Trend Management, Inc. End of Year Report 2016
There is an oft repeated saying on Wall Street that when a market goes down suddenly “We got caught with our pants down”. The opposite of that saying which is rarely heard is “We got caught with our pants up”. Without a doubt the rally in the stock market caught our clients with their “pants up” and we are thankful. 2016 turned out to be a good year and it all happened in about six weeks. There are concerns to be monitored that we will talk about next.
Interest rates on the ten-year US government bonds have risen from 1.70% on the day of the election to 2.55% today. The “price” of money went up 50% in 7 weeks. This is a very strong move which begs the question why? We can point to two things that are election related that can account for it. One is easy to understand and the other one is not. Let’s start with the easy one.
Donald Trump has proposed spending a trillion dollars on infrastructure projects over the next 10 years. That spending at a time when we have unemployment at 4.6% will drive up the cost of wages for your average worker. Construction jobs pay well. This will draw labor away from other low wage paying jobs. The bond markets fear of rising wage inflation from higher wages helped push interest rates up. That’s reason one. The second reason also involves employment but is more complicated. We have talked about it for the last few years. We are headed into a trade war with China and it’s going to be controversial.
Donald Trump has repeatedly said he wants to bring jobs back to America. One tool he has threatened to use is place tariffs on goods coming into the country. We wrote in the past about how Paul Volcker and Ricard Nixon did this in 1971. We thought a 10% or more universal tariff on imports was a possibility and it still may happen. However, we think it is more likely the new administration will change the tax code to achieve much of the same result.
There are two types of taxes countries use to get most of their money from corporations, corporate income taxes and a Vat tax. The United States only uses a corporate income tax which is a tax on the profits a corporation makes. The WTO calls this a direct tax (this matters and we will say why later) because the corporation writes their check directly to the Government. The other tax is a vat tax. It’s considered an indirect tax because you don’t write your check DIRECTLY to the government. Vat stands for Value added tax. The vat is considered a tax on the profit companies make on each step in the manufacturing process of a product. It is not considered an income tax. If you pay $100 for components to make a product and then sell the finished product for $150, there will be a tax of 17% on that $50 dollar gain if you are located in China or another WTO country. There would be a 16% vat tax if you made it in Mexico. The WTO has ruled that a vat tax is not a direct tax. Why does that matter? Confused yet? Keep reading.
There are 164 countries in the WTO and 163 of them have a vat tax. Only the Unites States does not. This becomes important when you realize what the WTO allows you to do when you have a VAT tax and you export or import products. If you are a corporation in China and sell something to the United States, the Chinese government will allow you to rebate that 17% VAT tax back to the Chinese manufacturer. The Trump Administration compares this to an unfair tariff or tax. The WTO will not allow you to rebate your income taxes which are viewed as not eligible because they are a direct tax. That ruling excludes US companies from being able to get a rebate on their corporate income taxes when they export. To make things more difficult for anyone trying to sell into China, when an American product comes into China, they will impose their vat tax of 17% on your product. The Trump administration is saying that the difference in the cost of a product through these Vat taxes rebates and assessments is 34%. Their math is you give a Chinese producer a 17% rebate and then charge a USA manufacture 17% to export into China. That’s 34%.
Because the United States is the only country who doesn’t have a vat tax, all products coming into the US are not assessed a 17% tax like they are assessed in China or elsewhere. This is the area that we think the new administration is going to try and change. We think they may follow the Paul Ryan plan which says if you export a product out of the United States you do not recognize the sale in your revenue. Hence, you won’t pay any corporate income tax on the export sale because the IRS will say there “was no sale”. If they can do this, they will be converting a direct tax into a REBATABLE indirect vat tax. The lack of corporate income tax (direct tax) you pay would be equivalent to what foreign countries do when they rebate a vat tax to their manufactures. There are more complicated examples but we will stop here.
Our point in bringing this up is to state the obvious, if the Trump administration does this it will increase the demand for products to be manufactured in the United States by raising the cost to ship products into the USA. Not paying taxes on USA exports will also lower your cost of production when you export out of the USA. This is their intent. We believe this change in taxes will cause higher inflation and interest rates. The tradeoff will be more US jobs. The consumer will also spend more money for their I-phones, clothing and anything imported into our country.
