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.

Disappearing Tenders

Every year since 1978, central bankers, leading economists, and prominent investors, have gathered in Jackson Hole, Wyoming to discuss economic and policy related issues. Considerable research and human capital is allocated to the conference. The research is technical, thorough, and thought-provoking – enlightening stuff for top-down macro economists.

Instead of making the long trip to Jackson Hole this year (my invitation was lost in the mail again!), I attended a slightly less prestigious, but in my opinion, a more valuable economic symposium. It was held in Orlando, Florida a few weeks ago. Leading participants included the parents, coaches, and players of over 50 softball teams.

I’ve always appreciated the demographic and economic diversity of softball families. If you want an update on the stock or real estate markets, you’re better off signing your kid up for a soccer, lacrosse, or tennis tournament. However, if you’re searching for a timely report from the front-lines of the U.S. economy, softball tournaments can’t be beat.

Attendees of softball economic symposiums have experience in a variety of industries and occupations. Presentations are informal and are typically given after games and during team dinners. Topics and Q&A sessions are broad-based, current, and very informative. So what did I learn at this year’s gathering of economic doers? Quite a bit, actually.

The common theme of this year’s symposium (by far) was rising wages and labor shortages. Given this year’s theme, it was fitting the symposium’s dinner was held at an insufficiently staffed Applebee’s. Instead of their normal eight server crew, the restaurant could only find four servers willing to work on this busy Saturday evening. On the bright side, one server per 30-40 hungry customers made for very long, but informative dinner!

My favorite presentation was given by a parent and restaurant manager titled, “Modern Monetary Policy, Labor Costs, and Disappearing Chicken Tenders”. The presentation began with a discussion on the tight labor market and the difficulty in finding adequate labor. As a manger responsible for recruiting, training, and retaining approximately 200 workers, he had a good feel for the current labor market. The manager pointed to the ceiling to illustrate the direction of labor costs, explaining, “These large retailers are picking off my employees by offering $12/hour. They’re trying to upgrade the quality of their workers, but they’re really just raising the costs of the same labor pool for everyone.”

I had a front row seat of the presentation and knew immediately this presenter was an expert on the real economy. Move over PhDs and monthly jobs reports, this is the guy I want to listen to for an up-to-date summary of the labor market. He continued, “And people think these wage increases are somehow free. Nah, not true. What do you think we do when I’m forced to increase wages?” I eagerly answered, “You raise prices!” While I was expecting a “You damn right we do!” he instead replied, “When we can we will, but not always.” He explained, “We have some crazy competitors that will be bankrupt soon if they keep giving food away. But until they go under, it’s tough to raise prices on everything.” I asked, “If you can’t fully offset rising costs with price increases, what are you doing?” He replied, “We cut back.” He provided an example, discussing how the company recently reduced the number of chicken tenders in their chicken salad.

Providing less for the same price is often referred to as lightweighting. When I think of lightweighting, I typically think of a manufacturer using less material or altering a product’s composition. However, lightweighting is a common practice in a variety of products, services (think longer lines and wait times), and industries – including restaurants.

As a young analyst, I’ll never forget the first time I listened to a management team explain their lightweighting strategy. I was on a conference call of a leading trash bag manufacturer. The manufacturer explained how it planned on offsetting rising resin costs by reducing the number of trash bags in each box. An analyst on the call pointed out the obvious, “This strategy doesn’t seem sustainable. At some point you won’t be selling trash bags, you’ll be selling empty boxes.” Management acknowledged the analyst’s logic stating, “You are quite right. Next question please.”

Whether it’s trash bags or chicken tenders, the key to successful lightweighting is to reduce the quality or quantity of a product (or service) without it going noticed. I asked the restaurant manager if anyone noticed the missing chicken tenders. He said he was aware of one complaint, but explained, “So I have one guy notice there’s less chicken in his salad. That’s not nearly as bad as the response I’d receive if we raised the price of the salad by a dollar.”

His comments caused me to think about the government’s inflation data and how it’s calculated. Specifically, does the U.S. Bureau of Labor Statistics (BLS) account for lightweighting? If so, do they go as far as counting the number of chicken tenders in a salad? It’s an interesting question that few presenters at our softball economic symposium were qualified to answer (myself included).

