Jesse Felder Podcast

Jesse Felder and I recently completed another podcast. Our discussion was focused on rising corporate costs and growing signs of inflation. In my opinion, inflation remains a difficult and unpopular topic to cover.  The bulls don’t like it as it interferes with the “rates will remain lower for longer” theme. Meanwhile, many of the bears don’t like inflation as it conflicts with the viewpoint that “the economy is weak and there’s too much debt” (both deflationary).

I’d like to thank Jesse for shedding light on what I believe remains a contrarian view — inflation is trending higher and does not appear transitory (at least until asset prices crack). I hope everyone enjoys our conversation!

Jesse Felder Podcast

 

Inflation — Subsiding or Accelerating?

Recent government reports (April jobs report, PPI, and CPI) suggest inflationary pressures may be subsiding. Meanwhile, many businesses continue to report rising wages, costs, and pricing. Who should we believe? That of course is up to each investor.

Many investors, economists, and policy makers depend on government economic data to form their macro beliefs. Personally, I prefer viewing the economy through the eyes of business, or from a bottom-up perspective. Regardless of how you develop your macro opinion, I thought it would be interesting to review what many of the companies I follow are saying about inflation.

Below are several examples of rising costs and pricing actions I gathered from my quarterly earnings review process. There are more, but I wanted to keep it concise 🙂

W.R. Berkley Corp (WRB): So, inflation from our perspective is clearly the topic of the day, I think it is the topic of the day across many industries and the insurance industry is certainly included in that. I think for some, it is a moment that people have been speculating or waiting for some extended period of time and it is upon us. Some of the obvious questions are how much, how quickly is it going to get here and how long will it stay. Obviously from our perspective there is – the impact that will come along is with a rising interest rate environment.

AptarGroup (ATR):  Look, I think everybody who is following the current environment sees inflationary pressures coming. And there is no way to escape that.

…we are recognizing increasing inflationary environment in the US and in Europe and are implementing price increases in the coming months in addition to our normal resin pass-through mechanisms.

But clearly these price increases will happen, and that’s just the current reality.

Fastenal (FAST): …as you all know, there is a meaningful inflation going on in our business.

In the local fastener business, we are seeing inflation in that product. Unfortunately, in that business, we’re not matching the inflation in our sale price. And we gave up about 130 basis points of gross margin, 130 to 140 in that 15% of our revenue. That’s disappointing and that’s a habit. And that’s a habit we need to fix. 

But, we did nice job growing the business. I challenged them on our fastener pricing at the local level. I challenged them on our freight that we charge at the local level. Fuel prices, as you all know are going up, and that impacts us like it does everybody else.

Our labor costs continue to rise.

I believe your propensity to charge freight in this environment goes up because every time I turnaround, I read an article about folks can’t add trucks and drivers and capacity fast enough. And so, freight is becoming more expensive and we were structural advantage there and we need to price for that.

United Natural Foods (UNFI): While we did leverage our expenses against our strong topline growth, we continue to have higher labor expenses in several of our distribution centers that are capacity constrained.

Additionally, our inbound freight rates have increased incrementally during the quarter, driven primarily by market supply constraints.

That the transportation industry is under a lot of pressure, capacity is scarce. The labor market is difficult. And we’re prepared to move forward in the back half.

Hubbell (HUBB): As you know, we’re targeting offsetting material cost increases with price, but typically with a three to six month lag.

So that’s the – you can’t with this much inflation, you can’t catch up overnight, but you got to be vigilant and really be disciplined about it. And so, I think it is, I think it will take us the whole year to fight that battle.

RPC Inc. (RES): Everyone pretty famously knows about shortages of skilled labor and employment issues. We think that’s just caused some friction throughout the oil field.

Forward Air (FRWD): Because you can have all the equipment in the world, but if you don’t have a fanny to put in that seat, it’s of no value. So we really are focused on drivers. I think if you talk to the most of the companies in the business, they’re focused on drivers and not on trucks.

Casey General Store (CASY): The average retail price of fuel during this period increased over 13% to $2.40 a gallon compared to $2.12 from the third quarter last year.

Darden Restaurants (DRI): Restaurant labor was 130 basis points unfavorable last year due to several factors…we continue to see elevated wage inflation of approximately 4%

…in January, we announced the $20 million investment in our workforce this fiscal year…

the real change that we’re seeing, as we analyze the benchmarks is that the check average appears to be growing and has picked up some steam.

The one place we are seeing a little bit of inflation in the food is on the distribution side. It’s getting a little bit tougher and tougher to find people to drive trucks. So, we’re seeing a little bit of distribution expense, but that’s driven by labor, not necessarily the food cost.

We’re still seeing in the 4% to 5% wage inflation.

Kirby (KEX): In the inland marine transportation business, we saw a positive change in market dynamics during the quarter. Spot market pricing increased approximately 10% to 15%

Tree House Foods (THS): Everyone is talking about how tight the freight market is right now. Not only are freight costs continuing to increase with no sign of short-term relief, but we’ve also seen our carrier acceptance rates decline about 25% over the last year. Declining acceptance rates forced us into the spot market, so it is critical that we become the customer of choice for our carrier partners.

If you’ll remember, commodities and pricing for commodities is something we started talking about with you last November. Our teams did a nice job getting after it and the remainder of that pricing will show up in Q2.

I think what we’re seeing is you can’t dodge these commodities, everyone is facing them.

So, I think we’re in an environment where most people are seeing the same kind of pressure. We have seen a number of customers, when confronted by what is a material amount of pricing, put us out to bid to check the market. But I think that’s just sort of prudent reaction to what’s really been the first across-the-board pricing for many years of this company and in the industry, I think.

Patterson UTI (PTEN): Average rig operating costs per day were also higher-than-expected at $13,970, due primarily to higher-than-expected labor cost….

Sherwin Williams (SWW): We did see an acceleration of raw material cost increases in our first quarter, and it predominantly impacted our Performance Coatings Group. And as you can imagine, when they go up that quick, it’s very hard for us to react and put another price increase into the market. That being said, we do have pricing implemented…if we see another increase that warrants a price adjustment, we’ll do that. So pricing actions are in progress.

Briggs and Stratton (BGG): …like many manufacturers, we have experienced fairly significant increases in freight rates beginning in calendar 2018. The availability of trucks has struggled to keep up with demand subsequent to the launch of electronic driver logs this year.

Higher commodity costs were offset by pricing increases

Chipotle (CMG): Comp sales were driven by higher average check, primarily from the price increase taken since Q1 of last year. The price increases averaged about 5% across the menu…

Labor costs for the quarter were 27.8%, 90 basis points higher than last year. Wage inflation of 5%

Labor is kind of the same story in terms of wage inflation continues. We expect it to continue

Steelcase (SCS): Back in the fall, we took a decision based on inflation we have seen through that date to initiate a pricing action in February. And since then, we have seen inflation up through the February price adjustment and after the February price adjustment up through just a week or two ago we have seen even additional inflation…that last piece of inflation is what we are going to start to feel more significantly in the second quarter.

We know with our customers that the best time to talk about the price adjustment is when you have inflation and we have inflation right now.

MSA Safety (MSA): We’re seeing some of the shipping expense going up slightly. There’s a little bit on our material cost, some increases there. But we’re doing a nice job from a pricing standpoint and managing that and we’re very mindful of that.

We talked about a supply chain, some supply chain issues. So those orders came in late cycle in the fourth quarter. We were caught a little bit off guard with one of our suppliers not being able to ramp up quickly enough for us

…we have rational competitors in the market place and we believe that as we see some increases we’ll pass some of those along and maintain our margin profile as we go forward.

We’re starting to see a big of wage inflation and so we’re taking a really close look at price increases in ways that we can mitigate an offset that inflation in our business.

I think the bigger trend to watch is inflation which Nish’s has talked about…inflation and what we’re seeing with the cost increases in certain areas of our supply chain and raw materials, electronic components, high density polyethylene.

Union Pacific (UNP): 5% improvement in average revenue per car drove a 7% increase in freight revenue.

In some of the more challenging labor markets, we are currently offering signing bonuses to make these jobs more attractive,

Domino’s Pizza (DPZ): Yeah, Chris, so just on food basket inflation, we’re still anchoring to the 2% to 4% for 2018, but what the stores in the U.S. will experience lines up pretty much with what we’re seeing in the rest of the industry.

As far as delivery cost of the supply chain system that we have, we were pressured in Q1 on some labor and delivery costs.

As you know, there are places that we’re at that have some pretty significant minimum-wage pressures, other regulatory pressures, that are a real headwind for the business.

HNI Corp (HNI): We are seeing higher than expected input costs across the board. As Stan mentioned, we are working to offset these pressures with additional cost savings and price increases. These higher costs will have a negative impact on the remainder of the year, particularly in the second quarter.

So we put price increases in January for the inflation that we knew about at that time for the majority of the business. And we’re also putting a secondary price in for the back half to compensate for this recent round of inflationary pressures we’ve seen.

The inflation is the big bet, and we think we have a good perspective on inflation going forward. But I think anybody who’s following the economy is trying to figure out exactly where will inflation settle out.

