Can You “Tariff-Proof” Your Portfolio?

How are portfolio managers navigating uncertainties, managing risks, and making informed choices amid the ever-changing landscape of trade policies? In a recent fireside chat, we asked Bernstein US Strategic Equities co-portfolio manager, Luke Pryor, to share his approach.

Q. How are you navigating the unpredictability surrounding tariffs—their timing, affected countries, and their magnitude—given that we don’t know the rules of the game just yet?

The tariff question is obviously front of mind for us and the market. The situation is fluid, with various proposals and no clear outcome as of yet. Some countries and sectors seem more in focus, but it’s a moving target.

As we think about how best to position our portfolio, our approach is to maximize the risk that comes from idiosyncratic company insights—because we get paid to take that risk, in our view. On the other hand, we are not going to be better at predicting tariff risk than anybody else, so we look to avoid that risk to the extent possible.

We do that through two levels, or layers:

1. Quantitative Risk Management: We analyze our portfolio’s exposure to tariffs using various tools to predict performance under different tariff scenarios.
2. Company Engagement: We assess how individual companies might be affected by tariffs, whether negatively, neutrally, or positively.

By combining these two approaches, we can manage the portfolio’s overall tariff exposure more effectively.

Q. You’ve acknowledged that you can’t completely eliminate tariff risk in a diversified portfolio, since tariffs can impact various countries, regions, and industries. Given that your goal is to minimize this risk—not eliminate it entirely—can you explain the baskets you use and how they help you gauge your tariff risk exposure?

Sell-side firms create baskets like “Canada tariff,” “Mexico tariff,” and “general tariff,” using their analysts to compile lists of companies with varying levels of tariff exposure. That allows us to compare our portfolio to these baskets to identify overlaps and potential risks. In other words, how many names do we have that show up in the basket?

Additionally, we analyze how our portfolio’s performance correlates with these baskets, especially on days when tariff news drives the market. This correlation helps us quantify our tariff exposure and identify companies not in the baskets that might still be affected. Plus, the benchmark carries tariff risk, too. So, we can understand if we have more or less risk than the benchmark, just by understanding our performance relative to those baskets.

Ultimately, you can think of them as a tool to take a first cut of what our exposure looks like.

Q: How do you engage with management teams in your portfolio, especially those exposed to tariffs like in the steel or industrial sectors? What reassures you about owning their stock?

We’re not looking for a rigid plan from management because tariffs are unpredictable. Instead, we focus on three key areas.

First, management attention and capability. We want to see that management understands their supply chains and exposure. Companies that navigated similar issues in 2017 often have a solid approach, but not all do. It’s crucial that management knows what they’re talking about.

Second, flexibility and diversity of supply chains. Companies that can move sourcing from one place to another, have backup suppliers, and different distribution networks tend to be better positioned. Those reliant on a single source might struggle to adapt.

Then there’s pricing power. Companies that can pass tariff costs to customers tend to be in a stronger position. This depends on contractual terms and the competitive landscape. If all competitors face the same tariffs, it’s manageable; if not, it becomes more problematic. Ultimately, some companies remain in the portfolio due to their flexible plans and execution, while others face challenges, and we might pass on them until the risk subsides.

Q. Can you tell us about a company that’s executing well and you’re still comfortable owning despite their tariff exposure?

We own a diversified industrial company that manufactures essential electrical equipment like transformers, switchgear and capacitors—vital components for anything from homes to massive factories and data centers. They have manufacturing operations in Mexico and China, both of which are potential tariff targets. The management team provided context on their sourcing: about 5%–10% comes from Mexico and China into the US. That’s not catastrophic, but it’s not zero either.

What makes us comfortable is their strong pricing power. They operate in a market with excess demand and years-long backlogs, both for them and their competitors. And it’s a market that’s really tough to enter. What all that means is they’re well prepared to pass the tariff cost through.

If their costs rise by 10%–20% due to tariffs, they believe—and we agree—they can transfer these costs to customers. They’re already discussing this with customers and given their sold-out status for the next 2–3 years, customers are willing to absorb the price increase.

Q. On the other hand, are there companies you would consider if not for the tariff issue? Can you share an example of one you’ve passed on despite otherwise attractive aspects?

There’s an intriguing company in the tool manufacturing sector, which has been in a down cycle but shows signs of an upcoming upturn. The company brought in new management focused on cost-cutting, which is promising. However, if you go back to 2016–2017, they sourced 40% of their US products from China. When the first round of unexpected Chinese tariffs hit, it was a significant challenge, and they spent years addressing it. They’ve since reduced their China-sourced products to just under 20%.

The catch is that they’ve shifted much of that production to Mexico. While this seemed like a smart move initially, it appears less so now with potential Mexican tariffs looming. Although Chinese tariffs are more likely to persist than the ones imposed on Mexico, the uncertainty remains. The company finds itself again with a significant portion of its products coming from countries at tariff risk.

What’s more, their main competitor sources primarily from Vietnam, which currently seems less likely to face tariffs. This creates a scenario where the company could see 40% of its cost base marked up due to tariffs, while its competitor avoids this issue entirely. That undermines their pricing power. This risk has led us to pass on including them in our portfolio, despite their otherwise strong attributes.