Steve Goddard and Jon Moody discuss the equity portion of the portfolio.
How might the recently passed Tax Reform bill impact the Fund's equity holdings?
We believe that overall the Tax Reform bill will benefit the Fund’s equity portfolio. Most directly, we believe the bill will be a positive for earnings. All other things being equal, we expect the effective tax rate for the Fund’s equity holdings to fall from an average of approximately 27% in 2017, potentially boosting earnings per share in 2018. The effective tax rate for the S&P 500 is about 25%, so we believe the Fund’s holdings should benefit more than the market overall.
Passage of the bill has also brought clarity. Some management teams may have put plans on hold in 2017 to wait for further clarification on tax reform, particularly regarding tax treatment on the repatriation of profits from abroad. With the reduction in both corporate and repatriation taxes, we expect an increase in acquisition activity, stock buybacks and dividend hikes over the course of the next 12 to 18 months.
The dividend payout ratio for the S&P 500 Index has been rising for several years. Do you expect it to continue to rise?
Yes, we do. Capital intensity has fallen over the last couple of decades, meaning that companies are spending less on building expensive factories and are instead spending on technology, the overall cost of which is lower. As a result, companies today do not need to spend as heavily on capital investment to grow, leading to the generation of excess cash flow. One of the ways management teams can return this excess cash flow to shareholders is in the form of higher dividends. We believe that while companies continue to generate excess cash flow, they may likely raise their dividends, and dividend payout ratios should continue to rise.
We note also that the Tax Reform bill will likely increase earnings for many companies next year, which will likely reduce the dividend payout ratio in the near term and give companies even more room to raise dividends.
Would you please discuss a few of the Fund’s recent equity investments?
Apple Inc. is a relatively recent investment for the Fund. An opportunity arose to buy Apple stock at a great price during a period when investors were worried about the iPhone cycle. At the time, the company had over $140 billion in net cash on its balance sheet and was trading at 6-7 times EBITDA (earnings before interest, taxes, depreciation, and amortization, a measure of pre-tax profits). Even assuming no future growth, we judged that the market was undervaluing Apple’s large user base and ecosystem, dominant market share, and strong pricing power. With the success of iPhone X sales and prospects for the repatriation of offshore cash, the stock has rebounded strongly.
In 2017, we established a position in Alexion, an orphan drug company focused on treating patients with ultra-rare diseases. We were attracted to the company when we saw a new management team with strong credentials and meaningful insider buying at the board and management level. The company has a strong balance sheet and has generated good returns on capital.
Southwest Airlines was also a new addition to the portfolio in 2017. The airline industry has gone through a long period of consolidation and, it is not as price competitive as it once was. Planes are flying at full capacity, and yields are high. Southwest is among the better-managed airlines, with a strong record of profitability, low costs and high returns on capital.
Could you talk about your outlook for the Fund’s equity portfolio for 2018?
We believe the economic outlook is favorable, with no signs pointing to an imminent recession. Instead, the economy could surprise on the upside in 2018, buoyed by the effects of the Tax Reform bill.
As of December 31, 2017, the S&P 500 traded at about 21 times earnings, which is not inexpensive. However, relative to the 10-year Treasury yield of about 2.5%, it appears reasonably valued in our opinion. Notwithstanding the overall valuation of the market, with our long-term approach to investing, we believe there are always opportunities to make new investments in attractive companies, particularly where consensus opinion appears overly pessimistic regarding a short-term issue.
Gary Cloud discusses the fixed income portion of the portfolio and factors to consider in 2018.
How might the Tax Reform bill affect the Fund’s fixed income holdings?
We believe the Tax Reform bill is a positive for the Fund’s corporate bond holdings. The bill includes a provision that reduces the tax-deductibility of interest expense, effectively raising the after-tax cost of debt. Over time, companies may be less likely to issue debt since it is more expensive, incrementally boosting existing debt’s scarcity value and adding upward pressure to bond prices. As a result, we believe the Tax Reform bill will be broadly positive for our holdings in the fixed income portfolio.
Why, after nine years of economic expansion, is inflation still so low?
In today’s global economy, we believe disinflationary forces are still very strong. In our opinion, these disinflationary forces are due, in part, to the following factors:
- There is excess capacity in manufacturing globally, making it difficult for companies to raise prices.
- The maturation and spread of e-commerce have brought greater price transparency and increased competition to many markets, which has been exerting a downward pressure on prices.
- Rapid technological change is boosting productivity, especially in the service sector (where it is difficult to measure), pushing costs and prices down.
- Finally, commodity prices have generally remained low. By one measure, the Thomson Reuters Commodity Index, commodity prices are currently more than 50% below their peak in 2008.
All these pressures are contributing to keeping inflation low, even through this long period of economic expansion.
What is your outlook for short-term interest rates?
We believe that with disinflationary forces keeping inflation relatively low, the Federal Reserve will be able to keep the pace of interest rate rises very gradual. We also believe that the new Fed Chairman, Jerome Powell, as a market veteran rather than an academic, could bring in fresh thinking to the Fed whose domestically oriented forecasting model for the U.S. economy has been working poorly for many years. It is possible he could recognize more fully the dominance of disinflationary forces, and as a result be less keen on raising rates and more inclined to let the economic expansion continue.
What is your outlook for the Fund’s fixed income holdings for 2018?
Several factors, including the strong economy, slightly faster wage growth and a potentially larger government deficit as a result of the Tax Reform bill, could put downward pressure on bond prices. However, U.S. bond yields remain substantially higher than bond yields in Japan and Europe. As a result, we expect international investors to continue as significant buyers of U.S. bonds.
We are more optimistic than the market about economic growth. We believe both short- and long-term bond yields could move up, and we plan to maintain an overweight position in corporate bonds compared to the Bloomberg Barclays Capital Intermediate U.S. Government/Credit Index, as they tend to outperform Treasuries during periods of economic expansion.