Convergys (CVG): We see wage pressure. We have seen some wage pressure in Europe that we have been pretty effective at addressing through working with our clients and then working with our teams in the region to do that. We have certainly seen some wage pressure in the U.S.

CH Robinson (CHRW): First, we are in a unprecedented freight environment. The healthy economy and rapid growth in e-commerce is driving a significant increase in the demand for freight. At the same time, driver shortages and enforcement of the electronic logging device mandate is motivating carriers to be increasingly selective in the loads they are willing to carry, resulting in a tightened capacity environment. The result is a very fluid and dynamic market. To illustrate this point, costs in our North America truckload business increased 21.5% this quarter, the largest single quarterly increase in our 21-year history as publicly traded company.

I think what you’re seeing in the current market is that we believe that the material or significant price increases are going to stay with us for the remainder of the year.

KB Home (KBH): 7% increase in our overall average selling price

Old Dominion Freight Line (ODFL): It’s obviously been a very favorable pricing environment and we’ve just continued to execute on our long-term pricing philosophy and trying to get the necessary increase to achieve or offset our cost inflation

Carter’s (CRI): …our teams are in Asia now negotiating spring 2019. We’ll have more visibility to those costs in July. We are assuming over the next five years that we’ll start to see some modest inflation. Our experience in recent years has been consistently lower product costs every year. But for modeling purposes, we’re assuming modest inflation in product cost and we expect to offset that inflation with better price realization.

AO Smith (AOS): Pricing actions in mid-2017, primarily due to higher steel and installation costs as well as higher demand for the company’s gas tankless water heaters and water treatment products, contributed to higher sales…

As a result of significantly higher steel prices and inflation in freight and other costs, we announced a price increase up to 12% on U.S. water heater products effective in early June.

The biggest issue both on the residential and commercial is getting labor.

Packaging Corp of America (PKG): We also anticipate continued price inflation in chemical and freight costs, incremental wage pressure with a tighter labor market or slightly lower recycle fiber costs and improving energy costs that will move into the seasonally milder weather.

A lot of freight contracts are coming due – most of my understanding kind of come due in that April-May timeframe. Do you have a sense as to what you’re seeing freight being up on a year-over-year basis? Is it in that 10% to 15% range?

That’s a good number, to your point, and it’s varying by region, by lane.  But nevertheless, we are facing those inflationary cost pressures. I think that’s a good number.

Well, I think, again, it’s a matter of there’s more competition for general labor. And so part of that is it’s a competition based on willingness to pay several wages, and then the environment in terms of are you in a metropolitan region? Are you in a rural region? And so I think we have a good story to tell. But nevertheless, we are dealing in a highly competitive labor market currently which is not all bad.

But that said, there’s no question that labor is a key element that we’re looking at since knowing full well that the costs are going up and that the quantity is going to be somewhat limited, so at least for the short-term.

UniFirst (UNF): In addition, employee wages continued to be impacted by the low unemployment environment. As we continue to invest in our people and infrastructure, we anticipate higher payroll costs as a percentage of revenues. Rising energy prices are also forecast to provide a headwind in the second half of the fiscal year.

Pool Corp (POOL): We — we’ve known for a while there has been a, a very tight market on the freight side, particularly when we’re talking about third party freight carriers and the cost for those services. So that’s kind of rolled into our expectation from an, from an expense standpoint.

My pivot here is with respect to our costs of products and there has been some raw material cost pressures on our suppliers specifically, I had mentioned I think last quarter about some of the components that are used for the manufacturing of the basic sanitizer for pools.

And most recently I saw, recently I saw that one manufacturer announced a 5% price increase effective in June. And I expect that others will follow as their costs pressures are driving them to do that.

I also expect later in the year to be additional price increases products that are affected by one raw material or another.

H.B. Fuller (FUL): We have three areas of focus as we enter the second quarter: first will be to realize over $50 million in annualized pricing to offset last year’s raw material inflation.

And I think, we see further inflation. So there is very much a potential for further price increases. But this is a nice catch-up quarter, if you will, on the margin.

I think logistics cost, especially in the U.S. are up significantly I think every business is seeing that right now. So I was probably little more than anticipated when we started the year…

KB Home (KBH): One, is that 5% cost inflation still what you expect to flow through?

Stephen, we are expecting similar cost. As this year goes forward, there’s pressure on a few of the commodities and we’re all dealing with some of the labor pressures that have been in the news.

Watsco (WSO): Yes, we have been seeing price increase announcements coming from most of the major OEMs. They’re – they range – it’s pretty much up to 6%, 7%, 8%, but obviously, they’re not going to realize that full amount.

I think this is going to be a trial balloon. I’ve been the industry many, many years and it’s unusual for us to have a midseason price increase. I can’t remember the last one, so I have no basis to say whether it will hold or not. I hope it does.

PotlatchDeltic (PCH): In general, I’d say costs are going up in trucking about 10% per year, but like I said at the start we’re really passing those costs along to our customers.

Pulte Group (PHM): Our revenue growth for the period reflects the combination of a 10% or $38,000 increase in average sales price of $413,000 combined with a 9% increase in closings to 4,626 homes.

Scotts Miracle Grow (SMG): The change in our outlook reflects the impact of rising commodity and transportation costs.

Murphy USA (MUSA): Higher gas prices, I mean, if you buy with a $20 bill, you’re going to have fewer gallons per trip. So you have more trips associated with that and we’re absolutely seeing that as well. And so there are pluses and minuses to a higher price environment.

Rent-A-Center (RCII): Same-store sales in the Core segment were positive 0.3% driven by better collections from lower promotional activity and a higher portfolio balance due to an increase in the average ticket.

Bemis Corp (BMS): That’s a normal part of our business. Processes, as contracts come up for renewal, customers are expecting lower input and that’s part of our strategy, is we are constantly working on lightweighting, downgauging and other initiatives, recognizing that that’s an expectation of their customers.

FARO Technologies (FARO): This increase was mainly due to a strong increase in our product gross margin reflecting higher average selling prices in our 3D Factory segment…

Regis (RGS): These benefits were partly offset by minimum wage inflation, healthcare cost increases that were substantially in our stylist community…

one of the things I’m most concerned about as a – not specifically it reaches across the service industries is the ability to attract employees in a virtually a zero unemployment environment. And our challenge is to find young and men and women or more experienced stylists

TPX: We also absorbed $12 million of commodity cost inflation during the quarter as our price increase did not take effect until mid-March.

And as we think about the rest of the year, if I were to digress for a moment, is that the industry typically has been very successful at passing along commodity cost increases in the form of price with a bit of a lag. As we – now turning back – as we talked about commodities for the full-year going into the year, we quantified it in around $30 million. And as we sit here today, we have seen commodity cost inflation. And we’re thinking about it more in the $45 million range. So, we’ve seen a bit of an increase…

Lowe’s (LOW): We recently announced plans to expand our employee benefits and a one-time bonus of up to $1,000 for our more than 260,000 hourly employees in the U.S.

WDFC: we are making some proactive price adjustments in the coming months to ensure our gross margins will remain within our target ranges over the long term.

Krogers (KR): This will be our first contract under Restock Kroger, and it includes an added investment in wages, raising the starting pay to at least $10 an hour and accelerating rate progression to $11 per hour after one year of service. These are the kinds of things we contemplated when we allocated $500 million to the talent portion of our Restock Kroger plan.

Hanesbrands (HBI): As we look out into 2019, we’ve begun communicating the pricing actions that we’ll take to offset the rest of this inflation, and we would expect to have those in place in early 2019.

Werner Enterprises (WERN): The driver recruiting market is increasingly challenging…

World Fuel Service (INT): Consolidated revenue for the first quarter was $9.2 billion, that’s up 12% compared to the first quarter of 2017. This increase was principally due to a 22% year-over-year increase in oil prices

Brinker (EAT): Restaurant labor increased 50 basis points as we experienced higher insurance claims during the quarter that added to the ongoing market-driven wage rate pressures which continued in the 3% to 4% range.

Church & Dwight (CHD): And with respect to the pricing environment, 8 of our 11 power brands had flat or lower percentage of products sold on promotion in Q1 2018 compared to Q1 2017, and still we grew.

As everybody knows, commodities and transportation costs are rising. That’s tempering the appetite to compete on price. Of course, to take price, typically you need a strong position in a category and a cost story to the retailer.

…the trade optimization plans and we have less couponing planned for the year.

And there’s lots of ways to get price. As I mentioned, there’s trade optimization. There’s also less couponing. There’s also pack sizes and how much product you put in the pack. So there’s lots of ways to do that without messing with the list pricing…

Core-Mark (CORE): Transportation continued to be a challenge and was the largest cost overrun…

Badger Meter (BMI): Now copper…from $2.50 a pound in the first quarter of last year to over $3 now, that’s a pretty big jump, and that did hit us for 100 basis points.

Sonoco Products (SON): Moving over the price, you see that prices were higher year-over-year by $22 million, driven by price increases both to cover higher material costs, as well as our other efforts to push through no- contract increase.

