First Quarter 2018 – Quarterly Commentary
LESSONS FROM HISTORY
In this report we focus on two themes: Earnings and Trade. Both matter a great deal to the markets – as they rightly should. Let’s start with the earnings picture.
Why Do Earnings Matter?
Over time, the key driver of equity prices will be a company’s earnings. In effect, earnings are what the shareholders actually have a claim on. Earnings are typically expressed as “Earnings Per Share” (EPS).
Corporate management has many options when it comes to allocating those earnings. Management might decide that the best course of action is to re-invest all of the earnings into new plant and equipment to improve productivity, cut costs or boost production so as to drive more sales and higher profitability in the future. Management could also decide to pay down outstanding debt to lower the cost of financing. Or they might choose to pay out some of those earnings in the form of dividends to the shareholders, or to repurchase the company’s shares in the open market (reducing the outstanding float and increasing earnings on a per share basis). They could also pursue any combination of the aforementioned.
But these choices are available only if there are earnings in the first place – so earnings matter. When one thinks about what one is willing to pay for shares, the higher the earnings per share, the more one should be willing to pay for those shares. Over time, while this is not the only driver of stock prices, this is arguably the single key driver.
RED Operating Earnings on S&P 500 BLUE S&P 500 Index Data: Thomson Reuters
At LWM, we like to focus on companies that do real things and generate (or have a clear path towards generating) actual earnings. In part, this is driven by an approach that says we prefer not to speculate. Of course, we realize and acknowledge that earnings do fluctuate over time. It is a matter of import that, at the very least, the trend in earnings is on an upward trajectory. But what about those enterprises that don’t have earnings or may (possibly) never have earnings?
For those who have been investing for (say) twenty years or more, memories of the “Tech Wreck” of 2000-2003 linger. That was a period during which the “old” rules of investing were chucked aside in favour of a “new paradigm” in which investors such as Warren Buffet were viewed as “old fogies” whose approach was out of date. Price-Earnings multiples (when one could be calculated) went sky-high. It was a period of rampant speculation and, of course, no one wanted to miss out. The rest, as they say, is history. The philosopher George Santayana had something to say about history: “Those who cannot remember the past are condemned to repeat it”.
This may have a familiar ring to it today. Consider the recent Bitcoin bubble, or Amazon – which has yet to report any significant earnings – becoming the second largest name (by market capitalization) in the American market, or Tesla (which to date has lost far more money than it has made cars) and the like. Chasing the promise of profitless growth is – especially in this environment in which interest rates are trending up after a decade being held at rock bottom by the Federal Reserve Board – a lesson some may be condemned to repeat.
High and…. Higher
Of course, such goings on are hardly limited to the U.S. market. Right here at home, we have our own examples of companies which fit that description. Bombardier, for one, continues to mystify us. How can a company that hasn’t produced more than a handful of its new C-Series planes, let alone a profit, be anything more than a penny stock? Yet it reached a price of over $4.00 per share during the quarter! But it’s the “pot stocks” that seem to have had investors really smoking something. Those companies’ shares soared with the news that Canada would be legalizing pot, but it was (for the most part) their overvalued share prices that went up in smoke. Companies such as Canopy Growth and Aurora have been market darlings but may yet come down from their current “highs” – if you’ll pardon the obvious pun. It’s always a concern when expectations are extreme and the market is, as yet, unproven.
We fully acknowledge that some, but by no means all, of such names will go on to succeed in their chosen market.
Amazon is clearly a successful and (by many) a feared company, but even Amazon has real-world issues to grapple with. Warehouses aren’t made of ether and logistics aren’t free. With only nominal earnings and a P/E ratio of 170 times anticipated earnings, its true value could be its present price, twice its current price or half its current price.
Once Bombardier works the kinks out of its long-delayed production, returns a pound of taxpayer-financed flesh back to the government and shows it can compete with much larger entities like Boeing and Embraer, it could commence earning money for its shareholders. But wait! Bombardier today actually owns less than a one-third interest in the C-Series planes it produces because of the terms of various government bailouts and the subsequent deal it struck with Airbus.
One could say the same about Tesla (minus the government and Airbus factors), as it will have to come back to the market (yet again) to raise (yet more) funds to get its Model 3 out the factory door. Tesla would seem to have a great product, but the longer it takes to get its product from the assembly line to the market, the better the odds are that more experienced and far better financed companies like BMW, Mercedes and General Motors will scoop up market share for electric vehicles.
At LWM, we question the market’s enthrallment with companies where profits are like a mirage – something viewed in the distance but never quite attainable – rather than earned and available to shareholders.
