The Bottom-Up Economist Q4 2018

In my December post, “Are All Bets Off?”, I wrote, “To what extent has the decline in equity markets influenced economic activity and corporate profits?” To answer this question, I noted I needed more information from the frontlines of business. Fortunately, that’s exactly what we received during Q4’s earnings season – a very thorough and informative update of the current economic and profit cycle.

As I made it through last quarter’s earnings reports and calls, it became clear to me that the Q4 operating environment was less consistent than the first three quarters of 2018. Based on my bottom-up analysis, the majority of business and industry results were trending higher throughout most of 2018. However, in Q4 2018, the dispersion in operating results and trends appears to have increased. For example, during my Q4 review, I’d read one conference call and results and outlooks were strong:

Packaging Corporation of America (PKG): January started out very strong. Through the first 18 days, we’re up 5.3%. Bookings continue to look strong going into February. So we’re very pleased with the start of the year.

And then I’d read another conference call and results and outlooks were slowing:

Matthew International (MATW): One area of particular concern for us is our traditional product identification and consumables business, historically known as our marking products. Traditionally,order rates in this segment have been the proverbial canary in a coalmine for upcoming slowing economic activity as a whole. Our orders have slowed for both our traditional printer products and the inks that they consume. So we’re cautious about the cadence of that business as we progress through the year.

In my opinion, the sudden and sharp decline in the financial markets in Q4 contributed to the growing inconsistency of corporate operating results. Several companies indicated they experienced a decline in demand as the markets fell. However, given the short duration of the decline, the negative effects may have been temporary and in some cases have reversed (along with asset prices):

Ethan Allen Interiors (ETH): We were doing extremely well to the middle of December, and then all of a sudden, with the issue of a number of factors, the stock markets were down substantially, the government shutdown, the tariffs — you could — we could see it that customers really held back in the last — and most of our — this change took place in the last 2 weeks of December. And as we said in our press release, the good news is that in January, people started coming back. And we’ve had sequential increases in traffic in our design centers so far in January.

Simpson Manufacturing (SSD):  We believe demand may have been impacted by uncertainty in regards to economic factors given the extreme market volatility and decline experienced in December.

So we had a December that was pretty low on a volume standpoint, as we’ve mentioned. We’ve seen it come back in January not only from just the price increase, but also, we have seen organic volume growth in January.

Sherwin Williams (SHW): In this case, the improving cadence of our business late in the fourth quarter was encouraging, and January has given us a solid start to the first quarter.

Monro Inc. (MNRO): …the softness we experienced around the holiday period was temporary and we are encouraged by the stronger top line trends we saw in the back half of January, which have led to comparable store sales growth of approximately 2% so far in the fourth quarter.

Another noticeable theme in Q4 2018 was the continuation of rising corporate costs and increasing pricing power. I was a little surprised by this as I was expecting some relief in costs and pricing given the increasingly mixed operating environment. Nevertheless, signs of inflation continued to show up in many of the Q4 2018 conference calls and earnings results. As I noted in past posts and podcasts, inflation is a process. As such, there is considerable evidence that cost and pricing pressures continue to proceed through the pipeline:

Flowers Foods (FLO): Good top line performance was offset by continuing margin pressure from cost inflation, primarily in commodities and transportation.

In 2019, we expect continued inflationary pressures in commodity, transportation and labor of approximately 150 basis points as a percentage of sales.

And the consumer understands that the costs are going up. And the pricing that we’ve taken, it’s encouraging to see the reaction so far. As we look forward again, pricing will continue to be an opportunity for us to address issues as costs continue to run up.

When you look at the commodity basket, I mean, again, 2018 was the first inflationary year we had seen in some time. So it’s fairly significant at high single-digit commodity inflation or input cost inflation for 2018. We do expect inflation to continue, and we don’t really see that turning in the near term.

Oil-Dri (ODC): In the quarter, we experienced higher costs of freight, packaging and non-fuel manufacturing costs.

Helen of Troy (HELE): As expected, this quarter, we also started to feel the impact of tariffs ahead of the pricing actions we began implementing in the third quarter and which will largely take effect over the next two quarters. Retailers and consumers are just now beginning to digest higher prices, which could affect short-term shipments and consumption.

While retail price points have been relatively stable for years, retailers will likely pass on some of the increases, testing consumer’s price sensitivity.

Our pricing actions so far have been successful. We have been able to take pricing in categories that traditionally do not have price increases as part of their normal cycle and that’s a statement measured in years.

…more people are working. So all those things put money in people’s pockets and now they go to the shelf. But for the first time in years, they’ll see products that have a bit of inflation in them and there has not been inflation in this country of any meaningful way in the last couple of years, and certainly not in our categories.

Matthew International (MATW): From a cost standpoint, unfortunately, it appears that commodity and freight cost increases will continue to be a challenge, but we will seek opportunities to mitigate them to the extent possible.

Hubbell (HUBB): …dealing with inflationary pressures, including tariffs. But we’ve exited the year with positive momentum and committed to offsetting the material cost inflation in 2019.

Church & Dwight (CHD): Our price increases have been well executed for ARM & HAMMER cat litter, baking soda and carbo deodorizers, and OxiClean prewash additives. Those price increases hit their shelves late in the quarter and will benefit 2019 gross margins. And the good news is, that competitors are raising prices in those categories as we speak.

Bridgford Foods (BRID): Overhead spending increased due to significant increases in hourly wages, healthcare expenses and indirect operating supplies.

Central Garden and Pet (CENT): A third factor impacting operating margin and EBITDA were higher freight, labor and raw material costs. However, a range of price increases were implemented in January, which will help mitigate the cost inflation pressures. 

Mid-America Apartment Communities (MAA): And projected average blended rent pricing, which is new leases and renewals combined of 2.7% for the year, which is a modest improvement over 2018. We expect operating expenses to grow at 3.1% at the midpoint coming off of two years of very low expense growth.

Martin Marietta Matrials (MLM): Annual price increases have already widely garnered market support, most importantly, in Texas, the Carolinas and Southeast. To that end, we expect aggregates pricing to increase in the range of 3% to 5%.

While there were many examples of cost and price increases in Q4, several companies reported declining or stabilizing raw material costs:

Kennametal (KMT): As expected, margins compressed mainly due to the timing of customer raw material pricing index adjustments. As material prices have now effectively stabilized since the start of the fiscal year, this timing issue should abate in the second half. Consequently, we expect that full year operating margins will improve year-over-year.

Badger Meter (BMI): We continue to see favorable impact of manufacturing absorption from the higher sales volume year-over-year, along with positive net pricing as brass input costs remained stable sequentially.

H.B. Fuller (FUL): Lower raw material cost provide the biggest potential positive impact that could enable us to deliver above the midpoint of our guidance range.