Even in Europe where pricing has been difficult for many years, the paper systems have tightened up allowing for price increases to stay.

In addition, resin prices were up 10% to 15% year-over-year in the quarter and some of the increase going into the second quarter. We have increased prices to contractual pass through mechanisms and by direct price increases. So while we’re somewhat behind the price cost curve we fully expect to catch up later in the year.

But we still have work to do to meet our growth and margin improvement targets for the year. Inflationary cost pressures and freight, labor, energy and material costs, particularly resin are requiring us to drive recovery through price increases in many of our businesses.

Valmont Industries (VMI): Steel cost volatility carried into the first quarter. Our historical experience has shown that over time we recover inflationary costs as all market participants face the same cost increases. We have been proactive in raising prices in all of our business…

Despite an inflationary raw material cost environment, we were able to mitigate much of this pressure through a combination of affected supply chain and factory management, as well as pricing actions.

Lincoln Electric (LECO): We will continue to aggressively manage the business against inflationary headwinds.

And I think that the challenge is that the inflationary pressures we’re seeing are really global. So we’ve got a price increases going in across the portfolio,

We’re in a very rapidly increasing inflationary environment.

Tennant Company (TNC): We remain confident in our ability to get adequate pricing pricing. We do — we feel we’re being successful in the market.

Crane (CR): From a price perspective, things are tracking according to plan. We had pricing put in our plans for this year from a guidance and plan perspective. And if anything, we’ve only — we’re only doing a little bit better, I would say, as we’re offsetting much of any material cost headwinds that we’re experiencing.

Astec Industries (ASTE): …price increases that you asked about and we have done that on the pricing side. How much of that sticks remains to be seen, we did that mostly late in the first quarter, our competition by and large is doing the same because the steel cost is a real thing.

Welders and fabricators we haven’t had as much trouble as we have with machinists. Probably the toughest labor market haven’t just gone to almost all of our places in the US and Canada last three weeks, I think South Dakota is probably our toughest labor market.

most of our divisions are running some level of overtime right now. Some of our capacity constraints

Alamo Group (ALG): And so, I mean, I think selectively, we’re buying a little inventory ahead of demand, where – especially – it’s not only where we think price increases are coming, but even more so where we think our lead times are getting longer.

Kennametal (KMT): Also, it’s important to note that we have relatively high utilization levels in some of our facilities currently due to strong market conditions. This affords us the ability to be more selective taking on certain sales, allowing us to liberate capacity to improve fill rates on our high-volume highest-profit products.

The first topic is pricing ability and general raw material cost increases. I think most of you on the call know that the three main raw material costs for Kennametal are tungsten, cobalt and steel, in that order, with tungsten by far being the most important. Raw material cost increases continued in the third quarter. That said, like the first two quarters in the fiscal year, we have been able to cover the raw material cost increases year-to-date and we expect that trend to continue through the fiscal year.

Franklin Electric (FELE): The decline in gross profit margin percentage is primarily due to product and geographic sales mix shifts as we believe the global realized price has offset material cost inflation in the quarter.

Standex (SXI): …we experienced high labor costs from overtime and travel for high value service workers to meet growing customer demand.

CIRCOR (CIR): …we raised prices in our pump businesses globally affecting about one half of the revenue.

Papa John’s (PZZA): So, we’ve had some pressure over the last couple of years on closures, most specifically the West Coast and the Northeast where we’ve had some wage pressures that’s driving some of the unit economic challenges

Dick’s Sporting Goods (DKS): But as far as getting deeper discounts or deeper into a new price battle, we don’t see that right now.

Stein Mart (SMRT): We are encouraged by the sales trend we saw in February and early March driven by very strong regular-priced selling

Aaron’s (AAN): We have pursued this trade-up strategy which has led to higher ticket items

We have our own fulfillment centers and we use outside shippers, so shortage in drivers and increases in fuel costs absolutely affect us. And we’ve seen a little bit of that in the first quarter and we continue to monitor it as we go into the year…

Sykes Enterprises (SYKE): We continue to execute on various actions to address labor tightness and wage inflation crosscurrents in the U.S. These entail employing a combination of tactics ranging from negotiating price increases where feasible, to shifting some existing and new client demand to either better position facilities or to at-home agent model or to other international geographies.

Transcript source: Seeking Alpha

Fabricating Inflation Data

Lincoln Electric Holdings (LECO) is a market leading manufacturer and supplier of welding equipment and systems. It’s one of the many high-quality cyclical businesses on my possible buy list. Although Lincoln’s valuation is too rich for me currently (2.3x EV/sales with cyclical EBIT margins of 5% to 15%), I’m very interested in owning its stock after the current market and economic cycle ends. While Lincoln’s business is performing well, I prefer buying cyclicals during recessions, not extended economic expansions.

Despite not owning LECO’s stock, I continue to monitor their business closely. Historically, I’ve found Lincoln’s conference calls to be very informative – effectively communicating industry and economic trends. Q1’s call was no different.

In my opinion, Lincoln’s Q1 2018 conference call provided valuable insight as it relates to the cost and pricing challenges many companies are currently facing. While there has been a lag (inflation is often a process, not an event), I’m noticing more businesses, such as LECO, are responding to higher costs by raising prices.

Below are some of the call’s highlights related to inflation [my emphasis].

Organic sales increased 9.4% from 5.2% volume growth and 4.2% higher price.

Our performance reflected solid progress in mitigating sharp increases in raw material cost to operational initiatives and pricing actions. We are confident that our global pricing actions and productivity initiatives will allow us to offset inflationary pressures. While there is lag to achieve the full benefit of our initiatives, we are confident that we have the right strategy.

We will continue to aggressively manage the business against inflationary headwinds.

Excluding the acquisition and special items, SG&A increased 11.5% to $133.4 million. The increase was primarily due to unfavorable foreign currency translation effects, higher incentive compensation costs and salary and wage costs. 

And I think that the challenge is that the inflationary pressures we’re seeing are really global. So we’ve got a price increases going in across the portfolio, and there’s no question that pieces of that are probably impacted by some pull forward. But we’ve been in an inflationary environment for these products for a considerable period of time.

We’re putting more increases into the market into the second quarter, but I would also say that the expectation of those normalized incrementals will come when the inflationary environment starts to stabilize.

So I would say the bulk of the price increases did stick the effectivity across our global businesses were very high.

But I think we’re going to continue to see these into very near future at least these mid-single digit types of pricing activities in the welding space.

Well, again I would point out that it is a global challenge associated with inflation. When you see the pricing actions that we took to the international business, I think that there was an enormous amount of price there, as well as our Americas business.

Q: …the biggest concern I hear from investors is around price cost…can you just remind us why you’re confident in the ability of LECO…to recover whatever inflation is out there?

A: Having seen our business perform…over a very long period of time…ability to seek recovery of increases and input costs historically has been a good result for the company. So I’m confident because of that history. I see it playing out again. We’re in a very rapidly increasing inflationary environment.

While I don’t have a PhD in economics, I’m fairly certain “a very rapidly increasing inflationary environment” and a 1.50%-1.75% fed funds rate rarely, if ever, have been seen together.

Despite the sharp rise in short-term rates over the past year, the fed funds rate continues to appear extraordinary low to me. Although I’m only halfway through earnings season, it’s becoming increasingly clear that corporate costs and pricing continue to trend higher. In fact, inflation is quickly becoming one of the most popular topics discussed on Q1 2018 conference calls.

Corporate cost pressures have been growing since 2017. It’s been no secret. Companies such as LECO have been openly discussing these trends. The big mystery, for me anyway, is when will rising corporate costs spill over into the government wage and inflation data? In effect, while businesses are experiencing inflation, many investors and policy makers dependent on government data have yet to be notified.

With labor availability becoming an increasing issue for many businesses, each job report feels like a potential “inflation recognition” land mine. The markets received a mini-scare after January’s report. Will this week’s job report confirm the bottom-up economic data and government data are converging? I don’t know, but I believe the company-specific evidence as it relates to wages and inflation continues to build.

As an absolute return investor, I’m thankfully not required to remain invested and can watch and wait from a safe distance. At this time, I have no interest in owning long-term bonds or equities priced as risk-free perpetual bonds. There are many risks I’m willing to take, but at this stage of the cycle and at today’s prices, duration risk is not one of them.

Transcript source: Seeking Alpha

Peak Promotions

For most of the current profit cycle, the retail industry has been burdened by overcapacity and unsettling ecommerce trends. As a result, the environment for many consumer companies has been challenging and highly promotional.

While deep discounting remains popular, not everyone has conformed to the promotional norms. In fact, based on recent earnings results and commentary, the reliance on promotions appears to be receding, while the emphasis on “full-price” sales is gaining momentum.

Two Bloomberg articles recently touched on this subject. The first article, “Clothing Retailers Are Finally Catching Some Breaks” highlights the improving same-store sales of apparel companies. While several reasons were noted, the following comment from Bloomberg’s apparel analyst caught my attention.

