Valuentum Exclusive Analysis for the Discerning Investor

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Tune in to President of Investment Research Brian Nelson’s Exclusive Yearly Roundup Call.

Ladies and gentlemen,

Thank you for joining us on our second annual Nelson Exclusive roundup call. I appreciate your interest very much, and I appreciate your attention even more. Just an important reminder, Valuentum is an information provider, not a broker or financial advisor, and we do not issue recommendations of any kind. With that said, let’s get started.

These are the best of times.

We have now surpassed the 9-year mark since the March 2009 panic bottom that sent shudders through the global financial system, and the US economy is as strong as it has ever been. US gross domestic product is now approaching $20 trillion on a seasonally adjusted annual rate, eclipsing the prior peak of $15 trillion before the Financial Crisis of late last decade -- by roughly a third. The US has been in an economic expansion since 2010, and all signs appear that the expansion will continue for the foreseeable future.

The unemployment rate in the US of 3.8% hasn’t been this low since 1969, in almost a half a century. Meanwhile upward pressures on wages are only intensifying, and the health of the consumer looks about as strong as it has ever been. The promises in the areas of autonomous vehicles, mobile devices that make our lives easier, and in medicine with CAR-T therapy are groundbreaking, and there likely has been no better time to be alive in America than in 2018.

President Donald Trump’s landmark legislation, the Tax Cuts and Jobs Act of 2017, has resulted in a pace of earnings growth that nobody could have ever predicted just a few years ago. FactSet (FDS) estimates that earnings growth for S&P 500 companies (SPY) is estimated at a whopping 20% during the second quarter of 2018, this being the second-highest earnings growth rate since the third quarter of 2010, when the country was bouncing back from the Great Recession. Growth of this magnitude following a 9-year expansion is highly unusual, almost ultra-cyclical in nature.

Borrowing costs, while rising, are still near all-time lows. The 10-year Treasury (TLT, TBT), a benchmark rate used in stock valuation and in setting bond rates, is hovering under 3%, despite moving sharply higher since its near-term bottom in 2016. Though we are watching the 10-year Treasury rate very closely, given its implications on stock and bond prices, we must point out that the 10-year Treasury rate was once north of 15% in the early 1980s. Many of you may have had double-digit interest rates on your first mortgage, and everything from the housing markets (ITB) to ancillary businesses (XHB) continues to benefit from today’s ultra-low rates.

The world perhaps has never been safer. There appears to be steady progress with respect to peace on the Korean Peninsula, and President Donald Trump’s “madman theory,” a strategy popularized by Richard Nixon--one of being irrational and volatile--seems to have brought North Korea to the negotiations table regarding denuclearization. We won’t know if the progress is the equivalent of Neville Chamberlain in 1938, who had thought he secured “peace for our time” through appeasement of Germany before the worst of the Second World War, but President Donald Trump is a student of history and has shown to not give his opponents an inch, for they may take a mile.

We believe President Donald Trump is aware of the negative impact that tariffs can have with respect to global trade, and we’re viewing his stance against China (FXI, MCHI) as merely posturing, as a means to extract a better trade agreement with the country that has roughly 1.4 billion people, more than 4 times that of the US. China needs the US today for its technology and business intellectual property, and we wouldn’t expect either country to erect trade barriers to the point where global GDP is devastated. Over the long haul, however, the US may need China more than China needs the US. A market of people 4 times that of the US represents considerable opportunity for US businesses.

US corporations perhaps have never been better positioned for growth. The reduction in the corporate tax rate to 21% from 35% has been a boon to companies’ free cash flow generation, giving US firms additional capital by which to invest and hire new workers, helping to aid in the natural multiplier effect of economic activity. The tax cuts, enacted January 1, 2018, are evident. Take investment bank and February 2017 income idea, Moelis & Co (MC), for example. During its first quarter of 2018, provisions for income taxes fell to $2.6 million from $7 million, a 60%+ reduction, translating into considerable improvements in cash flow generation.

The current wonderful situation in America is probably best summed up by the burgeoning performance of Boeing (BA), a tried-and-true Dow Jones Industrial Average (DIA) component. The world’s appetite for new planes appears to be almost insatiable. Global air travel is a good coincident indicator of consumer and business health, and the order books at the airframe makers are overflowing, despite trade tariff tremors. Boeing’s backlog of unfulfilled deliveries stood at $486 billion, almost a half of trillion dollars, with over 5,800 plane orders on the books. Expected to deliver 810-815 planes in 2018, that means Boeing’s backlog amounts to roughly 7 years’ worth of visibility. This is incredible for what has historically been a cyclical industrial, and the executive team may very well be right: airplane making is a long-term growth story.

