April 2018 Result: 2.41% Active Return TTM

April 2018 was yet another month where our US portfolio performed better than the S&P 500 in the trailing twelve month period (TTM). This time it was 2.41% which is noticeable lower than for the 12-month periods ending in Dec 2017 and Jan, Feb and March 2018. With raising interest rates dividend aristocrat behave a little bit more bond-like, that is as the interest rates go up the share prices will have some downward pressure. As a result the dividend yield for the dividend aristocrats tends to move somewhat in parallel with the yield on interest-free investments like for example the 3-months US treasury bills in the secondary market. Our US portfolio has allocated about 80% of its funds to dividend aristocrats at the moment.

We have previously discussed the rising interest rates. We continue to believe that these represent the biggest threat to gains in the share market for the time being. Unless the US Federal Reserve indicates that interest rates have reached the desired level, we believe the rising interest rates will continue to put downward pressure on share prices.

Taking a much longer timeframe such as 10 years or more, history tells us that interest rates fall and rise. After each rise there was a fall in the past. After each fall there was a rise. At the moment we are in a longer period where interest rates are trending up. At some point this will come to a halt. Nobody knows yet when that will be as it would require to predict the future.

If you buy shares with the intention to keep them indefinitely the current share prices doesn’t really matter at all. All that matters is what you think the earnings are doing which in turn feed dividend payments. Companies like Stanley Black & Decker (SWK) have paid dividends for 140 years and have increased their dividend each year for 50 consecutive years. It looks as if at least for SWK the ups and downs of the interest rate over the last 50 years didn’t really matter when it came to increasing the dividend. It just was more each year. We don’t expect this to change any time soon for SWK but also for a few more positions we have in our US portfolio.

Obviously we like a higher active return over a lower. Still, we are happy with 2.41% over the S&P 500 over the last 12 months. We are also prepared that until the interest rates in the US stop rising our portfolio may not return as much as in scenarios where the interest rates are flat or even falling. We’ll see. We cannot predict the future either.

Happy investing!

March 2018 Results: 4.09% Active Return TTM

The US stock markets had a negative quarter with declines of -2.49% for the Dow Jones and -1.22% for the S&P 500. The NASDAQ was hit in February and March as well but was able to hold on to year-to-date gains of +2.32%. The NASDAQ benefitted from a 7.36% gain in January.

How did the Optarix US portfolio do in this time frame? Year-to-date it’s down by -1.17% so did better than Dow Jones and more importantly better than our benchmark the S&P 500. Compared to end of March 2018, the S&P 500 is up +11.77% while the Optarix portfolio is up +15.86% given our portfolio and active return of +4.09% over the trailing twelve months (TTM). The S&P 500 gained about 7.89% per years over the last decade. If our active return would have been 4% of that time period, our portfolio would have made about +11.9% per year, and that would have been after tax.

The graph shows the active returns for the twelve months periods ending in Dec 2017, Jan 2018, Feb 2018 and Mar 2018. On average the active return was +4.36%. Any data we have from periods before Dec 2017 is not meaningful as our investment strategy change from about mid of 2016 to Feb 2017.

Of course, past results are never a guarantee for future results. Perhaps we were just lucky with our particular investment style. On the other hand we believe that our reasoning is plausible and this has so far been confirmed by the data. We typically invest about 80% to 90% in companies that have a track record of delivering increasing earnings per share (EPS) and/or increasing dividends, and combine that with 10% to 20% growth stocks that we believe have a proven business model with substantial growth. Frequently this will be well-established high-tech companies.

Obviously we look at other factors as well. For example we believe that if a company pays dividends, the payout ratio should not be too high. We prefer companies with a payout ratio of less than 50%. We also look at figures like the debt level and free cash flow. Typically we review our position in companies as soon as they become the target of an acquisition. With a buyer in the picture we think this brings with it a lot of speculation around the stock price. Sometimes it is just a rumor that doesn’t materialize. At other times the deal will fall through. We certainly will always do some research about the potential acquirer. Fundamentally, we are more interested in long-term potential than short term trading gains. Generally we follow a buy-and-hold strategy.

We have mentioned in earlier posts that we believe the increasing interest rates in the US represent a risk to the stock market. We continue to believe that the climbing interest rates will put at least a damper on stock prices. Perhaps what happened in the first quarter of 2018 was just an early taste of how much more negative things in the next quarters. We believe that the stock market is still a bit overvalued, so are not holding our breath that we’ll see another 20% or so gain in the S&P 500 in 2018. We are happy to be proven wrong, though.

