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Bigfoot, Aliens & Inflation
Successful long-term investing requires a long memory. Fortunately, we have three team members who were working during the last bout of inflation that ended with 15% 30-Year Treasury bond yields in 1981. Today’s investors seem to treat inflation as folklore. Not long ago, the mention of inflation would draw looks as if you had claimed to have seen Big Foot or been abducted by aliens. The verdict is still out on Big Foot, but the military has recently released footage of UFOs or UAPs (Unidentified Aerial Phenomena), and the number of inflation believers is growing.
According to Nobel winning economist Milton Friedman, “Inflation is always and everywhere a monetary phenomenon.” But in order for this statement to be true we need to define inflation. The government’s most popular measure of inflation is the Consumer Price Index (CPI). The Federal Reserve printed trillions of additional dollars for years during and after the Great Financial Crisis (GFC) of 2008/2009, yet CPI remained under 2%. Was Milton Friedman’s proclamation wrong? CPI can be useful, but the items that are measured are of a limited scope, and the government regularly makes arbitrary adjustments to the way prices are measured. As a result, the change in CPI has been muted for decades. The changes to CPI measurement, while arguably well-intentioned, is a flawed and incomplete attempt at measuring inflation.
We imagine Dr. Friedman would agree with our definition of inflation: an increase in price paid for a good or service without an equal increase in value received. For example, if the price for a 12-roll pack of Charmin increases from $15 last week to $16.50 this week, then the price of toilet paper has inflated 10% in one week. If consumers believe the price will continue to rise, they will rush out to stock their bathroom closets. This extra demand pushes prices higher, so that the belief in rising prices becomes a self-fulfilling prophecy. In this way, inflation is not only a monetary phenomenon, it is also a psychological phenomenon. We did not see a great deal of this type of consumer goods inflation after the GFC, so CPI assured bureaucrats that inflation was in check.
In contrast to what CPI reported, we assert that there was tremendous inflation after the GFC, just not necessarily in the price of consumer goods. During the GFC, stimulus checks did not go into the pockets of the ordinary consumer, instead banks and corporations were bailed out. Furthermore, extremely low interest rate loans were made available only to the most creditworthy borrowers. If you really needed money and you did not have a great deal of collateral, it was hard to get a loan. Those with excess cash did not need or want to significantly increase their spending on consumer goods and services. Instead, they purchased things such as securities, vacation homes, vintage automobiles, art and other collectibles leading to asset price inflation. Prices for these items were pushed higher with no additional value received for the price paid…our definition of inflation. It seems to us Dr. Friedman was correct. Inflation is always and everywhere a monetary phenomenon.
Among the items listed above as having experienced asset price inflation due to low interest rates, higher prices for securities were likely an intended consequence. However, it is unlikely the Fed intended for management teams to issue bonds in order to fund stock repurchase programs that pushed stock prices higher. For management teams, the decision to repurchase stock rather than hold cash was easy given that cash deposits and short-term bonds generated miniscule interest income. People respond to incentives. Management teams are people, and massive shifts in monetary policy are often accompanied by unintended consequences. For instance, managements are often incented by bonuses that are dependent on growing earnings per share. Consequently, instead of using borrowed funds to expand their businesses and hire more workers or increase wages which would have put cash in the pockets of consumers, many management teams inflated their bonuses with engineered earnings per share growth by reducing the number of shares outstanding through stock repurchases. Mathematically, even if earnings remained flat, the decrease in the shares of stock in the denominator would create growth in the earnings per share calculation. Soon, corporations became the largest source of demand for their own stock. Concurrently, nearly half of all new dollars invested in equity mutual funds and ETFs were flowing into index products. The mandates for these funds usually require them to be fully invested whether stocks are at bargain prices or multi-generational high valuations. These sources of price-insensitive demand inflated share prices.
Shareholders have an ownership interest in the earnings of a company. Historically, the most consistent determinant of the change in share price has been earnings growth. When we say that we are willing to invest in a stock if we can make a case for purchasing it based on the fundamentals, earnings are one of the primary fundamentals that we examine. The chart nearby illustrates the inflation that has occurred in stock prices as a result of the Federal Reserve’s aggressive monetary policy since the GFC. On the left side of the chart from World War II through 2010 the change in the price of the S&P 500 tracked, virtually one-for-one, its earnings growth. However, under the ultra-loose regime of the post-GFC Fed, the price of the S&P 500 has risen at nearly twice the annualized rate of its earnings. With compounding, the cumulative increase in price is almost two and a half times that of earnings. An increase in price without an equal increase in the value received, in this case earnings, fits our definition of inflation.
