Greetings from the Northwest.

Summer sunshine is warming us up in the West. It feels so good! The last few days have been the hot type, where individual bones in your spine feel like they are melting out the last of the ice and chill of winter.

The stock market has also been hot for a while. But not all parts or sectors have been feeling the heat. Frustratingly, the hottest sectors and companies are also the most richly valued companies and hence not attractive to us as value or momentum investments. The purchase prices of our investments are of paramount importance to us. Time can heal a lot of investment wounds, but it is most difficult to recover from overpaying.
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I hope the world is laughing with me when I ask, “Have you noticed the volcano of crazy, off-the-cuff, wacko ideas and plans that are being trotted out, run around the test globe and then re-evaluated?” Probably the biggest, loudest worries are coming from trade-war concerns. This has fired up volatility in currencies and stock markets around the planet. There is a lot of noise about potential longer term effects from tariffs and trade wars on U.S. companies and in particular industrial manufacturing. Please remember that manufacturing is only about 12% of GDP and we are in the 1st inning of a potentially long, hot, and politicized season.
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Patrick and Tim are both itching to add to this quarter’s letter, so I shall go back to the dugout.

The proposed DOL Fiduciary Rule, scheduled for implementation last year, was delayed numerous times before being terminated through court action in June. The courts determined that the Department of Labor had overreached its authority and that the topics addressed are better dealt with by the SEC, which in most other ways is responsible for the regulation of investment advisors.

What was this “DOL Fiduciary Rule” and why is this topic important? The growth of the employer sponsored retirement plan, such as the 401(k), has been tremendous over the last 35 years, with combined assets now above $6 trillion. These employer sponsored plans are now the primary tool for retirement savings, with fewer than 2% of Americans being enrolled in a traditional pension plan. The financial security of our next generation of retirees depends heavily on the success of these newer plans. This explosive growth has attracted much attention from the financial industry, which provides the investment platforms for these plans and for the various “Individual Retirement Accounts” or IRAs. Holding these assets, managing them, and providing advice on them is good business, and a core profit center for almost any investment oriented financial institution (Fidelity, Vanguard, Cairn, etc.).
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For decades the employer sponsored plans have been tightly regulated by ERISA (Employee Retirement Income Security Act). IRAs and the transfer of assets from employer plans into IRAs (rollovers) are not generally subject to ERISA. Some business models in the industry are intently focused upon this rollover process, and, like all great business opportunities, sometimes the interests of the consumer get overshadowed by the interests of the service and product providers, particularly without specifically designed legislation.

The DOL rule set out to fix this by making everyone involved in the process a“Fiduciary,” someone who must be true to the consumer and put the consumer’s interests first. This has caused major shifts in the industry, as firms were forced to evaluate their business models to determine how they were at risk of violating the new rule, how to eliminate conflicts of interest, and how to implement the prescribed procedures that came with this rule. An example of this is that Vanguard stepped away from advising clients on IRA assets. How could they maintain fiduciary standing when advising clients to purchase Vanguard funds? With the funds themselves being Vanguard’s primary business, they quickly and preemptively made the decision to stop advising.

For Cairn and other fee-only investment advisers, the DOL Fiduciary Rule had a much lower impact as we already were, are, and will continue, to act as a fiduciary. For us the change was the implementation of some required documentation that detailed why a rollover or IRA transfer was appropriate in each circumstance.

The DOL rule is dead, but the genie is out of the bottle, with many firms continuing to implement planned changes with the expectation that the SEC will soon roll out their own rules with a similar goal of improved consumer protection. What may be different is a more nuanced approach by a more informed SEC that recognizes the difference between commission-based brokers and insurance agents, and the fee-only advisers who are already acting as fiduciaries. Time will tell.

For now you can be assured that we will continue to act and advise in your best interests as we wait for the regulators to sort things out.

The takeaway from this chart is that higher wages should depress corporate profit margins, which are already sitting close to an all-time high. The possible retreat in profit margins due to higher wage costs is currently not being priced in by market participants (let alone higher input costs if large tariffs take place). As we continue to navigate a market that is on the expensive side, we continue to watch for other indicators that could change the corporate landscape. Rising wages are one data point we are keeping a close eye on. Our investment discipline helps combat these possible pressures as we consistently look for market leaders that have the ability to pass on higher costs to their end customer, regardless of the type of industry.

