Introspection - Part 2: Thoughts On 2017

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Includes: AKRX, FINL, HD, LOW, V
by: Detroit Bear

Summary

The political atmosphere can make you biased one way or the other - don't let it.

Trump-related fragilities are likely undervalued at this time.

Interest rates are going to be a huge story in 2017 with unforeseen consequences.

I'm short tax policy and a stimulus in 2017.

Remain flexible - when the facts change, I'll change my mind.

The end of the year is always a great time for reflection and self-evaluation. I have been much more motivated to write recently, so I've been trying to share as much work with the Seeking Alpha community as I can. My thoughts on my 2016 performance can be found here. It was an above average year personally, but 2016 was a terrible year for my portfolio. In 2017, I hope to change that and the most effective means will be by looking at what I believe are key drivers, challenges, bias, and sizing for the New Year.

Check your bias at the door

Like everyone walking this earth, I am full of helpful and hurtful bias that is both conscious and unconscious. On a conscious level, my primary challenge for 2017 will be separating political views from market views. Historically, I have simply incorporated political and regulatory conditions as a framework for my broader analysis. When Dodd-Frank included the controversial "Durbin Amendment" that capped debit card fees, I simply took it as a buying opportunity for Visa (NYSE:V), speculating that the regulation would simply shift behavior in favor of credit card consumption. I was correct.

However, the current landscape provides a much more challenging environment for managing bias. I have taken for granted that we have a competent White House that will avoid any dramatic changes in foreign or domestic policy. Even the Affordable Care Act, in spite of all of its challenges, simply created a new set of buying opportunities as healthcare companies capitalized on low financing costs and tax arbitrage to consolidate.

This environment is much different. For the first time in my investing career, we have a true wild card as President with strong legislative majorities. Certainly there are some positives for equity holders like a lower tax rate and potentially more generous deduction environment for capital expenditures. Conversely, the new administration seems less open to free trade, more open to government intervention in the economy (in some respects), and more aggressive in terms of environmental and financial deregulation. Some of these actions could have real negative impacts on society, but the object of investing is to achieve superior returns, not a moral high five.

Like 2009, I should take these regulatory changes in stride and react to the new subset of investment opportunities created by government interference. There may be opportunities in energy and financial stocks that did not make sense under the Obama administration.

However, what I find troublesome is that we do not have the slightest idea of what's coming. I do not mean the unseen risks and exposure to fragilities that the likes of Nassim Taleb have noted. Rather, I think the United States (and the world) have become a much more fragile place as we will soon have a commander in chief that lacks knowledge of the various tactical day-to-day responsibilities of being an executive and possesses a temperament drastically different from any head of the United States in my lifetime. A President inciting an arms race is unprecedented.

"Don't settle for less, even the genius asks his questions"

The world was far from a riskless place over the last 8 years, but I believe President Obama will one day be seen as a hero for not what he did while in office, but for what he avoided. Donald Trump does not, in my view, exhibit the skills of a robust risk manager. I do not have confidence that he has the intellectual humility or curiosity to follow the famous Keynes motto, "when the facts change, I change my mind."

What the last three paragraphs amount to are a roundabout way of saying that a Trump presidency makes me want to go all cash, preferably in Swiss francs, at the unconscious level. However, I know that is not the right call. The proper way to manage my portfolio is like I've always managed my portfolio - take what politicians do and incorporate it into your analysis accordingly. This is going to be my primary challenge for 2017 and potentially the next several years.

A decade under the influence of low interest rates

"Why did you throw the Jack of Hearts away,

it was the only card in the deck that I had yet to play"

We are now coming to the end of the robust monetary policy that has counteracted a lack of fiscal policy to drive asset prices. This is inevitably going to be positive for some sectors like financials, but there will be corresponding unseen shocks. Does the increase in mortgage rates negatively impact household formation and thus the likes of Home Depot (NYSE:HD) and Lowe's (NYSE:LOW) that are riding on its back to drive sales growth? I am not certain. The economy is far too complicated for me to make a jump like this, but I do see higher interest rates having a negative impact on plenty of businesses.

In terms of asset prices, real estate yields may have to adjust for a higher risk-free rate, which could have a negative impact on housing. Housing is a key driver of marginal propensity to consume, and if consumers are feeling poorer due to lower housing prices, the economy could be negatively impacted.