Lennar (LEN): As the lumber market dropped from $650 to $330 per 1,000 board feet in the fall of 2018, we aggressively renegotiated lumber pricing for our fourth quarter starts. We’ll begin to see the benefits of these lower prices with deliveries in – late in the first quarter and receive the full benefit of this lower pricing in the second half of the year.

On the other hand, the labor market remains tight with several companies commenting on rising labor costs:

Darden Restaurants (DRI): Total labor inflation of over 3.5% and incremental workforce investments drove restaurant labor 50 basis points higher than last year despite continued sales leverage and productivity gains.

Tractor Supply (TSCO): We are forecasting slight pressure on SG&A due to the ramp-up of our new distribution center, ongoing wage pressures and higher depreciation expense.

Simpson Manufacturing (SSD): We’ve noted that it’s a tight labor market and we’re seeing that impact on our gross margin there, particularly in the fourth quarter, that was one of the elements there.

Packaging Corporation of America (PKG): We anticipate higher labor and benefit costs with annual wage increases and other timing-related expenses.

Sealed Air (SEE): We’ll see some pricing that we’ll be able to go after because of increases in freight and labor cost.

United Natural Foods (UNFI): …like many distribution companies, we continue to be challenged with higher labor costs and productivity issues related to serving this busy holiday season and the addition of temporary labor where needed.

Cullen/Frost Bankers (CFR): While employment growth has begun to plateau, due to labor market constraints, unemployment continued to decrease to record lows. According to the Federal Reserve’s Dallas branch, Texas employment had expanded by 2.4% year-to-date toward the end of 2018.

UniFirst (UNF): during the quarter, we experienced larger-than-anticipated increases in our production and service payroll costs as well as our merchandise amortization.

…with an employment environment that’s very challenging…we’re finding ourselves chasing it a little bit. And I think we’re trying to get ahead of it in terms of the wages…there was a fair part of the year that we were understaffed quite a bit in particularly the service area, but even in the production area, which forced us to rely on in the production area a lot of temporary labor, and in the service area scrambled

Brown & Brown (BRO): We’re seeing a lot of construction going on around the country, and there’s a general shortage of qualified labor for many industries.

Transportation and logistics expenses remained elevated in Q4 2018, however, the outlook was unclear. Some companies expect transportation costs to moderate (mainly due to elevated comparisons, not demand), while others expect further increases:

Big Lots (BIG): Additionally, we continue to expect the transportation market to be challenging and do not see rates slowing down.

Oil-Dri (ODC): The cost of freight increased more than 2 million dollars, or greater than 20%,compared to the first quarter of fiscal 2018. While portions of the freight increase were one-time, we expect the majority of the increase to continue for the remainder of the year and beyond. This increase is not specific to Oil-Dri, but widespread in the market.

J&J Snack Foods (JJSF): If you look at our transportation costs as a percent of sales, if you do your calculation in that way, we’re talking about — that’s roughly $2 million a quarter higher than last year…this year than last year and we think that should be leveling off. And perhaps, it’s too early to really tell, but we may have no increase in that regard starting with this quarter that we’re in.

J.B. Hunt Transport Services (JBHT): We have had good conversations through the bid season. Early indicators for us is in the mid-single digits on price, but I think that depends customer by customer. I think as the year plays on, we’ll be able to have this conversation. It’s too early to tell for the full bid season.

Werner Enterprises (WERN): 2018 was a year buoyed by strong rate improvement. And as we think about 2019, knowing that the rate environment will not be the same as ’18, but we still believe has upside.

As we sit in January, freight is strong as we indicated, not as strong as 2018 but stronger than the majority of the preceding 5 years and it has remained so. It’s also been more orderly. So I feel capacity is tighter than people think. Our conversations with our customers continue to be positive, and we continue to have conversations about securing more capacity, not about an abundance of overcapacity.

Norfolk Southern (NSC): Our year-over-year pricing was the highest in 7 years with strength in all business units. Throughout the year, the trucking industry experienced capacity constraints and high truck rates, which supported strong growth in intermodal.

And yes, we’ve seen some loosening in the truck market. Although the market is still tight, and we’re encouraged by what we’re seeing so far in bid season.

Pricing discipline also remained a theme in Q4, with several companies reporting higher average unit prices and less promotions:

Tractor Supply (TSCO):  Our strong average ticket growth of 3% was driven by strength in product mix, inflation and, to a lesser extent, growth in big-ticket categories.

Cracker Barrel (CBRL): Cracker Barrel comparable store restaurant sales increased 1.4%, as a 3.0% increase in average check offset a 1.6% decrease in comparable store restaurant traffic.

Monro (MNRO): Similar to the last quarter, our comp performance was driven by a higher average ticket from improved in-store execution and sustained strength in our tire and brake categories.

Dick’s Sporting Goods (DKS):  We see that the — our inventory is in great shape. We don’t see needing to be as promotional.

Darden Restaurants (DRI): We felt it was with the demand environment being strong. It was a good opportunity to remove some of the incentives.

United Natural Foods (UNFI): Additionally, supplier promotional spending is also down significantly, driven primarily by very limited price elasticity at retail.

Regis (RGS): The same-store sales improvement was driven by a 5.2% increase in tickets, partially offset by a 4.7% decline in year-over-year transactions or what we have historically referred to as traffic.

Skechers USA (SKX): As we have mentioned previously in the retail environment, we had reduced some discounting activity and taking some limited pricing. That continues to power through the retail business, and they performed exceedingly well on a gross margin basis.

Signs of weakening demand showed up in more interest rate and asset price-sensitive markets such as residential housing and the automotive industry:

Toll Brothers (TOL): Despite a healthy economy, we are seeing a moderation in demand. Fourth quarter contracts declined 15% in dollars and 13% in units compared to a difficult comp from 1 year ago.

In November, we saw the market further soften, which we attribute to the cumulative impact of rising interest rates, rising home prices and the effect on buyer sentiment of well-publicized data of a housing slowdown.

Lennar (LEN): Overall, the housing market continued to slow through the fourth quarter of 2018 as higher home prices and rapid interest rate increases combined to create a mismatch between prices and buyer expectations. As we entered the seasonally slower fourth quarter, purchasers remained on the sidelines awaiting the market to adjust. Sales rates were slower than expected and increased incentives were needed to adjust pricing to entice a reticent market to transact.

Gentex (GNTX): At the beginning of the fourth quarter of 2018, vehicle production estimates from IHS Markit showed a net growth of approximately 2% in the combined regions of Europe, North America, Japan and Korea, and a slight decline for the China market. The actual unit production for these markets in the fourth quarter combined for a decline of nearly 6%.

…2019 will likely continue to have headwinds in overall vehicle production levels and the combination of tariffs and component costs will create additional cost impacts to the business versus last year.

Given the sharp drop in oil prices, it’s not surprising the outlooks provided by energy companies became less certain. Also during the quarter, several energy firms reaffirmed their commitment to keeping spending in-line with their internally generated cash flows:

Helmerich & Payne (HP): Discussions with several customers regarding CapEx outlook indicates a mix of increasing, decreasing and flat spending budgets. However, the consistent theme is discipline, principally keeping 2019 spending within cash flow.

