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Investing Insights: Tariffs, Volatility, and Quarter End

Morningstar.com

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David Whiston: Tesla's stock has set a new 52-week low recently and is off 35% from its all-time high and down over 20% this year. There are many headwinds facing the firm right now, especially around Model 3 production cadence, a recent Model X fatal crash in California, and GM and Waymo's progress in autonomous vehicles suggesting Tesla is not the technological leader in this emerging field. Tesla is also burning cash and has a lot of debt; we've been concerned about this for a long time and it is finally getting attention. The company finished 2017 with $7.2 billion in recourse debt and last year had an adjusted free cash burn of about $3 billion. Moody's cut its credit rating last week further into junk territory, and Tesla's 5.3% 2025 bonds issued last summer at what we thought was a very low rate are now trading at an effective yield of nearly 8%.

We don't care a whole lot about every quarter's Model 3 delivery rate. We are more focused on the long-term direction of production moving up or not, and for now we see no reason to think Model 3 production is crippled. We do care quite a bit about Tesla's lack of cash flow and debt levels. The problem with investing and balance sheets is it's usually too late for investors once they realize the balance sheet is a problem, because as long as the stock is going up and money is cheap, debt maturities never seem to matter. With the Fed raising rates and President Trump's trade rhetoric and anti-tech stance hurting the market, now is a good time to consider Tesla's debt profile for the next few years.

The company has many busted convertible bonds making up its $7.2 billion of recourse debt with a $230 million bond inherited from SolarCity due this November with a strike price of nearly $561 per share; a $920 million convertible in March 2019 with a strike price of about $360; another $566 million SolarCity convertible bond due in November 2019 with a strike of about $760 per share; a $1.1 billion revolver balance maturing in June 2020; and another $1.38 billion March 2021 busted convertible with a strike price of about $360. Tesla had $3.4 billion of cash at year end, and we expect a several billion dollar burn this year, so more capital raises are nearly guaranteed; but if the capital markets close to them, then the recent plunge in the stock price will look trivial compared to what will happen then.

Tesla could right the ship or this could be the beginning of the end, it's too early to know for sure. We've always felt the value of this stock today is based on what the company will look like 10-20 years from now--not how many Model 3s get delivered in one quarter. We think to buy the stock you have to believe in the vision of Elon Musk because the stock is basically a very long dated call option on Elon Musk. We think Elon is amazing but even he needs massive amounts of other people's money to fund his product expansion which includes a lot more Model 3s, a semi truck, a Model Y crossover, a new roadster, and possibly a pickup truck someday. 

The company is in a key phase of growth where it will either keep growing or sputter and perhaps die. If the market goes from treating Tesla as a firm with a rock star CEO who can do no wrong to a firm that is capital intensive, burning billions a year, and about to have a lot more EV competition, we would not want to own the stock in that outcome.

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After an up-and-down week following criticisms from President Trump, investors in wide-moat Amazon likely find themselves with greater uncertainty about what, if any, regulatory restrictions the current administration could impose.

This regulatory risk has grabbed headlines the past two weeks, with Trump stating that Amazon is taking unfair advantage of the USPS and pays little or no taxes, and that the Department of Justice should look into potential antitrust cases. We think it is difficult to make an antitrust case given the existence of other large retail players like Walmart.

Potential tax changes are more of an unknown, and we could conceivably see new revenue, or user-based tax structures like recent EU proposals, though this would likely take time to put in place, given the implications for other marketplace business models.

With respect to USPS shipping fees, we've always thought this could be a tangible risk to the Amazon investment story, though not one that would break its model. At this point, we'd say there is nominal risk of increased USPS fees, as any pricing changes could also lead to higher prices for consumers and increased costs for other merchants. Additionally, Amazon still has competitive countermeasures at its disposal, including fulfilling more products through its own logistics infrastructure or threatening to move more jobs overseas.

Despite the headlines, we see increased regulatory oversight as a low-probability event over the near future and see little reason to change our $1,600 fair value estimate. We believe our high uncertainty rating accounts for potential regulatory risks, and continued pressure may create a buying opportunity.

