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November 11, 2020
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204104 Sector Spotlight Capital Markets – Almeida, Indhu, Sholder 10.13.20
Title: Capital Markets Spotlight - 2020 Election: Let the Games Begin!
Hello. And welcome to the MFS Capital Market Spotlight for the fourth quarter of 2020. I am Indhu Rhagavan from the investment solutions group here at MFS. Elections are always a hot topic for markets, with investors trying to position portfolios to take advantage of likely outcomes. We would suggest that it is a mistake to make investment decisions based solely on the expected outcome of elections.
First, it's not just about who wins the presidency, it's about the composition of the House and Senate, as well as the contours of the different political parties, all of which interact with a host of other structural and cyclical factors to influence investment outcomes. Still, as we head closer to Election Day in the US, it wouldn't be a stretch to say that the stakes seem particularly high this year. There are several critical areas of policy differences between the Republican and Democratic candidates around taxes, trade, and health care, in addition to the pandemic response, with potential long-term implications for the economy and markets.
To share insights on these dynamics and their implications, I am delighted to be joined today by MFS global investment strategist Robert Almeida, Rob, welcome back.
And MFS equity research analyst with coverage in consumer cyclicals, health care, and financials, Matt Sholder. Matt, welcome.
Thank you so much. Very happy to be here.
Rob, could I begin with you? With any high level comments you have about this, or any election, as it relates to capital markets.
Sure. Well I was thinking before our call today. I have voted in eight US presidential elections. And I was thinking, given the paradox that you laid out earlier, and the wide, differing views between the two candidates, how did I feel in those past elections, and how did I feel after the election? And I guess, the point that I'm trying to draw is that, in past elections where I voted you had a recession. In past elections, you had hot, important, topical issues, like we do today. But in none of those did we have a recession, a pandemic, and probably, as divergence of views on policy as we have today.
And so I mention that because, obviously, elections matter. They're incredibly important in who governs society and leadership of countries. But as it pertains to financial markets, and investing, I would describe it as an input versus a driving factor.
So really, what we're asking, and what people are talking about is, this election, how pertinent it is to the future cash flows of investments, and enterprises, and companies within financial markets. And there are obviously no facts about the future, and how the executive, and how the legislative branches of our government, obviously, can influence the economy and what cash flows may be. But how they affect each individual company is truly idiosyncratic. It's going to affect some sectors more, some industries more, it's going to affect some companies less.
And every day, investors are, let's say, bombarded, with just an abundance of information.
So as it pertains to election, we need to think about, what are the policies that the candidates are looking to implement? Two, what are the probabilities that they're going to be able to actually implement those policies as promised? And three, most importantly, which I think we're going to get into with the help of Matt Sholder here today, is, how does this affect the individual companies and investments? How does this impact the individual cash flows at the company level? Because ultimately, that's what matters, and that's what drives asset prices.
Thanks Rob. Thank you for framing the conversation in those terms, in terms of what's really important. So if we were to get down to the specifics, as you pointed out, and understand some of the idiosyncratic factors, let me take it to Matt now, and touch on one of the policy areas that we mentioned. Taxes. Candidate Biden's proposal has been to repeal some aspects, at least, of the 2017 Tax Cuts and Jobs Act, specifically an increase of the corporate tax rate from 21% to 28%. Matt, as sector lead for the US consumers cyclicals team, could you walk us through how you and the team have been thinking about the impact of this dynamic on our investment holdings? 4:50
Yeah, absolutely, thank you Indhu. So, I think Rob put it really well. That we're focused on durable, sustainable changes to underlying cash flows. And tax rates being extraordinarily important to the total free cash flow that a business is going to generate, is something we're focused on. At the same time, it's also something that affects every company somewhat equally. And, it's also completely out of management's control.
At the end of the day, a tax rate, unlike other lines in the PNL, is truly out of management's control. So we're cognizant of that.
But as a team, because they are important to cash flows, we have taken a deep look at it. And so where we started was, we just wanted to group ourselves in where were tax rates previously? So we looked at all of our holdings in consumer cyclicals across the firm. Some of the biggest stocks that we own broadly. And just to remind ourselves, what were their tax rates before tax reform? Where did they land last year? And even though this isn't necessarily Biden's proposal, if we were to go back to the pre-2016, or pre-tax reform levels, how much would earnings be down? 5:54
And the most important thing we were trying to assess is, are we off sides? In other words, do we have a bet on, which would be unintended, that if tax reform were to be repealed, the stocks that we own would fair worse than the stocks that we don't own? 608
Importantly, we just didn't want to have any unintended bets, or any unintended consequences from a repeal on tax reform. So that was the beginning of the analysis for us.