“The improvement likely suggests clothing retailers lately have done a better job selling full-price goods, relying less on promotions and discounts.” [my emphasis]

While the full-price model isn’t new, I believe more businesses are considering and in some cases transitioning. Ralph Lauren (RL) is the first company that comes to mind when I think of companies choosing profits over promotions. Stein Mart (SMRT), my favorite apparel retailer (for shopping, not investing), is another good example.

In March, Stein Mart reported a significant improvement in earnings, causing its stock to spike 68%! Although Stein Mart’s same-store sales remained negative, operating income rose sharply due to a 380 basis point increase in gross margins. The quarterly improvement was driven by lower inventories, fewer promotions, and “significantly increased regular price selling”.

Stein Mart’s transition from relying on promotions to improving profitability wasn’t easy. From Stein Mart’s conference call:

“As you can see from our 2017 results however, transitioning to lower and healthier inventories can have a short-term impact on sales and margins. Through the third quarter of 2017 margins were hurt by additional markdowns to clear excess inventory.”

However, its transition is finally paying dividends…

“This better mix of more regular price sales and less clearance in the quarter as well as higher mark ups resulted in an overall better margin.”

…with higher margin trends continuing.

“Our sales are now much more profitable with the lower clearance level. Our current regular price selling results are strong.”

And finally, management provided an optimistic assessment of current sales trends.

“For the month of February with spring selling underway, our sale trends have improved dramatically compared to last year driven by higher regular price selling offset by lower clearance selling.”

While competition remains fierce, pricing pressure may also be stabilizing in other areas of retail. During Dick’s Sporting Goods (DKS) most recent conference call, management stated they hope to receive “full margin” on newly released innovative products. Furthermore, as it relates to promotions and the competitive environment, management implied stability.

“But as far as getting deeper discounts or deeper into a new price battle, we don’t see that right now. But that’s as of today that can always change tomorrow.”

[Side note: I’ve recently received an unusually high number of promotional emails from DKS. The last time I noticed this, they had a poor quarter!]

Another consumer company, Darden Restaurants (DRI), also discussed the current promotional environment and the possibility of changing trends. Below are management’s comments related to the industry’s rising check average.

“But, the real change that we’re seeing…is that the check average appears to be growing and has picked up some steam. And as we look at that, we’re trying to analyze whether that is the industry taking more pricing, is it a pullback on some discounting, is it change in promotional strategy?

Highly promotional trends may also be subsiding in other sectors of the economy, such as durable goods. A recent Bloomberg article, “Americans Urge to Splurge Making Inflation Hawks Edgy” analyzed the University of Michigan’s latest survey of consumer sentiment. The survey indicated shoppers of durable goods are anticipating lower promotions and higher prices.

“More American consumers than at any time in 27 years are convinced that it’s better to make big purchases now because retailer discounts and deals won’t be around much longer.

The director of the survey, Richard Curtin, made the following comments.

“When asked about buying conditions, the appeal of low prices has largely disappeared. For durables, it has been replaced by favoring buying in advance of anticipated price increases.

Excluding companies that are not required to generate an adequate return on capital (wink, wink, you know who you are 🙂 ), the path to prosperity is rarely filled with deep discounting and price wars. As such, it’s rational to assume the number of companies exiting the promotional mud pit — dead or alive — will continue to increase.

In my opinion, increasing wages, along with elevated store closures and bankruptcies, should benefit surviving businesses attempting to kick their deep discounting habits. Assuming more companies follow the less promotional path, it will be interesting to learn how sales, margins, and consumer prices respond. As Q1 earnings roll in, peak promotions is one of many trends I plan to monitor and analyze.

_____________________________________________

With earnings season picking up steam, I may be unable to post for the next 2-3 weeks. Good luck to those who remain in equities. And for those patiently investing in cash, t-bills, and short-term Treasuries, yields are becoming more and more interesting! Yesterday the 12-month Treasury hit 2.15%, with the 2-year USTN yield reaching 2.43%. It remains a great time to check those cash balances and make sure you’re not getting short-changed by a bank or money market fund.

Sometimes I feel like the only person excited about higher short-term rates. I attended a social event last weekend and no one, I mean no one, was talking about the sharp run-up in short-term yields. They should be. Just look at the 2-year yield chart — it’s beginning to look more impressive than most FANG stocks! Now at 2.43%, the 2-year was only yielding 0.75% a couple years ago. It’s been a huge move (link to 2yr chart).

Hopefully short-term rates continue to march higher, rewarding patient investors with either higher income or an abrupt end to the current market cycle (lower equity prices).

I hope everyone has a wonderful earnings season! I’ll be back in a few weeks.

transcript source: Seeking Alpha

Q&A with Michael Lebowitz

Below is an article by Michael Lebowitz of Real Investment Advice and 720 Global. In addition to asking several questions related to absolute return investing, Michael discusses the common sense approach of buying low and selling high. I always find it fascinating how such a simple and logical investment approach can sound so contrarian, especially during market extremes.

Although buying low and selling high may appear easy, in practice it is very difficult. When prices are low and declining, fear can overwhelm investors, causing them to freeze. Conversely, when prices are high and rising, greed and adrenaline can work like a drug, causing investors to become hooked and wanting more. In effect, it is fear and greed that make buying low and selling high so difficult and surprisingly unique.

While buying low (taking risk) and selling high (avoiding risk) is an important part of my process, to be clear, I am not a market timer. My buy and sell decisions are determined by the value, or lack thereof, within my opportunity set. In other words, portfolio cash levels are valuation-based and built from the bottom-up (individual security research and selection).

Currently, valuations within my 300-name possible buy list are very expensive and in my opinion, do not provide adequate future returns relative to risk assumed. Therefore, I’ve decided to hold cash instead of what I believe are overvalued small cap stocks.

With that, I’d like to thank Michael for his interest in absolute return investing! I hope everyone enjoys our discussion.

Value Defined: An Interview with Value Investor Eric Cinnamond

The UniFirst Jobs Report

As the financial markets fluctuate on trade war headlines, there remains a building and possibly underappreciated risk in the U.S. economy and financial markets – rising wages and labor availability.

Last week the U.S. Department of Labor reported jobless claims declined to 215,000. Although I don’t follow government data closely, even I know that’s an extremely low number. In fact, according to Bloomberg, jobless claims are currently at a 45 year low and “underscore a persistent shortage of qualified workers”.

The last time I remember the labor market being this tight was in 1999, when unemployment was near similar levels (low 4%) and labor availability was also a growing issue (chart). However, interest rates were considerably higher in 1999, with the federal funds rate near 5% and a long bond trading at twice today’s yield. With similar signs of labor market stress, I find it interesting the current federal funds rate is so much lower at 1.5%-1.75% (chart) and the Federal Reserve’s balance sheet is so much higher (chart).

In my opinion, the most glaring difference between today and 1999 is two asset bubbles. Considering the consequences of the past two market cycles, it shouldn’t be surprising if central bankers prefer appearing behind the curve versus being blamed for another bubble bursting and Great Recession (see I’ll Be Gone You’ll Be Gone Central Banking).

Tomorrow the government will release the March jobs report. Will the report show the economy is in a “Goldilocks” phase (February report) or will there be growing evidence the Fed is falling behind the curve (January report)? In other words, will risk asset holders receive a hall pass for another month, or be sent directly to detention for bad behavior?

While the macro headline game is very entertaining, I have no idea or interest in what the government will report tomorrow. Instead, I’ll continue to rely on the information I gather from hundreds of operating businesses to form my opinion on the health of the economy and labor market.

One of my favorite labor market indicators comes from the uniform companies. UniFirst (UNF), a market-leading uniform company that provides uniforms for nearly 2 million workers, often discloses useful data and commentary. UniFirst reported earnings last week, providing investors with a summary of their operating results and the current labor market.*

For the quarter, UniFirst’s uniform business generated organic revenue growth of 5%. Management noted the company continues to benefit from new accounts as well as “positive price adjustments”. Profitability also benefited from pricing, as operating margins increased to 10% from 9.2% a year ago. Offsetting several positive contributors to margins, were higher healthcare claims and payroll costs. Energy costs were also higher.

Management expects margins to moderate in the second half of the year due to difficult comparisons, partially from “positive price adjustments” made during the second half of last year. Furthermore, management noted, “…employee wages continue to be impacted by the low unemployment environment. As we continue to invest in our people and infrastructure, we anticipate higher payroll costs as a percentage of revenues. Rising energy prices are also forecast to provide a headwind in the second half of the fiscal year.”

And finally, management had some interesting commentary on the current labor market as it relates to their uniform adds and reductions.

“It’s very similar compared to a year ago. So, we’re not really seeing any significant pull from big adds hiring within our customer base. I think that’s a little bit of indicative as the economy and the low unemployment environment and the competition and the difficulty to find labor. And we’re seeing some of that on our side as well.” Management went on to note that they are seeing some improvement in their Texas markets due to improvements in the energy industry.

UniFirst’s quarter and commentary supports many of the recent trends I’ve been noticing and documenting. First, the labor market is tight, with some businesses having difficulty expanding or “adding” new employees. Second, corporate costs, on average, are rising. And finally, I’m noticing an increasing number of companies responding to higher costs and making “positive pricing adjustments”.

