Right Place Wrong Time

This article has been excerpted and edited from our quarterly newsletter to clients dated November 23, 2021.

Being in the wrong place at the right time is usually just an inconvenience or in market parlance a missed opportunity. In the wrong place at the wrong time, you’re likely a victim of poor circumstances. For an investor, a poor selection coupled with an unforeseen shock. The opposite—right place at the right time—implies luck. Right place at the wrong time, according to a certain someone’s significant other, means she’s always waiting for someone who’s invariably late. More than a mere inconvenience. While some of our equity selections have recently been operating on their own schedules, and our timing appears off, we still feel we’re in the right places. The adage ‘better late than never’ comes to mind.

Fund manager Bruce Berkowitz once quipped that he suffered from premature accumulation. We have felt similarly over the last few months because many of our positions have either lagged or declined outright despite fundamentals that we believe remain intact. Of course, when our positions are zigging while the markets are zagging, we reexamine our assumptions to ensure we are correctly positioned. We believe that only one of our securities suffered permanent impairment relative to our initial appraisal and we realized a loss because we saw better opportunities for the proceeds. We remain confident in our assessments of our other holdings. They trade well below our estimated FMVs (Fair Market Values) implying substantial upside potential. Though we don’t know when the market will come to its senses and see what we see.

Regarding the market in general, we feel like the little boy that cried correction. Though he kept calling for it, and was eventually correct, his too frequent calls were ignored. The S&P 500 is at a ceiling in our TRAC^TM work. From this level, it’s either moving on to the next ceiling, about 30% higher, or returning to its recent floor, over 20% lower. Neither event must take place all at once. However, with the market’s FMV currently lower, the likelihood of a material rise from today’s levels is low. We expect sideways or downward price action for an extended period until underlying values catch up. And, with the absence of the typical wall of worry, any exogenous shock could lead to a rapid decline.

GLOBAL TRAFFIC JAM

Speaking of poor timing, the concept of Just-in-Time inventories, designed to promote efficiencies, contributed to inefficiencies over the last year. Everyone encountered an IKEA (‘Swedish for out of stock’) problem. Demand has simply overwhelmed supply. With the economy essentially closed in the spring of last year, production was scaled back (i.e., a supply squeeze) only to require a substantial ramp-up over the last year as demand surged from massive government stimulus and vaccines which allowed for widespread reopening and a leap in consumer confidence. But this about-face created a logjam. Delivery times have been near record highs which has fueled higher costs and, in turn, increased prices. In the meantime, companies are adapting, finding other sources of supplies, different means of transportation, and implementing productivity enhancing measures. While this does not occur overnight, the congestion will dissipate.

The market must believe this is all transitory too because it hasn’t impacted the overall indexes. This, despite staffing shortages which, for example, has caused FedEx to reroute packages and airlines to cancel flights. Companies have had to boost pay for overtime and raise wages to attract new employees. There has been a record backlog of ships at ports because of staffing constraints and calls for the U.S. National Guard to loan terminals which would assist in moving goods. Rolling blackouts due to power shortages in China led to production slowdowns. For diversification purposes, some companies moved a portion of their manufacturing to Vietnam, only to have to cope with Covid related shutdowns. Despite these cost pressures, demand has been overpowering because profit margins remain at all-time highs.

The usual semiconductor deficit is a result of excess demand, spurred by work-from-home and advances in digitalization which increased the need for electronic components at a time when supply hasn’t been sufficient to fulfill needs. Since the length of time between ordering a semiconductor chip and taking delivery rose to a record high, nearly double the norm, new plants are being built, many in the U.S. being subsidized by the government. Nearly 30 new fabs will be under construction shortly in various jurisdictions, which is more than opened in the last 5 years combined. Looks like an eventual overshoot.

TIME HEALS ALL

The pendulum will swing in the other direction. The scarcity issues facing us now will beget surpluses. Look no further than the PPE shortages at the outset of the pandemic which were quickly met by increased production ultimately creating surpluses, even with demand still high. A capital goods spending cycle is clearly upon us as companies expand production which also bodes well for continued economic growth.

Some of the issues will immediately halt. How about the crazy story of Tapestry (maker of Coach purses and other brands) announcing it’ll stop destroying returned product? Apparently, employees were hacking up merchandise and tossing it. That’s one way of creating a supply constraint, and a PR nightmare.

Used car prices hit another record high—the normal ebb and flow gone. Prices have been leaping higher. But with production of new cars expected to be back to near normal over the next several months, used car prices should moderate. Commodity prices have surged too as inventories haven’t been sufficient to keep up with demand. However, nothing cures scarcity better than higher prices which encourages production.

