Q1 2022
Kinsman Oak Investor Letter Q1 2022
April 25, 2022
MARKET COMMENTARY
The macroeconomic backdrop is difficult as a plethora of tailwinds are simultaneously turning into headwinds. Inflation continues to accelerate, geopolitical tensions are rising, and supply chain uncertainty is creeping back into the picture with lockdowns in China. Yields have gone vertical and commodity prices are climbing quickly as well. Flight to safety has been the theme thus far as it feels like uncertainty lurks around every corner.
We continue to be surprised by the resiliency of the indexes. The S&P 500 is being held up by energy, utilities, consumer staples, and a handful of mega-cap companies (Appendix A + B). There is a stark divergence of performance beyond those sectors. If the only information we had access to was the S&P 500 performance year-to-date, we would be stunned to learn how many individual stocks on our watch list are down as much as they are. Said differently, based on our extensive watch list, we would have expected the index to be down at least double digits.
INFLATION OUTLOOK
Inflation was persistent long before any geopolitical conflict unfolded and, in a lot of ways, the war only accelerated existing inflationary pressures that were bound to manifest at some point. Energy shortages, exacerbated by counter-productive policy responses, will lead to sustained higher prices and/or demand destruction. Likely a combination of the two. We are not agriculture or international trade experts, but potential food shortages could be a real source of political and societal instability in some parts of the world.
Geopolitical instability will also encourage businesses to prioritize resiliency over efficiency within their supply chains and keep extra inventory on hand, both of which will hurt margins and increase working capital requirements. Businesses have spent the past three decades focused on optimizing efficiency and this swing back towards resiliency is inherently inflationary. Again, these trends were already underway before this year.
Headline CPI hit +8.5% in March, the highest it’s been since 1981, while the PPI hit +11.2%, the largest increase ever recorded. Most companies are forecasting continued inflation in commodities, logistics, and labour for at least the balance of the year. The longer the PPI remains higher than the CPI, the more likely companies are to pass along further price increases for end customers or reduce quality, or both.
Suddenly, consumers have gone from having excessive amounts of discretionary income (largely from last year’s stimulus checks) and too few options to spend it on, to having too little while the cost of basic necessities (food and energy) are rapidly rising. Real purchasing power is experiencing a tremendous crunch. At some point inflation will result in meaningful demand destruction and there is evidence to suggest it may have already begun.
Economists suggest we have reached peak inflation and headline CPI figures will decelerate from here. Maybe so. But what is more important is how long mid-single-digit inflation will persist for. For instance, 5% inflation for five years will erode 28% of your purchasing power. Politically speaking, clamping down on inflation is the Biden administration’s top priority heading into midterms. The Fed’s mandate of putting a floor under asset prices for the past twelve years has shifted to putting a lid on inflation. In our opinion, that would be an extreme regime change. The Fed has talked a big game about being aggressive with inflation, but their bark has yet to match their bite.
THE GREAT NARROWING CONTINUES
We want to expand a little more on what we wrote in our last investor letter with respect to narrowing breadth in the market. Most stocks on our watch list are so washed out, yet the overall market has barely budged. Narrow leadership in the S&P 500 has been masking utter carnage beneath the surface for the better part of a year. We feel like a broken record writing about it. The difference now, though, is those leaders are starting to bleed.
The Great Narrowing occurred in three distinct phases and, as of now, the equally weighted technology sector has surrendered almost all alpha generated during COVID. Below we will outline each phase. Each basket will be discussed in generalities. The exact magnitude and timing of peak-to-trough declines for individual stock within these baskets will obviously vary, but they are still close enough to demonstrate there are three distinct phases.
Faux-FAANGMs – Peaked in February 2021
Peak-to-trough decline for this group of stocks is approximately -70%. Investor demand for “innovators” and “disrupters” (at any price) heavily outweighed the supply of available companies that were truly disrupting their end market in some unique way. As such, the bar for what was deemed disruptive has been lowered so far, the definition of the word has lost all meaning.
In fairness, this particular basket can actually be split into two sub-categories. The first sub-category are stocks with real businesses and real growth but haven’t yet demonstrated sustained profitability or established themselves as having legitimate economic moats beyond being a COVID beneficiary. Valuation multiples were so unsustainably high, none of these businesses could have possibly ever grown into their valuations at the peak. The ARK Innovation ETF (ARKK) is comprised of these kinds of stocks and resembles the Nasdaq between 1998 – 2002 (Appendix C). Examples include ZM, CHWY, HUBS, DKNG, COIN, PLTR, SHOP, etc.
The second sub-category are stocks that never even proved having legitimate business models or working products in the first place. In some instances, these businesses generated no meaningful amounts of revenue and sold investors on hopes and dreams. In other instances, businesses took old and wildly unprofitable business models, added some layer of technological spin (that did nothing to improve underlying unit economics), and re-branded the whole thing as brand new and innovative. Examples include OPEN, NKLA, WE, HOOD, FUV, RIDE, XL, etc.
