Mackenzie Bluewater Team
The big story of the fourth quarter was broad based tax reform in the United States and the impact on corporate earnings and global growth.
From a company perspective, at first glance, the reduction in the statutory rate from 35% to 21% appears to increase after-tax corporate earnings in the United States by over 20%. This would be a massive increase in earnings, which would be expected to result in a one-time upward market move of a similar magnitude. The true impact on earnings, however, is considerably lower, as most companies already pay tax rates well below statutory levels, due to a combination of non-US sourced earnings and a wide variety of tax avoidance strategies. It appears that, in aggregate, corporate earnings are likely to increase 5-7%, with increases most pronounced for US domestically oriented companies. Unless the markets are extremely inefficient, this policy change should already be reflected in stock prices heading into 2018.
The more interesting questions, looking forward, is the impact on global growth from tax cuts and the spill-over effects on global tax rates as other countries respond to the change in US policy. In our view, tax cuts should be a modest positive for economic growth as the US Government will run an expanded deficit going forward, which makes the cuts a form of fiscal stimulus. Although a number of commentators have suggested that the cuts will unleash a “wave” of investments, we are quite skeptical, as we cannot recall a single conversation with corporate management over the past few years where they claimed to be holding off on investment due to capital constraints. In our view, higher earnings are more likely to be channeled into stock buybacks and dividends, which are shareholder positive, but do not translate into a higher rate of economic growth. From a broad policy perspective, given that the US economy is already in an expansion and has low levels of unemployment, the timing of the policy change is poor, as it will leave the US with less flexibility during the next downturn. In many ways, the cuts appear to be structured to cause a one-off boost to GDP, rather than bending the trajectory of growth upwards.
Interestingly, we are starting to see the initial hints of a competitive response from a number of other countries, suggesting that there may be a second round of impacts to the US policy changes on a more global scale. Low tax regions, which have been actively attracting companies through tax rate arbitrage, may be forced to respond to the US rate cuts. In addition, there are a number of developed countries that are now effectively become uncompetitive on tax rates, which may also choose to lower rates to become more competitive with the new US statutory level. Although lower rates are not great news for government budget balances, they certainly are supportive of earnings growth and we will be monitoring developments on the tax front closely.
Globally, equity markets have been fairly strong over the past decade, as valuations were low post the global financial crisis of 2008-9 and corporate earnings have undergone a long expansion period. In our view, which we believe is well supported by history, rising earnings have tended to be linked to rising markets. In this cycle, corporate earnings benefited from both GDP and margin expansion, with margins now at very high levels versus history. Despite the fundamental support from earnings growth, much of the market rise has been driven by valuation expansion. We have detailed in past quarterlies that we believe that there is a clear theoretical and historical relationship between inflation rates and valuations. With inflation rates at extremely low levels in developed countries, it should not be a surprise that valuations have expanded substantially.
As investors, we strongly believe that valuations matter, and that future returns are heavily influenced by current valuation levels. During 2016-17 we reduced, and then ultimately eliminated, several long standing holding for valuation reasons. Companies like Jack Henry, and ANSYS were significant positive contributors to our investment returns over the past few years, and although we believe both remain extremely strong businesses that will continue to perform well from a business perspective, we do not believe that they are currently at attractive levels. These are incredibly unique franchises that we would love to own again, but only at lower levels.
We do not target sector allocations from a top-down perspective, rather, they are driven by the investment opportunities that we are currently finding. Going back several years, we found that a number of companies in the Information Technology area were extremely attractive. The companies were dominant business with strong free cash flow growth prospects, had stellar management teams, and solid balance sheets. Equally important, at the time they were valued by the market as “run of the mill” average companies. In our view, although we are still able to identify a number of IT businesses with extremely attractive characteristics, the valuations of many of them have moved up to the point where we don’t see how we can generate an adequate rate of return. As a result, our long standing concentration in IT, once close to 25% of the entire fund, has been reduced substantially. From the perspective of new investment ideas, we have added 3 non-North American companies: Dassault Systems, Royal Philips, and Heineken, while continuing to look for new opportunities in the United States. In our view, the United States remains the premier investment market in the world, with the majority of the world’s best companies. It is important to note that the location of a company’s head office does not define geographically where they generate their revenues. In fact, the vast majority of our US domiciled companies generate revenue globally, rather than purely in the US. Our philosophy of owning global leaders, by definition, has attracted us to companies that are the best at what they do on a global, rather than regional basis.
While the US market continues to demonstrate resiliency, we continue to maintain a cautious stance on the Canadian economy. We are concerned about the excessive dependence on growth from the housing market, record levels of consumer indebtedness and rapidly rising minimum wages in Ontario and Alberta. Moreover, technological and policy changes in the energy sector and uncertainty around NAFTA renegotiations add to our longer term challenges that Canada faces.
In light of these issues, our pure Canadian domestic exposure remains limited and defensive in nature including best-in-class retailers and telecom providers including Dollarama and Telus. A large portion of our Canadian investments are focused on Canadian companies that have a meaningful international exposure, that are less constrained by the domestic economy and are able to capitalize on growth opportunities elsewhere. These would include global leaders such as CAE, CCL Industries and Spinmaster. The net result is that only around 28% of our portfolio revenues are derived from Canada. The portfolio is well balanced and geographically diversified to mitigate the aforementioned risks.