Although I’m uncertain as to what Friday’s job report will show, if I was using UniFirst as a guide, I would estimate a lower jobs gain number (down from 313k+ in Feb) and a higher average hourly wage number (up from +2.6%). In effect, fewer hires and rising wages would reflect the growing difficulty businesses are having finding qualified labor. While this is what I would expect, I have 0.0001% confidence in my prediction 🙂 . Although it can be fun to play “guess the macro number”, I’ve found government data to be very unpredictable and frequently more volatile than the underlying trends in the economy (see You’re Hired You’re Fired).

Regardless of the actual number, the government’s assessment of the labor market will not influence my opinion on the economy and decision making. I’ll continue to form my macro and profit cycle opinions from the bottom-up. With Q1 2018 earnings season quickly approaching, I’m looking forward to learning and reporting more soon.

*UniFirst transcript source: Seeking Alpha

Reader Comments and a Few Questions

With little company-specific news to discuss, I thought it would be a good time to do another Q&A post. However, instead of questions, lately I’ve been receiving more reader comments. Below are a few I thought were interesting along with my responses.

Q: Don’t worry the new FED guy is reported to have said the FED won’t worry if inflation exceeds 2% for a while.

A: I think that’s why stocks are up today…the Fed (or Bloomberg article) is hinting to the markets that maintaining asset inflation will take priority over fighting increasing signs of inflation in the economy. Not a surprise given what happened the last two cycles. They’re moving much slower this time. Lesson learned – policies that encourage asset bubbles are acceptable, but letting them pop is not!

Q: The Vanguard Long-Term Treasury bond fund is down 7.8% ytd. I’ll bet many investors thought that interest rates only move in one direction, now they are beginning to realize that at low rates bond duration increases and when rates rise you actually lose money in your fund.

Vanguard’s LT Treasury fund started in May 1986 when rates were much higher, its annualized return is 7.5% since its inception 32 years ago. Now that rates won’t continue their decline the long-term return of this fund is maybe 2.5-3%, the good old days of 7.5% are over. And after-inflation and tax your return will be zero.

A: Interesting. Just as stocks and bonds went up together for most of this cycle, if rising corporate costs eventually spill over into government data, it’s possible stocks and bonds could go down together. In effect, rising rates threaten all asset classes. As such, diversified portfolios founded on passive pie chart allocations may want to take note. Especially, as you state, if they’re plugging backward-looking/historical assumptions (7.5% for long bonds) in their models.

Q: You talk a lot about market cycles. How will we know when this cycle is officially over and a new one begins?

A: That’s an easy one. Current investment geniuses will look like idiots and current idiots will look like geniuses! 🙂

Q:  PPI up 0.4% and 2.7% y-o-y. Companies realize this is the first time in a decade you can ask for a price increase from customers. At the same time, employees also realize it’s time to ask for a more significant raise.

A: It’s interesting…government data may finally be acknowledging inflation trends are in the process of shifting. Quite a lag from what companies have been reporting since 2017, but better late than never! Based on operating results and management commentary, I believe current cost trends will continue…at least in Q1 2018. I’m very curious about wage trends. Wage pressure appears more obvious to me than corporate pricing power, especially in certain industries…but labor remains subdued in much of the data (relative to what I’m noticing).

Q: 10-yr at 2.91% is now 86 bps off its September lows. I’ll bet some of the strong housing market data is due to consumers realizing rates may never be this low again (absent a market crash) therefore it’s time to buy a home and lock in a cheap 30-yr mortgage.

A: You may be right. Bonds could be in trouble with one big exception – barring the stock market tanking (as you note). Funny thing I noticed today…an asset manager on financial television was saying inflation is good for stocks. The marketing departments of some of these Wall Street firms never cease to amaze me! 🙂

Q: Avg hourly earnings up 2.9% y-o-y, the fastest wage growth since 2009. No wage inflation??  Some commentary about the new FED chair Powell is that he is not a disciple of the asset bubble troika Greenspan/Bernanke/Yellen – good luck speculators if he raises rates.

A: The tight labor market seems pretty obvious when reviewing business results and management commentary. In my opinion, viewing the economy from the bottom-up has many advantages to relying on economic reports. However, after nine years of only up markets, how many investors are performing the necessary bottom-up work these days vs. buying into passive allocations built on past returns? There are many unintended consequences of eliminating down markets.

Q: Two funny article titles today: WSJ “Global Bonds Swoon as Investors Bet on Inflation, Growth” and Bloomberg “Market Euphoria May Turn to Despair if 10-Year yield Jumps to 3%”. US treasury rates remain less than 3% while many European country rates are close to zero in addition to Japan. The global economy has improved therefore inflation picks up and rates rise, Economics 101. The global asset bubble financial economy has made many leveraged bets on expensive assets under the assumption the global central banks will always keep rates low and if we have a correction bail investors out. These are the periods when you have the greatest risk of a market correction.

A: The assumption that rates will remain low indefinitely appears to be extremely popular. How else can investors, including the value type, justify remaining fully invested during the later stages of the current cycle? Higher inflation and higher rates doesn’t sit well with the bulls or the bears, in my opinion. It conflicts with many of their views and portfolio positioning.

Q: I thought tariffs and trade wars lead to economic slowdowns/recessions or did I read the wrong textbooks in college

A: After this cycle, I suspect many of the economic and investment textbooks will need to be rewritten. 🙂

Q: In today’s WSJ? Logistics section [article on tight trucking market]. Not new news, of course, but I don’t think many investors (that I talk to) understand how serious the cost-push issue is for most US companies that have to ship a tangible product from Point A to B.

A: The recent rise in transportation costs is one of the quickest and most aggressive I’ve ever seen. It’s a real issue for many of the companies I follow that rely on others for transportation and just in time inventory. They often have no choice, but to take higher rates and figure out a way to pass it on.

Q: [a question from me to a reader] What do you think of recent hints of weak dollar policy? Seems to me with lower tax revenue, we’ll need our creditors’ cooperation/funding. Assuming inflation eventually shows up in government data + weak dollar = bond market air pocket potential. Is the bond market discounting this and its impact on equities? In effect, short-end appears to be acknowledging rising inflation/rates, while the long-end is predicting the deflationary aftermath of higher rates/declining prices of risk assets. Or maybe we shouldn’t depend on information from the bond market until central banks lose their privilege to buy bonds/assets?

A: It’ll be a long time coming before CBs run out of innovative ways to prop up/fund budget deficits or ramp up the monetary base. I’m not worried about that.

I’m worried about the quality of financial leadership in DC. We have a Treasury secretary (who’s never impressed me with his grasp of global macro) making very cavalier statements about the dollar, and a POTUS who understands even less about the significance of the USD to the global CB system. These are not the kind of statements that will inspire confidence at BIS meetings in Basel, and CB governors/chairmen do have other alternatives than buying a dollar that is being talked down. And if “talked down” is too harsh a term, treated quite cavalierly.

If the global financial system is a shell game, so be it, but everyone is in the game together. We, as a country, need the world to have confidence in us. Confidence is a fragile thing and should be handled with care.

With budget deficits being what they are (and what they will be after the tax cut takes hold), I think we need the world to support the dollar, not give it reasons to sell. Or buy less.

I think the bond market is now primed to react at the faintest hint of anything less than robust Treasury auctions and the inflationary impact of a cheaper dollar. And gold will react too, it has too.

Q: The NDX/Composite is in full-fledged parabolic mode. A blow-off top is fast approaching, I think.

A: The 2yr yield is also on the rise! Inflation perked up in today’s GDP report. One of these days I wouldn’t be surprised to see wage inflation showing up in a jobs report too. Should get very interesting when it does. Hope you’re right about a blow-off top. That said, at this point, one 25bps hike every few months doesn’t appear to be intimidating many investors in risk assets. It appears the Fed is on a set course of raising rates gradually until they discover the straw (hike) that breaks the cycle’s back (similar to last cycle). No one knows which hike it will be…or at least I don’t.

Q: If this feels like almost a perfect analog to ’99-00, then I expect a 10-15% pullback in the market very soon that will scare out the weak hands on the bull side, and reassure the bears that they were right all along and that this party is over.

Remember the 10% corrections we had in the NDX in the early part of ’99? Those corrections set us up for the final insanity of Nov 99 to March ’00. In that case, I expect a final blow-off top in spring/summer to emerge after a 10% correction soon.

A: Good memories! Fingers crossed this is the final phase of the cycle. I agree w you…sure does feel like it, but I’m a horrible market timer, so I’m remaining patient instead of taking a stab on the short side.

Q: Seeing the same thing [rising wages] here! Snapped this picture when I dropped the dogs off at the boarder. I asked the lady at the front desk about it and she said they’ve never found it more difficult to fill positions.

A: Labor availability and quality of labor is a growing issue for many businesses. I recently spoke with a large electrical contractor who said they’re turning down work due to their inability to find qualified labor. They’re focusing on higher return projects (higher pricing) and not even bidding on lower margin work – smart.

Q: How does a bond PM explain to a client that they own European country debt at 0% yield?

