Q3 Earnings Season—Don’t Get Spooked
It’s that time of the year again where we can see a snapshot of the health of the economy through the corporate lens. That’s right: It’s earnings season! Over the next several weeks, companies will report their preceding three-month results through SEC filings and, usually, a conference call to discuss results with investors and analysts. These quarterly events are typically paramount for market participants to get a clear idea of business trends that help determine where a stock – and the market – could potentially go.
We anticipate this quarter will deliver strong prospects to warrant further long-term market appreciation but, admittedly, there will be much more “noise” and volatility as headline earnings growth rates won’t look quite as robust as prior periods. Nevertheless, when the onion is peeled back, we think core earnings remain strong and, more importantly, companies’ outlooks for the year-end quarter will add support to the market, keeping us bullish.
Part of the reason for the upward momentum in the equity markets over the last several years has been a result of consistent, rapid earnings growth. For example, in the first quarter of 2009 when the market bottomed during the financial crisis, the forward 12-month earnings per share (EPS) estimate for the S&P 500 was less than $50, compared to today where it’s over $140. That near-tripling in under a decade has been the result of cost cutting and sales growth. Companies have streamlined operations by improving materials sourcing, finding cheaper input costs, innovating and consolidating through mergers & acquisitions. Companies have also used low interest rates to finance expansion into new markets and business segments. This combination has created larger revenue bases and allowed for those revenues to flow more purely to a company’s bottom line.
However, that trend could be disrupted this quarter as two major hurricanes stalled the economy and caused billions of dollars in damage. This disruption will likely be exaggerated by a typical seasonal slowdown that happens during the summer. Waning year-over-year strength from the energy sector could also slow things down. Before the hurricanes, Wall Street expected S&P 500 earnings growth to be 7.5% for the third quarter. In wake of the destruction, analysts revised estimates down to 2.8%. That is a material slowdown from the second quarter where the S&P 500 delivered double-digit earnings growth. That said, we’d note that over the last five years, reported earnings have come in, on average, 4.2% above consensus expectations. If history is consistent, this would put the actual third quarter earnings growth rate around 7%, a much more respectable level given the circumstances.
Regardless of where the actual growth rate shakes-out, we believe the underlying fundamentals continue to improve. This is supported by expanding margins during a comparatively unimpressive growth quarter. The net margin (the amount of income a company earns on each dollar of revenue after taxes are stripped out) for S&P 500 companies is expected to widen to 9.49% in the third quarter, yet another record. That level of corporate profitability is up almost a full percentage point relative to last quarter and the same period of 2016, with only some of the improvement the result of a weak US dollar. To us, this is clear evidence the growth outlook will be much more robust going forward and the “lull” is just temporary due primarily to unforeseeable factors.
This quarterly earnings season is a friendly reminder that earnings are backward-looking, while stocks are forward-looking. This means the market is likely to eventually brush off meager earnings growth in the face of accelerating outlooks. Currently, Wall Street analysts expect 11.1% year-over-year earnings growth in the fourth quarter, a rebound that we think is likely to continue well into 2018. While there are always upside and downside macroeconomic risks, these earnings forecasts keep us bullish on the fundamentals of our portfolio and on the markets.
Does a Bond Bubble Mean Portfolio Trouble?
Many investors think that bonds are a necessary component to every portfolio. In the current market environment, Catamount has a more nuanced view.
How low can rates go and what it means for bonds in your portfolio:
Interest rates and bond prices move in opposite directions. As rates increase, bond prices decrease. Investors flock away from old bonds and towards newer bonds with higher coupons. Rates are currently near all-time lows and are expected to increase. This means that your upside is limited (if rates are low, the coupon payments from your bonds will be low) and that the downside is relatively high (as rates increase, existing bonds will decrease in value on the secondary market).* Even Alan Greenspan, the famous former chairman of the Fed, thinks that the bond market is currently in a bubble.
