At a macroeconomic level, Nintai has never tried to divine exactly where the equity markets, U.S. economy or global economies are headed. It’s a loser’s game if an investor feels they can time their exposure to any of them. We have always tried to find companies with deep competitive advantages where their product and services are vital to their customers' strategy and value proposition. Balancing that with incredibly strong financial performance and pristine balance sheets, we think our portfolio holdings will do well in nearly any market.
Certainly Wall Street disagrees with Nintai’s methodology. An enormous amount of sweat and treasure goes into calculating exactly where the economy will be 18 months from now, or what the federal funds rate will be after the next board meeting or how the slowdown in Chinese auto imports will affect U.S.-based auto parts stores. There are thousands of very bright individuals who work day and night trying to gauge the impact on individual stock prices or even the broader market indexes. As a result, I thought I’d share Nintai’s thoughts on the role macroeconomics can play in portfolio management, why most data is irrelevant for the average investor and what data is actually critical to a value investor.
Geopolitics and its impact on calculating value
The recent events surrounding the China-U.S. trading relationship is an example of the complexity that macroeconomics can present in calculating a portfolio holding’s intrinsic value. A note before I begin: This discussion will inevitability wander into the realm of politics. In the context of value investing, I have little interest in our current political environment with the exception of what impact it might have on my clients’ portfolios. I ask that any comments avoid purely political views or opinions.
The current administration made it clear in both their campaign and through current policy that existing U.S. trade agreements with China needs to change dramatically. The big issues include the current trade deficit, intellectual property rights, market access, government industry subsidies and currency exchange rates. At Nintai, the first step we take after identifying the core issues is to ascertain which holdings could be impacted by geopolitics. In this instance, we might ask several questions that would help us identify these companies.
- Which holdings have the highest percentage of revenue generated overseas with a focus on mainland China? (Further research might entail which competitors would also be impacted, finding local China-based companies that would not be impacted or the stickiness or depth of the Chinese relationship.)
- Which companies have supply chain or key outsourced partners in mainland China? (Here we would look to ascertain the complexity of the supply chain, number of subcontractors required and location of alternate supply chain companies.)
- How important are each of the five key issues listed above? For instance, which holdings are reliant upon intellectual property rights? This might be either in revenue generation (examples might include biopharmaceutical drug patents or author copyrights) or in operational costs (examples might include patent in production process or a technology patent in a product component).
- Which companies can find offsets to increased tariffs and what is the nature of those offsets? (Examples might include passing them off further down to distributors or consumers or relocating parts of the supply chain.)
- Last - from a policy standpoint – which holdings are in industries most (or least) likely to have the financial and political wherewithal to seek (and get) exemptions from any possible new tariffs or regulatory policies such as non-importation bans? (An example might be Apple (AAPL, Financial), which received a waiver from the Trump administration.)
Answering these questions should give an investor a relatively comprehensive (but high level) view of the risks facing each of their respective holdings. Will it - or can it - give an investor enough information to make detailed changes in their estimated intrinsic value estimates? It’s unlikely. But can it answer the “bigger than a breadbox, smaller than an elephant” when it comes to potential impact? Certainly. Answering these questions can give an investor broad enough knowledge to know which holdings are at risk, how big the risk is and whether there are tools or processes that can help mitigate that risk.
A working example: Skyworks Solutions
To show the difficulty in trying to define both the risk (where you can define possible outcomes) and uncertainties (where you cannot define possible outcomes) in a macroeconomic setting, I thought I’d use the China-U.S. trade issues and look at current Nintai portfolio holding Skyworks Solutions (SWKS, Financial). Starting with President Trump’s statement in March 2018 that “trade wars are good, and easy to win”, the current administration has made over 200 statements that a trade agreement with China is “very, very close,” “separated by the narrowest of margins,” “just about done,” “a done deal” to be compared with the less far less enthusiastic “a pretty significant gap,” “not much progress” and “they are going to have to give.” This isn’t making any judgment against the Trump administration (though we might quibble with the idea that trade wars are easy to win). The whiplash from so many contradictory and misleading statements by administration spokespeople has made any of their predictive qualities useless going forward. With threats of tariffs ranging from 5% to 15% on everything from auto imports to flamethrowers (Flamethrowers? Yup. Take a look at the full list here), it’s very difficult to make long-term profit projections. It’s particularly hard if you do the bulk of your business in the international markets.