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Andrew Lane: The Trump administration's highly publicized steel tariff program has driven U.S. steel prices sharply higher. In mid-February, to incorporate the impact of these tariffs on our steel price deck, we increased our forecasted spread between U.S. steel prices and global marginal cost. Accordingly, we raised our fair value estimates for every U.S. steelmaker we cover. However, we still expect global marginal cost to decline materially in the coming years, driven by decelerating Chinese fixed-asset investment, waning Chinese stimulus effects, and faltering cost support from steelmaking raw materials. Therefore, even though we've increased our steel price assumptions, we maintain a bearish outlook for the broader steel industry. Every U.S. steelmaker we cover is trading above fair value.

Additionally, the steel tariff program appears to have less bite than many initially feared, as a number of key steel exporters to the U.S. have now received temporary exemptions. Those exempt include Canada, Mexico, the E.U., Argentina, Australia, Brazil, and South Korea. Together, these countries accounted for 65% of U.S. steel imports in 2017. The Trump administration has indicated that additional countries and individual product types could receive exemptions going forward, but also that these existing exemptions could be rescinded at any time, pending the outcome of further trade negotiations. Therefore, although the situation remains fluid, U.S. steel stocks appear to be pricing in continued profitable growth, and we believe valuations are stretched. Accordingly, we'd encourage investors to seek out greener pastures.

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Chris Higgins: China unveiled another list of possible tariffs for U.S. products, and for the first time the proposed tariffs target U.S. manufactured commercial jets. Naturally, the inclusion of Boeing aircraft is disconcerting for investors. Wide-moat Boeing is down on the back of the tariff news and is now triggering our 3-star rating, indicating that the stock is fairly valued. The other name we cover with significant exposure to Chinese aircraft demand is no-moat Spirit AeroSystems, and right now we think it's slightly undervalued.

The possible tariffs target aircraft with empty weight of 15,000 to 45,000 kilograms. Based on operating empty weights, China's weight range means only older 737 variants would be impacted. The newer 737 MAX variants wouldn't be impacted--noting that it's not clear whether the smallest MAX version (the -8) would be subject to the tariff or not, due to possibly different definitions of "empty weight." Wide-body aircraft like the 787 or 777 are clearly excluded.

On the one hand, since the older 737 is nearing the end of production and wide-bodies are excluded, the tariff seems symbolic and likely a negotiating tactic. Indeed, if the MAX 8 escapes unscathed, the tariffs really don't mean much for Boeing or for China. On the other hand, the fact that China is now targeting U.S. made aircraft--a product that Chinese airlines need to meet air travel demand--indicates that the dispute is heating up. We continue to believe that if China really wants to hurt the U.S., it's more likely to shift airline orders to Airbus.

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Seth Goldstein: China proposed retaliatory tariffs on multiple U.S. goods including a 25% tariff on corn, cotton, and soybeans. This move will create near-term volatility in crop prices, especially soybeans, as China is the largest global importer of the crop.

While the tariff could have a substantial impact on U.S. farmers, we see a more modest impact to the agriculture stocks under our coverage. We expect grain merchandisers including Archer Daniels Midland and Bunge to benefit from increased near-term crop price volatility. As a result, we've raised our ADM fair value to $46 per share and our Bunge fair value to $73 per share. Bunge should benefit slightly more than ADM as the firm has a greater proportion of operations in South America. We expect Bunge's soybean processing volumes to increase over the near term and improve profitability on the trading desk for both Bunge and ADM.

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Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Volatility has come back in a big way in 2018 with worries from everything from inflation to new tariffs. I'm here with Christine Benz, she is our director of personal finance, for five things that retirees can do to take the edge off this volatility.

Christine, thanks for joining me.

Christine Benz: Jeremy, good to be here.

Glaser: Christine, your first piece of advice is just to rebalance.

Benz: That's right. I have been evangelizing about this for a while now. But the key reason is that if you have done nothing to your portfolio during this great bull run that we've all experienced, your portfolio has gotten progressively more equity-heavy, and in turn, it's more vulnerable to volatility in the equity market. A portfolio that was 60% equity, 40% bond back in March 2009 would now be upward of 80% in equities. Meanwhile, you are nine years older. It's valuable to revisit your portfolio's asset allocation. 

