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.