November 20, 2017
Recently Published Articles:
- 3 Bubbles Growing in the U.S. Economy (Updated)
- How to Value Cryptocurrencies (including Bitcoin, Ethereum, etc)
- Share Buybacks: the Good, the Bad, and the Ugly
The stock market continues to be at historically high valuations, surpassed only by the Dotcom Bubble in the late 90’s.
But some sectors are doing better than others, and tax reform can mix up the numbers a bit. Energy stocks, financials, and certain international stocks continue to be reasonably priced.
I still have a considerable domestic equity portion of my portfolio, but increasingly I am using cash-secured puts, international ETFs, and some precious metals investments to hedge and diversify for downside risk.
Tax Reform and Stock Valuations
I wrote about the potential for tax reform and how it may impact investments in the April 2017 newsletter issue, but now that some specific tax reform packages are on the table in the House and Senate, it’s time to have another look at the situation.
Taxation is a politically-charged topic and there are readers from multiple political backgrounds (including over a third of readers from outside the United States), but the viewpoint of this newsletter is simply to focus on how tax changes may quantitatively impact investments and investment strategy.
And for those international readers, changes in U.S. taxation might not affect your personal paychecks but may affect your U.S.-based stocks.
The Corporate Tax Cut (35% to 20%)
One of the key parts of the current House and Senate tax reform proposals is to permanently reduce the federal corporate tax rate from 35% to 20%. This is a big deal, but it’s bigger on paper than it is in reality.
If corporations truly paid a 35% rate, then the potential of tax reform could have a massive effect on after-tax corporate earnings. For example, if a company pays 35% in federal taxes, and that figure is decreased to 20%, that would represent an increase in after-tax income of 23%, since the company keeps 80 cents per dollar earned rather than only 65 cents.
If market valuations were to remain steady and a tax cut of that magnitude were to occur, it would lead to a massive 23% increase in stock prices due to a corresponding 23% surge in earnings per share. Alternatively, if stock prices were to remain where they are now, the price-to-earnings ratio would decrease from over 25 to under 21. The market would suddenly become more reasonably valued, although still a little bit pricey.
The statutory federal tax rate is 35%, but the average rate that profitable US corporations actually pay is already lower than that:
- The Government Accountability Office lists 14% as the effective federal rate for profitable corporations, or 26% for corporations as a whole, which includes unprofitable companies that throw off the numbers.
- The Congressional Budget Office lists the effective corporate tax rate at under 19%.
- The Treasury Department lists the average rate at 22%, which includes both profitable and unprofitable companies.
It’s a complicated topic, and it depends on how you measure it and which companies you include in the analysis. This is because there are various loopholes, tax credits, and other factors that result in effective tax rates that are far lower than the on-paper tax rates.
The current tax reform proposals in Congress do not really simplify the corporate tax code or reduce loopholes, but they do lower the tax rates.
If the effective corporate tax rate drops from let’s say 20% to 10% due to these changes, then companies will get to keep 90 cents on the dollar instead of 80 cents on the dollar, or a 12.5% increase in after-tax income.
Hypothetically, this could boost stock prices by 12.5% (assuming valuation remains constant), or reduce the price-to-earnings ratio of the S&P 500 from over 25 to under 23 (if stock prices remain constant), or something in the middle. It would still be historically expensive based on most metrics at that level.
Here’s the updated cyclically-adjusted price-to-earnings ratio of the S&P 500:
The S&P 500 jumped about 5% during the month after Trump’s election win, which is a sign that investors immediately factored in increased odds of a corporate tax cut and possibly other stimulus policies. And we’ve had a very strong year; the S&P 500 is up over 20% in the last 12 months.
But stock prices have outpaced actual earnings growth, hence the price-to-earnings ratio and cyclically-adjusted price-to-earnings ratio, and virtually every other metric of market valuation, have increased.
The stock market is like a constantly adjusting probability machine. When the odds of tax cuts went up, stock prices surged. When news came out that cast a bit of doubt on it, like when the Senate introduced a tax plan that differed significantly from the House’s tax plan, Wall Street got jittery and stocks dipped for the day.
Goldman Sachs, as one example, set the odds of tax reform passing at 65%. And then, as both parts of Congress began tweaking their tax proposals to figure out how to pass them, Goldman Sachs boosted their odds to 80%.