I think sometimes when we have the kind of market shocks that we've had here in 2018's early innings, there's a temptation to do radical shifts to your asset allocation. So, maybe go all to cash with your equity exposure. Rebalancing is really a healthy way to address asset allocation imbalances that may have cropped up in your portfolio.

Glaser: Your second tip is that it is OK to hold a little bit more cash right now.

Benz: I think so. For investors who are using the bucket approach that I often talk about where you hold some liquid reserves aside to help meet your ongoing living expenses in retirement--I typically say hold one to two years' worth of cash investments of the amount of living expenses that aren't being met by Social Security and other stable sources of income--hold that in cash. Right now, I think, holding two years' worth of cash is a reasonable thing to think about, especially when you think about the differential in terms of yields on money market true cash investments relative to, say, a short-term bond fund today. With cash, you get those FDIC protections. You are guaranteed stability of your principal. If you venture into a bond fund, you are going to pick up a little bit of principal-related volatility. I don't think there's a huge opportunity cost to holding a little bit extra cash these days.

Glaser: Your third piece of advice is to consider a balanced fund.

Benz: That's right. Look at a good, a solid all-in-one fund that really lets you set it and forget it. This can be a particularly good strategy of maybe you just have one smaller account alongside a larger account. With the smaller accounts, I think, it makes a lot of sense to try to get it done with a single-fund vehicle. When I did simulation of portfolio returns, retiree portfolio returns a few years back, I looked at an all-in-one portfolio relative to, say, a bucket portfolio with discrete asset class exposures. The all-in-one funds did underperform a little bit simply because by holding discrete equity and bond holdings you are giving yourself a little bit of discretion to pick and choose where you pull your withdrawals from. But the differential was not huge. On the other hand, with the all-in-one fund, you do get a lot of simplicity and you get that rebalancing built in typically. I think that there are a lot of attractions to the all-in-one-type funds.

Glaser: What would be some good options there?

Benz: Vanguard Wellington, Vanguard Wellesley Income, a simple balanced fund would, I think, make a lot of sense. People who are retired, might also look at some sort of a high-quality target retirement income vehicle, which is typically the last phase in a target-date series. Any of those options, I think, would make worthy choices.

Glaser: Your fourth piece of advice is to think about quality within your equity holdings.

Benz: Right. We've seen a little bit of underperformance in terms of high-quality stocks in 2016 and 2017. I do think that when we look back over periods of market volatility, a high-quality strategy has typically held up better than a lower-quality equity strategy or even the broad market indexes. Here I'm thinking about a fund like T. Rowe Price Dividend Growth or a Vanguard Dividend Appreciation. Another fund that I know our ETF team likes is Schwab U.S. Dividend Equity, which is kind of a hybrid of a yield-centric strategy as well as a growth-oriented strategy. Those are all good ways to shade your portfolio toward higher-quality stocks which I think will give you a little bit more of a hedge in high volatility markets.

Glaser: Finally, now might be the time to rethink some noncore asset classes that you have accumulated over the years.

Benz: In retiree portfolios, sometimes the noncore asset classes, whether it's emerging-markets equity or a high-yield bond, give retirees a lot of worries and aren't making a meaningful difference in the portfolio's returns. If you have some of those holdings where when you open your portfolio on Morningstar.com, your eyes go right to them because you want to see what's going on with them, those are the ones to maybe consider excising, especially if they are not very large positions. I think it's a great time to think about simplifying, moving toward quality, and shading a little bit more toward conservative investments overall.

Glaser: Christine, thank you.

Benz: Jeremy, great to be here.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.

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Christine Benz: Hi, I'm Christine Benz for Morningstar.com. The first quarter of 2018 marked a return of volatility to the equity market, and bonds didn't perform especially well, either. Joining me to provide a recap of mutual fund performance in the first quarter is Russ Kinnel. He is director of manger research for Morningstar.

Russ, thank you so much for being here.

Russ Kinnel: Glad to be here.

Benz: We waited until the very last minute to shoot this because the market has just been so volatile, especially here in March. We weren't sure where we would shake out. Where we sit today, which is on the last trading day of the quarter, it looks like most equity categories, most U.S. equity categories, are poised to end up the quarter in the red. Let's talk about the things that were weighing on stocks during this period.