We firmly believe that risk management is of high importance as we get to the later innings of the market and business cycle. However, we are still finding opportunities in the marketplace, and we will take advantage of them if the price is right. Please feel free to reach out to me with any questions regarding this or any topic.

As I’m fond of saying, please come on by when you are near. The coffee pot is always on.

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

Headquartered in Kansas City, MO, Cerner is a supplier of health care information technology solutions and services. Cerner is a leader in electronic medical records solutions for hospitals and health clinics worldwide.
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Brent Shafer took over as CEO on February 1, 2018 after the passing of Co-Founder and CEO Neal Patterson. Mr. Shafer joined Cerner after serving as CEO of Phillips North America.

Founded in 1979, Cerner is a global leader in healthcare IT solutions. Cerner enjoys a strong competitive advantage due to the high costs for customers to change to a competitor and long lead times for sales and product implementation. They are the number two provider of electronic medical records systems and services to hospitals, and the number one provider across the entire medical field. The company’s customer base is well diversified across numerous private companies and public entities. Recently, Cerner has gained contracts with the U.S. government starting a multi-year transition to the Cerner platform for the Department of Defense. Cerner is also a strategic partner with Adventist Health (an OHSU partner), in charge of the company’s day-to-day operation of their revenue management and clinical IT staff.

Cerner has been very conservative with their capital allocation strategy, choosing to reinvest most cash flows back into the business to remain competitive with software and solutions research and development. The company’s operating performance has been very strong over time. The firm generates high operating margins, averaging 19% over the previous 5 years.

The firm also generates over $700 million annually in free cash flow and has historically had a return on capital in the mid-teens. Their strong financial performance combined with their high quality balance sheet allows the company to fund operations internally, which we find attractive at this stage of the economic cycle.

Cerner is trading at attractive valuations compared to both historical operating performance and to free cash flow projections. Cerner is trading at 3.7 times sales and 11.9 times operating cash flows which is over a 20% discount compared to its ten year average. On a free cash flow basis, we expect the company to grow free cash flow on average at 9% annually, below its current growth rate of 20% over the previous 10 years, due to a more challenging health care spending and regulatory environment. If our conservative assumptions turn out to be overly optimistic, we feel there is a large margin of safety built into the current price based on the com­pany’s current valuation compared to its historical operating performance, and strong financial position.

Risks that we will monitor going forward surround market share strength and new client additions. Also, we would like to see the company continue to spend most of their excess cash on research and development to remain competitive. Weighing both potential rewards and risks, we are optimistic Cerner will be a good long-term investment.

So much for the low volatility that investors have become accustomed to over the previous couple of years. The first quarter saw markets rise to an all-time high by the end of January, only to finish the quarter in negative territory. The S&P 500 Index finished down 0.76% for the quarter while developed international stocks fared a bit worse, -2.2%. Emerging market equities fared the best of the major asset classes, returning over 2.4%. Bonds were also mixed as yields were quite volatile, reflecting consistent economic growth while the U.S. Fed continues on its interest rate hike path. As we have written previously, we view broad U.S. stock indices as richly valued and that view has not changed during the quarter. Finding bargains in this environment is challenging but we remain vigilant in our search for quality investments selling at compelling prices, while decreasing our exposure to companies that have become more fully valued. As Jim mentioned, I am going to discuss some of the changes that companies will be facing regarding tax rates and the rising costs of borrowing.

Last quarter we briefly touched on the changes in tax law that focused on individuals. There was also a broad overhaul to the corporate tax structure that many companies are still trying to dissect three months after the fact. The two primary changes that are being talked about the most are the lowering of corporate tax rates from a high of 35% down to a flat rate of 21%, and the changes to the deductibility of interest expense on corporate debt. The latter change is not talked about as frequently, but could be of more importance in the years to come.

We spent a lot of time in early 2017 identifying companies that could benefit the most from a lower corporate tax rate. That benefited portfolios later in the year, as companies with high effective tax rates were strong performers in the back half of 2017. Companies that benefited the most had similar qualities: low debt and a large proportion of U.S. revenues. The use of funds that companies are netting, resulting from lower tax, is still not completely clear, so it will be interesting to hear executives speak about their plans during upcoming earnings announcements. While an increase in productive spending (research, capital equipment, employee training and technology enhancements) would be welcome news, we remain skeptical, as historically tax savings have been used to increase executive compensation and share buybacks. Also, the increased chatter of trade tariffs/wars and possible effects on corporate profits could weigh on the benefits that were perceived from lower corporate tax rates.

