08/2018 Market Commentary
Trade War Continues
Neither the United States nor China were willing to back down this month, and so, tariffs continue to increase on each side of the ocean. The two countries agreed to relaunch dialogue, but that did not stop president Trump from threatening new tariffs. Much like a kinetic war, many are harmed in the effort to win. So too, in a trade war, many are harmed before a victory may be claimed. At first, casualty in the United States hit farmers. Already affected by a pullback in the Ag cycle, crop prices have dropped even more in response to China’s tariffs. Trump has asked farmers to take the long view for the country, but that can be difficult to do as their livelihood suffers. Realizing the pain, the present administration has provided USDA assistance.
It used to be that consumer staples were defensive investments because consumers would reliably purchase these products, and the companies would produce stable results. (Think personal paper products, beverages, or even breakfast cereals) Each of these have been under attack lately, with sales at mature companies declining, as marketing schemes of new companies chip away at old brands. In the case of beverages, consumers are not drinking less. They are just shifting to “healthier” choices. Global soda sales are declining, and this has led Pepsi and Coca-Cola to take decisive action. The former has acquired Soda Stream to participate in the healthy shift, while the latter has made its own acquisitions and market experimentation. Coca-Cola announced that it would acquire UK-based coffee house Costa, putting Coca-Cola in competition with Starbucks.
Last month, we discussed marginal buyers in a high valuation market. This month, we noticed an article highlighting one of the more highly valued real estate markets in the United States. In New York City, the luxury apartment market had soared for a few years, and then, it stagnated. In recent months, sales have declined, and prices have plummeted with them. We think this is a sign the marginal buyers are leaving. This can be either bad or good – bad because prices will fall or good because those with liquidity will have better buying opportunities. Will this show up in the rest of the market? We hope so. When? We don’t know.
This leveraged loan cycle won’t be like the last one. Recovery rates are expected to be lower because the market has reached a larger size, and loans are of lower quality (fewer covenants) relative to past cycles (according to research by Moody’s Investors Service). Further, the previous cycle and the current cycle were all underwritten on assets, producing income in a declining interest rate environment. We wonder what happens to the debt service of companies struggling to make money as interest rates rise. The Moody’s warning should make investors cautious about owning BDCs, CLOs, and high yield funds through any downturn.
Another month, a lot more Tesla. The month kicked off with Tesla’s CEO burning short sellers by announcing boldly via Twitter that he planned to take the company private for $420 per share. The stock price soared until analysts began penciling out how it could be done… it couldn’t, it wouldn’t. The price fell back to its previous trading range after a week or so of active news flow. It turns out when the CEO boldly said “funds secured” that was not the case. It also turns out that he did not discuss taking the company private with the board before making the announcement – nor with any investing group. Other circumstances surrounding this event cause plenty of head scratching. The Securities Exchange Commission is now investigating the matter. We do not expect much to result from the investigation, but we think if nothing to date gives pause, then this should cause investors to press for better governance at Tesla. This CEO needs a leash; at the very least, take his social media away or require that he screen his posts through the legal department first. Big money managers have a fiduciary responsibility to their clients’ capital. What about Tesla? It is up to investors to force corporate responsibility through governance.
Tesla has made plenty of splashes during the month over whether it could meet production goals (which have been elusive throughout the company’s entire history) for the month of August and the rest of the year. Evercore analysts toured the production facilities and concluded Tesla was on track for producing 6,000 Model 3s per week by the end of August. Then, Tesla concluded August by missing the Model 3 production target by 30%. Don’t worry. They still expect to meet third quarter production goals…
Elsewhere, a UBS analyst says the $35,000 Model 3 cannot be made profitable, but then again, did Tesla ever intend to sell a $35,000 mass market car? Not without tax credits, it seems.
Here is one final note related to Tesla, referencing this article. Something you should never be caught saying, especially not quoted as saying is: “I was impressed with their negative free cash flow.”
The bond bubble rhetoric continues. Although not the point of this article, often we hear “don’t buy bonds because there is a bubble, buy stocks”. However, if we are to believe there is a bond bubble, then why own stocks and why no mention of a stock bubble? Stocks are a residual, junior claim of the earnings and assets of a company. If one is to expect losses to bond holders, then what are we to expect of stock holders? At least with bonds the holder can expect to be paid regular cash flows and have contractual claim to principal value. What do stocks holders get? higher prices? We think not, but we’ve been wrong before.
WSJ Numbers explored some flawed consumer thinking that we found interesting and thought we would share. What’s better – 50% more product or 33% lower price? Here is the article.
We have not talked about Teva Pharmaceuticals in a while. The major news during August was that Teva’s competing product to EpiPen was approved by the FDA. Now, we will wait for the business execution. EpiPen is a commercial name that is ubiquitous for the product, which we think could make it a difficult market to penetrate. We are hopeful, and the timing couldn’t be better since EpiPen (parent company Mylan) has experienced a few controversies in recent years and is currently suffering a supply shortage.
Apple’s market capitalization reached $1 trillion during August. A first for the market. Wow. That is twelve zeros and one big company. A quarter of the trillion value sits on balance sheet as cash.