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Martin Capital Annual Letter: Trump vs. Obama vs. Reagan, 2016 Review, 2017 Outlook

Martin Capital Management 2016 Annual Report, February 14, 2017

2016 Review / Performance:

  • More evidence of an aging bull market in complacency, during which the apprehensions of absolute-return value investors were again elevated because of the generalized absence of fear itself
  • Little attention paid to valuation and tail risks in an economic, financial, and geopolitical environment that might be characterized as the triumph of hope over experience
  • Need assurance that the issues leading to undervaluation are not irreversible or fatal but instead, temporary afflictions from which the company will recover – such is the curse of being a value investor in late-stage bull markets
  • Few bargains got our attention in the oil & gas industry
  • Beyond being unable to find enough truly diversified investment ideas to putt all cash to work in this very expensive market, excess liquidity serves another more subtle purpose
    • Investors may well face wealth-threatening uncertainties today for which a normal frequency distribution is beguiling in its simplicity but dangerously inadequate
    • We do not consider these to be normal times – simply put, if one is going to use the bell curve as the measure risk, it should have pretty fat tails
  • When Black Swans unexpectedly appear, the scramble for liquidity tends to be an equal-opportunity scrum; asset classes that under normal conditions tend to be inversely correlated find themselves moving in the same downward direction under persistent and often panicky selling
    • Though holding cash and sacrificing yield are spurned by virtually everyone, it could prove to be the most potent asset in our portfolio if the winds of popular sentiment unexpectedly change direction

2017 and Beyond:

  • Trump vs. Reagan vs. Obama:
    • Trump’s and Reagan’s election wins saw similar reactions from the market – like Trump rally, in 1980, market celebrated the election of Reagan by advancing 8.9% in November; for the next 21 months, it was all downhill and by 1982, S&P declined 26.7%
      • Any accomplishments that eventually became part of Reagan legacy were overshadowed by recession
      • Importantly, economic contraction was unrelated to any direct action taken by the newly minted Reagan administration; it was an unavoidable response by the Fed to a clear and present danger whose origins can be traced back to 1971 (risk-free rate was 15% and equities traded at 8x earnings to compete with Treasuries)
    • During the last six years of Reagan’s presidency, S&P soared 200% before taking a breather during the Crash of 1987
    • Whereas Reagan began his term on the eve of back-to-back recessions, Obama entered the Oval Office just two months before the end of the worst economic and financial debacle since the Great Depression (took office at the beginning of a cyclical upturn)
      • Obama deserves some credit for standing watch during an economic recovery that has yet to achieve liftoff velocity
      • Obama can thank the elixir of easy money for propelling the S&P to new heights, gaining 166% during his tenure
    • Now in the eighth year of excessive monetary policy, Fed has enabled a bubble in domestic nonfinancial debt borrowed by households; non-financial businesses; federal, state and local governments; as well as in many nonproductive investments it financed
      • In the latest statistical year ending 9/30/16, debt of domestic nonfinancial sectors increased by $2.6 trillion, while GDP gained $450 billion
      • GDP totaled $18.7 trillion, compared with $47 trillion in debt
      • Last year, business debt rose $630 billion while total gross private domestic investment rose just $210 billion
    • Political posturing aside, the expected expansion of debt and deficits could not come at a worse time; it will likely be counterproductive to promoting economic growth and stability
      • The over-indebted economy that Trump is inheriting may stonewall government attempts to finance infrastructure spending by borrowing
    • Whatever real or imagined policy similarities might exist between Reagan and Trump (tax cuts, infrastructure spending, deregulation, pro-growth initiatives), economies they inherit are starkly different
      • What we do know is that Trump will take office after a seven-year bull market during which S&P rose 350%; Reagan’s eight-year presidency began at the end of a secular bear market dating back to 1966
      • Trump rides in on the back of a seven-year economic expansion; Reagan walked into double-digit inflation
      • Trump steps into a market price for perfection with S&P at 20.9x P/E; Reagan inherited S&P price at 8x P/E; bond yields are 2%+ and rising and during Reagan’s, bond yields were 15% and falling
    • We believe it is critically important to know:
      • Which direction and how strongly the economic and financial winds are blowing
      • Whether tail risks, which by nature cannot be handicapped, are more or less prevalent today
      • Whether overall valuation of the market favors buyers or sellers
    • What we will be doing in 2017:
      • First duty is to pay close attention to the companies we already own; constantly on the lookout for warning signs of impending structural change in a company’s profitability or financial stability
      • Careful to always monitor valuation; when market rises to the level where the 5-year expected return falls into the mid-single digits, will likely reduce the position size or sell the holding outright, ideally replacing it with another
      • Since investors are paying high multiples for companies on the mere anticipation of high growth rates, we will take an entirely different tack, thereby avoiding the fallout when projected earnings are missed and P/E ratios follow suit
      • There are many essential consumer products and services companies now “under review”; particularly interested in those not perceived as beneficiaries of Trumponomics, but whose anti-fragile characteristics are likely to stand them in good stead should the tide take an unexpected turn; the absence of bargain price is the only investment variable keeping them out of our portfolio
    • Trump’s proposed initiatives have likely spirited the increase in longer-term rates and given license to Yellen to tighten monetary policy on the assumption that stimulus will shift more toward fiscal policy
      • As dollar rises, both importers and exporters are finding it more difficult to compete on the basis of price
    • Corporate tax cuts will not be the free lunch for shareholders that had been presumed in many industries; rather, benefit of any real reduction in taxes will be indirect – first allowing the companies to be more competitive on the pricing front; if these moves are executed well, it will be the company’s bottom line

Top-Down off the Ground: High Rises, Interest Rates, and the Reality of the Middle Class

  • Since 2010, Manhattan office space is up 340%, suburban office space is up 64%, retail space is up 69%, and commercial real estate is up 87%
    • This is despite a decline in office jobs and pressure on brick-and-mortar retailers
    • GDP has grown only 17% since 2010
  • Since 2010 in the housing market, apartment prices are up 250%, Case-Schiller index for single-family homes has now reached 2007 levels
  • When prices go up without the purchasing power to pay them, prices will fall
  • Ground-level interest rates have driven sky-high asset prices; investors have sought returns anywhere they can regardless of risk: equities, real estate, corporate debt, and even fine art
    • However, it is the middle class that is the engine of our economy – not price of assets
      • Low interest rates have resulted in risky borrowing on the part of many Americans
      • 900% increase in federal student loans since 2007 with default rates already top 11%
      • Auto loans total more than $1 trillion with subprime auto sector with defaults of 10%
    • While S&P makes new high, narrative of public companies serving the middle class is telling a different story: Starbucks, Dollar General, and Casey’s General Store have all described their customers as “under pressure” in recent earnings call
      • If coffee budgets are tight, how much higher can housing prices rise?
    • We’re content to wait until reality reverses the trajectory of current optimism. Then the companies we track, those that have built their businesses like we build our research theses – solidly, on a firm foundation – will be priced to sell, and we will be buying
Image Source: FAZ.NET

 

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