Print Friendly and PDF

Stocks for the long terrm

Five tech hand

The Days Ahead: More corporate earnings, including Apple. Job numbers.

One-Minute Summary: Google and Amazon beat by a large amount and had small rallies. Netflix, Facebook and Twitter beat by small amounts and were hammered. There’s a lot of high expectations in the market. High, consistent growth is tough to find. Those companies that provide it are priced for perfection. But one miss and the leveraged and momentum buyers dump the stock. Volumes in the three that missed were 8 to 10 times higher than normal. We stand aside when that’s going on. It's not so much price discovery as sell first and ask questions later.

The S&P 500 didn't quite hit its all-time high of 2,872 but it probably would have if Facebook had behaved. It's 2% of the index. News on the trade front was better. The Trump/Junker deal was progress, even if some of the promises don't materialize. The ECB was optimistic on growth. European and Emerging Markets rallied. U.S. Treasuries were mostly unmoved, which is impressive given a big August refunding.

1.     Everything is awesome. In the most anticipated news of the season, Friday’s report on the Q2 GDP number was a barnstormer.  It came in at 4.1% more or less in line with consensus and pretty much as every economist on the street and the Atlanta Fed GDP Now guys predicted. Well done everyone.

So why are we skeptical? Well, first remember that GDP is skewed to the top 10%. They own/earn around 35% of GDP while the bottom 50% earn around 25% of GDP. Here are two scenarios which both produce GDP growth of 5%:

In Growth 1 everyone is happy. Everyone grew. Some more than others, yes, but all OK. In Growth 2 half the population saw negative growth, 40% none and 10% a nice jump. The outcome for total growth is the same in both: 5%. We think Growth 2 is far more like what is going on in the U.S. Which is why people look at the growth headlines and wonder where they missed out (h/t Equitable Growth via FTAlphaville).

Some of that is just the way economists calculate GDP. After all, in that world, the birth of a human detracts from GDP/PP and the birth of a calf increases it. We don't have a better way to measure growth. So, you know, good headlines and all but not a mic drop.

Moving on.

This is how GDP looked:

Good news

  • U.S. economy shot past $20 trillion. All the tariffs announced so far amount to less than 0.75% of the economy. At this rate, the U.S. economy would make that up in 10 weeks
  • Q1 revised up for Q1 and prior years
  • Exports were a big driver of growth. Have not been this big since 2016 and second biggest number in five years
  • Personal consumption (70% of the economy) was up 2.7% or 65% of the growth
  • PCE inflation (the one the Fed measures) was 1.9%
  • Nominal GDP grew 7.3%...good for equities

Not so great

  • Inventory buildup was negative. We see inventories very simply. If producers expect demand to be higher, they build up inventories. If they don't, they don't.
  • Some exports (the soybeans we’ve discussed) were brought forward to beat the July tariffs. 
  • Nominal GDP growth is way ahead of wage increases…consumption may not keep up
  • The 2017 tax bill front-end loaded spending and tax cuts.

The market had other things on its mind, like corporate earnings, trade stuff (stop me if you've heard this). Neither bonds nor equities moved much. It was all in the price. But, we’d still say it’s a good setup for the rest of 2018.

2.     One Fang just got smaller. The stock was down 20% in after hours trading on Wednesday and didn't recover much on opening. Why?

  • User growth was less than expected
  • Revenue growth revised down in 2H 2018
  • Expenses up
  • Missed (only slightly but there’s little margin for error with a stock like FB) advertising revenue target
  • Headcount up 47% YOY
  • Some negative comment about the EU privacy regs General Data Protection Regulation (GDPR…expect to hear more of this) where they lost 1m subscribers due to the new rules.

