02/18/2018

AFG50 Quarterly Review

The AFG50 returned 7.51% in the 4th quarter, outperforming the S&P 500 by 139 bps, with 8 of the 11 economic sectors outperforming their respective sector benchmarks. In 2017, the AFG50 returned 23.48% on a price return basis, outperforming the S&P500 by 406 bps, with 9 of the 11 economic sectors outperforming their respective sector benchmarks.

Each quarter we provide a more extensive analysis of performance and a short write up on our thoughts on the market.  Below is the Looking Back and Forward part of the review.

Looking Backward and Forward

With the S&P500 returning nearly 20% on a price return basis, 2017 delivered one of the best returns for the US large cap equity market in the past 15 years. The fourth quarter was a smooth ride, as the Fed’s unwinding of its balance sheet caused no disruption to the capital market, and Fed’s new Chairman nominee Jerome Powell is a solid consensus pick who will likely continue the steady path of rate hikes while accelerating de-regulation efforts. North Korea’s Nuke situation remains in flux as the country tested another intercontinental ballistic missile in late November, which supposedly could carry a war head and reach anywhere in the US. In response, the UN imposed tougher sanctions on North Korea which would ban 90% of the regime’s refined petroleum imports, as well as setting new restrictions on other essential imports. It is unclear if President Trump and Chinese President Xi have agreed upon any workable blueprint to solve the NK issue peacefully, though the world is hoping there is still an option for peace. Most importantly, despite previous legislative blunders, the GOP passed the tax reform in a 7-week sprint with the new bill becoming law on December 22, 2017. As importantly, the reform guidelines laid out earlier were largely fulfilled in the final bill such as reducing the US corporate tax rate from 35% to 21%; doubling the standard deduction for personal income tax and eliminating SALT deductions; reducing the tax on S corporations, partnerships and sole proprietorships. Also, companies would be allowed to repatriate existing overseas profits for a one-time tax of 8% on illiquid assets and 15.5% on cash.

It is no secret President Trump is passionately disliked by the media and most pundits have been reluctant to give him any credit for the economy or the strength of the stock market. While many have disputed the existence of the “Trump Rally” or dismissed it as a bubble outright, we have always argued that Trump’s promises to reduce both corporate and personal income taxes, his advocacy for deregulation, infrastructure spending, and draining the swamp in Washington, are all tangible, positive initiatives that will make good changes to the economy and serve as fundamental drivers for positive stock market returns. Despite lots of chaos and distractions, Trump and his administration have accomplished a lot in its first year: passing the most sweeping changes to the tax law since President Reagan; repealing the Affordable Care Act’s individual mandate, arguably the most controversial portion of Obamacare; dramatically rolling back regulations; reforming Consumer Financial Protection Bureau with Mick Mulvaney as the head, to name a few. Those accomplishments would directly and positively affect corporations and the US economy immediately.

On the monetary policy side, the Federal Reserve raised short-term interest rates for the third time in December for 2017 and remains on track to chart a similar path next year. Officials predicted three 25 bps rate increases for 2018, and two increases each in 2019 and 2020. New projections also show Fed officials now expect the economy to grow at a 2.5% rate in 2017 and 2018, up from September projections of 2.4% and 2.1%, respectively. The Fed still expects the economy to grow at 1.8% over the long run, with growth surpassing that level through 2020. Though the current economic expansion has lasted more than 8 years, one of the longest in the modern US history, a recession is not on the near-term horizon and we don’t believe it has to be, as some fear. Recessions have been fewer since the 1980s averaging ~8 years between each, as the U.S. economy has matured, and the Fed has become much better handling interest rates. With consumer confidence remaining at historical highs, a fresh tax cut taking effect in the new year, hundreds of billions of cash likely to be repatriated from abroad in the coming years, and inflation and interest rates staying at moderate levels, we think the current expansion is well positioned to be the longest since the 1920s. Let’s also not forget, in 2018 the White House and the GOP controlled congress will likely take on infrastructure right away. This initiative is reportedly having a price tag of $1 trillion, and the Federal government will provide $200 billion in funding in the next decade, with states, localities, and private investors picking up the rest of the bill. With all the fiscal initiatives about to unleash their power, we are optimistic that US economic growth will have a good chance to accelerate in 2018 and 2019. With the corporate tax cut increasing after tax returns and making more investments acceptable to pursue, corporations will make more investments which will result in higher economic growth. The corporate tax cut will also bring higher wages given the labor market is already tight, and higher wages could lure more people back to the labor force to increase the labor participation rate. Should the infrastructure spending bill be passed and enacted in late 2018 or 2019, more stimulus will be created to increase economic activities in the mid-term. More importantly, better infrastructure will provide productivity gains for the US economy for the long term.

