News & Events
Greetings from the Northwest.
The News: Lower inflation has reduced the Fed’s sense of urgency to prevent economic overheating.
The Result: The Fed may slow the rate increase pace… I think.
The news, and yes, the fake news, is flying through the airwaves at an amazing pace. As someone who attempts to keep track of the investment world, I would vote for a breather so we can look objectively at both the good and the bad economic news.
The current U.S. economic expansion has already had a long life. That doesn’t mean it will end now. Periods of growth don’t end just because of old age; they generally end when something goes wrong, such as unchecked inflation, or a bubble in housing prices, or a central bank pushes interest rates up too fast. Patrick is going to cover more of the economics of today in his comments.
In general, but not always, our investors’ portfolios performed quite well. Relative returns versus the market can be measured in many different ways; volatility, income flow, relative expensiveness, liquidity, and environmental and social objectives are just some variables. The 4th quarter of 2018 has been tough. But our portfolios are up to the task. Generally, we hold a group of companies that have lower price/earnings, lower price/sales, lower price/cash flows and higher dividends than the S&P 500. Patrick touched on this in our September letter. Please give your reports a good read, and then give us a call. Tim, Patrick, and I are available.
Optimism about the economy, and more specifically about equities, clearly faded during the 4th quarter as stocks experienced a U-turn from the exuberance that they had felt during most of the year. The S&P 500 Index closed down -13.52% for the quarter and -4.38% for the year, after posting impressive gains through the first nine months. International stocks fared slightly better during the quarter, only retreating -12.86% for developed stocks and -7.63% for emerging market stocks. High quality bonds and cash were safe havens during the quarter as investors flocked to safety during December. We have spent many quarters talking about the risks in equity markets and how we manage those risks through patience, not paying a premium for growth, and waiting for compelling value investments to come to us. As volatility increased during the quarter, we sent out an email in December describing our investment process. Our viewpoint and process have not changed over the last few weeks.
One of the primary areas of financial markets that we feel need to improve, in order for investors to feel comfortable taking increased risk again, are the credit markets (i.e., corporate bonds). During this current market cycle, many companies used the low interest rate environment to issue billions of dollars in debt (bonds) to fund share (stock) repurchases and dividends. In essence this was a large, debt for equity swap, and that changed the dynamics of how companies are now capitalized. This generally has no effect on the financial markets, as long as interest rates remain low and profitability for companies remains high so the debt can be serviced. Concerns over the level of corporate debt start to arise when the interest rate environment and maturity schedule start to change. The Federal Reserve has continued down the path of raising short-term rates, which sends a ripple effect through the rest of the bond market as rates across all risk spectrums adjust accordingly. When rising interest rates combine with slowing corporate profits, which we are witnessing due to higher wage and input costs, and large volumes of maturities need to be rolled over at higher rates, the bond market starts to become more volatile. The chart below shows the upcoming maturity schedule for U.S. corporate bonds (both investment-grade and high-yield).
As the chart illustrates, there are large amounts of corporate debt that will need to be refinanced in the coming years at potentially higher interest rates than when the original debt was issued. This should not have a heightened effect for companies that have low leverage and high profits, but will be much more worrisome for companies that already have bloated balance sheets and a lower ability to fund operations internally. When you have excessive valuations in broad U.S. stocks, combined with rising interest rates and economic growth that is showing signs of slowing down, markets can become skittish. Needless to say, highly indebted companies will have some big decisions to make as a large volume of maturities start to take place.
Another reason we bring up the corporate debt topic is that the amount of debt and financial leverage a company has is an important part of our analysis when considering an investment. It’s not just the amount of debt that is important; it’s the ability to service the debt with consistency of cash flows and profits while also having the ability to repay that debt without having to issue additional stock. The low interest rate environment of the previous ten years has truly created some interesting times for corporate America as senior management make decisions on how to navigate the next market cycle.
Please feel free to drop me a line if you have any follow-up questions or concerns as we navigate through this choppy market environment.
Thank you, Patrick.
