Home > General > Second Quarter Review-Sent Oct 1, 2018

Second Quarter Review-Sent Oct 1, 2018

November 4th, 2018

The following is but a small portion of that sent to clients


What conducts of equity direction are observable, logical, and have shown to be determinants of valuation?

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We know though the reporting season has just begun (98 firms reporting) a greater number (76) have ratcheted down their expectations for the coming year.

We know sovereign and trade risks have increased worldwide, driven by the China-US dispute and stiff tariffs, as well as US-Iranian sanctions.

We know the upcoming election cycle given prevalence of political risks could well bring tangible change, some of which can be expected to impact firms cash flows, return on capital as well as other determinants of valuation. Sections of the recent Tax Reform Act could be in jeopardy, and consumer confidence could swoon if impeachment talk gains momentum or economic activity stalls as rates continue its rise.

It is with this backdrop we focus the bulk of this report on risk.

We outline herein why, therefore, account performance has been acceptable though trailing S&P 500, specifically why we believe the portfolio is “set up” to minimize risks of the back-end of the cycle while our firms cash flow generating assets should allow them to continue their histories of solid credit and additions to capital geared to prospective free cash flow, while giving space to flexibility many concerns would need to bypass. No firm wants a credit downgrade under a slowing economy.

Many of the outperforming stocks in the benchmarks this year have been older firms which have primed the earnings pump through reduced pension expense yet will now need to make large cash infusions to their assets, having been beneficiaries of such reduced funding the past three years, boosting reported cash from operations and engaging in large share repurchases. Pension debt and its annual cash outflow effects 326 firms in the S&P 500, or slightly over 65%, so this large liability is certainly nothing to sneer at.

We are sitting in the “catbird’s seat” with these holdings (see highlighted box), a time when equity prices in general could be challenged.

Add to that multi-employer debt (this liability is excluded from balance sheet listing) and overseas pension liabilities, State’s cumulative $1.6 trillion deficit, and the $74 per employee (increases are certainty with new indexing) charge to PBGC, and one can’t help but adjust potential cash flows and credit valuation multiples downward if markets stagnate.

Of general consequence as impacts the portfolio remains the full brunt of the Tax Reform Act, where our holdings will almost certainly see incrementally favorable benefits versus the ever-so popular FANG companies. That investors have in so many instances failed to properly examine and account for future (including compounding of) tax benefits is unremarkable given the proclivity for investors to react in arrears based on the news of the day.

The new GILTI ensures a residual U.S. tax of at least 10.5% when the foreign effective tax rate is less than 13.125% and with the uptake to 100% bonus depreciation and territorial approach the legislation favors the majority of the portfolio, especially with their 21% Fed rate versus the FANGS lowly four-year average cash rate of 12.7%.

Let us not fail to mention the FANG’s are mainly one product consumer tech firms; a major obstacle to our investment decision approval process.

The EC is resolute these mammoth tech-driven firms pay their fair share as opposed to a “negotiated rate.” Ireland and Luxenberg will not enjoy their current tax advantage indefinitely, as seen with Apple having to recently cough up $14.3B.

The GILTI, after exemptions and credits will hit fewer firms than originally thought, though the Treasury and IRS are still issuing clarifications. Undoubtedly, there be an offset to many firms’ previous cash flow expectations and rate of growth, especially with the final chapter not yet written.

Analysts refusing to accept the new tax realities under the guise of a bull market and economic expansion are being foolish.

Of significance, should the 10-year risk-free rate rise another 50 basis points or so we will likely see more leveraged entities having significant debt due within the upcoming three years or reliant levered customers/suppliers see their valuations react rather suddenly. Should such take place, we reason investors will look towards the more consistent firms with wide financial flexibility, including those such gems contained in our portfolio.


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