BY ERIC STURDZA
The ongoing shift in the economic narrative and consequent upside has largely been attributed to the potential impact of President Trump’s agenda. However, one has to be cognizant of the fact that the US economy was already gaining traction even before the election and therefore was already poised to generate real GDP growth ahead of the post-recession average.
Hence, on a short term basis, the election’s outcome has helped mitigate downside risks from an already solid starting point and through fiscal policy stimulus, offers the potential to shift the growth trajectory for a number of years. Therefore, (1) the Federal Reserve, (2) economic data releases and (3) the ongoing earnings season were the primary factors to focus on whilst investors await more clarity on the new administration’s various plans of action.
(1) The Fed was obliged to make a significant shift in their risk assessment as they had considered the chances of a unified US government to be slim. Now, with a substantial fiscal package on the cards, there is a commensurate reassessment of the economic outlook. The deflation risk narrative has taken a backseat, but while most Fed members highlighted the upside risks to economic growth from prospective fiscal policy, and close to half incorporated some stimulus in their projections, the changes were in fact minor. For all the noise, the Fed’s forecast for 2017 GDP barely rose (from 1.9-2.2 to 1.9-2.3). Inflation forecasts were also marginally tweaked. Nonetheless, the Investment Adviser believes that once more clarity on the actual fiscal policy framework emerges, the Fed will not only have to reassess growth and inflation projections but also their take on the “correct” policy path to adopt. In other words, the Fed seems to have adopted a “let’s wait and see” stance.
(2) Economic data releases are still supportive:
(a) Consumer confidence is still at cycle highs, household balance sheets are solid, nominal aggregate wages are close to 4% on a year-over-year basis, real personal consumption came in at 2.5% for the 4th quarter of 2016, and the labor market is not showing signs of stress. All these sound fundamentals should keep spending on a healthy track and point toward little downside risk on a short term basis whilst any tax reform could provide a significant boost to the upside.
(b) For the labor market, the January employment report was mixed. From a net new jobs standpoint the report was positive as headcount numbers beat expectations (227k) and the breadth of job gains remained robust. However, in terms of wages and labor market tightening the report wasn’t outstanding. Average hourly earnings came out below expectations (+0.1% month-over-month) and the December figure was revised down from 0.4% to 0.2%. So basically, without the December revision the market would be looking at a negative read for January.
(c) The housing market has met a more skeptic environment due to the recent move in Treasury yields (rising yields are associated with higher mortgage costs). Nonetheless, the Investment Adviser believes that a rising rate environment is not necessarily negative for housing. As long as this process is implemented for the appropriate reasons (such as a better growth outlook) then the improved backdrop could significantly compensate for any rise in mortgage costs. Additionally, the increase in rates needed to make a serious impact on mortgage costs is large, especially when taking into account the fact that ownership cost is low from a historical standpoint.
(d) The December Consumer Price Index (CPI) advanced by 0.3% as expected. Overall, inflation has been close to the Fed’s target but going forward headline inflation will also depend on how energy prices evolve. Given the pronounced move in the forward energy curve since the OPEC meeting, headline inflation seems poised to rise and stay above the 2% target.
(3) For the S&P 500, the 4th quarter of 2016’s earnings season is on track to be the best season in two years for growth. Up to 3rd February 2017, 42% of companies representing over half of market value have reported their results, of which 79% managed to meet or beat consensus estimates. Analyst consensus earnings forecasts for the 4th quarter indicate a +2.2% increase in earnings year-over-year on +4.3% revenue growth. At the moment, stocks that have reported are tracking above those estimates with year-over-year earnings growth at +14.4% on a 6.2% increase in revenues. This represents the best performance since 2014 and is led by technology, financials, and healthcare. Overall, investors remain hard to impress as only companies beating both top and bottom line estimates outperformed the S&P 500. On average, companies that missed their consensus estimates fell by 2%, whilst companies who beat or met estimates went up 0.8%, indicating that, up to now, investors have been more responsive to downside risk over upside gains.
