AMM Dividend Letter Issue 25: 2016 Prediction & Year-End Review
This is from the AMM Dividend Letter released January 7, 2016. If you want to see the latest “Dividend Stock in Focus” as soon as it’s released then join our mailing list here.
Predictions. We humans love listening to, making, and trusting predictions. Since it’s the start of a new year we’re going to be inundated with a lot of predictions about the year to come. The thing is we are really bad at making predictions; especially stock market predictions.
The chart below, from Morgan Housel’s The Blind Forecaster, shows the average wall street strategist’s forecast for S&P 500 returns each year compared to the actual gain/loss in the S&P 500 for that year since 2000.
According to Morgan Housel, the average Wall Street strategist was off by 14.7 percentage points a year! And these guys and gals get paid the big bucks.
What if you simply took the S&P 500’s long-term average return of about 9% and used that as your guess? Morgan Housel took a look at this too and this strategy beat the pros, but you still would have been very wrong. Your forecasts would’ve been off by 14.1 percentage points per year.
Why is it so hard to make stock market forecasts? It seems fairly easy right. Get a reasonable estimate of earnings for 2016, apply a basic multiple, and voila you have the S&P 500 target price and the return for the year. It’s that easy!
Not quite. The stock market is a dynamic system. It is an interplay between millions of moving parts and participants. Like the weather, another dynamic system, each little change ripples throughout the system causing large and unforeseen effects rendering predictions useless.
It’s the butterfly effect; a butterfly flapping its wing in some far off place causes a hurricane. Or to put it another more official way.
In chaos theory, the butterfly effect is the sensitive dependence on initial conditions in which a small change in one state of a deterministic nonlinear system can result in large differences in a later state.
Always Know Your Base Rate
If we’re planning a trip to San Diego 6 months from now we don’t need to know exactly what the weather will be like. We can reasonably expect the weather to be sunny and about 71 degrees Fahrenheit, the average June climate in San Diego. We can make this reasonable assumption because we have centuries of weather data that we can average. This is called the Base Rate.
The long-term average return of the S&P 500 is a reasonable base rate for stock market returns. Once an investor knows the base rate, they should then determine whether they have any special knowledge to adjust the base rate up or down to make a better prediction. Given the poor track record of Wall Street strategists who are literally paid to make these predictions, we should assume we have no special knowledge. In this case, all investors should simply use the base rate.
We don’t need to come up with a better prediction than the long-term average returns for the equity markets. We’re not trying to get in and out of the stock market at just the right time. Because the markets are dynamic systems, a decision to sell one day will look completely foolish the next. All the buying and selling leads to more transactional fees, a guaranteed loss of your money.
We also enter 2016 knowing that the market will not likely return its exact average (i.e. the base rate) for the year. It rarely ever does as the chart below shows.
The other big issue with market predictions, and maybe why investors are inclined to trust them so much, is that the people who make them are typically both confident and very specific. In fact as the data show, the forecasters are terribly overconfident in their ability to make predictions. In dynamic systems like the stock market, it is better to think probabilistically with a range of potential outcomes as opposed to trying to predict a single outcome.
To be as confident as the other market prognosticators, we want our range of outcomes to fall within the 95% confidence interval. The following is our prediction of probable returns for the S&P 500 in 2016. Feel free to use this prediction to wow your friends with your clairvoyance.
The S&P 500 will return between -25% and +25%!
And you wonder why CNBC has not called us to appear on TV yet.
How is This Useful?
What can anyone do with this prediction
While the range we give is wide the actual skew of the distribution curve is shifted more towards positive returns. Even though no one knows what the stock market will do each year the odds favor positive returns and, over longer time periods (10-30+ years), the odds greatly favor positive returns. Also, the longer the time period the tighter the range of probable return outcomes with a clear shift towards more positive outcomes.
And that’s what you do. You make a plan to save and invest for a long period of time, 10+ years, and then stick to the plan. You avoid the Siren’s call to trade around yearly market predictions. It is the best way to keep the odds ever in your favor.
Happy New Year!
Your Portfolio Management Team
Novartis (NVS) from Volume 13
Novartis is a large well-diversified pharmaceutical company. It operates in branded pharmaceuticals, generic pharmaceuticals, eye care, and consumer health.
Novartis’ branded drug divisions had its heart failure drug, LCZ696, approved in the U.S. and EU and officially named Entresto. Sales are off to a strong start and peak sales are expected to top $5 billion. Cosentyx, an immunology drug, was also recently approved and its peak sales are expected to reach $2 billion.
