A Christmas tree story
January 21, 2018
Market Summary – 4th Quarter, 2017
“Someone’s sitting in the shade today because someone planted a tree a long time ago.”
There are many enduring holiday traditions. Whether it’s watching the 1983 film, A Christmas Story, about a boy’s pursuit of a Red Ryder model air rifle or seeking out the news reports of the frenetic race by shoppers to secure that year’s version of the “hot toy.”
This holiday season included an unusual development that was not centered on scarcity of a specific toy. Instead, we saw numerous reports of a notable shortage of one of the most iconic symbols of the holiday season – Christmas trees. The source of the dwindling supply of trees may well date back a decade, to the onset of the financial crisis and Great Recession. Stressed-out consumers cut back on discretionary spending – tree purchases included. Short-sighted tree farmers mistakenly extrapolated this anomaly into a long-term secular trend, and scaled back their plantings. With the typical growing cycle for Christmas trees lasting about ten years, there were too few mature trees to meet the demand in the 2017 season.
Why does all of this matter to investors? The tree shortage (and significant inflation of tree prices) provides a cautionary tale for those who put their money to work in the markets. Investors often forget that patience is fundamental to long-term success, and base too many decisions on immediate influences in the markets and the day’s headlines. They have a tendency to react in the moment, rather than looking further into the future. To put it another way, they can’t see the forest for the trees.
Forgetting history and doubting the future
Some tree growers, who should have known better, lost faith in the future of their businesses when they reduced plantings in 2007 and 2008. By contrast, the subsequent rise in Christmas tree prices led to a windfall for growers who remained steadfast and disciplined in their planting regimen. This is not unlike the principles that drive sound value investing – it is profitable over time, but not all of the time. Even the most successful business and investment strategies can suffer temporary periods of weakness. Investors who understand value realize that they are often buying stocks that are viewed as unattractive by the broader market at the moment. We believe that ultimate success is centered on shrewd number crunching and savvy investment selection, and is eventually accomplished by maintaining a steadfast investment approach.
The current investment environment offers striking parallels to what happened to Christmas tree growers. Many investors have been too skeptical about their ability to generate wealth in a volatile geopolitical environment and a long-running bull market. They’ve also become accustomed to a world characterized by muted economic growth. As recently as fall of 2016, annualized growth in U.S. Real Gross Domestic Product averaged just two percent since the economy bottomed out in June 2009. This is the slowest improvement for any economic expansion since World War II1. This created an environment of skepticism, as some investors became convinced that the U.S. economy would never regain its past luster – again failing to see the forest for the trees. From where we stand, the outlook is far more promising – provided you maintain patience.
It’s not just trees that are in short supply
Just as many were surprised to learn of the dearth of Christmas trees, a number of investors are just learning the tale of the incredible shrinking stock market. While stock values have soared, the supply of publicly traded companies has dropped nearly in half in the past two decades. There were over 7,300 domestic companies listed on U.S. exchanges in 1996; today there are fewer than 3,700.2 Some of this is due to mergers and acquisitions, while some companies have been taken private. Meanwhile, many startups and privately held companies have foregone initial public offerings for a variety of reasons, including the availability of private capital, what many view as onerous regulatory requirements for public companies, and the reduced control that comes from selling your business to the public.
There’s even more to this story. As companies have stockpiled cash in an era of rising profits, many are put- ting that cash to work through share buybacks. Creating a scarcity of available shares can, in many cases, contribute to the rising value of these stocks. Within MPMG’s portfolio alone, some prominent firms have significantly reduced their shares outstanding.
The newly enacted cut in the corporate tax rate, from 35% to 21%, can create an even bigger stash of profits for already cash-rich U.S. corporations. It is likely that some of that money will be used for more share buybacks, further reducing the supply of stocks available to investors. The simple economic laws that apply to Christmas trees also come into play here. As the supply shrinks but demand holds steady or rises, stock prices are likely to rise. In addition, with growing earnings spread over fewer shares outstanding, the earnings per share (EPS) will also improve. This should, in our judgment, lead to higher stock prices.
Strength in numbers
A strong economy should be a tailwind for corporate earnings. Some pundits argue that there can’t be much steam left in the current economic expansion, which is now in its ninth year. However, it’s possible that the economy may actually be gaining momentum. We won’t know for certain until economic data for the 4th quarter of 2017 is released in late January, but we may be experiencing the first “back-to-back-to-back” quarters of 3%+ growth in real Gross Domestic Product (GDP) since 2003. The unemployment rate, at 4.1%, is at its lowest levels since in the 1950s.3 Consumer confidence indicators are the highest we’ve seen since 2000.4 In short, the economy is stronger than many realize.
We believe that improved earnings were the primary driver of the strong stock market in 2017. According to S&P, 2017 earnings are expected to grow by 18% compared to the previous year. They are projected to grow at a comparable rate again in 2018 – and in all likelihood, these 2018 figures do not fully capture the earnings boost to be received from recently enacted tax reform.
Skeptical investors need to adjust their expectations and position themselves for the “long game,” which we assert is ultimately the key to being in a position to put more presents under the Christmas tree, as well as more gelt to spin the dreidels for. Just as was the case in 2017, continued improvement in corporate earnings can be a trigger for the stock market to extend its bull run through 2018 and beyond.
What worked before may not work so well going forward
Part of the fallout from continued economic improvement is that it could create more inflationary pressures, particularly if the low unemployment rate helps drive wages higher. As concerns about inflation mount, it will likely be reflected in rising interest rates – creating challenges for the bond market and bond proxies in the stock market.