For the Fund, 13 companies or close to 1/3 of the portfolio have published their earnings results with an average top line beat of 2.1%. The most significant beats, defined as the largest upside surprise compared to analyst consensus estimates, were (a) Bank of the Ozarks (OZRK), (b) Union Pacific (UNP), (c) Citrix Systems (CTXS), and (d) Sherwin-Williams (SHW).
(a) OZRK beat both EPS and sales estimates by 2.9% and 5.3% respectively. On a year-over-year basis the company’s earnings per share have grown by 25.8% and sales by 60%. 4th quarter results were marked by better-than-expected non-purchased loan growth, a 12 basis point increase in Net Interest Margin, further improvement in their already pristine credit trends, improved operating efficiency and stronger-than-forecasted profitability. The company is still trading at a discount to peers and taking into consideration its outsized loan growth profile and stronger than peer profitability (19% ROA) combined with the outsized short interest (12.3%) the Investment Adviser continues to see the risk/ reward as positive on this story.
(b) UNP reported revenue of $5.2B and EPS of $1.30 beating estimates by 0.7% and 4.5% respectively. The clean beat mainly came from a better operating ratio and core price deceleration moderating. The company did report a deceleration in its lagging core price metric from 1.5% in the 2nd quarter to 1% in the 3rd quarter which was somewhat already priced in by the market. While it is a preoccupying trend, UNP guided to price above inflation in 2017 which should counterbalance some of the bears. Additionally, the company guided to a better outlook with further margin improvement expected.
(c) CTXS’s results were also good for the 4th quarter as it beat street expectations on revenue, margins and EPS. On the release day the stock was down 4% in the after-market as it seemed many investors may have not fully appreciated management’s usual conservatism as it relates to forward looking statements. Overall, the Investment Adviser continues to believe that CTXS will be able to (1) drive their operating margins higher in the near term and in the longer run possibly even into the high 30s while (2) driving revenue growth at what management guided (3%-4% year-over-year) for core CTXS, and (3) returning much more cash (starting after GoTo spins into LogMeIn) which could also include a dividend. Generally speaking, CTXS has made impressive progress in rationalizing their business and driving both growth and margin improvement over time. The Investment Adviser still believes that CTXS can continue delivering growth in its core virtualization and networking businesses alongside cloud.
(d) Finally, for SHW the 4th quarter report was good and it gave investors two important positive inflection points on both growth and the merger with Valspar. $2.34 EPS came in above consensus of $2.2 and sales of $2.8B was also above expectations. The sales beat was led by stronger than anticipated same store sales comps for paint store and, as expected, management noted that quarter over quarter same store sales improvement was due to the easing of labor constraints. In terms of the Valspar deal, SHW now expects that a divesture is required to gain FTC approval, but the good news is that it will be significantly below the $650M initially announced threshold. Therefore, management announced that it expects to seal the deal at $113 per share for Valspar. So, the Investment Adviser feels that SHW’s solid results, return to robust growth and the confidence management conveyed for the merger to take place not only depicts the strength of this company’s unique moat but also removes an overhang and indicates coming accretion. The cherry on top of the cake here is that SHW offers a great way to play the nascent recovery in construction markets (>70% of sales/EBIT tied to US construction) and the Investment Adviser expects its industry-leading growth, margins, and cash flow generation to continue expanding as construction markets improve due mainly to the high correlation between architectural coatings volumes and existing home sales.
For January the Fund outperformed its benchmark by 0.12%, and yielded a total return of 2.16%. This outperformance can be primarily attributed to sector allocation. The Fund’s overweight in healthcare and underweight in energy helped whilst its stock selection in financials also supported the outperformance. Looking forward, the Investment Adviser is cognizant of the various risks (mentioned in previous reports) but still believes that the Fund is poised for continued outperformance and to deliver above average returns over time as the companies it selects continue to generate superior growth profiles.
The views and statements contained herein are those of the Eric Sturdza Banking Group in their capacity as Investment Advisers to the Fund as of 15/02/2017 and are based on internal research and modelling.