Quotes from the transcript (here) probably didn't help:

  • “…deceleration in ad revenue growth, kind of consistent with the trends we've seen” CFO
  • “…because the effective levels of monetization in Stories [videos and photos with a story; disappears in 24 hours] are lower.” CFO
  • “We're being very slow and deliberate with monetization [with Messenger]” COO
  • “But we won't know for a while if it's going to monetize at the same rate [when FB places Stories across Messenger, Facebook and Instagram]”. COO
  • “[Europe monthly average usage (MAU) was down] On Europe, yeah, we don't have any update on trends. We had indicated in the first quarter that we would expect to see a decline. We're not providing any guidance on MAU and DAU in Europe on this call.” CFO

Some of the +30% growth days must be numbered. This is a stock that's under regulatory scrutiny but, unlike Google, the facts and fines aren't known yet. There wasn't one reason for the miss…just lots of small ones such as privacy, currency, new ad formats etc. Since 2013, revenue and expenses have “beat” (i.e. been better than forecasts) by 5% to 7%. This time they missed by 1% and 2%. So, that's new for them.

But it’s a cash fortress. FB has a very strong balance sheet. More than $50bn in cash, which is half the balance sheet. Operating margins dipped but are at still at 44%. High ROE, EPS growth of 40% and large cash position, all shown here.

Bull case:  New products, management tends to guide low, mobile ad volume, ad pricing, not overly expensive

Bear case: Regulatory problems will grow, slower growth, expenses higher, opting out/privacy issues

Bigger picture: We’ve written about the FAANGs a fair amount in recent blogs. They’re big, profitable and growing. But there are high expectations around the stock and it sells at 75% more than the market and 85% more than Apple.

It’s one reason why we like small cap and the dividend Aristocrats. They lag when Big Tech is on a run but they're less likely to have a big sell off.

And if you own it: Many clients have low cost positions in FB, so selling is not an option. The stock is not going to crash. It’s a 20% correction so needs a 25% increase to break even. We'd certainly trim where possible if only for diversification reasons and we can help on that. Also, if you have tax gains elsewhere, or want to create a loss to offset some current income, we can help on that too. But otherwise it’s a HOLD.

Bottom Line: Earnings are matching the hype. They’re good and numbers for the back half of the year are being revised up. The market is on forward P/E of 16.5, cheaper than all of 2016 and 2017. But growth will slow.

Please check out our 119 Years of the Dow chart  

Subscribe here for our investment updates

Other:

Astronomy photographs of the year

 --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.

Friday Music: Valerie

The Twins at Work

The Days Ahead: Second round of Q4 GDP. Italy heads to the polls.

Bonds are grappling with higher expected growth (even though we had some disappointing existing home sales, retail sales and Industrial Production) and the reawakening of the twin deficits story. For those of you of a certain age, this was a big deal in the 80s and 90s. It’s basically a fear that growth will suck in imports and the, ahem, reformed tax regime won't bring in as much revenue as they hoped because, you know, “tax revenues are going down”.

How bad are those deficits?

Well we already have one of the highest federal deficits at a time of low unemployment. We expect them to go up when recessions take hold but this time they've stayed high despite the halving of the unemployment rate. We also now have a much weaker dollar and the fear is that the two lower lines (the deficit and trade balance as % of GDP) will grow as the dollar weakens (the black line going up). It’s a messy chart and we’d warn about interpreting it too literally but it’s in the background and we expect it to come up in future Fed meetings.

Meanwhile the bond market rallied and moved further away from the key 3% on the 10-Year Treasury. We're very comfortable with this move and don't expect any major pick up in rates. Meanwhile: 

1.     Long-term investments returns:  We're pretty comfortable with long term investing. We don't market time, we keep turnover low, avoid the fads and keep to your asset allocation targets. So it’s nice when we see Credit Suisse’s Global Investments Returns Yearbook, which measures returns from 1900 to 2017. Here are some highlights:

  • The U.S. equity market was one of the best in the world, returning 6.5% in real terms. South Africa and Australia were better probably because of their commodity bent.

  • Equities were a way better asset class than anything else. Better than housing (0.3%), collectibles (2.9%) and bonds (2.0%) and, of course, cash (0.8%). Gold and other precious metals failed to keep up with cash.