The coffee pot is stocked with a new grind of Nossa Familia Coffee medium roast. Seven scoops in a #4 filter make a great 12-cup pot. We are always excited to have investors stop by for a visit at our world headquarters.
Jim Parr, Principal
Cairn Investment Group, Inc.
Greetings from the Northwest.
The unexpected has become the expected, the bizarre has become commonplace, and the unpredictable is where we are. As investors our goal is to purchase equity in companies or debt from a variety of sources at a value price. Later, our goal is to sell equities at a higher price and debt instruments at their maturity value. The single biggest question over the last quarter from our clients has been: “Can this economic expansion keep on going?” The most common concern is that no one wants a repeat of the past recession or corrections. Got it. No easy task. We have found that it is extremely difficult to “time” the market. So we don’t. What we can do is pay attention to valuations and the “expensiveness” of what we own. Expensiveness? Patrick will explain. We are reducing our exposure to market fluctuations by reducing the “expensiveness” of our investors’ portfolios.
The U.S. equity markets pushed aside many headline risks to finish up 7.71%, as measured by the S&P 500 Index. Its best quarterly return since 2013. The same could not be said for international equities, as concerns over global trade and growth caused broad-based international indices to return only 0.76%, lagging behind their U.S. counterparts by a wide margin. The large positive return for U.S. stocks over the quarter did nothing to improve valuations, which are near historical highs. We have talked about this numerous times over the last couple of years, so we want to touch on our process and how we are generating positive returns with much lower risk of permanent impairment of capital. Lastly, I will go over some updates that have taken place within the S&P 500 Index which could cause some changes in how investors view certain sectors going forward.
Through our quarterly letters and individual meetings we have discussed our process for uncovering successful investments, our current view of U.S. stocks, and how we are managing assets concurrent with that view. First, we are always on the lookout for industry leading companies that generate significant cash flows, with balance sheets that can provide financial flexibility. The final, and what we believe is the most important piece, is paying a price for a company that is significantly lower than what our analysis says the business is worth. We use a combination of cash flow analysis and the historical operating performance of the business to identify suitable investments, avoiding ones for which we would be paying too high a price, therefore limiting appreciation potential. The end result is that your portfolios are less “expensive” than the broader market, which should help us to weather bouts of higher volatility that will eventually take place. The chart below shows the aggregate of the companies we own and how their valuation metrics compare with the S&P 500 Index:
As you can see, by all metrics listed (Book Value, Cash Flow, Sales, and Earnings) your portfolios trade at a lower price than the broader market. We believe our focus on valuation, combined with the patience to wait for value, and a disciplined sell process, will provide satisfactory returns if the market continues to levitate higher, while being prepared for when the market decides it’s time for a reversal period. We don’t know when that will happen, but we want to be prepared for that inevitable event as we enter year 10 of this market rebound.
My second topic surrounds a new sector in the S&P 500 Index and the reclassification of companies into that new sector. On September 28, the Communication Services sector was created, replacing the Telecommunications sector. The chart opposite shows the changes that took effect and the companies that now make up this new sector. The main takeaway from this change is that the historically “boring” telecom companies such as AT&T and Verizon are going to be included in the same sector as Alphabet (Google), Facebook and Netflix. Needless to say, sector index investors might be in for a much different experience from what they historically had envisioned investing in some “old school” communication stocks. Though it’s not a primary point of emphasis in our company analysis, we do pay attention to index representation in the companies we own so we can try to gain an understanding of what might cause excessive volatility besides company specific events.
In closing, we continue to find good companies that the market has ignored; however, the number is not as plentiful as it was a few years ago. In light of higher than normal valuations in U.S. stocks, we are pleased that opportunities exist, but remain acutely aware that risks are higher than normal. Thank you for your continued trust and please drop me a line if you want to discuss any of these topics in greater detail.
Thanks, Patrick. Please take him up on his offer to talk about anything related to his analytical work.
Most readers will recognize that it just would not be a Cairn Newsletter if I didn’t say “Come on by, the coffee pot is always on.”
