Strong Results and Innovation at a Reasonable Price (IRP), Terry Gardner, CJL Market Comment 4.29.21 – YouTube Video & Transcript

In this video, C.J. Lawrence Portfolio Strategist, Terry Gardner, discusses the strong 1Q21 results being delivered by S&P 500 companies, examines profit margins and margin expectations, assesses the “market playbook”, and advocates investing in IRP (Innovation at a Reasonable Price).

https://youtu.be/fgnm13pZgdk

Video Transcript

Terry Gardner, Jr.:

Hey, good morning, everyone. It’s Terry Gardner from C.J. Lawrence on Thursday, April 29th, coming to you with some brief market commentary. We’ve got four topics that we want to cover today. The first being we want to take a look at first-quarter 2021 earnings and see how they’re coming in versus expectations. Two, we want to take a look at profit margins and expectations for the remainder of the year. Third, we want to discuss the market playbook, which is something we’ve discussed in previous videos and take a look and see how the market has reacted to changes in economic data and in treasury bond yields. And then finally, we want to discuss an investing strategy, which we dub innovation at a reasonable price.

Terry Gardner, Jr.:

So first off with regards to earning season, who could complain? 40+% Percent of the companies in the S&P 500 have now reported first-quarter 2021 earnings. And over 85% of them have been positive surprises, meaning that the earnings have come in higher than analysts’ expectations. And that’s the highest percentage of earnings beats since 2008. So a really strong start to 2021 and the biggest surprises … no pun intended, but the surprises, at least to us, the highest number of surprises have been in the technology and financial space.

Terry Gardner, Jr.:

Financial is not so much of a surprise because as the yield curve has steepened, improvements are expected in the financial company profitability. But technology was expected to be a little bit of a laggard in the quarter and it’s come in really at the top of it. So a great start to earnings for 2021. And the prospects for the remainder of the year look very, very strong.

Terry Gardner, Jr.:

Secondly, we want to talk about profit margins, which is something we haven’t talked a lot about in the past. And profit margins tend to rebound coming out of a recession and economic slowdowns, but often take several quarters to rebound. Well, not in this quarter.

Terry Gardner, Jr.:

The first-quarter profit margins are one of the highest quarters seen since 2008 and is remarkable for the speed at which margins recovered. On a four-quarter trailing basis, which is kind of how we like to look at margins, net margins are currently around 11%. What’s interesting to us is that expectations are calling for margins to continue to widen right through the end of 2022. In fact, peaking at the end of 2022 at 13%, which would be an all-time high in terms of net profit margins for the S&P 500.

Terry Gardner, Jr.:

And why does that catch our eye? Because, we do see some headwinds on the horizon for corporate profits, for margins, including, and I think it’s probably safe to assume that raw material prices are higher and going higher. Corporate taxes are likely to increase. Transportation costs are on the rise and the cost of labor is rising. So that’s not a particularly constructive backdrop for margin expansion. So we think this is something worth watching in the coming quarters. If there are risks to future earnings and future earnings expectations, we would think that that margins could pose them.

Terry Gardner, Jr.:

Our third point reflects some comments we made in our last video about the market playbook. And by that, we mean that as economic circumstances change, oftentimes you’ll see a response in the stock market with regard to rotation or movement from one asset class to another. We saw this manifest in the beginning of this year, 2021, as the ten-year treasury bond yields started to rise and inflation expectations are starting to rise. In the market, in the stock market, we saw leadership shift from large-cap to small-cap, from growth to value and from high-multiple to low-multiple. All is a result of that rapid ascent in the 10-year treasury bond yield.

Terry Gardner, Jr.:

And the market continues to grapple with leadership as it looks to the 10-year for clues with regard to future growth and inflation expectations. And you can see this movement and how it manifested, how it followed the playbook. When you look at year-to-date performance of the S&P sectors, the reading sectors year-to-date on the back of that 70 basis point increase in treasury bond yields were energy, financials and industrials. So oftentimes, considered the value related sectors or early cyclical related sector. You could see on the back of the 10-year rise why those sectors would do well.