Dividend stocks as an alternative:
In the current market, we think stocks that pay out a dividend are a great alternative to bonds. They provide investors with income that can match that of bonds in some cases, but also allow for some of the upside of the equity markets. As a real-world example, let’s take a company in the Catamount portfolio that has highly-rated, investment grade bonds: Unilever (NYSE: UL). In the last year, one share of UL has paid out a dividend that is effectively 3.1% of the price of the stock a year ago. It has also seen an incredible stock price surge of 25%. If you had instead purchased a bond issued by Unilever, you would have lost 2.2% of the amount you invested. For some more nitty gritty detail, see the Appendix.
How we got to today:
After the 2008 market crash, prime interest rates were lowered to effectively zero. To put the period in historical perspective, below is a chart of the federal funds rate encompassing more than six decades. Recessions are highlighted in grey. To boost the economy out of a recession, the Fed will generally lower interest rates to stimulate the economy. As the economy heats up, the Fed will raise rates to cool things down and temper inflationary pressures on prices.
Federal Funds Rate 1954 to Present
What is amazing about the graph above is that the Federal Funds Rate was above 20% in the 80’s but is now only about 1%. As Big Lou likes to say, if we were in the 1980’s again, we would have a portfolio full of bonds.
What this means for bonds and your portfolio:
This means that return on bonds you can buy in your portfolio are historically very low. In the mid-1990s, highly-rated bonds (Moody’s Aaa rated bonds for instance), would yield 7.5% – 8.5%. This September, those same bonds have a yield of just 3.6%. With rates expected to rise, your returns on those bonds could be even worse.*
Should I sell my bonds?
The answer is not an automatic “yes”, or “no”. At Catamount we understand that each investor and each portfolio has specific needs. With highly-rated bonds do not generate as much income as they did in the 1990s. Investors looking for income from their bonds should consider this. If you look to riskier bonds that have higher returns, you run the risk of default. This can be seen with the recent bankruptcy bid by Puerto Rico that encompasses $70 billion of debt. On the other hand, if 3-4% income fits your portfolio’s needs, you should absolutely own bonds.
Every investment has a risk and reward tradeoff. In the current market environment, we think that investors should look at dividend yielding equities to as they consider income in their portfolio.
*Note: A standard bond will repay its principal in full (so long as it there is no default). This statement reflects the secondary market where bonds are traded and prices of a bond can move daily.
After Disney’s recent announcement about building a pair of video streaming services – one is an ESPN-branded platform and the other is Disney-branded – to accelerate its “direct-to-consumer” initiative, there has been an uptick of chatter over cord-cutting in the news. The topic is getting almost as many hits as ‘John B. McLemore’ when the S-Town podcast premiered in March or when the Dothraki crossed the Narrow Sea. Although Disney currently holds the spotlight, the shift to streaming has been in the works for well-over a decade, and it was (surprisingly) CBS who deserves credit as the true trailblazer among large media after All-Access was launched back in 2014.
This cord-cutting trend should come as no surprise given that nearly two-thirds of all households in the U.S. subscribe to a service like Netflix, Amazon Prime or Hulu, up from less than 50% three years ago. In addition to the aforementioned “streamers,” Facebook, YouTube and even Twitter are offering live streaming options, while virtual pay-TV providers like Sling make switching extremely affordable for customers uninterested in traditional plans.
In essence, cord-cutting is truly just beginning as households start to question why they’re overpaying for cable, especially when considering the average household doesn’t view over 90% of the channels to which they have access, and recognizing that their monthly charges have risen too quickly. For example, the average household paid $100 a month to cable companies in 2016 compared to just $70 in 2011, a 43% increase or 6X the inflation rate!
While cord-cutting is not a new phenomenon, it really started to accelerate in 2016 after 1.9 million pay-TV customers cancelled their contracts. Prior to last year, the attrition rate was around 1 million a year. This higher pace is expected to continue as media think-tanks estimate that at least 10 million more customers will follow suit over the next 5 years. As a result, M&A within media has been a common theme throughout 2017; AT&T is acquiring Time Warner, Sinclair – one of the country’s biggest local television station owners – is in the process to buy Tribune and Starz was approved to be taken-out by The Hunger Games and La La Land producer, Lionsgate. This consolidation likely continues.
