The Dividend Cafe - What To Make of Earnings Growth?

Episode Date: March 8, 2019

Topics discussed: Earnings Valuations Tell the Tale The Emerging Case for Emerging Markets European Stimulus or Something Else? Links mentioned in this episode: DividendCafe.com TheBahnsenGroup.com

Welcome to the Dividend Cafe, financial food for thought. Hello and welcome to this week's Dividend Cafe podcast. This is David Bonson. I'm the Chief Investment Officer of the Bonson Group. We're bringing you our kind of weekly market commentary. We hope you are subscribing to this here podcast. It's only about 10 minutes a week. You are more than welcome to share it, review it, subscribe to it, say good things about us, whatever you like to do. We certainly appreciate that if you're so

inclined. But in the meantime, I'm going to just kind of go through our written DividendCafe.com entry, the weekly commentary, and some of the things I'm going to elaborate on for you, our podcast listeners, and a few things I'll have to peel back because they're sort of visual, graphic, chart-driven. It'll be a little harder to communicate via podcast. Let me first just kind of allude to what's gone on in markets this week. They've definitely cooled off a bit, nothing meaningful, but just kind of a slow drip of barely negative days. Although, you know, as I'm sitting here recording, we're down a couple hundred points on Thursday

and that could very well accelerate, become worse through the rest of the day, Thursday or into Friday. But so far, we're on track for the first negative week in quite some time, and it's not at all unexpected. We're in that stretch of time where one's quarterly earnings season is behind us, and the next quarter is not here yet. And so we have the Fed on the sidelines. And there's just not a lot of newsmaking action that drives markets. We need to look at fears around earnings growth today.

We're going to unpack that topic. And I'll try to give you a little recap of markets year to date and what's hot, what's not, all those fun things. So let's jump into the Dividend Cafe. Let's talk earnings growth to start things off. Q4's earnings season is now essentially wrapped, and it was obviously being reported on through the middle of Q1. quarter in which S&P earnings were up 14%, meaning fourth quarter 2018 earnings up 14% over fourth quarter of 2017. The revenue for the quarter was up 7% year over year, which is below the 9.7% that the rest of 2018 saw, but still a robust revenue top line growth as well, which as I pointed out countless times, cannot be attributed simply to tax reform. What's getting a lot of attention is not the results of the earnings season we just had,

but the results of the earnings season we will soon have. Companies projected their Q1 earnings downward enough that many now expect earnings growth will be slightly negative for the quarter versus the same quarter last year. But interestingly, revenues are still projected to be up about 5.5% in Q1 versus last year's Q1. So for earnings growth to go negative, we are talking about a pretty significant decline in margins. growth to go negative, we are talking about a pretty significant decline in margins. Full year, I see earnings likely coming in around $162 a share for all of 2018, and projections are now down to about $168 or $169 a share out of the S&P 500 for all of 2019. So we're still talking about an up year in earnings growth, but maybe just around a 4% annual clip. Now, I can easily see that expectation of $169 earnings coming down further,

and that would likely serve the purpose of allowing companies to lower expectations so they can outperform results later. But I would make two comments on this, and this is important. But I would make two comments on this, and this is important. It's hard to believe that the P.E. ratio of the overall market expands much if the growth of earnings for the overall index is declining or flattening. So to the extent that one strategy is heavily dependent on multiple expansion, a higher P.E. ratio, it makes sense to wonder if market prices have a lot of the juice one is expecting already baked in. And then number two, that said, it's inconceivable to me that one would formulate their investment strategy right now around multiple expansion. Earnings growth is, in my opinion, likely to end up outperforming the new round of pessimism around such, but underperform last year's excessive optimism around such. Our philosophy is not to speculate on what the entire broad market may deliver in earnings growth in the aggregate, and especially not in earnings valuation, but rather on the bottom-up dividend growth of

