2012 Year-End Investment Commentary
Looking forward to 2013
“Saw things clearer, once you, were in my rearview mirror” – Pearl Jam
“It is better to be roughly right, than precisely wrong” – John Maynard Keynes
With 2012 in the history books, it time to take a look backwards at the year that was, and forwards to the year that will be. Obviously the benefit of hindsight makes reflection an easier exercise than forecasting; however, we think this year brought some significant catalysts to the fore which will shape things for the economy and many companies moving forward. In the pages ahead, we will use what we perceive to be the five most meaningful series of charts in order to tell a story about what has happened and how it will impact your portfolios moving forward.
In our 2012 Investment Outlook we used a chart of the market’s long-run P/E ratio in order to outline our case for equities as the place to be investment-wise over the long run. Our case was premised on the following excerpt:
At today’s prices, owners of stocks should think of them more like perpetual bonds with outsized yield, where the annual cash flow yield in percentage terms is the coupon, and any growth from here pure upside. The reason that equities work in this way right now is that good companies generate a certain percentage of their market cap in cash earnings each year. That is called the cash flow yield, where the stock price is the equivalent of the principal in a bond, and the cash flow yield is the equivalent of the interest. The principal yields in perpetuity, or so long as you own the company. Companies can use that cash flow yield in one of three ways: dividend it out to shareholders, conduct share buybacks, or invest in the organic growth of their business.
While the market’s P/E multiple has contributed to more of the market’s appreciation in 2012 than organic earnings growth, the case remains strong for stocks, particularly in relation to bond yields today. While some would take issue with asserting a valuation based on comparables, we think the significance runs far deeper into the fundamentals and we will outline the case using some of the charts ahead. In essence, the crux of our argument relies on the fact that the low interest rate environment has enabled households to delever via lowering their debt burden (without necessarily paying down debts), and for corporations to increase their leverage, without increasing the cost of that leverage.
2012 began with a heightened focus on Europe and ends with Europe largely an afterthought with the Fiscal Cliff here on the tip of everyone’s tongues. We think this is a mistake. Ultimately it’s far easier for catalytic negatives to make headlines than pervasive calm, and as such, the mainstream “story” of Europe’s increasing stability has been lost. On that note, let us begin with our #1 chart chart seriesfor 2012:
Series 1: Europe gets better
Italy 10-year bond yields:
Italy and their substantial long-term budget deficits has been the subject of much consternation over the course of the “Euro-crisis.” In fact, at the end of the day, it wasn’t corruption or solicitation of prostitute charges that brought down embattled Prime Minister Silvio Berlusconi, but rather, the bond yields on the country’s sovereign debt in 2011. This happened despite Italy running a primary surplus on their budget. Yet as you see in this chart, Italy’s bond yields cratered early in 2012, then suffered a mid-year relapse, they continued to settle at levels not seen since 2010-2011 to end the year.
Throughout the year, we argued that it was Europe’s prerogative to escape crisis mode in order to build the enduring infrastructure necessary for stability in a more constructive environment. 2012 was a monumental year with progress on both fronts, and as such, we have allocated an increasing share of your portfolios to the region. One of the factors that gave us conviction on the European region is the immense wealth that’s located even in the “worst” of countries. When seeing this in visual form, it’s increasingly clear how this crisis was borne out of political, rather than economic concerns:
As a result of the improving political situation in Europe, we see that the odds of a break-up of the Euro have declined substantially (with the caveat that Intrade is merely a proxy, not a definitive authority on the true odds of a breakup):
We will caution that this was not without some reservations about the political will necessary to cement in stone the crisis solutions.
As such, we focused on companies who derive a significant portion of their revenues outside the Euro zone. This is something we are very happy with, for high quality European businesses are far more globally oriented than their American brethren, and are an outstanding source of exposure to emerging markets in Asia, Latin America and Africa. Further, in our inquiry into European businesses, we discovered several elements on the corporate governance and capital allocation side which we think offer tangible long-run benefits in contrast to the American way:
a) European businesses pay far better dividends, and do so by targeting payout ratios, rather than gross values. This offers more flexibility to adapt to varying economic environments, and encourages paying out excess cash when it’s there.
b) European businesses that undertake share buybacks actually highlight their buyback progress front-and-center on their investor relations pages. This is in stark contrast to American businesses, which frequently announce buybacks and sometimes never even buy back a single share.
c) European businesses report earnings only twice a year (though some that are dual-listed in the US report quarterly). We find that even amongst those who report quarterly, there is a much more long-term oriented management culture, in contrast to many companies in the US who focus on meeting quarterly thresholds, rather than building long-term shareholder wealth.