A: “Everyone was doing it” “no one saw it coming” “it was a 100 year flood” “TINA” “FOMO” etc 🙂 But most likely career risk/benchmark dispersion risk. The relative return game is played globally, not just in the U.S.

Q: I would love your thoughts on the unemployment & labour force participation dynamics currently playing out?

A: I’m more confident in my belief the current labor market is tight than how it plays out going forward (except near-term: outlooks and commentary suggest trends will continue in Q1). I’m more of an observer through the eyes of the companies I follow vs. an economist guessing where we go next.

That said, I believe labor market trends will be partially tied to asset prices, as I believe the current economic cycle has been influenced by significant asset inflation. If stocks and bonds were to decline meaningfully, I believe the economy (and employment) would be impacted.

In my opinion, somewhere in 2017 something changed with labor. Things started getting tighter and comments regarding tight labor become more noticeable. At that time I noted I felt short-term rates would no longer cooperate with rising asset prices and an improving economy. And they haven’t (see two year treasury yield since mid-2017). I suspect this trend will continue as long as asset prices remain inflated.

Q: [question from me to reader]: What do you think of the reported rising wage growth? I think “front line” skilled blue collar wages are growing noticeably. Maybe bond mkt actually is set free…we’ll see. There’s hope anyway.

A: Oh yes, as we said last fall, I don’t know whether it will come this Thursday or next, but come it will. And it did. In the end, a lot of micro pressures eventually add up to one big macro headline number.

I had to dissuade a few of my friends who thought the jump was because of these $1k bonuses that are being handed out by every company you can think of….the survey actually excludes one-off wage receipts.

The bond market has finally broken out of Alcatraz. I was actually surprised that the equity market didn’t react faster or harder because 2.70-2.72 (depending on which technical analyst you’re listening to) is one of the most well-defined, obvious and well-publicized chart levels in the world over the last many years. You know that bond trading desks and CTAs trade completely off charts and I expect the wall of money that’s in CTA/systematic strategies to pile on and press the trade. That’s what systematic trading is all about – you look for trend and you pile on. The trend, after breaking through 2.70-2.72, is clearly upward in the intermediate term.

Oddly enough, I don’t think this week’s breakout in the 10Y is the end of the equity bubble. Fevers take a long time to break (I should know, I’ve been down with the flu for the last week) and I think there will be one more surge higher in spring/summer this year. But we’re going to have a short correction before that, just long enough for bears like us to feel good for a New York minute.

Q: You mention you like to receive notice of research or other writing on the profit cycle and related items. Below the link to a quarterly research letter from an investment bank in Luxemburg. I have no idea if it will give you any new info, but it is well structured, to the point and gives a good global overview.

On another note, here in Belgium all pundits and media can talk about lately is the historically low unemployment rate yet very high rate of job vacancies that don’t seem to get filled in. Our most widely read economics magazine just devoted their latest issue to these topics. Maybe we’re on the verge an uprise in demand for higher wages as you’re also noticing. Just thought I’d let you know.

A: Thanks for the report and charts. Very interesting. I think labor costs will remain an issue as long as asset prices/economy remain elevated. We’ve finally reached a point where labor will get their share. Of course if asset prices tank, all bets are off. We’ll see…at least things are getting more interesting! Thanks again for the charts.

Q: [reader sent chart of the number of market declines without a recession]

A: Very interesting. In 2015 we were close to having a market decline w recession, but the energy credit bust wasn’t big enough to drag entire economy negative (but earnings were for several qtrs). Global QE and the ECB deciding to buy corporate bonds certainly helped keep asset prices inflated…not to mention encouraging overseas capital into the US…including reflating energy credit availability. What will stop central bank intervention and end this cycle? Not positive, but my best guess remains inflation…and possibly the bond and currency markets’ response to a Fed reluctant to confront.

Q: Looking forward to getting your feedback on our letter [qtrly letter attached].

A: Great letter and I agree! You covered it all on valuations. It’s interesting at this stage of cycle – it’s often disciplined value investors who have to defend themselves for not overpaying. Why? Given the facts, as you laid out succinctly, why isn’t it the fully-invested crowd needing to explain their positioning. Of course it’s possible they’ll ultimately need to…and I’m not sure what they’ll say considering how past cycles with similar valuations ended.

Also good point on private equity. I think a lot of institutional investors may be pouring money into PE thinking it’s less risky/expensive…and an effective diversifier. BRO had some interesting comments on the topic last conference call. Anyway…great letter. I know they’re not easy to write. Oh…and great performance too given amount of capital at risk.

Q: I understand it’s an accounting practice to add D&A back to net Income because technically it’s not an actual cash expense when calculating Operating Cash Flow (OCF). However, Buffett & Munger (link below) indicate D&A are actual expenses, and if that is true isn’t that a ‘flaw’ for reported OCF, and hence Free Cash Flow.

A: Great points on valuations. I like to exclude depreciation and also believe it’s an expense. While I don’t use multiples for valuations, if I did I’d probably look more towards EV/EBIT.  I prefer using a discount rate, fcf (typically near normalized net income), and mature growth rates. Traditional FCF/k-g.  I don’t like multiples as it’s difficult to know the exact implied discount rate and growth rate…I like to see both assumptions. Hope this helps. Everyone has their own methodology. Whatever makes most sense to you probably makes the most sense!

Q: Thanks for sharing your observations. Indeed, the financial repression for the past several years has been unavoidable for savers both in US and here in Denmark, unless one was willing to take bigger and bigger investment risks. Today 2-year Danish government bond yields -0.37%. One would think, that inflation down the road is inevitable, however, I’m struggling to come up with ideas, how to protect me and my clients in inflationary world, when:

  1. a) short term rates are negative
  2. b) most real assets (real estate, infrastructure) are funded with historically low rates and maximum gearing, thus, when rates rise – would asset prices really hold and increase with the rate of inflation? A big if…
  3. c) gold seems no longer to be a safe house for rich people, when cryptos are available…
  4. d) bond proxies (Nestle, Coca-Cola, …) – dirty expensive, slow growth, lots of debt on balance sheets

I would appreciate if you could type couple lines to your colleagues/followers outside US, that don’t have the pleasure of 2% government rates J of how to protect from inflation?

A: Great points and questions. It’s unfortunate real rates remain so low and in many cases negative. There just aren’t a lot of great options currently. Even cash has its own set of risks. In addition to remaining patient, the idea of owning some hard assets as a cash hedge may make sense for some absolute return investors. I wrote a post on this about a year ago. I know people who own farmland, antique cars, wine, real estate, art, gold/silver, miners, energy producers, etc. Currently I’m doing work on some precious metal miners that I’ve owned in the past. I’ve also owned energy E&Ps. But that’s me…each investor’s expertise, needs, and comfort levels are different.

Q: Thought you might find this of interest if you hadn’t seen it already. Maybe a subject for a future post. Curious to know your thoughts. [article titled: Waiting for the Market to Crash is a Terrible Strategy]

A: Maybe. Maybe not. I’m not positive how this cycle ends, but being patient while valuations are expensive and aggressive when valuations are cheap has worked well for me over the last two cycles. No guarantees it will work again this cycle…but it’s what makes the most sense to me.

I also believe the last three cycles have been extreme (rotating asset bubbles) and has made measuring the effectiveness of many investment strategies trickier. For example, buy and hold passive vs absolute return active may look great or awful depending on the performance measurement ending date. In 1999 buy hold looked great. 2002 it looked awful. 2007 great. 2009 awful. 2017 great. Once this cycle ends how will it look??? We’ll see, but things are definitely getting more interesting!

But regardless of the near-term direction of equity prices, I have no interest in knowingly overpaying simply to keep up with the crowd. In other words, I have no FOMO. 🙂

Q: BKD forecasting 5.5% to 6% increase in labor costs in 2018. This 2018 forecast followed 6% labor increases in 2017. Maybe you are right that labor pressures are building.

A: Great data point thanks!  I’m surprised by how bold investors have become as it relates to implications of inflation. There may not be a Fed backstop/more QE in an environment with rising inflation (at least initially). No Fed put + higher fiscal deficits = rising discount rates on most risk assets. 2yr ustn now 2.19%…I like it and hope yields continue to rise. Higher rates help patient investors enjoy the show more comfortably!

Q: Generally, I’m a bit surprised, that new oil/gas shale projects have access to capital so easy, while gold miners such as NGD can come under severe stress, when it had ramping hick-ups. But as you’ve mentioned, b/s is critical for these companies, especially in the coming years, if my expectation of higher corp credit spreads (which are absurdly low right now) will be true.

A: It’s a great point about energy’s access to cheap capital vs many of the miners. I think it’s due to how most investors are raised or taught to “know” miners are bad businesses. Miners are nearly career killers to own. In my opinion, our industry hates these things. Hence, the difficulty miners have raising capital.

Believe it or not, I’d rather own a developed mine that’s fully paid off with a 15 year operating life (AGI’s Young Davidson good example) and is cash flow positive versus lending to a leveraged energy E&P that’s focused on growing production with a short reserve life. A lot of it is industry perception, in my opinion.

