Since Donald Trump’s unexpected election as US president in November 2016, US equity markets have been betting on the Trump reflation trade. The thesis was that he would engineer higher growth, resulting in higher inflation and as a result, higher interest rates. This would help the US (and the world) out of the current low-growth, ultra-low interest rate rut. However, Trump’s failure to pass a new healthcare bill has once again doused the markets in uncertainty. For investors, this means that investing in quality companies and staying calm amidst short-term noise is more important than ever.
The optimism about Trump’s ability to push through reforms is waning
Trump’s ‘Make America great again’ campaign was based on, among other things, lowering the US tax rate, reversing excessive regulation (especially in the banking and financial sector), reversing trade deals that favoured other countries more than the US, and protecting American jobs against cheap foreign labour (the best known example being erecting the ‘Mexican Wall’).
Although Trump’s presidency has had small set-backs (e.g. the flight bans against Muslim countries), reading through the above list makes it evident why both populists and capitalists voted for him.
However, Trump’s recent failure to reverse the inefficient, costly, liberal and bureaucratic Obamacare healthcare system is a warning to markets: markets may have been too optimistic about Trump’s ability to push through reforms. This mistake was typical of what we’ve seen from Trump’s presidency so far. He tried to bully Congress into passing the healthcare bill by rushing it and threatening that his team had negotiated long enough.
The healthcare bill failure proved that politics is not business, challenging the Trump administration
Most US presidents build teams made up of academics and career politicians who, to use a Trump phrase, ‘know how to operate in the Washington cesspool’. Trump is building a team consisting of successful business people who understand efficiency and profitability and know how to get things done in the business world. However, his recent defeat highlighted a weakness in this strategy: high pressure bullying tactics don’t necessarily work in politics, especially when you haven’t spent enough time listening to objections. A handful of Republican senators, who felt they couldn’t support the bill as it was and still look their electorate in the eyes, ultimately led to Trump’s failure, and a victory for democracy. Look at the figure below and see if you can also spot it.
With uncertainty lying ahead, investors should guard against over- and undervaluation
The increased risk that Trump’s tax and other bills may be defeated as well is not good for markets that were starting to discount lower tax rates, higher interest rates and less regulation. To worsen the situation, Brexit negotiations are about to start, France and Germany are having elections, and China is at risk of slowing down (with commodity stockpiles at record highs).
At any point in time there are too many short- and long-term variables at play to confidently predict how markets will perform. However, what we do know is that the more expensive markets are, the lower the subsequent five-year returns will be (and the other way around).
In David Dreman’s article Investor overreaction and contrarian strategies, he writes that investors tend to extrapolate positive or negative outlooks too far into the future. As a result, they overvalue (and overpay for) the prospects of their favoured investments, while they undervalue the prospects of ‘out-of-favour’ investments. When the herd behaves like this, it is difficult for the individual investor not to get swept along. To counter this behaviour, successful investors will always focus on the quality of earnings streams of individual companies and the valuations thereof.
Quality companies continue to grow shareholder value even in periods of uncertainty
There is no doubt that both the US markets (the S&P Index) and the JSE are expensive by historical terms and might not deal well with uncertainty about future growth at this stage. We could certainly see a correction or a period of low returns.
However, while the uncertainty does weigh on allocators of capital and postpones new ventures, life goes on. To demonstrate this I chose three financial stocks (shown in Figure 1) that continued to grow shareholder value right through 2008 – arguably the period with the highest degree of uncertainty in many decades (with many fearing a repeat of the 1930s depression). The three banks cover the spectrum of US banks in terms of size: J.P. Morgan is the largest US bank, US Bancorp is the most conservative and fifth largest bank, and Signature Bank ranks 50th in size.
Figure 1: US financials – compounding of shareholder value (2006-2016)
Source: Denker Capital, Morningstar®
It is important to focus on the quality of the company, instead of trying to forecast macro events
While Figure 1 shows how quality companies grow shareholder value for the patient investor, Figures 2 and 3 show how noise-driven markets can be.
