The stock market was rattled during the fourth quarter as investor sentiment over Fed tightening and tariff wars overshadowed solid economic data. The S&P 500 Total Return Index (“Index”) declined 13.5% for the fourth quarter. This decline erased positive market returns through the first three quarters of the year, resulting in the Index being down 4.4% for the full-year 2018.
Investors overreacted in the fourth quarter as our analysis suggests the economy remains on sound footing. Further, market corrections have often-times created favorable long-term investment opportunities through disruption and panic selling. Our belief is it essential to adhere to your investment philosophy and process during times of disruption. We must remember that the value of companies is based upon their ability to grow revenues and earnings over the long-term. Both the Fed tightening (i.e., increasing interest rates) and additional tariffs raised concerns about whether the U.S. economy will enter a recession. Our view is a U.S. recession is not on the horizon as evidenced by the strength of the U.S. economy, businesses and consumers.
U.S. Gross Domestic Product (GDP) has four key components: Consumer Spending, Government Spending, Investment Spending and Housing. Consumer Spending represents almost 70% of GDP and the following data indicates that consumers remain financially stable:
- Unemployment rate at nearly a 50-year low of under 4%;
- Inflation at an historically low level of 2%;
- Household debt interest payments at generational lows; and
- Household net worth up over 50% from 2007.
Furthermore, the Federal Budget projects Government Spending growth of 5.4% in 2019, a figure well ahead of historic GDP growth in the 2%-3% range. We acknowledge that the current shutdown puts this growth rate at risk and creates some headwind to first quarter GDP growth. However, we believe the effects will be transitory and ramp once the shutdown ends.
Investment Spending by businesses (e.g. technology, research and development, new factories and machinery, etc.) also shows no signs of a looming recession. For instance, two of the largest components of Investment Spending – Business Fixed Investment and Change in Private Inventories – are both substantially below historic recessionary levels.
Conversely, the Housing component of GDP has decelerated. However, housing now represents less than 4% of GDP and housing development did return to normalized long-term levels post the 2007 housing bubble.
We closely monitor eight economic indicators that have historically predicted a recession is imminent. Currently, only a slowing housing market is flashing a warning yellow light. In early 2018, inflation expectations were also flashing a yellow light, but inflation now remains in check. In fact, the Fed recently reduced its inflation expectation for 2019.
In conclusion, an analysis of the different components of U.S. GDP, as well as various recessionary leading indicators, reinforces our view that the U.S. economy remains strong.
Yet, investors panicked toward the end of last year and created a market dislocation. By contrast, we stuck to our fundamental investment conviction: “Know what you own and own what you know.”
On an investment portfolio level, we know in 2018 the companies we own:
- Generated over $400 billion in free cash flow, approximately a 6% Free Cash Flow margin.
- Repurchased over $300 billion of their own stock, roughly 4.4% of the companies’ market capitalization.
- Paid out dividends of over $160 billion, about a 2.0% dividend yield.
Lastly, based on this “know what you own” theme, we would like to share our thoughts on one of our top portfolio holdings, Apple, Inc. (Ticker Symbol: AAPL).
Apple’s stock has sold-off from its record high level in late 2018 based on investors’ concerns that iPhone sales will slow. While we recognize the issue of potentially lower sales growth rates for the iPhone, we see several fundamental and compelling reasons to remain long-term investors in the stock.
First, Apple has is an installed base of roughly 1.5 billion iPhone users. Importantly, this figure is forecasted to grow at the rate of about 100 million users per year. As a result, the “ecosystem” for Apple’s full spectrum of products and services is enormous and continues to grow.
Second, the revenues and earnings contributions form Apple’s Services Business (e.g., Apple Music, Apple Pay, apps, etc.) is expanding at a very strong low-teens growth rate. Our view is this increasing stream of recurring revenues is not fully reflected in the current market valuation of the stock.
Third, Apple continues to generate significant amounts of free cash flow and has a substantial amount of cash on its balance sheet. The combination of free cash flow and the balance sheet cash represent about 35% of the total value of Apple’s stock market value. Clearly, this provides a high degree of flexibility in terms of enhancing shareholder value, as well a meaningful downside protection of the valuation of the stock.
In summary, we feel Apple will maintain its position as a dominant market leader and has several drivers for long-term growth. Furthermore, its valuation is attractive based on a Price/Earnings (P/E) ratio of 12x forward earnings. This represents a 20% discount to the overall market, as measured by the S&P 500 Index.
As we look into 2019, we see the economy growing at 2%-3%, S&P 500 earnings growing within a 6%-9% range, and valuations below historic averages. Against this backdrop, we are bullish on portfolio returns.
Please find attached your fourth quarter 2018 portfolio review to supplement the monthly accounts statements available through Schwab. The report provides a performance summary of your portfolio compared to our benchmark S&P 500 Total Return Index and lists the portfolio holdings by industry sector.
As always, we are always excited to hear from you. Please do not hesitate to call us with any questions.
Talbot Financial, LLC1Excludes banks and insurance companies