2019 was a triumphant year for the US large cap equity market, with the S&P500 index up 31% on a total return basis. The resolution of two major concerns in the year, namely the US Fed being too aggressive on rate hikes, and the US/China trade relationship hanging in a total impasse, drove the market higher, particularly in 1st and 4th quarter (up 13.65% and 9.07% respectively). Fed Chairman Powell in early January indicated inflation was muted and the central bank would be in no hurry to raise rates. In late March, the Fed formally trimmed the number of rate increase expectations in 2019 from two to zero. Then during the rest of 2019, the Fed actually cut its fund rates three times to a targeted range of 1.50-1.75%, citing uncertainty surrounding trade. In July, the Fed also stopped shrinking its $4 trillion asset portfolio. The trade war created some market volatility, as US/China trade talks took many dramatic turns rather than following a linear path. The two sides were supposedly ready to sign a comprehensive deal in early May before President Trump suddenly tweeted on a Sunday that he would raise tariffs on $200 billion of Chinese imports from 10% to 25%, blaming China for trying to renegotiate the trade deal. On August 1, Trump announced new tariffs on $300 billion of additional Chinese imports. In the following days, the Chinese yuan slipped to below 7 Yuan per USD, a symbolic threshold and its weakest point since 2008. In early October, however, Trump announced the US and China have reached agreement on a phase one deal. In mid December, the US formally canceled tariffs that were supposed to go into effect before year end, and agreed to roll back existing tariffs in phases. In exchange, China promised to ramp up its purchases of U.S. farm products to $40-$50 billion per year. The two sides will formally sign the phase one deal later this month.
In 2019, the Valuation 50 strategy has outperformed the S&P500 index by 293 bps, with 8 of the 11 sectors outperforming their respective sector benchmarks. Strong outperformance was achieved in Consumer Discretionary, Healthcare and Financials. In Healthcare, two holdings received take out offers – Celgene (CELG) and Allergan (AGN), while Danaher (DHR) benefited from its planned acquisition of the GE’s biopharmaceutical business in a $21.4 billion deal. Thermo Fisher Scientific (TMO) also posted strong performance, as the company continued to deliver better than expected top line growth and profits. TMO’s business of providing equipment and technology to help with life science research escaped the debate of medical cost in Washington, which created big headwinds for certain healthcare industries. In Discretionary, the outperformance is broad based though Target (TGT) is the indisputable winner delivering more than 110% in total returns. Despite its sometimes volatile price moves, Target’s operational results in the past 3 years since its turnaround plan took shape have been consistent. In 2019, Target solidified investors’ support that its turnaround is durable and its business model will thrive for the long run. Entering 2020, we very much appreciate Target CEO saying in one of the latest interviews that, “If there’s anything I worry about, it’s becoming complacent, feeling as if we have arrived and we are winning. Retail will always be a very, very competitive marketplace.” With the right strategy, right asset mix and a capable management team wary of complacency, we are confident Target’s best days are still ahead. In Financials, Ameriprise (AMP), Bank of America (BAC), and JP Morgan (JPM) were among the biggest winners as the robust US equity market returns boost those companies’ wealth advisory and asset management business. Further, BAC and JPM’s core banking business benefited from a healthy US economy, which continues to provide growth for lending while yielding low credit losses.
In 2019, most of the big 2018 “losers” in the Valuation 50 turned around, including Celgene (CELG), Nvidia (NVDA), Facebook (FB), LKQ Corp (LKQ), Tyson (TSN), Quanta Services (PWR), Ameriprise (AMP), Aptiv (APTV), and Cummins (CMI). Host Hotel & Resorts (HST) continued to underperform its REITs sector peers in the most part of the year as investors continued to fear a late hotel cycle and instead favor other REITs property types which specialize in datacenters, industry logistics, and residentials. HST is the only investment grade lodging REIT and one of the few undervalued names in the REITs sector in the SP500 when assessed from Applied Finance intrinsic value perspective.