Jim Parr, Principal
Cairn Investment Group, Inc.
Greetings from the Northwest.
Summer sunshine is warming us up in the West. It feels so good! The last few days have been the hot type, where individual bones in your spine feel like they are melting out the last of the ice and chill of winter.
The stock market has also been hot for a while. But not all parts or sectors have been feeling the heat. Frustratingly, the hottest sectors and companies are also the most richly valued companies and hence not attractive to us as value or momentum investments. The purchase prices of our investments are of paramount importance to us. Time can heal a lot of investment wounds, but it is most difficult to recover from overpaying.
I hope the world is laughing with me when I ask, “Have you noticed the volcano of crazy, off-the-cuff, wacko ideas and plans that are being trotted out, run around the test globe and then re-evaluated?” Probably the biggest, loudest worries are coming from trade-war concerns. This has fired up volatility in currencies and stock markets around the planet. There is a lot of noise about potential longer term effects from tariffs and trade wars on U.S. companies and in particular industrial manufacturing. Please remember that manufacturing is only about 12% of GDP and we are in the 1st inning of a potentially long, hot, and politicized season.
Patrick and Tim are both itching to add to this quarter’s letter, so I shall go back to the dugout.
The proposed DOL Fiduciary Rule, scheduled for implementation last year, was delayed numerous times before being terminated through court action in June. The courts determined that the Department of Labor had overreached its authority and that the topics addressed are better dealt with by the SEC, which in most other ways is responsible for the regulation of investment advisors.
What was this “DOL Fiduciary Rule” and why is this topic important? The growth of the employer sponsored retirement plan, such as the 401(k), has been tremendous over the last 35 years, with combined assets now above $6 trillion. These employer sponsored plans are now the primary tool for retirement savings, with fewer than 2% of Americans being enrolled in a traditional pension plan. The financial security of our next generation of retirees depends heavily on the success of these newer plans. This explosive growth has attracted much attention from the financial industry, which provides the investment platforms for these plans and for the various “Individual Retirement Accounts” or IRAs. Holding these assets, managing them, and providing advice on them is good business, and a core profit center for almost any investment oriented financial institution (Fidelity, Vanguard, Cairn, etc.).
For decades the employer sponsored plans have been tightly regulated by ERISA (Employee Retirement Income Security Act). IRAs and the transfer of assets from employer plans into IRAs (rollovers) are not generally subject to ERISA. Some business models in the industry are intently focused upon this rollover process, and, like all great business opportunities, sometimes the interests of the consumer get overshadowed by the interests of the service and product providers, particularly without specifically designed legislation.
The DOL rule set out to fix this by making everyone involved in the process a“Fiduciary,” someone who must be true to the consumer and put the consumer’s interests first. This has caused major shifts in the industry, as firms were forced to evaluate their business models to determine how they were at risk of violating the new rule, how to eliminate conflicts of interest, and how to implement the prescribed procedures that came with this rule. An example of this is that Vanguard stepped away from advising clients on IRA assets. How could they maintain fiduciary standing when advising clients to purchase Vanguard funds? With the funds themselves being Vanguard’s primary business, they quickly and preemptively made the decision to stop advising.
For Cairn and other fee-only investment advisers, the DOL Fiduciary Rule had a much lower impact as we already were, are, and will continue, to act as a fiduciary. For us the change was the implementation of some required documentation that detailed why a rollover or IRA transfer was appropriate in each circumstance.
The DOL rule is dead, but the genie is out of the bottle, with many firms continuing to implement planned changes with the expectation that the SEC will soon roll out their own rules with a similar goal of improved consumer protection. What may be different is a more nuanced approach by a more informed SEC that recognizes the difference between commission-based brokers and insurance agents, and the fee-only advisers who are already acting as fiduciaries. Time will tell.
For now you can be assured that we will continue to act and advise in your best interests as we wait for the regulators to sort things out.