No, that's great. Thank you Matt. Perhaps I can ask you a related issue on which we have some uncertainty right now, which is the stimulus bill. We know that the first coronavirus relief package, the CARES Act, which was implemented in record time, had no small part to play in the economic recovery we've seen thus far, and there's continued uncertainty on any subsequent stimulus. If I could just get your thoughts on how important has the stimulus package been for the companies that are in your coverage or in the team's coverage. And what, if anything, is a likely consequence of not having a subsequent stimulus on these companies from a long term perspective?
Sure. Absolutely. Well I think the impact of stimulus likely cannot be overstated. And so one of the ways we've looked at it, we went back, just to use one company as an example. [x] And we just went back and graphed their comparable sales going back to 2006. And they bounced along. There's recessions, there's periods of negativity, there's periods of expansion. And then there's mid-2020 too, where literally, the comp sales are off the charts they're record breaking, there's nothing like it going back 15 years or longer in company history.
Then the question for us as analysts is, we have to unpack that. And so what's the impact of stimulus? And then importantly, what's the impact of some retailers either being shut, or being ill-advantaged, or not as advantaged in this environment? In other words, they may not have the same digital offerings. They may not have an ecommerce business that's as robust. And so, as consumers are looking to maybe drive to the store and pick up product. 807
And then there's also this powerful wallet share shift away from eating out and travel, which is an important undercurrent that a lot of retailers have benefited from. And I'm sure many can relate.
And so the direct answer to your question is, we don't know the exact element of stimulus. But we know from talking to management teams, and just looking at the record breaking comp sales results in the most recent quarter, that it's been a key element of the comp surge that many retailers have experience.
So what you're saying is, even though the stimulus has been a tailwind broadly, it's important to ask these questions on a company by company basis and see how they're positioned.
Absolutely. I think one of the biggest learnings for me as an analyst, and I think for all of us looking at these companies is the investments that managements and companies made five years ago, frankly, to compete with Amazon, first and foremost. And I'm thinking about having a really robust app. Having the ability to search inventory in a store online, to see if it's actually available. Have curbside pickup. All of the ecommerce backbone. Investing in that over the past three to five years so that a company could compete with Amazon effectively. The same investments have served them extraordinarily well during the COVID-19 pandemic.
Indhu, if I could add to that.
... If we listen to what Matt's describing, ultimately, it's getting down to the idiosyncrasy of each individual company. And so those that were prepared for this, perhaps against maybe those that were less than prepared. Maybe this is just semantics, but when I think about the difference between an economic rebound and a healthy economy, they're two different things. So we call this stimulus, but it's really transfer of payments. So we're just issuing debt to replace income that was lost or destroyed. Now I'm not saying that we shouldn't have done that,
I'd argue that all the money that government and companies have raised, it lacks, perhaps, sustainability or durability. So what Matt's describing is just so important to do what he and his peers are doing, which is peeling back each individual company and trying to understand, is this is a one time effect do to the pandemic? And/or is this representative of something, of an economic moat that a company has long term?
Rob, no, thank you for making that finer point. I think the sustainability of all of these measures is a key question that investors should be considering, and that we are considering every day. 1038
If we could shift gears a little bit now to the pandemic response and health care policy. Rob, I want to come back to you on this. You highlighted the election issue as one area of uncertainty. But the other major uncertainty we face around the globe today is the resolution of the coronavirus health crisis. And the two candidates and political parties differ on the appropriate response to this. You've written previously about the risks that remain in the economy, even as the US economy reopened, and the importance of the marginal customer. If I could just ask you to elaborate on this a little bit, in terms of how critical it is for a sustained economic recovery and health companies.
Sure. And I'll oversimplify this. But corporate profit margins, which is ultimately what investors care about, right? They're not buying GDP, they're not buying economic policy, they're buying cash flows, they're buying profits, they're buying margins, future margins. And so, the trajectory of US corporate margins have peaked in 2018, and had been decelerating, or had been falling since. So margins had peaked before the crisis. Pull forward to what happened in February during the lockdown. GDP in the US, globally, fell by anywhere from a third to 40% on an annualized basis. We issued trillions of dollars of stimulus, which we talked about.
