Rising Valuation Multiples
The US stock market had an especially strong year, with the broad indices up roughly 30% on a total return basis. As discussed in previous commentaries, the rise in the market was more due to multiple expansion and less due to earnings growth. In fact, the S&P 500 started the year with a trailing twelvemonth price/earnings multiple of 16.5x and it rose to 21.6x by year-end. This 30% multiple expansion mirrors the 30% market appreciation almost exactly. In other words, there was a dramatic increase in what investors were willing to pay for earnings.
The banner year in stocks for 2019 stands in stark contrast to the 20% ‘peak to trough’ selloff that equities experienced between September and December 2018, a period marked by interest rate hikes by the US Federal Reserve (“Fed”) combined with trade unrest with China. This period coincided with a multiple contraction (see Figure 1). Fears of an international economic slowdown drove the dramatic reversal in course by the Fed from raising rates in 2018 to cutting the benchmark rate three times in 2019 to 1.75%, and as a result, accounts for the lion’s share of the increase in stock valuations.
The pattern of rate hikes/cuts and multiple contraction/ expansion since the start of 2018 is highly correlated. It’s also indicative of a market, that while not cheap, is not particularly expensive in relation to where it has traded in the past relative to the Fed Funds rate.
We’ve alluded to the 3 components of total return:
- Dividends: typically +1.5-2.0%.
- Earnings per Share Growth (EPS): typically +6- 8%.
- Valuation: what investors are willing to pay for #’s 1 and 2 which varies in any given year. In 2019 it was up about 30% and in years where rates rise, earnings growth slows or we have a recession, it actually contracts.
Our assumptions for total return in 2020 are far more modest than those achieved in 2019. We do not believe valuations can expand much further against the backdrop of continued modest economic growth, a neutral Fed stance on interest rates and an uncertain Presidential election. This implies that the burden of total return for 2020 falls squarely on dividends combined with corporate earnings growth.
Tariffs and Trade
Besides the Fed’s rate cuts, the other macro news dominating 2019 was the trade war. The current trade war between the US and China started in 2018, ostensibly due to national security concerns, and originally focused on steel and aluminum imports. Tariffs specifically targeting China started in July 2018 and now include about $500B of products traded between the two countries. The uncertainty has caused disruption in the economy and the stock market.
Some of the tension was eased in mid-December when a Phase One Deal was reached. The US reduced tariffs and China promised to increase the purchase of agricultural goods and change its intellectual property, technology transfer and currency policies. The deal did not address thornier issues such as China’s industrial subsidization of state-owned companies via low-cost loans, cheap electricity, etc. and there are still questions as to China’s commitment to deliver the above promises.
The trade war will continue well into 2020, so from an investment prospective, how are companies reacting? The most important point is that companies are not sitting by idly waiting for the US and Chinese governments to settle their differences. Companies are proactively taking steps to mitigate the effects of the tariffs.
For example, tariffs have resulted in increased product costs for O’Reilly Automotive. O’Reilly hasn’t adjusted its business model or sought alternative product sources—it has simply passed through the increases via higher prices to the consumer. The company can accomplish this because of the non-discretionary and immediate need for many automotive parts. O’Reilly also has such a strong market position that competitors are not able to underprice its products.
Nike has less ability to simply pass along the impact of tariffs, so the company relies on continued improvements in the efficiency of its supply chain. Examples of improvements include: expanding distribution centers and increasing the usage of radio-frequency identification (RFID), which enables more precise tracking of inventory. These benefits will continue even if the tariffs are scaled back.
Like Nike, Alphabet’s Inc.’s Google cannot pass along tariff costs. The company has looked to simply avoid the tariffs by shifting production out of China. Examples include server hardware and Nest thermostats. Due to the important role server motherboards play in Google building its own data centers, which power its search, mapping and cloud service platform, the company moved motherboard production to Taiwan.
These three examples illustrate the different steps that can be taken: pass along the higher costs, improve your efficiency to mitigate the costs or simply avoid the costs all together. Not all companies can take advantage of these options. This differentiation highlights the value of our active equity management approach which identifies and invests in individual businesses with unique strengths.