RPC Inc. (RES): Revenues decreased compared to the same period in the prior year due to lower activity levels caused by year-end budget depletion among many customers.

We believe that oil prices fell at a difficult time of the year because it was our customers’ budgeting season. So the oil price decline happened as they were budgeting. Now in January, oil is up a little bit, but they’re extremely uncertain about what 2019 looks like.

Patterson-UTI (PTEN): The sharp drop in oil prices in December resulted in some of our customers notifying of us of their intent to release rigs. Recently, with the sharp rebound in oil prices above $50, we have seen an improvement in operator sentiment and discussions with operators about putting rigs back to work is slowly increasing.

Carbo Ceramics (CRR): In the oilfield sector, E&P operators’ focus on free cash flow, coupled with recent oil price volatility, creates a less than certain environment with regard to drilling and completion spend in 2019. Current expectation by some industry analysts are predicting 2019 drilling and completion spend to be down high single digits on a percentage basis compared to 2018.

Currency is a growing headwind:

H.B. Fuller (FUL): Currency will have a negative impact on revenue in the first half of the year at a similar level to Q4 of 2018.

Graco (GGG): The effect of unfavorable currency translation at current rates is more pronounced for the first quarter of 2019 when compared to the first quarter of 2018 with an unfavorable effect of as much as 3% on sales and 6% on earnings.

And of course, China and tariffs remain an issue:

Kennametal (KMT): Yes. We did see a significant decline in China. Everyone understands the situation there and the fact that the automotive industry is actually depressed at this point.

Regal Beloit (RBC): The Commercial and Industrial business will have more of a headwind out of China and out of Europe.

Helen of Troy (HELE): While we currently anticipate achieving our fiscal 2019 revised full year outlook, the current U.S.–China trade environment is certainly a concern and could provide a meaningful headwind next fiscal year if we ultimately realize the full year impact of tariff changes in their current form.

Ethan Allen Interiors (ETH): China was impacted, as we know, by number of factors. First, the Chinese economy has slowed down. Secondly, the tariff situation also created a big problem, they held up.

H.B. Fuller (FUL): In mid-September, due to the timing of our quarter-end, we were one of the early companies that called out the slowdown in China and a shift in currencies as a headwind in the second half. These impacts were seen in the fourth quarter, but the impact was somewhat more than we expected.

A.O. Smith (AOS): We are assuming continued weakness in the China economy and relatively flat consumer demand for the full year in 2019.

…the Chinese consumer is no different than a U.S. or any other consumer when their job has slowed down, when they’ve seen maybe some layoffs in various parts of the industry and their friends, that they simply just pulled back. And so we believe that tariff has had some impact on consumer confidence, on their spending patterns just for the fact that that’s what we would do here in the U.S.

While there are signs of a slowdown in certain industries and uncertainty remains, overall, many companies in a variety of industries continue to report positive organic growth and outlooks:

Hubbell (HUBB): All markets up again in the quarter across the board, and particularly, some major end markets: core industrial, outside-plant communication, gas distribution, and most particularly, positive towards Lighting. It’s real stronger than anticipated, particularly on the residential side. And we expect this end-market growth overall to continue into 2019.

Darden Restaurants (DRI): Right now, we think the consumer is in a really good place. I mean, we’re operating the lowest unemployment in 50 years. Confidence remains high. As we watch the guests, they continue to buy across our menu, they’re adding on to their entrées, they’re buying up, it feels like it’s a really good environment.  

AMETEK (AME): We expect overall sales in 2019 to be up high single digits. Organic sales are expected to be up 3% to 5%, with a similar level of organic growth across each reportable segment.

So overall, we feel very good about the environment we’re operating in. And we feel good what we’re hearing from our business and our customers. And we continue to see a solid underlying demand.

Sherwin & Williams (SHW): I’d say that it’s — when you speak with our customers, it’s a very bullish discussion that we’re having. Our customers remain very confident about the year, the bidding that they’re doing and the backlog that they have had as well as what they see going forward.

Moog Inc (MOG/A): Our major markets are doing well with defense particularly strong across all our applications. Commercial aerospace is also very healthy and our industrial markets remain solid. With one quarter in the bank, we are increasingly confident about our forecast for the full year.

CSX Corp (CSX): Over the past few days, I’ve spoken to a number of large customers across different industries. General customer feedback has been positive and is consistent with the demand levels we are seeing today. While it’s hard to ignore the volatility in the equity markets, I cannot call out any trend in our business today that would point to a significant slowdown in our business.

Graco (GGG): We saw sales growth in all segments and regions in the fourth quarter, with an increase of 8% from the prior year, including 2 percentage points of growth from acquisitions. Currency translation was a headwind for the quarter and reduced sales growth by 2 percentage points.

It has seemed to be the case here for at least the last 6 months that we’re doing the very best we can to talk ourselves into problems, right? The headlines are negative. All the political back and forth that has been going on has been creating a lot of negativity. In reality, in most of the areas that we’re selling, business is good. So there is a bit of disconnect there from my standpoint.

Pentair (PNR): Today, we are introducing our 2019 outlook. We expect core sales to grow 4% to 5%, which is comprised of about 3% of price and 1% to 2% of volume.

Arthur J. Gallagher (AJG): Looking forward, 2019 Brokerage organic growth feels like it will be around 5%.

Cintas (CTAS):  Our second quarter rental organic growth rate of 6.6% rebounded as expected from the first quarter’s rate of 4.9%. In fact, this organic growth rate of 6.6% exceeded our internal expectations.

We — I think from — based on our results, which we believe are pretty good, we’ve seen a pretty good economic environment for the last quarter and we’re not hearing signs of slowdown right now. And I would suggest that our guidance is pretty strong as well and reflects confidence that we’re going to finish the year pretty strong, so no.

Kennametal (KMT): …we are confident in our assumption of organic sales growth of 5% to 8% for fiscal year 2019.

Martin Marietta Materials (MLM):  In summary, for 2019, we expect aggregates shipments to increase 6% to 8%, with growth in all 3 primary construction end-use markets.

Underlying market demand should continue to support ongoing pricing momentum.

Mid-America Apartment Communities (MAA): I mean, our confident — our confidence if you will as it pertains to 2019 rent growth despite the supply pressures is really based in what we see as continued very strong demand. And we see no evidence that the demand side of the equation is weakening. We continue to see very low move-out occurring and the job growth numbers continue to be encouraging.