Part of the draw beyond availability is due to the better quality of content being developed by streaming providers with shows such as Westworld, House of Cards, Orange is the New Black, Transparent and Ozark (Catamount’s newest obsession on Netflix – hop on the train, people! Another suggestion that will not disappoint: The Jinx on HBO. Anyway, we digress…). And have you heard that Shonda Rhimes, Grey’s Anatomy and Scandal producer for ABC, is bringing her creativity to Netflix after being with the network for 15 years? This move potentially raises the bar even further. Perhaps we should all get more comfortable couches.
We’re in the midst of a media boom today and the most obvious winners from this dynamic will be consumers as Americans still have a habit of sitting in front of the television. With the explosion of high quality content and more outlets to view the next hit show about vampires or a behind-the-scenes documentary featuring René Redzepi’s next Danish creation (can one of our readers please make this happen?), media companies have recognized that the model needs to evolve. Unfortunately, we are still a long way from seeing how it settles beyond plain, old “bundling.”
The next buzzword to watch for in media? Cord-nevers. You heard it here first.
Many investors look to oil stocks for dividend payouts and view these stocks as conservative investments. It is important to understand what moves these stocks and what that can mean for your portfolio. Oil stock performance is highly correlated with the price of oil. Oil itself is a commodity that is subject to complex, and often sudden external forces. For instance, in the 19 months from June 2014 to January 2016, the price of oil dropped 75%. Major oil stocks lost about 30% of their value while the S&P 500 only dropped 8%. The forces behind that price movement have changed the dynamics in the oil market forever. We will dive into these dynamics further later in this post.
Oil companies around the globe are adjusting to a new normal in a price environment that experts have called “lower for longer”. Many companies, especially large US operators, have survived the downturn and regained sales and profitability. However, the stock market has not rewarded them. Given the lower correlation to the stock market generally (e.g. stock prices that move as oil moves, and less along the lines of the general market), these stocks add value in diversifying a portfolio. That said, investors should also consider other traditional conservative sectors like consumer staples and defense to build a properly rounded portfolio. Catamount has representatives from each of these sectors in our portfolio.
OPEC gives way to US producers
Let’s start with a bit of history to give better context for the most recent changes in the market. Since the mid-1960s, OPEC, an organization of oil producing states, has tried to bring calm to the oil markets by regulating the production of its members. It maintained this power because it was comprised of the global “swing producers”. These countries could effectively turn the tap “on” or “off” at their convenience. While this arrangement has been disturbed by geopolitical disputes from time to time, most spare oil production capacity remained in OPEC’s control.
However, technological advances in areas like “fracking” and relaxed environmental policies enabled the United States to nearly double oil production from 2008 to 2015. In effect, the US became the swing producer for oil. This growth in production led to a glut of oil in the marketplace. As a result, prices plummeted. Instead of cutting production, OPEC allowed the glut to continue to drive higher-cost producers in the US out of business. This strategy worked to some extent, with around 100 US-based oil and gas companies going bankrupt. However, most all major US producers emerged leaner and lower-cost than ever.
Fast forward to today. Over the last year, oil prices have been bouncing around between $45 and $55 per barrel, without breaking out in either direction. In that same time, the largest US independent oil producers have turned earnings from negative to positive, and about doubled revenues. Despite incredibly positive fundamental rebound, and general upswing in equity markets, only a few have outperformed the S&P 500.
What does the future hold for oil?
Looking to the future, even the Middle Eastern oil titans appear to have a bearish sentiment. The man who founded modern day Dubai once said, “My grandfather rode a camel, my father rode a camel, I drive a Mercedes, my son drives a Land Rover, his son will drive a Land Rover, but his son will ride a camel.” That man’s name was Rashid bin Saeed Al Maktoum. This quote reflects a commonly held view that even though oil can bring about tremendous wealth, that wealth will only last a few generations. Dubai has actively sought to diversify its economy away from oil and has become an economic powerhouse by investing oil dollars in trading infrastructure. Saudi Aramco, the state-owned oil company of Saudi Arabia that also represents the largest oil company on the planet, has announced plans to IPO and plans to diversify away from oil starting in 2018. You can see similar public diversification plans announced recently in Egypt, Qatar, UAE, and Oman.
