WEEKLY ISSUE: Confirming Data Points for Apple and Universal Display

WEEKLY ISSUE: Confirming Data Points for Apple and Universal Display

Key points inside this issue:

  • The Business Roundtable and recent data suggest trade worries are growing.
  • Our price target on Costco Wholesale (COST) shares remains $250.
  • Our price target on Apple (AAPL) and Universal Display (OLED) shares remain $225 and $150, respectively.
  • Changes afoot at S&P, but they still lag our thematic investing approach

 

While investors and the stock market have largely shaken off concerns of a trade war thus far, this week the stakes moved higher. The U.S. initiated the second leg of its tariffs on China, slapping on $200 billion of tariffs on Chinese imports of food ingredients, auto parts, art, chemicals, paper products, apparel, refrigerators, air conditioners, toys, furniture, handbags, and electronics.

China responded, not only by canceling expected trade talks, but by also implementing tariffs of its own to the tune of $60 billion on U.S. exports to China. Those tariffs include medium-sized aircraft, metals, tires, golf clubs, crude oil and liquified natural gas (LNG). Factoring in those latest steps, there are tariffs on nearly half of all U.S. imports from China and over 50% of U.S. export to China.

Should President Trump take the next stated step and put tariffs on an additional $267 billion of products, it would basically cover all U.S. imports from China. In terms of timing, let’s remember that we have the U.S. mid-term elections coming up before too long — and one risk we see here at Tematica is China holding off trade talks until after those elections.

On Monday, the latest Business Roundtable survey found that two-thirds of chief executives believed recent tariffs and future trade tension would have a negative impact on their capital investment decisions over the next six months. Roughly one-third expected no impact on their business, while only 2% forecast a positive effect.

That news echoed the recent September Flash U.S. PMI reading from IHS Markit, which included the following commentary:

“The escalation of trade wars, and the accompanying rise in prices, contributed to a darkening of the outlook, with business expectations for the year ahead dropping sharply during the month. While business activity may rebound after the storms, the drop in optimism suggests the longer term outlook has deteriorated, at least in the sense that growth may have peaked.”

Also found in the IHS Markit report:

“Manufacturers widely noted that trade tariffs had led to higher prices for metals and encouraged the forward purchasing of materials… Future expectations meanwhile fell to the lowest so far in 2018, and the second-lowest in over two years, as optimism deteriorated in both the manufacturing and service sectors.”

As if those growing worries weren’t enough, there has been a continued rise in oil prices as OPEC ruled out any immediate increase in production, the latest round of political intrigue inside the Washington Beltway, the growing spending struggle for the coming Italian government budget and Brexit.

Any of these on their own could lead to a reversal in the CNN Money Fear & Greed Index, which has been hanging out in “Greed” territory for the better part of the last month. Taken together, though, it could lead companies to be conservative in terms of guidance in the soon-to-arrive September quarter earnings season, despite the benefits of tax reform on their businesses and on consumer wallets. In other words, these mounting headwinds could weigh on stocks and lead investors to question growth expectations for the fourth quarter.

What’s more, even though S&P 500 EPS expectations still call for 22% EPS growth in 2018 vs. 2017, we’ve started to see some downward revisions in projections for the September and December quarters, which have softened 2018 EPS estimates to $162.01, down from $162.60 several weeks ago. Not a huge drop, but when looking at the current stock market valuation of 18x expected 2018 EPS, remember those expectations hinge on the S&P 500 group of companies growing their EPS more than 21% year over year in the second half of 2018.

 

Any and all of the above factors could weigh on corporate guidance or just rattle investor’s nerves and likely means a bumpy ride over the ensuing weeks as trade and political headlines heat up. As it stands right now, according to data tabulated from FactSet, heading into September quarter earnings, 74 of 98 companies in the S&P 500 that issued guidance, issued negative guidance marking the highest percentage (76%) since 1Q 2016 and compares to the five year average of 71%.

Not alarmingly high, but still higher than the norm, which means I’ll be paying even closer than usual attention to what is said over the coming weeks ahead of the “official” start to September quarter earnings that is Alcoa’s (AA) results on Oct. 17 and what it means for both the Thematic Leaders and the other positions on the Select List.

 

Today is Fed Day

This afternoon the Fed’s FOMC will break from its September meeting, and it is widely expected to boost interest rates. No surprise there, but given what we’ve seen on the trade front and in hard economic data of late, my attention will be on what is said during the post-meeting press conference and what’s contained in the Fed’s updated economic forecast. The big risk I see in the coming months on the Fed front is should the escalating tariff situation lead to a pick-up in inflation, the Fed could feel it is behind the interest rate hike curve leading to not only a more hawkish tone but a quicker pace of rate hikes than is currently expected.