Last fall I wrote about inflation and how the slow growth in average hourly earnings was not matching the inflation worries that were being discussed by market pundits. Recently, with the passage of individual and corporate tax law reform, growth of average hourly wages has started to pick up. The chart below shows a measure of corporate profit margins (red line) and the year-over-year change in average hourly earnings (blue line). As you can see, these two lines tend to move in opposite directions; the higher wage growth tends to be, the lower corporate profits tend to be. Inherently this makes sense, although many factors determine overall corporate profitability. The salaries paid to employees are a large fixed cost. Contrast this expense with, for instance, the cost of raw materials, which can be adjusted based on short term dislocations between supply and demand.
The takeaway from this chart is that higher wages should depress corporate profit margins, which are already sitting close to an all-time high. The possible retreat in profit margins due to higher wage costs is currently not being priced in by market participants (let alone higher input costs if large tariffs take place). As we continue to navigate a market that is on the expensive side, we continue to watch for other indicators that could change the corporate landscape. Rising wages are one data point we are keeping a close eye on. Our investment discipline helps combat these possible pressures as we consistently look for market leaders that have the ability to pass on higher costs to their end customer, regardless of the type of industry.
We firmly believe that risk management is of high importance as we get to the later innings of the market and business cycle. However, we are still finding opportunities in the marketplace, and we will take advantage of them if the price is right. Please feel free to reach out to me with any questions regarding this or any topic.
As I’m fond of saying, please come on by when you are near. The coffee pot is always on.
Jim Parr, Principal
Cairn Investment Group, Inc.
How many of you have taken a trip to one of the fabled movie lots in California or elsewhere across the country? Movie lots where fabulous, action-packed scenes have kept us all at the edge of our seats. Well, that’s where I feel we’ve been. I can see and feel, almost taste, the dust in the clapboard buildings. The peeling paint, a couple of window panes broken out. Maybe a curtain flapping in the breeze through the broken window. I can smell dust, maybe I can smell the livery stable, maybe I can smell a little coal smoke, maybe someone cooking. And here we are on a quiet Easter weekend and April Fools’ Day, when out of the East, with the sun to his back, comes a wild cowboy with pistols in both hands. The bullets begin flying and I start dancing, I jump up to avoid a bullet hitting my ankle, I dodge to the left, I dodge to the right, I keep on dancing as the bullets fly around me. Breaking another window, splintering some other wood boards, and of course punching a couple of holes in that classic water trough near the livery. This is what the last few months have felt like, unplanned, and very unsettling. It may be that disruption is the way to get people focused on the issues that our country needs to address. But, my gosh, it is difficult for the markets and investors to have a sense of stability with all of the disruptive, High Noon activity.
Over the years many of you have heard me say that I don’t worry too much about the markets overall. What I care about are the individual companies that we own. Companies where folks are making decisions daily on how to make their business more profitable, more appropriate, and more relevant. These are the things that I’m focused on, and it may be that the business environment is changing in a positive way. Earnings, dividends, backlog of work not yet done, promising future new technologies: These are important to me as we wrap our thoughts around what we as investors should own.
In the past I’ve talked about our wall of worry. I’m not going to do that. From time to time I’ve talked about interest rates. I’m not going to do that either. But I do think there is a change in the way businesses are being managed from a tax perspective, and how we need to think about taxes and the way we own our investments. How we as investors are going to act and how it may have an effect on our returns. Patrick is going to take an important part of the message today and reflect upon the changes that we see in the way companies are aligning with new tax rules and with increasing interest rates.
I would encourage you to call up and schedule a time to come and see us. If you haven’t had a chance to talk with Patrick and/or Tim lately, it’s a great thing to do. Any of us are happy to sit down and review your world and your investments. Patrick has been with us nearly three years and has a wonderful handle on so many of the companies we invest in.