You will soon be reading about Senators in Congress from both parties who hate this idea because they are “friendly” to the retailers who have outsourced the making of these products they sell to overseas manufacturers. Whether it be Target, Home Depot, Amazon or Wal-Mart they will fight this. They will claim it is a regressive tax on the poor and not fair to those on limited incomes. We think Trump will win this battle but that prediction is not cast in stone. We will keep you up to date on this in later letters.
Two stocks we own that would most benefit from this new policy are Berkshire Hathaway and Nucor. Nucor’s ex CEO is the one who helped Trump pick the new commerce secretary, Wilbur Ross. Wilbur’s view on trade can be found in this article which we are linking below.
Those views are similar to what we wrote about above. Berkshire owns a huge number of US manufactures that are also like Nucor. We think that is one of the reasons Berkshire’s stock made all time new highs this year. We are also looking at smaller manufactures in the US to invest in should the tax code change. We will keep you updated on this issue through our letters.
Level 3 is merging with CenturyLink and we think it’s a good deal for us. This deal was announced on Halloween and is a little complicated. CenturyLink is going to pay each Level 3 shareholder $26.50 in cash on the date of closing. At closing, each share of Level 3 you own will be converted into 1.4286 shares of CenturyLink stock. At the end of this transaction Level 3 will own 49% of the new entity and CenturyLink will own 51%. The company is predicting that this deal will close in the third quarter of 2017 after passing regulatory and antitrust scrutiny.
The new CenturyLink stock will pay a dividend of $2.16 per share which at today’s prices for CenturyLink ($24.09) works out to a dividend yield of 9%. We view that dividend as secure if the merger goes through. The combined company would control 100% of any new long haul fiber or empty conduits in the United States. Should the demand for long haul bandwidth needs grow as we expect, that’s a great position to be in. What could go wrong?
CenturyLink is one of the old regional bell operating companies that was part of AT+T in 1986. They were called US West and they were the incumbent carrier in 14 states. This is good news because they have lots of local fiber which is very valuable. It is also bad news because they have a lot of “old technology” and software tied to that fiber. That software is going to be rewritten and “merged” with Level 3’s. That is never a risk-free event. Level 3 got a head start on this type of integration by rewriting their software five years ago. This will make it easier to put CenturyLink’s data on Level 3’s fiber. That said, it’s not going to be a risk-free deal and some bumps could happen as they do this. Both companies say the integration will take three years.
Level 3 is a large position for our clients. The payment of $26.50 in cash per share is a return of 40% of our investment back to us. We cannot stop them from giving us the cash, It’s part of the deal. That payment will raise the cash levels of our accounts. We are looking at other things to do with that money. Until the deal closes, we will just have to wait until we get it. Stay tuned.
As we write this letter our average account this year is up about 15%. On the day of the election we were up around 3%. A question we have been receiving a lot lately is “when do we get out”? We view some sort of pull back as inevitable in 2017. Will this pullback be like the one in 2008? We don’t think it will be. Most investors and pension managers totally missed this move and are sitting on too much cash. When you miss a move like this you have two predominant choices, get fired for staying in cash or get invested in stocks. We think job security factors will win out. Portfolio managers will buy more stocks.
We think the herd mentality of “getting invested” will prevail for a while. The public has not been active in stocks and most pension plans have invested significant money in alternative assets classes like hedge funds, long-short funds and private equity. These alternative asset classes have done poorly versus just owning stocks. We think there will be a rethink of that approach in the first quarter of 2017 with managers selling alternative assets and buying plain old stocks.
That said, are stocks over valued today versus history? The answer would be yes by about 10%. Are bonds over valued versus stocks? Yes. Will investors sell bonds and buy stocks? We think so. Will earnings go up to make stocks cheaper if the new corporate tax rate is 20% versus 35%? Yes. Will placing a “vat equivalent” tariff on imports into this company increase earnings for most US companies? Yes. Because we answered yes more than no, we are willing to give this market some more room to run. Keep in mind we will be receiving cash from Level 3 sometime this year which will build up our cash positions.
As you can tell, there are more moving pieces going into this year than any year we can remember. We have a game plan to attack it but that plan will depend a lot on what happens in Washington. Feel free to call us with your views. We will do our best to navigate what is going to be an interesting year.
Mark Brueggemann IAR Kelly Smith IAR Brandon Robinson IAR