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LBW Commentary Q3 2018


How LBW Sees It

This piece of our quarterly commentary has been easy to write for 2018. The amount of economic and political events that have transpired has provided several topics to discuss and has allowed us to write a nice 2018 economic story. Q1 we discussed the extreme volatility we experienced, Q2 we wrote about four major topics within the economic sphere, and now in Q3 we want to take a deeper dive into understanding tariffs as questions from others continue to come in.

Trade Wars

In our Q2 commentary we wrote about the difficulty one may have in understanding or anticipating the economic effects the trade wars may have. This quarter we want to provide insight into what tariffs mean and their potential effects.

A tariff can be defined as a “tax imposed on imported goods and services.”[1] For example, let’s assume in 2017 it cost $100 to buy and import 10 pounds of candy from a country outside of the U.S. And in 2018 the U.S. government decides to place a 25 percent tariff on all candy imported from other countries. The same 10 pounds of candy one year later would now cost $125 dollars to import. Unfortunately, the end consumer would now witness a potential 25 percent increase in their beloved Snickers Bar.

Now that we understand how a tariff works, the next logical question is why do governments want to increase the price of an imported good? Countries around the world have the capability of producing the same goods and services. However, the cost to produce those goods and services may differ greatly depending on the country. For example, the cost of labor in emerging countries is significantly cheaper than those of developed allowing emerging countries to produce a final product at a cheaper price. Other factors may include government regulation or even access to natural resources. These factors create competition for domestic industries. For example, if it is cheaper to produce and import candy from Australia then it is to produce domestically, then the candy-making industry may be significantly reduced in the domestic country.

This is where tariffs come into play. Tariffs are used as a mechanism to disincentivize the use of imported goods and services to protect domestic industries from foreign competition. However, the effectiveness of tariffs has been debated amongst economists for years. Some believe tariffs can have unintended side-effects. There is a possibility of decreased innovation or for monopolistic behavior such as price-setting due to lack of competition. Furthermore, in today’s environment, there may be the lack of domestic infrastructure to support the reduction of certain imported goods and services thereby creating imbalance of supply and driving prices higher.

Shifting away from the economics of tariffs, they can also be used as bargaining chips. Developed countries can use tariffs to throw their weight around in the global economy forcing others into trade deals for their own benefit. They could also be used as punishment to other countries, potentially debilitating them from an economic perspective. In short, tariffs can be used for political reasons as well.

As we mentioned in our Q2 commentary the U.S. continues to feud about trade agreements with countries around the world. The U.S. has been doing so by imposing large tariffs on multiple goods and services. For example, the U.S. has imposed global tariffs of 25 percent on steel imports and 10 percent on aluminum imports[2]. These policies are an attempt to make the U.S. more competitive globally. In addition, it seems to be a mechanism to bring other countries to the table to renegotiate trade agreements. The results may be mixed. Increased prices of raw materials such as aluminum may squeeze companies that produce aluminum cans. This increase in price may lead to lower profit margins driving potential job loss. On the other hand, it may increase demand for domestic goods thereby increasing domestic production and creating a more robust job environment. Furthermore, it may lead to better trade negotiations with other countries. Or, as it seems with China, it may lead to other developed countries flexing their newfound muscles. The effect on the markets depends on how it all shakes out. However, the shakeout phase means uncertainty and uncertainty equates to volatility in the markets.

Understanding tariffs and their potential effects is a burdensome task as we may not know the true effects until years down the road and the incentives to enact tariffs may go further than just economic protectionism. Furthermore, years later there may be intense debates on if they even accomplished their intended goals. With that said, tariffs will directly affect certain industries. We recognize this and we will pay attention to their impact on individual companies. However, as we state ad nauseam we pay attention to macro-economic factors, but we do not allow them to dictate how we invest. We will continue to keep our eye on the market and as the trade wars march on we will watch for prices to drop to investable levels.

Nathaniel's Beautiful Mind

The Act of Doing Nothing

Humans are biologically wired to act. This has been proven in multiple studies. Most of us are incapable of sitting still for long periods of time before feeling the urge to move around. In the investment world, those incapable of sitting still typically trade on the smallest piece of news, constantly trading for prospective short-term returns. We all saw an example of this during the week of October 8 - 12 as markets decreased and investors scrambled to sell their positions. However, there is a small group of investors that have consistently displayed the ability to sit for long periods of time doing nothing. This isn’t because they are inherently lazy, but rather because they are looking for the so-called “fat pitches”. As you can imagine, these types usually have investment records that beat their respective benchmarks. How they find the fat pitches is a story in and of itself.

Let’s call this small group of investors incapable of doing nothing for long periods the “Short-Termers” or the “STs”, and those capable will be called the “Long-Termers” or the “LTs” for short. These LTs realized long ago that good investment ideas (e.g. fat pitches) don’t come around all the time. There isn’t always a consistent flow of actionable ideas. Companies must be researched even while they aren’t buyable. For example, a good LT worth their salt typically has a watchlist of companies that they have compiled and consistently monitor. The LT typically will have come across these watchlist companies via quantitative and qualitative screening, reading newspapers and other newsworthy publications, subscribing to other LTs’ blogs, or networking online and/or offline with other LTs.

Before the LT adds a company to their watchlist, they must put the company through their idea filtering process, like LBW’s Four Filters[3]. LTs will read the watchlist’s candidate’s primary source material, which include SEC-filed documents; transcripts of quarterly conference calls, annual meetings, and conferences; and any pertinent news articles[4][5]. From these documents, they can begin to piece together and analyze what the company does, how they earn their revenues, etc. (their financial statements), and how management has allocated the company’s capital. If the company candidate passes these first three filters to the LT’s satisfaction but fails the fourth and final filter (is the company trading at a significant Margin of Safety to its intrinsic value?), it will go onto the watchlist.

Fortunately, the LT’s work is never done. Even after they have successfully added a company to their watchlist, they must now maintain their research on the company by monitoring the primary sources listed above for new developments. Sometimes, there are cases where new developments in the news or in the company’s financials may cause the LT to remove them from their watchlist. And in others, LTs get the chance to swing at a fat pitch. As you can see, these fat pitches are great opportunities only because the LTs have put in the work before the opportunity arises. If a market price decrease temporarily occurs for a company that the LT may have glanced at, but didn’t do a deep dive on, they may lose the opportunity if the market is quick to realize the fat pitch’s existence and thereby causes the prospective buy’s price to increase again. Some LTs experienced this in the Great Financial Crisis and have since admitted to missing opportunities as a result.

When downturns hit, like the slight one experienced during the week of October 8 - 12, LTs may have the opportunity to use their watchlists and buy great companies at great prices. It is this filtering process in tandem with a long-term investment horizon where LTs can show their true colors and attain a high rate of return for themselves and/or their clients.

Sincerely,

LBW

[1] https://www.investopedia.com/terms/t/tariff.asp

[2] https://www.cnbc.com/2018/05/31/trump-administration-will-put-steel-and-aluminum-tariffs-on-canada-mexico-and-the-eu.html

[3] For a refresher on the Four Filters, please re-read Nathaniel’s Beautiful Mind in our 2017 Q3 commentary.

[4] When I say “pertinent” news articles, I mean articles that describe facts about the company as they may arise. I’m not referencing articles that give opinions on what specific news may mean for the company. It is up to the LT to create their own opinions based on the facts pertaining to the company.

[5] Some LTs may even go to industry trade shows, attend annual meetings, and interview management to get a more in-depth understanding of their watchlist companies. This additional approach has its pitfalls, principally cost (industry trade shows and annual meetings) and falling victim to the halo effect bias (interviewing management).


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