Financials: Operating Leverage Improvement Has Been Impressive and Should Continue
The financial sector has been a hot topic for the last couple years in the market. And it’s for a good reason: with the market close to record territory and the bull run nearly a decade long, cracks in the financial system could appear as the business cycle turns (so the logic goes). However, we believe financials, specifically global banks, remain healthy and wise places to invest despite the noise, given a robust global economy, rising rates, deregulation and accelerating earnings growth.
Two of the most closely watched ETFs that track financials, the SPDR Financial ETF (ticker XLF) and SPDR S&P Bank ETF (ticker KBE), are up about 490% and 455%, respectively, since bottoming in March 2009. That is well over 100 percentage points better than the S&P500 and Dow Jones Industrial Average. So why are we still positive on the group?
It’s first helpful to look at why they outperformed. One factor is partially due to the extreme sell-off for the group in which they fell 85% from peak to trough, compared to the market which shed about half of its value. The severe decline across the sector was warranted as questions around bank solvency lingered, coupled with deteriorations in credit availability and damaged investor confidence, to name a few. Therefore, some of the outperformance was merely just the result of too much fear priced in. To put that decline in perspective, from the bottom, the group needed to grow over 550% to get back to its previous peak, which means we still aren’t there yet.
Another factor is the product of the financial crisis itself: financial companies had a chance to cut costs through internal initiatives and consolidation and tweak their business model by deleveraging and diverting resources to areas they deemed strategic. These investments and changes have only recently shown through in results over the last couple years.
Now that the appropriate business model and cost structure are in motion, banks remain well-positioned today to take advantage of the tailwinds at their back. For one, the US (and global) economy is strong, evidenced by a greater than 4% GDP growth rate in the second quarter. A strong economy brings more business to banks. Consequently, interest rates are rising. Banks typically raise rates for borrowers first, while dragging their feet to pass them through to savers. This spread is bolstered by individuals’ tax savings from the recent reform bill that further increases net interest margins.
What’s more, we are in a period of deregulation, which reduces expenses and, therefore, augments profitability. Fewer onerous regulatory burdens, coupled with a lower corporate tax rate will make future earnings growth compelling through 2019. Additionally, the capital markets environment remains constructive through M&A and new issuances and share repurchases remain high. On top of strong top- and bottom-line growth, returns on investment are in general solid – particularly JPMorgan which posted 14% in the most recent quarter. These returns suggest banks are using their cash wisely.
But it’s not just sunshine and roses, which is partially why financials have been in the crosshairs and traded sideways this year. One key indicator is the “yield curve” (the difference between the 10- and 2-year treasury yield), which is currently less than 20-basis points. Furthermore, loan growth has yet to meaningfully accelerate despite the aforementioned positive dynamics. Some of the reason for this is the ongoing tariff jostling. Although this has partially abated it still lingers. Lastly, political volatility in the US ahead of mid-term elections in the Fall has impacted stock prices. However, any near-term setbacks should be cushioned by solid balance sheets for the group.
Although we watch these closely, we view them as transient and fundamentals will prevail. In the meantime, we will get a decent dividend as we patiently wait, slightly lowering any associated risk. Our top ideas in the space remain JPMorgan and Bank of America, along with two hybrids: Visa and Berkshire Hathaway.
What’s in Catamount’s Glass?
“A good person can make you feel confident, strong, and able to take on the world….oh sorry….that’s wine….wine does that.” – Associate PM Matt Monroe (just kidding: anonymous)
As most are aware, we at Catamount have a strong affinity for the stock market, but also “occasionally” indulge with a glass or two of wine. It’s not hard to connect the two as both require knowledge and research, along with the appreciation of history and use of your gut. (However, the “gut” we reference regarding wine leads to something a little more, shall we say, cosmetic!) Additionally, an understanding of the bigger picture is critical in both investing and wine.
For this month’s blog, instead of discussing the market or tariffs or cord cutting, we decided to take a slightly different approach by talking about a few grape varietals and regions that we plan on enjoying this summer! And we welcome feedback – what are you looking forward to drinking? Please share…
Laurie’s Pick: Albarino from the Rías Baixas
In Spain you see a full range of expressions, from sherry to Rueda. (Side note: sherry is truly one of the great traditions!) Albarino from this region of the Galicia “autonomia” is particularly a favorite. The wines tend to be well-made, with clean and bright flavors. And they are priced reasonably! Traditionally the vines here have been cultivated on granite pergolas called parrales to lift them off the damp ground and to give greater exposure to summer sun. Albarino is zesty, briny, minerally with hints of peach.