Series 2: Household balance sheet improvement accelerates
In our mid-year outlook this past June, we introduced you to a chart labeled “Household Debt Service Payments as a Percent of Disposable Income.” Now is a great time to revisit:
This chart just keeps getting better by the day. Up until June, the vast vast majority of improvement occurred via the reduction in interest rates; however, just this past fall, we shifted even more beneficially towards a double-edged improvement. Right now, disposable income is finally on the rise for the first time since the initial bounceback from recession, AND interest costs continue to plummet as Americans refinance their mortgages. As you can see, debt burdens are as low as they have been throughout the recent past, and they are consistent with levels that have precipitated strong economic booms. While we would caution that risks do remain, this certainly does bode well for the economy moving forward as it increases the balance sheet flexibility of households, and affords more of a cushion should the economy experience another negative shock.
What many fail to acknowledge is that the debt burden is ultimately more important than the gross level of debt, for debt with a 3.5% interest rate is not nearly as harmful as the equivalent amount of debt at an 8% interest rate. But let us take a look at household debt over the long-run:
We are just about near the long-term trend line. Factor in the reduction in gross debt levels, with a low interest rate environment and it’s hard to be as pessimistic about the economy as the press will have you believe. One force we know drives markets over the long-run is the “reversion to mean” whereby certain critical indicators cannot stay elevated (or depressed) in perpetuity, and ultimately return to the normalized level given enough time.
Real estate, the subject of our next chart series, is a major beneficiary of this improvement, but a lesser-discussed area where we see measurable levels of progress is the auto sector. And let us not underestimate the influence of autos on the economy at large. Autos are the largest capital good purchased by households, and over the past few years, consumers didn’t buy nearly enough cars in order to maintain the age and state of the existing stock of vehicles. This calls for a period of catch-up demand in order to replenish and restore, and this is a mean-reversion which has been consistent ever since the mass adoption of the motor vehicle as the primary mode of transportation. Let the charts do the speaking:
We can see that this recent shock to the economy saw car sales plummet well below the scrappage rate, to levels not seen since the late 1970s/early 1980s. Only recently did we get above the break-even level, and this improvement started by real positives, but was accelerated by the damage wrought by Hurricane Sandy. We would argue that the Sandy impact is largely transitory, thus the real improvement should continue to accelerate. This is but one reason why we recently purchased a holding company which owns a large stake in a global automaker.
Thus far however, the improvement in real estate has been much more pronounced than in autos:
Which leads us to our next point…
Series 3: Real Estate, real resurgence
Declining interest rates are no-doubt an important driver for real estate markets. Yet even still, there are other drivers. As we referenced above, markets have important mean-reverting tendencies over the long-run and it just so happens that the bust phase of the boom-bust cycle in real estate has now lasted longer and been more pronounced than the boom phase.
This means that over the past five years of crisis in real estate, there has not been enough new housing built in order to match population growth. One impact of recessions is that household formation slows through a variety of forces, like college graduates living with parents for longer periods of time. These numbers are only now starting to bounce back towards normalized levels.
Further, even college grads who did move out, did not have enough certainty in order to be serious buyers of real estate. This uncertainty stemmed from higher turnover in jobs, as well as a general unease about the economy, thus many who would have bought real estate in years past became renters:
Renting now has taken preference to home ownership, a rare historical occurrence:
Sources: Department of Commerce, U.S. Census Bureau.
Supply and demand are the two driving forces behind price, and right now we have both a tight supply and a growing demand. Housing starts are picking up, and should help boost the supply, but we are only now seeing a pickup in household formation.
Household Formations vs. Single-Unit Housing Starts
Source: Silver Bay Form S-1
And here is just how far off trend this important number has been:
Meanwhile, over the very long-run, prices of real estate tend to correlate pretty tightly to per capita income, and while prices leaped tremendously ahead of that rate during the housing bubble, they now have reverted to, and are moving tightly in conjunction with income. This should provide considerable stability to the real estate market moving forward:
In fact, for those who look for mean-reversion to “overshoot to the downside,” we did see that with house prices, and only now are we back at the per capita income level.
