The market selloff this week has erased much of the year’s gains, and put the major indices in or near correction territory. But the outlook isn’t all doom and gloom, especially when it comes to US earnings. Kim Parlee speaks with Damian Fernandes, Portfolio Manager at TD Asset Management.
- Well, as we have been talking about, the market sell-off this week has erased much of the year's gains and put the major indices in or near correction territory. But my next guest says the outlook isn't all doom and gloom, especially when it comes to US earnings. Joining me is Damian Fernandes. He is Portfolio Manager at TD Asset Management.
Nice to have you here.
- Thanks, Kim.
- Let's start with-- we were just talking with David as well about kind of the, I'd say, the earnings profile.
- Fun times.
- He talked about the fact that this is more of a hiccup than destruction of earnings right now. And I understand that's your perspective too. When you say don't count US earnings out.
- I completely agree. And I think that this is a small hiccup, similar to what we've had in these last 10 years. When you think about the last 10 years, just taking a step back, think about the big picture. We've actually had, despite what you hear in the news, and despite the macroeconomic conditions and the negativity you hear, we've had an explosion in earnings.
The reason market returns have been great is because earnings in the US have been great.
KIM PARLEE: Let's bring up the chart because we have one that you brought in. And I think the chart-- a picture's worth a thousand words. We can bring it up right here. This does show earnings growth by region. And you're right. The US is looking awfully good here.
DAMIAN FERNANDES: Yeah, exactly, right? And Kim, to think about that, the white line is the US. And it has literally outperformed the rest, the red line being China, by about 100 points. You've had this massive explosion in earnings.
And this is why the market's up. The rest of those other lines are other regions-- China, Canada, EAFE. Those markets have lagged because they haven't had the same degree of earnings outperformance as the US.
So I think what's important to remember as we're going through the thick of this, right now this current crisis, is does this impair the earnings outlook longer term? Because ultimately, similar to what David, your guest, said before, we don't really know what the outcome is going to be for the next quarter.
There's a fair degree of uncertainty. It's pretty wide what potentially could happen. But is this going to impair the long-term compounding of earnings and cash flows?
KIM PARLEE: Does it?
- I don't think it does. I don't think it does for a few reasons. I don't think it does, because the US, unless this infects US consumption, which has actually been driving-- what's been driving a lot of these earnings throughout these last few years, I think we're pretty-- we might have a few hiccups for this one quarter.
For example, Microsoft after the close today said, Q3 guidance for them, which is this quarter, is going to be lower because they can't sell as many SurfacePads. They make SurfacePads in China. Their supply chain is under stress.
And so yes, they cut Q1 guidance. They haven't set the rest for the year. So I think that's what's important to remember.
And I also think that policymakers, whether it's governments or like the central banks, they just don't want to let this go. So they have sufficient tools. And you saw what happened overnight in Hong Kong with fiscal stimulus. Like, they are ready to see, to provide stimulus, if needed. So I think that's constructive.
KIM PARLEE: I want to ask and just throw this in at you. Any chance we could see some kitchen sink quarters coming from some companies? Because they know they're going to have to warn on a few things. So why don't we throw some other stuff in there at the same time?
DAMIAN FERNANDES: Well, look. The history of earnings is that managements want to beat. You want to beat your earnings estimate.
- But if you're not going to beat?
- Yeah. So if you're not going to beat, and if why not set the bar really low? A good example is a stock that we, in the payments space we like, either a MasterCard or Visa MasterCard two days ago came out and said that we are going to cut our guidance for the full year. We were supposed to do high double digits. Now we're going to do the high end of low single digits. So think 8 to 10, so basically a 3-point, 3, 4-point reduction, MasterCard.
Does that really change the long-term reason to own a payment company like MasterCard or Visa? They have massive opportunity for making people-- for as long as you have cash in your wallet, that's growth for them.
KIM PARLEE: Yeah. It's a drop in the bucket. That's what I'm thinking.
- Let me ask you. You brought another chart here, which I think is interesting. And I think this, if we bring it up, we can have people take a look, thesis being that earnings drive stock prices. And so if you have confidence in where earnings are going, that's what we've seen.
DAMIAN FERNANDES: This is, Kim, one of my favorite charts. So this, the white line right here, is just-- this white line right here-- that's earnings per share, if I can write. So let's clear that out. That's EPS.
And that's what it's done for the last 10 years. It's gone from 80 to basically 180. So it's more than a doubling of earnings. The reason the market's up so much is because it follows a path of earnings.
And I think what's more interesting of when you think back about the last 10 years is that in this 10 years, you've had a collapse in rates. The alternative for equities is, if you're getting defensive, is you own government bonds. But you're earning a lot here. Like, the inverse of these earnings are the earnings yield.
So you're actually getting compensated taking a lot of risk in owning equities. There is a fair degree of benefit, just given how low rates are. So I think that's what's actually lost.
But look, we don't think that white line, the path to that white line, like, yes, there might be a dip currently, and there will be a dip because companies are guiding down, but we don't think the path is impaired. And for us, that's our focus. We don't know where the market's going to be the next quarter, but we feel fairly confident that the earnings path isn't impaired. So longer term, which is the horizon of most of your investors, we feel pretty good.
- One thing I wanted to ask you is you said we're talking about-- this is going to have an impact. Is it 1 quarter? Is it 2 quarters? Is it 10 quarters? Is it 11 quarters? Where do you see it? And I know we have imperfect information right now. But based on what you're seeing, what do you think?
- From what companies have said so far, basically, this quarter is going to be a write-off, depending on the industry. For example, a few days ago, United Airlines said this year is going to be a write-off. They have no clarity. Like, they said that--
KIM PARLEE: And that's such a low-margin business.