Sandoz is Novartis’ generic drug division. It is one of the biggest generic businesses in the world and will receive a boost from the billions of dollars worth of branded drugs losing their patents over the next 5-10 years. Part of this growth will come from the new and developing biosimilar market, “generic” versions of biologics. Many of the world’s first and extremely profitable biologics, e.g. Amgen’s Neupogen, have gone off patent and generic drug companies like Sandoz are selling their cheaper versions.
At the current price around $84 per share the market is undervaluing the potential of Novartis’ branded drug pipeline, generic drug opportunities, and the return of growth to its eye care division, Alcon.
BlackRock Inc. (BLK) from Volume 14
From December 1, 2015 to December 14, 2015 BlackRock (BLK) lost about 11% of its market cap. During this time, another famous asset manager Third Avenue Management had to shut down its Focused Credit Fund (TFCIX) because of mounting withdrawals and the lack of liquidity in the junk bond market. BlackRock runs one of the largest junk bond ETFs (JNK). Never missing a chance to throw the baby out with the bathwater, BlackRock shares sold off even though JNK represents only 0.22% of BlackRock’s total AUM. To be fair, whatever affects the overall bond and equity markets affects all of BlackRock’s business but to be hyper-concerned about one ETF is too narrow of a focus.
BlackRock is the world’s largest asset manager and is well balanced between fixed-income and equities, including both active and passive strategies. We expect short-term market gyrations and fears to present more opportunities to add to our position in BlackRock.
*Volume 15 was the 2014 year end review
General Electric (GE) from Volume 16
General Electric had a busy year. It jumped through all of the regulatory hoops to buy French company Alstom’s power business. GE had a deal to sell its appliance business to Electrolux only to have U.S. anti-trust regulators nix the deal. CEO Jeff Immelt says he expects to find another buyer at the start of 2016.
In 2015, GE finalized the spin-off of Synchrony Financial. We were hoping to get GE’s remaining 85% stake spun-off directly to current shareholders, but that didn’t happen. GE did an exchange offering whereby it offered to sell SYF shares to current GE shareholders at a 7% market discount. Then GE would use the cash raised to buy back more of its own shares, about 7% of its then shares outstanding. We declined to participate in the offering. We wanted to maintain our complete position in GE to participate further in its restructuring and plans for returning more capital to shareholders.
GE sold its commercial lending and leasing business, the last big chunk of GE Capital, with $32 billion in assets to Wells Fargo. The bulk of the proceeds from the sale will go to returning capital to shareholders.
Finally, GE received a boost when activist investor Nelson Peltz and his Trian Fund announced they owned 1% of GE. Mr. Peltz then publically said they are in agreement with everything Jeff Immelt is doing and their new stake is not an activist stake.
Norfolk Southern (NSC) from Volume 17
When we discussed Norfolk Southern we mentioned that the failed merger of Canadian Pacific (CP) and CSX (CSX) opened the door for Norfolk Southern to be involved in a deal. Then in early November Candian Pacific announced that they would like to buy Norfolk Southern in a $28.4 billion deal. NSC rejected the offer because it did not “fairly value” the company and NSC management does not think the deal will pass anti-trust regulation. Canadian Pacific revised its offer on December 16, 2015, to include a bonus payment of up to $3.4 Billion to NSC shareholders if the combined company’s shares are not worth $175 by October 2017.
Then the CEO of Berkshire Hathaway owned BNSF made the statement that they would be interested in making a competing offer for NSC. There are so few Class 1 railroads left that if the industry begins another round of consolidation then all operators have to get involved.
Finding the right dollar amount or the right bidder to get the deal done are not the biggest issues. Given the high level of concentration in the industry the railroad operators face large anti-trust/regulatory hurdles to any prospective merger. While we think the optimum number of Class 1 operators is two, we don’t think there is a high probability that the regulators will see it that way.
If/when NSC is bought it will take a long time for the deal to consummate (likely a year at minimum). In the meantime, we will continue to buy NSC below our estimate of fair value and wait to see what happens with any potential merger deals.
PayChex (PAYX) from Volume 18
The big news for PayChex is that the Federal Reserve raised short-term inerest rates. PayChex’s payroll processing service takes control of its clients’ funds before distributing it out to its clients’ employees. Like insurance companies these funds become float or cash in PayChex’s accounts that it can earn interest on. Unlike insurance companies that can invest their float for long periods of time because their liabilities are many years into the future, PayChex’s float is extremely short-term. PayChex has to balance the ability to earn interest on their float with the short-term liabilities of their Clients’ payroll. PayChex does this by buying short-term paper like 1-3 year U.S. Treasuries, 1-3 year corporate bonds, and commercial paper.
