“Never let the truth get in the way of a good story”-Mark Twain
The first quarter has been punctuated by a volatile market that appears even more jarring following the unusually orderly market conditions of last year. In Washington, President Trump’s administration is delivering on its “America First” platform using an unconventional approach. Tariff threats are drawing China into discussions with an uncertain outcome and market participants are concerned that a potential trade war could offset the favorable effect of the recently passed tax reforms. Since markets abhor uncertainty, particularly regarding economic policies, investors should be prepared to endure further volatility until tariff and trade issues are resolved and the outcomes from the President’s unique governing style are more visible.
While investors cannot set the investing environment, they can control the characteristics of the businesses in which one invests. We focus on owning companies generating excess cash flow that reinvest in their businesses in ways that maintain or enhance return on invested capital and return on equity. Evidence of a successful capital investment program is visible in rising earnings per share, and companies owned in client accounts generated 22% earnings growth in 2017. Surplus cash flow that isn’t needed to expand the business should be returned to investors via share repurchases and dividends. Of the 33 companies owned in client portfolios 25 raised their dividends by an average of 12% in the last year. Share repurchases reduced the number of shares outstanding at 21 of the 33 businesses owned. During challenging market conditions, free cash flow serves as a ballast for stock valuation and provides an assuring measure of longer term potential.
The market multiple of the S&P 500 index has fallen from 20x to 16x projected 2018 earnings since the beginning of the year. The lower valuation has been driven by the stock market decline and by an improving earnings outlook for S&P 500 component companies, as the 2018 estimate has increased from $147 to $157 (FactSet estimate). The stock market, which began the year trading near the upper end of historic valuations, is now trading closer to the midrange. Assuming the economy remains strong, the market valuation should find support near current levels. However, because the equity market discounts the future, should President Trump’s policies backfire and undermine the strength of the economy then company earnings could be at risk.
Regarding interest rates, the Federal Reserve increased the discount rate at its March meeting and indicated it plans to raise rates approximately 2-3 times over the remainder of the year. The outlook is premised on the strong outlook for GDP near 3%, and a healthy labor market in which unemployment is hovering near historic lows of 4%. The Fed also signaled its plan to continue tapering its Treasury bond purchase program, a form of quantitative easing left over from the financial crisis of 2008. The yield on the 10 year treasury has risen from 2.4% to 2.8% and market strategists are beginning to debate when bond yields will become more competitive with stocks. We think that investors will be drawn to reallocate some money from stocks to bonds when inflation adjusted real returns approach 3%, which suggests bond yields over 4% using current inflation trends.
During the quarter we made some changes in client portfolios. In early January we purchased shares of General Electric. We were wrong and sold the position at a loss in February when it became clear additional restructuring of the business would be necessary before a turnaround could occur. We purchased Illinois Tool Works (ITW), a high quality manufacturing company with a long track record of redeploying excess cash flow in shareholder friendly activities. We sold remaining client positions in Duke Energy as rising bond yields make owning utilities less attractive. We also sold our long term position in Henry Schein, a dental distribution company we’ve owned for many years, due to our concern that Amazon and other online competitors could hurt future profit margins.
While the current environment is presenting a greater level of uncertainty, focusing on a disciplined investment strategy is the compass that will help us navigate the turbulence. Thank you for entrusting Ayrshire Capital Management with the management of your money. We look forward to speaking with you in the coming months.
JM Sam Nevin, Jr.
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