We here at Tematica have talked quite a bit over consumer debt levels and the recent climb in both oil and gas prices is likely putting some extra squeeze on consumers, especially those that fall into our Middle-Class Squeeze investing theme. Any pick up in Fed rate hikes means higher interest costs for consumers, taking a bigger bite out of disposable income, which means a step up in their effort to stretch spending dollars. Despite its recent sell-off, I continue to see Costco Wholesale (COST) as extremely well positioned to grab more share of those cash-strapped wallets, particularly as it continues to open new warehouse locations.

  • Our price target on Costco Wholesale (COST) shares remains $250.

 

Favorable Apple and Universal Display News

Outside of those positions, we’d note some favorable news for our Apple (AAPL) shares in the last 24 hours. First, the iPhone XS Max OLED display has reclaimed the “Best Smartphone Display” crown for Apple, which in our view augurs well for other smartphone vendors adopting the technology. This is also a good thing for our Universal Display (OLED) shares as organic light emitting diode displays are present in two-thirds of the new iPhone offerings. In addition to Apple and other smartphone vendors adopting the technology, we are also seeing more TV models adoption it as well. We are also starting to see ultra high-end cars include the technology, which means we are at the beginning of a long adoption road into the automotive lighting market. We see this confirming Universal’s view that demand for the technology and its chemicals bottomed during the June quarter. As a reminder, that view includes 2018 revenue guidance of $280 million-$310 million vs. the $99.7 million recorded in the first half of the year.

Second, Apple has partnered with Salesforce (CRM) as part of the latest step in Apple’s move to leverage the iPhone and iPad in the enterprise market. Other partners for this strategy include IBM (IBM), Cisco Systems (CSCO), Accenture (ACN) CDW Corp. (CDW) and Deloitte. I see this as Apple continuing to chip away at the enterprise market, one that it historically has had limited exposure.

  • Our price target on Apple (AAPL) and Universal Display (OLED) shares remain $225 and $150, respectively.

 

Changes afoot at S&P, but they still lag our thematic investing approach

Before we close out this week’s issue, I wanted to address something big that is happening in markets that I suspect most individuals have not focused on. This week, S&P will roll out the largest revision to its Global Industry Classification Standard (GICS) since 1999. Before we dismiss it as yet another piece of Wall Street lingo, it’s important to know that GICS is widely used by portfolio managers and investors to classify companies across 11 sectors. With the inclusion of a new category – Communication Services – it means big changes that can alter an investor’s holdings in a mutual fund or ETF that tracks one of several indices. That shifting of trillions of dollars makes it a pretty big deal on a number of fronts, but it also confirms the shortcomings associated with sector-based investing that we here at Tematica have been calling out for quite some time.

The new GICS category, Communications Services, will replace the Telecom Sector category and include companies that are seen as providing platforms for communication. It will also include companies in the Consumer Discretionary Sector that have been classified in the Media and Internet & Direct Marketing Retail subindustries and some companies from the Information Technology sector. According to S&P, 16 Consumer Discretionary stocks (22% of the sector) will be reclassified as Communications Services as will 7 Information Technology stocks (20% of that sector) as will AT&T (T), Verizon (VZ) and CenturyLink (CTL). Other companies that are folded in include Apple (AAPL), Google (GOOGL), Disney (DIS), Twitter (TWTR), Snap (SNAP), Netflix (NFLX), Comcast (CMCSA), and DISH Network (DISH) among others.

After these maneuverings are complete, it’s estimated Communication services will be the largest category in the S&P 500 at around 10% of the index leaving weightings for the other 11 sectors in a very different place compared to their history. In other words, some 50 companies are moving into this category and out of others. That will have meaningful implications for mutual funds and ETFs that track these various index components and could lead to some extra volatility as investors and management companies make their adjustments. For example, the Technology Select Sector SPDR ETF (XLK), which tracks the S&P Technology Select Sector Index, contained 10 companies among its 74 holdings that are being rechristened as part of Communications Services. It so happens that XLK is one of the two largest sector funds by assets under management – the other one is the Consumer Discretionary Select Sector SPDR Fund (XLY), which had exposure to 16 companies that are moving into Communications Services.

So what are these moves really trying to accomplish?