These constraints have pushed U.S. inflation to the highest since the mid ’90s. While some argue it’s a monetary phenomenon, as central banks have poured money into the system, it appears to us more related to the overall supply/demand imbalances. A step-up in demand for raw materials and labour, when ports became congested, simultaneously increased shipping costs, and led to other logistical bottlenecks, all of which combined to ignite prices.

Housing prices have also lifted materially. Single-family home prices in the U.S. have risen by a record 19.7% in the last year because of ever-growing demand (spurred by demographics, the shift to work-from-home, and low rates) and, perhaps more importantly, a dearth of listings. While construction costs are up, house prices have outpaced so new builds will in due course help level off prices. That’ll be the Economics 101 feedback loop between prices/costs and supply/demand at work.

Core PCE, the broadest inflation measure, was 3.6% for September, moderating since the April highs, a positive sign. Since supply disruptions are beginning to alleviate, it bodes well for a further diminution of inflationary pressures especially since most of the rise in inflation is attributable to durable goods which have suffered the brunt of the bottlenecks. As consumer spending moves from goods back towards services, this should help too. Though growth rates should slow, we are still experiencing an economic boom. Look no further than global air traffic which, astonishingly, is running virtually at 2019 levels.

THE MARCH OF TIME

Watching inflation is important because it directly impacts our pocketbooks in the short term and our real-spending power over time. Not only because inflation erodes purchasing power but because it also influences the level of interest rates which affects the valuations of financial assets.

Longer-term interest rates are likely heading higher, not just because they’re coming off a really low base or inflation is rising. Serious supply and demand dynamics in the bond market are inplay. Fewer bonds will be bought (tapering) by the Fed, who’s been buying, a previously inconceivable, 60% of all U.S. 10-year Treasury issuances. Yet extremely elevated deficit spending still requires massive government bond offerings, at a time when foreigners and individuals have been disinterested in bonds at such low yields. Increasing rates will be necessary to attract buyers (i.e., create demand).

Interest rates should remain relatively low though. Primarily because inflation should remain low as a result of poor demographics (nearly every developed country’s birth rate isn’t sufficient to generate population growth), the strength of the U.S. dollar which is disinflationary, and high government debt. These factors should temper economic growth rates. Q3 U.S. GDP grew by only 2% over last year. Aggregate demand may be weakening just when supply constraints are diminishing. On a good note, lesser growth may bode well for an extended economic cycle with low interest rates and relatively high market valuations as the Fed may not need to quell growth. On the other hand, debt laden Japan’s growth rate was so slow since 2008 that it slipped into recession 5 times while the U.S. suffered only once.

FOR A BAD TIME CALL…

Speculators have been winning big, but it almost never ends well. Right now, speculation is still running hot—too hot. Call option purchases (the right to buy shares at a set price for a fixed period) have leaped. Investment dealers, making markets as counterparties on the other side of the call option trades, buy sufficient shares in the open market to offset (i.e., hedge) their positions. As stocks run higher, and call option prices increase, higher amounts of shares are bought. Tesla’s run-up to recent highs is a good example as call-option buying was extreme and a disproportionate amount of buying was attributable to dealer hedging.

On a related side note, Tesla ran to about 43x book value recently. In our TRAC^TM work that’s one break point, or about 20% below, the 55x book value level that only a small number of mature companies have ever achieved because it is mathematically unsustainable since a company cannot produce a return on equity capital sufficient to maintain that valuation level. Historically, share prices invariably have materially suffered thereafter until underlying fundamentals catch up. This is probably not lost on Elon Musk who has tweeted about the overvaluation of Tesla and just sold billions of dollars of shares. Insiders at other companies have been concerned about their share prices too which has led to an uptick in overall insider selling. Meanwhile, use of margin debt as a percent of GDP is at an all-time high of 4%, about 25% higher than at the market peaks in 2000 and 2007. Purchases of leveraged ETFs are at highs too.

U.S. equity issuances (IPOs/SPACs) are also at all-time highs as a percent of GDP. The record addition of supply of shares should cause problems for the stock market, especially if demand for shares suddenly wanes if interest rates spike, profit margins shrink, or an unforeseen negative event occurs. Stock ownership generally has reached a high (50% of household assets) which doesn’t bode well for stock market returns when other asset classes shine again.