With stability in the housing market, we see this key economic driver shifting from a 5 year drain on GDP to a significant tailwind. Importantly, as those who have bought real estate know all too well, housing comes with an important multiplier force, i.e. people don’t just buy real estate, they buy to support it. New home purchases come with significant needs, ranging from furnishings to installation services, which all employ many people in their own right. This is but one reason the economic slump has been so pronounced in the recent past, and another reason why things look considerably better from here on out.
Now we need to caution: we do not think the real estate market will approach the lofty levels of the prior decade any time soon. There is a strong case to be made for the permanence of some would-be homeowners to renters. Further, there remain a considerable number of underwater homes unsold and waiting to hit market should prices reach their purchase levels. But this is a constructive development overall. Stability in housing provides much stronger footing for economic growth than does rapid escalation in pricing.
Series 4: Energy independence is here
This has been both a political and economic theme for decades. The US has been reliant on international energy for years, and considering the location of global oil supplies in some of the most politically volatile regions, this has caused dangerous price volatility to a key US economic input. We all know this story, but do we all know that 2012 marks the year that it finally breaks down? A key tell of the breakdown is the pronounced spread in the two global benchmarks for energy. In the US, crude oil trades as West Texas Intermediate (WTI) and globally it trades as London Brent. The sources for these two supplies vary, with WTI a domestic supply-base and Brent a global one. This chart shows the spread between the two:
We see pretty clearly how tight this spread has been over time, with Brent trading at a slight discount to WTI more often than not. Recently, this spread has surged, with Brent becoming far more expensive than WTI. Because the US has been an energy importer for so long, we don’t have the requisite infrastructure to export oil, and thus the excess supply created within the US has been driving down domestic prices, without changing the global balance of supply and demand.
Granted, some of this oil supply isn’t purely “domestic,” as it comes from Canada, it is however trapped on the North American continent. Meanwhile, along with the oil boom has come a natural gas boom. This has driven natural gas prices to multi-decade lows, and has created a powerful ripple effect through the economy. During this past election, one of the most manipulated and misunderstood discussions centered around energy, natural gas and coal. Our growing natural gas supplies are the primary reason why coal is in a state of decline. It is not due to any regulatory change:
Abundant supplies and low prices have led to a major shift in capital investment by utilities into producing more energy from natural gas. This makes sense in basic supply and demand. And it’s not just coal that’s suffering as an energy source. The boom in natural gas has hindered the development of alternative energies, and has further helped prevent the new nuclear power-plant development curtailed following the Japanese Earthquake fallout.
The surge in natural gas hasn’t just helped drive down utility energy production, it’s also helped lower the cost of manufacturing and refining in many industries. Natural gas is a key input in industries ranging from fertilizer production to mining to steel production.
Increasing natural gas use by industry has several important positive ripple effects for our economy. The lower cost of energy has been a major force behind making American manufacturing more competitive globally. In fact, while off-shoring was a topic in the presidential election, 2012 saw some major global manufacturers like General Electric and Boeing “re-shore” industry back to the US. It would be great to see re-shore enter the vernacular of economic punditry in the US, and our abundant supplies are proving to be an important catalyst.
We expect to see more such talk during 2013, and more investment in infrastructure through which the US will ultimately become a net exporter, rather than importer of energy in the years ahead. Capital investment in these areas should continue, and provide a beneficial ripple effect for the long-term US outlook.
Series 5: Technology’s technical woes
We are living in the technologicy age, yet for some reason, no sector in the stock market is more unloved than technology. In fact, industrials, perhaps due to the natural gas renaissance in America, are far more loved at the moment:
Source: Business Insider
Meanwhile, Apple the stock has been, and continues to be the only technology story that hits the mainstream media headlines. It’s a sexy story for many reasons, including the untimely passing of Steve Jobs, the company’s resurgence from the brink of extinction, and its status (or already former status) as the largest company by market cap in the world. Yet Apple is only part of the story.
The sorry state of technology is the story that brings this New Year commentary full circle from last year to this. We highlighted the multiple contraction in the broader stock market last year, and nowhere is this more stark than in the technology sector. Sure enough, that trend not only continued this year, it accelerated:
Tech once was a premium sector, with investors willing to pay above-market multiples for decades on-end due to its faster growth rates, and leaner capital requirements. Today, tech is valued just like any other sector, begging the question as to whether it is now nothing but a normal part of the economy (it is) requiring average market multiples (maybe so, maybe not). There are a few forces driving the multiple contraction in tech, two of which we think are pronounced and important: the remaining fallout from the dot.com bust, and the accelerating rates of disruption and obsolescence in and from technological advancement.