A very important part of the tax law change surrounds the deductibility of interest expenses for corporations. Historically, the interest expense on the debt issued by companies was fully tax deductible. Over the last 10 years, this allowed these firms to access the bond market at historically low interest rates and have the interest expense be tax deductible (what a deal!). Under the new tax law only part of the interest expense is tax deductible (up to 30% of operating earnings before depreciation). Companies that have large amounts of debt or increasing interest expenses are now more susceptible to lower profits. We feel this is a risk that is currently underappreciated by equity markets. As the chart below shows, corporate America has taken on large amounts of debt over this past cycle, rising from roughly $3.6 trillion to over $6 trillion. This is at a time when the costs of corporate debt have started to rise (indicated by the red line, 3 month LIBOR). See chart below.

We will get past this tariff noise. We’re going to continue to keep our eyes open and try to dance around those surprising puffs of dry dust that are poofing up near our feet. Please remember that any time you are in town we’d love to see you. Don’t hesitate to come on in. The coffee pot is always on.

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

Headquartered in Dublin, OH, Cardinal Health is a pharmaceutical distribution and medical device company. The company provides its services to healthcare providers, pharmacies, and pharmaceutical manufacturers.
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With the company since 1990, Mike Kaufmann became CEO on January 1, 2018. 

Cardinal Health is the third largest pharmaceutical distribution company by revenue behind McKesson and AmerisourceBergen. The company is the largest supplier to CVS pharmacies. In 2014, the two companies started a joint venture for generic drug sourcing and distribution, forming the largest generic drug sourcing entity in the US. The high barriers to entry in this space allows Cardinal Health to produce consistent and stable operating results as their large distribution network would be hard to emulate for a new company entering the market. In recent years, the company has expanded into medical device manufacturing and distribution via internal development and acquisition of Medtronic’s patient recovery business (professional products for patient care). This 2017 acquisition furthers their focus on higher margin medical products and distribution, generating roughly $2.4 billion in additional sales. The acquisition will complement the company’s strong supply chain management and large customer relationships allowing them to generate significant cash flows even in a low margin business.

Cardinal Health is trading at a discount compared to its historical valuations and below fair value based on scenario analysis of free cash flow growth. Cardinal Health has a dividend yield of 2.75% and generates over $1.5 billion in free cash flow to give them the flexibility to continue to raise their dividend over time. On a free cash flow basis, we expect the company to grow cash flow at 3.0% annually over the next decade. This is below its historical growth rate due to higher pricing pressure on pharmaceuticals and high revenue concentration. Modeling our conservative assumption places a price of $80 on shares, which is almost a 21% premium, based on the price as of the date of this report. If our conservative assumptions turn out to be overly optimistic, we feel there is a margin of safety built into the current price based on the company’s high returns on capital and strong cash flow generation.

Though Cardinal Health has only two main competitors in the pharmaceutical distribution business, it is a highly competitive environment. We would like to see continued discipline in regard to capital spending while continuing to grow their dividend. Continued focus on the company’s revenue breakdown, along with integration among its recent acquisition, will be areas to monitor closely.
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Weighing the potential rewards and risks, we are optimistic that Cardinal Health will be a good long-term investment. 

Greetings from the Northwest.
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The essence of these reports from Cairn to you, our investors, should be primarily focused on you, the investment results and some sort of a gaze into the future, and thinking about how that future might affect the way we handle our investments. This time I’m going to start with a more personal note. Lara and I had a chance to meet up with our son, Tygh, who is an exchange student from OSU Forestry Engineering Program to the École Supérieure Du Bois in Nantes, France, focusing on International Timber Trade. Well, that’s a tongue twister of a sentence. We had a wonderful opportunity to spend Christmas and the New Year abroad. It was an unusual time to be out of the office as we went from one year to the next. Especially when there was so much news about potential, and eventually real, tax law changes. Patrick is going to pick up most of the load, describing some of these changes for us. Tim is going to update us on the phenomenon known as Bitcoin. And in general we’re going to be focusing on some of the things that we find particularly important at Cairn to keep all of our investment energy going in the correct direction.