In 2019, the Valuation 50 acquired some new problem children, as there are always new stocks that emerge with operational challenges in a given year. In 2019, Walgreens (WBA), Pfizer (PFE), HP Inc (HPQ), and Unum (UNM) significantly lagged the market and their respective sectors. Interestingly, Walgreens is rumored to be the subject of take out interest from private equity firm KKR. For HPQ, Xerox (XRX) in November offered to buy it for $34 billion or about $23 per share, involving $17 in cash and 0.137 Xerox share for each HP share. Considering the size of the deals and the capacity of the buyers, we believe both transactions will be hard to pull off. That said, the buyout interests in both WBA and HPQ are indications that recent underperformance of the two stocks is likely an overreaction to their latest operational struggles and significant value can be unlocked for patient investors. For Pfizer, its share prices collapsed in late July when the company announced a plan to spin off its generic drug unit, Upjohn, which experienced significant growth challenges in China, and merge it with the beleaguered generic drug maker Mylan (MYL), to create a company called Viatris. Pfizer management continued to tout its laser like focus on its core biopharma business, and its forecast of organic compounded annual revenue growth target of 6% over the next five years for the business. As for Unum, investors remain wary of its long term care (LTC) business which was put in the closed block a long time ago. With a market cap of $6 billion, a 50% discount to its net intangible book equity value, Unum suffers from an extremely pessimistic view of the value of its LTC business, which is subject to enormous margins of judgement error. Should long term interest rates rise in 2020, Unum stock likely will benefit. Separately, we suspect some event will happen to help crystalize a more reasonable valuation for Unum’s LTC business, which could be reinsurance, a sale, or some other third party solution. Regardless, Unum has a strong core business and we continue to believe its shares are undervalued based on its current corporate structure.
Looking back at the past 10 years, 2010-2019 has turned out to be extraordinary for the US large cap equity market, which likely shocked most market participants and pundits when we entered the decade dealing with the enormous aftermath of the financial crisis. Where do we go from here? As Yogi Berra famously quipped – “Its difficult to make predictions, especially about the future”. Indeed. The past decade followed the disastrous decade of 2000 – 2009, which was marked by the tech bubble at the beginning and the great recession and market crash in the end. Therefore, “of course since the mean always reverts”, the ensuring decade likely won’t be kind, some argue.
It is important to remember that markets attempt to see through temporarily good or bad times to estimate future cash flows and set current valuations. With this in mind we believe the US markets continue to be attractive despite what has been an exceptional equity market for the past 10 years. If any firm understands the concept of “mean reversion”, its Applied Finance, as we pioneered applying the mean reversion concepts of zero economic profits to value companies. We are also keenly aware that mean reversion concepts require a stable underlying structure. We are confident competition will drive future excess returns towards zero for the vast majority of firms. However, we are not so certain that US equity valuations are scary. We reach these conclusions from two perspectives. First, we do not believe the US economy is poised to enter a recession anytime soon. Second, despite an incredible 10-year run, we do not believe US large cap equities are over-valued.
First the US Economy. The odds are ~25% for a 2020 US recession and ~60% for a 2021 US recession, according to economists surveys floating around. We find the odds high, however. From a much more favorable regulatory environment compared to 3 years ago, to new incentives to reinvest domestically versus abroad, as a result of the US corporate tax reform, we continue to see strong lasting tail winds to propel the US economy forward into the intermediate future. The US continues to be the most attractive neighborhood to invest in globally, a trend likely to accelerate. Putting aside any discussions of its merit, current US policy is pushing De-Globalization. As a result of this, if US markets become more difficult for other countries to access, there are no immediately viable alternatives to make up those lost sales, making companies based in those countries less attractive investments. Recent case in point is the US-China-Germany triangle. As the US reduced purchases from China and the Chinese economy slowed, the Germany economy nearly fell into a recession as Chinese purchases of German goods declined. China contrary to common beliefs, runs trade deficits with many countries, with Germany being the largest. Should the US continue to diversify its China supply chain throughout Asia, and negotiate bi-lateral trade deals as has been its norm under Trump, China and the EU will face a difficult economic decade ahead. We believe the global economic structure is changing away from default globalization which has favored China and the EU in the past decades. The underlying economic structure is moving towards a more US centric model of bilateral trade agreements, which at the margin will shift economic activity out of China and the EU markets towards the US, further boosting domestic economic tailwinds. US dynamism is unrivaled globally when left to thrive, from technology to pharmaceutical, to banking, to energy. We do not see any structural changes to threaten this dynamism anytime soon resulting in an alternative region being attractive enough to reduce US attractiveness from an investment perspective.