The simple answer is they taking an out-of-date classification system of 11 sectors – and are attempting to make them more relevant to changes and developments that have occurred over the last 20 years. For example:

  • Was Apple a smartphone company 20 years ago? No.
  • Did Netflix exist 20 years ago? No.
  • Did Amazon have Amazon Prime Video let alone Amazon Prime 20 year ago? No.
  • Was Facebook around back then? Nope. Should it have been in Consumer Discretionary, to begin with alongside McDonald’s (MCD) and Ralph Lauren (RL)? Certainly not.
  • Did Verizon even consider owning Yahoo or AOL in 1999? Probably not.

 

What we’ve seen with these companies and others has been a morphing of their business models as the various economic, technological, psychographic, demographic and other landscapes around them have changed. It’s what they should be doing, and is the basis for our thematic investment approach — the strong companies will adapt to these evolving tailwinds, while others will sadly fall by the wayside.

These changes, however, expose the shortcomings of sector-based investing. Simply viewing the market through a sector lens fails to capture the real world tailwinds and catalysts that are driving structural changes inside industries, forcing companies to adapt. That’s far better captured in thematic investing, which focuses on those changing landscapes and the tailwinds as well as headwinds that arise and are driving not just sales but operating profit inside of companies.

For example, under the new schema, Microsoft (MSFT) will be in the Communications Services category, but the vast majority of its sales and profits are derived from Office. While Disney owns ESPN and is embarking on its own streaming services, both are far from generating the lion’s share of sales and profits. This likely means their movement into Communications Services is cosmetic in nature and could be premature. This echoes recent concern over the recent changes in the S&P 500 and S&P 100 indices, which have been criticized as S&P trying to make them more relevant than actually reflecting their stated investment strategy. For the S&P 500 that is being a market-capitalization-weighted index of the 500 largest U.S. publicly traded companies by market value.

As much as we could find fault with the changes, we can’t help it if those institutions, at their core, stick to their outdated thinking. As I have said before about other companies, change is difficult and takes time. And to be fair, for what they do, S&P is good at it, which is why we use them to calculate the NJCU New Jersey 50 Index as part of my work New Jersey City University.

Is this reclassification to update GICS and corresponding indices a step in the right direction?

It is, but it is more like a half step or even a quarter step. There is far more work to be done to make GICS as relevant as it needs to be, not just in today’s world, but the one we are moving into. For that, I’ll continue to stick with our thematic lens-based approach.

 

The Role of Regulations in the 2008 Financial Crisis

The Unintended Consequences of Regulation and Subsidies

My apologies for the length of this piece, but this is a complex topic and I’ve had a lot of coffee!

In our investment practice, we use tactical asset allocation to vary the mix of assets in a portfolio in response to changing prices, economic and business conditions.  We believe this will both reduce the investment rollercoaster ride and provide opportunities for better returns over time.  We believe that valuation matters most, so we first determine whether an asset class is currently cheap, expensive or fairly priced.  If you pay too much for an investment, all the time in the world won’t fix it, contrary to many popular how-to investment books.  We also believe that we cannot forecast the future, but we can make judgments on whether the macro economic conditions are favorable or unfavorable for a particular asset class and adjust our portfolios accordingly.

Any discussion of investments invariable leads to the broader economy.  Any discussion about the economy invariably leads to politics, as governments have significant influence over the global and domestic economy.  Two of the most impactful tools governments use to impact the economy are regulations and subsidies.

Subsidies distort markets in that they artificially increase demand.  This artificial boost in demand raises prices and pushes the market to allocate more resources, (workers, money, equipment, land etc.) into the subsidized industry than it otherwise would have.  When the subsidy invariably ends, those mis-allocated resources have to go elsewhere, but the shift can take considerable time and be very painful.  In the recent housing crisis, the subsidies discussed later in this piece added a lot of workers to the payrolls of construction firms and induced investments that would have otherwise gone elsewhere.  When it all came crashing down, as it always does, those workers had to find jobs in other industries and investments were lost.

Regulations distort incentives.  Regulations are typically implemented to keep a nation’s citizens safer than is believed they would be under free markets.  This theoretical protection can range from hazardous products to foreign competition or financial irresponsibility.   Without regulations, companies will behave according to their individual views on the opportunities and risks in the marketplace.  Their views and corresponding actions may be contrary to what a regulator or regulation deems appropriate.  However, the unfettered behavior in the free markets, which some may argue is more risky, does tends to create a diversified set of positions, which helps prevent industry-wide failure.  All participants don’t put all their eggs in the same basket as companies tend to follow different tactics to gain a competitive edge.  Regulations are intended to force companies to all behave in a similar manner with respect to the regulated area, so now everyone has their eggs in the same basket.  Thus the industry as a whole may be more vulnerable to systemic changes that are not anticipated by the regulation.