The restaurant manager’s Q&A session eventually concluded and was followed by presentations from a retail maintenance manager, electrician, and truck driver. All supported the theme of this year’s symposium – the labor market is very tight and wages are rising. However, to be fair, there were other presenters who were less supportive of a strong job market, including a marijuana stock day trader and absolute return fund manager — both were unemployed!

Whether it’s in the form of rising prices or disappearing chicken tenders, there is growing evidence that companies are taking action as it relates to higher corporate costs and rising wages. It’s an environment I’ve been reporting on consistently over the past year and it’s why the Federal Reserve has been forced to raise rates and implement quantitative tightening. Until something in the financial market breaks (consequential asset deflation), I continue to believe the trend in short-term interest rates will remain higher. As such, patient investors, in my opinion, will likely remain the beneficiaries of either higher rates or lower equity prices (Patience – A Possible Win Win).

The BUE Consumer Report

Based on the valuations of my opportunity set, I’ve been bearish on small cap stocks. However, unlike your typical bear, I haven’t been negative on the economy – at least over the past year. In fact, I’ve been relatively positive on the operating environment for most small cap businesses. I began noticing the improving economy, along with rising wages and corporate costs, during the second half of 2017. Since then, the majority of the businesses on my possible buy list have performed well.

One of the interesting aspects of rising growth rates throughout 2017 and early 2018, was how consumer companies lagged their more cyclical peers (in growth and pricing power). Companies involved in transportation, energy, heavy industry, and construction, generated noticeably higher growth rates. However, the dispersion between cyclicals and consumer businesses appears to narrowing as organic growth of many consumer businesses has risen throughout most of 2018.

To help readers analyze the current consumer operating environment, The Bottom-Up Economist published a report today detailing the economy through the eyes of consumer businesses.

The report, on average, was slightly more positive than I expected. In fact, it was so positive, I reached out to my former analyst and BUE colleague and asked, “Are consumer businesses really doing this well, or have you been reading Tony Robbins again?” He replied, “Funny. But this is what our companies are reporting and what managements are discussing.” I responded, “With interest rates increasing, corporations responding to tariffs, and financial instability on the rise, our next consumer report may not appear as rosy.” He agreed, but reminded me that we are bottom-up economists, not economists for a sell-side firm. As such, it isn’t our job to predict the future or mold a narrative to fit our business needs. We should avoid subjectivity and describe the environment as it is, not as we want it to be. As bottom-up economists, we are simply relaying what businesses are reporting and communicating. In effect, we are messengers of real world economic data, company forecasts, and the opinions of management (but never ours).

Although I knew my BUE colleague was right, I remained reluctant to publish a bullish report on the consumer. My hesitation is likely a result of my history with asset bubbles. I know all too well what happens to the economy and consumer spending when an asset inflation boom abruptly turns to bust – consumer demand plummets.

With the financial markets finally responding to the sharp and consistent increase in short-term interest rates, I’ve become increasingly confident in my belief that the clock on the current market cycle is ticking (Tick Tock). As such, I’m also growing more concerned about the future operating results of many of the small cap businesses on my possible buy list.

While interest rates remain very low, there are already early indications that demand for large ticket items may be moderating. Although there are few signs of sharp declines, as Lennar (LEN) recently reported, home sales (I’d also include autos and RVs) may be taking a “pause” as sales and traffic trends slow. The degree and duration of any consumer pause remains unclear, but it is something I plan to monitor closely during the current earnings season. I’m also very interested in how companies are responding to rising interest rates, tariffs, wages, and inflation.

Speaking of inflation, last week the CPI and PPI reports came in low and below expectations. The Consumer Price Index only increased 0.1%. While I don’t analyze the government’s inflation data closely, a headline alerted me to the fact that according to the government’s data, used car prices declined -3% in September, or the most since the 1960s! The headline caught my attention as I just read CarMax’s (KMX) conference call, which described a different used car pricing environment. On the call, management did not talk about used car deflation, but instead was surprised by how well prices were holding up.

