For printable version which includes all graphs and tables, click here.
Time to Hide?
We suspect that this commentary will not be the first time many of our clients learn that securities markets have recently been volatile. One of our partners was speaking with a client recently who said, “I am too scared to look at my account since I know the markets are down so much this year!” As most of our clients hopefully know, this client missed an opportunity to feel reassured given our portfolios have been more resilient year to date. This quarter seems as good a time as ever to remind our clients that even amidst volatility, there are reasons to be optimistic as an equity market investor, particularly as an equity market investor who has hired a firm that thinks independently.
Interest rates underpin every decision in financial markets. One of the publications we read most fervently is Grant’s Interest Rate Observer, which recently described interest rates aptly as “the traffic signals of a market economy. Turn them all green, as the central bankers did for years on end, and fender benders will eventually clog the intersections.” We feel like a broken record in saying again that the recent unprecedented experience of near-zero percent interest rates since 2008 has had a profound impact on securities markets. But never has this impact been more evident than now, as inflation and the resulting higher rates are reversing the impact of the recently accepted “relativity dogma,” which rationalized paying historically high valuations for securities because interest rates were so low.
Throughout history, investors have required a return for taking on the risks of providing equity capital for a business. There are three aspects of risk assumed by equity investors for which they should be compensated. The first two risks are generic risks and are not specific to equity investment. The first is opportunity cost. If investors take their capital and invest in Option A, this action precludes them from having funds available to spend with, lend to or invest in Option B. Therefore, investors have generally expected some level of compensation for giving up alternative uses of their capital. The second risk requiring compensation is inflation. Because of inflation’s reliable existence, investors should be compensated for the declining purchasing power of their dollar over time. Traditionally, investors have been taught that these first two sources of return to an equity market investor (i.e. opportunity cost and inflation) are combined into one figure – the “risk-free” rate represented by United States government bonds. The third risk for equity investors is the risk of loss. While equity investors receive the upside from a successful enterprise, they are the first in line to lose money should the business fail. Thus, equity market investors have traditionally accepted the prevailing risk-free rate as compensating them for opportunity cost and inflation risk, and then they have typically added an equity risk premium to arrive at a reasonable total return requirement.
When the Federal Reserve decided to artificially hold the risk-free government bond rate near zero for an extended period of time, most equity investors reduced their total return expectations accordingly instead of asking themselves whether it was reasonable to assume that opportunity cost and inflation risk had gone away. When investors lower their required return for providing their capital, they are willing to pay more for the same investment. This was the “relativity dogma” that resulted in elevated market valuations across every securities market in existence as investors in all markets lowered their required future returns in lockstep with the Fed’s artificially low risk-free rates.
There were several unintended (or intended?) consequences of the Federal Reserve’s policies. One was that pricing opportunity costs at zero distorted the time value of money, so the market did not distinguish between a company that produces $1 today and another company that might possibly hope to produce $1 in 10 years. This led to a phenomenon where the bolder and brighter the story a company could paint about the future, the higher it could inflate its stock price. FRM did not fall for this fallacy, and we continued to emphasize the here and now by investing in companies that were profitable in their present operations or would be in the near future at the very least. The second consequence was that investors began assuming that inflation would never return. We have reminded you previously of the now infamously poorly timed April 22, 2019 Businessweek cover “Is Inflation Dead.” On the contrary, FRM continued to believe that the radical growth in the money supply since the financial crisis was the very definition of inflation where more dollars existed in our economy to chase the same quantity of goods and services. The pandemic then came along and served as an accelerant to this growth. Consequently, we continued to look for opportunities to provide our clients with protection against the risk of inflation, which we believed was higher than ever.
Because we did not believe that opportunity costs nor inflation risks had disappeared simply because the Federal Reserve priced these risks as non-existent, we took the “radical” step of expecting that our clients should still be compensated for assuming these dual risks. As a result, we did not lower our hurdle rate, the analytical return we required for making a new stock investment. It is hard to overemphasize how extremely rare such a position was. Our refusal to lower our return hurdle resulted in a time where fewer and fewer companies met our expected return requirements. We at FRM found ourselves with fewer opportunities to buy new stocks and more cash in our clients’ portfolios.