Q: 10-yr rates: UK 1.62%; France 1.00%; Germany 0.76%; Spain 1.46%; Japan 0.08%. The Bank of England is threatening to raise rates from 0.5% to 1% by year end, wow, courageous central bankers.

A: It’s interesting. With a Fed going extremely slow, it seems the only thing that may reverse rising inflation/wages/interest rate trends in the near-term is a bust in asset prices. The stock market appears to be in a bind – if it goes higher, so does inflation and rates; making it tough for stocks to go considerably higher. The economy and earnings were relatively sound in Q4, I thought. And based on outlooks, I’m not expecting major changes in Q1 2018.

Q: Hope you’re doing well.  Looking forward to more on your take re tightness of labor market.  A big question for me is how much the growing demand for labor will pull those that “are currently out the labor force (i.e., not seeking employment)” back in.  How much of the increase in the proportion not in labor force due to boomers retiring, opioid addiction, other disabilities, etc. that will remain outside the workforce no matter how much labor demand surges? The skills mismatch thesis hasn’t played out yet? Will it? Will be interesting to watch how all this develops if economy continues to grow, and immigration continues to decline.

A: Great questions on unemployment and the true participation rate. I’m not certain. I’m more of an economic reporter (what I’m seeing through the eyes of business) than an economist guessing where things are headed next. That said, based on my observations, if you want a job right now you can find one. What will it take to entice the remaining unemployed to get off the couch? $15-$20/hr min wage??? I can’t speak for my fellow unemployed, but for me to return it will take considerably lower small cap valuations! 🙂

Q: Some corroborating top-down stuff…

A: Thanks for sending! Here’s my unqualified economic prediction. Asset prices remain inflated = economy good. Asset inflation deflates = economy bad. I should write a blog!!! Wait a minute…  Although possible, I think it will be tough for the market to go considerably higher as that would likely maintain current corporate cost pressures/tight labor market and drag rates higher. And the most effective way to get rates to go down is for stocks to decline…bonds would bounce. It’s an interesting game of financial market chicken. In any event, it’s good to know patient investors are getting paid a little more (1yr tbill now yielding 2.05%) to watch the greatest show on earth. I’m enjoying it!

Q: Article on rising inflation.

A:  I think inflation first and deflation later could happen. I don’t have a strong opinion, except about what the companies are reporting — I’m confident corporate costs are rising. However, if stocks and bonds were to tank, I suspect the inflation picture would change.

Q: I’m still refining my own valuation process, but prices these days don’t make much sense to me no matter how I slice it. And I really can’t see what a way that this great monetary experiment ends well for any asset class.  But, I eagerly await the opportunities that I know all of this capital misallocation will one day create.  My only cause for doubt is that the bear case seems so obvious. The dot com and housing bubbles were before my time, so maybe the red flags then were just as prevalent.

A: I feel your pain on difficulty finding value; however, I suspect, as you do, “this great monetary experiment will end” at some point. And yes, the tech and housing bubbles were just as obvious, but in a mania no one seems to care…the assumption is it will continue and when it doesn’t, investors playing along can react properly and in time. But it’s so tough to do. I prefer being patient during periods of elevated asset prices and attempt to make money after the cycle ends…or buying 50 cent dollars, instead of hoping 150 cent dollars go to 200 cent dollars!

Q: Article on why it’s right to warn about bubbles.

A:  He has good points. However, I also believe during every cycle there is a time to get aggressive. There was tremendous value in 2008-2010 and moderate areas of value in 2011-2012. Post QE3 is when things got nutty, in my opinion. Thanks for sending!

Q: Small cap stock idea (start-up business).

A: Thanks for the email and research idea. It gave me something to read during my daughter’s basketball practice! It looks very promising, but I don’t buy exciting young businesses. I tend to stick with old boring fuddy-duddy small caps that have been in business for decades.

Not very exciting, but it allows me to know the businesses well over time and value the businesses with a higher degree of confidence. While I’ve missed a lot of home runs investing this way, my relatively fixed opportunity set has allowed me to meet my absolute return goals over the past three cycles. However, considering how expensive my opportunity set has become, I’m now just waiting and waiting some more.

Q: I understand your frustration about losing clients, especially when clients often focus on storytelling and chase 5* funds after the fact. When investing in value companies in our fund, I often feel like an idiot trying to explain, how great it is to buy something that everyone else is selling. Oh..It’s so difficult to make marketing on value investing…

A: Investment banks are supposed to have a firewall between their research and investment banking departments. Maybe asset management firms, or the buyside, should have a firewall between research/portfolio management and their marketing departments! I bet money would be managed a lot differently 🙂

Unexpected Events

I’ve been unable to post over the past three weeks due to some unexpected events. While “life happens” is a constant theme for most of us, lately things seemed to have piled on quicker than normal.

The first unexpected event occurred after a large pickup truck slammed into the back of our minivan. Thankfully no one was seriously hurt, but our van (below) wasn’t as fortunate and was determined to be a total loss.

With the “minivan dream” in jeopardy, I quickly began to search for a replacement. For a starved value investor, shopping for a deal on a minivan was surprisingly refreshing. While they aren’t giving them away, there are some “relative” values out there if you’re willing to be patient and disciplined. Unemployment also helped, especially in sharpening my negotiating skills! In any event, after a week of wheeling and dealing, our transportation issues have been solved, with the minivan dream rolling on.

A less unexpected, but still difficult event occurred last week when our dog, Pete, passed away. Pete was diagnosed with lung cancer a year and a half ago. We expected to lose him shortly after his diagnosis, but Pete was determined to stay with us longer. We were very fortunate to have Pete as a family member and friend – the kindest dog I’ve ever known.

We met Pete at our local animal shelter 13 years ago. How could anyone consider putting this dog down? Unfortunately, many dogs like Pete are unable to find homes and are put to rest during the prime of their lives. According to the Humane Society, “2.4 million healthy, adoptable cats and dogs – about one every 13 seconds – are put down in U.S. shelters each year.”

If you’re looking for a dependable investment analyst who is a good listener and never asks for a raise, I strongly recommend adopting a dog. Some of my best ideas and portfolio management decisions were made after long walks with Pete and his best friend Jimmy (our other dog). We believe Pete was 14 or 15 years old. He will be missed dearly.

Last, and certainly not least, a very good friend was diagnosed with cancer and began chemotherapy a few weeks ago. His cancer is treatable, but after visiting him in the hospital, I learned his path to recovery will not be easy and will take tremendous courage. Understandably, his sudden and unexpected illness has altered his view on his past and future. Life-changing events like these often cause us to put things into their proper perspective and reconsider our priorities.

It wasn’t long ago when I reassessed my life’s priorities. When I recommended returning client capital over a year ago, I took a hard look at my past and what I wanted out of my future. For most of my adult life, I dedicated a considerable amount of time and effort to my career. While I don’t regret my professional path and continue to have tremendous passion for investing, as recent events have reemphasized, there is more to life than discovering high-quality small cap stocks selling at 70 cent dollars.

I often joke about how grateful I am for global central banks and their asset inflation. But it really isn’t a joke. Without their trillions in asset purchases and a decade of negative real interest rates, I’m confident I’d still be behind my desk, consumed by the markets and my career. Although I plan to work again (I managed a mutual fund, not a hedge fund 🙂 ), I intend to remain committed to my newfound appreciation for a healthy and productive work-life balance.

If you’re sitting behind a Bloomberg and your eyes are tired from watching the green and red lights flicker, it may be constructive to reflect on how you’re allocating your time and what matters most to you. In my opinion, there hasn’t been a better time to take a temporary break from the markets. Given current valuations and opportunity sets, what will you really be missing? While it’s important to be prepared, maintaining balance can go a long way in successfully completing the current market cycle with your capital, family, and sanity all intact!

In any event, after taking a few weeks away from the markets, I’m back up to speed and should be posting again soon. In the meantime, I recommend reading General Mills’ (GIS) most recent earnings conference call. It’s a good summary of many of the themes I’ve been discussing over the past several months; especially as it relates to rising corporate costs.

As I was reading General Mills’ call, the following headline crossed Bloomberg, “Powell: No Sense In Data That Inflation About To Accelerate”. I’ll never fully understand why so many economists, investors, and policy makers rely on the “data” to form their macro views. Viewing the economy from the bottom-up, or through the eyes of business, makes so much more sense to me.

Nevertheless, until “New Trends with Few Friends” makes its way into the data, I suppose the Fed’s plan of going gradual — as long as nothing breaks — will continue. Until something does break (sharp decline in asset prices), I continue to believe rising corporate costs and inflationary pressures will persist. While few see it in the data currently, I would not consider inflation first, deflation later (higher rates causing a bust) an unexpected macroeconomic event. In fact, at this stage of the cycle, shouldn’t it be expected?

Policy Distractions and Pricing Actions

I was multitasking Tuesday. While listening to Chairman Powell discuss his expectations for price stability in the medium term, I was reading a press release from H.B. Fuller (a leading provider of adhesive solutions) that communicated the company’s intention to raise prices 5% to 12%. Apparently corporate America hasn’t gotten the memo explaining inflation is expected to remain stable.

