Q2 2022
Kinsman Oak Investor Letter Q2 2022
July 22, 2022
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MARKET COMMENTARY
The U.S. stock market has experienced one of the most overwhelming displays of indiscriminate selling in recent memory. As of the end of the second quarter, the S&P 500 posted its worst first half of any calendar year since 1970. Fifty-two years is not a small amount of time. There have been worse six month stretches for the market, of course, but the top of this cycle coincides almost perfectly with the prior year-end.
Despite the official peak in January 2022, it appears most stocks have been in a bear market since long before then. We’ve written about this ad nauseum and would prefer not to rehash it here once again. Looking back, the Russell 2000 has surrendered all gains since pre-pandemic highs and the S&P 500 has only annualized ~5% since then. While that sounds bad on its own, most stocks have performed far worse than these indexes suggest. Suffice it to say, capital gains – not inflation – proved transitory.
We hear investors justify the buy the dip mentality by pointing out that XYZ stock does not deserve to be down X% from all-time highs. But the underlying assumption embedded in that kind of approach is the core belief certain stocks deserved to be there in the first place. Few did, but most didn’t. If you remove the notion peak prices were justified by something beyond bubble multiple expansion or extrapolating abnormal earnings, then the high watermark reference point for peak-to-trough drawdowns become meaningless. And so, what’s the difference between down 30%, 50% or 80% from highs? Said differently, instead of asking “Does this stock deserve to be down this much?” ask yourself “Did this stock deserve to be up that much from pre-pandemic highs?”
The S&P 500 currently trades at ~16x forward EPS estimates which is relatively inexpensive, in our view. We believe one of two things must be true: a) this is a good buying opportunity or b) the market believes those estimates need to come down. Thus far, valuation multiples have been abruptly reset lower. EPS estimate reductions would cause another leg down for equities but from there you could find a sustainable long-term bottom.
Our base case is earnings estimates remain too optimistic given we are probably already in a recession. Recessions are defined as two consecutive quarters of negative GDP growth. U.S. GDP growth in the first quarter was -1.4% and the Atlanta Fed forecasts -1.9% GDP growth for the second quarter (Appendix A). With the technical definition of a recessional practically met, the focus shifts to how prolonged it will be. Generally, the severity of a recession is proportionate to the boom that precedes it which doesn’t bode well.
Anecdotally, we are beginning to see headlines of mass layoffs at large companies and the consumer confidence index is registering multi-decade lows (Appendix B). Obviously, there is a massive hangover from the tsunami of fiscal stimulus rolling off. Yet, at the same time the official unemployment rate remains extremely low at 3.6%, and many businesses are experiencing widespread labour shortages and significant wage inflation. Economic data is all over the place, giving both bulls and bears legitimate arguments for what may come next.
What’s interesting about this particular sell-off is there has been nowhere to hide. In the past, those bearish on equities bought Treasuries or other bonds instead, but those assets are getting slaughtered right now too. 1H22 has been the worst first half of the year the traditional 60/40 portfolio has ever experienced and it’s not even remotely close (-16.1% 1H22 versus -6.7% 1H08), according to Compound Capital Advisors (Appendix C).
FEDERAL RESERVE DILEMMA: BETWEEN A ROCK AND A HARD PLACE
The Fed, along with other central banks around the world, find themselves with no good options, seemingly having to choose between higher inflation or higher risk of recession. The true cost of living in the U.S. has increased a lot more than the headline +9.1% inflation figure would suggest. Averaging the cost of utilities, gas, food at home and electricity components of the CPI equals +30% (!) meanwhile wage inflation grew a paltry 5.1% year-over-over. With midterms approaching quickly, there is tremendous political pressure for the Federal Reserve to “fix” this.
Inflation, at its core, is a supply/demand imbalance where too many monetary units chase too few goods and services. The pandemic, and the subsequent fiscal response, caused unprecedented shocks to both sides of that equation. Compounding those initial shocks were geopolitical conflicts, nonsensical energy policy and rolling lockdowns around the world that have persisted for two years. The economy is not a light switch that can be turned off and then back on again at ease. All of this has contributed to the persistent inflation we are experiencing today.
Central banks are limited in their approach to fight inflation insofar as they can really only influence one side of the supply/demand imbalance. The tools at the Fed’s disposal are a variety of blunt instruments used to take a hacksaw to an economy’s aggregate demand in the hopes of curbing inflation. Since the Fed cannot increase the supply of goods and services directly, it must pull the levers of inflation by attempting to control demand instead.
Some may argue that artificially ultra-low rates can spur otherwise uneconomical investment to bring new supply online and, while that may be the case in some sectors, government policy, regulatory landscapes, and geopolitical conflict are bigger drivers of such business decisions especially in the energy and agriculture sectors.