Terry Gardner, Jr.:

Interestingly, over the last month, as the 10-year has somewhat stalled out here, the best performing sectors are technology, consumer discretionary and communication services. So kind of the shift back to growth as the 10-year got stuck in a range. So we’re watching to see if the market continues to follow the playbook as rates rise. But we made the point in our last video and want to make the point again today that even though the market is rotating, it’s not a cause to sell your high-quality companies, your winners. Because the point we made in the last video and we make again today is winners can keep on winning and you can see that playing out in the stock market today and in the earnings results.

Terry Gardner, Jr.:

Some of the companies that have the most dominant market share positions that continue to innovate are doing particularly well and posting excellent results. We don’t think they should be sold just because the market internals are shifting one way or another. The bottom line is our quality never goes out of style. So as styles do shift within market internals, quality will outperform over time.

Terry Gardner, Jr.:

And that brings us to our fourth and final point regarding innovation and investment. So a common theme for successful high-growth companies is that they plow a lot of their cashflow back into plant, property and equipment, but also into R&D spending. In fact, the company’s ability to innovate is a key consideration in our C.J. Lawrence investment processing and security selection process. And we like to find companies that have strong cash flow, that plow a lot of it back into developing new products and services, to disrupting industries, to constant innovation and improvement, because those are the companies that will perform and outperform over time. And our conviction is that they will have times where they’ll fall out of favor. But over longer periods of time, they’ll continue to outperform.

Terry Gardner, Jr.:

And we call this investment style or philosophy IRP investing because everything needs an acronym, so we gave it one. And it stands for innovation at a reasonable price. Companies that plow a lot of money into R&D, that trade at a reasonable price, that generate a lot of cash flow, they’re innovators and disruptors.

Terry Gardner, Jr.:

Decades ago, the list was dominated by pharma companies and auto companies. But more recently, you can see that the top of the list is populated by software companies, social media companies, technology companies. In fact, as I look at the list here, we run these screens regularly as part of our investment process to see who is plowing money back into R&D, there’s some stark differences in sectors and even in companies. At the top of the list for 2020 R&D spending was Amazon at $42.7 billion. They spent $42.7 billion on research and development. It really makes you wonder what do they have going on in the basement or in the garage that we don’t know about.

Terry Gardner, Jr.:

And they’re followed in second place by Google at 27. So 27 to 42, that’s a massive gap from one to two. The gap is even more stark when you look at some of the pharma companies. So Amazon spent five times as much as Pfizer on research and development and you expect that big pharma would be leading the list. So let me just give you the top five. Amazon at the top with 42.7, Alphabet at 27.5 is number two. Number three is Facebook at 18.4. Apple is at 18.7 in the number four spot. And the number five spot is held by Microsoft. So, these are really remarkable numbers and worth keeping an eye on because this is where innovation is coming from.

Terry Gardner, Jr.:

That’s our final point. But in summary, we wanted to suggest that those are the types of companies that deserve meaningful weights in client portfolios, whether it be growth portfolios or balanced portfolios. These are the companies that have continued to perform over time. With regard to the market, wrapping it up, we remain constructive on the stock market. Earnings continue to rise, to rise and to climb and they’re coming in strong. We’re keeping an eye on margins, as we discussed earlier, to see whether there’s any risk-to-rate 2021 or 2022 earnings expectations.

Terry Gardner, Jr.:

We do continue to add a little cyclicality to our portfolios to take advantage of the global economic reacceleration. And we maintain a very healthy weighting in our favorite disruptors and market share gainers. So if you’d like to get a copy of this list or want to talk about any of the topics that we’ve covered today, feel free to give me a ring either at (212) 888-6403 or shoot me an email at tgardner@cjlawrence.com. Have a great day.