“FANG” stocks, an acronym standing for Facebook (FB), Amazon (AMZN), Netflix (NFLX) and Google (GOOG, GOOGL), continue to take the market by storm. We include Facebook and Alphabet, the parent company of Google, in the simulated Best Ideas Newsletter portfolio, and the performance of all four continue to be phenomenal during this multi-year bull market. We value Facebook’s equity at $250 per share on an advertising business-model-only basis, far above where shares are currently trading. Amazon is disrupting industries at will, the latest with respect to the grocery complex with Whole Foods and the pharmaceutical supply chain with PillPack. Netflix seems to have found an investor base that is undeterred in the face of significantly negative free cash flow and rising net debt, and at Alphabet, it’s business as usual with its dominance in search, as the company remains a daily part of consumer lives.

Prices at the pump aren’t giving travelers too much of a headache. Though crude oil prices (USO, OIL) have advanced at a double-digit clip thus far in 2018, they remain well off their previous highs set years ago. August West Texas Intermediate crude oil stands at ~$74, in-line with what we had been expecting at the start of 2017, offering breathing room for many independents (XLE) as well as the pipeline infrastructure (AMLP). There are myriad factors driving the price of crude oil, but geopolitical uncertainty seems to be fueling most of the recent gains. The White House continues to put pressure on Iran, for example, with oil buyers now encouraged to cut Iranian crude imports by November. Such uncertainty is adding to the geopolitical premium embedded in crude pricing, despite OPEC’s recent deal to raise production, albeit modestly.

The legal environment is fast-changing on the state level in the US, and two particular measures look to impact a few pockets of the economy. The legalization of sports betting will open the door for additional state tax revenue as vacationers now won’t have to travel to Las Vegas to bet legally on their favorite sports team or event. We think Churchill Downs (CHDN), which shares its name with the legendary race track in Louisville, will be a big winner of this development, as it seeks to offset a generally weakened backdrop of thoroughbred horse racing, despite another Triple Crown winner in 2018 in trainer Bob Baffert’s Justify. It was just in 2015, too, that American Pharaoh took the racing industry by storm with its own Triple Crown sweep, two now in the last four years.

Another Supreme Court ruling overturned a 26-year old precedent that said businesses that didn’t have a physical presence in a state need not collect sales taxes there. The development should help level the playing field for brick-and-mortar retailers (XRT), but we note some of the larger online powerhouses, including Amazon, have already been collecting sales taxes, meaning the impact itself may serve to merely enhance state tax coffers but truly do little to help some of the most troubled retailers. We believe department-store retail is in for a lot of pain during the next recession, and we doubt J.C. Penney (JCP) and Sears (SHLD) will make it to the other side of the next downturn with shareholder equity intact. Online purchasing is wreaking havoc on their business models, much to the benefit of the credit card networks such as Visa (V) and MasterCard (MA) and payment processors such as PayPal (PYPL) and Square (SQ).

These are the best of times, but there are risks, some we know, and some we simply cannot possibly know. Donald Rumsfeld may have said it best: “There are known knowns. These are things we know that we know. There are known unknowns. That is to say, there are things that we know we don’t know. But there are also unknown unknowns. There are things we don’t know we don’t know.” The prices of equities will always be a function of future expectations, and those expectations can take a turn for the worse rather quickly, especially as market participants remain guarded about the possibility of an impending bear market. The average bull market, according to research from First Trust, lasts 9 years with an average cumulative return of 474%. The current bull market is over 9 years in duration with gains north of 330%.

Nothing is ever average though--and using history as a means of precisely predicting the future is rather foolish, but such a view helps to provide some perspective. As companies anniversary the earnings growth expected in 2018 that has been driven in part by tax reform, a breakneck pace of earnings expansion in 2019 and 2020 may only grow more difficult to achieve, as the idea of companies investing for growth also indirectly implies increased competition and the threat of profit pressure. Deflationary trends in generic drug pricing, for example, have wreaked havoc across the healthcare complex (XLV), while gross margin pressures at tried-and-true consumer staples (XLP) entities such as Campbell Soup (CPB) have revealed heightened tension. Consumers have been absorbing price increases for years, and the weakness at Starbucks (SBUX), which is facing challenging same-store sales trends, may be telling of this theme. Consumer spending may be healthy, but has the incremental consumer reached a point where he or she is balking at paying up, trusting more in private-label and shunning the $5 venti white mocha from the corner Starbucks?

