China leapt back onto Wall Street’s radar last week after stop-and-start trade negotiations hit another presidential road block. With tariffs back on the table, the S&P 500 dropped 2%, taking all but roughly a dozen of our recommendations with it. We find the timing less than convincing and lay out our thoughts in The Big Picture.
Nonetheless, the BMR universe is still up a healthy 23% YTD despite this speed bump and earnings season has been good enough for us (and the market as a whole) that this downswing looks like it will be fleeting. The fundamentals looked like they’d hit a short-term wall three months ago, but the S&P 500 rallied to break last year’s records after all.
And we’re now three months closer to the return of the earnings growth that ultimately sustains record-breaking rallies. Day by day, markets discount the past and anticipate the future. The only quarter of zero growth in nearly three years is behind us. It’s time to look toward the time when we see how much money Corporate America is making now.
The 1Q19 numbers were strong enough to make us suspect that our own targets for 2Q19 are a little too low. In that scenario, growth will be back on the market’s side by July. If not, we’ll be three months closer to our next shot at real fundamental progress. Even if it takes until the end of the year to see significant year-over-year earnings improvement, that’s not so distant as far as the market is concerned.
Of course a season can feel like an eternity when Wall Street benchmarks are spinning and every channel is blaring meaningless chatter. Eight months ago, the S&P 500 embarked on a rollercoaster that started by crushing a lot of unrealistic expectations and more recently took stocks all the way back from the brink of bear market territory. Investor assumptions were tested and in some cases broke under the pressure.
But here’s the thing: If you tuned out the noise and held onto our recommendations throughout that wild ride, you’d be up 6.5% in those eight months. That’s not a thrilling annualized return by our standards, but it’s well above the S&P 500’s performance, which is flat at best. Some stocks will always be stronger than others. We’re in the strong spots, where growth never faltered and there’s plenty of upside left to capture.
There’s always a bull market here at The Bull Market Report! Much of our subscriber-only discussion this week revolves around the BMR stocks that led the way down, starting with mighty Apple. The defensive Microsoft held up well.
The Big Picture challenges Wall Street’s logic in punishing strong companies as well as weak ones. Let's start there.
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Key Market Measures (Friday’s Close)
BMR Companies and Commentary
The Big Picture: No China Crisis Here At Home
While last week was allegedly all about trade tension, we couldn’t help but notice that stocks moved in patterns that didn’t match that narrative. For one thing, Chinese and U.S. markets lurched in different directions more often than not, defying the theory that commercial relationships on both sides of the Pacific are facing complete and permanent disruption.
Then there’s the fact that stocks that do a lot of business in China dropped in line with those that are completely insulated from that country, its economy and its trade policy. Let’s start with Netflix (NFLX: $361, down 6%), which has yet to enter China in any meaningful way, and Twitter (TWTR: $48, down 6%), which is banned there.
These two companies have zero skin in this game so the notion of a setback in tariff negotiations triggering their retreat doesn’t compute. But on the other side of the argument, if Netflix and Twitter lost ground, can we really blame the trade talks? We just don’t find the logic convincing, especially when stocks that are closely associated with China like Caterpillar, soybean exporter Bunge and our own Apple (AAPL: $197, down 7%) aren’t in appreciably worse shape.
You can’t have it both ways. Either this is about trade and China-driven stocks would be at the center of the selling, or stocks are simply getting sold across the board and Wall Street can’t find anything better to blame. With all the data points supporting the latter scenario, we suspect that nothing is going on beyond a slightly overextended market catching its breath as a solid 1Q19 earnings cycle winds up.
Cutting through the noise, we know Pacific trade won’t go over an immediate cliff. Since this is the fear factor of the moment, let’s quantify how important China actually is to our stocks and the market as a whole.
First, there’s a huge distinction between “trade” and China. Sure, they’re our biggest international partner but most U.S. companies that depend on foreign markets are actually focused elsewhere. All of Asia put together accounted for 8% of S&P 500 revenue last time we checked and only a handful of big stocks are heavily involved with China in particular, as opposed to India or Japan.
While we’ve steered clear of most of those “China Syndrome” companies, you couldn’t really tell from last week’s synchronized slide. Semiconductor makers like Skyworks Solutions (SWKS) should be ground zero in any trade war, with a staggering 85% of all revenue coming from Greater China. And yet they didn’t drop any farther last week than Twitter, which once again doesn’t officially operate in the country at all. Some actually held their ground better than stocks with zero Chinese presence.
Then there’s Apple, which used to depend on this market for a $13 billion slice of its $61 billion 1Q revenue and has seen ebbing demand for high-end iPhones take $3 billion of that revenue away. Admittedly, those phones are made in China anyway so import tariffs cast a shadow on future U.S. sales, but we’re not overly concerned.
All it takes to circumvent a price shock is to route those phones through a country like Canada where trade barriers remain low. Even if it’s a little more complicated, you know Tim Cook will find a way to juggle the rules and get the best possible outcome. And since the phones were already priced at the most luxurious end of the Chinese market, we’re unlikely to see a lot of erosion there either way.