In conclusion, based on my review of Q4 2018 results, I believe the corporate operating environment has become increasingly mixed versus Q1-Q3 2018. However, on average, organic sales and earnings growth remains positive. As such, I do not believe the decline in asset prices in Q4 was severe enough or lasted long enough to push the economy and profit cycle into recession. That said, I believe there is sufficient evidence to conclude the financial markets’ recent decline created hesitation and uncertainty among consumers and businesses. In effect, I believe the economy and financial markets are increasingly becoming one and the same. If true, while 2019 corporate outlooks are generally positive, I’m viewing them as stable, or as unstable, as the underlying foundation of the current economy – asset prices.

The Quality Conundrum

Last week I spent some more time screening through possible buy ideas. A sector that has been roughed up caught my attention – the asset managers. Given my view on equity valuations, combined with the fact that most asset managers are relative return investors, I believe the industry could lose considerable assets and revenues once the current cycle ends. And of course there remains the ongoing threat of passive investing. Nevertheless, several equities within the group seem to be pricing in some pretty difficult times, so I decided to take a closer look.

One of the asset managers I reviewed has an investment process that appeals to me. Specifically, this particular manager states it invests “with a quality bias” and may lag in up markets and outperform in down markets. I like this concept, especially at this stage of the market cycle. In fact, if I was selecting an asset manager today, I’d be looking for managers that have historically outperformed in bear markets and have underperformed over the past 3-5 years. Interested to learn more, I opened the hood and reviewed the firm’s 13-F. And yes, there it was, a portfolio “with a quality bias”.

As I sorted through their holdings, I bumped into many high-quality names that are also on my possible buy list. There was no doubt in my mind that these were good businesses. But were they selling at good prices? Many of the businesses I was familiar with were mature companies with low-to-moderate growth rates. However, their valuations implied above-average, and in my opinion, unrealistic future growth rates. As such, while I concluded they were in fact good businesses, I did not believe they were selling at good prices.

It’s no secret high-quality is preferred over low-quality for investors seeking safety near the end of a market cycle. It’s a go-to play in the portfolio manager handbook (page 37 paragraph 4). The thinking goes that when the market and economy are in decline, high-quality businesses – particularly those with good balance sheets – will outperform their lower quality peers. In theory, higher quality companies will have steadier cash flows and will be impacted less by declining demand, faltering liquidity, and widening credit spreads.

The 2000-2002 bear market is a good example. In addition to avoiding technology, owning quality and strong balance sheets paid off handsomely during this period. In fact, it worked so well many high-quality value stocks generated positive absolute returns in what was a relatively nasty bear market (S&P 500 declined -47% from its peak in March 2000 to its low in October 2002).

High-quality protects capital best when it’s being ignored and valuations are attractive. Such an environment often occurs near the end of a market and economic cycle, when trend-following investors are favoring lower quality or highly cyclical companies (think energy in the summer of 2008). And that’s the glaring difference between today and past periods, such as 2000-2002. Currently, quality is not being ignored and valuations are not attractive, in my opinion.

Lancaster Colony (LANC) is a good example of a high-quality business that was ignored during the late stages of past cycles, but is cherished today. Founded in 1961, Lancaster Colony is a manufacturer and marketer of specialty food products. When I think of their business, I think of salad dressing, dinner rolls, and croutons. It’s a boring but high-quality business with a strong balance sheet and consistent cash flows.

Before the bear market in 2000 began, Lancaster Colony was trading at 13x earnings and was priced as a value stock. Given its relatively low valuation, Lancaster Colony’s stock provided investors with a healthy margin of safety heading into the bear market of 2000-2002. In fact, its stock was so attractively priced, it actually increased 58% while the Russell 2000 declined -44% from the 2000 peak to 2002 trough! During this period, owning Lancaster Colony and quality worked magnificently.

Currently trading at 35x earnings, I no longer consider Lancaster Colony a value stock. And that of course is the big difference between high-quality this cycle and when quality worked in the past – valuation! In the case of Lancaster Colony, the difference between 13x and 35x earnings is considerable. From a risk management perspective, it’s the difference between swimming with a life jacket and a bag of cement.

While it remains up for debate, let’s assume the end of the current market cycle is approaching. Let’s also assume most investors believe high-quality companies outperform during the end of market cycles and are positioned accordingly. If these assumptions are true, is it possible that investors seeking safety in quality are actually piling into overcrowded positions with elevated risk?

Based on the large dispersion in valuations between high-quality businesses and lower quality businesses with well-known risks, I believe investors may be relying too heavily on the “what worked last cycle” playbook. Instead of flocking into high-quality, what if buying equities that are already in bear markets (preferably with strong balance sheets) provides better downside protection? And let’s also not forget, investors have the choice of not owning high or low quality equities and waiting out the end of the current cycle in the comfort of T-bills (3-month currently yielding 2.42%)! Of course that’s if you have that option. Many asset managers focused on relative returns and with fully-invested mandates do not.

Goose Eggs

When I recommended returning capital in 2016, I felt small cap stocks were broadly overvalued. The cash in the portfolio I was managing was rising to record highs and I was unable to find investments I felt would adequately compensate clients for risk assumed. Hence, I felt the best course of action was to return capital. Two and a half years later, the investment and economic landscape has changed considerably and currently appears to be in transition.

I initially noticed a shift in the macro environment in 2017 when several companies on my possible buy list began reporting rising costs. Later in 2017 and early 2018, I also discussed and documented improving operating trends for many of the businesses I follow. During this period, short-term interest rates also began to increase. The rise in interest rates was an encouraging sign for patient absolute return investors. In my post “Patience a Possible Win Win” I wrote:

“Waiting isn’t easy, but with short-term interest rates trending upward, it’s gotten a little easier. As the later stages of the current market cycle unfolds, I believe patient investors will likely be rewarded with either higher returns on their liquidity or a more attractive opportunity set.”

Interestingly, over the past year we’ve seen both – higher rates, and more recently, an improving opportunity set. In hindsight, I don’t believe the Federal Reserve had a choice but to increase rates and implement QT. Throughout most of 2017 and all of 2018, rising wages and increasing corporate pricing power were too obvious to ignore. Negative real rates simply do not mix well with record low unemployment, signs of labor shortages, and corporations openly communicating their intentions to raise prices.

As wages and inflation picked up steam throughout 2018, the yield on the 2-year Treasury followed. During this time, I became increasingly fascinated with the 2-year and its upward sloping yield. In my post, “Tick Tock Where Does the 2-Year Stop?” I wrote:

“Since I began noticing rising corporate costs in 2017, the 2-year Treasury yield has increased considerably. Trading near 0.50% only two years ago, the yield on the 2-year hit 2.79% today! As someone patiently waiting for the current market cycle to end, I’d like to know the rate the 2-year needs to reach before something in the financial system cracks.”

Assuming the current market cycle’s peak is behind us, it appears the 2-year yield that caused something in the financial markets to crack was approximately 2.75%. Not long after stocks began to fall, the 2-year yield peaked at 2.98% (November 8, 2018). It’s not exactly a high yield for a cycle peak, but one needs to keep things in perspective. The fed funds rate was between 0-1% for nine years! A tremendous amount of debt accumulation, asset inflation, and capital allocation occurred while rates were pegged near 0%. As such, it didn’t take many rate hikes (along with QT) to cause investors to revise their “lower for longer” valuation assumption.