So the response to the pandemic was to plug huge gaps in revenue, whether it was at the household level, at the corporate level, or at the government level, even at the municipality level, is to plug huge gaps of revenue holes with more debt. Debt is fine on its own when those proceeds are being used to invest in a project, or to invest in a project that's going to produce a level of cash flow. But when debt is used to replace income that was lost, the balance sheet is worsened.
So, during the crisis what we've seen is, in order to keep employees and customers safe, costs are going higher, balance sheets are more levered than what they were before the crisis, and profits and margins are down anywhere from 30 to 40%. Now clearly, the market is discounting an economic rebound, discounting a recovery, and I guess, where I slightly disagree is more of the magnitude. And what I think is getting lost on investors, to some degree, is just how important scale is. The last 10 to 20% of revenues drives a disproportionate amount of operating leverage and profits for companies.
And so absent a vaccine that has 100% efficacy where you have 100% compliance amongst its citizens, we're going to be left with months, and perhaps quarters, if not years, of an environment where we have to be, perhaps, wearing masks, and more socially distanced, etc. And my larger point is, as you see revenues not materializing to what they were in 2019, on the back of higher debt and more costly to run your enterprise, again, to keep employees safe, and keep customers safe, and the like; I think the market is assuming too much of a degree that we're going to see 2019 margins very, very soon. And we're less optimistic that that's going to happen. 1403
So Matt, clearly, the resolution of the coronavirus health crisis is an important element in overall economic recovery. So, how are you and the team viewing and thinking about the impact of the differences in the health care policy vis-a-vis paying for health care between the two candidates?
Yes, absolutely. Drug prices seems to be an issue that never goes away. And yet simultaneously, nothing ever changes. So it's an interesting area to cover as an analyst, because I'm constantly aware of it for the stocks that we own. I live in fear of it. Maybe for the stocks that we don't own I'm rooting for it, depending on the situation. But the status quo seems to prevail. So I guess, as analysts, I think what we're preparing for is, we understand quite a bit about the Trump administration's view of drug pricing, because there's been a number of executive orders which we've been able to analyze. There was also the blueprint which I believe they put out in 2018 that was an architecture for getting lower prescription drug prices for Americans. So that's a document we can sink our teeth into and analyze.
And then on the other side of the aisle we have HR3, which made it through the House of Representatives, which is sort of the Democratic view, or maybe a slightly more left view of the way to tackle high prescription drug prices. And then there's slightly more moderate views in between. And so I think what we've done on the health care team, since we don't know exactly what's going to happen, is we've wanted to understand the details of each policy, how they could impact certain companies, and there are some, when you look at this bottom up.
For example, a company that has the vast majority of its revenue in the United States. A company that has the vast majority of that revenue in the United States from Medicare part B, that's going to be highly, much more exposed to reforms and drug prices than say, a multi-national with 50% of revenue coming from the United States and only 10% of that in part B of Medicare. 1605
Great. Thank you Matt. Rob, I want to come back to you on a different topic that we wanted to cover today. Back in May, together with our chief sustainability officer, Barnaby Wiener, and ESG analyst, Rob Wilson, you wrote a piece for clients titled The End of Shareholder Primacy and Its Impact on Equity Evaluations. Specifically you discussed how many companies may not be able to generate the same level of returns, because the level of economic value extracted from labor is unsustainable. Now, does a Biden presidency bring a sense of urgency to this?
Oh, I think it does. I think a Biden outcome, or Biden presidency, brings that forward. And he has de facto said as much with the potential for raising minimum wage from $7.25 to $15. Now obviously, we don't know how long that legislation would take to be put into work, and over what time period, but when we think about the significance of input costs... And you can break down every company's margin structure or profit structure and simply it into three things. It's units, price, and the cost of making and selling those units. And so, labor, particularly in some of the areas that Matt covered, are a big portion of input costs.
And so for the last decade plus, in the absence of above average, or even average, economic growth, in the absence of, again, even average revenue growth, particularly companies in the United States got creative and found other ways to drive or finance returns since they couldn't get returns from traditional business operations. So you saw balance sheet financialization, so issuing debt to buy back stock, pay dividends, etc. You saw an elongation of supply chains, a factoring of accounts payable, factoring of accounts receivable, and of course, suppression of one of their biggest inputs, which is wage pressure.