Management explained, “…we’ve seen unusual depreciation curves. In other words, normally, you see continued depreciation during this time of year, and we just really didn’t see that. It’s very different than in past years. It’s been very flat.”

Management had an interesting explanation as to why used car prices haven’t declined, stating, “I think there’s probably — and, this is just my belief — some of what’s driving that may be anticipation of tariffs on new cars and people speculating and trying to buy up used cars, but to be honest with you, I don’t really know why that is. New car prices are obviously still as high as ever, and they continue to go up.”

Bloomberg also picked up on the dispersion between the government’s data and other measurements of used car prices. In the article “Used-Car Price Plunge in CPI Contrasts with U.S. Industry Data”, Bloomberg pointed to the Manheim Consulting’s Used Vehicle Value Index, which set a record for the third straight month. Bloomberg quoted Stephen Stanley, a chief economist, who said, “This is one of the weirdest CPI reports that I can remember.” He went on to state the government’s used car data was “entirely at odds with the underlying reality in that market.”

Based on my bottom-up observations and analysis, I’m not convinced inflation is as low as advertised. And I’m not alone. While turning on CNBC last week to assess the media’s reaction to the recent stock market decline, I unexpectedly caught an interesting interview with Tilman Fertitta, CEO of Landry’s and owner of the Houston Rockets.

As a CEO and operator in the economy, Mr. Fertitta is very aware of rising costs and prices. As such, it shouldn’t be a surprise that he doesn’t buy into the “no inflation” narrative. In addition to pointing out wages are rising, Mr. Fertitta discussed his disagreement with the Federal Reserve’s view on inflation, stating, “People say there’s no inflation, but why does it cost us more to go to a restaurant, more to buy a car, more to stay in a hotel like this? There is inflation out there, and that’s where I disagree with the Fed.” Mr. Fertitta’s views on inflation are very similar to other CEO’s and management teams as we described in the BUE Inflation Report.

In summary, based on operating results released to date, many of the trends discussed in our Q2 2018 report, such as improving consumer demand and rising inflation, remain intact. Nevertheless, with many economic and market variables becoming increasingly volatile and uncertain, I believe the next two earnings seasons will be extraordinarily important and informative. I’m very interested in gathering timely information and data on inflation, wages, tariffs, and rising interest rates.

We plan to release our Q3 BUE quarterly report in November. I expect it to contain a tremendous amount of interesting and useful information. Until then, I hope everyone enjoys The Bottom-Up Economist Consumer Report.

The “V” or the “L”

With inflation and interest rates on the rise, I’m becoming increasingly optimistic about the winding down of the current market cycle. Based on my macro views – derived from the bottom-up analysis of my opportunity set – I expect the Federal Reserve to continue raising interest rates (barring a sharp decline in asset prices). As the picture I took last week illustrates, the economy is showing classic signs of late-cycle strains, especially as it relates to wages and labor availability.

How long can rising interest rates and elevated equity valuations live in harmony? It’s a great question, and possibly the most important question for investors attempting to ride the cycle a little longer. Although I don’t have the answer, each basis point increase in risk-free rates applies stress to balance sheets, the economy, and the justification for owning risk assets. However, for now, the Federal Reserve’s gradual approach to raising rates appears to be going relatively smoothly. Similar to past cycles, rising rates may appear inconsequential for months or even years, and then one day investors wake up to discover everything has changed (it is true, they don’t ring a bell!).

As has been the case in previous cycles, once the unexpected occurs and asset prices decline, central banks will likely end their attempt to normalize and reverse course. After the last market cycle ended, the Federal Reserve slashed the fed funds rate from 5.25% in July 2007 to near 0% in December 2008. Other emergency responses, such as quantitative easing, were also implemented.

As the Federal Reserve slashed interest rates and purchased trillions of dollars of assets, financial markets responded in a “V” shape fashion – rebounding sharply and relatively quickly. While the financial pain resulting from the last cycle’s decline was severe, the Federal Reserve’s put option was effective in limiting the bear market’s duration.