Happy Investing!

US Labor Market Report February 2018

The US Labor Market Report for February 2018 shows an increase of 313,000 added jobs to the nonfarm payroll employment. The unemployment rate was unchanged at 4.1% (Chart 1). Both numbers were reported by the US Bureau of Labor Statistics on 09 March 2018. This compares quite favorably with economists’ estimates who thought the number would be closer to 200,000. This is the highest increase in a single month since July 2016 (Chart 2). Total employment rose by 785,000. Year-to-year average hourly earnings have increased by 2.6%. This latter number was lower than the 2.8% economists expected.

The markets took this as indications that the economy continues to grow nicely while wages do not grow as fast as anticipated. This was interpreted as allowing the Fed to continue their gradual approach towards raising interest rates. If the wages growth is lower, it is expected to create less of an upward trend on inflation. As a result the markets responded with gains of major indexes of between +1.74% for the S&P 500 and +1.79% for the NASDAQ.

Our take on this is: we believe that although this may take some pressure off the Fed it nevertheless means that interest rates will continue to rise. The rate of unemployment is already low, the participation in the labor market is increasing and therefore employers will have to offer more money. This puts upwards pressure on wages. Growing wages in turn create more demand and that may push prices further up which is what we call inflation. It remains to be seen if the Fed is able to let inflation run to the value they feel comfortable with and then bring it to a stop with the currently planned measures.

We continue to believe that the higher and increasing interest rates are not sufficiently reflected in the valuations of the share markets yet. Some companies have increased their profits and/or their dividends and share buybacks, but some of the profits were windfall profits because of the tax reform and some of the dividends were special dividends that won't repeat. While we remain fully invested with our US portfolio we believe that the overall growth for this year will be more on the more moderate end of the spectrum. We are convinced that the Optarix US Portfolio continues to be well-positioned for the current scenario.

Happy Investing!

Source for images: Bureau of Labor Statistics, U.S. Department of Labor, https://www.bls.gov/news.release/pdf/empsit.pdf (retrieved 10 March 2018)

Realizing Gains as an Instrument for Portfolio Management: The Example of Brown-Forman

Managing your own portfolio can be exciting in particular when you invest long-term and your strategy pays off. Long-term usually means that you buy shares (or other securities) that meet all your requirements and are (relatively) low in price and then keep them for the foreseeable future. "Foreseeable future" is a bit abstract. We mean by that a minimum investment term of 10 years. At least that is the plan for each position we start.

Having said that, at times it pays off to not just site and wait but to realized gains if a stock had a really good run. Factors that influence the decision are various. For us this includes if a particular position has grown too large in proportion to the overall portfolio. We have a simple set of rules that guide us in respect of this factor. Other factors may be significant events that may have an impact on a particular company, e.g. being the target of an acquisition, an investigation by market authorities or even allegations of illegal actions like "cooking the books".

Brown-Forman (BF.B) is a solid company and we created our position in October 2016. We bought the initial shares at a price of about USD 46.00. At a time in February 2018 the price had increased to about USD 69.20, a plus of about 50.4%. At that point this position had grown faster than the average portfolio, giving BF.B more weight than we liked. Therefore we sold a portion of the position. We deduct the sales proceeds from the total costs of the position. This reduces the unit costs. In our case the unit costs decreased from USD 46.00 to about USD 32.70.

In the meantime BF.B also executed a 5 for 4 stock split. Our unit costs decrease further to about USD 24.90. Of course the stock price decreased in line with the stock split, so as such we didn't "gain" anything from the stock split.

However, what makes all of this significant is the news about the possible trade war between the USA and the EU. The EU is considering to put tariffs on Kentucky Whiskey which would affect Brown-Forman's brand Jack Daniels. As a result their share price declined by over 5% today in response to those news. However, given a unit cost of about USD 24.90 and a current share price of about USD 52.90 this means that also because of realizing gains before the news our US portfolio still has an unrealized gain of about 112%. Not too shabby at all!

While we certainly do not enjoy the 5% decline of the BF.B share price, there are two things that confirm our approach:

1. Spread the risk over a large number of positions and 
2. Realize gains to re-balance your positions according to your appetite for risk

Taking this advice to heart will help enjoy long-term success with investing in the share market.