So perhaps, what you have, potentially, in 2021, is a presidency that will work to shift some of that and alter the compensation structure and a major input to many companies. So we've been thinking about this for some time. And what we want to own, across a cycle, is companies that we believe can derive sustainable revenues and profits versus maybe artificial or one time levers from manipulating parts of their balance sheet or their income statement. But really, running a business that provides economic value to all stakeholders. And so I think, perhaps what we're seeing, and a big and important part of this election is, what will happen to labor costs? And really, just getting at what has been a multi-decade widening of the inequality gap. 1907
Yeah. Matt, so from your vantage point, and based on your discussions with company management, and discussions within the global research platform,[RI(1] [FMR(2] are you seeing any early indications of this impetus to rebalance the inequities between labor and capital? And how are companies thinking about dealing with that?
The labor costs and upward pressure on wages is a key topic for us on the consumer cyclicals team. So just to dimensionalize it and put some numbers on it, when you look at restaurants and retailers, over 50% of their operating costs are often labor. After cost of goods, labor is by far the most important cost input.
And so on the cyclicals team, what we've tried to analyze is, what are... And companies, by the way, don't always give the best disclosure on these metrics. So it's not as if XYZ retailer or restaurant is quick to advertise labor is this percentage of our operating costs, and our starting wages are $10, and our average wage is $12. So this is all information that as analysts, we have to piece together with expert network calls, with piecing together comments that corporate managements make, and then talking to former employees.
And the way we've sort of divided the world is, okay, if a company is paying below $15 for their entry level minimum wage, what else are they giving their employees? Are there education subsidies? Are there health care subsidies? Are there retirement contributions? Are there other things that potentially that $15 goal is not capturing? And that if you added up all the wages and benefits, it's actually well north of $15. Therefore, if the starting wage needed to creep up, there are potentially other things that might need to get cut back in order to manage the profitability of the business in a higher wage environment.
In addition, what are companies doing within... So using retail as in example, within the four walls of the box to manage labor costs? Are they investing in automation? Are they investing in things like self checkout? Are they doing things to make employees more productive so potentially you need fewer employees if each employee becomes more expensive? And then, if we talk to company managements and they sort of have their head in the sand, for lack of a better expression, it tells us a lot. Because it means that they're not prepared. And if this were to happen, and we don't know if it will, that they're unlikely to thrive.
Rob Almeida: 2133
Over the last two decades, we've obviously seen a huge growth in passive investing, huge growth in factor based investing, quantitative investing, and then more recently, ESG, or environmental social governance related portfolios and products, and the like. And I think at the end of the day, there is no substitute for rolling up your sleeves and doing what Matt's describing. There are certain things that a computer or a model just aren't going to be able to capture. And being able to sit in front of a company management, even virtually, in 2020, and understand how they're thinking about the business. And are they prepared for what may come under a different presidency? Or, to use Matt's expression, maybe they aren't ready for it and they have their heads in the sand.
It's interesting being an analyst looking bottom up and thinking about individual companies and individual company's strategies and operating plans. Because I can think of a number of retailers where I feel really good about the operating margin picture on a three to five year view. And therefore, they're stocks that we own and that we feel good about.
And so it's just interesting, you could have this concern coming from the top down, but then you get comfort and you get conviction based on the deep analysis that we do and the conversations with management, and seeing strategies in action. That wow, this company... Even in the context of falling margins for the market as a whole, is actually going to execute extraordinarily well based on their track record, based on these specific initiatives that I've been able to analyze. And so, I think that's just how we get conviction as analysts and portfolio managers.
Well, and that's so important. Because I think clients, when they hear me express that view, read it as a bearish one, and it is. But if we think about the concept of scarcity value, when there's an abundance of something it's not worth very much, and when there's a shortage of something it's worth a lot more. And so when I think about in aggregate falling margins due to all the things that we're talking about, that doesn't mean that there aren't going to be profound, clear winners in these varying industries. And if your wallet share is increasing, or if you're managing your costs better than somebody else, and your margin profile and trajectory looks now disproportionately better than your peer universe, that asset should be worth materially more because it has scarcity value, where it was much harder to attain that scarcity value, really over the last 10, 11, 12 years. 2404
Another area that I would love to get both your thoughts on is trade and tariff policy, which has been in a very high frequency news cycle. It's gotten a lot of airtime. Rob, this is obviously another long term trend. We had seen the trend toward deglobalization for a while now. But the pandemic has perhaps provided another impetus to this. And both candidates have discussed protecting American jobs and companies. How[RI(3] [MOU4] material are their policy stances? And how should investors think about this from an investment standpoint?
If there's one thing that I think both parties agree on, it's improving the health of the US job market here in the United States.
