Forester Value Fund Quarterly Update

GuruFocus.com
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- By Holly LaFon

Trump changes everything. This is not just a conclusion on how to run a political campaign. We believe that Trump and the Republican Congress will try to change the corporate tax structure as well as the economy. We examine the possible impacts of Trump on the economy and the stock market.

Trump's slogan was "Make America great again." It is one of those political slogans that allows a person to make of it what they want. So what does it mean in the way of policy changes? On the campaign trail, Trump bashed China for stealing our manufacturing jobs. He picked up a lot of support in the Rust Belt by promising the return of those jobs. He has named Peter Navarro to a new White House office overseeing American trade and industrial policy. Navarro has called for a 45% tariff on Chinese imports. Trump also chose Wilbur Ross (Trades, Portfolio) for Commerce secretary. Navarro and Ross penned a white paper saying that Trump should label China a currency manipulator and should renegotiate most of the trade deals the US has entered into. Trump advisor, Steve Bannon, said that if they are successful, he would see Republican majorities for 50 years. Taken together, it appears to us that the strategy is to incentivize companies to manufacture in the US by increasing "border adjustment" import taxes ("tariffs") and cutting corporate taxes to increase jobs in the US to the benefit of Midwestern state employees, who VOTE. (This is not meant to be a political piece, but the two seem to be so intertwined, and since it drives the economic agenda, we felt it necessary to include.)


According to the Bureau of Economic Analysis, manufacturing is about 12% of the economy. However, this is only the value added portion, that is, sales to final users. Sales to other industries (not final users) are referred to as "intermediate inputs." Manufacturing gross output, which are the net manufacturing shipments, is 35% of the economy. In 1997, value added was 16% while gross output was nearly 45%. The Trump people believe that there is at least 10% of GDP that could be brought back to the US with the proper use of the tariffs and the tax code. If done correctly, they would increase GDP, bring back jobs and add majority voting blocks in the Midwest. Will they be successful? Who knows, but this seems to be the game plan.

Valuation context

In order to assess the market impact of the Trump agenda, it is important to understand the valuation context of the current market. Some are comparing Trump's call for a tax cut to the Reagan tax cut years, and assuming that the market will likewise take off like it did then. After Reagan was elected, stocks rose by about 10%. However, the rally did not hold and stocks were down nearly 40% from the peak over the next couple of years. Like the Reagan years, the market rallied nearly 10% after Trump won the election. Will the drop happen next?

The context of these two rallies could not be more different. When Reagan was elected, S&P 500 P/E was below 10 and the 10 year UST rate was nearly 12%. Currently, the S&P 500 P/E is nearly 24 (trailing 12 months) and the 10 year UST is 2.5%. When Reagan was elected, P/Es had nowhere to go but up and long interest rates had nowhere to go but down. The bar was very low for significant stock returns with beginning low valuations and high historic interest rates.

The opposite is true now. An S&P P/E of 24 is very high, especially as it is based on historically high profit margins. So if profit margins return to their historic average and the market stayed the same, the P/E would be much higher still. Also, 10 year UST rates are historically at the lower end of their range. Higher long rates usually lead to lower stock values. They also increase mortgage costs which lead to lower home prices, all else equal. So Trump's starting place of high valuations and low interest rates is a very high bar from which to see strong stock returns. (Note: chart below shows Cyclically Adjusted P/Es (CAPE)). CAPE P/Es are currently 28 and were only higher in 1929 and the 2000 bubbles.

Underlying drivers

The two main drivers of market performance the past few years have been the Fed keeping interest rates exceptionally low, and corporations buying back their stock. (stock buyback chart). With product demand growth slow and interest rates low corporations have used their cash flow and issued debt to buy back stock at unprecendented levels. This has kept GDP growth low as CEOs have limited capital expenditures due to low demand growth. Several things are happening that may curtail these buy backs.

Profit margins have been at historically high levels for some time. Much of what Trump is proposing could boost wages which would hurt profit margins. Globalization has eroded labor's share revenues (chart). While globalization makes the world economy more efficient, those gains are not shared evenly. Trump realizes that corporations don't vote. His call to bring jobs back to the US is politically savvy even if it is less efficient. Corporations have outsourced jobs because it was much cheaper to do so. As some of those jobs are brought back to the US, expect costs to increase and profit margins to go down. This will limit earnings growth and the cash flow to buy back stock.

As more products are produced in the US, expect prices to increase due to the higher costs. Expect more tariffs, like the current one on steel imports to allow corporations to sell the higher priced product here in the US. While this is less efficient, it is better for those who now have better jobs even if they have to pay more for what they consume. Remember corporations don't vote, but the people with the better jobs do. That is the root of populism.

Limiting immigration has a similar impact. It is like a tariff on cheap labor. Hotels, restaurants and construction companies will complain, but if it lifts wages, those that vote will be happy.

These increasing costs will also increase inflation. If this happens quickly, the Fed is greatly behing the curve. Not only do they need to raise rates, but they also have a few trillion dollars of excess liquidity they will need to take off. Deutsche Bank has modeled the impact of Trump plans, ECB taper and Fed rolloff and projects 3.5% 10 year rates by the end 2017. This would imply mortgage rates of around 5.25%. That is quite a jump from 3% mortgage rates earlier in 2016. The average home buyer could only afford to pay 25% less for a home at the higher rates. That would be very negative to the collateral backing all of the mortgages written over the past few years. It also dries up the fees that come from buying or refinancing homes. It also pinches home flippers and remodellers, as well as the Home Depots of the world. That is a bad scenario for corporate buy backs and stock valuations as well.