When developing my opinion on inflation, I prefer skipping the middleman (Wall Street economists and central bankers) and going directly to the source – businesses operating in real-time and in the real economy.

H.B. Fuller (FUL) is a good example of a company currently experiencing rising costs and implementing price increases. They are not alone. In fact, I thought H.B. Fuller’s explanation of its price increase was a good summary of the current cost and pricing environment for many of the companies on my possible buy list.

The past 12 months have seen continued increases in feedstock costs, logistics costs and labor costs. Inflationary pressures in global markets have occurred due to trucking shortages, Hurricanes Harvey and Irma in the United States, regulatory and environmental actions by the Chinese government, and robust demand. These increases will affect products in the company’s hygiene, packaging, durable assembly, construction, paper converting, and engineering adhesives segments.

Based on my bottom-up research, evidence of a tightening labor market, cost pressures, and pricing actions continue to build. Assuming corporate costs rise further and the Federal Reserve’s preferred measurement of inflation exceeds 2%, how will policy makers respond?

According to a recent Bloomberg article, instead of defending their target, the Federal Reserve may simply move it. Bloomberg explains, “Federal Reserve Chairman Jerome Powell and his colleagues may be willing to accept inflation rising as high as 2.5 percent as they seek to extend the almost nine-year economic expansion.”

If the Fed is willing to move its inflation target, why should investors assume it won’t move again? If inflation exceeds 2.5%, will policy makers move their target to 3%? And why not 4% or 5%? A slippery monetary slope indeed.

The bigger risk, in my opinion, isn’t if the Fed changes its inflation target or raises rates three or four times in 2018, it’s investors discover – as I have through my bottom-up work – that our central bank is falling behind the curve. In effect, as inflation moves through the pipeline, perceptions and investor psychology could suddenly change, causing the bond market to question the Federal Reserve’s ability and determination to confront rising prices.

While I believe an “inflation recognition” scenario is possible, investors do not appear very concerned. In fact, I recently watched an investment professional on financial television explain why inflation was good for stocks. And I thought the equity ownership justifications of TINA (there is no alternative to stocks) and FOMO (fear of missing out) were creative! What is next, trade wars are good for stocks too? 🙂

As the Federal Reserve debates inflation targets, companies aren’t waiting around for help with rising costs. Many are acting now. As H.B. Fuller’s actions illustrate, corporate pricing decisions are based on what businesses are experiencing, not an arbitrary and possibly fluid central bank inflation target.

It’s a tricky time to be an investor in stocks and bonds. In my opinion, to justify current equity valuations and experience further gains, stock investors need perpetually low interest rates and a stable bond market. While ideal, is such an environment possible considering rising equity prices would be stimulative, leading to additional inflationary pressure and higher interest rates? On the other hand, bond investors (ex junk) would likely benefit from stock market instability, sharply lower stock prices, and the economic drag it would bring.

Although stocks or bonds may rise in the near-term, if inflation targets and trends become unhinged, I believe many of the assumptions used to justify owning stocks and bonds would be challenged. In such an environment, the days of indiscriminate asset class inflation (everyone wins) would likely come to an end – a victory for capitalism and free markets.

Have a great weekend!

What’s Happenin’ Q4 2017

There is a growing debate about interest rates and why they’re rising. Is it inflation, expanding fiscal deficits, quantitative tightening, reduced foreign demand, lethargic policy response, late-cycle fiscal stimulus, or a weakening dollar? After reviewing Q4 2017 operating results, it seems simple to me. The economy is expanding, labor markets are tight, and signs of inflation are building. In my opinion, interest rates are acting as they should at this stage of the economic cycle.

When I put on my “bottom-up economist” hat, I’m viewing the economy through the eyes of business, not government data. While my macro views (especially on inflation and wages) have differed from government data for several months, recent CPI and PPI reports were more in-line with my observations. Furthermore, the latest job report confirmed the rising trend in wages I documented for most of 2017. Lastly, the government’s Q4 2017 GDP report showed an increase in inflation and an economy continuing to grow in a 2-3% range. In summary, my bottom-up opinion and government data appear to be converging.

Assuming government data continues to follow the path of my observations and conclusions, I expect to see further confirmation of a tight labor market and building inflationary pressure. In effect, I believe the reports on rising inflation and wages are most likely a start of a trend, not a one month anomaly.

While I continue to believe my opportunity set remains very expensive, the operating results for most of the businesses I follow and analyze was generally positive in Q4 2017. Barring a shock to the economy or sharp decline in asset prices (possibly one and the same), I’m not expecting a meaningful shift in economic activity in the near-term — business outlooks and backlogs are healthy, on average. That said, several variables that influence corporate profits are in transition, increasing profit margin uncertainty.

I have many questions as it relates to future corporate profits. Will volume growth and price increases be sufficient to offset higher costs, wages, and interest rates? Will a tight labor market help or hurt the economy (some companies noted labor constraints impacted operating results)? How will lower corporate taxes impact labor, demand, and inflation? Will positive business sentiment spill over into decision making? Will freight market constraints subside or intensify? How does a weakening dollar impact inflation and an already hot industrial/export market? Will efforts to lower inventory reduce promotions and increase consumer prices? Will consumer businesses experience a noticeable benefit from rising wages? Will rising interest rates and prices offset the stimulus from wage gains and lower taxes?

I’m looking forward to discovering the answers to these and many other questions. While patient investing can be unexciting at times, the shifting macro environment is making things much more interesting! I will be monitoring Q1 2018 operating results closely to learn more.

Below is a summary of several business trends I noticed during Q4 2017:

  • Rising costs, especially wages, are becoming increasingly noticeable. Frequent discussions on strategy to pass on prices increases. In addition to labor, freight and commodity increases mentioned frequently. The shift from deflationary tone (2015-2016) to inflationary (2017-2018) is becoming more evident with costs and wages accelerating in Q4. Based on results and outlooks, this trend does not appear transitory.
  • New tax law discussed frequently. There remains uncertainty, but overall the consensus is the law will be positive for most companies and the economy. Currently it’s more sentiment than actual data supporting optimism. We’ll need to learn more in Q1-Q2 2018. The tax benefit varies between companies and industries (depending on international exposure and expiring deductions). Most initial EPS estimate increases range from 10-20%. Capital allocation priorities remain unchanged, on average. However, some companies stated they plan on investing immediately in employees/wages.
  • Consumer companies reported mixed operating results, with sales trends improving on average. It’s been over a year since I noticed the consumer slowdown (see post Elevated Consumer Discretionary Risk); therefore, it shouldn’t be surprising that year over year comparisons are easier and improving. Companies have had time to make adjustments, including large reductions in inventory and other costs. While the environment remains somewhat promotional, deep discounting is less widespread with more full-pricing noticeable (lower inventory strategies affecting). That said, there remains store closure pressure which initially hurts comps/increases promotions, but eventually helps. Lower inventories may also be responsible for recent uptick in inflation (last month’s large gain in apparel prices makes sense).
  • Industrial operating environment is healthy. Growth is broad-based with construction and aerospace/defense reporting above average growth (mid to high-single digits). Material costs rising and pricing being passed on. Exports healthy, on average.
  • Domestic energy industry showed further signs of improvement in Q4. Confidence in 2018 is growing with higher energy prices. E&Ps continue to appear to be more disciplined this cycle, with many attempting to drill within cash flow. Credit/capital, on average, remains available and relatively inexpensive. Most commentary suggest North American activity will be robust in 2018, while international has stabilized, with some predicting growth will return. The drag from the energy credit bust in 2015-2016 is officially over. The energy headwind has become a tailwind for many businesses.
  • Auto manufacturing flat to slightly down. Little changes expected with estimates for small decline in auto production in 2018.
  • Agriculture remains weak, but stabilizing.
  • Rising freight costs mentioned on several calls. Transportation capacity utilization is high. Pricing and availability is becoming a greater issue. Difficulty in finding sufficient capacity and labor increasing. Barring a decline in economic activity, expect transportation costs to become a growing issue – was very noticeable this quarter. Companies are attempting to figure out how to pass on rising freight cost and maintaining sufficient transportation availability.
  • Financials continue to do well on average. Bank loan and deposit growth healthy with low losses (as one would expect at this stage of the credit cycle). Insurance catastrophe losses increased in 2017. Premium pricing has firmed from declining to flat/increasing slightly. Despite increases in underwriting losses in 2017, there remains excess capital in the insurance industry. Interest income improving for banks and insurance.
  • Technology results were mixed, but grew on average.
  • Currency expected to shift from minimal variable to a noticeable tailwind in 2018. Several companies noted Q1 2018 should benefit from currency.
  • Housing and construction is strong. Labor availability and cost remains an issue to meeting demand.
  • International results were healthy. Asia strong. Brazil/Latin America stabilizing – more optimistic tone from several companies with sales in Latin America.
  • Weather had mixed impact. Colder than normal (especially vs. last year) weather mentioned by some businesses, but did not influence quarter significantly.
  • Supply reductions from China environmental efforts mentioned on several calls. Price increases could result for several raw materials.

Have a great weekend!