And one way to do that is to, of course, bring jobs back to the United States. When we think about one of the consequences of the pandemic and the scarcity of being able to source parts, or products, and ultimately bring products to customers, I think you had a multi-decade period of just in time inventory management. And I think, perhaps what the pandemic brings forward, along with so many other things, is more of a just in case. So this idea of elongating supply chains and suppressing wages to drive higher revenues, and to drive higher returns, I think perhaps you see somewhat of a reversal of that. And you see supply chains shortening, regardless of which candidate wins in just a few weeks.
And that's going to come with higher costs. But I think it's just more important for companies to have products on the shelf available to people and customers when they want it and when they need it.
Matt, from your vantage point again. Are you seeing any early indications of a trend towards bringing back production closer to home markets or changes in supply chains?
I am picking up on some of that. And the supply chains are sticky, and it's not something that a company can change overnight. But I think in general, in addition to the just in time factors that Rob was just talking through, I think companies also learned a lesson of overly concentrating on a single market. And so the idea of having all of your supply in China at the time when a trade war breaks out isn't great. If you ideally could be much more diversified around the world and have backup supply, and be able to have a really flexible supply chain, I think that has shown to be incredibly valuable. 2632
Rob and Matt, we've covered a lot of ground here today in terms of policy issues that are on the table and concerns that investors are grappling with. And beyond the policy issues that we discussed, there's also a non-zero probability that we may not have a clear winner on Election Day. So Rob, what are your closing thoughts on how investors should think about navigating the next few months, let's say, with heightened uncertainty?
Sure. I guess a couple of comments. So, in the last several weeks, we've seen some consistent pattern across financial markets, not just within equities, but you're seeing it in commodities and in the rate markets. So nominal yields are rising. Real yields are rising. Break evens are rising. Commodity prices are rising. And in the equity markets, you're seeing substantial outperformance of small-caps over large. So what this is signaling to me, or at least it feels comparable to what you saw after the Trump election in 2016 which was tremendous market euphoria surrounding an economy that was going to be reflated out of its below average weak economic state.
And then of course, in 2017, when the economy didn't reflate and disappointed, you saw a reversal of that, where secular growth companies outperformed cyclical companies, break evens fell, real yields fell, nominal yields fell, etc. And this feels a little bit similar to me. So I think investors are perhaps over discounting the ability of a new president, because if I just go based on what polls are telling us and what betting websites are telling us, and given Biden's lead, I think investors are discounting that a Biden presidency will have this reflationary aspect in the economy.
And so at the end of the day, regardless of who's in the White House, and the contours of the legislative branch, and the balances of power, ultimately, what does a company do? How do they do it? And can they keep doing it? That's what's material to each individual asset. So I'd be, maybe less worried about who's going to be in the White House from an investment standpoint, and be more focused on, how does this impact the potential cash flows over the next two to four years of the companies that you own?
Matt, any closing thoughts from you on what you're keeping in focus in this environment?
Yeah I think, certainly, this election's important. And we're all going to be waiting with baited breath to see the results. But at the end of the day, what I think we're focused on is, how are companies operating in a very challenging environment? And every company has responded to this pandemic differently. Whether how they take care of their employees, how they view their customers and the value they created for society. And so the companies that I think were most excited about, and frankly, we'd be looking to buy more of in a period of market turbulence, are those that we think are well-positioned to deliver sustainable, durable growth, and free cash flow on a multi-year view.
And the companies that we've been most interested in in 2020 where the market volatility has created opportunities for us to get more active in certain stocks, or revisit stocks that maybe we haven't owned in the past, are all of those companies that we feel like have executed well in a very challenging environment. And no matter what the market throws at us, and how the political environment might change, we think are well positioned to continue delivering, hopefully continue to outperformance in the years ahead.
Thank you so much. To reiterate some wise counsel, it's important for investors not to let news headlines knock them off course. Maintaining a disciplined investment approach, a long term investment horizon, and a sensible rebalancing plan, continue to be sound approaches in this election year as any other. Rob and Matt, thank you so much for joining me in this conversation today.
And thank you to all of our listeners who've tuned in. You can access additional MFS thought leadership on mfs.com, Twitter, and LinkedIn. And specifically on this topic, we have a 2020 US Election content center for investment insights. If you have any follow-up questions, please reach out to your MFS relationship manager, and stay safe.
The views expressed are those of the speaker and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as a solicitation or investment advice from the Advisor.
[RI(1]I would bring this back in the conversation cause that part seems choppy jumping from Rob to Matt.