For many absolute return investors, it’s been an incredibly long, frustrating, and even fascinating market cycle. While I continue to be uncertain as to when this cycle officially ends, as I’ve stated in recent posts, I’ve become more encouraged and optimistic regarding future opportunity. In fact, as volatility has increased, several of the small cap stocks I follow are down meaningfully and are trading below where they were when I recommended returning capital. With prices declining and my opportunity set improving, I’ve increased my time devoted to research and finding new potential buy ideas.

After sorting through the carnage on my possible buy list and equity screens, I’ve come to the conclusion that small cap stocks, on average, remain expensive. Several aggregate valuation metrics, such as EV/EBIT, support my bottom-up conclusion. Below is a chart of the Russell 2000’s median EV/EBIT (excluding financials). I prefer EV/EBIT to P/E as it takes net debt into consideration and excludes the impact of what I believe are below normalized interest rates and tax rates.

While I researched potential buy ideas, I was also reminded of how much debt has accumulated on corporate balance sheets this cycle. As noted in my post The “V” or the “L”, one of the most glaring differences between this cycle and past cycles is corporate balance sheets.

Higher debt levels can be seen from a bottom-up and top-down perspective. From a top-down perspective, most aggregate measurements of corporate debt are elevated. For example, the median net debt/EBITDA of the Russell 2000 is currently 3.2x versus 0.9x in July 2007 (the last market cycle peak).

The increase in debt is also noticeable from a bottom-up perspective. For example, United Natural Foods (UNFI) is a company I follow and have owned in the past. Its stock has declined -74% over the past year and is trading well below the price of my last purchase. So why am I not buying? Unfortunately, due to acquisitions, the company’s debt has increased considerably and no longer passes my financial strength criteria.

In my attempt to avoid permanent losses to capital and potential bankruptcies (goose eggs), I follow a simple financial strength rule of thumb. Specifically, I require a debt-to-free cash flow ratio of 3x or less for cyclical businesses and 5x or less for non-cyclical businesses. Debt-to-free cash flow limits have saved me from multiple distressed situations in the past. And given how much corporate debt has grown, I expect the use of leverage limits will become increasingly valuable as the current credit cycle matures.

So why do I use 3x-5x debt-to-free cash flow? As an equity holder, I want to make certain a business can pay off its debt, if needed, before a large bond or credit line matures. The maturity wall for many small cap companies typically hits in 3-5 years; hence, I use 3x-5x debt to free cash flow limits. In effect, I never want to be at the mercy of a volatile credit market or fickle banker. And this is also why I use debt-to-free cash flow instead of debt/EBITDA. In my opinion, debt/EBITDA is less effective in helping me understand a business’s discretionary cash flow and ability to repay debt.

In summary, while many small cap stocks are down meaningfully from their highs, I believe valuations, on average, remain elevated. Nevertheless, given it’s been so difficult to find value for so long, it’s understandable to want to research and possibly buy a beaten-down stock. For absolute return investors diving in and searching for new ideas, happy hunting! Just watch those balance sheets. Financially distressed businesses and potential goose eggs can be devastating to performance and full-cycle absolute returns.

Are All Bets Off?

For my final post of 2018, I planned on writing a detailed post on the consumer sector. Unfortunately my blogging time has been limited, so instead I thought I’d at least provide a brief summary.

Based on recent operating results, the consumer continues to spend; however, results do not appear as consistent and vibrant as Q1-Q3 2018. Furthermore, interest rate sensitive sectors are showing further signs of slowing. It’s possible, in my opinion, that rising wages are sustaining consumer spending in certain areas, while rising interest rates (and now declining equity prices) are causing other consumer-related businesses to slow. In effect, consumer business conditions have become more mixed versus the first three quarters of 2018, when operating results were broadly trending higher.

We’ll have a clearer picture after Q4 earnings season; however, based on recent results, there are signs that certain economic variables may be in transition. For example, the following comments from Toll Brothers (TOL) suggest a possible shift in labor availability and wages:

“…we believe we will likely see some relief on the labor front. While it is still early, we expect to see some softening on labor pricing and increased availability in some of our markets. We are actively rebidding jobs with the goal of reducing our costs.”

Toll Brothers’ comments are noteworthy as a “softening” labor market would represent an abrupt shift in recent trends. During 2018, the majority of companies on my possible buy list were experiencing a tightening labor market, not softening. Inflation and other macro variables have also been trending higher.

For most of 2018, I expected rising wages and inflation, along with elevated asset valuations, to support the Federal Reserve’s decision to continue increasing interest rates. However, there was one important caveat. Specifically, I noted if asset prices declined sharply or something in the financial markets broke, then all bets were off.

With many of the major stock indices down considerably from their highs, we’re approaching the formal definition of a correction, or even bear market, in certain sectors and benchmarks (as of December 17, 2018 the Russell 2000 is down -20% from its highs).

To what extent has the decline in equity markets influenced economic activity and corporate profits? It’s a good question that I’m currently unable to answer as my recent sample set is too small and does not reflect December’s sharp decline in equity prices. And it’s why I’m extremely interested in Q4 2018 corporate operating results and 2019 outlooks. In order to better measure the effect recent asset deflation has had on the economy, I need additional information from the front lines.

Regardless of the potential impact on the economy, it appears asset prices have moved enough to catch the attention of the Federal Reserve. Based on “The Fed Cheat Sheet”, the Federal Reserve will likely implement a wait and see approach (or pause) after raising rates tomorrow. If their cry of “monetary uncle” isn’t enough to appease investors, I expect the Fed will eventually communicate their intention to end QT and possibly cut rates. Per my cheat sheet (wild guess), I expect the next olive branch will be extended to investors near 2,300 on the S&P 500.

In summary, the financial markets, and possibly the economy, appear to be in transition. With uncertainty increasing and equity prices declining, it’s not surprising 2018 is shaping up to be a good year for investors practicing patience and prudence. Of course 2018 isn’t over. It’s possible recent declines in equity prices will cause the Fed to refrain from raising rates tomorrow, sparking a violent year-end rally. Given how much is at stake (how dependent we’ve become on asset inflation), nothing would surprise me. Nevertheless, in my opinion, the days of making money with little effort and risk to capital appear to be fading (at least for this aging cycle).

For patient absolute return investors rooting for a more favorable opportunity set, the past few months have been refreshing and encouraging. As I’ve stated in recent posts, I’m becoming increasingly optimistic regarding future opportunity.  Will 2019 be the year capital can be allocated at prices that adequately compensate investors for risk assumed? I don’t know, but I’m hopeful and can’t wait to find out!