individual well-run companies. That changes the conversation entirely, as the conversation has always changed for the better when one chooses to focus on what can be known, studied, and understood versus what is inerrantly unknowable and unpredictable. Now let's talk about the state of valuations. What has this two-month rally in stocks done to valuations? rally in stocks done to valuations. The S&P 500 now trades at 17.1 times the last 12 months of earnings, and it trades at 16.1 times the next 12 months of forecasted earnings. The price to book value is 3.3 times, which is versus an average of about 2.7. And these metrics are all more attractive than they have been the last couple of years, but they're certainly well off their low levels of Q4 2018. So where do we go from here? Earnings valuations are a reflection of what is anticipated

a reflection of what is anticipated from earnings in the future. For earnings to grow further at this point in the cycle, continued revenue growth is needed and greater productivity is needed to drive profit margins higher. Both top line revenue growth and greater productivity are reliant on continued growth and business investment. The GDP numbers released last week for Q4 2018 were not just significant in that they reflected a real annualized growth number of 2.6 percent, enough to maintain a full year 2018 number above three percent real GDP growth, but they were also significant in that they reflected a really robust growth in business investment in Q4. And longtime readers and listeners know that is what our primary focus is right now, is seeing the capital expenditures out of non-residential fixed investment go higher. I have a chart breaking this down for you from Q4 in the new Dividend Cafe.

If you believe in omens, and I don't, by the way, it may be interesting for you to know there have been 30 times since the Great Depression that the market was up in both January and February. And in 30 out of 30 times, the market ended the year up. 26 times, the return was actually double digit. The average return is actually over 20%. So I'm going to say it, even though I hope it doesn't need to be said. Does that 30 for 30 mean that there will be 31 for 31? Of course not. We don't know.

But I'll share the omen anyways. February specifics, the energy sector and the industrial sector led the pack. They lead the pack year to date in the stock market. Each are up roughly about 16% coming into March. The consumer staples and healthcare sectors are the laggards at only 7.5% return. Keep in mind it was health care that led the way in 2018. In the bond market, high yield is on fire. Of course, it is a far more equity-like asset class than bond-like, but they have a roughly 6% year-to-date return in the high yield bond index.

Floating rate bank loans are just behind, up about 3.75%. Investment-grade corporate bonds are also up nicely on the year as spreads have tightened. They're up about 2% in the first couple months. So spread product has been the winner year to date, though even more conventional bonds are also positive on the year. Around the world in developed markets, the debt divided by earnings has risen to 1.5 times. That's not excessive. It's certainly higher than it was nine years ago. But in emerging markets, debt divided by earnings, debt divided by EBITDA, has been reduced to just 0.8 times, the lowest level in years. Total world debt in the publicly traded universe, and we're talking about company debt, not sovereign debt, has risen $2.6

trillion since 2010, now standing at $8.7 trillion. You can imagine that the very easy monetary policy on the globe has supported this. But for that aggregate number to see its re-leveraging concentrated in developed markets and its de-leveraging in emerging markets, it is both surprising and contrary to the common narrative. And again, there's a chart to this effect at DividendCafe.com. Debt in the land of the rising sun. We knew when we took on our Japanese dividend equity positions in late 2017 that the corporate economy there had experienced tremendous deleveraging. And that many companies were running at a positive net cash position, meaning cash on hand was greater than total debt. This obviously provides higher dividend sustainability and less pricing pressure from economic distress. So that thesis remains intact. Japan's debt-to-earnings ratios are far more conservative than the United States, Europe, China.

I want to talk about safety and risk, some interesting things. Another dynamic that's unfolded worth monitoring for us dividend growth investors is how debt-to-earnings ratios have levered higher in the more defensive sectors in the United States. This makes pressure from higher rates, even though that appears to be on hold for a while, more important. We expect higher debt in the more capex-sensitive sectors like energy, industrials, and utilities, but the ratios have been on the rise in consumer staples and health care as well. Developments like this reinforce the thesis that it must be intense bottom-up security analysis that drives selection decisions to avoid taking on a risk that one previously thought sector selection would help to mitigate.