Regulations played a significant, although not widely discussed role in the recent financial crisis.  We watch for these distortions in the market place, among others, and adjust our clients’ portfolios accordingly to both protect from and take advantage of the “bubbles” they can cause.

The recent financial crisis was impacted in a large part by a series of well meaning regulations and subsidies designed to make home ownership more widespread and banks stronger.  When piled on top of each other, the combination created a whopper of unintended consequences.  In order to keep this piece as short as possible, I am only discussing what I believe to be the primary regulations and subsidies involved in the recent financial crisis.  Any omission is in the interest of brevity.  There are other factors involved in the recent crisis, but the ones discussed here are noteworthy and I believe have been overlooked by many.

By subsidizing housing with low cost loans, low down payments, and increased access for sub-prime borrowers, good intentions pushed housing prices into the stratosphere.

Increasing home ownership for low income earners has long been a mission for the Federal Housing Authority.  This sounds like a fantastic goal as what politician would say they don’t want families to own their homes?  The problem is that by subsidizing something, you increase the demand for it by effectively lowering the purchase price.  Increase demand and prices go up!  The Federal Housing Authority (FHA) insured around one million no-down payment mortgages in each fiscal year from 1998 to 2001 (England 2002, 73).

Traditionally non-FHA mortgages required a minimum of 20% down, but in 1994, the Department of Housing and Urban Development (HUD) ordered Fannie Mae and Freddie Mac to supplement and eventually to far surpass the FHA’s efforts, by directing 30% of their mortgages to low-income borrowers, which lead Fannie Mae to introduce 3% down mortgages in 1997.   In 2000, HUD increased the Fannie Mae and Freddie Mac low-income target to 50% of all loans! (Schwartz 2009).  In 2005, HUD increased the target again to 52%.

In 2000, Fannie launched a “ten-year, $2 trillion ‘American Dream Commitment’ to increase home ownership rates among those who previously had been unable to own homes.” (Bergsman 2004).

In 2002 Freddie Mac joined with the “Catch the Dream” program combining “aggressive consumer outreach, education, and new technologies with innovative mortgage products to meet the growing diversity of home buying needs.” (Schwartz 2009)

All these subsidies increased the supply of mortgages to low income homeowners, but what was the source of the money to fund these loans?  Welcome to the Mortgage Backed Security.  Banks would pool together mortgages that could then be sold as a mortgage backed security (MBS).  By doing this, banks could sell off the loans they’d given to homeowners and get more cash for the next set of loans.

In 1997 Bear Stearns completed the first private securitization of subprime loans that had been pulled together by First Union Capital Markets.  Normally a bond, including an MBS, needs to be rated so that investors know how secure the bond is likely to be from default.  This issuance was unrated, but since the mortgages in the pool were guaranteed by Freddie Mac, they produced an” implied AAA rating,” according to a news release from First Union.  So here we have sub-prime loans, meaning loans with a higher likelihood of default, receiving AAA ratings because they are backed by GSEs (Government Sponsored Enterprise).  A collection of subprime loans magically became low-risk because of the GSE backing.  Now that is some powerful fairy dust!

So now we have created a way to turn a pool of sub-prime mortgages into AAA rated bonds.  But why was there such incredible demand for these bonds?  For this we have to look at the Basel Accords and the ratings agencies.

In 1975 the Securities and Exchange Commission effectively conferred the three rating agencies that were then in place, (Moody’s, Fitch and Standard and Poor’s) oligopoly status by ensured that only these three firms were Nationally Recognized Statistical Rating Organizations (NRSROs) and that only an NRSRO’s ratings would fulfill a given regulatory mandate for investment-grade and AAA ratings.   Thus the success of these entities was no longer based upon the quality of their ratings, but rather the government’s protection.  Without government protection, a rating agency who published inaccurate ratings would suffer financially and potentially go out of business entirely.  Thus there was no competition among ratings agencies that could highlight potential weaknesses in their methods of the various agencies.   The 1975 ruling effectively prohibits anyone else from competing with the 3 ratings agencies for the institutional investors’ mandatory business.

We now know that these bonds should not have been receiving such high ratings.  Why did they?  The NRSROs all used models based on historical default data.  Clearly this data was relatively useless for the mortgage environment in the recent decade.  Never before in our nation’s history had government done so much to subsidize housing and never before had so many loans been given out with low or no down payment.  Without skin in the game, a homeowner is much more likely to walk away from a home that is no longer worth the debt on it!  A low or no money down mortgage effectively makes the home “owner” a renter from the bank, and can just walk away if the “rent” to home value becomes less attractive, especially in the non-recourse states.