Many of you have heard me talk with enthusiasm when it comes to my belief that the economy will continue to march along, sometimes at a bustling rate and sometimes slower. Currently we are at a fairly brisk rate, and that’s a “good thing” for investors. So, as I often do, while driving down the road and see other people in their cars, or if I’m in the office and look out and see other office windows or other business doors, I remember that behind every single one of those cars, businesses, or offices is somebody just like you and me, trying to figure out how to put some more money in their wallets for all of the things that they would like to do in their lives. It’s a very compelling economic growth story. As we see businesses hiring more, we are enthusiastic about an ongoing improving and growing economy. That being said, we all know that if there is one thing that causes jittery markets, it is uncertainty, and right now we have a lot of uncertainty.
So much for the low volatility that investors have become accustomed to over the previous couple of years. The first quarter saw markets rise to an all-time high by the end of January, only to finish the quarter in negative territory. The S&P 500 Index finished down 0.76% for the quarter while developed international stocks fared a bit worse, -2.2%. Emerging market equities fared the best of the major asset classes, returning over 2.4%. Bonds were also mixed as yields were quite volatile, reflecting consistent economic growth while the U.S. Fed continues on its interest rate hike path. As we have written previously, we view broad U.S. stock indices as richly valued and that view has not changed during the quarter. Finding bargains in this environment is challenging but we remain vigilant in our search for quality investments selling at compelling prices, while decreasing our exposure to companies that have become more fully valued. As Jim mentioned, I am going to discuss some of the changes that companies will be facing regarding tax rates and the rising costs of borrowing.
Last quarter we briefly touched on the changes in tax law that focused on individuals. There was also a broad overhaul to the corporate tax structure that many companies are still trying to dissect three months after the fact. The two primary changes that are being talked about the most are the lowering of corporate tax rates from a high of 35% down to a flat rate of 21%, and the changes to the deductibility of interest expense on corporate debt. The latter change is not talked about as frequently, but could be of more importance in the years to come.
We spent a lot of time in early 2017 identifying companies that could benefit the most from a lower corporate tax rate. That benefited portfolios later in the year, as companies with high effective tax rates were strong performers in the back half of 2017. Companies that benefited the most had similar qualities: low debt and a large proportion of U.S. revenues. The use of funds that companies are netting, resulting from lower tax, is still not completely clear, so it will be interesting to hear executives speak about their plans during upcoming earnings announcements. While an increase in productive spending (research, capital equipment, employee training and technology enhancements) would be welcome news, we remain skeptical, as historically tax savings have been used to increase executive compensation and share buybacks. Also, the increased chatter of trade tariffs/wars and possible effects on corporate profits could weigh on the benefits that were perceived from lower corporate tax rates.
A very important part of the tax law change surrounds the deductibility of interest expenses for corporations. Historically, the interest expense on the debt issued by companies was fully tax deductible. Over the last 10 years, this allowed these firms to access the bond market at historically low interest rates and have the interest expense be tax deductible (what a deal!). Under the new tax law only part of the interest expense is tax deductible (up to 30% of operating earnings before depreciation). Companies that have large amounts of debt or increasing interest expenses are now more susceptible to lower profits. We feel this is a risk that is currently underappreciated by equity markets. As the chart below shows, corporate America has taken on large amounts of debt over this past cycle, rising from roughly $3.6 trillion to over $6 trillion. This is at a time when the costs of corporate debt have started to rise (indicated by the red line, 3 month LIBOR). See chart below.
As interest rates have begun rising in the corporate market, this creates a headwind surrounding balance sheet strength, financial flexibility, and corporate profitability going forward. While we continue to look for attractive investments, these potential headwinds will be considered. We always strive to invest in companies we feel are financially healthy. Financial health and cash flow strength could separate the winners from the losers as we reach the later innings of the market cycle. Where we cannot find these suitable investments, we are comfortable being patient to protect against downside risks.
We will get past this tariff noise. We’re going to continue to keep our eyes open and try to dance around those surprising puffs of dry dust that are poofing up near our feet. Please remember that any time you are in town we’d love to see you. Don’t hesitate to come on in. The coffee pot is always on.
Jim Parr, Principal
Cairn Investment Group, Inc.