Happy Investing!

Disclaimer: We own shares in BF.B. We have no intentions to add or reduce our position within the next 24 after publishing this post.

Thoughts on Steel and Aluminum Tariffs

US President Donald Trump has announced that he is going to impose tariffs on import of steel and aluminum. This has seen the shares of US producers of these materials increase quite significantly. In our view if those tariffs become a reality, then there are a number of things that can happen.

Just looking at the initial step, this would mean that any products made from steel or aluminum will increase the price. The price will go up, even if the manufacturers manage to buy domestic instead of importing. The reason is very simple: The supply of US produced steel and aluminum will stay fairly the same but the demand increases. As a result the prices will go up. If tariffs stay in place for longer periods, then two main courses of actions are available to the consumers of those materials: They can use alternative materials. For example, instead of putting beer in an aluminum can, you could put it into a glass bottle. In other words: you replace it. The other option might be that the producers may increase their capacity. The problem with both of these options are that you can't change these over night. But both are definitely options to consider long term. Even if the producers increase the capacity the question remains, how many additional jobs does this really create? We would argue that it probably would be a very small number compared to the overall number of people who are in work already or are actively seeking employment.

Other businesses may have to increase prices because certain types of steel are not produced in the US at all. For example in car manufacturing you need special types of steel that need to be imported and are hard to replace with domestic materials.

Once the tariffs are in effect, there is a high likelihood that affected countries will retaliate. About 50% of the US steel exports go to Canada. That might not be much but Canada could impose the same tariff on those. It is also our understanding that Mexico has a trade deficit in terms of steel. Tariffs imposed by Mexico on US steel at the same level would potentially generate more money for Mexico than for the US. The European Union is an even more formidable opponent. They have already indicated that they have plans prepared to retaliate with import taxes on Harley-Davidson, Kentucky Whisky and other products that come from areas with a Republican majority. President Trump has already threatened to then impose tariffs on German cars. He has long questioned why the Europeans do not buy more US cars. Perhaps the question should really be: Why are US cars not as attractive as German cars despite a substantial price advantage? BMW, Mercedes, Audio: They are premium brands who can ask a premium price. Despite that, US citizens and US residents seem to have a preference for these over the US brands if they can afford it. It is unlikely that a German consumer will prefer a Chevrolet over a VW Golf any time soon.

The entire matter can certainly spiral out of control into an outright trade war. Perhaps it would make sense for the Europeans and Japanese to consider slapping tariffs on services and products from Google, Facebook, Microsoft, and other high-tech companies. And then take the money collected to give their own high-tech industry a tax credit. It just doesn't make sense. On a very simple, even trivial level, international distribution of work using market mechanisms benefits everyone. No-one would try growing pineapples in Alaska or Bananas in Europe. Equally there are industries that are better suited for other geographies. It makes sense to manufacture specialty steel at a massive scale near cheap energy to reduce costs. Arguing that putting tariffs on Canadian steel in the interest of "national security" doesn't make any sense. There is no record in the history books that the Canadians every attacked or threatened to attack the US. On the contrary: Canada is a partner in the five-eyes group of spying nations.

Let's hope that reason prevails in the long run. Paul Ryan, republican speaker of the house, has already broken with Donald Trump about the planned tariffs on steel and aluminum. There are more level-headed politicians that hopefully reign in a president who at times appears to act without thinking through the possible consequence of his actions.

Long-term investors have "survived" other presidents already. We will survive this president as well, no matter how good or bad he runs the United States. We just have to out-wait him. His term is limited to a maximum of 8 years, and that is only if he is reelected so it might be only 4 years. So stay calm and carry on!

Happy investing!

US Interest Rates Are Rising

Over many years investing in shares benefitted from falling and low interest rates. The yield on 3-Month Treasury Bonds was between 0% and 0.2% from January 2010 to about September 2015. From then it started to increase moderately, then faster. As of market close on 02 March 2018 this number is 1.63%. This still appears to be a small number but the diagram shows how this actually does indicate a sharp rise in short term interest rates. The yield on 3-Month Treasury Bills is often used as the reference for the yield of a risk-free investment. There is a general opinion that the likelihood of the US government to default is close to zero for a three-month time frame.

