Second Quarter 2019
Financial markets continued to defy gravity in the second quarter of 2019. Stocks were up, bonds were up, and gold jumped over 9%.
As noted in the first quarter letter, the Federal Reserve continues to maintain a decidedly dovish tone. The bond market is pricing in a 100% probability of at least 25 basis point cut by the July 31 FOMC meeting. The current merits of a cut are certainly debatable given resilient economic data & unemployment rates. Perhaps the only signal to support a cut can be found in deteriorating economic expansion indicators for several developed nations. As the domestic bond market continues to be the developed nation “high yielder” we can expect continued calls from the Trump administration to cut rates to devalue the US Dollar.
On balance, we interpret the current environment as a race to the bottom, which persists ten years into the global recovery. As the Fed ponders a “beggar-thy-neighbor” rate policy as a response to the European Central Bank’s likely monetary easing, an overly-dovish stance would drive short-term upside to risk assets. The longer-term implications could set us up for an environment where investing in gold would no longer be construed as overly-pessimistic.
Figure 1: Q2 2019 Asset Class Returns (Source: Century Bank, Bloomberg)
Turkey: “The era of rights, law and justice is here.”
Ekrem Imamoglu – a Turkish pro-democracy mayoral candidate – was swept to victory in Ankara on June 23rd. The outcome is seen as a major blow to Turkish president Recep Tayyip Erdogan. Erdogan has spent years consolidating power while implemented anti-democratic measures in Turkey such as censorship of the press and social media. The election is certainly a directionally positive development for Turkey. The country plays a critical role in bridging Western and Islamic cultures.
The Wall of Corporate Cash
The level of share buybacks for companies comprising the Standard and Poor’s 500 Index took a breather in the first quarter. Based on the surge in equity prices, it is likely to have accelerated in the second quarter. While we do not frown upon companies that repurchase stock, we consider the price they are willing to pay (valuation) as a metric that warrants objective scrutiny. For example, companies spent $220 billion on stock buybacks during the 4th quarter of 2018. The implied annual “buyback yield” was 3.3%. This means ownership would increase by 3.3% if the same level of buybacks continued for a year while prices remain flat. Combined with the dividend yield, the impact to total return is significant. However, if we compare the impact of buybacks during Q4 of 2018 to Q1 of 2009, the narrative is muted. During Q1 2009 companies spent $32.3 billion with an implied annual buyback yield of 3.7%. Therefore, companies spent 581% more cash to buyback a lower percentage of shares outstanding in Q4 of 2018 …
Figure 2: S&P 500 Stock Buybacks ($) since 2009 (Source: Century Bank, Bloomberg)
Dividend payouts have also been on the rise since 2009 (see chart below). S&P 500 dividends comprised $123.5 billion in Q4 2018. It makes sense that the absolute increase in dividend dollars paid out would lag buyback dollars: senior management never wants to cut back on dividends when the economy goes south because it is rightfully interpreted as a desperate attempt to conserve cash. Share buybacks, on the contrary, are accepted as ephemeral when compared to dividends.
Figure 3: S&P 500 Dividends since 2009
By now, you may be asking yourself ‘who cares’? In short, the historical ratio of buyback expenditures to dividends paid has averaged under 1.0. Since the crisis, however, the ratio has averaged 1.39. To the extent share buybacks are expected to be a key driver of earnings growth going forward, one of two things are a certainty: companies will need to pay a higher price (based on relative valuation to 10 years ago) or companies will not be able to justify the financial engineering expense should we run head-first into an economic downturn.
Figure 4: Ratio of Buybacks to Dividends paid ($) (Source: Century Bank, Bloomberg)
A New Age for Healthcare Consumerism?
One last topic for our Q2 letter: price transparency in healthcare.
Several weeks ago President Trump signed an executive order that directs relevant agencies to write regulations supporting increased healthcare price transparency for American consumers. The move was politically motivated – the debate circuit for 2020 Democratic nominee hopefuls has kicked off. Several candidate platforms advance the case for a socialized model. Trump’s executive order is a practical attempt to create a more efficient, market-based approach to healthcare, thereby promulgating an alternative platform to socialized care going into the 2020 presidential cycle.
Like any savvy politician, Trump will take credit for any productivity gains wrung from the healthcare sponge in the coming years. However, we believe the primary drivers of healthcare improvements will sprout from seeds planted over the past 10-15 years.
As healthcare approaches 18% of the nation’s GDP, corporate executives, litigators, and state policymakers are stirring. The 18% figure is approximately twice the share compared to other developed nations. Not only do we spend twice as much, Americans do not even live as long! The healthcare topic is certainly far too complex to cover in one quarterly investment letter. That said, we believe real change is afoot in the space and significant disruption in healthcare is finally at the United States’ doorstep. A confluence of events and circumstances below provide a high-level overview of why we believe ‘this time is different.’
The Economist newspaper covered the executive order in its June 29th edition. The story noted a New Hampshire price transparency law that had the effect of forcing the state’s most expensive hospital to address its relative pricing advantage:
“Until 2010 New Hampshire’s most expensive hospital charged nearly 50% more than its competitors. That year, the state’s biggest insurer used data made available by a price-transparency law to shame the hospital as a pricing outlier — getting public support which forced the hospital to lower its prices.”
The available data was harvested from the state’s so-called all-payer claims database, or APCD. Accessing the NH data requires only a simple one-page application (by far the most consumer-friendly law of any APCD). The implication is that on a going-forward basis there will be eyes on price trends in the state. This is important because one argument against price transparency is that it may induce low-cost providers to increase pricing. Any provider attempting this in NH would be called out for it. As a result, we believe there is a high likelihood the intended impact is more likely than not to be experienced for NH residents: increased productivity and more value for consumers derived from market-based competition. We expect more states to ease access restrictions following NH’s success.
Figure 5: Example of healthcare price dispersion for a commoditized service. (Source: The Economist)
Second, a joint venture between Berkshire Hathaway, Amazon, and JP Morgan announced last year is now coming together as Haven Health. Jeff Bezos’ famous quote ‘your profit margin is my opportunity’ resurfaced when the Haven plan was announced - shockwaves through every corner of healthcare are still reverberating. While the Haven initiative will take time to have any measurable impact on national spending trends, the smart incumbents (large provider groups and insurance companies) will realize they are swimming naked at low tide and had better come clean.
Last, most large private health plans are self-funded, meaning the company will use an insurer’s network, but the claims are paid from company funds. Any self-funded healthcare plan is subject to ERISA law, meaning the company assumes a fiduciary responsibility that the plans maximize employee dollars. While the media has widely covered fiduciary breaches for retirement plans under ERISA jurisdiction, health plan breaches are not reported because until recently the litigators have not sniffed out the opportunity. Suffice to say, litigators are poking around self-funded health plans today and the liability dollar amount at stake is in the trillions, dwarfing any 401(k)-fiduciary breach. We expect this to be a top story in 2020. We are not eager to invest in any managed care stocks these days, to say the least.
In conclusion, higher markets are a wonderful thing. Client portfolios are up across the board. Positive change is afoot in healthcare and if the Fed lowers rates the markets may have more to run. We plan to enjoy it while it lasts, but we are also well-positioned to weather any market or economic storm. Please do not hesitate to reach out with any comments or questions.
Go US Women’s Soccer!
Carl R. Hall, CFA
Chief Investment Officer