Assuming interest rates rise, the US is very likely to see further dollar appreciation. This is a huge headwind for all multinationals. For one, earnings and sales will decline on a reported basis. Earnings may actually decline on a real basis depending on where inputs are sourced. Further, companies could suffer from a drag on motivation. Many multinationals are compensated on sales growth targets that are based on US dollars but are translated from foreign sales dollars. You could see some productivity losses from companies facing these huge headwinds unless human resources departments adjust accordingly. This sounds simple, but I would be cautious.

How will I deal with this? If my investment thesis is predicated on low interest rates or a weak dollar, it's time to reassess.

Short Change

Remember what I just said about the amount of change that could take place under a new political regime? I would be long that sort of change. However, I think some of the other changes-tax rates and infrastructure investment-I would be short.

The tax rate story is the most overblown story I have seen in the last few months. Though GAAP tax expense may change, I do not see a tremendous amount of upside for cash taxes. The effective tax rate in the US at the moment is about 27.1% versus 27.7% for most OECD countries. If tax rates fall to 25%, we will not see a ton of cash earnings upside, particularly for multinationals that operate with subsidiaries in foreign tax havens that may even may lower rates. Some US-only tax players like Akorn (NASDAQ:AKRX) and Finish Line (NASDAQ:FINL) will undoubtedly see some tax upside, but in total, the sum of the action is not going to revolutionize corporate America.

But what about repatriation? This will be positive, undoubtedly, but I would be hesitant to call it positive for capital spending in the United States. Several companies with large OUS cash balances have acquired OUS cash balances because they have sizable foreign operations. Consequently, it often creates value to reinvest this cash in foreign domiciles.

As for infrastructure spending, a basic tenant of this investment rationale would be that many Americans are unemployed and desperately seeking work. The facts show that this is not the case. The unemployment rate sits at 4.6% and Q3 GDP grew 3.5% y/y. This data could indicate topping behavior, but it does not indicate a country desperately in need of fiscal stimulus.

Further, there is a well-known skilled labor shortage in the United States. Investment dollars may increase, but there may not be workers to staff these investment projects. I doubt the current administration will directly hire employees, so "crowding out" won't be an issue. However, construction companies will have to weigh bids for government work and private development. It almost seems as if we need an increase in the total available working solution via a radical means like immigration.

What's the takeaway? I have used the rally to cut positions in multinationals that I believe rallied for no particular reason

Size does matter

I make no qualms about running a fairly concentrated book, with position sizing usually weighted on a combination of conviction and lack of downside. I do not believe Visa has a ton of upside right now, but I also do not believe there is much downside. Combined with the dreadfully high tax bills I would face, it remains my top position.

Overall, after my Valeant experience, I am running a slightly less concentrated book. I have had times in the last two years where I had no more than 3 stocks, but going forward, I will target 6-10 positions. Additionally, I am going to remain disciplined about my cash position, always targeting reserves of 10-20%.

Investors can always make a case to be concerned about the macro picture. In the uber complex and massive economy that dominates, something bad is always happening. Thus, I take solace in the edict of buying good businesses trading at attractive prices, preferably prices below fair value. That said, I have a few shorter duration positions on at the moment that will be converted to cash upon conclusion and invested in more event-driven securities. I tend to look for long-term holdings that I believe make sense for the next 2-5 years; however, there is no reason to shy away from attractive merger arb opportunities, odd-lot tenders, or cheaply priced options. One of my favorite scenarios is to find a pharma deal with CVRs where there is some risk to close and you can essentially get a free option. I target about 10-30% of my portfolio in event-driven securities, depending on the opportunity set that's available.

Bringing it all back home

"I try my best to be just who I am,

But everybody wants you to be just like them."

Like every year, 2017 will be exciting for financial markets. Such is what I love about markets-they are endlessly fascinating, dynamic, and challenging.

I think the consensus feeling right now is that Trump = businessman = good economy. It is in my nature to fade that view, but as I noted, I will attempt to check my bias at the door and attempt to find attractively priced securities with strong businesses behind them. I will now give you the least helpful advice that I can:

  • Trump-related risks are probably undervalued, find a way to gain exposure to new systemic fragilities
  • Interest rates are going to have a very complicated impact on the economy-be wary of an investment thesis that is ultimately predicated on a weak dollar or low rates
  • If you want to play a "lower US tax rate" company, use your accounting knowledge to find an effective tax rate that is actually well above 30% Size matters; conviction, duration, balance sheet strength, and cash are three of the factors I use position sizing.
  • Size appropriately
  • Most importantly: change your mind. If Trump turns out to be the best President in US history, I will happily admit my mistake and adjust my equity positions accordingly

What factors are you using to shape your investing framework? Thank you all for a wonderful 2016.

Disclosure: I am/we are long V, AKRX.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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