Our trip involved mostly France, although we had a wonderful few days in Iceland on the way over, and a few days in Amsterdam on the way back. We focused on a couple of locations with longer stays on the Brittany Coast and in Paris, renting an apartment in both places and doing most of the meal prep and grocery shopping ourselves. We had an opportunity to sort of sink into and enjoy France. The overarching condition that must be communicated to our investors is that there is a tremendous amount of economic horsepower happening in Europe. It is busy. Even in the winter there are lots of people spending lots of money.

Loads of construction plus many products being invented and manufactured. They are absolutely determined to create new and interesting results in the way of transportation, education, banking, and healthcare. Over the last couple of years our investments have shifted to more exposure in European companies than in the past. I am extremely pleased to be in that situation, especially since it helps us move toward companies that are comparatively less expensive than some of their counterparts in the USA. Thank you for putting up with the anecdotal research that we carried out whilst being consumers in a foreign land. It is the place to be and we should look forward to enjoying international investing results.

Only one of these tasks was accomplished (barely), yet the equity markets marched to all-time highs. US stocks, measured by the S&P 500, returned 21.83% with international markets faring a bit better. We feel two acronyms can describe why investor euphoria continued in 2017 despite high valuations and continued geopolitical concerns: FOMO — “Fear of Missing Out” and TINA — “There is No Alternative.” Record low bond yields and paltry interest rates on safe haven investments have caused investors to reach for yield, raising already high risky assets, due to their fear of missing out and lack of an alternative to earn a satisfactory return. TINA can explain the most recent American Association of Individual Investors (AAII) poll where household allocation to stocks reached over 68%. This high allocation to stocks has not occurred since the late ‘90s, so clearly investors are feeling the need to reach for risk as fixed income and cash rates remain low. In our view, FOMO is the reason that many companies with little to no profits and high cash burns (Tesla and Netflix come to mind) trade at current prices.

Other reasons given by financial pundits and talking heads on TV for the continued rise in equity prices are mostly noise and do not hold much water when analyzing the data. Ignoring the noise, FOMO and TINA, while sticking to our disciplined process, allow us to find ideas and investments that still offer attractive risk/reward traits. The silver lining is that not all companies are treated equally by investor euphoria, so we are still able to sift through the investment landscape and find bargains that the investment public has ignored. As an example, throughout the year we were focused on companies that had effective high tax rates that could benefit from tax reform. Many of these companies meeting that criteria are being cast aside over what we believe are excessive worries of competition and market share erosion.

We are pleased with how our portfolios have done in spite of our conservative bias, as we continue to view the US market as expensive. We will continue to be vigilant in finding opportunities without losing sight of the fact that risks are higher than normal and preservation of capital is of equal importance while this nine year bull market matures.

During the last week of December a new tax law was signed by the President. While there are many changes that are still being analyzed by tax experts, we want to touch on a few that we find meaningful.

• The Estate (Death) Tax exemption amount was raised to $11.2 million (indexed to inflation), per individual, starting in 2018.
• For filers using the standard deduction, charitable donations will not be tax deductible.
• 529 education plans became more flexible. Funds can now be used for K-12 expenses, up to $10k per child annually.
• Unearned income by a minor (Kiddie Tax) was previously taxed at the parents’ tax rate. The tax rates starting 2018 for unearned income by a minor will be the same rates used by estates and trusts.
• 2% miscellaneous itemized deductions were eliminated, doing away with the deductibility of tax preparation and investment management fees.
• The state and local tax (SALT) deduction is now capped at $10k per year.

Again, these are just some of the changes that were signed into law. For any detailed questions on how the new tax law affects you, your professional tax preparer will have the answers. I’m going to pass it over to Tim so he can talk about something much more exciting: BITCOIN! Enjoy.

​Bitcoin?
Lately we’ve had a number of our investors ask about Bitcoin (big sigh). It seems to be in the news daily, whether it’s up, down or both. While there are many sources that can provide a deeper plunge into the inner workings of Crypto-currencies and Block Chain Technology, we’ll take a moment and give our perspective on this phenomenon.