Electric cars are a strong headwind here as well. While not all of oil goes into fuel (some goes into plastics and other chemical products), a good portion of it does. In the US, about two thirds of the petroleum products consumed are in the form of fuels that could be replaced by electric vehicles. Goldman Sachs predicted that by 2025, 25% of cars will have electric engines. Major car producers around the world are moving towards electric vehicles. Whether it is the all-electric Tesla models in the US, or Volvo vowing to make non-petroleum cars by 2019, the future is looking dimmer for oil. Additionally, Britain recently vowed to ban diesel and petroleum cars by 2040.
How does this fit into Catamount’s strategy?
In summary, there are strong headwinds in the long term for oil. While oil stocks can be valuable in a portfolio from a diversification and dividend perspective, it is important to look at other sectors that can also add these characteristics to your portfolio. At Catamount, we have some exposure to oil, but also to other conservative, dividend paying stocks like those in consumer staples and defense. Considering the challenges facing oil and gas going forward, we are also closely monitoring new energy technologies like renewables, energy efficiency, and energy storage. More to come on these sectors…
What is the 4% Rule and Should I Use It?
What is the 4% rule and should I use it? These are questions we hear often from clients and potential clients. The 4% rule was created by William Bengen in the 1990s. After research into historical rates of return on stocks and bonds, Bengen concluded that 4% was the largest annual withdrawal rate one could exercise on their savings if they wanted their savings to last for 30 or more years. The idea is that in the first year of retirement, one would withdraw 4% of aggregate savings and then each following year increase this withdrawal number in direct proportion to inflation. For example, if a couple has $1,000,000 in savings and inflation is 2% a year, they would withdraw $40,000 (4% of their savings) in their first year of retirement, and $44,800 the second year and so on.
So should you use the 4% rule? Is it too ambitious? Is it too conservative?
Many Financial Advisors think that a 4% annual withdrawal rate is in fact too ambitious and that a 3% rate is more appropriate for most retirees. Sure, a 3% annual withdrawal rate means less cash to spend every year than a 4% rate, but it also provides a higher level of assurance that a retiree’s savings won’t run out prematurely – and what could be worse than that?
However, other Financial Advisors, such as Michael Kitces, are quick to point out that there has not been 30-year period over the past 150 years in which a retiree employing the 4% rule would have run out of money. Instead, Kitces notes that about two thirds of the time one employing the 4% rule would end up with more than double their original principal!
What does the future hold? How will markets perform? No one knows and, yes, it is possible to encounter a 30 year period in which a retiree following the 4% rule would run out of money.
Ultimately, it is nearly impossible to accurately forecast a perfect withdrawal rate that would both protect a retiree against the risk of running out of money without also leaving him open to the risk of ending up with more savings than he needs later in life. At Catamount, we understand that your situation is unique and that you can’t always rely on a simple formula to guide your retirement plan. Together, we can establish and continually adjust your withdrawal rate so that it meets your needs and ensures you won’t outlive your money. We would be excited to help you start planning for your retirement today! Please contact us for more information or any questions you might have. We are always happy to chat. email@example.com, or 203.226.0603.
Today, we are highlighting Amazon (NASDAQ:AMZN) and Tesla (NASDAQ:TSLA). For years an out performer, we see Amazon as significantly undervalued. Here is why we are bullish:
- Amazon’s P/S ratio (price per sales) is relatively low given Amazon’s revenue growth. And beyond recent revenue growth, Amazon’s valuation multiples don’t fairly encompass future growth prospects across its e-commerce and web services businesses (Amazon AWS). Amazon experienced 22% year over year sales growth in the first quarter of 2017, which we feel renders its 3.2x revenue multiple as cheap.