The impact of tax cuts is already partially factored into the stock market due to probabilities like that.
If tax reform passes, assuming no other factors differ substantially (like signs of a recession, or a North Korean conflict escalation, etc), then a market increase won’t be surprising, because the probability of tax cuts suddenly would become 100%. The stock increase shouldn’t be huge, because the probability would jump from say 65 or 80% to 100%.
However, if tax reform falters and Congress doesn’t pass it on schedule, a market decrease won’t be surprising, because the probability of corporate tax cuts would have suddenly declined from 65% or 80% to some lower figure going into 2018.
But hey, nobody really knows for sure what the market will do in any given scenario. In the short-term, psychology can drive market movements more powerfully than numbers alone can.
I just look at valuations, and focus on allocating assets or buying stocks that offer good returns compared to their valuation. Right now, valuations are very high across the board, except in a few industries.
Tax Repatriation = Share Repurchases
These current tax reform proposals in Congress include a tax repatriation holiday- a temporary tax cut for corporations that bring their international earnings home to the United States.
Many countries have a territorial tax system for corporations, meaning that they only tax their corporations for income earned in their home country. The United States, however, taxes its corporations’ earned income regardless of where in the world they earned it.
The catch is that foreign income is not taxed until it’s brought home. So if Apple sells a bunch of iPhones in China, they don’t pay U.S. federal taxes on that cash until they bring that cash back to the United States. As long as they keep it international, they can reinvest it or just hold it in cash and not be taxed yet.
This creates an awkward incentive for U.S. corporations to never bring cash home. So, tax repatriation holidays try to fix that by offering corporations a one-time low tax rate for any foreign income they bring home right now. Like a Black Friday tax sale.
The last time we had a repatriation tax holiday was in 2004. When that happened, American corporations brought $300+ billion home to the U.S., and mostly used it for dividends and share repurchases. Half of all the money was brought back by just 15 large companies, and they cut a total of 20,000 net jobs in 2005-2006 despite that windfall. Over 90% of cash brought back home went to shareholders as dividends and buybacks.
It’s not as though companies don’t have any excess cash to invest and expand- they’re already using excess cash to pay for share repurchases and such. They’ve already done the analysis to determine how much money to invest in growth over the next few years, based on estimates of the returns they expect to achieve on those investments, and are returning the excess money to shareholders.
So if they get tax cuts or are able to bring money home at a lower tax rate, it’ll mostly just boost how much money they can pay in dividends and buybacks again, and have a negligible effect on expansion or R&D activity or domestic job growth per se. Profitable large U.S. corporations are not strained by capital- they have all the capital they want already. Their goal is to figure out how to allocate the billions in dollars of capital they do have for the best returns possible.
That being said, from an investment standpoint I generally like share repurchases, at least when they are done correctly and at the right price and not at the expense of gaining market share in their primary areas of business.
Marketwatch has a list of the top 5 companies that currently have the most money stashed abroad:
- Apple: $230 billion
- Microsoft: $113 billion
- Cisco: $62 billion
- Alphabet (Google): $49 billion
- Oracle: $52 billion
The top five are all blue-chip tech companies. And all of them except Alphabet are already spending billions of dollars per year on share repurchases and reducing their share counts. If they can bring money home, it’ll increase how much money they can spend on share repurchases.
It might make those names temporarily more attractive.
I’m reasonably bullish on all five of them already to varying degrees, let alone any extra share buyback windfall they may get from a temporary tax repatriation holiday and permanent domestic corporate tax cuts.
Stocks I Like Right Now
It’s tough to find good companies trading at attractive prices in this type of highly-valued market. That’s why I’m investing a lot with cash-secured puts at this stage of the market cycle, to decrease my downside risk a bit and generate returns and income even if the market should go sideways for a while.
That being said, I’m highlighting these picks this month as stocks I wouldn’t mind owning and holding at current prices. Always do your own due diligence on individually-selected stocks.
Starbucks Corporation (SBUX)
Starbucks is encountering growing pains as it is transitioning from a fast-growth company to a blue-chip dividend payer that happens to still have significant growth. They issued fourth-quarter results earlier this month, and the news was mixed.