Bitcoin as a currency — Not so much
The reason it was created was to provide a secure and cheaply transferred currency useful to people and businesses worldwide. Despite its promise as a medium of exchange free from central banks and banking industry controls, it is not currently viable as currency for the ordinary human. Some reasons for this: Bitcoin is treated as any transaction that involves Bitcoin a tax may be due. Just as selling appreciated stock to buy a car will result in a 1099 for the capital gains, a “sale” of Bitcoin occurs during the conversion to dollars to facilitate the purchase of goods or services, which could result in a taxable event. Imagine getting a 1099 for the purchase of a sandwich! This is of course not happening, but it’s one of the novel effects that will need to be dealt with.

In relation to the US dollar and other currencies, the value of Bitcoin is extremely volatile. Until prices of goods and services are quoted in Bitcoin across the globe, a conversion to traditional currency (i.e., US$, Euro, etc.) must happen in order to finalize transactions. This makes it unlikely that Bitcoin will be appropriate for widespread public use any time soon.

Another issue for Bitcoin is that “depository” accounts used to hold it have been frequent targets for cyber theft; in some cases entire brokerage firms have been emptied of their Bitcoin. Normal monetary controls, developed over decades of experience, do not yet exist with Bitcoin; a fundamental benefit to some is a fundamental risk to others (think bearer bonds).

VISA just cancelled a pilot program of Crypto-currency payment cards for some of these very reasons.

Bitcoin as an investment — Hmmm
In the sense that one can pay dollars for Bitcoin, and have more or fewer dollars at a future point in time, Bitcoin can be considered an investment, or at least has some features of investing. There is no way of measuring the value or potential value of Bitcoin in relation to the dollars one might invest, except by the market price at any given moment. There’s no productive enterprise being owned that may pay a dividend or rent, and otherwise have a widely agreed upon intrinsic value, as an investment in real estate, stocks or bonds would have. While Bitcoin holds promise for a future with a universal currency, it is unlike gold or other precious metals, which have held value to humans and governments for thousands of years and are unlikely to see this erode. Bitcoin and other Crypto-currencies are very new and it’s possible that they are but a transient experiment leading to something more permanent and useful in the future, in which case they will be worthless. We’ll see.

If you decide to jump in
Buy only what you can afford to lose! Enjoy the experience and learn from it. Don’t use the kids’ college fund!

​As we go forward, and I have an opportunity to speak with you on the phone or in person, I’d be excited to give you a little more information on the places we explored abroad. Two adventures stick out as really remarkable: One was a fantastic storm on the Brittany Coast of France and then several days following, hiking the rocky, craggy, storm-ravaged coast line. Very, very beautiful and quite stimulating. Second, and without any particular planning, somehow we ended up at the top of the Eiffel Tower on Christmas Eve. That was a blast, absolutely gorgeous wonderful experience, chilly, people packed, fun. I look forward to seeing you throughout 2018, and until then…
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Happy Trails,
Jim Parr, Principal
Cairn Investment Group, Inc.

Headquartered in Houston, TX, Occidental Petroleum is an international oil/gas exploration and production company with operations in the US, Latin America and the Middle East. The company operates three segments: oil/gas exploration, chemicals, and midstream/marketing.
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With the company for over 35 years, Vicki Hollub became CEO in 2016.

​Occidental Petroleum is the largest producer of oil in the Permian Basin (New Mexico and Texas). Since 2013 they have been reorganizing their asset base focusing on acquiring low cost, high return assets in the Permian Basin. This included spinning off their California oil/gas assets into a separate company, selling their non-core assets in the Middle East and North Dakota, further concentrating their effort in the lucrative Permian Basin. This strategy has strengthened the company’s profitability potential even if oil/gas markets come under pricing pressure. Occidental Petroleum also operates a chemicals segment, accounting for 35% of sales, manufacturing basic chemicals and vinyls.

Occidental Petroleum is trading in line with their historical valuations and below fair value based on scenario analysis of free cash flow growth. Occidental has a dividend yield of 4.46% and generates over $1.3 billion in free cash flow, giving them the flexibility to continue to raise their dividend over time. The company forecasts their cash dividend will be raised if West Texas Intermediate (WTI) crude oil stays over $50 per barrel with the current dividend maintained at a WTI price above $40.00 per barrel. On a free cash flow basis, we expect the company to grow cash flow in the mid-single digits over the next decade, due to the company’s shift to higher margin assets. Modeling our conservative assumption places a price of $80 on the shares which is almost a 20% increase based on the share price as of the date of this report. If our conservative assumptions turn out to still be overly optimistic, we feel there is a margin of safety built into the current price based on the company’s strong cash flow generation and balance sheet.