I’d like to wish readers a Merry Christmas and Happy Holidays! Here’s to a wonderful 2019 filled with considerable volatility and opportunity! 🙂 

I’ve Been High

I’m not sure what surprises me more. The fact that I’ve been writing a blog for over two years or that I haven’t fit America’s best rock band (according to Rolling Stone) into one of my posts. Of course I’m talking about R.E.M.  

I don’t remember exactly when I was introduced to R.E.M., but I remember the first song. It was “Radio Free Europe”. It was like nothing I’d ever heard. I went on to discover other R.E.M. gems such as “Gardening at Night”, “Driver 8”, and “So. Central Rain”. I was hooked and soon owned all their albums (or cassette tapes).      

While R.E.M. was initially known as an alternative college band from Athens GA, after the release of their album Document, the band became more well-known. And after their albums Green and Out of Time were released, they became famous.

Their cycle of popularity likely peaked in the early 1990’s. As the band matured, they experimented with different sounds and song writing. Later albums such as Up, Reveal, Accelerate, and Collapse into Now, were all good in my opinion, but never caught a bid from the mainstream. It’s possible their newer music deviated too far from R.E.M.’s earlier and familiar sounds to please the masses.  

While their later albums contained fewer top hits, it’s where many of my favorite songs are located. One of my favorites, and I believe most underrated R.E.M. song, is on their album Reveal. It’s called “I’ve Been High”. Unlike “It’s the End of the World as We Know It”, “Orange Crush”, and “Losing my Religion”, it’s not a particularly catchy or upbeat song. Nevertheless, I find its flow, vocals, and lyrics mesmerizing.

Similar to most R.E.M. songs, the lyrics are open to interpretation, but unlike their older songs, the lyrics are clear and can actually be understood! The last four verses below:

So what in the world does R.E.M. and their song “I’ve Been High” have to do with absolute return investing? Everything!

In order to achieve attractive absolute returns over a full market cycle, it’s very important to avoid permanent losses to capital. Based on my experience, an effective way to limit large mistakes is to generate accurate asset valuations.

A common error made in business valuation is related to extrapolation, or assuming current operating conditions will persist far into the future. Instead of extrapolating and thinking of a company’s profit cycle as linear, I believe most business results are cyclical, with profit margins gravitating towards their mean.

To take the cyclical nature of business into consideration, I typically use a normalized cash flow assumption in my discounted cash flow model. In effect, I want to avoid being too optimistic during the peaks and too pessimistic during the troughs. In my opinion, a normalized cash flow assumption provides investors with a more accurate valuation than extrapolating current trends far into the future.

Similar to businesses, I view the economy and stock market through a cyclical lens. As is the case with many things in life, there are natural highs and lows. Despite the natural cyclical tendencies of the market and economy, a significant amount of effort and capital has been allocated towards maintaining the current cycle’s high.    

In my opinion, the desire to maintain this cycle’s high originates from the 1999 stock market bubble. The high created from that cycle’s asset inflation was exhilarating. Record equity prices contributed to strong economic growth, rising wages, and a fiscal surplus. Unless you were a short seller or disciplined value investor, it was very easy to make money. All you needed was a brokerage account and a cash advance from your credit card!

Things were so good in 1999, some economists, including Alan Greenspan, were concerned the United States would eventually pay off its debt (concerned because the Treasury market would disappear)! It was truly an amazing and prosperous period few had ever seen – so unique, it was labeled the “New Economy”. Unfortunately for many, the boom couldn’t be maintained, the bubble popped, and reversion defeated extrapolation.

Ever since the 1999-2000 bubble peak, it appears to me that we, as a society, have been trying to relive that high. Policy makers in particular have increased their focus on the wealth effect and financial stability. Once used mainly as an economic indicator, the financial markets have become the go-to lever to pull when the economy needs a boost. Reflating asset prices has become synonymous with reflating the economy. If a stock market bubble pops, replace it with a housing bubble. If a housing bubble pops, cut rates to 0%, buy trillions of assets (global QE), and watch everything fly.      

In my opinion, the tremendous amount of effort and resources used to sustain the current cycle stems from the desire of investors, corporations, and policy makers to live their lives on high. Unfortunately, as nice as it would be for profits and asset prices to remain near peak levels indefinitely, it’s not how the markets, or life for that matter, typically works. Eventually “the light washes over” and the cyclical nature of business, markets, and the economy is revealed.  

The Fed Cheat Sheet

In a recent post I noted, “…barring a consequential decline in asset prices, I believe the Federal Reserve will be forced to continue increasing rates and unwinding their bloated balance sheet.” While I did not have a number in mind when I used the word “consequential”, I certainly didn’t believe a flat YTD number on the S&P 500 would cause the Fed to alter their plans. And that, of course, is what markets were led to believe yesterday after Jerome Powell stated the funds rate is “just below” the Fed’s theoretical neutral rate.

Now that we have a better understanding of the Federal Reserve’s tolerance for financial instability (not much), I believe investors are in a better position to gauge future policy responses related to further declines in equity prices. I put my best guess together in the Federal Reserve Cheat Sheet below:

S&P 500 YTD       Policy Response
5%+                      Gradually raise rates
+5% to -5%          Hint at a pause
-5% to -15%         Pause
-15% to -20%       Hint at rate cut/ending QT
-20% to -25%       Cut rates and end QT
-25% to -30%       Hint at QE4
-30% or worse    Implement QE4

Source: Conversation with myself on the way home from grocery store
Margin of error: +/- a lot

So there you have it. Of course this is just a wild guess from an unqualified guesser of monetary policy. And I’ve certainly been wrong in the past. In fact, before yesterday I thought Chairman Powell might be different. Not Paul Volcker different, but possibly less willing to backstop the financial markets relative to Greenspan, Bernanke, and Yellen. However, after yesterday, I’m now leaning towards more of the same. And I suppose I can’t blame him. Powell inherited a tremendous amount of asset inflation. Similar to a banker with a large book of loans, no one wants to see the loans go bad on their watch (especially if they weren’t the underwriter).

I also believe the recent decline in certain commodities is providing the Fed with some cover to pause. In fact, it’s beginning to feel a little more like 2015-2016. It will be interesting to monitor the impact from the recent decline in energy prices. Similar to the last decline in 2015, will we have another earnings recession? And let’s not forget the high yield market and credit spreads. As can be seen in the charts below, energy prices, along with the health of the energy industry, can have a considerable effect on the economy, the credit markets, and earnings growth.

Source: www.multpl.com

2018 is turning out to be a very interesting year — there are many important variables in motion influencing the profit and market cycles. I’m looking forward to analyzing Q4 2018 corporate operating results to learn more. In the meantime, I’m currently in the process of reviewing recent quarterly results of many of the consumer businesses I follow. I should have an update soon, providing timely information on the health of consumer businesses and trends in consumer spending.

