Over the past few months, the dominate cause of volatility in the stock market has been the fear of a trade war. You might wonder just how exposed our portfolio is to trade and tariff issues? The short answer is not very.
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Before we go into detail, it’s worth noting that global trade is extraordinarily complex. Changes in one area can have ripple effects (good or bad). The classic “butterfly effect” example from the Chaos Theory branch of mathematics comes to mind (at least the Jurassic Park movie version anyway). In this example, a butterfly flapping its wings causes a chain of events that leads to a tornado several weeks later. Global trade can be similar. There are many second, third, and perhaps infinite order effects to consider. To keep this article a reasonable length, we focus on the first and a little on the second order effects of a trade war with China (the dominate target of Trump’s ire).
In our portfolio, we own health care and financial stocks via index funds at their approximate market weights. We also have a small allocation in an energy sector index fund to partially hedge against rising gas prices for our auto parts retailer stocks. (Energy is a beaten down sector, so owning it just for that reason isn’t a bad thing either). We’ll skip discussion of these sectors and focus on our individual stocks.
Most of our companies produce intellectual property or services. Very few of our holdings “make stuff.” We own several defense contractors, but the vast bulk of their sales are to the US government and thus relatively immune to a trade war. Only about 13% of our stock portfolio is invested in companies that produce physical goods.
We have a little over 5% invested in companies that are either not based in the United States or have no international sales. We also have almost 8% invested in companies that are based in the US and sell domestically and internationally. Finally, we have about 4% in defense contractors that produce physical products. The vast bulk of our portfolio has little or no exposure to China.
Let’s go through each holding.
No China Exposure
We will name the easy ones first. We own two stocks focused on major league US sports teams: Liberty Braves Group, which owns the MLB Atlanta Braves; and Madison Square Garden (and the affiliated MSG Network) which owns the NBA Knicks and NHL Rangers. Both have nothing at all to do with China. We also own Formula One Group. Although racing is a global sport and Formula One holds a race in China, the company does not import or export any tangible goods or intellectual property. It also is perceived as more European than American. (Only one team, Haas, is from the US. The rest are international.) Despite its US ownership, Formula One seems highly unlikely to end up in the crosshairs of a trade war.
Charter Communications is another easy one. It’s a US cable company with no Chinese assets. While cell phone tower companies SBA Communications and American Tower Corp have international assets, none are in China. So, they’re safe too. Home builder D.R. Horton also has no operations in China.
Altria Group is another US only company. It’s conceivable that tobacco imports could get “tariff-ed,” but Altria makes no mention of China in its financial filings and the US has quite a vibrant tobacco-growing environment. We don’t see how Altria has any notable exposure to China.
We also can eliminate tariff worries about defense contractors Lockheed Martin, Northrop Grumman, Raytheon, and Leidos Holdings. We definitely are not selling any weapons systems to China any time soon. True, steel and aluminum are significant input costs in many of those companies’ products (excluding Leidos, which is an IT and consulting company). However, a good portion of defense companies have cost-plus contracts in which they receive payment for the direct costs of the product plus a fixed profit. If costs go up, their payment goes up. Additionally, most have long-term supply contracts and the ability to go back to the US government and request changes to contracts. We believe the exposure to China for these companies is minimal.
Google and Facebook are two other easy ones. Facebook is banned in China. Although some Google services like Gmail are available in China, Google China’s market share is zero for all intents and purposes. Credit card companies MasterCard and Visa are also shut out of China.
Credit rating agency S&P Global has no Chinese operations, but it does hope to enter the market soon. Consumer credit rating agencies Equifax and Fair Isaac Corp also have no Chinese operations of note.
Moody’s Corp owns 30% of China’s largest domestic credit rating agency, CCXI. We couldn’t find exact details on the transaction (we also didn’t try hard and you’ll see why in a second) and value of CCXI. CCXI has only 220 employees while Moody’s has 12,000. Whatever CCXI is worth, it is less than 1% the size of Moody’s. Such a small amount is not close to being big enough to care about.
Merchant services company Total System Services has a minority interest in a Chinese company, but it amounts to only .04% of the value of the company. We think it’s safe to round that down to zero.
Rolls-Royce is British, so we’ll skip that discussion. Philip Morris International is technically a US company because it is incorporated in Virginia although its headquarters are in Switzerland and the company has no US operations other than licensing one of its products to Altria. The company has a miniscule share of the Chinese tobacco market, so it’s probably safe to round this one down to zero as well.
Booking Holdings has a $2.2B investment in Ctrip, its Chinese equivalent. This is only 2% of the market cap of Booking Holdings. Again, not enough to worry about.
Some Possible China Exposure
Now, we get into some tricky ones. Advance Auto Parts and O’Reilly Auto Parts are two US and Canada only replacement auto parts retailers. They have no direct exposure to China, but many parts they sell are produced in China (often times by American and European companies with Chinese factories). The question is what happens if costs go up on those parts. Will the parts manufacturers be able to pass those costs on to the retailers? Will the retailers pass them on to customers?