From where we stand, it appears to be growing more likely that consumers are becoming more discerning and cost-conscious about the prices they pay for things, particularly as a new generation of millennials (MILN) is ushered in, a generation that suffered financially through the Great Recession and its aftermath. Many that graduated shortly after the worst of the credit crunch may finally be getting their financial lives back on track. Over the years, they’ve been trained to be “money wise,” and consumer preferences are changing, too, perhaps best illustrated at Harley-Davidson (HOG). Hitting the open road on a Harley, for example, may no longer be considered cool by the coming generation, and many bikes are priced beyond what many of them can afford. President Donald Trump’s protectionist policies have only given the bike maker more headaches, too, as it seeks to move some production oversees to avoid retaliatory tariffs from the EU. Where business is booming at one American icon, Boeing, business is significantly challenged at another, Harley.

What a difference a few years can make for a company, too. General Electric (GE), once a staple of the Dow Jones Industrial Average, is no longer a part of the prestigious index, recently replaced by Walgreens Boots, which itself is now facing myriad challenges from Amazon’s entrance into the grocery and pharmacy arenas. Coming on the heels of the announcement that Walgreens would be added to the index, the timing of the news release of Amazon’s acquisition of PillPack proved to be quite interesting. Perhaps Amazon’s CEO Jeff Bezos thought his company should be the new Dow component instead. Regardless, it was clear by the share-price reactions of Walgreens, CVS Health (CVS) and Rite Aid (RAD) on the news of Amazon’s purchase of PillPack that the online retailer is one powerful influence on the economy--often good for consumers, often bad for the profits of other companies.

As the economic recovery and bull market ages, valuations remain at generally lofty levels, in our view, especially in the context of a rising interest-rate environment. The forward 12-month P/E ratio on S&P 500 companies stands at 16.1 times, which is about in-line with its five-year average, but still above its 10-year average of 14.4. We don’t view the market as significantly overpriced, per se, but we think there are risks to the downside as, to put it quite simply, the economy and market have both been “juiced” by ultra-low interest rates and rising government and corporate debt, which stand at $21.1 trillion and $6.3 trillion, respectively. The change in the tax code has made the cyclically-adjusted price-to-earnings ratio, or the CAPE ratio, a less meaningful statistic, but the idea of a potential reversion in the tax code during the next recession to prop up federal tax stuffs cannot be ruled out.

Corporate tax reform has helped employees with one-time bonuses at a number of companies, but it seems most of the incremental benefits to free cash flow from tax reform may go to buybacks, some at relatively elevated price levels and 9+ years into an economic recovery and bull market. Estimates are calling for $650-$800 billion in stock buybacks this year, money that if not executed at a value-creating price could do nothing more but destroy value for shareholders and wealth of Americans. Said plainly, money that could have gone to government tax receipts to potentially aid in balancing budgets and curtailing the growing US national debt load is now being pumped into the market at what could very well turn out to be peak or near-peak levels of this bull-market run. If the US economy should weaken and earnings and valuations are reset lower, we could see significant wealth destruction from buybacks that have only increased the burden of debt owed by the United States. Today, each of the roughly 326 million people in the US individually owes about ~$65,000 in national debt. The situation has gotten out of control, it appears the current administration may have made matters worse.

My long-held view is that the global economy, including that of the US is cyclical, and it is not a matter of if we have another recession, but rather when and how severe it will be. The reduced corporate tax rate coupled with the new capital-expensing provision may result in substantial budget deficits during the next downturn, prompting a potential reversal of this administration’s corporate tax policy, which may then only exacerbate the conditions of what would have been a “normal” recession. The ultra-cyclical nature of positive earnings growth at this point in the economic cycle may also result in ultra-cyclical weakness during the depths of any coming recession, the timing of which is the only uncertainty. Could the next recession faced in America be the culmination of what government efforts have only delayed with the expansionary policies to bounce back from bubble after bubble in prior years, the last two the dot-com and housing crash? Possibly.