- Amazon Web Services, the company’s cloud computing division, represents an undervalued asset within Amazon. In the first 2017, AWS represented ~10% of aggregate revenue for Amazon, but contributed ~88% of operating profits. AWS did $3.7B in sales in the first quarter of 2017, up 43% from the prior year, and reaching an annual run rate of around $15 billion. For comparison, Equinix (NASDAQ: EQIX) is the largest pure play publicly traded cloud computing company, and its first quarter 2017 revenue was only $949MM, with a much lower 12% year over year growth rate. In a market where other comparable cloud computing companies like EQIX trade at 8-10x revenue, AWS would be worth around $130B as a stand-alone entity. Amazon continues to grow this business and has recently added ~300 new services and features to AWS. This should continue to drive adoption and revenue growth to a business that already has lots of momentum.
- Amazon’s international segment currently operates with negative margins. However, Amazon has strategically operated many of its businesses at a loss to offer better prices than competitors, win new customers, and ultimately drive penetration and take market share. This has been effective and Amazon has grown revenues in this division by 16% year over year. We expect Amazon to replicate its North American success elsewhere and operate profitable businesses when it strategically makes sense. Its international business represented ~30% of aggregate revenue in 2016 and we expect this number to grow, coupled with increasing margins over the long term.
Despite recently trading at all-time highs, we see significant upside and growth potential for Tesla. Here is why we are bullish:
- Tesla has had impressive growth recently; it delivered 25,000 vehicles globally during the first quarter, a 69% year over year increase from the first quarter of 2016. And, with a 2018 target of delivering 500,000 cars, Tesla is on track for sales of $25B. It is important to note that Tesla’s already impressive 26% gross margin per car will increase as it delivers more cars, and analysts have speculated that this margin could reach 30%. For reference, most car companies, like GM and Ford, have gross margins per car that hover around 10%.
- Despite impressive manufacturing build out, the company has kept a relatively low debt level. International market leaders Daimler (DIA) and General Motors (GM) both have total debt to total capital ratios of ~66%. Tesla’s comparable ratio is 57%. This indicates that Tesla is below market leaders in its use of debt to finance its operations and that the company room the use debt to finance future manufacturing build outs.
- We see Tesla as more than a traditional car company, we see it as an innovative tech and design company; like Apple, Tesla produces industry leading cache’ products with justifiable premium pricing and a differentiated delivery model. We see Tesla as a diversified business that will continue to capture the shift in consumer preferences toward electric cars, while being a leader in the nascent self-driving car space, and building a significant battery business.
2016 was a volatile year across the global geo-political landscape and the inherently connected financial markets. Seemingly unlikely events, Brexit and the election of Trump, shook the world. 2017 too will be filled with unknowns and volatility. Here are a few tips for protecting your wealth and navigating the market’s ups and downs.
Diversify Your Investments
Diversification has always been the key to distributing and managing risks inherent in investing. What does it mean to be diversified? Let’s start with an example: Imagine a portfolio that was entirely comprised of holdings in just two stocks, Facebook (FB:NASDAQ) and Twitter (TWTR:NYSE). This is called a “concentrated” portfolio; if Facebook has a bad quarter in terms of earnings, or one of its core products like Instagram loses market share to a competitor like Snapchat, or any number of things goes wrong, our concentrated portfolio will be very sensitive to any downward move in the stock price. Beyond just owning two stocks, both Twitter and Facebook are technology sector stocks; if President Trump were to announce policy unfavorable to this sector, the portfolio would be incredibly sensitive. Alternatively, a diversified portfolio has a balanced mix of holdings across assets classes – stocks across different sectors (International, Emerging markets, Tech, Consumer, Telecom, Industrial, Energy), bonds, precious metals, real-estate, and cash. The more diverse the holdings, the less reliant a portfolio is on the success or failure of any one asset class, sector, or stock. At Catamount, we construct appropriately diversified portfolios based on the risk appetite and goals of our clients.