Another Spanish white that is amazing is Godello from Valdeorras, which has aromatic florals, grapefruit notes and sometimes peach or melon.
Judy’s Pick: Cabernet Sauvignon
Cabernet Sauvignon is one of the world’s most used and recognized red grape varieties. It is produced on its own and also blended with other grapes (think Bordeaux). For most of the 20th century it was the most planted grape in the world, although Merlot takes the cake now. The grape itself is actually an offspring of Cabernet franc and Sauvignon blanc, hence the name!
If you’re gilling steaks, burgers, mushrooms or vegetables and you prefer red wine, cab is your best friend! Its taste varies incredibly depending on where it is grown. In cooler climates it develops black currant, green bell pepper, mint and cedar flavors. In warm climates it will produce a more jammy taste. In Australia, Cabernet Sauvignon often has a menthol quality.
Traci’s Pick: Champagne
Who doesn’t like a little bubbly on the beach? Or for breakfast? Champagne has a long history of wine making, only it was not sparkling. Being on the trade route from the north to the Mediterranean, champagne if you can imagine, competed with…Burgundy. This competition was furthered with the growth of the medical profession during King Louis XIV’s reign in the 1660s. One doctor “prescribed” the wines of champagne, while others suggested the wines of burgundy. However, Napoleon bolstered its popularity after comments like, “In victory I deserve it, in defeat I need it.”
For the most part, bubbles were seen as a flaw at first. And, contrary to what most people believe, it was not Dom Perignon (the monk) that honed the bottle fermentation process as it predates him by nearly 100 years. Two of the Dom’s greatest contributions were blending grapes for balance and structure and creating the basket press to produce clear wines from dark grapes (like pinot noir).
There are three grapes that primarily make up champagne: chardonnay, pinot noir and pinot Meunier. If you see “blanc de blanc” on the label, it means it’s all Chardonnay (the only “white” grape of the three majors). A top pick for the money: Egly-Ouriet. Also, we’d suggest trying sparkling wine from England if you can find it.
A Collective Catamount Pick: Chardonnay
The versatility of Chardonnay is amazing. Chardonnay is one of the major grape varieties grown worldwide. It is also one of the most popular grapes for drinkers due to its mild flavor and vintners because it is easier to grow than other grapes. The Chardonnay grape originated in the Burgundy region of France. There are many theories about its inception but the most accepted, based on DNA mapping, is that it is a cross between Pinot and Gouais blanc. It is likely that the Romans brought Gouais Blanc from Croatia to Eastern France where it was grown by peasants near where the French upper class grew Pinot, giving the two a chance to mingle.
The taste of Chardonnay is versatile but alone it is fairly neutral. Oaking and “terroir” can produce Chardonnays that taste of pear and apple or have sweet honey or vanilla notes. Cool climate Chardonnays taste of green plum, apple and pear, while those from a warm climate taste more of citrus, peach and melon. In very warm temperatures the grapes give a tropical flavor to wine with the most common notes being those of fig, banana and mango.
Lou’s (Obvious) Pick: Sangiovese
There is no red wine more refreshing when grilling than a bottle from Chianti or, better yet, a Brunello, the “purest” expression of Sangiovese! Historically, Florence was the center of banking for Europe, thus the prominence of families like the Antinoris creating quality vine planting and winemaking. There are eight subzones of Chianti, including Chianti Classico, which was established 1984.
Sangiovese means the Blood of Jupiter and is Italy’s most widely planted grape. Historically in Chianti, Sangiovese was blended with Colorino and / or Canaiolo, but a Brunello needs to be all Sangiovese grosso. With medium acidity and soft tannins, this is just the grape to consume during a hot afternoon with sausages or tomatoes on the grill.
Matt’s Pick: Sauvignon Blanc of the Loire Valley
Sauvignon Blanc is one of the most expressive and recognizable grape varieties thanks to its intense aromatic nature and lively freshness. Due to its popularity, Sauvignon Blanc has spread from France to almost all the wine-producing countries of the world and has found a second home in the Marlborough wine region of New Zealand.
Sauvignon Blanc tends to have a bright yellow color and an intense nose that can differ depending on where the grape is cultivated. It often shows a citrus backbone with green aromas of bell pepper or basil. With a bit of warmth, it develops tropical fruit flavors such as pineapple. In the mouth it is characterized by a good acidity, a light to medium body and medium alcohol content.
