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Paul Roukis, portfolio manager of the large-cap value strategy at Rothschild and Company Asset Management.
Earlier in the year, there were a lot of questions about economic slowdown and, in particular, a slowdown for corporate earnings. Well, fortunately, the first-quarter earnings results are proving to be more resilient than initial expectations. Remember, companies are dealing with a number of revenue and expense headwinds.
On the revenue side, it was the prospect of slowing global economies and the stronger dollar. On the expense side, it has been higher input costs. Wages and benefits usually get the most press regarding cost inflation, but it’s much broader than that. When you listen to companies, it’s across most line items, like property taxes, liability insurance—not to mention fuel costs—that have all risen.
In effect, it’s good to see companies able to withstand cost inflation pressures and largely maintain their operating margins. The thought was that U.S. companies—and, again, as I’m saying “U.S. companies,” it’s measured by the S&P 500—would see an earnings decline year-over-year in the first quarter, not by much, by a few hundred basis points, say, 200 or 300 basis points. Well, the good news is that didn’t happen. We are largely through earnings season, and the scorecard would show about 75% of companies exceeding expectations.
Now, instead of a modest contraction, we are looking at about 2-3% year-over-year growth. The $1-million question is, what’s the outlook for the stock market and, in particular, corporate profits for the balance of 2019?
We start with the premise that we can’t predict the market’s direction with any degree of accuracy. However, what we do focus on is corporate profits and market expectations, which are good indicators for the market over time. As we think about the corporate earnings picture, I think it’s important to remember where we started from about six months ago, or the fall of 2018.
Expectations were for about 8-9% year-over-year EPS growth for 2019. However, reflecting the weakness in global economies; higher interest rates, in general, back then; the stronger dollar; and rising input costs, expectations were reduced to about 3% year-over-year growth as recently as January and February of 2019. With the positive first-quarter results now behind us, EPS growth expectations have likely crept up to the 4-5% level for 2019. Though, I would highlight that company management teams remain cautious given the potential binary outcomes of certain events. Trade negotiations being at the top of the list, and I wouldn’t just include China. I think it’s more broad than that.
Barring any unexpected shocks to the system—which, again, should not be ruled out, as we’ve seen in most of May with the re-escalation of trade uncertainty—companies should be able to deliver about 5%-plus EPS growth in 2019. The U.S. economy seems healthy. Employment gains remain strong, and inflation is benign, which should encourage the Fed to remain sidelined with respect to further monetary tightening. The backdrop appears good from a macro perspective, though not without risk, as we’ve seen with the headlines in May, and the potential for tail risk. Extension of trade uncertainty will, most certainly, moderate growth, in my view. Though, it doesn’t appear we are there, just yet.
As it relates to valuations, because that’s another part of the storyline here, the forward-looking PE multiple, which is based on 2019 earnings expectations, is about 16 and a half times, so not too different from the long-term medium. With lower interest rates, low inflation and a generally healthy economy, a PE multiple in the mid-to-high teens seems pretty reasonable, though not likely to expand much from current levels. That is why we think corporate profit growth is essential to further market gains from here, and why it’s also important to keep an eye on inflation, and central bank monetary policies.
There are individual stocks that we certainly invest in, but we also have to keep in mind, every stock we own is part of a broader, roughly, 70-stock investment portfolio. We believe stocks have a place in a diversified portfolio. Charles Schwab is a 58-billion market capitalization stock and one that has proven to evolve with the times. The business model has transitioned from being a pure-play retail brokerage to a diversified financial services company that includes financial advisory and banking services. Total client assets are, now, right about 3.6 trillion. The company also serves as a back office for independent financial advisors, things like processing and custody services.
I would highlight, however, Charles Schwab as a stock is procyclical, which means the ideal backdrop would consist of a strong economy, active and rising equity markets, and positively trending interest rates. In other words, while there are company specific characteristics to point out, which I’ll talk about, the stock is very much influenced by macro factors. With that diversification of the business model has come a shift in perception, by investors, and rightfully so. The growth in the company’s banking operations, and its reliance on spread income, have exposed the company to interest rate volatility. The low interest rate backdrop has not been viewed that positively.
The stock sold off about 30% from its highs in 2018 in the aftermath of the Fed’s policy shift. In essence, investors felt the company was over-earning in the near-term and the pre-tax margins in the mid 40% range are not sustainable, which we acknowledge they may not be right. However, when the stock traded down to about 14-times earnings, the cheapest it’s been in about a decade, we thought the stock was beginning to discount the prospect of potential downward earnings revisions. For comparison, Schwab is often traded at, roughly, 20-times-plus forward-looking earnings, so it’s a significant discount to where the stock has historically traded, even assuming that earnings could be cut.
Listen, we recognize and appreciate the interest rate market sensitivity here, which would put the company at some risk in the near term. However, we are comfortable with taking that risk, given the discounted valuation and given our view that the company is a secular winner in the asset-gathering game. Through time, Schwab has organically grown its net assets by, roughly, 6% per year. What we also haven’t talked about yet and which is extremely important to the investment piece is Schwab’s low-cost expense structure, which provides a competitive advantage in such a price sensitive industry.
If you listen to other companies, you certainly would find out that Schwab is one tough competitor. Earnings are projected to grow about 13% in 2019, with current expectations of 8% growth in 2020, which seems reasonable to us. Now, again, very much subject to the macro environment. I think one area that often gets overlooked by investors is on the capital allocation side. While the company does have limits on capital allocation due to regulatory thresholds, we believe Schwab is able to accelerate returns to shareholders through next year. The company recently raised its dividend and has a $4-billion share buyback authorization, which essentially represents about 7% of total market cap.
So, net-and-net, we view Schwab as a cyclical company—however, with the secular underlying growth story and one that provides optionality to higher interest rates.
My views expressed today are my current opinion of a company, not an indication of the fund’s intention to trade or hold a position. I would also like to highlight that my opinion may change in the future and it should not be viewed as investment advice.