Despite our optimism of the economy in the near to mid term, we understand every economic expansion comes to an end at some point. The same is true for the stock market, as the current bull market will experience a correction sooner or later. Predicting a recession or stock market downturn, however, is a largely futile exercise in our view. it is extremely difficult to predict the beginning and duration of any recession with precision. To make matters worse, the US stock market has exhibited mixed performance prior, during, and after the recessions in the past 90 years, though the stock market has delivered mostly positive returns in the 12 months following a recession. Investors tend to take great satisfaction in avoiding a dip, which seems to provide enormous psychological rewards, while readily ignoring the lost opportunity of at least missing the initial bounce back from the trough. With all the imperfect timing, we suspect the monetary benefit and cost of trying to avoid stock market dips amount to much ado about nothing at best even for most sophisticated investors. For equity investments, the best strategy really is to invest in undervalued stocks (not the index) and let the cycles take care of themselves, which would allow investors the luxury to reap the benefits of time arbitrage.

Granted though the recessions have become more infrequent, the last two bear markets were severe. From August 2000 to Sep 2002, the S&P500 lost nearly 50% of its value, and from late 2007 to early 2009, the S&P500 was halved again. The 2000-2002 bear market was largely a result of a severe valuation bubble, as at the peak, the P/E ratio for the SP500 was ~35 times. Then we had 9’11, a rare and extremely negative macro event happening on American soil. The 2007-2009 bear market was as severe but more swift, which was largely caused by a financial crisis due to heavy housing indebtedness of consumers and financial institutions, exacerbated by liquidity crunch. It was also global, creating epidemic fear as investors feel there was no place to escape. We don’t think the current situations bare much similarity to the conditions preceding those two crashes. The 12 months forward P/E for the SP500 is ~18 times excluding the tax cut benefit, which suggests an attractive earnings yield of ~5.5% relative to the ~2.4% yield of the 10-Yr US treasury. Back in 1999/2000, the earnings yield of the SP500 was ~3% relative to the ~6% yield for the 10-Yr Treasury. Financial institutions have largely deleveraged since 2008 and their capital positions are strong. For consumers, household debt service payment as a percentage of disposable income is around 10%, down from 13.2% in late 2007 and is the lowest in the past ~30 years. It is true the historically low interest rates are a major factor to the low indebtedness of the US consumers. Some say the biggest risk of the next recession is that consumer consumption would collapse once interest rates settle at higher levels. Should that happen, it will be a conventional recession with economic tractions caused by decreasing demand and it will be relatively easy for the economy to recover. The stock market may also react relatively benignly to a classic recession.

As a long only portfolio, the AFG50 is largely relieved of the burden to time the market. Our focus remains on valuation, which is the best defense in the long run in any bear or bull market, in our view. In 2017, the AFG50 has taken advantage of some irrational pessimism in the “traditional” retail and technology segments. The passage of the US corporate tax cut will result in increased values for most of the names in the AFG50. As we enter 2018, some of the names in the AFG50 have surpassed our target prices estimated after Q3 results and before the tax cut. We will carefully assess their absolute and relative valuation after Q4 results and we are very interested in hearing management comments about 2018 in terms of their plans for: capital investment, employee wages, hiring, and returning capital to shareholders. We are optimistic about 2018, without being naïve in thinking all will be “hunky dory” and not have its share of ups and downs. The country is more divided than ever, but we hope sustained economic prosperity will help unite us all.