One of our favorite regions for the grape is Sancerre, within the Loire Valley of France. Sancerre’s soil specificity is of interest in what it adds to the experience. This area is well endowed with Kimmeridgian clay, a limestone based and highly fossilized clay originating in Kimmeridge, England. This soil can be found from England to Scotland and into Champagne and Burgundy.
In each of the areas where this soil is associated with grape growing and wine making there are a specific series of characteristics which can be found. In Sancerre as well as Chablis, you should find some degree of salinity, or brininess in the wine, along with some level of oyster shell (next time you drink a Sancerre, think oyster shells – trust us!). The wines of Sancerre are in general, made in stainless steel and do no go through malolactic fermentation (give a jingle if you want to discuss further!). These two wine making techniques coupled with an effort to press quickly to insure little to no skin contact are employed to insure the cleanest possible expression of soil and grape.
Runners Up: Riesling from Germany’s Mosel or France’s Alsace, Gruner Veltliner from Austria’s Kremstal, rosé from the Rhone Valley in France and pinot noir from Oregon.
So while swirling that glass of wine as you watch a beautiful sunset, relax on the porch reading a book or start a new series on Netflix in the comfort of air-conditioning, try to think about from where it came and what you enjoy about it. Maybe take a minute to look into the region or the producer to build a better appreciation of what you’re drinking. Like investments, wine should provoke thought and discussion! And understand that a bottle of wine is a bit analogous to a portfolio: the wine’s (or portfolio’s) characteristics are unique to the person experiencing it and there are varying rationales for liking or disliking certain aspects of the wine (or stock!) so keep an open-mind.
Strong Fundamentals Despite A Dwindling Safety Net
Although volatility remains elevated relative to last year, financial markets have stabilized somewhat after a tempestuous February and March. While markets, and riskier assets in general, remain off the highs seen in January, several risks that stirred volatility have largely abated or were misunderstood. As a result, we believe the positive economic and market backdrop will eventually triumph, which keeps us positive on stocks.
Over the last several years, rising asset prices and low volatility began to feel all too normal. Aside from an occasional dip, equity markets seemed to be a one-way bet. That created more anxiety over the market correction that began in early-February. However, by historic standards, that initial decline of nearly 8% in the S&P 500 does not look all that notable. What was remarkable was that, until February, the S&P had not seen even a 5% decline for more than 400 days, surpassing the previous record set in 1996.
We think that much of the market’s movement was due to rekindled inflation fears and concerns that interest rates might rise more swiftly than expected. Additionally, the winding down of quantitative easing globally (the “safety net”) and certain portfolio strategy repositioning created wild movements in the market that lead to the first correction since early-2016.
With that in mind, we’d point out that market “tops” take time to form and, in our opinion, greed is harder to shake-off than fear. Earnings growth remains a key catalyst for equities over bonds and credit. Additionally, rates, the US dollar and wage growth are not yet high enough for an inflection point in corporate profitability, which could be a headwind for risk assets.
We maintain our positive outlook for most equity markets and do not expect bond yields to continue to rise at their recent pace. In fact, yields on government bonds have even leveled out in recent days. Overall, we remain constructive for equities, due to the synchronized global recovery, which we expect to underpin strong earnings growth. Given that until recently, investor sentiment was near record highs, we think that some sort of correction was indeed overdue. For stock pickers, such phases can certainly bring opportunities. And below we lay-out five top ideas as the market digests the “noise.”
A Few Favorites
- Amazon (AMZN): The company has been allowing profit margins to drift higher while still investing in the business which has resulted in further “wallet share gains” as it leads the offline/online retail convergence. Additionally, Amazon has expanded its lead in cloud with AWS and invested in categories such as voice and advertising, which has made it one of (if not the most) forward looking companies out there.
- Bank of America (BAC): Bank of America is one of the world’s largest financial institutions, with ~$2.3 trillion in assets. The company should be a direct beneficiary of continued synchronized global growth, rising interest rates and from a “troika” of confluences from tax reform: accelerating earnings growth from a lower tax rate, improved profitability that can be redeployed for a higher dividend payout and rising deposit growth from taxpayers’ savings which are then loaned out at higher rates.