Plenty of employees at the three ratings agencies criticized their firms’ models for risk assessment of the GSE guaranteed MBS.  If the government protection of the three NRSROs didn’t exist, these employees could have started competing firms and brought to light the errors they perceived in their former employers’ models.  With this protection, no competitor could take advantage of the three agencies’ mistakes and bring differing opinions to the market.

So why was so much of the MBS risk concentrated in the banks? The Basel Accords.

The 1988 Basel Accord required an adequately capitalized commercial bank to maintain at least 8% capital against its assets in reserve.  Reserve requirements have been around for quite a while, but Basel changed the required capital to reflect differences in risk among different types of assets owned by the banks.  Thus an asset deemed to have zero risk of default, such as a US government bond, required no reserve capital.  Commercial loans were given 100% risk weighting, thus required the full 8% capital.  Mortgages in general were given 50% risk, thus for a $100 mortgage, the bank was required to keep $100 * 8% * 50% = $4 in reserves.

Then the magic of AAA rated GSE backed bonds emerged and since Basel assigned a risk rating of only 20% to any issuance by a GSE, which includes Fannie Mae, Freddie Mac, for a $100 AAA rated GSE backed bond, a bank would only have to hold in reserves $100 * 8% * 20% = $1.60.

Here’s the insanity.  A bank issues a mortgage for $100, which would require it to hold $4 in reserves.  If it then sells that mortgage to Fannie or Freddie, then buys it back in the form of a GSE backed MBS, it would only have to hold $1.60.  This reduction is required capital reserves, which increases the bank’s leverage – its borrowing and lending power, and thus increases its potential profitability by a whopping 60%, simply by round-tripping mortgages!

These regulations explain why commercial banks found it so profitable to originate sub-prime mortgages, sell them off to Fannie and Freddie for securitization and buy them back as MBS.  If Fannie and Freddie weren’t there to buy them OR if the Basel Accords didn’t give a discount for a GSE backed securities, things might have played out very differently, despite the Fed’s artificially low interest rates.  It is interesting to note that five days before declaring bankruptcy, Lehman Brothers held a “Tier 1” capital ratio of 11%, almost three times its effective minimum requirement.

Private securitizers such as Bear Sterns, (as opposed to a bank like Wells Fargo) also became heavily involved in subprime securitization in 2002, because 10 years after the 1991 implementation of Basel I, the Federal Reserve, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, and the Office of Thrift Supervision adopted the “Recourse Rule,” which added to Basel I’s assignment of 20% for GSE-issued securities the same risk weight for privately issued asset-backed securities, include MBS that had received a AA or AAA rating from an NRSRO.

Starting at the end of 2006, Basel II adopted a similar rule for the entire developed rule, thus banks anywhere in the world could dramatically reduce their reserve requirements by purchasing GSE issued or AA or AAA asset-backed securities.

So much for the financial crisis being a failure to regulate, unless by that we mean a failure FROM the regulations in place.

Lastly, was it bankers’ greed? 

It is a popular notion these days to blame the crisis on those evil bankers.  Problem with that assessment is if all this was driven by bankers’ insatiable greed, they would have purchased primarily AA ratings.  These provided exactly the same reserve benefits, but produced a higher yield: same benefit, bigger profits.  But they didn’t do that.  Of the $1.323 trillion in MBS held by banks and thrifts in 2008, 93% were either AAA rated or issued by a GSE.  (Acharaya and Schnabl 2009)  Then to get even more safety, the bankers bought additional insurance against these securities in the form of credit default swaps (CDS), again sacrificing profit for security.  There were a good many mistakes made by the banks during the past decade, as in the case of any business, and not all of the banks took the same level of risk, but blaming it all on those greedy bankers is too simplistic.

So what does all this matter to an investor?

As we analyze the markets, we keep in mind the impact regulations and subsidies can have on the economy and are incessantly skeptical when we see bubbles form so that we can both protect and take advantage of the distortions they create.

References:

  • Acharya, Viral V., and Philipp Shnabl. 2009.  “How Banks Played the Leverage Game.” In Acharya and Richardson 2009b.
  • Bergsman, Steve.  2004. “Closing the Gap.” Mortgage Banking (February): 52-29
  • England, Robert Stowe.  2002.  “Giving it 100 Percent.” Mortgage Banking (February): 68-76.
  • Friedman, Jeffrey. 2009. “A Crisis of Politics, Not Economics:  Complexity, Ignorance, and Policy Failure.” Critical Review Volume 21: 127-183.
  • Schwartz, Anna J.  2009.  “Origins of the Financial Market Crisis of 2008.”  Cato Journal 29(1): 19-23.