Wannabe-FAANGMs – Peaked in Q4 2021
Peak-to-trough decline for this group of stocks is approximately -40%. The Wannabe-FAANGMs are high quality growth businesses with legitimate competitive advantages and strong margin profiles. These companies are not as big or as dominant as FAANGM, and they all have smaller TAMs, but they are still wonderful businesses. The problem was that their valuations got extremely stretched, especially since many of them were COVID beneficiaries. Growth deceleration coincided with rising yields so, at peak valuations, a sharp move lower seemed inevitable. Examples include: ADBE, INTU, NVDA, CRM, MTCH, etc.
FAANGMs – Currently Splintering
Peak-to-trough decline for this group depends entirely on the specific company. This group of stocks has collectively been the market leadership backbone for the S&P 500 over the previous few years. For a long time, these stocks were considered practically bulletproof as the big continued to get bigger and bigger. However, even these behemoths have started to bleed.
Meta Platforms (FB) and Netflix (NFLX) are the obvious broken duo within the FAANGM bunch, being down -52% and -71% from their respective highs. But Amazon (AMZN) has gone nowhere since July 2020. Alphabet (GOOG) and Microsoft (MSFT) are both struggling lately, down -20% and -21% from their respective highs. The only heavyweight in this group within spitting distance of its all-time-high is Apple (AAPL), which is -12% peak-to-trough. These are some incredibly big moves for companies worth hundreds of billions of dollars.
FB and NFLX both traded like over-levered mid-caps flirting with bankruptcy when they reported earnings. If you told investors one year ago that the FAANGM stocks would be this far from highs, while the S&P 500 was barely down on the year, they would have recommended getting a CT scan. Market corrections occur when breadth troughs. The tide rolled out for the Faux-FAANGMs in February 2021, progressed to the Wannabe-FAANGMs in Q4 2021, and has now reached the small group of stocks most investors considered indestructible six months ago.
Drawdowns, Volatility, and Compounding
Volatility is magnified when stocks fall this much this quickly. A +25% bounce after being down -65% results in a peak-to-trough decline of -56% instead of -65%, which is barely noticeable in the grand scheme of things. A stock that is down -50% and falls another -20% is only -60% from highs. Putting it in perspective, a drawdown of -60% means the stock needs to compound annually at +25% for five years to achieve a +4% IRR on the position.
YESTERDAY’S GAIN; TOMORROW’S PAIN
The technology sector wasn’t the only COVID beneficiary. Plenty of consumer discretionary businesses have benefitted from stimulus checks and lock downs. The pull-forward of demand has been incredible in some instances. Businesses that over-earned for two years are poised to under-earn for a while going forward. Over-earning yesterday and under-earning tomorrow will pave the way for an earnings re-normalization at some point. Investors with long enough holding periods could find undervalued stocks after forward estimates come down, especially if the underlying business fundamentally improved by gaining market share or right-sizing store count.
We recommend paying close attention to the relationship between margins and inventory for potential red flags. Even in normal times, companies experience inventory overhangs as demand slows. COVID’s impact on supply chains supercharged this problem as many businesses overpurchased inventory. Unprecedented demand shock combined with unprecedented inventory builds will result in an unprecedented inventory overhang.
There is serious potential for stuffed supply channels, bloated balance sheets, and operating leverage working in reverse. Over-earning occurred when sales growth was accelerating, inventories were decreasing, and margins were increasing. Businesses accumulated excess inventory anticipating continued sales growth. Eventually, sales growth will decelerate, and these companies will be forced to liquidate excess inventory, sacrificing margins. Cheaper products with shorter replacement cycles and more affluent consumers will be relatively best positioned.
LOOKING AHEAD
The macroeconomic backdrop is fraught with risk as a confluence of tailwinds turn into headwinds. Inflationary pressures are a threat and will likely remain so for the time being. Real discretionary income is getting squeezed. Quantitative tightening introduces another element of uncertainty. The Fed is so far behind the curve, there is a tail risk the bureaucrats in the Eccles Building are forced to make an abrupt ultra-hawkish pivot. Rising mortgage rates pose significant risk for the housing market.
We expect sustained volatility going forward, especially on the downside. Plenty of stocks on our watch list are beginning to get very cheap despite the indexes not being down much. While the S&P 500 had a nice bounce off its March lows, most individual stocks on our watch list are still making new lows. We continue to hunt for bargains and will use our long-term time horizon to benefit from interim volatility. While stocks could get even cheaper, we will deploy capital patiently and add to our positions that we expect will outperform the market going forward.
Sincerely,