On another note, the reality of rising interest rates brings all kinds of questions to the fore regarding valuations of equities as well as bonds (and rates don’t have to go to 10% for this to be true). For example, it calls into question a company’s ability to finance its operations. The more it costs to finance the company’s debt, the less will be available to pay out to shareholders by way of dividends or to reinvest in the business itself. Also, the level of interest rates also impacts the multiple that investors are willing to place on a company’s earnings and hence that of the overall market. Higher interest rates typically crimp economic growth. The more a company depends on overall economic growth, the more sensitive its earnings and share price will be to the level of interest rates. As can be viewed in the chart below, valuation levels on the S&P500 are near levels associated with previous peaks.
Of NAFTA and Other Trades
“A broom is drearily sweeping up the broken pieces of yesterday’s life
Somewhere a queen is weeping…. Somewhere a king has no wife
And the wind, it cries Mary”
Those words from a famous Jimi Hendrix song came to us as we thought about the trade woes which came to the fore again in the latter half of March of this year. Why?
One of the key drivers of global expansion since World War II, and certainly since the late 1980s and the fall of the Berlin Wall, is the growth of global trade flows. It had been more or less a one-way street (more and more, up and up) until the election of Donald Trump. Even his election didn’t change the direction of the tide as his rhetoric had not been matched by commensurate actions. That looks like it’s changing.
The re-negotiation of NAFTA (the North American Free Trade Agreement), which has been in place since 1994, has been underway for over a year now with little real news – one way or another – to report. It’s been a bit like reading tea leaves, and one could be forgiven for wondering for how long the U.S. representatives would be sitting in their chairs. That said, the latest soundings appear to be relatively positive, as the American side has dropped many, or at least most of, its demands regarding U.S. content in autos. This is a big deal for Canada and Mexico! The same however, cannot be said for softwood lumber. There, for the moment, things have gone from bad to worse.
The big news, which broke in the third week of March, was the imposition of tariffs on $50 billion worth of Chinese exports to the U.S. The equity markets, which were already under pressure from many factors, wilted yet again. Back to George Santayana for a second and remembering the past. The Smoot-Hawley Act, passed on June 17, 1930, is widely credited with triggering the trade war that accentuated the Great Depression as it raised tariffs on some 20,000 goods being imported into the U.S. To no one’s surprise, China has reacted by identifying $50 billion worth of U.S. exports to the Middle Kingdom which may attract significant import duties in retaliation.
It is not an understatement to say that markets are “anxious” over this latest turn of events. Tit-for-tat trade issues can spiral out-of-control almost without warning. The markets are paying attention, but they have not panicked – thus far.
Standing Back from the Smoke of Battle
We have focused on two key issues in this report: Earnings and Trade. Both are key drivers of the market – up or down (or perhaps we should say up and down).
Overall, corporate earnings continue to look reasonably solid. Oh, they may not be as robust as the analysts’ tout at the beginning of this (and almost every) year, but they are still significantly above last year’s, with earnings growth estimates for the S&P 500 generally in the range of 15-25%. And, as we’ve already stated, we like to invest in companies that have earnings.
Rising interest rates, while a point of note and possible concern if they rise too far too fast, are also a sign of strong growth (3%+) in the North American economies. So, on balance, that’s not a bad thing.
Stepping back for a moment, we should note that the low level of volatility experienced by markets for most of the last two years (from the end of the first quarter of 2016 to the end of January of this year) was very much the exception and not the norm. The extreme lack of volatility in the markets over that period was, in fact, record-breaking. The VIX Index which measures volatility in the market was at an all-time low. Thus, as investors, we must remember that we have simply returned to a more normal level of variability of late, but that it feels worse because of where we have been. Of course, the numbers are larger (one hears of 1000-point drops, or 500+ point gains) but, if converted to percentages, we’ve seen all this before. A good downdraft can be both therapeutic for the markets themselves, and also an opportunity for us to take out the shopping cart and invest some of the cash reserves that have built up because we have been more cautious of late.
In all, it was a tough quarter across-the-board as the Canadian and U.S. equity markets were down while the fixed income markets were flat. The decline in equity markets were relatively modest in context of historical market declines. Bear markets (defined as a decline of 20% or greater) are generally tied to a recession, and, at this point, there are no signs of a recession with GDP growth remaining quite strong. There remains, of course, the potential for a ‘crisis’ event to change that. A rapidly escalating trade war is one such possible crisis, however, as we close this report, that story appears to still be in its early chapters.
Logan Wealth Management Inc.
April 6, 2018