This Time is Different
While we agree that inflation is always and everywhere a monetary phenomenon, let us acknowledge that running the monetary printing presses on overdrive is not, by itself, sufficient to create inflation in consumer goods prices. The excessive printing of dollars is the necessary fuel in search of a sufficient spark. Almost 28% of all the M2 money stock (cash, checking deposits, and easily convertible near money such as money markets) in existence was created in the last two years. The nearby M2 Money Stock chart is a flashing red light for inflationary risk. But wait! Who cares? So far, during the last two decades, money printing has equaled higher stock prices. Why not invest every last dollar into stocks? What makes this time different? Would we dare to utter the costliest phrase known to investors, “This Time is Different.”? No…and yes. No, it is not different from post-GFC in that we expect inflation, again. Yes, it is different from post-GFC in that we believe the risk of inflation lies in where it will appear: consumer goods and services.
Inflation has already reared its ugly head in many of the inputs for goods and services (see charts nearby). The risk is that the trend continues and prices are passed on to consumers in an accelerated fashion. Why? Much of the $2 trillion CARES Act (March 2020) wound up burning holes in the pockets of consumers, including $560 billion designated for direct payments of $1,200 per individual, an extra $600 per week for the unemployed on top of their regular benefits, and unemployment benefits stretching out to 39 weeks instead of 26 weeks. Another $900 billion was injected in December. This past March a further $1.9 trillion was injected into the economy, including $1,400 checks for individuals, extra child tax credits and an extension of existing enhanced unemployment benefits. Most of the funds not given directly to individuals would indirectly find their way into the bank accounts of individuals through forgivable loans that helped businesses and state and local governments keep the doors open, lights on and payrolls solvent. Currently, members of both parties have come to an agreement on an eight-year, $1.2 trillion infrastructure bill.
We are not arguing that the government should not have intervened. However, we believe damage has and will be caused by the degree to which government provided monetary aid. Cumulatively, the stimulus bills poured $4.8 trillion of current stimulus and $1.2 trillion long-term infrastructure spending into an approximate $700 billion hole in GDP created by the pandemic. That’s approximately $72,500 of stimulus/infrastructure spending per family of four. It appears to be overkill. When that many dollars are created in that short of a time frame, dollars begin frenetically competing to buy assets, goods and services whose supply cannot be expanded easily in short order. The result is rising prices. This would be similar to doubling the money all players receive in a game of Monopoly. It is easy to see how property prices might increase despite the fact that the amount of rent they provide does not increase.
The demand-side spark to set this monetary kindling alight appears to be “the reopening” from the pandemic. As alluded to above, there are also supply-side constraints that are boosting costs including: skilled and unskilled labor shortages; international travel restrictions; tightness in transportation capacity for trucking, rail, air and sea; semiconductor shortages; and lack of investment by energy producers and miners to increase supply. Businesses that are able to pass on the additional costs to consumers have already begun to do so. Companies such as Kraft Heinz and Proctor & Gamble often struggle to pass through higher costs but have recently announced price increases.
Lemonade From Lemons
Sometimes as investors we find ourselves in the awkward situation of benefitting from a negative event. We do not hope for bad things to happen. We do not delight in others’ pain. We do owe it to our clients to do our best to protect them from known risks. We are not always successful. Some risks are unknown. Some are known but unlikely yet happen anyway. Still, others are known and likely but do not happen. While the probability of damaging inflation is vigorously debated among investors and economists, the fact that it is being debated is evidence that it is a known risk, and we believe it is one worth guarding against. In the nearby “Lost Decades” chart , you can see the vulnerability of investment returns when valuations are high.
The years in the shaded bars in the chart nearby illustrate long periods of poor returns that are immediately preceded by high valuations, not unlike today. It is during times like those in the shaded bars that active investment management is rewarded. For the last decade, investors who parked their money in a broad stock index experienced handsome returns with little thought needed to be given to which companies made up the index. A period of higher-than-expected inflation and rising rates would likely bring an end to the era of cruise control investing.
The performance in the “Lost Decades” chart is that of a portfolio with allocations of 60%/40% S&P 500 and 10-Year U.S. Treasuries, respectively. As active investors, our clients’ allocations to sectors and industries rarely look anything like the sector and industry allocations of the S&P 500 or any of the other broad indexes regularly used as benchmarks in the investing world. In fact, our clients are positioned so that they may benefit from inflation. We have purchased shares in several mining companies that produce gold, silver, copper, zinc and molybdenum, which have already benefitted from inflation in metal prices. We also have purchased shares in several energy companies (oil, natural gas, refineries and uranium) that have historically benefitted from inflation. Furthermore, in the past, pharmaceutical stocks have been able to price their products to keep pace with, if not exceed, inflation. Finally, our clients are invested in a real estate development company that owns and develops residential and commercial real estate in a geography where there are few opportunities to expand the housing stock outside this company’s land. Inflation could be very friendly to such a company’s profits and stock price. The low valuations for all of these stocks indicate that the prospect of inflation is low in the eyes of many investors.
