Peak Passivity

Trade Wars Drive Macroeconomic Uncertainty

President Trump wasted no time throwing the gauntlet down with respect to trade wars.  The White House announced on February 1^st a series of tariffs targeting goods imported from Canada, Mexico, and China citing “the extraordinary threat posed by illegal aliens and drugs, including deadly fentanyl.”

Economists at the Peterson Institute for International Economics have shown the median loss to U.S. households would be approximately $1,200 and even the conversative / libertarian CATO Institute is imploring the Administration to rethink its trade war strategy citing tariffs in Trump’s first term hurt American consumers to the tune of $830 per year and this go around a weaker Mexican economy, hurt by the tariffs, could actually increase the number of illegal border crossings, the opposite of what the Administration claims it wants to achieve.

Investors are grappling with pricing in the impacts of the trade wars as the Mexico and Canada tariffs were delayed by 30 days and the extent and duration of the trade war with China is unknown.

The Age of Peak Passivity

The benefits of index investing are clear: diversification and the convenience of not having to actively manage your portfolio. As the volume of passive mutual funds and electronically traded funds (ETFs) have increased over the past few decades, many investors have watched their wealth grow in the markets, especially since the Great Financial Crisis of 2008-2009.

But could this be dangerous?

Let’s do a thought experiment: what would happen if the percentage of the passive market reached 90%? Say you are in the minority 10% of active investors and you see that one company — ABC Corp — is undervalued, and so you and some of your fellow active traders purchase lots of ABC stock, and thus the price begins to rise. The higher price results in a larger market capitalization, which means that ABC represents a higher percentage of the index than before the active folks purchased shares.

Now, as net new funds flow into the market (e.g., 401k contributions and dividend reinvestments), a greater proportion of the net new funds are used to buy ABC since ABC now represents a higher percentage of the index, further driving up the price, further driving up the market capitalization, and thus the percentage of the index, creating a multiplier effect. Thus, the higher the percentage of passive investing in the overall marketplace, the higher this multiplier effect on any given security is likely to be. 

The bull case for the M7 stocks is that these companies are bringing in the lion’s share of the revenues, profits and growth and thus have earned their dominant market caps and will likely continue to grow in a similarly dominant way in the future. But history shows us that markets sometimes become irrationally exuberant and that even great companies cannot reproduce those historical results forever.

For new investors, avoiding M7 stocks may forgo short-term gains, but could protect against significant downside risk. Likewise, investors in broad market indices or holders of M7 stocks should consider trimming positions and looking for less exposure to these firms just as they should look for less exposure to other larger companies included in the index that have narrow economic moats or are currently struggling with revenue and profit growth

An Evolved Investor, one who takes an active approach using value investing principles, should be better positioned to outperform the market in the long run.

Sponsored Post

PEP

Pepsi Co. Inc. is a firm that needs no introduction. The perennial number 2 to Coca-Cola, starter of the 1990s cola wars, and infamous non-provider of a Harriet Jet. Investing in this consumer staples stalwart might be the “taste of a new generation” of Evolved Investors. 

Let’s break down the value case here:

• PEP has a wide economic moat supported by a portfolio of strong brands, extensive distribution network, and product diversification.

• It trades close to its 52-week low at $145

• It has a PE ratio of ~21 with a dividend yield of 3.72%

• Exceptional ROIC (look at the 10, 15, and 20 year views)

• Short term volume declines will likely not last forever

The stock is down more than 20% since May 2023 high and part of that is driven by changes in consumer consumption habits in North America, perhaps in part due to the popularity and proliferation of GLP-1 medications. However, PEP has been innovating and acquiring its way into healthier food options and management expects to see growth in the years ahead in unit sales as well as “resilience” in their international business.

A key factor for the longer term growth is, of course, domestic US volume growth. Studies have shown that most patients that take GLP-1 medications regain the weight after they stop taking the medications. We do not believe most US consumers will be able to finance GLP-1 medications indefinitely and thus expect unit volumes of snack foods will eventually resume their upward trajectory after some time.

The guidance for 2025 was low single digit growth with mid-single digit growth in constant currency EPS, combined with a commitment in 2025 of $8.6B in shareholder value return ($7.6B in dividends and $1.0B in share buybacks).

We believe PEP is a good long-term play for an investor looking for a good Dividend Reinvestment Plan (DRIP) candidate, re-investing solid 3-4% per year into a stock that has a long-term upside potential.

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_{Legal Disclaimer: The Evolved Investor is for information purposes only and is, by law, not personal investment advice. Concepts and ideas are for your consideration only. We encourage our readers to do their due diligence. Investing has inherent risk, and investments can lose value.}