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The Days Ahead:
Earnings and China and Germany updates
Sometimes market and economic data looks like this:
Not really a pattern or system but a lot of noise. So, you have to wait, stand back and see what the big picture is, which in this case is this (the above is the black rectangle) and of course, well known to Ferris Bueller fans.
In the last week we had some very odd payroll numbers, the first job losses since October 2010, an uptick in consumer confidence, some weak retail sales and FOMC minutes that revealed a very lively debate about whether inflation is dead, mostly dead or just sleeping. The CPI numbers on Friday came in at 1.7% which is well below what it was when the Fed started tightening in 2015 and 2016 when they were on hold. We know there’s a lot of hurricane noise in the data right now but recent trends don't seem that much different from trends before they hit.
Our view is that inflation will stay stuck at less than 2%, simply because wage pressure seems low and likely to remain so. The 10-Year Treasury market seems to think so as yields fell 10bps in the week. Meanwhile stocks pushed on ahead based on some early but strong earnings reports, the prospect of tax cuts and ongoing good economic reports out of Europe. Elsewhere:
1. People are talking about tax cuts:
More than that, it’s been the major driver of stocks for the last few weeks and one reason why small companies, with an average tax bill of 28%, have ripped ahead of large cap, with an average tax rate of 19%. A cut in corporate tax falls immediately to the bottom line, so there’s no waiting around for the benefits. Of course, we're short on details and whether the House version, which reduces tax revenues by $2.4 trillion over the next 10 years, will square with the Senate version, which limits deficit increases to $1.5 trillion, will square with the White House version, which cuts taxes by $1 trillion… remains to be seen. We'll hold off on opining but there is little doubt that changes are coming.
One item that seems certain to change is the treatment of overseas cash holdings. S&P 500 companies hold around $1.8 trillion in cash, or 8% of market cap and 27% of equity. Tech firms dominate, holding 40% of all cash, which makes sense for businesses that have very low needs for working capital or physical assets. We looked at seven of the biggest firms with high (over 20%) overseas cash as a percent of market cap. Here’s the chart:
We know there are many other factors at play here but the immediate benefit of a tax cut for companies repatriating cash should cause shareholders to bid these stocks up. Which they did for a while. The top line sloping up shows they outperformed the S&P 500 by around 12% for most of the year. But this changed in September and they began to underperform. Why?
Well one reason is that the market had already discounted the likelihood of a tax cut. But we think it’s also because that with stocks expensive (and they're in the 95th percentile of valuations like Price to Earnings Growth, EV/Sales, Forward PE etc), management won't only use the proceeds for share buybacks. That leaves special dividends, M&A, capex investment or just keep it for dry powder.
We'd prefer investment for organic growth. At least that would indicate confidence in future demand. But either way, we’re not convinced the tax cuts on repatriation will make a big difference to market returns despite the press attention and the market seems to have drawn the same conclusion.
2. Investing with Uncle Warren:
We're fans of Berkshire Hathaway (BRK) and, full disclosure, I own it. This is not the place for an exhaustive recount of the wonders of Warren Buffet. There are plenty of books about him here, by him and of course, the annual reports are always worth a read. We were surprised to hear that JP Morgan just initiated coverage on Berkshire, which seems odd for one of the largest sell-side firms to start looking at the country’s sixth largest company by value and second largest by sales. Anyway, here's how we think of BRK:
- It’s four businesses i) insurance (personal and corporate) ii) rail iii) manufacturing and iv) utilities. Those account for 84% of sales. There’s other stuff like real estate, candy, furniture, Duracell, a motorcycle apparel company and a mobile home builder. Fine businesses but the big four drive the stock.
- It has a fortress balance sheet, with $86bn of cash. Most of the big four fund their operations internally or with debt not guaranteed by BRK.
- The well-known investment portfolio is around 30% of the company’s value or $137bn. To us, they're a sort of gimee. If they do well, they throw off more equity value and cash and if they fall, say 30%, in a stock market crash, they only reduce book value by 9%.
- There’s a sort of floor on the price at 1.2x book value, which would be around 20% below what it sells at today. Buffet goes into some detail about what this means but to us it just means he’s not going to stand by and let the company become a value trap.
- Finally, BRK uses an “intrinsic” value method, which to us, is the cash that can be taken out of the business for their remaining life and the value of the businesses over recorded book value. Sometimes, this is just the difference between a goodwill write-down and market value but in some cases it’s the value of the business after accounting for big but initial underwriting losses on its insurance businesses.
Basically, GAAP and Statutory accounting must expense the pure loss of an insurance contract and so ignores the deferred benefit of the float. So say, BRK writes an insurance contract for $10bn. They receive $10bn in premiums but must recognize that eventually they will pay $16bn in claims. So that’s a loss on the income statement in year one. But the claims come in over many years so BRK gets the famous “float” or investment returns from excess cash. This is way above the claims cost (e.g. $10bn at 5% for 25 years returns $34bn) and eventually flows back through the income statement and to shareholders.
Anyway, it’s all part of conservative financial management.
Finally, the ROE number looks pretty meager, right? I mean 8%. That's the bottom third of S&P 500 companies. But that incudes the $137 bn equity portfolio, which has a zero return on an ROE basis because it's just stock holdings. Exclude that and the number is more like 12%, which is pretty good for a financial and manufacturing company. And look at the two smaller charts. The growth in book value and earnings (the green lines in the second and third chart) is poised to grow by around 10% for the next two years, mainly because rail, insurance and businesses like Precision Castparts are rebounding.
JP Morgan figure the book value of BRK is at least around $210 in 2018 (price today is $187) at a 2% growth and up to $266 at 4% growth. We'd look at it more simply. It’s a collection of superb businesses that operate independently and probably worth a lot more if they were ever sold. At this time of highly appreciated stocks, that’s somewhat comforting.
We're not big experts on Catalan independence but given the Scottish referendum and the history of separatist moves in Spain, it seemed bound to happen. The Spanish constitution allows for some pretty drastic intervention if the region tries to break away. For now, tensions have lowered and we saw spreads on Spanish bonds lower this week. This does not change our view on European stocks, which we increased some six months ago, but is a reminder that political risk can come from very unlikely sources.
Stocks are at or near all-time highs and the S&P 500 continues to trade at around 17.5x earnings. Expensive but not at nose bleed level by any means. It’s an earnings week with inevitable Washington stop/go progress on taxes.
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We need to talk about Kevin Marsh
Tax cuts not good for rich…no scratch that
--Christian Thwaites, Brouwer & Janachowski, LLC
Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice. We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security. The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended. Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data. Past performance is no indication of future results.
All charts from Factset unless otherwise noted.