So, what is the Fed to do at this juncture? Leave rates too low and risk rising inflation or hike rates too aggressively into an already slowing economy? Quite the dilemma. Given fiscal stimulus has already rolled off, we are inclined to believe current inflation is predominantly caused by lingering supply side factors. If that assumption is correct, tightening monetary conditions and raising rates is a wildly inefficient way of reducing inflation going forward. It will work, but the negative consequences of doing so will likely outweigh the benefits.
We understand the Fed is under tremendous political pressure to fight inflation by any means necessary but compounding an initial policy error (keeping rates too low for too long) with another policy error (hiking aggressively into recession) is fraught with risk and increases the likelihood of a hard landing. The difficulty investors face is anticipating what the Fed’s reaction function may be if inflation continues rising while unemployment begins trending in the wrong direction. Addressing one problem would exacerbate the other. Which will they prioritize?
Kicking the Can Down a Long, Long Road
Further out, budgetary issues will eventually come into focus. The U.S. government collected ~$4 trillion in tax revenues in 2021 and expects to spend ~$6 trillion this year. Mandatory spending (entitlement programs such as Social Security, Medicare, Medicaid, unemployment compensation, etc.) is estimated to be ~65% of that, meaning every nickel of tax revenue collected is already earmarked before any discretionary spending takes place.
Running $2 trillion deficits prior to a recession means exploding deficits are on the horizon. Even minute rate hikes have huge implications for debt service costs and quantitative tightening means the federal government will need to find other incremental buyers for that debt. You don’t need an advanced mathematics degree to figure out this kind of trajectory is unsustainable. Something will (eventually) have to give.
OVERSHOOT ON THE WAY UP; OVERSHOOT ON THE WAY DOWN
When inflation does decelerate, and we don’t know when that will be, we can envision a scenario where the overshoot on the way up will be followed by a similar overshoot on the way down. Accommodative monetary policy combined with increased purchasing power (via fiscal stimulus) and a lack of supply (due to lockdowns) created conditions for rapid inflation. We may be entering a period where all three of those factors are reversed.
Equity markets and other risk assets benefited from a liquidity overshoot on the way up and we believe it’s reasonable to expect the withdrawal of said liquidity (and tightening beyond that) will lead to a similar overshoot on the way down. Declining asset prices, abating inflation and slowing economic growth would almost certainly cause the Fed to pivot to a more dovish stance.
The most compelling argument we hear for secular inflation pertains to structural supply/demand imbalances in the oil & gas and housing sectors. We tend to believe sustained higher energy and housing prices would probably just offset consumer spending in other areas of the economy and come out as a wash in official CPI metrics. It’s worth noting other commodity prices such as lumber, copper, wheat, corn, and cotton are all down significantly from recent highs. Again, this kind of price action suggests slowing economic growth.
Inflation — The End of Uniformity
Headline inflation metrics are heavily influenced by substitution effects and hedonic adjustments but generally CPI components are at least directionally the same. That kind of uniformity may no longer be the case. We believe inflation will be more nuanced and complex than it has been in previous cycles. Higher interest rates may cause disinflation for most goods and services while exacerbating inflation in others.
For instance, raising interest rates and tightening monetary policy will not address the structural lack of supply in energy markets. An economic slowdown may result in lower short-term demand but bringing new supply to market requires multi-year investment horizons. Increasing the cost of capital will make fewer exploration and production investments profitable, exacerbating the long-term supply/demand imbalances. Further, with elevated regulatory uncertainty, it’s difficult to envision a scenario where structural supply issues are resolved anytime soon.
Higher mortgage rates will be an immediate headwind to housing prices, but the two following knock-on consequences will exacerbate the inadequate lack of supply. First, homebuilders will bring fewer new builds to market if home prices are lower and internal hurdle rates are higher. Second, existing homeowners (locked into ultra-low mortgage rates) may be less inclined to sell their properties, further limiting potential supply.
Non-ZIRP cost of capital will revoke unicorn licenses to incinerate an unlimited amount of cash for an unlimited amount of time. Unit economics will have to start making sense and that means higher prices. End users have been acclimated to abnormally low prices as venture capital investors have spent the past decade generously subsidizing their experience for the sake of growth at any cost. But that generosity expires when the cost of capital rises above zero.
Plenty of unicorns are under the false impression their business model possesses some form of competitive advantage when in fact all they had was a lower cost of capital and the ability to irrationally price products versus traditional competitors bound by traditional economic principles. We suspect switching costs for many of these ‘disruptive’ businesses are perceived to be much higher than they truly are.