We saw this first force of a period of over-investment leading to under-investment in the real estate series above, and we see this second force, disruption, all the time in our everyday lives. Remember the Zach Morris cell phone? Remember your first cell phone? Are you even still using your first smartphone?
But technology is also becoming more normal, and many everyday companies are engaging in what were formerly technology’s core domains to enhance their own businesses. We see this with the internet’s growing share of the total retail market:
Perhaps one force behind tech becoming just another sector in the S&P is that the index itself is increasingly composed of technology companies:
And this is certainly true as well. But we think this effect has been enhanced by the decline of some former stalwarts of technology (like Hewlett-Packard, Dell and Intel) and is embodied by both the rise and fall of Apple this year. There are crucial subdivisions in technology which require varying perspectives, and at no time in history is the case more pronounced for reshuffling or even scrapping the “tech” sector designation altogether.
Hardware companies are prone to one of the most powerful economic forces—direct competition. When a period of disruptive innovation is recently passed (think the iPad), then in hardware in particular, profit margins come under attack as competitors are able to undercut price without asking the consumer to take a substantial hit in the quality and efficacy of the product. Over the long-run, technology hardware in particular has barely above-average returns on invested capital (ROIC):
Yet semiconductors as a tech-subsector have far better ROICs. We think these are two specific sub-divisions in tech that make sense. Computer software and services also enjoy great long-run returns, though labeling gets a bit difficult. For this reason, we would argue that the labels of some traditional technology companies need to be redefined outside of the tech sector altogether, for how is Amazon not a retailer who simply retails via technology, and Google a media company who advertises on the Web, rather than a tech company first? That is how these companies earn their revenues after all. If you see these companies redefined for their relevant sectors, it is clear that you can gain a better understanding of the returns investors should expect over the long-run.
Due to these technical forces driving the technology sector, we have continued our above-average allocation to the sector via high quality companies that have disrupted traditional industries, and in our opinion, should enjoy the benefits of the returns enjoyed by those traditional industries in larger scale. Further, we have added exposure into the semiconductor sector, while largely avoiding traditional hardware altogether, as it’s evident that semiconductor companies can earn higher ROICs over time for good reason.
On to 2013:
2012 has certainly been an interesting year. While 2011 saw decent earnings growth, the market was stagnant. In 2012, we saw decent appreciation in the market, but earnings growth was stagnant. While we can never know for sure what 2013 will bring, we do have a clearer picture of the powerful forces which will drive our economy moving forward.
2012 has been an exciting year of growth at RGA Investment Advisors, with the addition of Elliot Turner to the practice, and the continued development and refinement of our technology platform for our clients. We look forward to the continually evolving our practice for the benefit of all our clients, and to building a happy and prosperous future together.
We wish you and your families the very best in 2013. Thank you for your trust and confidence, and for selecting us to be your advisor of choice. Please call us directly to discuss this in more detail. You can reach Jason or Elliot directly at 516-665-7800. Alternatively, we’ve included our direct dial numbers below.
Wishing you and your family a happy and healthy New Year!
Warm personal regards,
Jason Gilbert, CPA/PFS, CFF
Jason@rgaia.com Elliot Turner, Esq.
Past performance is not necessarily indicative of future results. The views expressed above are those of RGA Investment Advisors LLC (RGA). These views are subject to change at any time based on market and other conditions, and RGA disclaims any responsibility to update such views. Past performance is no guarantee of future results. No forecasts can be guaranteed. These views may not be relied upon as investment advice. The investment process may change over time. The characteristics set forth above are intended as a general illustration of some of the criteria the team considers in selecting securities for the portfolio. Not all investments meet such criteria. In the event that a recommendation for the purchase or sale of any security is presented herein, RGA shall furnish to any person upon request a tabular presentation of: (i) The total number of shares or other units of the security held by RGA or its investment adviser representatives for its own account or for the account of officers, directors, trustees, partners or affiliates of RGA or for discretionary accounts of RGA or its investment adviser representatives, as maintained for clients. (ii) The price or price range at which the securities listed in item (i) were purchased. (iii) The date or range of dates during which the securities listed in response to item (i) were purchased.