Kinnel: I think it starts with getting a whiff of inflation, which also means rising interest rates from the Fed, and of course, the markets don't like either of those. That's a little unsettling. We've had a very long run of low inflation and low interest rates, and of course, that's great for stocks.

Benz: When we look at the categories that performed relatively well, it's mainly the growth categories, which have been outperforming for a while now, technology stocks in particular. We saw them give up a lot of ground recently here in March. Let's talk about the news that was weighing on some of the growth-oriented categories in tech stocks.

Kinnel: If you had asked me a couple of weeks ago, at that point, large growth was up maybe 7% or 8%, and now, it's about flat. What's happened is the FANG stocks that have been so good for the last few years really …

Benz: Let's just tell people what the FANGs are.

Kinnel: Facebook, Amazon, Netflix and Google or Alphabet as it's also known. These have been dominant stocks. Of course, there are some other go-go large growth names that have done well, too--Apple another one. It's really been a story of stocks that have really had a great run but now have really sold off, Facebook being the biggest sell-off because it came out that, one, Facebook sold user data in a way no one expected, but also it came out that Facebook was maintaining data records on people far greater than people thought. Those are big negatives for Facebook. And then some other issues, too, and so really all of those names have sold off, but Facebook the most.

Benz: Yeah, spooked the whole sector. Let's talk about overseas. If investors have foreign stock funds in their portfolio, they've probably seen a little bit of red ink there as well for the quarter. It seems like the more aggressive you were in terms of your foreign stock fund holdings, the better you fared. What's been going on there?

Kinnel: In both foreign and domestic, you had growth doing better than value and small growth doing about the best. But as you say, emerging markets were among the best places to be in foreign equities. They more or less had modest gains of about 0% to 1% was typical for diversified emerging markets. Latin America did even better than that.

I'm not sure exactly why they did better. One possible reason is their valuations were fairly cheap. They had less to go off. Of course, the U.S. is maybe the highest valuation, so hat could be one thing working in their favor. It's an interesting illustration that emerging markets don't have to be the area that gets burned when there is a sell-off. Sometimes, they do just in sympathy. The U.S. sells off 10% and emerging markets will go down 20%, because of course, a lot of that money in emerging markets is from U.S. and other developed market investors. It doesn't always work that way and it didn't work this time.

Benz: Another big topic I want to cover with you, you touched on rising interest rates and the implications for equity fund performance. Bonds have also had a rough go of it here in the first quarter. Let's talk about some of the better and worst performing fixed-income categories.

Kinnel: The long end of the yield curve really got smacked, so therefore long-term corporate or government bond funds bore the brunt. Naturally, the short and ultrashort held up the best. We also saw some currency plays, for instance, because the dollar sold off. The funds that were diversified out of the dollar, tended to hold up a little better.

Benz: Those emerging markets local currency-denominated bond funds, which, I guess, we should point out, that's not a core fixed-income category. You'd want to hold it around the margins of your bond portfolio.

Kinnel: Very much a niche category, but a nice diversifier if you use it correctly.

Benz: This return to volatility really has spooked some investors. We have not seen this certainly for a while. Maybe some of us had gotten a little bit complacent just about how strong returns were for so long. What's your best guidance to investors, and does it depend on their time horizon and their proximity to needing their money?

Kinnel: It really does. I think, for one, we are returning to more normal levels of volatility. We talked at the beginning about low interest rates and low inflation. That's kind of given us an unusually less volatile time period and a time where markets have gone up really steadily. You might have a bad six months or a year, but then you make it back with a nice 20% or 30% gain the next year, which is awesome but not typical. I would say, both, get ready for more volatility as well as the chance that a three or four-year investment, you might still be in the red or just have really modest gains, because that's more common in the markets and certainly the longer run you have, the tougher that can get.

And as you say, your time horizon really matters, and it's good to focus in on what are your investments for, what are your goals, and have those aligned properly so that if there's some money you want to spend in the next few years, that's in really short-term, stable investments, than the things like retirement goals or rather really long-term. You should be able to tolerate volatility. Remember when there is a sell-off or a spike in volatility, this is a really long-term investment and so it shouldn't matter. I think, that approach should help you to weather these sell-offs and really just aligning your investments with your goals is always a good idea.

Benz: Russ, great advice as always. Thank you so much for being here.