Another metric worth monitoring is the yield on 10 Years US Treasury Notes. These have been falling until about March 2016. Since then they have been moving up as well with the latest number being 2.862% (as of market close 02 March 2018).

Why is this important? Yields increase as the price for bonds and bills decrease. For investors it means that as the yield on investments with a lower risk increases, they either pull out money from investments with higher risks or they need the investments with higher risks to create a higher return. Shares are generally considered to be an investment option with a higher risk than T-bills or government bonds. Given that the US share markets have enjoyed gains of almost 20% in 2017, their valuations have now reached lofty levels. Rising interest rates will put pressure on shares prices as gradually more investors will tend to sell shares and invest in lower risk assets.

So far, some companies have been able to stem the tide somewhat in that they have raised dividends and share buybacks. Both are ways to return money to shareholders. The total return, being the combination of share price increases plus dividend payments and other distributions (e.g. stock splits), improves. However, this works only so far. Some of the dividends are special one-off dividends. And even though the tax reform in the US helps companies to reduce their tax bill, the amount of interest they have to pay increases. The low interest rates over many years was a big incentive to take on more debt in the balance sheets. As the interest rates increase, this can backfire and offset the gains from reduced tax payments.

Also, some companies experienced windfall profits as they need set aside less reserves for future tax obligations. Some have opted to give their employees a pay increase which also increases the cost base.

And then there is the Federal Reserve. It is expected that they will continue to increase the interest this year. Most commentators seem to expect three or four increases in 2018. We don’t know yet by how much. In any case they have several reasons to increase the interest rates. Inflation is picking up and this is driven by several factors including the low rate of unemployment in the US driving wages up and also the weak dollar that drives up prices on everything that needs to be imported. And that is even before tariffs are imposed, tariffs currently known (steel and aluminium) and potential future ones. Even the “most American” of cars consists of at least 50% parts that are imported.

Inflation, the weak dollar and tariffs are potential topics for future posts, so we won’t go into further details here. Suffice to say, interest rates are more likely to continue to rise than they are to stay flat, let alone fall. And this is likely to be a factor for the time being that puts a downward pressure on the US share markets.

We believe, though, that our Optarix US Portfolio is in a good position to do as well as its benchmarks if not better. Stay tuned and observe how all of this will play out. It’s exciting times!

Happy investing!

Optarix US Portfolio February 2018: Active Return +5.07%

Feburary 2018 turned out to be a very volatile month. After a very long period of new highs each month the US stock market saw wild swings and are down for the month. They are still up year-to-date, though.

The Optarix US portfolio is up year-to-year by 19.89%. However as always this number is not what we focus on. Instead we look at our benchmarks, which are the S&P 500 index and the S&P 500 Dividend Aristocrats index. The S&P 500 is up 14.82% year-to-year while the S&P 500 Dividend Aristocrats is up by 11.89%. This means that our portfolio had an active return of 5.07% compared to the S&P 500, and of 8.00% over the S&P 500 Dividend Aristocrats. Active return is the additional return that a portfolio produced compared to a benchmark.

Of course, it is possible that we just got lucky with our selection of stocks. There are reports that a monkey throwing darts at the news paper page with the stock quotes does as well as the average active fund manager or stock picker. We also need to keep in mind that the results for a single time frame are not statistically significant. Instead we need to look at multiple time frames.

We started the Optarix US portfolio in January 2017 based on decades of investment experience. For the US portfolio now we have data for three 12-months periods. Admittedly, they overlap but as we add one data point each month we expect the numbers to establish a trend as time goes by.

The active returns (i.e. the additional gains) over the S&P 500 are as follows:

• 12 months ending December 2017: +4.31%
• 12 months ending January 2018: +3.96%
• 12 months ending February 2018: +5.07%
• Average of these three months: 4.45%

Please be aware that past results do not guarantee future results. We believe, though, that with our set of simple rules, discipline and a long-term investment time frame, the Optarix US Portfolio is well positioned to generate returns similar to our benchmarks. For the last 10 years the S&P 500 returned about 9.51% per year while the S&P 500 Dividend Aristocrats increased by about 12.36%. Going forward, if we continue to manage creating a positive active return, then the Optarix US Portfolio might be able to even beat both benchmarks long-term.

Happy investing!

Disclosure: We have no plans to change any existing position in our portfolio or start new positions within 48 hours after publishing this post.