Secondly, the US large cap equity market is priced for success. The SP500 nearly tripled in the past decade, far outpacing the rest of the world. This market, however, is not poised for a crash, as some fear, who conveniently compare it to the tech and housing bubble. While torpedoes could always be lurking somewhere, we don’t see similar circumstances resulting in a market crash in the foreseeable future. During the peak of the tech bubble, the P/E ratio was ~35 times for the SP500, and ~175 times for the Nasdaq. Before the Great Recession, the subprime mortgage loans generated in 2004-2006 accounted for nearly 20% of the overall residential loan market, vs. a historical 8% norm. A high percentage of these subprime mortgages, over 90% in 2006 for example, were adjustable rate mortgages. Housing speculation also increased, with the share of mortgage originations to investors rising significantly to around 35% in 2006–2007. The ratio of household debt to disposable income was around 130% by the end of 2007, up from 90% in 2004.
Today, the SP500 commands a P/E of ~18 times based on consensus 2020 SP500 EPS forecast of $178, lofty by historic standards, but not crazy and consistent with a low interest rate environment. When we look at the Equity Risk Premium (ERP), it is currently at 5.75% for non-financial US firms in nominal terms, significantly higher than the historical 5-year median of 4.46% and 10-year median of 4.75%. The current market valuation might be a bit full but we don’t believe it is close to a bubbly level knee jerk emotions aside.
Applied Finance Research – Nominal Industrial ERP at Yr end, 12/31/19
Looking at the US economy, the consensus is there is not any exuberant sector in the US economy, though some worry the credit worthiness of corporate debt is overstated and US companies are over-leveraged. The US non-financial corporate debt of ~$10 trillion currently counts for nearly 46% of US GDP, a multi-decade high. When we examine the debt servicing capacity, however, the numbers are not nearly as bad. Non-financial net debt / EBITDA is just around 1.7 times for the SP500 companies in aggregate and 3 times for SP600 companies, according to S&P Global. The US financial companies are also well capitalized and the top 18 banks continue to undergo and pass the stringent annual Fed stress test. This is not to understate the importance of credit analysis when it comes to individual equity investment, but we doubt US corporate debt as a whole presents a severe systematic risk to the overall economy like subprime mortgage debt did 15 years ago.
To summarize, while we hesitate to make predictions about the future, we are rather confident current economic conditions and market valuations are unlikely to trigger a market crash anytime soon, and bear little resemblance to 1999 or 2007.
In 2020, we believe there are at least three tailwinds for the economy – reduced uncertainty on the trade front with China, the implementation of USMCA, and Brexit. The trade war probably reduced the US GDP growth by 10-20 bps in 2019 and the phase one deal could help provide a modest boost to the economy on the margin. More importantly, as China benefits from the partial truce, Germany and the EuroZone could get a boost of their exports. As the US and EU economies pick up more steam, the overall developing regions would benefit as most have cited trade concerns as the driver behind their latest GDP growth deceleration. Secondly, USMCA, which is a larger deal than the phase one agreement with China, encompasses more than $1.3 trillion of trade as the U.S. conducts nearly $700 billion of goods and services trade with both Mexico and Canada. Lastly, part of the Brexit uncertainty is gone now that the UK will leave the EU on January 31 of 2020 and leave the transition period at the end of 2020.
A more critical event in 2020, however, is the US election, whose outcome will set the tone for the new decade. The US ended the past decade with one of the lowest corporate tax rates in the world, and an unfinished ambition to rebalance the trade order around the world. On the international front, the relationship with the middle east and North Korea are waiting to be rewritten. Regarding election, we believe that “it is the economy stupid” still holds true in today’s world. The US economy is quite good and the stock market has been very strong. Importantly, people who may not have benefited much from the strong stock market are now registering strong wage increases. The latest data shows wages for rank-and-file workers are rising at nearly 4% y-o-y, the quickest pace in more than a decade, and faster than people in managerial positions. We believe the economic expansion is having an undeniable positive impact on a broad spectrum of workers’ lives, which will be hard for the opposition party to discredit.
For all of us who are alive and breathing, a decade will be a long time, though the 2008-2009 financial crisis felt like just yesterday. One lesson we have learned is, the US will always be ok, and it will become a better place with time. With that core belief, we will always invest in America, and invest in good American companies, when the price is right. There will always be political turmoil, technological and social changes that impact people’s lives, good and bad, but the country will pull through, adapt, and become better. That is why investors buy the US, because this country is the safe haven, and we should never squander that privilege. Recession is nothing to fear about, what is scary is if we abandon what made the US the shining city upon a hill.
We are excited about the new decade!