Kinnel: You're welcome.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.

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Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. In an unusual move, asset manager BlackRock released a list of questions that they were asking gun retailers and gun manufacturers in the aftermath of the Parkland, Fla., shooting.

I'm here with Jon Hale, he is our director of sustainable investing research, to see if this kind of engagement from an asset manager is a way to make an impact.

Jon, thanks for joining me.

Jon Hale: Thank you.

Glaser: Let's look at this letter. As I said, it was somewhat unusual. We know this engagement goes on behind the scenes. But this was very public. Why do you think BlackRock decided to make this public? How do you make sense of this engagement?

Hale: BlackRock has been ramping up its engagement activities in general for a couple of years now and there was a very widely publicized letter that CEO Larry Fink released in January basically stating that they were going to engage even more. And so, kind of in the immediate aftermath of that came the Parkland tragedy.

Glaser: When we think about BlackRock, a lot of their funds are passive. Is this kind of engagement effective given that they can't actually sell these shares in many cases?

Hale: I think engagement can be a very effective approach, especially when you're talking about the world's largest asset manager in BlackRock. In the case of guns, we've seen actions taken by some of the largest retailers that they are invested in, retailers like Dick's Sporting Goods; Walmart; The Kroger Company, which just announced earlier this week that they were going to end gun sales completely in the Fred Meyer stores that they had been selling guns in. And just yesterday Dick's CEO, Edward Stack, published an op-ed in The Washington Post saying that Congress needs to take more decisive action.

So, I think, a lot of these efforts by investors are behind the scenes. You don't know exactly what they are talking about. Although BlackRock has said in its letter pretty much here the things we are talking to them about. But whether it's investor pressure behind the scenes or whether it's sort of public and reputational, I think, it's a mix of those two that are causing the action to be taken by these gun retailers.

Glaser: You mentioned the retailers here, but the makers themselves, this is their business. What are they going to do in response to a letter like this?

Hale: Well, investors have been engaging with the three publicly traded gun makers. And these businesses are obviously not likely to stop selling guns altogether. But investors are asking them about how they monitor violence associated with their products, their efforts to research and produce safer firearms, and also just sort of how gun violence may affect their corporate reputation and risk.

Glaser: We know that not all investors are necessarily interested in this kind of engagement. If you are in a BlackRock fund, how should you think about that, that this is something that BlackRock management is so engaged in?

Hale: I think if you agree with CEO Larry Fink that companies ought to pursue a sort of public purpose as a part of their overall strategy and mission, then you should be thinking that BlackRock itself is actually trying to do that as well. That's number one. 

And then number two, from a more of a fiduciary standpoint, I think, you really should be thinking in terms of BlackRock in their passive funds, which you are most likely to be invested in if you are a BlackRock investor, they can't sell out of them. So, what they are trying to do is improve the performance of those companies through engagement.

Glaser: Jon, thanks for joining me today.

Hale: My pleasure.

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Sonia Vora: Pepsi pays one of the more attractive dividends in the beverage space, with a yield around 3%. The company’s annual dividend has increased for more than 40 years in a row, and its payout ratio has averaged about 60% over the last decade, which has translated to high-single-digit dividend growth. We expect Pepsi’s commitment to returning cash to shareholders to continue over our forecast and anticipate an average payout ratio in the mid-60s over the next 10 years.

In our view, Pepsi’s wide moat should ensure the company continues to return excess cash to shareholders over the long term. The company has 22 brands in the beverage and snack categories that generate above $1 billion in annual sales, allowing it to form entrenched relationships with retailers that depend on leading brands to drive store traffic and inventory turnover. Pepsi’s substantial investments in advertising and research and development, which totaled nearly $5 billion or more than 7% of sales last year, should support these brands over time, and help the firm defend its share from competition.

We surmise the combination of Pepsi’s food and beverage businesses has also created an advantaged cost structure, given synergies in shipping and promoting its offerings. We expect strengthening profitability as higher-margin products, like premium beverages, snacks for more health-conscious consumers, and smaller pack sizes, continue to grow and the firm’s efforts to drive cost savings yield further benefits.

In addition to the attractive dividend yield, shares are currently trading at more than a 10% discount to our valuation, which could provide a favorable entry point for investors.

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