The most important lesson is that it is seldom possible to forecast major events such as the oil price falling to $40, or President Zuma replacing the finance minister (more than once). It is therefore much better for investors to focus on what can give them a higher probability of getting a good outcome. This means focusing on the track record and quality of management, and using times of economic stress to increase positions at the right time (rather than spending time on trying to forecast macro events). In fact, macro crises present excellent buying opportunities.
Figure 2 shows that the 2007 valuations of the three US banks in Figure 1 were clearly too optimistic, reflecting an expectation that the bull market era would continue into the future. Figure 3 shows how the market overreacted in 2008. Yet, an investment made early in 2009 would have doubled in value over the next four years.
Figure 2: US financials – price-to-net-asset value ratios (2006-2016)
Source: Denker Capital, company financials
Figure 3: US financials – share prices responding to market events (2006-2016)
Source: Denker Capital, company financials
History proves the importance of investing in quality companies and staying calm in times of panic
To summarise, we can make the following important observations from these figures:
- Pre-2008 valuations were too high, i.e. expectations were too optimistic.
- Although valuations corrected sharply in 2008, they bounced back afterwards due to the continued growth in shareholder value (as shown in Figure 1).
- Even though the three banks grew shareholder value at a compound annual growth rate of between 14% and 19% (in US dollars) between 2008 and 2016, investors received a lower return because the valuations in 2006 were excessive. An investment made when markets are too expensive will seldom generate good returns.
- There are always exceptions. In this case it was Signature Bank, which excelled in a period of uncertainty by taking market share from larger peers.
These observations teach us that it is vital to do two things:
- Invest in companies that have a robust business model managed by competent, rational and ethical business people with experience. These companies will grow shareholder value almost regardless of the circumstances.
- Don’t panic when these companies are sold down when the market falls – rather use this as an opportunity to increase your investment.
The proof is in the pudding – Citigroup versus Berkshire Hathaway
Comparing these two companies is my favourite example of what happens when a business is built on the loose sand of poor practices (Citigroup) as opposed to having a robust business model and quality management (Berkshire Hathaway). Only during and after the crisis did the difference really become apparent (as shown in Figure 4). No matter what you paid for Citigroup, it was far too much in terms of the subsequent loss of opportunity. This is an excellent example of the danger of accounting valuations. When valuing markets, valuations can be good indicators, but on an individual stock basis, valuations say little about the quality of earnings. Nevertheless, if your investment process is right and you repeat it consistently, it is easier to spot a Berkshire Hathaway or Citigroup than it is to forecast a recession.
Figure 4: Berkshire Hathaway versus Citigroup – share price and net asset value per share
Source: Bloomberg, J.P. Morgan
Despite the short-term uncertainty, the long-term outlook remains hopeful
In this article, I’ve tried to show the danger of overreacting to short-term market events. Applying this to the current international macro environment, two facts are important:
- The US is a large, diversified and dynamic economy and a continuously changing market – there are always investable companies that are temporarily disliked.
- Reflation started before Trump was elected as president. Both inflation and interest rates bottomed mid-2016 and even the wave against more or new regulation gained traction mid-2016 as politicians started realising excessive regulation kills growth.
So yes – Trump’s failure to pass the healthcare bill does increase the risk that we don’t see lower tax rates in the US, or that tax rate cuts are postponed by a year. A lower tax rate is very important to stimulate US growth. Personally, however, I think Trump is a fighter and enjoys the battle. He will learn from this and come back stronger. (Refer to our article following Trump’s election, Trump’s game changer: Make inflation great again).
Nevertheless, one cannot build an investment strategy on ‘I think’ or ‘I hope’. Indications are that there is a high probability that the wave of disinflation, low growth and low interest rates has turned. The valuations of neither emerging markets nor global financials reflect the potentially higher growth rate of shareholding value going forward.
In the meantime, Trump’s loss, while not good for the markets today, is a victory for democracy and good for markets over the longer term.