This should represent an inflection point that truly marks the end of what has been a 35-year bull market in bonds. Certain stock market sectors, such as utilities and consumer staples, are similarly susceptible to the negative impact of rising rates. Measured on a weekly basis since 2010, the yield on 10-year Treasury bonds rose in less than half of those weeks. Yet in the weeks when the 10- year Treasury yield moved higher, utility and consumer staple stocks performed miserably (-36.3% and -24.5% respectively). By contrast, financial, technology, materials and industrial stocks generated positive, sometimes impressive performance during those same periods.3 Savvy investors need to position their portfolios for the possibility of these changes.
The bond market has another strike against it – the Federal Reserve’s continued pullback from its active bond-buying initiative known as Quantitative Easing. The Fed’s significant investment in the bond market helped keep interest rates in check, reflate asset prices, and grow the economy. The Fed is now scaling back its balance sheet of bond holdings, leaving the fate of interest rates in the hands of more traditional investors. At the same time, the projected rise in the federal deficit due to the tax bill will likely result in increased issuance of government debt. The issuance of additional bonds may push rates even higher.
Where we’ve been – a review of 2017
As we wish all of our clients a healthy and prosperous 2018, we also take this opportunity to reflect on observations we shared in our newsletters over the past year:
- In our first quarter letter (“I’m Not Emotional…I Just Have a Feeling!”), we focused on the fact that investors could easily lose sight of the fundamentals of investing in a distracting political environment. The active news cycle of the past year could easily have preoccupied investors and readily convinced some that there was more risk in the market than what was reflected in the improving economic environment. We recommended that successful investors with an eye toward value not lose sight of the fact that what matters most are long-term results, and that they should avoid getting sidetracked by the constant din of noise inside and outside of the markets.
- Our second quarter letter (“The Madness of Crowds”) revisited some of the more notable examples of investment “bubbles” in history. We suggested that the latest bubble was likely to be in various forms of passive investing (such as index funds and ETFs). We pointed out that investors who settled for a passive approach to the market were prone to paying too high a price for too many stocks represented in the indices they follow. The downside risk of paying too much for a stock is significant. The way to avoid that risk is to take a more selective approach that focuses on value. Even as we approach the start of the 10th year of the bull market, we noted that good values still exist, and finding them is more critical than ever to overcome the risks that exist in the market.
- In the third quarter (“Patience…is…a…Virtue”), we explored the idea that many were on an endless search for the so-called “secret sauce” of investing. We suggested that above all else, what is needed to succeed as an investor is patience. If all other aspects of the investment process are executed properly (i.e., paying the right price), investors are likely to ultimately prevail. However, we noted that there are temporary periods when even the best-intended strategies will be out of favor. Markets are unpredictable in the short term, but the patient pursuit of an effective long-term strategy will likely be rewarded.
Planting the seeds
2018 begins with markets at lofty levels, though it hardly could be described as a euphoric environment. Still, the key market indicators set record after record throughout the past year. Some may wonder whether that can continue. But to us, this is not the critical question when it comes to long-term wealth building.
As we stated in our last letter, anything can happen in the short term. While many investment firms and market prognosticators will make predictions about what type of return the S&P 500 will generate in 2018, these represent little more than guesses. Just as many Christmas tree farmers guessed wrong a decade ago, and failed to plant sufficient supplies, investors don’t want to be caught in a guessing game based on short-term expectations.
The economic underpinnings look more favorable today than they have in some time. Growth in the U.S. economy exceeded expectations in 2017. The global economy is enjoying synchronized expansion for the first time since the Great Recession. Now, the tax reform package is likely to further bolster the environment for corporate profits and equities in general.
No matter what happens, maintaining an investment approach grounded in sound principles is as important as ever. This is not a time, like the boy in A Christmas Story and his dogged pursuit of the Red Ryder rifle, to put all of your energies into grabbing that one, highly-desired stock or sector that everyone is chasing. Selectivity will continue to be paramount.
MPMG IN-HOUSE NEWS
MPMG is pleased to announce that Mikalen (“Mikki”) Prince has joined MPMG as a Marketing and Operations Associate. Prior to joining MPMG in November, Mikki worked at Oppidan Investment Company. She grew up in Chanhassen, MN, and is a graduate of Iowa State University (BA, Marketing and Advertising). Though she has only been with MPMG for a short time, Mikki has already proven to be a valuable addition with her technical know-how, engaging personality, and attention to detail. We are confident that our clients will love working with her. Please feel free to say hello to our newest team member the next time that you call.
Established in 1995, Minneapolis Portfolio Management Group, LLC actively manages separate accounts for individuals, families, trusts, retirement funds, and institutions. Our proven value-oriented investment philosophy has created long-term wealth for our clients.
Visit our website at: www.MPMGLLC.com
Although the information in this document has been carefully prepared and is believed to be accurate as of the date of publication, it has not been independently verified as to its accuracy or completeness. Information and data included in this document are subject to change based on market and other condition. All prices mentioned above are as of the close of business on the last day of the quarter unless otherwise noted. Market returns discussed in this letter are total returns (including reinvestment of dividends) unless otherwise noted.
The information in this document should not be considered a recommendation to purchase any particular security. There is no assurance that any of the securities noted will be in, or remain in, an account portfolio at the time you receive this document. It should not be assumed that any of the holdings discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable. The past performance of investments made by MPMG does not guarantee the success of MPMG’s future investments. As with any investment, there can be no assurance that MPMG’s investment objective will be achieved or that an investor will not lose a portion or all of its investment.