We have reason to be optimistic, however. The stress tests of the US banks (XLF) continue to show resiliency, and while buybacks in general pose a risk in potential wealth destruction, that banks are returning capital to shareholders is a positive foundational element to a sound global financial system, which runs primarily on confidence. The threat of a combination of Deutsche Bank’s (DB) troubles and Italy’s (EWI) sovereign credit risk may be largely contained, too, and the worries over Brexit (EWU) seem to have faded with time. It has become more and more difficult to outline a scenario that may cause the next recession, but that doesn’t mean that one is not on the horizon. It is our contention that even posturing by the US and China with respect to trade--should it cause a pause in spending and hiring by US companies--may do damage to economic growth.

The pace of news regarding cryptocurrencies has slowed in recent months, particularly as the price of the most widely-watched cryptocurrency Bitcoin (BTC, GBTC) has fallen from over $19,000 around the holiday season late in 2017 to roughly $6,000 today, a decline that is nothing short of precipitous, yet the price remains well above the sub-$1,000 levels at the start of 2017, just 18 months ago. We view Bitcoin as a good example of the “greater fool” theory at its finest, and as with any currency, the value is only relative to that of another currency and based on widespread confidence that it will hold its value, not necessarily a function of future free cash flows or dividends to shareholders. We think the dramatic fall in Bitcoin illustrates not only the speculative temperament of the marketplace to absorb cryptocurrency assets, but also the tremendous value in basing investment decisions on fundamental-based principles that lead to the derivation of cash-flow-based intrinsic values in order to avoid price bubbles.  

More recently, I have been more outspoken on the risks of widespread index investing and the shortcomings of quantitative research processes that may not be soundly measuring the business values of companies. I believe the proliferation of indexing and quantitative algorithmic trading systems may pose structural risks to the market, which itself is a leading indicator to economic activity and a source of wealth for many Americans. Earlier in the year, the breakdown of a volatility ETF (XIV) caused a substantial dislocation in the market, and we think this newfound volatility may be illustrative of changing market conditions, where buyers and sellers are relying less and less on fundamental-based intrinsic value analysis and more and more on portfolio management theory, which could have shortcomings, if based solely on quantitative backward-looking analysis. Where a rising 10-year Treasury rate or a reversion in the corporate tax code may be fundamental issues that may cause declining stock values, a structural dislocation of the marketplace is something different in its entirety, likely reducing investor confidence in the markets themselves.

Many of you are following our income ideas very closely, and I think it makes sense to address a broader theme regarding the inverse nature of interest rates and high-yielding equities. Though future operating performance is critical to the valuation of any equity, so is the rate at which future free cash flows are discounted. As key benchmark rates such as the 10-year Treasury increase, the value of equities, in general, falls, all else equal. Income-oriented ideas face this broader headwind, but also another unique risk. In the event fixed-income instruments begin to approach yields that make them more attractive on a risk-adjusted basis than income-oriented equity considerations, assets could shift away from equity income into fixed income, pressuring equity prices on higher-yielding income entities even more. We maintain our view that a holistic view of a company’s fundamentals in the derivation of an intrinsic value estimate remains core to any investment process.

With these risks plainly said, I believe the stock markets can be a fantastic way to generate wealth over the long haul, and I believe the Nelson Exclusive publication is an excellent source of information to consider new ideas in thesis form, and to revisit our work over time should prices of prior-highlighted ideas warrant further interest. The value of such a publication shows itself over time, and thus far, the quality of ideas has been absolutely phenomenal, far better than I could have ever imagined when I wrote the introductory letter July 2016. We continue to monitor ideas, and we expect to post a more comprehensive update soon, but our preliminary tally is that through June 1, as many as 80% of capital appreciation ideas have advanced, including dividends received, from highlight price to current or ‘closed’ price, and approximately 70% of short idea considerations have fallen from highlight price to current or ‘closed’ price, considering dividend headwinds. Income ideas have also performed wonderfully. Adjusting for currency, not one income idea has cut its dividend, and many have increased them meaningfully.

I could not be more pleased with the quality of the content of the Nelson Exclusive publication, and I hope that you continue to enjoy it. Thank you.

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Brian Nelson does not own shares in any of the securities mentioned above. Some of the companies written about in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.