June 8, 2021
Cycles and Rotations – Are We Talking Spin Studios or Financial Markets?
Optimism abounds as we approach the summer months, with a return to pre-pandemic life appearing closer than ever. Economic optimism has also returned as businesses have reopened their doors and individuals have reentered the labor force. Consumer confidence is near all-time highs with the US personal saving rate remaining well above pre-pandemic levels. Not long ago, market pundits were debating what letter best describes the shape of an economic recovery. It is no longer debatable; the recovery unambiguously resembles the letter “V”. Unprecedented monetary and fiscal policy coupled with the global rollout of highly efficacious vaccines have resulted in a swift and sharp economic recovery. Naturally, optimism around the economic recovery has fueled a powerful rally in the most economically sensitive sectors (e.g. Energy, Financials, Industrials and Materials sectors). Moreover, the lowest quality sub-industries and companies (i.e. commoditized business models, debt-laden balance sheets, low ROICs, etc.) within these sectors have performed even better. This is partly due to fiscal and monetary accommodation that provided much needed support to the most challenged industries and companies. With that said, it’s not atypical for highly cyclical industries and/or low-quality companies to outperform when the market anticipates an improvement in the economic backdrop. Early in an economic cycle, market participants with short-term time horizons gravitate to stocks with the highest beta, operating leverage, and financial leverage. If markets are pricing in terrible results, the lowest-quality spectrum of securities can produce outsized returns if one accurately anticipates economic conditions improving from bad to less bad. During the early phase of an economic cycle, these same market participants aren’t interested in securities that offer consistency, resiliency, and profitability. “Risk off” attributes often become more relevant in the later phases of an economic cycle. But, with economic momentum building and pent-up demand across many consumer activities, why even hold late cycle industries and/or the anointed “COVID winners” in an equity portfolio? And why isn’t the rotation into highly cyclical industries (aka the reopening trade) a sound investment strategy?
While it’s true that stocks with the greatest sensitivity to the reopening of the economy have performed best lately, it is important to keep in mind that the stock market is a discounting mechanism. In other words, markets are always forward looking and constantly calibrating expectations 6 months to 1 year into the future. For example, the cruise line industry has been deeply impacted by travel restrictions, and yet the enterprise value of Carnival Corporation is approximately 20% higher than pre-pandemic levels. Carnival’s revenue, however, isn’t expected to fully recover until the end of 2023, while a full earnings recovery is estimated to occur no sooner than 2026. Carnival’s revaluation isn’t unique; many companies (American Airlines, Macy’s, and AMC Entertainment, just to name a few) have significantly recovered well ahead of any meaningful fundamental improvement. Therefore, the “reopening trade” is likely priced-in to some extent, and an optimistic view on “reopening stocks” must be based on an economic outlook that extends beyond 2022.
The prospects for strong economic growth are certainly encouraging over the next several quarters; however, accurately predicting how the economy and markets perform over the medium term is not possible on a repeatable basis. When faced with complex investment questions and puzzles, I regularly turn to Warren Buffett’s teachings for guidance. When making investment decisions, Mr. Buffett espouses the need to concentrate on what’s important and what’s knowable. There’s no doubt that interest rates, inflation rates, currencies and many other economic factors are important, but the long-term direction of these factors is often unknowable. In some instances, even if one can predict an economic event, the second order effects are still unknowable. For example, one would naturally surmise that lower corporate taxes would not only be good for corporate profits, but also for stock prices. However, the Tax Cuts and Jobs Act of 2017 illustrated that even the implications of lower corporate taxes are unknowable. The Tax Cuts and Jobs Act of 2017, which was enacted on December 22, 2017, reduced the federal corporate statutory tax rate from 35% to 21%. And while corporate profits did in fact substantially increase in 2018, the S&P 500’s PE multiple meaningfully de-rated, more than offsetting the increase in corporate earnings. In fact, the S&P 500 was down 4% in 2018, registering its first annual decline since the financial crisis. In the coming years, tax rates will likely need to be increased; however, it is not a foregone conclusion that higher corporate taxes translate into lower stock prices.
Similarly, investors might be concerned about the recent increases in inflation rates. Some might be tempted to sell high-quality businesses that have been unresponsive to current market conditions and buy inferior businesses purely as an inflation hedge. Currently, inflationary pressures appear to be transitory, as COVID-19 related supply chain disruptions and elevated consumer demand from high personal savings and stimulus checks are the likely culprits. That being said, long-term inflation rates squarely fall in the highly important but unknowable category. We do know, however, if inflationary pressures persist, then the ownership of high-quality businesses that can mitigate input cost inflation will be critically important. Only the strongest companies will have sufficient pricing power to absorb and pass on higher input costs, without diminishing volumes and operating margins. Within our Intrinsic Value Strategy*, we own several global consumer franchises (e.g. Nike, Nestle, Mondelez, and Starbucks) that have long histories of exhibiting nominal and/or real pricing power. Also, portfolio companies like PayPal, Visa, and S&P Global earn revenue often by taking a fixed transaction rate on nominal values, be it from facilitating payments at the grocery store or from providing credit ratings on corporate bond issuances. Additionally, these companies generate high operating margins and even higher incremental margins. Lately, many of our large capitalization technology companies have been inversely correlated with interest rates. However, if rising bond yields portend higher inflation, then we believe many of our technology companies are actually well positioned to navigate an inflationary environment. Businesses that generate high returns on capital are better insulated against inflationary pressures, as they inherently require less incremental capital to support higher levels of revenue. Moreover, many of our technology stocks are not only capital efficient, but also their business models aren’t overly dependent on traditional input costs such as lumber, copper, or corn. In some cases, our tech companies have business units that generate gross margins in excess of 80% and have marginal costs that are close to zero.
Instead of trying to outguess market participants on economic trends, our Intrinsic Value Strategy investment philosophy is based on the long-term ownership of competitively advantaged companies that possess unique positions within their respective industries. We accept our inability at market-timing, and therefore we make no attempt at playing an economic cycle or sector rotation. Our goal is to preserve and adequately compound our clients’ assets over the long-term. We seek not to generate the highest total return for a given unit of risk. Our aim is to earn above average returns over long periods of time, while minimizing the fundamental risks that we underwrite. We attempt to achieve this goal by concentrating our efforts on a select group of exceptional and attractively-valued businesses, with a keen focus on what’s important and what’s knowable. Importantly, many of our portfolio companies are well positioned to participate in the current economic recovery; however, even our most cyclical businesses are durable enough to withstand and potentially benefit from an unforeseen economic disturbance. Ultimately, we know that the economic value created by our businesses will drive their share prices over the long-term. Conversely, we also know that commoditized businesses earn unattractive returns on invested capital and that shareholders’ returns will be highly dependent on the accurate timing of such investments, and not the time in the investments. Finally, we know that the attainment of investment objectives requires patience, discipline, and a long-term orientation, all of which are of the utmost importance.