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Looking Back, Looking Forward – 2021Q2

Corporate America is chugging along and reporting strong earnings. For the SP500 index, 87% of its members have reported actual 21Q1 EPS above estimates, well above the five-year average of 74%. In aggregate, SP500 companies’ 21Q1 earnings grew 52% y-o-y, while revenues grew 13.5%. The latest IBES estimates call for SP500 EPS growth of 36.9% in 2021 (at $190.92), and 11.6% in 2022 (at $213.36) respectively. It is worth noting the forecast 2021 EPS for SP500 would be 17% higher than actual 2019 EPS. Entering 2021, the consensus estimates only called for 2021 EPS to be ~5% higher than 2019. Not surprisingly, with corporate America firing on all cylinders, the US economy is now expected to grow faster, and the US Fed in June upgraded its 2021 US GDP growth outlook to 7%, from the 6.5% growth it provided in March, and the 4.2% expected at the end of 2020.

As 2021 proceeds, the discussion and chatter about high prices and labor shortages have become mainstream. We don’t think this confluence of high prices from materials to labor has happened over the past 2 decades. On the other hand, though consumer prices continued to exceed economists’ forecast, with core CPI (excluding volatile food and energy costs) rising 0.7% in May, and 0.8% in April’s m-o-m, the 10-year U.S. Treasury note ended Q2 at ~1.44%, down from 1.749% at the end of March. The 5-year breakeven inflation rate, which implies what the market thinks the inflation rate will be on average over the next five years, remained at ~2.5%, its highest level since July 2008, though down from ~2.7% in mid-May. Some attributed the 10 Year yield’s fall to investors buying into the “transitory inflation” theory. We believe, however, the decline in long term yield in Q2 was probably more driven by other factors, such as treasuries were oversold in Q1, the US Dollar depreciated too quickly in April and May (DXY declined nearly 3%), and demand from pensions and other central banks was high. We are of the belief that a part of current inflation is definitely transitory, evidenced by the recent slump in lumber prices and retreating copper and steel prices. There is speculation, hoarding, supply/demand imbalance, and some of the price increases will alleviate and reset in the months ahead. However, we suspect some of the latest inflation may very well spill over to the future years, allowing inflation to hover around at higher levels in a sustainable way. As stated before, we believe slightly higher inflation is a good thing, as long as the US economy’s real growth rate can also sustain at a slightly higher level, ie. around 3%.

Some also argue the recent retreat of the 10 Yr yield is due to waning confidence about the mid- long term economic growth in the US, as progress on the infrastructure bill has been slow. We do not believe the GOP would give the White House an easy time to pass a “bipartisan” infrastructure bill, only to pass a large spending bill later through a partisan reconciliation process with all sorts of tax hikes. The democrats, however, likely will not allow any bipartisan infrastructure bill to pass without also passing a spending bill. This infrastructure/spending bill however will be President Biden’s legacy and we suspect he will ensure some version of it will come to fruition. We believe chances are high some kind of spending/infrastructure bill will pass and taxes will be raised, whether the GOP is on board or not. Moderate democrats seem to be ok accepting a 25% corporate tax instead of the proposed 28%, (vs. current 21%); a ~30% capital gain tax for people earning more than $1 million a year, instead of the initially proposed 39.6% (vs. current 20%), and raising top individual income tax rate to 39.6% from the current 37%. Given any spending bill passed through reconciliation will have to be revenue neutral, lower tax hikes should only accommodate a smaller spending increase. Mathematically higher corporate taxes will increase the cost hurdle of starting and operating businesses while raising personal income taxes and capital gain taxes will reduce companies’ ability to raise funds for new investments due to higher required rates of return by investors. While smaller tax hikes are certainly more favorable to bigger tax increases, we are skeptical those proposed tax increases, albeit more moderate, will be conducive to higher economic growth for the long term, especially if they are used to fund non-productivity related spending increases. (The latest on this topic is the Democrats would push for a $3.5 trillion spending bill through reconciliation while passing a bipartisan $1 trillion infrastructure bill. Those are big numbers and require more than moderate tax hikes to pay for. We will all have to stay tuned and see how the legislation process plays out.)

While short term investment themes and trends can be overpowering, Valuation and Wealth Creation is Timeless™. We continue to believe for investors with long term horizon, investing in companies with attractive valuation, credible management team, strong wealth creation track record and strategy is key to outperformance. Even in the past 6-7 short months, we have witnessed the quick boom and bust of multiple themes such as lumber, SPACs, crypto currency, and the ebb and flow of semiconductor stocks’ fortune, to name a few. Wealth accumulation however is a marathon not a sprint, and requires investments that can ride through short term volatility to stand strong when the dust settles. Though we need to be cognizant of short-term fads and the reasons behind performance at a given time horizon, that reasoning is largely irrelevant to our resolve to hold our existing investments. With retail investors/traders becoming a growing makeup of the investor base, small bubbles could form and burst more frequently due to a shortening of investment time horizons. Some of our investment holdings might fit or fall out of favor of some of the short-term bubbles or fads, affecting our short term performance, but we are investing for the long haul, as long as the investments remain attractively priced based on long term fundamentals. Separately, we stress the importance of approaching equity investing from a portfolio’s perspective. The Valuation50’s sector neutral discipline and our emphasis on diversification within a sector allows the strategy to have broad exposures to a wide spectrum of the economy, which tends to perform consistently through cycles, despite particularly strong impact some factors might have on certain industries at a given time, be that interest rate, inflation, or regulation. We will continue to focus on companies’ fundamentals and their valuation attractiveness.

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Author

  • Jun Wang, CFA – Applied Finance Partner Joined Applied Finance, 2003. Portfolio Manager and Fundamental Research Analyst. B.A. Southwest University China, MBA from California State University, Fresno.

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