As we continue to monitor our investment in Occidental Petroleum, we would like to see continued discipline in regards to capital spending and their amount of leverage while continuing to grow their dividend. Continued focus on the company’s revenue breakdown and operating margins will be areas to monitor closely.

Weighing the potential rewards and risks, we are optimistic that Occidental Petroleum will be a good ​long-term investment. 

​Headquartered in Issaquah, WA, Costco Corp. operates warehouse wholesale-membership stores. Through its stores it offers a variety of grocery products, clothing and other household goods.

​Craig Jelinek has been the CEO since 2012 and has been with Costco for over 20 years.

Costco operates over 740 warehouses worldwide with over 200 stores outside the U.S. Costco offers over 90 million members a variety of household goods at low prices. According to Costco they are the 2nd largest retailer in the world with over $126 billion in sales for their 2017 fiscal year. Costco’s key strategy is to grow revenue through offering low prices on a number of bulk items. As an example, Costco sold $7.5 billion in meat and $1.6 billion in seafood during their 2017 fiscal year. 

Costco has a broad footprint across the U.S. with most warehouses located in larger populated suburban areas. With only 4% of sales currently via the internet, there is ample ability to expand their e-commerce business as more customers shift to an experience called “click and collect” in which they buy on line and then pick-up in the store.

Costco has demonstrated consistent operating performance across many financial metrics. Though the grocery and retail business is fiercely competitive, Costco manages to generate high returns on capital (averaging over 13% during the last 5 years) and free cash flow generation. This allows the company to continue to invest in future growth initiatives (e-commerce and international expansion) while rewarding shareholders via an increasing dividend.

Costco is trading at premium valuations compared to historical operating performance and peer group. As of the date of this report, Costco traded at over a 15% premium to its historical ten year sales multiple. Based on numerous free cash flow growth possibilities, we’ve assumed an overall compound annual growth rate (CAGR) in free cash flow of 7.0% over the long-term. This blended growth rate is well below the growth rate achieved historically. This reflects conservative assumptions based on increasing competition from new entrants into the market, such as Amazon, and pricing pressures from existing competitors like Walmart. Based on the probability of different growth rates for the company going forward, even our most optimistic outlook does not support the company’s current valuation, therefore caution is warranted.

Costco is a well-managed, high quality company but with the increased risk of competition and the company’s elevated valuation we feel new investments in Costco should be deferred until valuations are more in line with the company’s operating performance. 

​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.

Often I begin these letters reflecting upon those topics we have hanging on our wall of worry. It would appear, during this particular period of time, that the wall of worry is not that worrisome. At a very local level the recent forest fires that clouded our skies and challenged our transportation are diminishing. It’s wonderful to have some rain and it’s even better that we’ve been soaked with several inches of it. Over this last weekend, I took a trip up the Columbia River Gorge, traveling up the Washington side and coming down the Oregon side to see the extent of the Eagle Creek Fire. Yes, lots of terrible damage, but it really looks as if (like so many times before) the forest, the views, and the beauty will return.

Instead of a wall of worry, we have a wall of a-lot-of-things-going-on. It’s a very exciting time at Cairn; many of you have been into the office over the last year and have experienced our new technology-bristling conference room and of course the espresso machine. In person and over the phone many of you have gotten to know Morgaine, who came to us not very long ago with a different kind of background, as a scholar of Ancient Mediterranean History, looking for a temporary job to rebuild her finances and head back to the Mediterranean and continue her education. Well, the time has come. Sadly for us, she is leaving. But, happily for us, Jesyca will be taking her place. Jesyca is a recent graduate of University of Colorado Boulder, and has moved to Portland to enjoy the vibe and the Northwest. She will be the person many of you will get to know on the phone or as you visit the office. Additionally, she will be helping Theresa with many of the tasks that happen in our office on a daily, weekly, monthly basis. Jesyca is one of the 110 new Portlanders who arrive each day to our fair city. Welcome to Portland, Jesyca!