Although I’ve been critical of the Federal Reserve from time to time, I’ve also benefited from their policies. Over the past twenty years, the extraordinary booms and busts caused by easy money have also created opportunity. For instance, after being conservatively positioned leading up to the end of the last cycle, the market’s sharp decline in 2008 and 2009 allowed me to rotate out of cash and into attractively priced small cap stocks. Due to the Federal Reserve’s decision to lower rates and purchase assets, many of the stocks I acquired in 2008-2009 rose sharply shortly after purchase. In hindsight, I was very fortunate – the cycle’s trough could have been considerably worse and lasted much longer.

While the last bear market was shortened by extremely accommodative monetary policy, there are no guarantees future bear markets will act similarly. For instance, what if during the next bear market 0% interest rates and central bank asset purchases are less effective or even counterproductive? While such a scenario seems implausible today, considering current trends in inflation and fiscal deficits, a less cooperative bond and currency market may be something investors should consider, if not expect.

Assuming central bank policies lose some or all of their effectiveness during the next bear market, I believe it’s possible the end of the current cycle could look more like an “L”, instead of a “V”. Given current valuations and trends in equity markets, investors do not appear overly concerned about the Federal Reserve’s ability to revive asset prices during the next market decline. And why should they? Over the past twenty years, many investors, including the “buy and holders”, have been conditioned and rewarded for assuming all bear markets and recessions will recover quickly and in a V-shape manner.

While investors have been conditioned to expect the next bear market to be short-lived, I’m positioning and preparing for either the “V” or the “L”. To properly prepare, I believe it’s important to understand the differences between today’s cycle and past cycles and how these differences could influence absolute returns in a variety of bear market scenarios.

In my opinion, and based on my opportunity set, one of the most glaring differences between the current market cycle versus past cycles is corporate balance sheets. During the last bear market (2008-2009), there were significantly more businesses on my possible buy list with strong balance sheets. Many of the stocks I purchased had zero debt and limited liabilities. Today, many of those same businesses have increased their financial risk by taking on debt, often to fund stock buybacks and acquisitions.

The energy industry is an interesting example. Energy was an area I was finding tremendous value during the financial crisis. During the first half of 2008, many energy companies were selling at significant premiums to the replacement cost of their assets. Later in 2008, as oil crashed from $147/barrel to $33/barrel, large premiums quickly turned to deep discounts. As such, I became an enthusiastic buyer. In fact, the energy weight in the absolute return portfolio I was managing increased from practically nothing in early 2008 to approximately 20% in March 2009.

The energy companies I purchased during this period shared an important characteristic – they all had strong balance sheets. Patterson-UTI Energy (PTEN), a market leading onshore drilling and pressure pumping business, is a good example. In 2008, Patterson had a very strong balance sheet with no debt and $81 million in cash. During the crash, I was confident their liquidity and lack of meaningful liabilities would allow the business to survive a prolonged recession and energy bust.

Patterson’s balance sheet looks much different today. Mainly due to acquisitions, Patterson’s net debt has risen considerably since its debt free days of 2008. During the next cycle bust, the decision to buy Patterson will not be as easy, especially for absolute return investors attempting to avoid combining operating risk and financial risk.

In my opinion, the strength of corporate balance sheets will be a very important variable to monitor during the next market and economic decline. Assuming the end of the cycle resembles an “L” rather than a “V”, companies with strong balance sheets will likely have a tremendous competitive advantage over their more leveraged peers. Who wants to do business with a company nearing bankruptcy? And for investors, fifty cent dollars in bear markets are nice, but if your investment doesn’t have the balance sheet to survive a prolonged recession, attractive valuations and healthy margins of safety can quickly become irrelevant.

In order to successfully navigate through the next bear market and recession, investors may find it valuable categorizing potential buy ideas by balance sheet strength. In fact, I’ve recently put together a list of “A” balance sheets, or companies I believe will survive an extended market decline and recession.

Whether or not high-quality businesses go on sale will likely depend on the severity and broadness of the next bear market. Given the current breadth of overvaluation this cycle (including high-quality stocks), I’m optimistic investors seeking liquidity will eventually be forced to sell the good along with the bad. If so, I will be ready.

