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Strategic Insights

Volume 6, Edition 38 | October 9 - October 13, 2017

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A Case Study in Quality and Value

Doug_Walters Doug Walters | Articles

Read Time: 6:00 min


As U.S. equities continue their nine-year bull run, we remind investors the importance of remaining disciplined. A dual mandate of Quality and Value is our preferred investing moral compass.

Market Review

Contributed by Doug Walters

Stocks continued their upward trend as the Q3 earnings season ramped up, with Banks taking their usual lead in the reporting season. With Retail Sales picking up and the U.S. equity market showing no signs of slowing, we take this opportunity to highlight the virtues of an investment approach grounded in Quality and Value.

A Healthy Retail Appetite

U.S. Retail sales for September bounced back after a decline in August. However, these monthly changes are notoriously volatile. More important is the trend in year-on-year growth which is nearing a healthy 5%.  The Federal Reserve, which watches these economic figures closely, confirmed their comfort with the economic data this week, making a rate hike in December look highly likely. As we discussed in our Q3 Perspectives report, The Eve of Change, a transformation is afoot at the Fed, the implications of which could be widespread.

Monday Morning Quarterback

It is easy for investors to get complacent in the ninth year of a bull run in U.S. stocks. Chasing momentum becomes too commonplace, and investors of average skill can look like heroes. For those not riding the momentum, it is tempting to play Monday morning quarterback and wish you owned more high-flying growth stocks or high yield debt. However, as we learned in the Dot-com bubble, chasing returns is a dangerous game. Sticking with a well-thought-out investment process provides your best chance at long-term investing success. For us at Strategic, that is a relentless focus on Quality and Value. As we discuss in our Asset Allocation section below, this approach helped us avoid the Puerto Rican debt crisis.

Indices & Price ReturnsWeek (%)Year (%)
S&P 500 0.214
S&P 400 (Mid Cap)0.09.5
Russell 2000 (Small Cap)-0.510.7
MSCI EAFE (Developed International)1.218.5
MSCI Emerging Markets1.730.1
S&P GSCI (Commodities)1.60.0
MSCI U.S. REIT Index1.62.5
Barclays Int Govt Credit0.31.0
Barclays US TIPS0.70.8

Economic Commentary

Contributed by

Good Things Come in Small Packages

Our investment process here at Strategic focuses on identifying catalysts, risks, and valuation for potential investments. Ideally, our investments capture the upside from specific catalysts, while having downside protection from key market risks. In effect, our analysis is designed to lead us to high quality, attractively valued investments that can outperform over time. The small capitalization asset class has been in focus, with key catalysts:

  • Reducing levels of regulation,
  • Corporate tax cuts, and
  • Higher merger and acquisition activity.

The median tax rate for a company within the small cap asset class is 31%. A potential for a corporate tax rate cut to 20% (or even 25%) would greatly impact the bottom line of these companies. In addition, higher merger and acquisition activity asymmetrically benefits smaller companies which could be an acquisition target. However, risks exist, such as:

  • Higher interest rates, and
  • A United States recession.

The latest Leading Economic Index (shown below), appears to be trending upwards, which argues against a looming recession.

101317_GraphWe have seen strong growth in earnings per share of 12% per year over the past five years for small cap stocks. Also, small companies have increased their research & development (R&D) spending over this time at a 22% per year rate, led by the Health Technology sector. An expansion in R&D spending indicates companies are investing in growth opportunities and a good sign for the current state of the economy. At Strategic, our model portfolios are currently overweight the small cap asset class.

Week Ahead

Contributed by

BRIGHT lights on earnings next week

Banks are dominating the calendar for the 3rd quarter earnings this week, with our focus on Strategic’s Equity Income holdings U.S. Bancorp (USB), BB&T Corporation (BBT), Bank of New York Mellon (BK) and M&T Bank (MTB).

  • Investors will be focused on loan growth, expense cuts, and the all-important interest income.

Roundtable, the annual get together of global central bank governors, will see the governors debate the most important financial and systemic issues facing the global monetary regime.