Unicorns will be forced to implement price rationalization strategies across their product lines in an attempt to cover overly excessive cost structures. When forced to generate profit or at least operate at breakeven their growth window will slam shut and their customers will be hit with way higher prices simultaneously. If interest rates continue rising, we believe a lot of paper wealth will evaporate as private investments are marked significantly lower.
Suffice it to say, there will be strong cross currents within the inflation data going forward. Plenty of gives and takes, and most importantly, it will be nuanced. Pockets of certain goods and services may be directionally different from one another. Lower prices in discretionary goods and services may be offset by higher prices in energy, housing, and unicorn price rationalization. There is a good chance that the relationship we have historically believed to be straightforward (interest rates up, inflation uniformly down) becomes murky and complex going forward.
Ultra-Low Interest Rates Can Create an Illusion of an Economic Moat
Rising interest rates also create competitive implications that extend beyond unicorns and inflation. With a rising cost of capital, we’re going to see which large companies have legitimate economic moats versus ones without moats that simply benefitted from easy access to capital, acquiring potential competition via the issuance of cheap debt and/or overvalued stock instead of investing in organic growth. Business models that are overly reliant on M&A and financial engineering rather than internal innovation will be most adversely impacted.
LACK OF DETERMINISM
We seldom invest in the energy sector because business fundamentals are mainly dictated by the whims of global oil & gas prices. As such, most companies are not in control of their own destinies regardless of how talented or inept their management teams may be. An incompetent CEO can still look like a genius if the price of oil triples during his tenure. Likewise, a genius CEO can still look utterly incompetent if the price of oil declines precipitously.
In a way, that is almost every company right now. In our opinion, management teams across most sectors have the least amount of control over their own destinies today than at any other time in the past. Everything is macro driven and none of these executives can magically see around corners. Business fundamentals are at the whims of macroeconomic forces outside of their control. Rising input costs, labour inflation, dysfunctional supply chains, component shortages, waning consumer demand, rolling lockdowns across China, etc. are all factors largely beyond C-suite control.
Earnings and Profit Margins Coming into Focus
Corporate profit margins are poised to face a litany of headwinds. In addition to the aforementioned macroeconomic forces, businesses will also have to work through potential inventory overhang (which we have previously written about) and grapple with a rising cost of capital. Best case scenario, higher interest rates will make rolling over outstanding debt more expensive. Worst case scenario, higher rates will impair certain business models.
Great management teams will adapt better than bad ones, but everyone is subject to the same noise for the foreseeable future. All of this is to say operating deleveraging from a variety of sources will be a significant headwind to corporate profit margins. Businesses that possessed a high degree of operating leverage over the previous two years are about to be reminded that characteristic cuts both ways and the reverse can be quite painful.
Where We See Opportunity
We believe investors would benefit from lengthening their time horizons during market drawdowns and periods of fundamental volatility. The challenge is the further out you forecast, the wider the range of possible outcomes will be. But it beats the alternative of trying to chase price momentum or overreacting to short-term idiosyncrasies in underlying business performance.
We remain focused on companies that can not only weather the storm but emerge from it stronger. Specifically, businesses with clean balance sheets, recurring revenue, pricing power, and strong margins are all desirable characteristics. Management teams with proven track records of effective capital allocation almost always take market share from their competition during economic downturns (either organically or via shrewd acquisitions). On the flip side, the most vulnerable companies will be ones that require continuous external funding and have overextended their cost structures and/or balance sheets heading into this potential downturn.
Market sell-offs provide investors with an opportunity to ‘high-grade’ their portfolios. High-quality businesses that are normally too expensive to justify owning can be purchased at more reasonable valuations. While even the best companies are not immune to macroeconomic challenges, they often find ways to use such circumstances to their advantage.
LOOKING AHEAD
Equity markets started the year with a macroeconomic trifecta of ugly: (1) Over indebtedness, (2) High inflation, and (3) Extreme starting valuations. While valuations are less extreme today than they were six months ago, inflation continues to accelerate, and high levels of indebtedness are likely here to stay. If EPS estimates are meaningfully revised lower, then we can envision a scenario where broad indexes essentially experience a lost decade throughout the 2020s in real terms, possibly only annualizing MSD returns for the next ten years.
On the other hand, we think certain stocks have approached valuation territory where satisfactory risk adjusted returns can be earned over the next 3-5 years investing in the right businesses. Even if current estimates are too high, at today’s prices, we believe many high-quality stocks possess a margin of safety. We cannot predict where the broader market will go, but instead remain focused on individual stocks and their prospective returns.
Sincerely,
APPENDIX
Appendix A - Atlanta Fed
https://www.atlantafed.org/cqer/research/gdpnow
Appendix B - Bloomberg
Appendix C - Compound Capital Advisors
https://compoundadvisors.com/2022/7-chart-saturday-7-8-22