The Bottom-Up Economist Q3 2018 Report

Below is a link to The Bottom-Up Economist Q3 2018 Report. Q3 was a very interesting quarter with some operating trends continuing, while others taking a noticeable turn. Although the report is a very thorough analysis of Q3, given the recent decline in asset prices and hints of a slowdown in certain industries, I’m very alert to possible changes in trends and outlooks in upcoming quarters.

This will be our last quarter publishing The Bottom-Up Report (BUE). My good friend and colleague who was working on the report with me accepted an opportunity that will require significant time and focus. The BUE report includes a tremendous amount of company-specific information — it’s very labor intensive to accumulate and organize. Because of its time requirement, we’ve decided it will be necessary to place BUE in hibernation at this time. We plan to leave the website up and running for those interested in the practice of bottom-up economics, or viewing the economy through the eyes of business.

I continue to believe bottom-up economic analysis is a viable alternative for investors and economists dependent on top-down data. While it won’t be as organized and detailed as the BUE report, I plan to continue providing a quarterly update on the economy based on the operating results and outlooks of my opportunity set (300 name possible buy list).

I’m looking forward to Q4 2018 – it should be a very informative quarter. Will the recent increase in financial instability affect demand and cause corporations to alter their 2019 investment plans and expectations? While it’s too early to know for certain, things are clearly becoming more interesting! As a patient absolute return investor, I’m encouraged and looking forward to learning more.

The Bottom-Up Economist Q3 2018 Report

Happy Thanksgiving!

Got Some Splainin’ to Do

In recent posts I mentioned I was becoming increasingly optimistic regarding future opportunity. Does this mean a sharp decline in stock prices is imminent? I wish I knew, but I don’t. As a bottom-up investor focused on small cap equity analysis and valuation, I remain unqualified to time markets. Regardless of my inability to determine when the bids disappear and the current cycle ends, recent market trends have been encouraging.

When I recommended returning capital in 2016, interest rates were near 0%, inflation was subdued, and global central banks were buying over $2,000,000,000,000 a year in assets (that’s a lot of zeros!). The investment environment has changed considerably since then. A growing number of objective and subjective variables that influence asset prices are in motion, with most indicating the current market cycle’s clock is once again ticking.

Objectively, inflation and interest rates are on the rise. The 2-year U.S. Treasury continues to move higher, reaching 2.95% last week, or up approximately 230 bps from its 2016 lows. Short-term Treasuries have suddenly become very competitive relative to normalized earnings yields of equities and other risk assets.

While some investors point to an improving economy (bullish) to explain rising interest rates, increasing wage pressure and inflation (bearish) have also contributed. From a bottom-up perspective, signs of inflation have been building noticeably over the past year. Labor availability/shortages, wage growth, and company responses (higher prices), are finally beginning to show up in the government data. Given these trends, and barring a consequential decline in asset prices, I believe the Federal Reserve will be forced to continue increasing rates and unwinding their bloated balance sheet. With the ECB in the process of ending QE and the Bank of Japan questioning the effectiveness of its asset purchases, the days of unlimited central bank bids may finally be coming to an end (at least for now).

In addition to influencing monetary policy, inflation is beginning to affect demand in certain industries. For example, several homebuilders recently blamed affordability (asset inflation), higher building costs, and rising mortgage rates as possible reasons for the recent slowdown in demand. While it’s too early to determine if the slowdown in housing (along with other interest sensitive industries) will accelerate, early indications suggest some spillover into corporate earnings could be expected.

In addition to objective variables, such as inflation, interest rates, quantitative tightening, and earnings growth, there are subjective variables emerging that also appear to be influencing the markets. For example, investor sentiment weakened during the Q3 2018 earnings season as investors appeared to be in a less forgiving mood. There are many examples of investors punishing stocks 10-20% in response to lower than expected operating results. For most of this cycle, that wasn’t the case. In fact, I remember many instances when poor results were met with a yawn and in some cases shareholders were actually rewarded!

There are many possible reasons why investors and stocks are behaving differently at this stage of the market cycle. In addition to variables already discussed, sometimes it’s as simple as markets getting tired and falling on their own weight. At higher market caps, and without the price insensitive bid from global central bankers, it’s likely becoming more difficult to muscle asset prices higher.

Another theory I’ve considered relates to the natural rotation of capital that occurs throughout a market cycle. As a portfolio manager who has generated some very good and very bad relative returns, I’ve seen my share of capital inflows and outflows. Inflows often occur after periods of strong performance, while outflows typically occur after periods of poor performance. As I’ve noted in the past, I’ve often been hired when I should have been fired and fired when I should have been hired.

The rotation of capital away from underperforming managers and towards managers with strong performance is nothing new. Chasing top performing managers isn’t much different than investors crowding into the best performing stocks. Similar to stock cycles, the capital transition cycle eventually runs its course as the number of managers remaining to pull capital from dwindles. I call it capital allocation capitulation – when asset allocators give up on a set of managers, style (includes active vs. passive), or asset class. I’ll never forget 1999 when many value managers I respected stepped down or were fired. By early 2000, there weren’t many disciplined value managers still in business! The capital transition cycle was complete, just as the market cycle was about to turn.

Based on the duration of the current market cycle, along with its elevated valuations, I believe a tremendous amount of capital has already been transitioned away from lagging managers. After a raging ten year bull market, many managers unable or unwilling to keep up with their benchmarks and peers have likely been replaced. And even if they’re still around, their assets under management (AUM) have certainly declined. As the market cycle ages, so does the capital transition cycle. Eventually capital becomes concentrated, breadth narrows, and the funds winning the AUM game become increasingly crowded in the “best” securities.

Near the later stages of a market cycle, portfolio managers who apply thorough bottom-up analysis and have strict valuation disciplines, may find it difficult owning the best performing securities. As a result, it is not unusual for disciplined active managers to lag during periods of significant asset inflation and overvaluation. As such, I believe it’s rational to assume much of the capital rotation this cycle has moved away from disciplined active managers and into funds and ETFs that are less analytically rigorous and valuation sensitive.

And this finally gets back to a theory of mine as to why certain stocks are beginning to act differently, especially after reporting weaker than expected operating results. As a portfolio manager, holding a stock that has a large unrealized loss isn’t easy. It requires a tremendous amount of research, analysis, and conviction. It also requires frequent and detailed communication with clients – expect to be grilled during the next quarterly meeting! 🙂

One way to avoid having to defend positions with losses (and time required to know positions well), is to refuse holding them. Why go through the pain when you can simply sell? For funds and managers that are less likely to have the necessary process, discipline, and conviction to defend losing positions, selling can be a tempting and easy solution. And that’s the foundation of my theory. As the current capital transition cycle matures, fewer portfolio managers and investment strategies remain that are willing or able to defend losing positions. As a result, I believe the capital transition cycle has contributed to the rising number of price gaps lower as stocks that require “some splainin’ to do” are sold and forgotten (easy) instead of held and defended (hard).