Where has debt-to-earning earnings most intensified in recent years? The U.S. utility sector, so go figure. The principle of play here is one I've studied my whole career and one that really does beg for understanding. And in our portfolio management, it begs for monitoring. And that is this. A low-risk asset eventually becomes a high-risk asset when investors leverage up what they believe to be low risk. It's a self-risk asset when investors leverage up what they believe to be low risk. It's a self-fulfilling prophecy. It does not matter how low the operational leverage is when financial leverage is put on low risk assets. At some point the risk level inherently changes. By the way, there's a chart, you'd call it a heat map that kind of

shows where the most intense leveraging has taken place in different sectors and in different geographies, and then where it's been more benign. And it just kind of gives you a graphic illustration. I think it's fascinating. I encourage you to check that out. Okay, let me talk taxes real quick. I got to wrap things up for you. When tax narratives don't meet tax facts. 50 years ago, the top tax rate was 91% and one half of 1% of taxpayers paid 16% of all taxes. Today, the top tax rate is 37%, yet the top one half of 1% of taxpayers pay 28% of all taxes. Today, the top tax rate is 37%, yet the top one half of 1% of taxpayers pay 28% of all taxes. So as that top tax rate has come down almost by two thirds, the percent of the Uber wealthy, the percent of taxes being paid by the Uber wealthy has nearly doubled. So the idea that you need a higher marginal rate to have the wealthier taxpayers paying a greater amount is not just disproven on the margin,

but disproven exponentially, dramatically, powerfully, mathematically. All I have to say about that, there's a chart at Dividend Cafe. The emerging case for emerging markets is one of our big themes for 2019. The case has, in my mind, been enhanced in recent months. Number one, the Fed sitting tight on policy tightening in the United States reduces the concerns about dollar shortages in emerging markets. Two, a trade war at least appears to be headed towards a better outcome. That risk is still there, but it's being mitigated more and more by the day. And number three, continued valuations that are screamingly attractive. Look, every emerging market stock market besides Brazil in the world is trading below its 20-year average valuation

measured by price-to-book ratio. The average price-to-book ratio versus the current one, the only country whose stock market is right now above that 20-year average is Brazil. And again, there's a chart to this effect at DividendCafe.com. Finally, let me talk. European stimulus just got announced this morning. I didn't have a whole lot of time to digest it before my submission deadlines around this podcast and our weekly writing. But I did enough to be able to tell you this. They're announcing greater monetary stimulus for their troubled economy and banking system.

And people are surprised that the market would react negatively to the announcement of stimulus. But this announcement is an admission that things are not good. It is can-kicking, and it jeopardizes their credibility. Most meaningfully, it comes with a reduction in their growth forecast from 1.7% to 1.1%, although I guess I'm still trying to figure out who ever really believed that the European Union was going to grow 1.7% this year. The special lending facility to European banks that they announced has one major problem behind it. European banks are not suffering from a liquidity crisis.

They're struggling with a solvency crisis. Confusing those two things is at the root of much policy error. Okay, our Advice and Insights podcast this week, and there's some coverage of it at our marketepicarian.com, deal with this financial transactions tax. So I'd encourage you to see my perspective on that issue. You may think it's political and perspective on that issue. You may think it's political and you don't care. You may think it's granular and don't care. It's not. It has a big impact on all investors. And I unpack it for you. I think there's some good content there. Flip over to our Advice and Insights podcast. The chart of the week at DividendCafe.com,

dealing with the year-over-year change in capital expenditures from S&P 500 companies. Very much worth looking at to understand why that issue is so important to us. With that said, I will call it quits for today's Dividend Cafe podcast. Once again, please do subscribe and put in your feeder of choice, your player of choice. And in the meantime, thank you so much for listening. Reach out with the SEC. Securities are offered through Hightower Securities LLC. Advisory services are offered through Hightower Advisors LLC. This is not an offer to buy or sell securities. No investment process is free of risk, and there is no guarantee that the investment process

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