  • Emerging Markets lagged the U.S. here:

  • But the Russian and Chinese revolutions er…redistributed those assets and the Second World War hit most of SE Asia hard. Since 1950, the annualized returns for Emerging Markets were around 12% vs 9% for the U.S.
  • The U.S. is dominant. At its 1990 peak, Japan accounted for almost 45% of the world index, compared with 30% for the USA. It fell to just 8%. The US regained its dominance and today comprises 51% of total world capitalization. Here: 

Where does that leave us? We appreciate that no one has a time horizon of 117 years and that some periods have been very painful to investors. If you invested in the market peak of 2000, it took 13 years to make any money. Japanese investors from 1989 are sitting on a 40% loss. But we would say:

  • Equity returns may be lower in coming years, mainly because of low interest rate
  • The case for equities is that, over the long term, stockholders have enjoyed a large risk premium over cash. On average it has been 7.5%
  • Even with a lower equity premium of around 3½%, equities are still expected to double relative to cash over a 20-year period.

2.     A funny thing happened on Thursday, which is sort of a modern parable on corporate governance. SNAP, the disappearing photo app, fell some 17% on the news that one of the Jenner/Kardashians didn't like the new look. Here’s the chart:

Ms. Jenner has 24m Twitter followers and 325,000 of them hearted the comments. That was enough to wipe $2bn off the value of the firm. At the same time, the founder sold stock under SEC Rule 10b5-1, which basically says an insider can sell stock on a pre-determined schedule and avoid running into material non-public information rules…which most of us know as insider trading. How much did he sell? Some $620m making him the highest paid CEO of a public company by a very large margin. It was around 3% of the company’s worth and Snap lost $3.4bn last year. Tim Cook earns around $12m or 0.00001% of the company’s value. And they make a great deal of money.

Now, I’m the first to admit I’m not Snapchat’s target market either for their app or stock. And we made fun of Snap last year.  But a number of things come to mind:

1.     A company like Snap trades on very thin air. It’s one of those winner-takes-all and network effect businesses. You probably only have time in your life for one disappearing app so the company either makes it big or is copied and left in the dust. And if one unhappy client can send your stock plummeting, it seems to me like it’s a very risky business. It’s should not be like the Department of Defense calling United Technologies and saying, “Hey, we don't like your Black Hawks any more.  Or is it just me... ugh this is so sad."

2.     The governance at Snap reached a new low. The Class A shares have no vote, the Class B have one vote and the Class C have 10 votes. Guess who owns the Class C? There are plenty of other companies who issue dual share classes (Berkshire for one) but this seems one step too far for the index providers who ganged up on Snap and said “you can't be in our index”, which turns out is a problem because index funds own some 15% of the S&P 500.

3.     On a higher level, it complicates the IPO market. There are plenty of Unicorns playing in Silicon Valley’s magic forest but they seem content to stay private. And who can blame them? The public markets are going to ask awkward questions like “do you make money?” We need a healthy IPO market for stocks. There have only been around 100 in the last six months and many of those are small or relaunches or spin-offs.

Bottom Line: Earnings are winding down. It’s been as strong quarter with growth at 15% compared to estimates of 11%. Emerging Markets remain very well supported.

Please check out our 119 Years of the Dow chart  

Subscribe here for our investment updates

Other:

Credit Suisse yearbook on investments returns

Berkshire Hathaway annual report out this week

 --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.

 

"Equities to Perform Poorly" says Fed

Actually, they said it back in 2011. Here it is. Since then, the S&P 500 has risen 130% in price terms and by 162% with dividends. Here it is:

S&P Total Return since 2011_SP50-USA.jpg

It’s not that we’re making fun of the Fed. We would never do that. But it shows that making stock market predictions can trip up even the sharpest and most objective minds.

The Fed made the reasonable argument that stock markets returns were driven by multiple expansion (basically more expensive) and that was driven by demography (a larger population buying stocks).

This is true but stocks are driven by many variables including the price of risk-free assets, earnings, demand, dividends, valuations, cash flow and about another 100 we could think of and more beyond that.

Right now, we think stocks are somewhat expensive but well supported by earnings and the synchronized growth in the U.S. and overseas. It’s enough to keep us confident.

Subscribe here for our investment updates

Take me to Attorney Briefs

 

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.