity in companies or debt from a variety of sources at a value price. Later, our goal is to sell equities at a higher price and debt instruments at their maturity value. The single biggest question over the last quarter from our clients has been: “Can this economic expansion keep on going?” The most common concern is that no one wants a repeat of the past recession or corrections. Got it. No easy task. We have found that it is extremely difficult to “time” the market. So we don’t. What we can do is pay attention to valuations and the “expensiveness” of what we own. Expensiveness? Patrick will explain. We are reducing our exposure to market fluctuations by reducing the “expensiveness” of our investors’ portfolios. 

The U.S. equity markets pushed aside many headline risks to finish up 7.71%, as measured by the S&P 500 Index. Its best quarterly return since 2013. The same could not be said for international equities, as concerns over global trade and growth caused broad-based international indices to return only 0.76%, lagging behind their U.S. counterparts by a wide margin. The large positive return for U.S. stocks over the quarter did nothing to improve valuations, which are near historical highs. We have talked about this numerous times over the last couple of years, so we want to touch on our process and how we are generating positive returns with much lower risk of permanent impairment of capital. Lastly, I will go over some updates that have taken place within the S&P 500 Index which could cause some changes in how investors view certain sectors going forward.

Through our quarterly letters and individual meetings we have discussed our process for uncovering successful investments, our current view of U.S. stocks, and how we are managing assets concurrent with that view. First, we are always on the lookout for industry leading companies that generate significant cash flows, with balance sheets that can provide financial flexibility. The final, and what we believe is the most important piece, is paying a price for a company that is significantly lower than what our analysis says the business is worth. We use a combination of cash flow analysis and the historical operating performance of the business to identify suitable investments, avoiding ones for which we would be paying too high a price, therefore limiting appreciation potential. The end result is that your portfolios are less “expensive” than the broader market, which should help us to weather bouts of higher volatility ​that will eventually take place. The chart below shows the aggregate of the companies we own and how their valuation metrics compare with the S&P 500 Index:

As you can see, by all metrics listed (Book Value, Cash Flow, Sales, and Earnings) your portfolios trade at a lower price than the broader market. We believe our focus on valuation, combined with the patience to wait for value, and a disciplined sell process, will provide satisfactory returns if the market continues to levitate higher, while being prepared for when the market decides it’s time for a reversal period. We don’t know when that will happen, but we want to be prepared for that inevitable event as we enter year 10 of this market rebound.

My second topic surrounds a new sector in the S&P 500 Index and the reclassification of companies into that new sector. On September 28, the Communication Services sector was created, replacing the Telecommunications sector. The chart opposite shows the changes that took effect and the companies that now make up this new sector. The main takeaway from this change is that the historically “boring” telecom companies such as AT&T and Verizon are going to be included in the same sector as Alphabet (Google), Facebook and Netflix. Needless to say, sector index investors might be in for a much different experience from what they historically had envisioned ​investing in some “old school” communication stocks. Though it’s not a primary point of emphasis in our company analysis, we do pay attention to index representation in the companies we own so we can try to gain an understanding of what might cause excessive volatility besides company specific events.

In closing, we continue to find good companies that the market has ignored; however, the number is not as plentiful as it was a few years ago. In light of higher than normal valuations in U.S. stocks, we are pleased that opportunities exist, but remain acutely aware that risks are higher than normal. Thank you for your continued trust and please drop me a line if you want to discuss any of these topics in greater detail.

Thanks, Patrick. Please take him up on his offer to talk about anything related to his analytical work.

Most readers will recognize that it just would not be a Cairn Newsletter if I didn’t say “Come on by, the coffee pot is always on.”

​Happy Trails,
Jim Parr, Principal
Cairn Investment Group, Inc.