From a long list of important topics, there are several that are really worth focusing on this quarter. Number one, while we’re all interested and worried about the global economy, it has become clearer as the months roll by that the fear people had of debt after the recent “Great Recession” seems to be subsiding, and we are now becoming more comfortable with the increasing global debt. That’s typically not a good thing, but the expansion of our economy and economies globally seems to be taking it in stride. Number two, the Equifax security leak is a tremendous problem. We’ve taken a look at this and would encourage all of our readers to read the blog post Morgaine and Jesyca compiled on the current options to protect your personal private information. I believe it is important we all take this situation seriously and do everything we can to keep our personal data as safe as possible. The third topic that I’m confident will be fascinating to watch over the next months is the proposed changes to our tax laws. This could cause everybody to really think about the question: “What do you want your government to do for you?” And after you’ve made the list of what you want our Government to do, how do you finance it? So hang on and let’s get ready for some really interesting conversations about taxing ourselves so we can pay for what we want our Government to do.

​I’m going to pass this over to Patrick, and I think Theresa has an important message to deliver to us as well. I look forward to the next time we meet or speak and I look forward to a wonderful fall with a lot of delight in living in the Northwest.

Global equities shook off a number of negative geopolitical headlines during the quarter. U.S. stocks rose 4.50%, while international stocks continued to outperform, rising 4.80%. Fixed income continued to defy the worry of rising interest rates as the U.S. 10 year Treasury yield remained at a low 2.32%. Economic growth around the world has shown better signs of life through the first 9 months of the year, which brings me to my topic for the quarter: Is the pick-up in GDP growth inflationary, and how will interest rates be affected? I’m not going to touch on the stock market, as our opinion has not changed from last quarter’s letter that U.S. indices, like the S&P 500, are becoming expensive. However, we continue to find value in individual companies, though not at the same level as a couple of years ago, so patience is warranted.

Over the last 10 months the Fed has started the slow process of normalizing interest rates and reducing the size of their balance sheet. Since December 2016, there have been three 0.25% interest rate hikes. These increases have brought the fed funds rate to 1% - 1.25%. Historically, the Fed has raised interest rates in an attempt to cool down an overheating economy and to put the brakes on inflation. One indicator that we look at to take a reading on the health of the economy is the change in employee earnings versus inflation. The chart below shows the year-over-year change in inflation (red line, measured by CPI) and the year-over-year change in average hourly earnings for employees (blue line).

As you can see, historically there has been a very tight relationship between the two. Actually, year-over-year changes in average hourly earnings tend to lead changes in inflation. As the bottom right of this chart shows, the growth of average hourly earnings peaked in 2016 and has been steadily declining since. This is in contrast to the pick-up in inflation that has taken place since 2015. This matters when taking a look at Fed policy going forward and how future interest rate increases could affect the economy. If inflation is set to decline in line with what hourly earnings growth is telling us, then the Fed will have some very tough decisions about how quickly to raise interest rates going forward. Overall, the pick-up in GDP growth does not look to be inflationary at this point. If that is the case, monetary policy risks will remain high as the Fed will have to weigh continued normalization of interest rates against the risk of slowing down the economy.
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These are just some of the many data points we look at when thinking about your investment portfolios. Please email or call if you want to discuss any of these topics in more detail.

Often fall is a time to regroup and get organized. Maybe even catch up on some neglected chores. When you have a change of address, please contact me. I would like to coordinate the address change for you at both Cairn and the custodian. Not having a current address on file can cause information delays, and can eventually cause restrictions on your accounts. I will need your signature to change your address at the custodian. You may contact me directly via phone 503.241.4901 or email.

Thank you Theresa. Please take me up on my standing offer to swing by for some local joe. The pot is always on.

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

​P.S. Our website relaunch was a great success. The first 20 people responded to the challenge within two hours! Many more over the next several days! We sent coffee cards to all who responded, even after the first 20. I haven’t told Tim the grand total because it will bust the marketing budget. Thanks for participating.

Detect
Check  the status of your accounts (financial and credit history)

• TrustedID Check
• Dark Web Email Check

​
Prevent

• Consider a credit freeze : See “A” below
• Fraud Alerts : See “B” below
• Improve your login security with strong, unique passwords for each online account you use. Use two-factor authentication if it’s available to you.

Plan

• File your taxes as soon as possible.
• Think about “What-if” it happened to you.

Check with Equifax to see if you were affected by the breach:

• At Equifax, click on “Check Potential Impact,” then enter your last name and the final six digits of your Social Security number. Equifax will supply a message noting whether it believes your personal information was compromised. Even if your information wasn’t compromised, you’ll have the option of signing up for a free year of credit monitoring and identity theft protection services from Equifax’s TrustedID Premier. 