On one hand, the company lowered its long-term EPS growth target from 15-20% per year to at least 12% per year.
But on the other hand, they continue to report extremely strong growth in China and excellent returns on invested capital throughout their business, a much-needed consolidation effort in their tea brands, and a big increase in the amount of money they plan to give back to shareholders as dividends and share repurchases, including a 20% increase of the quarterly dividend.
Last week, I wrote an article on Starbucks on Modest Money, so rather than repeat everything here I’ll refer to that.
The summary is that the stock is expensive, but the price is justified by expected growth. It may continue to trade sideways for a while, but over the long-term I think it’s decent at these prices, at least compared to the other stocks I see out in the market right now.
It’s not a screaming buy but I think it’s a fairly conservative pick in the mid-$50’s, and positioned for decent risk-adjusted returns going forward. The company’s revenue and net income held up very well in the previous recession and I expect it to continue to perform profitably during the next one.
Discover Financial (DFS) & Synchrony Financial (SYF)
I’m bullish on both of these banks over the long-term at current prices, but it’ll be a bumpy ride.
Both of them operate lean online banks to acquire deposits, and then use that money to offer credit card lending. From there, they are different.
Discover operates its own payment network, and is known for exceptional customer service compared to all other card brands. They also make personal loans and private student loans to consumers with high credit scores, and have a conservative underwriting strategy. The CEO David Nelms has been at the helm for 13 years and guided the company through the 2008 financial crisis, during which time Discover held up better than most other financial institutions. You can read my full analysis of Discover here.
Synchrony was spun off from GE Capital a few years back, and provides a huge number of store cards to retailers. When you get an Amazon, Lowe’s, Walmart, Paypal, or other store card, it’s probably issued by Synchrony in partnership with that retailer. They’ve done a great job of partnering with online retailers and payment solutions, and they also offer Care Credit, which lends to consumers for healthcare needs. I wrote about Synchrony in more detail here.
Discover trades at a price-to-earnings ratio of about 11, and Synchrony trades at a price-to-earnings ratio of about 13. Both of them are growing their loan portfolios, both of them pay dividends, and both of them are buying back large numbers of cheap shares to boost earnings-per-share and dividends-per-share.
The reason they are so cheap is that credit card lenders have the biggest loan loss rates during recessions, compared to mortgage lenders and other types of banks.
Here is the most important chart of the 2017 Dodd-Frank Act Stress Test report on key banks, and something all bank investors should be familiar with:
Source: U.S. Federal Reserve
The chart shows the percent of their total loans that various financial institutions are expected to lose should we encounter a recession as bad as the 2008 one, including these specific criteria:
- The unemployment rate goes up to 10%
- GDP falls by 6.5% from its pre-recession peak
- Equity prices fall 50%
- Residential real estate prices fall 25%
- Commercial real estate prices fall 35%
- International developed markets also face severe economic recessions
Custodian banks like Mellon and State Street are at the low end of projected losses. Mortgage lenders like Wells Fargo and Bank of America are in the middle. Credit card lenders like American Express, Discover, and Capital One are on the high end of projected losses, with Discover topping the list at 13%.
Synchrony is not listed there, but their expected loan loss rates are even higher at 20%.
In other words, the loan portfolios of Discover and Synchrony will likely get slammed in a recession. This is not because they are sloppy underwriters, but rather because of the industry the operate in. The average Discover cardholder has a great credit score, and Discover has very conservative underwriting standards and lower credit card loan loss rates than just about any other bank. But because their portfolio is so concentrated in credit cards, they’ll get hit harder anyway. In exchange, they earn much higher returns on equity during good times.
The thing is, these stress tests are done to ensure that banks are well-capitalized enough to withstand these types of hits. Discover and Synchrony have more cash on hand as a percentage of assets than most other banks on the list, which is their defense against such large projected loss rates. As such, they pass the stress test just as well as banks with more conservative assets like mortgages. The more volatile the loans are projected to be, the less leverage and higher reserves the bank needs to have to balance that fact out.
But, there’s a good chance that Synchrony and Discover will be scarier and their stock prices more volatile when we have a recession compared to more conservative banks, despite the fact that they are financially solid. They have extra cash on hand, and they are trading a lower valuations, both of which provide a buffer against economic downturns.