Here is the first reason for optimism. There has finally been a dramatic change in the air since last fall. The attraction to the “relativity dogma” fallacy has begun to wane, and equity market investors finally appear to be requiring some semblance of compensation for exposing their capital to risk. Warren Buffett has described interest rates as “financial gravity.” If interest rates are high, they pull the value of other assets down. If interest rates (like gravity) are low, values drift higher. Just as quickly as valuations went up when returns demanded by investors went down, valuations are coming down as return requirements increase to historically normal ranges. This is what we have been witnessing in the broad stock markets so far this year. While broad stock market declines are not fun to experience, we believe that normalized interest rates and return expectations will be a good thing for our clients, our economy and our world. The stock market is beginning to trade on the fundamental measures of value that FRM has focused on all along. This has caused the markets to begin recognizing the value FRM saw in the businesses we own, businesses that are profitable and produce cash today. This should be encouraging to any long-term investor, especially to our equity clients who have generally been shielded so far from the broad market’s decline in the first half of this year. It is refreshing to begin seeing investors return to expecting compensation for assuming risk with their capital.
Another reason that investors should be optimistic today is that as valuation levels come down, stocks actually become less risky. The less you pay for something, the higher the odds of a successful investment. Our cash balances have gradually been coming down over the last two years as we found new opportunities to invest in businesses at what we believed to be absolutely attractive (not merely relatively attractive!) levels. Recently, June’s volatility has allowed us to add two new names to our clients’ equity portfolios, both with high dividend yields, great balance sheets and diversifying exposure to two unique industries: beverages and specialty chemicals. Clients can read about both investments below in the Investment Activity section.
Bear markets (declines of 20% or more) are not unicorns – they have happened on average about every three and a half years since the beginning of reliable stock market data in 1929. But they seem to take investors by surprise nonetheless. Bear markets are often referred to as “black swans,” meaning they are rare and unexpected events. However, we agree with Laurence B. Siegel who wrote in 2010 for the Financial Analysts Journal that stock market crashes are more like “black turkeys” – they are events that happen all the time but to which most are willfully blind. As long-term oriented investors who own interests in a variety of businesses, we must remember that a change in the market’s assessment of the worth of our companies does not in and of itself change what we own. On a day when you wake up and notice that many of the stock prices in your portfolio are red just remember – you own the very same businesses you did yesterday when the prices were green. The companies we own have hundreds of thousands of people who get up and go to work every day regardless of where the stock market is valuing their company. We own real, cash-flowing businesses that produce products and services that people need. The nearby chart from Morningstar reminds us that over time it has proven to be highly advantageous to own equity interests in businesses through the public stock market. These reminders should inspire confidence in the long-term worth of your investments, regardless of an emotional market’s pessimism about the future on any particular day. Also, do not forget that a value investing approach has historically produced better investment results than the general stock market.
Inflation and Interest Rates
We are frequently asked when inflation will calm or when interest rates will peak. We do not know the answer to either of these questions. We do know that of the $6,350,300,000,000 US dollars added to the money supply since March of 2020, $6,295,500,000,000 are still outstanding and circulating in the economy. There is still a lot of dry powder that could result in high inflation for a while longer. Even if inflation settles down to a rate of 5% (from the current 8.6% annualized), this is still much higher than the Fed’s 2% target rate and would continue to present challenges for every citizen and business. There is a self-fulfilling nature to inflation expectations that can take a while to develop and play out. We are swinging in a pendulum from the “just-in-time” inventory that made sense in a low inflation environment to the “psychology of inflation” whereby every purchasing manager is inclined to buy more than they need on every order since they know prices will just be higher next time. Time will tell how our current bout of inflation resolves.