The NASDAQ is extremely overbought. Similar levels in the recent past have led to double-digit declines. The fact that so much of the major indexes are now concentrated in so few companies could hurt too. Worrisome, Apple, Microsoft, Amazon, Alphabet, and Meta Platforms (Facebook) are all at ceilings or have given “sell signals” in our TRAC^TM work.

Buyout valuations paid by private equity firms has doubled over the last 10 years to levels that don’t make economic sense.

Cryptocurrencies may have found a permanent role in the financial system; however, demand is too frothy. Just talk to teenagers or Uber drivers. Since it’s in weak hands, demand already running rampant, prices well above cost of producing coins, and supply virtually unlimited as new cryptos keep cropping up, prices could collapse.

The overall hype should soon wither. While markets have already ignored the rise in 10-year Treasury yields, further increases could be harmful. Headline risk from inflation worsening in the short term, and rates rising further in reaction, could spoil the party. Valuations of growth companies are the most vulnerable to rising rates given their higher multiples and the more pronounced impact on cash flows which are further out in time.

The forward-12-month S&P 500 earnings multiple is just about 30% above its 10-year average. The earnings yield less the inflation rate is at all-time lows.

Earnings estimates themselves are likely too high, which is typically the case. Growth expectations are way above trend as analysts extrapolate the recent spectacular growth. But growth must moderate, if only because the comparison over time becomes much more challenging than last year’s trough. The added boost we’ve experienced from lowered tax rates and share repurchases should disappear too. Profit margins should eventually be negatively impacted. Not just from less sales growth but also from escalating costs, particularly on the labour front. Wage pressures are likely, and productivity may drop for a period, if companies cannot hire qualified workers. Job openings have skyrocketed, and job cuts haven’t been this low since 1997. Teens who’ve just graduated high school in California are training to drive trucks. This may be positive for teen employment but yikes! And global oil inventories have been plummeting. The inventory situation is expected to worsen which could lead to $100, or higher, oil prices, a level that would not be favourable for the economy.

Investors generally are still expecting above-average returns for U.S. stocks over the next several years. Meanwhile, since valuations are so high, models that have been historically accurate predicting 10-year returns point to negligible returns.

OUR STRATEGY

We continue to hedge (by shorting U.S. stock market ETFs in Growth accounts or holding inverse ETFs in registered or long-only accounts) principally because valuations have only been this high on 4 occasions in the last 50 years. Since we are not concerned about a recession, and the bear market that usually accompanies one, we’d like nothing better than to cover our hedges after a meaningful market correction.

We sleep well at night knowing that we are partially hedged and that our holdings are growing, high-quality companies that, unlike the overall market, trade at substantial discounts to our estimates of FMV. The track record of most of our holdings shows steadily rising earnings over the last several years. And we foresee further growth ahead. Securities that are already detached from FMV can fall even further away if sentiment worsens. However, it doesn’t mean the companies are worse off, only that they’re temporarily losing the popularity contest.

While the prices of our Chinese holdings have not gotten materially worse since last quarter, these holdings are still a drag on the portfolios. Since the ones we own are dominant high-quality companies, now trading at less than 40 cents-on-the-dollar in our view—a 60% off sale, we continue to wait for the end of the bear market in these shares. The entire KWEB, a Chinese Internet/technology ETF, is down 54% since February. Meanwhile, economic growth in China is expected to be 5% annually for the next several years, outpacing the U.S. which is expected to grow by less than 2% per year. By 2030, China should have the largest consuming middle class globally. The Chinese growth engine remains attractive. And the companies we hold continue to grow. With valuations so attractive and the stocks nearly universally shunned, we believe a new uptrend should be close.

ALL IN GOOD TIME

We remain concerned about several factors, primarily high market valuations, which could trigger a market decline and reestablish a wall of worry. The average S&P 500 high-to-low annual decline since 1980 has been about 14%. In the last year, it’s only suffered just shy of a 6% correction. Prices have risen too far above underlying values and should revert. Many of our holdings, in contrast, have gone in the other direction, already enduring their own bear markets.

We don’t expect to be right all the time. Nor do we need to be, to have respectable performance. But we’ve suffered unduly recently. We can’t turn back time and alter our selections. And we certainly don’t wish to rush time. Time is precious. But we do believe that good things happen to those who wait. And we will continue to wait patiently, biding our time, because our process is designed to select out-of-favour securities, the ones that are underappreciated but whose quality businesses we expect to advance, causing the disconnect between prices and values to alleviate, all in good time. We look forward to recovering from our recent lull and notes from clients stating, “It’s about time!”