When buying a stock, we are buying a small piece of ownership in a company. In turn, the company is run by individuals looking to maximize its value. This means the company adapts to changing market conditions, whether it be a recession, lower interest rates or a trade war. We are not buying commodities that passively react to changes in supply and demand. We also do not make macro bets that only perform well if the economy is going one way or the other. In this manner, we have always considered ourselves ‘bottoms- up’ investors who focus first on the analysis of individually great businesses and de-emphasize the significance of macroeconomic and market cycles. In fact, when researching a company, we carefully review its ability to make money through a market cycle, not just during the boom times. The above examples demonstrate how companies can continue to grow earnings, and thus increase value, even during difficult times.
SECURE Act: No More Stretching Inherited IRAs
Congress passed the Setting Every Community Up For Retirement Enhancement Act of 2019 (the SECURE Act) and the president just signed it into law during the last week of 2019. This law which went into effect January 1st provides modest incentives for retirement saving but limits the attractiveness of IRAs by limiting the life of Inherited IRAs to 10 years.
Positive impacts of the new law include:
- Allowing workers over age 70 to continue to contribute to IRAs and 401K Plans
- Delaying the age at which IRA account holders must begin withdrawing funds from their accounts until 72 from the current 70 ½
- Encouraging more cost-efficient retirement plans by allowing small businesses to form combined plans across multiple business entities which should lower the administrative costs of providing retirement plans
The downside of the legislation is that it requires all beneficiaries that inherit IRAs, excluding spouses, to withdraw the balance of the account within 10 years. This provision makes IRAs—both Traditional and Roth—less attractive since children and other younger beneficiaries are not able to stretch their required minimum distributions (“RMDs”) over their own lifetimes. For Traditional IRAs, this provision could cause much higher distributions and push beneficiaries into higher tax brackets. The law requires rethinking estate plans which relied on these “stretch IRAs” to pass assets to succeeding generations. As expected, the law will increase taxes collected on IRAs since assets will be sheltered from taxation for a far shorter period than under the earlier framework.
Given these changes, it may be necessary to update your planning around withdrawing RMDs if you are under 70 years of age. It also may make sense to revisit your beneficiary designations so that your whole estate plan works well together. We would be happy to help problem solve in the coming year if these changes impact you in any way.
The Field Narrows: Schwab buys TD Ameritrade
Charles Schwab eliminated commissions for most trades in the beginning of October. This dramatic move has already rocked the brokerage industry and forced consolidation as TD Ameritrade agreed to merge its business into Schwab. TD Ameritrade realized that its prospects in a commission-free world were far less attractive than joining with its largest competitor.
Clients at TD Ameritrade will transition to Schwab’s brokerage platform sometime next year. This transition will permit marginally lower trading fees and allow its clients to access Schwab’s technology.
Here’s a comparison of fees between Schwab and TD Ameritrade:
From our perspective on the Institutional side of the business, Schwab’s service is more consistent than TD Ameritrade’s. Schwab’s existing customers will experience business as usual without any disruptions. The combined company plans to move its headquarters and more of its employees from California to Texas to lower its tax bill and overhead. The physical move will be unlikely to impact the day to day services provided by the company since most of the service is delivered remotely.
Many view the brokerage industry as commoditized since there is not much differentiating the offerings of one broker from the next. All brokerage firms allow individuals, trusts and business entities to open accounts, buy and sell securities, and view pertinent information about their portfolios. However, the business models and the delivery of these services vary considerably.
Schwab’s business model has differed from its competitors for a while in that Schwab makes the bulk of its revenue on money held within its money market sweep vehicle offered to customers. Schwab pays a very low rate on its money market funds and/or bank deposits and then lends that money out to others to make a healthy spread on that money. On the other hand, Schwab’s competitors relied much more heavily on commissions from securities trading to generate revenue. Therefore, Schwab was able to hurt its competitors by eliminating trading fees.
Consolidation within the brokerage industry has been a positive trend as larger firms have been able to handle back office tasks more efficiently and reduce costs. There is still enough competition within the business since Fidelity, Vanguard and other large financial services firms such as JP Morgan and Black- Rock are all competing for their customers’ business. Eagle Ridge uses a number of custodians to hold our clients’ assets and will recommend changes as necessary so that our clients receive the best services available.
Eagle Ridge Client Portal
We are rolling out a website so that clients can access current information on their portfolios. Features of the site include:
- Updated Account Balances
- Performance Statistics
- Tax Information
- Secure Document Vault
Our goal is to provide a clean snapshot of relevant account information. The document vault will also allow us to exchange files in a secure manner without relying on clunky emails or password protected attachments.