Growth & Income Review and Outlook for 2017

Craig Goryl, CFA, Portfolio Manager

2016 was full of the unexpected. Oil’s dip to $26 per barrel in February, Brexit, and the US election are the glaring examples of outcomes that defied expert predictions. We should expect a similarly wild ride in 2017, which may or may not bring sweeping changes to US taxes/regulation/deficits, interest rates, foreign trade, and the fate of the European Union.

Cabot’s Growth & Income portfolios were not immune to surprises. We owned a profitable UK-based airline called EasyJet when the Brexit vote occurred (Argh.) We’ve held our position in a great Mexican tortilla company through political rhetoric that has raged against open trade with Mexico. On the other hand, rising interest rate expectations boosted our shares in JP Morgan and First Republic. Rapidly improving economic expectations helped conglomerate Berkshire Hathaway, another holding.

My strategy for handling the unexpected remains the same: build “all weather” equity portfolios that offer some appreciation in good times, and some protections in bad times. What does this mean?

  • Diversification away from US large cap stocks. This can include foreign developed countries, emerging markets, and frontier markets.
  • Focus on high quality companies wide moats, proven management teams, strong balance sheets, and an established ability to make profits through the economic cycle. Purchase them at a discounted price.
  • Hold some cash, gold and gold-related stocks like miners which are likely to hold or increase their value when equity markets fall.

2016 in Review

2016 did demonstrate a shortcoming of building such a portfolio. US large cap stocks, as represented by the S&P 500 (+12%), outperformed foreign developed markets (+1%), emerging markets (+11%), gold (+9%), and cash (0%). This also happened in 2015 and 2014. Allocating part of your portfolio to those other areas is a bit like paying for insurance that you didn’t use.

And how about owning quality companies at reasonable prices? That is a strategy that makes intuitive sense and is historically successful. However, 2016’s market rewarded risk rather than safety or quality. For evidence, witness the rallies that followed Brexit and Trump, despite higher probability of geopolitical and trade disruptions. Researchers at Goldman Sachs crunched some numbers to find out what kind of attributes or characteristics “worked” in 2016. According to the Goldman data:

  • More volatile stocks beat less volatile ones.
  • Weak balance sheets (companies with excess debt) beat strong ones.
  • Companies with low return-on-capital (a measure of profitability and efficiency) beat high return-on-capital.
  • Was it a bizarro market? Not entirely. At least cheap stocks beat expensive ones.

Outlook for 2017

We ended 2016 with a strong rally. Stocks are near an all-time high, US is nearing full employment, CEO surveys indicate great optimism, and markets expect a new presidential administration to usher in a triple whammy of tax cuts, deregulation, and infrastructure spending. Happy days are here again, or so it certainly seems. Even so, I don’t believe now is the time to be cancelling that insurance against US large cap stocks.

For starters, US stocks are expensive compared to history and to the rest of the world. The S&P 500 is priced at 21x earnings compared to a 50 year average under 17x earnings. Put another way, one dollar invested in the S&P 500 would traditionally have bought you $6 in proven earnings power. Today it only buys $4.72. Valuation doesn’t tell you when to buy or sell, but it is the major determinant of long term portfolio returns.

Valuation aside, geopolitical and trade risks stemming from the same global populism that powered the Brexit and Trump campaigns are still ahead of us, not behind. Furthermore, tax cuts and infrastructure spending do boost corporate earnings but they also come with future costs, and markets tend to recognize this.

That brings me back to my original point. I expect the unexpected to happen again in 2017, and continue to prepare for that by constructing portfolios that can withstand a few surprises.

Since Cabot clients are frequently interested in the companies they own and the reasons why, I’ll share a few of the names that I hope will drive Growth & Income portfolios in 2017. Among US holdings, JP Morgan (JPM) is a very high quality bank that had an excellent 2016 but remains inexpensive. If interest rates rise in 2016, its true earnings power will surprise Wall Street. Disney (DIS) faces a lot of skepticism over the health of its most profitable franchise, ESPN, but I think that is overblown, leaving this global consumer powerhouse undervalued. Rockwell Automation (ROK) helps factories become more efficient, which will be in demand if manufacturers’ path to lower cost offshore labor is blocked. Cintas (CTAS), the uniform company, should also benefit from same political emphasis on US job growth. Finally Newmont Mining (NEM) has led a slowly healing gold mining industry which will really get going if gold price rise in response to more unexpected geopolitical events roiling economies and currencies.

On the international side of things, I believe Sony (SNE) is a very compelling turnaround worth double what it trades at today, if management continues to shake things up, highlight the sum of Sony’s disparate parts, and reap a reward or two from the $4billion it spends annually on R&D. Novo Nordisk (NVO) got pummeled last year as competition forced it to lower long term growth targets, but now looks inexpensive with achievable expectations. HDFC Bank (HDB) is an Indian bank that has grown as that underdeveloped economy’s citizens join the banking system; recent cash reforms will accelerate this trend. Finally Gruma (GRUMAB MM), the Mexican tortilla maker I mentioned earlier, will continue to export to the world, feeding global trends in demographics, taste, and diet. The tortillas just may have to fly over The Wall to do so.

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