For patient absolute return investors, the recent shift in investor behavior has been refreshing and encouraging. As capital has moved away from disciplined active managers and into funds or ETFs that have little loyalty or conviction in individual holdings, I’m hopeful the current “gap down” phenomenon in equities increases in frequency and magnitude.

The Four Gross Margin Horsemen

As Q3 2018 earnings season comes to a close, there are several important themes and trends I’m looking forward to discussing in our upcoming The Bottom-Up Economist (BUE) quarterly report. While there were many similarities between Q3 and Q2 2018, there were some subtle, but important shifts in trends. One in particular relates to corporate costs.

I’ve been discussing and documenting rising corporate costs for over a year. While the upward trend in corporate costs continued in Q3 2018, the growth rates of the major cost components fluctuated.

On its Q3 conference call, Tennant Company (TNC) addressed this earnings season’s most frequently discussed corporate costs. Management noted,

“ There are…several macro factors impacting gross margin. These take the form of higher freight costs, raw material inflation, labor shortages that periodically impact productivity and tariffs.”

I thought Tennant’s comments were a good summary of the top four gross margin headwinds most corporations are currently facing: freight, raw materials, labor, and tariffs. The effectiveness of management’s responses to these rising costs is often determining whether or not companies are winning the quarterly “beat the earnings estimate” game. Some companies have done very well by addressing rising costs in an aggressive and timely manner (probably BUE readers 🙂 ). Meanwhile, other companies waited too long to respond and fell behind the rising cost curve (probably government data readers 🙁 ).

While we’ll review the four profit margin horsemen in more detail in our upcoming BUE quarterly report, I thought I’d provide a brief summary of this quarter’s important cost trends.

First, transportation and logistics. Conventional wisdom suggests freight costs are plateauing and will possibly decline as comparisons become easier. While rate increases are expected to moderate year over year, the freight market (and truck driver availability) remains very tight. As such, unless the demand environment changes abruptly, moderation in rate increases can be expected, but not declines.

Second, raw material increases were mentioned frequently again in Q3, but similar to freight, these costs will soon lap higher increases from a year ago. Therefore, assuming there isn’t another leg up in commodity prices, the rate of increase is expected to slow in upcoming quarters.

Third, responses to tariffs increased during the quarter and are clearly inflationary. We’ll spend considerable time discussing tariffs in upcoming reports. There are literally hundreds of examples of how companies are being impacted and responding to tariffs – most are raising prices.

And finally, labor costs. Rising wages and labor availability is a growing issue and is showing no signs of slowing. Therefore, while freight and raw material inflation may be moderating, wage growth remains resilient and elevated. Thanks to a reader who recently sent the following visual example of wages increasing in real time (starting wage at distribution center increased from $15.35 to $16.85 — not bad!).

And from another reader…humorous, but also illustrates the frustration many employers are having finding qualified labor.

In summary, certain corporate costs are moderating (freight and materials), while others remain elevated and are showing signs of accelerating (labor and tariffs). With so many costs in motion, it’s becoming an increasingly tricky environment for those attempting to measure and respond to inflation. In fact, I can’t remember the time in my career when the risk of misjudging inflation has been this high for corporations, investors, and policy makers.

Policy makers are in a particularly precarious position. Underestimate inflation and risk losing the confidence of the bond market and the ability to implement future financial market bailouts (asset purchases). Overestimate inflation and risk bursting this cycle’s asset inflation boom and sending the economy into a recession. It’s quite the predicament.

The unpredictability of inflation and interest rates, in opinion, remains one of the largest risks to asset prices and the popular belief that the next bear market will be promptly rescued by another round of aggressive monetary policy (The V or the L).

While I can’t predict the future, I can see current trends in corporate costs and pricing clearly – they are rising. And if corporate costs and pricing power are on the rise, when and how will these inflationary trends reverse? Is it even possible for corporate costs (especially wages) and inflation to recede without a meaningful decline in asset prices and economic activity? It’s a good question and one I’d be asking myself if I was invested in risk assets.

Based on the valuation of my opportunity set, I remain uninterested in most small cap stocks. Until I believe I’m being adequately compensated to assume risk, I’ll be watching this market cycle age from a safe distance. With inflation and interest rates on the rise (see below), I’m becoming increasingly optimistic in future opportunity.

Short-term Treasury yield update: 3-month 2.34%, 6-month 2.52%; 12-month 2.68%; and 2-year 2.92%.

Capital Guilt Management

It’s that time of the year again. Of course I’m talking about tax loss selling season.

As a fund manager, I tried to avoid allowing capital gains or losses to interfere with my investment process. For example, if I incurred an above average amount of capital gains YTD and had a stock trading over fair value, I’d sell the stock regardless of the tax implications.

My rational was simple. First, I had a healthy mixture of taxable and non-taxable clients. While delaying the sale of an overvalued security would lower the tax bill for taxable clients, it would also increase the valuation risk assumed for non-taxable clients. Valuation risk was and remains the overriding factor. In effect, I believe the risk of holding an overvalued asset outweighs the tax implications of assuming capital gains.

While my process places a greater emphasis on valuation risk than capital gain management, I understand why portfolio managers attempt to avoid sending clients a large and possibly unexpected tax bill. It can be bad for business and in some instances it’s just plain rude!

This year’s capital gain setup is becoming increasingly uncomfortable and possibly awkward for many managers. For most of the year, the equity market was decidedly positive and ripe for assuming capital gains. And after a ten year bull market, there were plenty of gains to take! However, as the current cycle’s legs have begun to wobble, large YTD gains have disappeared and in many cases have turned to losses (50% of the stocks in the S&P 500 are down -20% from their highs).

Imagine for a moment you’re a fund manager invested in many of this cycle’s leading stocks, such as those in the Nasdaq 100 (QQQ). Now imagine it’s September 30, 2018 and your fund is up 20% and you’ve taken considerable gains throughout the year. Although you’re aware of the large tax bill you’ve been racking up, given the fund’s impressive YTD performance, you’re not concerned. Client meetings have been going great — filled with smiles and applause.

Now fast forward to today. The realized taxable gains you incurred earlier in the year are still there, but your YTD gains have disappeared. In fact, your fund is currently showing a loss YTD!!! You’re staring to feel a little guilty and your marketing department is becoming anxious. What do you do? I know one thing you probably don’t want to do — send your clients a large tax bill after losing their money!

The recent market decline is putting a growing number of portfolio managers in a difficult situation. The further the market falls, the greater the pressure on managers to avoid sending clients a tax bill. As such, and assuming the current decline in stocks continues, I expect this year’s tax loss selling season could add additional pressure to many of the market’s laggards.

For patient absolute return investors, this could turn into an interesting opportunity. I have several stocks on my possible buy list that are down considerably YTD that I’m closely monitoring. While I believe the average small cap stock remains expensive, I’m hopeful an amplified tax loss selling season could provide investors with the opportunity to pick up a few discounts heading into year-end.