Here’s the thrilling part: When you factor out companies that do most of their business overseas, earnings for domestically focused stocks are a whole lot better than most investors think. These companies still have 6% growth in 1Q19 to crow about. That’s a whole lot better than the flat quarter the S&P 500 as a whole is tracking.
Granted, the global exporters are huge and heavily weighted, but their struggle to sustain last year’s tax cut boom is more a matter of absolute scale than geopolitical tension. When they talk about China, they highlight slowing economic activity there feeding back into their business. Tariffs aren’t on their radar except in a general climate of rising costs.
And “global” business is a lot more than China. The biggest exporters leading the 1Q19 drag are actually companies like Exxon Mobil (XOM), where earnings per share last quarter got cut in half from $1.10 to $0.55. They sell to Europe and Canada. General Electric (GE) is big in Africa and Europe, which is where weak demand has hurt its overall performance. DowDuPont (DWDP) is Africa. International Business Machines (IBM) is Japan. Ford Motor (F) is the United Kingdom.
If you’re worried about a global slowdown, that’s your prerogative. But don’t blame China and don’t flinch at every twist in the trade talks. Wall Street loves it when people flinch. What we know is that there’s zero recession for U.S. companies like Twitter (and Microsoft, Amazon, Johnson & Johnson and on and on) where the home market remains the center of gravity. Stick to those stocks and the growth is still on your side.
Apple (AAPL: $197, down 7%)
With a $900 billion market cap, the giant of Cupertino needs a 10% boost to get back to $1 trillion. Does anyone really think it won’t make it there again?
Sure, the days when iPhone sales blew the market away may be in the rearview mirror, but in case you haven’t heard, the company is diversifying into so much more than a smart-device maker. Strong growth in Apple’s Services sector (led by the App Store), along with recently-announced pushes into Gaming, Credit Cards, News, and TV, will all drastically diversify the revenue streams and transform Apple from a hardware/software maker into a multi-platform Tech behemoth.
That’s not to say the core business is going anywhere. iPhone revenue was $31 billion last quarter, in-line with consensus estimates, which is a nice bounce back from the dreadful 4Q18. The iPad also brought in $4.2 billion, or 16% more than what Wall Street was expecting. So the underlying business is sturdy, even though Apple had a rough quarter for iPhone sales. And when 5G and foldable phones become a thing, expect sales to move higher once again.
BMR Take: Apple is well on its way to transforming into a one-stop-shop for digital media and entertainment. As the top hardware maker, any software they develop (think Gaming, News+ or the Apple Card) will leverage an installed user base of 1.5 billion devices. Investors know this, which is why the stock is up 27% YTD despite last year’s flagging iPhone sales. No one genuinely thinks that will be the new normal. iPhones will pick up again, and by that time Apple will have diversified into other promising business lines. The return to $1 trillion is only a matter of time, as long as the overall market remains steady to higher of course.
Microsoft (MSFT: $127, down 1%)
We only took only a slight hit this week, and the stock is still up an impressive 24% YTD. We’ve been calling Microsoft a Blue Chip that acts like a growth company for a long time now, and that’s exactly why the company crossed $1 trillion recently, and now stands 5% below that lofty metric.
It’s no secret that the company is making a strong push into Cloud computing, which grew revenue 40% YoY last quarter, thanks to strong Azure and 365 sales. The company has so many strong product lines (Office, LinkedIn, Xbox) it can be tough to keep track. So let’s look at the big picture: Revenue last quarter was just over $30 billion, a 15% jump from last year. It’s not often you see a $950 billion company grow revenue by 15%.
The company has also been improving margins, as gross profit margin and net profit margin came in at 67% and 28%, respectively. Compare that with Google, which posted 56% gross and 18% net. Though Google brought in $20 billion more in revenue over the last 12 months ($142 billion for Google vs. $122 billion for Microsoft), Microsoft wins out on an earnings basis, thanks to its stellar margin growth.
BMR Take: Microsoft is the envy of nearly every Tech company; a seemingly-limitless line of innovative businesses, fabulous revenue and margin growth, and a staggering mountain of cash ($130 billion, to be exact). The company can purchase its way into any industry it can’t organically expand into. Oh by the way, we haven’t mentioned the winner-take-all $10 billion Department of Defense JEDI contract, which will land with either Microsoft or Amazon. Both are in our BMR portfolio, so we’re going to benefit either way, but given Microsoft’s recent DoD contract announcements, don’t be surprised if they get the nod. Buy the dip on Microsoft and get ready to reach $1 trillion again.
NOTE: In our weekly paid subscription Newsletter, we do between 5 and 7 of these SnapShots, like Apple and Microsoft, above, and as earnings season continues we provide in-depth updates on dozens of companies. Plus, we have the Weekly High Yield Investor, whereby we discuss the 17 stocks in our High Yield and REIT Portfolios.
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