Most investors fear volatility. For those that don’t mind volatility and focus on long-term returns, these two banks are well-positioned to offer that in my opinion. They have higher volatility but also higher profitability. I personally prefer Discover for overall risk-adjusted return potential, although Synchrony might offer slightly higher absolute returns.
A key piece of monitoring the risk of these companies is to pay attention to overall consumer debt and specifically credit card debt.
Here’s the current chart of how much credit card debt U.S. consumers have:
We are now up to the same level of credit card debt as in 2008. However, the country’s GDP is almost 30% higher now than it was then, and we’ve had considerable inflation and population growth over this past decade.
So, inflation-adjusted and per-capita credit card debt is much lower now than it was back when Americans became overleveraged in 2007 and 2008. We’re still in decent shape here.
To highlight that, here’s a chart of household debt as a percentage of GDP:
United States household debt as a percentage of GDP peaked at almost 100% prior to and during the recession and has since been reduced to about 80%.
There are some areas of lending I’m wary about. Auto loans, for example, have risen quickly over the past decade, so there’s more leverage there than ever before. And student loans have increased even more dramatically.
But when it comes to credit card debt and overall debt, Americans are in better shape than they were before the prior recession.
Precious Metals ETFs (SLV and GLD)
In contrast to U.S. stocks that are historically overvalued by most metrics right now, gold is moderately valued relative to its inflation-adjusted history, and silver is somewhat undervalued relative to both its historical inflation-adjusted price and in its price ratio to gold.
The ETFs GLD and SLV are decent ways to get exposure to these metals.
I don’t care to predict short-term movements in the prices of these metals, but instead I use them in a specific way to generate investment income from them. It helps diversify a small portion of my net worth away from equities and bonds while also paying decent income.
For example, I hold exposure to silver through the SLV ETF, and use covered call options to receive about 5%-6% cash per year on those holdings (kind of like dividends) as I wait for it to eventually go up in price, however long that may take. If it decreases in price, I’ll increase my exposure a bit.
My Personal Portfolio Updates
In addition to holding a diversified set of automatically re-balancing index funds in my primary account (domestic stocks, foreign stocks, and bonds), I hold these investments in my other accounts:
I manage all of my accounts and monitor my net worth by using the free tool from Personal Capital, which makes everything easy.
Changes since the previous issue:
-My previous cash-secured puts on Discover Financial Services at a strike price of $60 expired profitably as the stock rose in price, so I reinvested that capital to sell more puts at a strike price of $62.50 for a few months later.
-Microsoft and Texas Instruments both surged very high in share price, meaning that the cash-secured puts I sold on them months ago had become very profitable and were at a strike price so far below current market prices that it no longer made sense to keep them active until expiration, and so I bought them back at pennies to the dollar, for a nice gain. I then used that capital to sell cash-secured puts for Intel and Starbucks. And I invested new money to sell puts on Synchrony Financial, albeit at a half-sized position compared to my Discover stake.
Virtual ETF Portfolio Updates
Each newsletter for fun, I update a virtual ETF portfolio.
It takes about 5 minutes per month to manage, and helps show where I think value is in the market without focusing on individual securities.
You can see the previous version from the October issue here.
For reference, the S&P 500 is at 2,578.85 and the S&P 500 TR is at 5,017.45.
Changes since the previous issue:
The 11/17/2017 $122 put on GLD expired out of the money for a profitable gain, so I’m selling another cash-secured put at $122 for 3/16/2018 for the Monday morning bid price of $2.30/share in option income.
I get a lot of email questions about investing in cryptocurrencies, like Bitcoin, so I recently wrote an article on the topic of how to approach valuing them and what some of the main risks are. (Short version: there’s a lot of risk).
I also wrote about share buybacks, including the pros and cons of that form of capital allocation. The summary is that they can be a great source of returns as long as a) company management takes a long-term view with company performance, b) they only buy back shares at reasonable prices, and c) they don’t rely too heavily on share repurchases to the extent that they sacrifice market share and real growth. Some industries are better served by buybacks than others.
I’ll be traveling in southeast Asia throughout December so I plan to publish my next newsletter issue in January. I hope all readers have a happy Thanksgiving, merry Christmas, and safe holidays!