The Politics of Stocks, Part 2: Earnings Per Share

On the 2/22/2019 edition of Stock Talk, CIO Chris Perras takes a look at one of the key components of stock returns, earnings per share, and discusses the impact that politics can have on it.

 

Chris Perras: This is Chris Perras, Chief Investment Officer at Oak Harvest Financial Group. Welcome to the February 22nd edition of our weekly Stock Talk Podcast: Keeping You Connected to Your Money. Each week we try to recap the prior week’s events, share with you our thoughts and views on the markets, try to educate you a little bit along the way. This week’s title is the Politics of Stocks Parts Two Earnings Per Share. Two weeks ago, we had a client ask about the impact of politics on stocks in the market. It’s a great question with the 2020 election moving into focus this year.

This is a second part of our five-part series on the topic. The politics of stocks. Much of this material is on our website at oakharvestfg as in financial group .com. It’s under the investment management tab, under the sub-tab ideas and insights. Then look for the tab labeled lessons from the market. As we discussed last week, there are three components of equity market returns. First component is a company’s earnings per share and free cash flow. The second component is the change in valuation or multiple priced earnings multiple, a lot of you know about.

Third component of stock market returns are dividend yield. Today, we’re going to focus on how politics can change the first component, earnings per share and free cash flow. Now earnings per share is the most important variable in determining a share price of a stock. It’s the portion of a company’s profit after paying all costs, including product costs, salaries, wages, rents, interest on a company’s debt if they have it outstanding, and finally, taxes to the government. After you pay all of those costs, what’s left over is allocated to each share of stock.

When an investor buys a share of stock, whether it’s 100 shares or a million share, this is what an investor is valuing. It’s essentially the leftovers after all costs are paid. It is not a guarantee, it is variable. It’s subject to the business and investment decisions in the management team running the company. Getting back to the question of politics, investors should ask do government or political policies change either or both the revenues of a company or the cost of doing business for a company as a public company because that’s what we’re concerned about in public markets.

Policies that might help a company or industries from a revenue standpoint point might be government spending on military, companies in the defense business gain or lose depending on whether we’re building more aircraft carriers or spending more on the defense budget. Additionally, companies in the construction and building infrastructure area might be benefiting from additional infrastructure bill. Think of repairing roads in bridges or just rebuilding America and the infrastructure that has been talked about many times about its crumbling overuse in age.

Think of companies like a caterpillar which provides the huge earth-moving equipment to move dirt around. Maybe cement companies that help build roads and freeways and buildings, engineering construction companies that help do the design work, Fluor is out there in the public market. They do a lot of big projects for the government. Steel companies provide steel and rebar that goes inside the cement when you build a bridge or when you build a road. That’s another industry that can be affected by politics. How do policies change healthcare spending?

Medicare and Medicaid, we spent hundreds of billions of dollars a year. They’re government-funded programs whether they’re for the state or from federal spending that are subsidized and paid for by taxes. Companies such as in the health care drug area affected by drug reimbursement pricing, companies in a hospital area are affected by reimbursement rates from the government for going in and using one of their bed or using one of their doctors. Those are all areas of the market that can be affected from a revenue standpoint.

Second area that can be affected by politics is on the cost side. Think of policies that either increase or decrease cost of running a business. Lately, lots is in the press about tariffs. Those are essentially increased taxes, increased costs of building products, usually in steel right now. If you have to use a lot of steel in building a washing machine or a car, your costs go up, and if you can’t raise your prices to your end consumer, your earnings per share are going to go down and it will hurt the shareholder. Think about policies like the 2017 Tax Plan that was pushed through that decreased corporate taxes for almost all of America.

Those policies decreased taxes to the point that it increased earnings per share of most companies in the S&P 500 between anywhere 12% and 15%. As a shareholder, you get the benefit of getting higher earnings per share from your investments. Another policy that might change because of politics is wages. Word in the press about the minimum wage and whether you believe in the minimum wage or not, talk of increasing minimum wage mandated to $15 per hour. If a company cannot pass on those costs to people buying its products or services, those costs have to come from some place.

Ultimately, they run through the income statement and they come out of earnings per share, so you would have a lower earnings per share due to rising wage costs. The first thing to think about with regards to stocks when you’re thinking about the political environment, is regardless of one’s political affiliation or emotional leanings is, will this change the EPS level or the EPS growth rate of the market as a whole or the industry I’m investing in and or the individual company? That’s the first question to ask. Does this change the EPS earnings per share or cash flow of my investments?

If it does, you should think about it, think about do I want to make a change in allocation with regards to stocks or the sectors I’m investing in and if it’s going to be a short-term change on EPS or a long-term change in EPS. Short-term changes hit the market very quickly and the market moves on. Things that change the level over a long period of time probably want to move out of those investments and find something else because your marginal return on invested capital has changed in the market. Generally, it takes quite a while for a company to recover from that.

Quickly, I wanted to share our near-term outlook on the market. We think there’s only about 2% upside left in this move up and that will happen over the next two to four weeks. We’ve been very positive since December on the market. We expect there to be a rotation in the market for three to four months. The second quarter particularly we think there’ll be a rotation probably out of a lot of cyclical stocks back into safety stocks. We’ve actually been buying names in the telco service space, names in the healthcare space more. I hate to say it, but boring names, staple names.

We’ve been actually buying a lot of those names and adding to those names over the last two weeks while people were chasing semiconductors and some other names that we were buying back in November and December when no one liked them. Think of names like Verizon, Pepsi, Johnson & Johnson. Those are the names that we’ve been adding to or initiating positions for new clients. On a side note, we do not own Kraft Heinz for clients. The reason I bring this up is it’s down 28% today on accounting concerns and it’s a high-paying dividend stock that’s in a lot of people’s dividend portfolios out there.

Oak Harvest Financial Group does not own it. We’re not looking at buying it right now. We stay away from accounting issues in the market. The second reason I bring it up is Berkshire Hathaway and Warren buffet are out there as its largest number one shareholders. There’s a lot then in the and the press over the last three or four years about his investment in the company. We do not own it as a firm and are not looking to buy it here as it moves down 28% to 30% just today alone. Just in closing, if you find this content helpful, please feel free to forward it to your friends or anyone else or have them give us a call here at our home office in Memorial, or point them to our website @oakharvestfg.com.

Our website has been populated with a lot of new content. It looks totally different than it did about two weeks ago. Go there. We’re excited about it. Can’t talk enough about it and the core four investment philosophy that we have here that integrates financial planning and investment management. You can find all sorts of new educational materials there. In closing, just remember, you shared your vision with us of retirement with what you wanted to do with your savings. Occasionally, we make changes to the investment portfolios because the investment environment changes.

The investment environment changed in the fourth quarter of last year. Most people were getting very negative in December, we were actually getting very positive. Now people are very positive, we’re actually getting a little more conservative only for the next three to four months. We’ll be back to our patient allegation of making changes to the portfolios 46 months for new money coming in to get it fully invested in the models that your financial advisor has worked with you to develop, amongst the core four and the four pillars. If you need us, we’re here for you. Please give us a call. Many blessings. Chris Perras.

Speaker 1: Content contained within this Oak Harvest podcast is for informational purposes and is based upon information current as of the time of recording. It should not be considered an offer or solicitation to buy or sell securities, nor is it taxed for legal advice. Investments involve risk. Unless otherwise stated, particular investment returns are not guaranteed.