Sunday, December 24, 2017

2017 Year-End Client Letter, Part 3: Sectors, Section 1: Financials and Technology

Link to Part 1
Link to Part 2

Along with our perspective on general conditions, in our year-end letters we like to offer up some detail in terms of what inspires our sector weightings going into the new year. After bullet-pointing financials and tech below, I realized that if I carry this year's narrative through each major sector in one post I'd be asking our readers to devote far too much of their precious time herein, especially during the holiday season. So we'll stop this one at technology, and dribble out the rest between now and the end of the year.

The views we held on sector-by-sector prospects at the beginning of 2017 are best expressed by our target allocations (as a % of equity exposure) for client portfolios on January 1.

Here they were, along with the year-to-date results  (through 12/22) for each:

Financials: Target 20%, YTD Return +20.1%
Technology: Target 15%, YTD Return +33.3%
Materials: Target 15%, YTD Return +21.1%
Industrials: Target 15%, YTD Return +20.97
Energy: Target 12%, YTD Return -4.28%
Consumer Discretionary: Target 10%, YTD Return +21.46%
Health Care: Target 8%, YTD Return +20.08%
Consumer Staples: Target 8%, YTD Return +9.98%
Utilities: Target 0%, YTD Return +8.24%
Telecom: Target 0%, YTD Return -8.67%
REITs: Target 0%, YTD Return +5.04%

S&P 500: +19.70%

Now, before you do the math (assuming you haven't already), and realize that the above target percentages add up to 103%, you should know that those are base targets. We allow for a 2% move above or below those numbers. I.e., a given client's allocation will only flash a warning signal if, for example, their financial sector weighting (20% on January 1) moved above 22% or below 18%. Also, we tend to push a given sector above or below our target (within the allowed range) depending upon our view of its present prospects. For example, presently we're allocating financials to the higher end of our current range (today that would be between 18% and 20%) and technology to the lower end (10% to 12% today).

By and large -- save for their energy exposure (which we adjusted during the year) -- our client portfolios took advantage of the opportunities that presented themselves throughout 2017.

Adjustments we made during the year were as follows:

Reduced financials to 18% early in the year.
Reduced technology to 12% recently.
Reduced energy to 6% early in the year, increased to 8% in the fall.
Increased industrials to 18% mid-year.
Reduced staples to 6% mid-year.
Increased healthcare to 10% early in the year, reduced back to 8% in the fall.
Increased utilities to 2% early in the year, reduced back to 0% in the fall.

Here's a brief synopsis of what we view as today's key fundamental aspects of the financial and technology sectors. We want to emphasize "brief", as we could easily offer up a lengthy research paper for each. 

Note, the following relates primarily to the prospects for sectors within the U.S. economy. Our targets are also influenced by our assessment of each sector within other countries -- as we maintain target allocations to foreign markets as well. A topic we'll tackle in Part 4.


The financial sector stands to benefit from a number of potential developments in 2018, including the following:

1. Prospects for higher long-term interest rates amid a growing economy: Banks borrow on the short end of the yield curve and lend on the long (higher lending rates [relative to their cost of money] increase their net interest margin -- an important earnings component).

2. Prospects for deregulation: The President has made it clear that deregulation will be a hallmark of his term in office, plus, the incoming Fed Chairman has stated his intent to loosen financial regs.

3. Tax Reform: It's estimated that the 21% corporate tax rate will boost bank earnings by 11.1%.

4. Valuation: On a price to forward earnings basis, financials are second cheapest (to telecom) among the major sectors.

5. Trading volume: 2017 is about to go down as one of the least volatile years in market history. Thus, an important revenue source -- securities trading -- for major financial firms faced a real headwind for much of the year, as volatility equates to trading activity. While, as discussed in Part 2, we like the macro setup going forward, we believe that the likelihood of a repeat of 2017 (in terms of volatility [lack thereof]) is very low indeed. Thus, the prospects are decent for a pickup in trade-related revenue for the big banks going forward.

As suggested above, we are indeed presently bullish on financials. For now we're maintaining our base target of 18% of equities exposure (our presently largest weighting) -- with a bias to the upper end of our range (i.e., 18-20%)


While we remain constructive on tech given the global macroeconomic setup and the current pace of innovation in both products and services, we'd be surprised to see the sector maintain its lead (relative to other sectors) during 2018, for the following reasons:

1. Foreign-denominated revenue: U.S. tech companies, as a group, earn the majority of their revenue outside the U.S.. Therefore, should the prospects for economic growth and higher interest rates in the U.S. result in a stronger dollar going forward, foreign denominated earnings will take a hit when translated in U.S. dollar terms.

2. In a rising dollar environment, U.S. goods are more expensive to foreign buyers. However, we don't (at this juncture) see this as being a major impediment to international technology sales (plus, a higher dollar is beneficial when we consider foreign-made inputs/components as well as foreign labor). That said, the trading community can be very sensitive to dollar-related dynamics, and we believe it may be especially so heading into 2018.

3. Given the sector's outsized returns in 2017, we think that it'll take outsized hits (relative to other sectors) when volatility visits the market, and profits are taken, in 2018.

4. Tax Reform: The tech sector stands to gain the least from the corporate rate reduction (4.5% boost to earnings) among the major sectors. 

5. Threat of U.S. protectionism: Tech underperformed other cyclical sectors measurably between last year's election and the beginning of this year. Our view is that -- along with the at-the-time appreciating dollar -- the poor relative results stemmed largely from traders reacting to the prospects for a negative impact on the most internationally-centric U.S. companies, should rhetoric become reality. After the inauguration, however, it appeared as though the more aggressive of the Trump campaign's protectionist propositions would not come to fruition, which remains the case for now. Any new trade barriers erected at this juncture could prove to be significantly negative for the sector, in our view.

Again, we're not bearish on the tech sector (in fact, we believe there are some very compelling individual stories), we're simply assessing its prospects for 2018 relative to other opportunities, and for now believe them to be a bit less compelling compared to a year ago.

Next up, industrials and materials.

Oh, and before you (you readers who aren't our clients) run out and put all you got into the financial sector, remember our basketball analogy from Part 1: Even the very best 'shots' will miss the mark from time to time, it's part and parcel to the business of investing. 

Once again:
....while good investments can, and often do, lose money, if we take only shots where the setup makes good sense -- i.e., if we take only good shots -- and we take them from multiple angles and distances (diversify), we believe that we give our clients the absolute best odds of achieving long-term investment success.
Link to Part 3, Section 2

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