- Facebook (FB): The company’s reach, targeting and ad-unit quality make it one of the most unique and dominating ad platforms in the world. Yes, there is “noise” and Facebook’s user growth is slowing, but we believe continued improvements to ad targeting and ad units are driving improved ROI for advertisers, which will ultimately lift demand. In addition, the company has incremental growth prospects from Instagram, where monetization likely remains well below the core Facebook platform despite a highly engaging and visual experience, Watch, which increases the potential to capture TV ad dollars, and messaging.
- com (CRM): Salesforce has an impressive track record of execution achieving the $10B revenue run-rate milestone this year with high ambitions to double revenue to $20B as it expands its leading market position in sales force automation tools into a more broadly adopted digital cloud platform that also spans service/support, marketing, commerce and application development. Successful cross-selling and continued share gains could sustain 20% or higher revenue growth, with operating margins (an indication of profitability) can expand 1.0 to 1.5 percentage points a year.
- Visa (V): Visa is a key beneficiary from secular growth across the globe that is leading to strong double-digit underlying revenue growth and 15-20% EPS growth over time. We believe the company is in a situation with several possible catalysts and tailwinds this year, such as tax reform, continued solid spending trends, foreign exchange benefits and further Visa Europe synergies. Additionally, it’s a good play on rising rates, inflation and gas prices.
On March 1, President Trump claimed he would impose stiff steel and aluminum tariffs on imports. This news rattled the market. Trump abruptly proposed tariffs of 25% on steel and 10% on aluminum. He said the tariffs would be put in place the following week. These comments came after a Commerce Department investigation last month determined that imported metal was degrading the US industrial base. US metal manufacturers surged that day, but the rest of the market fell on the prospect of an escalating trade war. There are many facets to this topic that are worth diving into.
Market reaction: Fueled by unfounded inflation fears
The market is heavily driven by the Fed and its interest rate changes. The Fed is largely driven by inflation figures. When investors heard that tariffs might come into effect, it stoked inflationary fears. However, steel and aluminum tariffs would hit only about $40bn to $50bn worth of imports, out of total imports of $2.9 trillion last year – that’s just 1.6%. Commerce Secretary Wilbur Ross also came out with a statement on March 2nd that inflation from the tariffs would be minimal.
Political angle: Fighting for a NAFTA deal
Since then, there has been a lot of discussion on real motives and the likelihood that these tariffs will actually come to pass. While much of the rhetoric has been aimed at China and Russia, a lot of the subtext about this story revolves around the current NAFTA negotiations. As you can see from the graphic below, two of the top 3 steel exporters to the US are our current NAFTA partners: Canada and Mexico. Indeed, on March 6, Treasury Secretary Steven Mnuchin said Mexico and Canada could escape the tariffs if NAFTA gets done.
Source: New York Times
Politics: Tariffs are not great for political parties involved and do not have desired result
Historically, when elections were at stake, tariffs did not work well for the incumbents:
In 2002, George W Bush imposed steel tariffs with a similar thesis. The tariffs exacerbated several issues that they were trying to fix. The US ITC later found that they did not have a positive effect on the industry’s job count. In 2003, the tariffs were repealed after a WTO ruled that the tariffs were illegal.
Since the announcement, Trump has lost some of the support of his party. A cohesive party will be critical as the Republicans are working hard in primaries for upcoming 2018 mid-term elections.
So what now?
Over the last few days the White House has backtracked from some of its statements, offering potential for compromise. Additionally, big investors, like hedge fund billionaire Ray Dalio, have dismissed the rhetoric as just that: rhetoric. With tariffs looking less like a global trade war and more like NAFTA posturing, the market rallied on March 5.
Departure of Cohn
On March 6, Gary Cohn, Trump’s chief economic advisor and former Goldman Sachs COO, announced that he intended to resign. This is the latest in a string of departures from the Trump Administration. Neither Cohn nor the Whitehouse gave specific reasons for the resignation. However, Cohn was seen as a long-time believer in free markets and as a great advocate for Wall Street. Many believe he resigned specifically because of the tariff proposal. Markets opened lower on March 7.
We think the market will ultimately look beyond the rhetoric and jockeying in the near term. We will still see volatility around this topic until it officially plays out, but we remain positive on the market because:
- Earnings growth remains solid and have an upward bias due to tax reform
- A healthy, and accelerating, global macro backdrop
- Positive consumer sentiment
- Rates that are still low relative to historical norms
- A weak dollar
As always, if you have any questions, we are here for you!