Amazon and EBay have a weird relationship with China. Domestic Chinese e-commerce sites, like AliBaba, are dominant, so both US companies sell very little into China. Many Chinese merchants, however, sell products out of China to both the US and other countries. They could certainly be caught up in a trade war if things escalate. At this point, it seems highly unlikely.
PayPal has no local Chinese operations but has partnered with a Chinese company to allow Chinese users to have access to its services. Its direct exposure to China is small, but it could be vulnerable in a trade war if China did anything about PayPal’s relationship with its local Chinese partner.
Very Small or Unknown Exposure to China
Next, we have a few companies that have minor exposure to China.
Lennox International has a small refrigeration equipment manufacturing facility in China that accounts for only 2% of the company’s total manufacturing and distribution footprint. It’s likely that its sales exposure to China is similar. However, steel, aluminum, motors, and condensers are big cost inputs for the company so there could be second order effects.
General Dynamics is primarily a defense contractor, but it also gets 20% of its revenue from commercial aviation sales of its Gulfstream jets. Last year, China accounted for 10 of 80 deliveries. While that comes out only to about 2.5% of General Dynamics’ total revenue, China is an important source of growth for jet aircraft. There is currently a proposal from China to increase tariffs from 17% to 25% on Gulfstream-sized jets.
We own several companies that don’t disclose specific sales to China but do get about 10% of their sales from the Asia-Pacific region. We could guess that China might account for somewhere around the low to mid single digits of total sales for many of these companies.
Autodesk does not break out its sales by country, but it does get 11% of its revenues from emerging markets and has called out emerging markets as a source of growth. A good guess is that a decent chunk of that 11% is from China. Adobe Systems used to have an R&D center in China, but it closed in 2014. Adobe gets about 15% of its revenue from the Asia-Pacific region, which includes China. Accenture gets about 19% of its revenue from “growth markets,” which includes China. Based on other disclosures in their annual reports, we guess that China is its second or third largest “growth” market behind Japan and/or India.
Rockwell Automation’s largest market outside the US is China, but it is still less than 13% of the company’s total revenue. Like Autodesk, the 13% figure is the total for its emerging markets category. The largest portion of that 13% is China.
China Is Important
Finally, we have companies where an escalating trade war could have an impact worth worrying about.
Microsoft is probably one of the most exposed software companies. China accounts for about 10% of the company’s revenue, although that figure is decreasing. Microsoft is heavily dependent on Chinese authorities to protect its intellectual property and crackdown on counterfeit software. As Microsoft transitions to cloud services versus a licensing model, this change should reduce its vulnerability to counterfeiting. Also of importance, the company has been under an antitrust investigation by the Chinese government since 2014.
DowDuPont derives 22% of its sales from the Asia Pacific region (its fastest growing region). China is an important part of that 22%, especially for DWDP’s agriculture business. Here again, DWDP depends on the Chinese government to protect its intellectual property. Like Microsoft, it has legal exposure as well. Chinese regulators needed to (and did) approve its “merger then split into three companies” plan. An autocratic government could easily undo its previous approval.
Texas Instruments and AMD both have significant exposure (44% and 33% of sales, respectively) to China but with one large caveat. Much of their Chinese sales are components for inclusion in other products destined for sale elsewhere in the world. A trade war with China is likely to cause supply chain issues as manufacturers relocate production of products that use TI and AMD components. The result of those movements might not have as a big an impact as you might think based on the 44% and 33% sales numbers.
ActivisionBlizzard, Electronic Arts, and Take-Two Interactive have significant sales in China. It’s the third largest market for ATVI, while EA and TTWO have less exposure. Additionally, the Chinese government must approve all games to be sold. It’s easy to imagine a situation where Chinese regulators could make it difficult for these companies to sell their games in China. As with other software companies, they depend on the Chinese government to enforce their intellectual property rights and prevent piracy. As distribution moves to digital, this is becoming less of a threat.
In all, we are comfortable with our exposure to China and any trade war issues. We have a sizable number of domestic-only investments, and a number of our largest multinational holdings simply don’t do any business in China.
We don’t own companies that are manufacturing and exporting large amounts of goods to China or depending on China to fuel their growth. The same can’t be said about Starbucks, for example. Although its exposure to China isn’t great, almost all of its reported growth is coming from China. Companies like Caterpillar and Brown-Forman export substantial amounts of goods (heavy equipment and whiskey, respectively) to China (and Europe).
Also, most of the companies we own have no readily available substitutes. Much of Microsoft’s software offerings either compete with other companies we own (Amazon, Google) or their own counterfeit versions. Additionally, many of our stocks supply “mission critical” products. It’s easy for China or another country to buy a Hitachi or JCB excavator instead of a Caterpillar. Chinese people can drink another brand of alcohol. But, how would the EU substitute something for Visa or MasterCard?
For all these reasons, we wish our clients peace of mind about your investments even as you hear others worry about a trade war.
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Article by Ben Strubel, Strubel Investment Management
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