Trump has proposed lower corporate tax rates to soften the blow to income statements. However, both McConnell, the Senate majority leader, and Ryan, the Speaker of the House, have said that any tax cuts need to be revenue neutral. It is unclear which deductions will be eliminated or cut, but the impact may be more neutral to earnings than the market is assuming.

Currently, the US is borrowing about a $1 trillion per year. That is about 5% of GDP. There isn't a lot of room for more deficit spending, so expect a lot of deduction cuts. One possible of revenue increases are so called "border adjustment" taxes. These tariffs should shift the corporate tax burden towards importers and away from exporters at the margin. It should quickly increase the prices of imported goods. This is similar to the VAT system in European countries.

We think that corporate tax cuts are great. However, ageing demographics, slowing population growth and large debt levels will mute demand growth. All in all, expect profits margins to drop, but wages and prices to increase. Voters may be happy, but stocks may not be.

Trump has proposed spending $1 trillion on rebuilding the nations bridges and infrastructure. This sounds like a huge number, but it depends on what time period this is spent over. Usually these projects are spread over 10 years. If so, this would amount to $100 billion per year, or 0.5% of GDP. It is additive to GDP growth but not as much as the $1 trillion sounds like.

We think that these moves will be beneficial to US workers which will, over time, benefit the economy and stocks. However, much of the stock benefit may be offset by higher inflation and interest rates. All in all, Trump's impact may be more political than financial.

China

Some have noted that many commodities turned around in December based on rumors of China slowing. If our thesis is correct, it could also be that the market is understanding that China may be hurt by the current changes. China is very highly leveraged in both a financial and operating sense. Because they continue to add to capacity, they need exports to operate profitably or to breakeven. Trump is trying to move some of that capacity back to the US. If you are a steel producer running at 70% capacity and breaking even and you lose 10% of your market, you don't just lose a little bit, you lose a lot because of how operationally leveraged you are. You make a lot when you are running near full capacity, but lose a lot when your capacity utilization drops too much. Those extreme profit and loss swings are further exacerbated when financial leverage is added. Countries also find that growth slows dramatically when debt levels grow too large.

Also, China was a developing country when most of the treaties were written. Developed countries wanted to see China grow as a way of growing global GDP and hence demand for their products. China is now the second largest economy in the world. They are a major competitor. Other developed countries are starting to treat them as an equal and not just trying to foster a developing country.

While, globally, society is better off with free trade, there are still winners and losers, which are not equally distributed within country or trade-bloc borders. US manufacturing employees were losers.

During WWII US manufacturing was around 40% of GDP, while today it is closer to 12%. We won WWII in no small part due to our manufacturing ability. Today, China is the world's largest manufacturer. From a strategic standpoint, is the US, under Trump (and his advisor generals), okay with that? If not, then one would expect the administration pressure to move manufacturing back to the US sooner rather than later.

US Economy - We think that two large drivers of the economy are peaking and rolling over, autos and housing. Housing we mentioned earlier that due to increasing 30 year mortgage rates, home prices are dropping and will be a headwind for the rest of the year for builders and banks.

Generational low interest rates have been very helpful to auto makers. However, pent up demand is largely satiated and with the huge number of leases expiring in 2017, expect used car prices to be under pressure and write offs from leases to increase.

During WWII US manufacturing was around 40% of GDP, while today it is closer to 12%. We won WWII in no small part due to our manufacturing ability. Today, China is the world's largest manufacturer. From a strategic standpoint, is the US, under Trump (and his advisor generals), okay with that? If not, then one would expect the administration pressure to move manufacturing back to the US sooner rather than later.

US Economy - We think that two large drivers of the economy are peaking and rolling over, autos and housing. Housing we mentioned earlier that due to increasing 30 year mortgage rates, home prices are dropping and will be a headwind for the rest of the year for builders and banks.

Generational low interest rates have been very helpful to auto makers. However, pent up demand is largely satiated and with the huge number of leases expiring in 2017, expect used car prices to be under pressure and write offs from leases to increase.

FUND INFORMATION

January 1, 2017

The fund's largest equity positions as of 12/31/2016 were Pfizer, Aon and Microsoft.

Pfizer (PFE)'s revenues have been pressured the past few years as they lost patent protection on some of their large profitable drugs, such as Celebrex and Lyrica. But those headwinds are subsiding just as some of their newer drugs are experiencing attractive growth (Eliquis, Xeljanz, Ibrance). In addition, the company recently acquired Medivation, which has Xtandi, a fast-growing drug for prostate cancer (and seeing positive trial results for breast cancer). Pfizer expects the deal to be $0.05 accretive in the first year, which we view as conservative. Pfizer's 2016 return was +13.1%.

Aon (AON) (+16.3% in 2016) provides Risk Management and Human Resources solutions to companies around the globe. The company has attractive organic revenue growth and margin expansion opportunities as they reap benefits from prior investments in the businesses. In addition, the company generates significant free cash flow, which will be used for share buybacks, further investment in the business, dividends and acquisitions.

Microsoft (MSFT) (+20.8% in 2016) is emerging as one of the key winners in cloud computing (storing and accessing data and programs over the Internet instead of from the computer's hard drive). The company's rapid growth in cloud computing is offsetting declines/slow growth in the company's legacy businesses. In 2017 cloud margins should materially improve as massive 2016 investments are leveraged and capex slows.

LOOKING FORWARD

We try to produce the best risk-adjusted returns available. As risks have increased, we have increased our protection. If risks subside or are priced in, we will gladly reduce our protection. But until the market more fully reflects these risks, we will remain cautious.

Best regards,

Thomas H. Forester

CIO and Portfolio Manager

The foregoing does not constitute an offer or recommendation of any securities for sale. Past performance is not indicative of future results. The views expressed herein are those of Thomas Forester and are not intended as investment advice.
This article first appeared on GuruFocus.


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