- Exactly, right-- airlines. But they basically said, so think about the eye of the storm-- airlines, hoteliers, casinos, travel-related consumption, travel-related spend. Think about that going to 0.
But that's still a small portion, right? That's why the US market's interesting. And this probably is a good segue is that there's not a lot of that stuff or commodity-driven industries, which like, for example, the oil price today was lower. And commodities are under pressure because concerns about demand.
But there's not a lot of that in the US market. It's more tied to secular growth themes that are independent of the cycle, which is why we still have a preference for it.
- This is a great chart you brought in. And I hinted when we were going to break that there's been a structural change to your point and kind of what's in the index and what's being-- what companies are doing. And it shows up in profitability. So bring this up. This is something called-- your chart-- an "Explosion in Profitability." So is this kind of part of your thesis why you think things are a little more protected?
DAMIAN FERNANDES: Yeah, sure. So for us, we're a fundamental team. We believe the value for business is how much cash that business generates. So this is just free cash flow margin. So if you have $100 in revenue, 10 years ago, that would convert it to $5 in free cash flow-- what was entitled to you as a shareholder.
Look what's happened. Free cash flow has exploded, right? It's now in that same $100 in revenue, you have double the amount of cash flow that generates. You're twice as more profitable. And yet, people are concerned. The companies today are operating at some of the highest levels of profitability, in terms of cash flow generation, than they ever have.
KIM PARLEE: It's interesting too because, I guess, it's the what those companies are doing, and who's doing it. This is the bigger is better, and then obviously there's over clubbing on tack too, right?
- Well, it's completely that case because the largest companies in the US market right now are technology companies that don't have a lot of capital investment, who are tied to themes that are independent of coronavirus, Brexit. For example, Amazon is tied to Cloud adoption and e-commerce penetration.
Coronavirus, Brexit, the European debt crisis, yes, they do affect on the margin. But the core business is still operating at this very high run rate. These large companies are the bulk of the market. That's what's helping support that earnings.
KIM PARLEE: Let's bring up a chart that you brought in. And this is titled "Bigger is Better." And this is I know hard for people to see. Damian said it had too many numbers. But I still want to show it on the screen.
If you take a look, this shows us the top 20 S&P 500 constituents. And this is earnings for the fourth quarter. And what is interesting, and actually, I'll let you point out what's interesting. But it's a fascinating chart.
DAMIAN FERNANDES: Well, a few things that we can just point out-- just ignore the numbers for a second. The top five names in the S&P are tech names. They are growing earnings by that rate, Q4. So on average, the lowest one was Amazon. But Apple, because if its new cycle, grew earnings 19%.
Apple's a $1.4 billion company. This is for just a few weeks ago. So when I say bigger is better, what I'm really trying to say is that you have this cohort of winners whose fortunes are tied to their own business models that are relatively insulated from global macroeconomic concerns.
Yes, they're tied to it. But they are also highly profitable. They don't have debt. They have high margins. They don't require significant capital investment. This is exciting.
KIM PARLEE: And the one thing too that stood out for me when we're talking is that 4.3 number in the bottom. So that was the S&P earnings growth, was it? Tell me what--
DAMIAN FERNANDES: No, no. That 4.3 is how much the top 20 names in the US market contributed to earnings growth.
KIM PARLEE: Got it. And the sum of the top five though is more than that.
DAMIAN FERNANDES: Yes, exactly. The sum of this right here is even more than that. And to be clear, in Q4, US earnings are going to be about 3%. So the top five names contributed basically the bulk of earnings. It's the other stuff, the commodity sectors that had negative earnings that are weighing it down.
I think it's a very interesting thing when you're thinking about just how the world's changed. 10 years ago, or actually, before the crisis, the biggest companies in that top five were actually commodity companies, were the Exxons, were the banks, companies that don't have that level of profitability, companies whose fortunes are tied to where interest margins are or what the commodity cycle is doing.
It's a very different-- you almost have a higher quality index right now. And I think this is lost in the conversation.
KIM PARLEE: Well, it's lost in the sell-off today.
- I think the sell-off today was sell everything and sell everything because of worries, which if you have a long-term investing horizon is actually quite-- it does throw up good opportunities.
- I've only got about, I think, 45 seconds. I just want to throw up a name or two that you think that could be interesting opportunities right now. HD?
DAMIAN FERNANDES: Yep. Home Depot.
KIM PARLEE: Yep. Tell me why.
- Home Depot, first of all, is insulated from e-commerce. Like, most of retailers are sold wrestling with the Amazon threat. Home Depot, last time I checked, you couldn't ship two-by-fours in the mail. Maybe you can.
But Home Depot is benefiting from lower rates. We talked about lower rates here. Previous guest David Sykes talked about lower rates. Well, lower rates means increased housing activity.
If you have increased housing activity, if home sales are selling faster, you have to renovate. You have to remodel. All of that stuff is Home Depot's bread and butter. It operates an oligopoly. And it hasn't built a new store.
So it's like, CapEx, there's no CapEx. It's tied to these good themes. So we like names with that property.
KIM PARLEE: I've got 10 seconds, and I want to get this name in just because they reported Microsoft. In 15 seconds, what's compelling about Microsoft still, despite what was said?
- Well, Microsoft is compelling because it's in an oligopoly with Amazon for Cloud adoption. Every single company will-- it's a better mousetrap when you think about moving your services to the Cloud. And Microsoft operates an oligopoly. And it has a long pathway for growth.
KIM PARLEE: Damien, always a pleasure. Come back soon.
- Sure. Thank you, Kim.