A.  Placing a Security Freeze on Your Credit (Guidelines from Consumers Union):

Deciding Whether to Place a Security Freeze

• http://consumersunion.org/wp-content/uploads/2007/11/Things-to-Consider-When-Deciding-Whether-to-Place-a-Security-Freeze-2.pdf

How to Place a Security Freeze
In order to effectively freeze access to your credit files, you must request a security freeze to be placed at each of the three major credit bureaus. Pricing is determined by state but paid to the respective agency.

​By Phone: Call each of the credit bureaus at the number provided below:

• Transunion: 1-888-909-8872
• Equifax: 1-800-685-1111
• Experian: 1-888-397-3742​​

​​​​Online: On each credit bureau’s website (TransUnion, Equifax and Experian), you can find an online form to place your security freeze.

• https://www.transunion.com/credit-freeze/place-credit-freeze2
• https://www.freeze.equifax.com/Freeze/jsp/SFF_PersonalIDInfo.jsp
• https://www.experian.com/freeze/center.html

​B. Initial Fraud Alert
To set a fraud alert, contact just ONE of the credit card bureaus and ask for an initial fraud alert. Once the alert is set, it will last 90 days. After that, you'll have to renew it:

• Equifax: 1-888-766-0008
• Experian: 1-888-397-3742
• TransUnion: 1-800-680-7289

More information here.
 
C. Purchasing Identity Theft Protection vs. DIY:
While this article is promotional, it gives a very clear rundown of the difference between identity theft protection and credit monitoring. This article goes through many aspects to consider when deciding the next steps of action to take after this Equifax breach.

Headquartered in Cincinnati, Ohio, Kroger Co. is the largest U.S. grocer. It operates multi-department stores, jewelry stores, and convenience stores throughout the United States. Kroger also offers its own private label that it produces from its 38 food production plants. 

​William McMullen has been the CEO since 2014, spending over 37 years with Kroger. 

Kroger operates, either directly or through its subsidiaries, approximately 2,800 supermarkets and multi-department stores, approximately 1,400 of which have fuel centers. Kroger operates under 21 banners that include Fred Meyer, QFC, Kroger, City Market, Dillons, Food 4 Less, Fry’s, Harris Teeter, Jay C, King Soopers, Ralphs, and Smith’s. Kroger also operates over 700 convenience stores, either directly or through franchisees. Kroger has an additional 319 fine jewelry stores, which alone account for $345 million in annual revenues, making it one of the largest fine jewelers in the U.S. Kroger is the fifth largest pharmacy operator in the U.S. by number of locations. It offers pharmacy services in over 2,200 of its stores, which accounts for close to 10% of its revenue.

Kroger operates one of the broadest footprints in grocery with a vast majority of its supermarkets within 2-2.5 miles of its customers’ homes. Their size and scale puts them in an enviable position to compete through digital platforms for home delivery or curb side pick-up services. This is a key differentiator when comparing Kroger to competitors, and a big asset moving forward as the grocery business adapts to new competition. Kroger recently opened its newest store concept, “Fresh Eats MKT,” which is a combination convenience store, pharmacy, and gas station, focused on higher quality food offerings.
​
Kroger has demonstrated consistent operating performance across many financial metrics. Though the grocery business is fiercely competitive, Kroger manages to generate high returns on capital (averaging over 12% during that last 5 years) and free cash flow generation. This allows the company to continue to invest in future growth initiatives (e-commerce and small store formats) while rewarding shareholders via an increasing dividend and timely share repurchases.

Kroger is trading at attractive valuations compared to historical operating performance and peer group. As of the date of this report, Kroger traded at over a 25% discount to its historical five year sales and cash flow multiples. Based on numerous free cash flow growth assumptions, we assume an overall compound annual growth rate (CAGR) in free cash flow of 4.5% over the long-term. This blended growth rate assumption is well below the growth rate achieved historically. This reflects conservative assumptions based on increasing competition from new entrants into the market (Amazon) and pricing pressures from existing competitors like Walmart and German-based Lidl. If our conservative estimates turn out to be overly optimistic, we feel there is a margin of safety built into the current price.

​These risk factors will be monitored, but at current valuations combined with the company’s financial strength, we feel the risks are represented in the current price and that future growth potential remains strong.

​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.