  • Possibly up for discussion is the lack of inflation in the developed countries after several years of quantitative easing.

International Monetary Fund (IMF) meeting will commence this Saturday in Washington, DC.

  • The IMF is an international organization of 189 nations charged with fostering global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable growth, and reduce poverty around the globe.

Germany’s State election results, as well as Great Brittan’s developments in Brexit negotiations, are the major events within the Eurozone.

  • Regional elections are expected to spotlight a strengthening right-wing AfD party at the expense of Chancellor Merkel’s Christian Democratic Union Party.
  • The European Union has criticized Great Brittan for not moving Brexit along fast enough. The “deadlock” has prohibited the EU from negotiating post-Brexit trade agreements.

Healthcare sector 3rd quarter earnings commence with reports from Strategic Growth holdings Johnson and Johnson (JNJ) and UnitedHealth Group Inc. (UNH).

  • Analysts will be seeking any comments from health insurers on the impact of Trump’s executive order to end subsidies for ACA insurers.

Trade Data will shed some light on export and import prices and what effect a weaker dollar has had.

  • Analyst estimate a 0.50% increase in prices for both imports and exports in September.

Strategy Updates

Contributed by Max Berkovich


Port of Debt

The debt load of the Commonwealth of Puerto Rico is $73 Billion, $12 Billion of which is insured by MBIA or AMBAC. In February of 2014, Standard & Poor’s downgraded the General Obligation debt from BBB- to BB+, this was the beginning of a downward spiral leading to default.  Earlier this month the President implied that the debt should be wiped out.

The debt load accumulated thanks to Puerto Rico’s unique status for taxation.

  • Income from municipal bonds of the Commonwealth are tax-exempt from not only federal taxation but also state and local taxation. This enticed municipal bond investors (single state mutual funds in particular) in need of state exempt income and diversification away from a single state, to shower the island with money.
  • Investors overlooked the dangers of investing in this small, weak economy in favor of “diversification.”

Our investment principals of Quality and Value kept us out! These two basic investment principals coupled with our macro view on Puerto Rico’s economy kept our clients out of harm’s way.

  • We require underlying credit quality to be A rated or better by the rating agencies at purchase. Puerto Rico’s General Obligation was a BBB rated by S&P as far back as 2008.
  • For bonds that were insured or did carry above A rating, they were often more pricey than similarly rated bonds of other municipalities, even after calculating the tax benefit, offering us little value.
  • We also reviewed client mutual fund holdings to identify tax-exempt funds who had significant Puerto Rico exposure and advised them to exit those holdings.

The future of how this plays out is very cloudy since Puerto Rico is not a State. One thing is sure; bondholders will be asked to take losses.


Trian Hard, but Fallin’ Short

The Consumer sector had a bullseye on its back this week with analysts taking shots at several companies ahead of 3rd quarter earnings. The Industrial sector was the leader this week. In other strategy news…

  • Consumer product giant Procter & Gamble Co. (PG) survived an attempt by activist investor Nelson Peltz of Trian Group to infiltrate the company’s board of directors. The bitter battle went in favor of the existing board, and Peltz lost the vote for a board seat. Not all is lost. The battle will put the incumbent board on the hot seat and force them to pursue value-creating initiatives, even if they are not Peltz’s.


Wal-to-Wall Good News

The Utilities sector was the top sector for the week. The Consumer sector was the weakest. The Financial sector was center stage as the biggest asset manager, BlackRock, Inc. (BLK), and one of the biggest banks, J.P. Morgan (JPM), were the first to release earnings, which topped expectations. But the biggest story this past week was…

  • Wal-Mart Stores, Inc. (WMT) released a strategy update ahead of its meeting with investors. Some of the investor treats include guidance of 3% sales growth for 2019, 40% sales growth for eCommerce and a 2-year $20 Billion share buyback. $20 Billion is roughly 9% of the company’s market capitalization.

About Strategic

Founded in 1979, Strategic is a leading investment and wealth management firm managing and advising on client assets of over $2 billion.