Before the current low-interest rate environment, PayChex used to earn a blended yield of 4% on funds held for clients. Now that blended yield is 0.9%. Higher rates will allow PayChex to earn more interest income on funds held for clients. We don’t expect to reach pre-2007 interest rates levels for some time. If the Federal Reserve continues to raise short-term rates then one of PayChex’s most profitable divisions will benefit greatly.
ExxonMobil (XOM) from Volume 19
ExxonMobil is the only remaining position we have in the oil supermajors. As we highlighted, ExxonMobil has one of the lowest breakeven price points in regards to the price of oil to cover operational costs and its ability to continue to pay its dividend. ExxonMobil’s revenue and income are balanced between upstream operations (exploration and production), and downstream operations (refining and marketing). ExxonMobil was even able to grow its dividend this year by 6%. The company also has room on its balance sheet to make a large acquisition of another oil company during this period of industry stress. Management has successfully done this during past oil bear markets.
ExxonMobil is the largest oil and company and its fortunes are tied to the price of oil. When oil prices rise ExxonMobil’s cash flow and share price will rise with it. As long as oil prices remain low, ExxonMobil will be under pressure. Our job is to monitor ExxonMobil’s financial statements for its ability to maintain its current dividend policy and ExxonMoibl’s ability to grow its dividend well into the future. If things change to the point that ExxonMobil cannot maintain the dividend policy then we will sell.
Philip Morris (PM) from Volume 20
Philip Morris is probably the most controversial position we own. For those clients who’ve requested not to own any tobacco stocks we understand your position and we have not bought Philip Morris for your account. Tobacco stocks have been unloved for a long time. It is the general disdain that has kept the price of shares in tobacco companies well below their intrinsic value. In general, tobacco companies need very little capital to grow and maintain their business. Tobacco companies also turn their inventory over so quickly that they generate high returns on invested capital and even higher returns on tangible capital. Philip Morris is no exception. The excess returns and low capital needs mean more capital can be returned to shareholders through increased dividends and share buybacks. Combined with the low price to intrinsic value equates to higher shareholder returns over time.
One of the biggest threats to Philip Morris and the other tobacco companies is plain packaging laws circulating among the world’s legislators. It looks like Philip Morris and other tobacco companies will lose their challenge to the EU’s top court plain packaging laws. Other countries will follow suit. Advertising and brand building allows Philip Morris to charge premium prices. When cigarette packages all look the same will Philip Morris be able to charge premium prices?
Baxter International (BAX) & Baxalta (BXLT) from Volume 21
As soon as the spin-off of Baxalta from Baxter occurred both companies experienced positive catalysts. Activist Investor Dan Loeb of Third Point took a 10% stake in the new Baxter (BAX). Mr. Loeb and his investment firm sought and received a position on the company’s board and a role in bringing in a new CEO. The new CEO, Jose Almeida, is a proven deal maker. He became CEO of Covidien in 2011 and built a truly global company through a series of acquisitions and growth initiatives. Then Mr. Almeida sold Covidien to Medtronic for $49 Billion in 2014.
Baxalta upon separation from Baxter immediately received a $30.6 Billion buyout offer from Shire Plc. Baxalta rebuffed the offer stating it was too low and that they had no interest in doing a deal. Shire Plc maintained their interest and the persistence paid off as management from Baxalta and Shire met recently to discuss terms. Because of Baxalta’s recent spin-off and to maintain its tax-free status the deal will involve a mix of Shire shares and cash. With more shares than cash. If/when a final deal is announced we’ll decide whether we want to maintain our position in the new company or sell our position.
Union Pacific (UNP) from Volume 22
The concerns facing Union Pacific are: slowing economy/recession, lower oil prices, lower commodity prices. We made our first purchase of UNP in the face of these headwinds and the environment is still the same. Railroads remain the most efficient way to move goods over long distances within the U.S. Short-term economic fluctuations will weigh on UNP’s stock price. However, in the long-run we expect the U.S. economy and global economy to continue to grow and railroads will be there to transport the goods.
Johnson & Johnson (JNJ) from Volume 23
Nothing new to report since we first wrote about Johnson & Johnson. An acquisition of a biotech company is still a possibility with valuations of potential targets still coming down. If Johnson & Johnson does not make an acquisition in the coming year we would like to see a more aggressive return of capital to shareholders. Interest rates are still extremely low and JNJ has the room on their balance sheet to take on more debt to finance aggressive share buybacks and/or a special dividend to shareholders.
The Walt Disney Co. (DIS) from Volume 24
Disney was the subject of our most recent letter so there is nothing new to report. Except that Star Wars VII: The Force Awakens is destroying box office records as if they were a Death Star getting proton torpedos sent into its thermal exhaust port by a rebel X-Wing fighter.
All previous letters are archived here.