Regarding interest rates, we do believe the Federal Reserve is behind the curve. We have mentioned in the past an oft-cited tool for projecting where interest rates should be given three factors: 1) inflation, 2) the Fed’s targeted real interest rate and 3) economic growth versus targeted growth. This tool is called the Taylor Rule and was developed by John Taylor of Stanford University in the 1990s. The nearby chart plots the Taylor Rule formula for optimum interest rates (blue line) versus the Federal Funds effective rate (red line) back to the 1950s. The Taylor Rule tracks quite closely to historical Federal Reserve Policy, but you can see that when inflation drives the Taylor Rule higher, it has not been uncommon for the Federal Reserve to take some time to react with the higher interest rates necessary to bring inflation under control.
We find Stephen Roach’s recount of working at the Federal Reserve during the inflationary period of the 1970s to be very revealing. He describes a “whack a mole” process of facing the various inflationary forces they came across. Arthur Burns, the Fed’s chairman at the time, always found an idiosyncratic reason why the inflationary factor of the day should be ignored. Burns began removing highly inflating items from the Consumer Price Index (CPI) one at a time – first oil, then food, then used cars and children’s toys and even women’s jewelry – and by the time he was finished only about 35% of the original inputs to the CPI rate remained. Only in 1975, when even these remaining items were inflating at a double-digit rate, did Burns finally admit that the United States had an inflation problem.
While we do not know the answer to when this present inflationary environment will go away, we continue to believe that industries that have historically benefitted from inflation remain inexpensive given the imbalance of supply and demand. Thus, we continue to have outsized exposure to several of these asset-rich industries in our clients’ portfolios. These companies are also well-positioned to use their increasing cash flows to return cash to shareholders via dividends and buybacks, a position we celebrate!
A Balm for Inflation Woes
All of us have experienced the recent frustration of either filling up our vehicles with gas or buying the weekly groceries. With the national average gas price up around 55% so far this year, it is understandable to experience frustration every single time your gauge hits empty. The Federal Highway Administration says the average person in the US drives 14,263 miles each year. Assuming a reasonable average miles per gallon of 20, the typical US driver needs to purchase around 713 gallons of gasoline each year. With the 56% increase in the price of gas in the last year, this average driver would be facing an increase in annual gasoline expenditures of $1,236. We write with a good news reminder for our clients that you have portfolio exposures that protect you from these price increases. Our largest energy investment across our clients’ equity portfolios is Exxon Mobil (NYSE: XOM), a company that is so high quality we would never have expected to be able to own it as value investors! If you owned at least 48 shares of Exxon you would have made a profit over the last year that covered the annual increase in your gasoline expenditures. And this is to say nothing of the hedge value of the many other energy-related companies we own in our portfolios. Even readers who aren’t clients could easily hedge their own additional gas expenditures by purchasing shares in an energy company.
The same can be said for the increased expenditures at the grocery store. We own many companies that serve as a hedge to food inflation but one of our largest positions that protects our clients against this continued risk is Mosaic (NYSE: MOS), the crop nutrient company. Over the past year, the average cost of food for a family of four has increased by 11.26% or around $1,500 annually. If you owned at least 97 shares of Mosaic your total return would have already covered this additional household expense. Once again, even a non-client reader may purchase shares in a food or food input company as a hedge to inflation in their daily food expenses. It takes fewer shares than one might imagine.
Disclosure
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Foundation Resource Management, Inc. “FRM”), or any non-investment related content, made reference to directly or indirectly in this commentary will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, personalized investment advice from FRM. Please remember to contact FRM if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services or if you would like to impose, add, or modify any reasonable restrictions to our investment advisory services. FRM is neither a law firm, nor a certified public accounting firm, and no portion of the commentary content should be construed as legal or accounting advice. FRM claims compliance with the Global Investment Performance Standards (GIPS®). GIPS® is a registered trademark of CFA Institute. CFA Institute does not endorse or promote this organization, nor does it warrant the accuracy or quality of the content contained herein. A copy of FRM’s current disclosure Brochure (Form ADV Part 2A) discussing our advisory services and fees or our GIPS-compliant performance information is available by emailing Abby McKelvy at amckelvy@frmlr.com.
Comments