Above we mentioned mining, energy and real estate companies should benefit from inflation and rising rates, and in the case of pharmaceutical companies, be resilient at the least. In addition to owning shares of companies in each of the industries mentioned, our clients also own several financial companies that can benefit from rising rates due to inflation. In the short-term, asset managers may be negatively impacted by a decline in bond prices due to rising interest rates. However, the long-term benefit of attracting yield hungry investors is likely to cause an increase in overall assets under management and fees. Furthermore, a group of insurance holding companies held by our clients will be able to reinvest their maturing bond portfolios at higher yields. These large insurance holding companies also own companies outside the insurance business that can benefit from rising rates due to inflation.
The Mechanics of Inflation Sensitivity
Before we move on, we want to put in writing that we have no idea what the exact rate of CPI inflation will be at any point in the future. However, as discussed in depth above, we do believe the probability for future inflation in goods and services has increased dramatically with the amount of money printed to combat the pandemic and accompanying economic interruptions. Furthermore, broad inflation in consumer goods is often accompanied by higher interest rates.
For bond investors, interest rate risk due to inflation is straight-forward. As a “fixed” income product the purchasing power of your interest income is eroded by inflation. Consequently, investors who put new dollars to work in bonds will demand higher yields (lower bond prices). Not only will bond prices fall as interest rates rise to compensate for inflation, but some will fall more than others due to their duration risk, a type of interest rate risk. Duration is the amount of time before the “average” dollar is repaid and whatever the duration is calculated to be is the percent a bond’s price will drop in response to a 1% increase in interest rates.
Duration takes into account three important bond pricing factors: maturity, coupon rate, and yield to maturity (YTM). The relationship of duration to these factors can be summed up in three general statements: 1) A lower fixed coupon rate results in a longer duration, holding the other two factors constant, 2) A longer maturity results in a longer duration, holding the other two factors constant, and 3) A lower YTM results in a longer duration, holding the other two factors constant. Coupons and YTMs are currently at all-time lows, making investment grade bonds suitable for meeting cash needs over the next few years but likely a poor source of total returns over longer periods.
For equity investors, the answer is more complex because more variables are involved. For example, some businesses are better able to pass on cost increases to their customers. However, in general, significant increase in interest rates brought on by inflation will depress stock valuations.
Total equity returns depend on three components (excluding transaction costs and expenses): dividend yield, earnings growth, and the change in the level of valuation (Price-to-Earnings ratio (P/E)). Two of the components can be combined (dividend yield and earnings growth) since they both flow from the earnings received as owners of the underlying business. This return on equity can vary substantially year by year but over time these returns have remained fairly steady, just under 13% since 1990 for the S&P 500. (An investor’s return may be lower or higher, depending on the price paid for that 13% return on equity.) As pointed out by Warren Buffett in a May 1977 Fortune article titled How Inflation Swindles the Equity Investor; “to raise that return on equity, corporations would need at least one of the following: (1) an increase in turnover, i.e., in the ratio between sales and total assets employed in the business; (2) cheaper leverage; (3) more leverage; (4) lower income taxes; [or](5) wider operating margins on sales.” We deem the prospects for any of these five opportunities as dim at this particular juncture, just as Buffett did in his article.
In fact, the change in the level of valuation has driven much of the S&P 500 return since 12/31/2010 as the P/E ratio rose from 15.36 to 30.34 at 6/30/2021, an approximate doubling of the P/E. This elevated valuation leaves stocks vulnerable to a sustained increase in interest rates. Since stocks can be assigned an approximate duration similar to bonds, we can use that to explain why. Given the same expected future earnings stream, the higher the price paid for a stock, the longer it will take to recoup the purchase price through earnings. The higher the valuation multiple, the more dependent a stock price is on distant cash flows, and because it takes longer for the earnings dollar to repay the “average” purchase, higher duration is the result. The duration of the S&P 500 is near its historic peaks (see chart to right) leaving it vulnerable to the possibility of increased interest rates that often accompany inflation. Once you understand this mathematical logic, you can see why growth stocks are more vulnerable to inflation than value stocks due to their higher expected future earnings growth and lower dividend yields.