Over the long run, the stock market has a long-term tendency to rise – this simple fact is something to remember through the market’s day-to-day and even year-to-year volatility. The key to growing a portfolio is to stay put and patiently ride through the market’s turbulent peaks and valleys. If you can do this, you will take advantage of market’s long-term rising trend. However, studies show that most people often do the exact opposite and instead of staying put they can’t resist the natural urge sell their positions during market corrections, set-backs, and crashes. These people are in effect buying high and selling low, or buying low and selling low, when the ultimate goal is to buy low and sell high. In fact, a market correction often presents a great opportunity to be investing in the stock market instead of selling. This idea is summarized well in this tweet from macro-investor Cullen Roche:
Do you have a 360 degree all-encompassing view of your assets? Are they are working cohesively under the same risk parameters and growth thesis? We often come across potential clients and clients who are working with several different wealth advisors, tax-advisors, or estate-planners. This can lead to a redundancy in positions, unnecessary fees, and a confluence of different philosophies, yielding a less effective approach to growing and protecting wealth. One of the first things we advocate across our clients is a consolidated and simplified approach. At a minimum, it is important to make sure that there is communication between different moving parts so that you have a well-defined and universal approach to market volatility and market corrections.
With a mix of new features, businesses, and opportunities, we expect Facebook to have a great year in 2017. Here is why we are bullish:
- Cheap Valuation based revenue growth (56% in 3rd quarter year over year[i]) (will add specifics and elaborate on P/E when we are going to actually post this so that the #s current)
- Facebook has the potential to be a dynamic and large player across the e-commerce landscape. Over the past year, FB has made had strong entrance into several e-commerce markets via partnerships with companies like Uber, Domino’s, Kayak.com, and more.[ii] These partnerships enable Facebook users to communicate and transact with these brands within Facebook Messenger. Additionally, FB has created its own version of Craigslist, a marketplace native to Facebook where users can buy or sell items with each-other. FB will take market share across the e-commerce landscape over the coming years and ultimately increase its revenues.
- Instagram’s “Stories” feature is both an attack on Snapchat’s market share in the teen demographic and a significant addition to Facebook’s advertising inventory. In 2016, Instagram effectively copied the Snapchat stories feature and did well incorporating it into the Instagram interface. Stories enables users to broadcast photos & video clips to their followers; these photos & videos expire 24 hours after they have been posted. Stories also enables users to live stream video content. Instagram has been incredibly successful in driving users to this new feature, and, having demonstrated strong engagement, Instagram is partnering with large brands such as Nike (NYSE:NKE) to distribute branded video content and ads.
Coming off a strong 4th Quarter in 2016, where EPS (earnings per share) registered $0.40, Bank of America should to continue to do well in 2017. In particular, BAC stands to benefit from President Trump’s promise of deregulation and the FED’s intent to raise interest rates.
- The Dodd-Frank Act and post financial crisis stress tests, both intended to safeguard the broader economy, have limited Bank of America and its banking peers in their ability to generate returns on capital. These regulations prohibit the banks form being illiquid, which effectively means that they need to keep lots of cash on hand and limits the assets that can be tied up in illiquid things like loans. Currently, BAC has ~$500 billion of cash on hand. If Trump is able to relax or even dismantle Dodd-Frank, BAC will be able to allocate a portion of that cash to its loan portfolio which yields ~4% annually – this redistribution of cash would boost BAC earnings significantly.[iii]
- Almost half of BAC revenues are tied to interest rates and a 100 basis point (1%) upward move in interest rates would yield an additional ~$5 billion in revenues. Of the big banks, BAC most benefits from rate hikes because it has the largest portion of its earnings tied to interest rates. If rates rise and are coupled with a cash redistribution into its loan portfolio, BAC would dramatically increase its annual earnings.
“The information contained within this blog is provided for informational purposes only and is not intended to substitute for obtaining professional financial advice. Please thoroughly research everything you read here and seek professional representation before acting on any information you may have found in this blog.”