Skyworks has faced a double blow with the government’s on-again, off-again tariff threats with China (theoretically resolved with the “Phase 1 Agreement” agreed to on Dec. 13) and its equally confusing approach to large Skyworks’ customer Huawei. The stock price over the past year has a range from $60 to $103 per share. Which price is closer to intrinsic value? Utilizing macroeconomic issues, it’s pretty difficult to come up with any solid number. For instance, in its recent earnings call (November 2019) management stated earnings would have been 20% higher with business from Huawei (the company is currently banned by the U.S. government from purchasing chips from Skyworks).
Between the risk of certain tariffs (which we can define by products affected, tariff rates, etc.) and the uncertainty (we simply cannot measure the probabilities of the Trump administration implementing such tariffs) of the U.S. pressing forward, it is very difficult to estimate the possible impact on our estimated intrinsic value. What we can do is summarize some of the bigger issues and keep an eye on certain high level risks and uncertainties.
- Skyworks generates a significant amount of revenue from overseas markets. In particular, the company works with some of the largest players in 5G based in Asia. Any tariffs implemented with China would have a moderate impact on Skyworks’ revenue, and thus our valuation.
- Approximately 47% of fiscal 2018 revenue was from one customer – Apple. As stated earlier, Apple received a waiver from the Trump administration in relation to tariffs placed on Chinese imports. This helps mitigate the impact of any tariffs that center on Apple products.
- Skyworks is limited in its ability to offset any additional costs related to new tariffs or regulations. The company will likely offset these with a blend of increased costs to customers and cost savings generated within the supply chain.
- Last, Skyworks faces threats in two of the five issues cited earlier. This includes intellectual property rights (China requires access to proprietary information as part of many contracts) and supply chain location (the greatest threat here are new tariffs proposed by the Trump sdministration on Mexico).
In most cases, I don’t go beyond this in terms of research. I’ve learned that great management is many, many steps ahead of me in identifying where the economy might be headed and how this might impact their core strategies, product development, competitive landscape, etc. Going forward, I will look for how management has addressed these issues and how successful their efforts have been.
The devil is in the details
Having discussed why I place such limited concern and effort on macroeconomic issues, there is one large caveat to apply – a very small amount of macroeconomic data is essential to calculating intrinsic value. It’s not a lot and it doesn’t require an enormous amount of work to gather it and apply it to your valuation tools. But one of the most important legs in the value investing stool - calculating intrinsic value - is impossible without it. Here are the macroeconomic data I follow closely.
Interest rates and cost of capital: Federal Reserve policy can have a huge impact on short- and long-term interest rates. This directly impacts a portfolio holdings’ average weight cost of capital (if they need to tap the debt markets). This in turn has an enormous impact on return on capital and investment value generation. I’ve discussed this in greater detail several times, but it’s important enough to summarize it again. When utilizing a discounted free cash flow model to generate intrinsic value, even the slightest change in Federal Reserve policy can move valuations by 5% to 10%. This can be the difference between an adequate margin of safety or not.
Regulatory and compliance: Over time, changes in the macroeconomic environment can lead to significant changes in state and federal regulatory oversight. As an example, the crash in the credit derivatives market during the Great Recession forced the Federal Reserve and Congress to implement sweeping changes in the financial markets, including new capital requirements and the elimination of several core business lines in the largest banks. At Nintai, we are always looking for macroeconomic data that might directly impact financial and valuation models specific to any of our portfolio holdings.
Conclusions
I was once having a conversation with several co-workers when the issue of spousal jealousy came up. After several individuals bemoaned their lot in marital life, one individual said, “Our therapist said that jealousy is like paying interest on a loan you never took out.” I’ve found that in most cases, spending time worrying about macroeconomic issues is much like the therapist’s advice. In most cases, the data really isn't that helpful in ascertaining how much investor value can be generated over the next decade or two. In those limited cases (such as the federal funds rate) a simple check on the latest 10-year Treasury will tell you everything you need to know to get started on generating the company’s average weighted cost of capital. The most important thing is to understand which data can help you focus on truly important issues (such as calculating the company’s value) and disregard the rest. Over time, you will be amazed how much time can be spent on company-specific research. Much like the therapist’s couple, life is much easier when you focus on the things that matter.
As always, I look forward to your thoughts and comments.
Disclosure: Nintai Investments LLC is long Skyworks Solutions.
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