For illustrative purposes, we will use the Russell 1000 Value Index and the Russell 1000 Growth index to illustrate (chart to the right). The P/E ratio for the Russell 1000 Growth index at 6/30/2021 was 43.95 versus a 25-year average of 25.32. While the P/E ratio of the Russell 1000 Value at 6/30/2021 was 24.94 versus a 25-year average of 17.27. The Growth index would have to fall 42.4% to get back to average and the Value index would only fall 30.8%. Furthermore, because we practice what is considered absolute, rather than relative, value investing, our clients’ portfolios are tilted even more toward value than popular value indexes. These indexes include many stocks that are considered “value” only on a relative basis in comparison to growth stocks. We believe an absolute value focus will be protective and likely beneficial in an inflationary environment with rising interest rates.
Winds Of Change
Although we believe the risk of inflation for consumer goods and services is high, it is not a necessary ingredient for our clients’ portfolios to perform well. While most investors seem to be assuming that supply can be expanded at will to meet any foreseeable increase demand, many of the products supplied by our portfolio companies face long-term constraints on expanding production. We believe demand for these products is likely to trend higher over the long-term. We see a number of long-term trends shifting from a head-wind to a tail-wind for our clients’ portfolios over the coming years. In addition to stocks that may benefit from deflation shifting to inflation and rising interest rates that would likely accompany it, our clients own shares of companies that should benefit from the current move from Just-In-Time management to de-globalization of supply chains, a strong global push to decarbonization, and a sustained increase in infrastructure spending.
Just-In-Time Inventory to Deglobalization
Recent experience in supply chains has highlighted that the total cost of the supply chain, which includes safety stock to increase resiliency, is more important than short-term gains from extremely low levels of inventory driven by Just-In-Time supply chain management. Just-In-Time manufacturing developed over the past 50 years after being conceived and perfected at Toyota in the 1970s. The idea was to maximize margins by keeping inventory and the associated expenses at a minimum. To accomplish this, manufacturers and other businesses built highly integrated supply chains. Over the last couple of decades, these supply chains were stretched longer and longer as industries sought out more efficient and cheaper suppliers.
Supply chains were being rethought due to the US and China trade tensions even before the COVID-19 pandemic, and the rethinking has gained momentum after the supply chain interruptions experienced over the last 18 months. These include the shortage of semiconductor chips, the interruption of the petrochemical industry due to the polar vortex in Texas, the week-long blockage of the Suez Canal by a container ship, the lengthy backlog at ports worldwide, and the extreme capacity constraints in all logistic providers to name a few. Under the Just-In-Time approach, supply chains have evolved to be efficient but fragile.
We do not believe we will see massive increases in inventories, but even slightly higher inventory levels will lead to a decrease in turnover and put pressure on companies’ margins and earnings. The global supply chain does not have the capacity to suddenly shift production closer to end markets, so the movement towards geographically dispersing risk and creating back-ups will be a decade-long trend. In the meantime, the increase we will likely see in some industries’ inventory levels should benefit several of the companies in our clients’ portfolios.
Decarbonization of our energy sources will likely continue to be a global priority over the coming decades. Our clients own investments that stand to benefit from this global theme. One such investment is in uranium. There is increasing global consensus that nuclear power will have to play a large part in helping the world achieve ambitious reductions in carbon emissions. Nuclear is currently the only carbon-free, reliable and scalable baseload source of power generation. We have exposure to this critical energy source. Additionally, we own positions in companies that mine copper, a key input in electric vehicles. The average electric vehicle has 4x the amount of copper used in an internal combustion engine. Copper is also a key input in offshore and onshore wind turbines. Additionally, we have exposure to the production of Zinc. Zinc is used on wind turbines as a protective coating against corrosion and is also a galvanizing input for batteries. Ownership in the companies in our portfolio is a far less speculative approach to benefitting from decarbonization compared to buying “green” stocks like Tesla or hydrogen fuel cell developer, Plug Power.
Increased Infrastructure Investment
Another theme to which we have exposure is a sustained increase in infrastructure investment across the country. Total federal spending on infrastructure in the United States was up 48% in 2020 versus 2019, and as we mentioned above, a bipartisan infrastructure plan is in the works to spend more than $1 trillion on upgrades to roads, bridges, transit, airports, broadband, water and electric vehicles over the next few years. We have a number of portfolio positions that stand to directly benefit from this push to upgrade our nation’s infrastructure. Infrastructure buildouts require heavy machinery that is still powered by diesel fuel derived from oil. Buildouts of electric vehicle charging stations or bridges and airports all require other petrochemical inputs such as plastics and coatings. Our clients hold stocks of energy companies that provide the necessary petrochemical inputs for these underlying products. Their portfolios also include copper mining companies (discussed above) that stand to benefit from increased demand for copper used in electric grid expansion and improvements. Additionally, increased focus on broadband internet access and continued 5G capability expansions should increase demand for services offered by our telecommunications holdings. We are happy to have portfolio exposure to all of these “tailwind” themes.
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