As I prepare for the end of the current market cycle, I want to be properly positioned for either the “V” or the “L”. While a sharp recovery in asset prices appears to be the most popular and preferred shape of the next bear market, history shows every cycle is different. With trends in inflation and fiscal deficits on the rise, the market’s response to the next round of ultra-easy monetary policy is becoming increasingly unpredictable, in my opinion. In fact, assuming the next bear market will behave like the last could be as costly of an assumption as believing the current bull market will never end.

Tick Tock Where Does the 2-Year Stop?

It’s been an interesting two weeks of macro inflation headlines. On September 7, the Bureau of Labor Statistics (BLS) reported average hourly earnings increased 2.9%, or the largest year over year increase since 2009. Meanwhile, the Fed’s Beige Book was released last week, highlighting the difficulty companies are having finding sufficient labor. The report stated, “Labor markets continued to be characterized as tight throughout the country, with most Districts reporting widespread shortages.”

The picture below (provided by a reader) is one of the many help wanted signs sprouting up across the country. Based on company reports and commentaries, entry level positions continue to be difficult to fill and are often paying well above minimum wage. These are similar to the wages Jesse Felder and I discussed in his podcast on inflation. In effect, we weren’t crazy after all — $12 to $15 an hour appears to be the new minimum wage in many regions.   

With the latest reports on labor confirming wages are indeed rising, I was beginning to believe the market’s “Inflation Recognition Moment” was finally approaching. However, just as I was getting my hopes up, last week’s PPI and CPI reports came in below expectations (PPI -0.1% and CPI +0.2%).

Shortly after the PPI was released, a reader asked, “Shouldn’t the inflation you’ve been writing about show up in the PPI?” I responded, “After I saw the PPI declined -0.1% I emailed my former analyst and asked him to name one producer experiencing lower costs. He couldn’t think of one. And I couldn’t either!”

In effect, the corporate cost trends I’ve been documenting over the past year do not appear to be reversing. That said, I remain open-minded to changes in inflationary trends, especially if the dollar rises sharply (similar to 2014) or asset prices collapse. However, based on my bottom-up analysis, real world inflation in wages and operating expenses continues to be a common theme for many businesses.

Since I began noticing rising corporate costs in 2017, the 2-year Treasury yield has increased considerably. I continue to be amazed by the 2-year’s determination to march higher, not to mention its steep slope. It’s one of the most exciting, underreported, and important trends in the financial markets, in my opinion. 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.

During the past two market cycles, the 2-year Treasury yield topped near 5-6%. Can short-term rates reach similar levels this cycle? While I believe current trends in the labor market and inflation support mid-single digit interest rates, the U.S. government’s fiscal position is much weaker this cycle. In 1999, the United States was generating a fiscal surplus vs. a deficit of $895 billion during the first 11 months of fiscal 2018. And in 2007, federal debt was significantly lower ($9 trillion vs. $21 trillion today or 62% vs. 107% debt to GDP). Based on current debt levels and fiscal deficits, can the U.S. afford a doubling of its interest expense?

And what about asset valuations? It will be very difficult to justify 3% normalized earnings yields on equities assuming 2-year Treasuries are providing 5-6% yields – not to mention the trillions of dollars of other investment decisions made while interest rates were pegged near 0%.

Of course, many investors believe the 2-year Treasury will never reach previous cycle yields of 5-6%. In addition to there being too much debt, the Federal Reserve has become increasingly sensitive to financial instability and the consequences of deflating asset bubbles. Maybe so, but someone needs to tell the 2-year and rising inflationary trends – they don’t appear to be listening.

In my opinion, the maximum 2-year interest rate the market can withstand will ultimately determine when the current cycle ends. If asset prices can hold together until 5-6% yields are reached, the cycle could last another two or three years (assuming the continuation of gradual rate increases). Or maybe the peak 2-year rate this cycle is near current levels. I really don’t know, but I continue to watch the 2-year closely as it marches higher without interruption or concern. In essence, I view the 2-year yield chart as my market cycle countdown clock. After being stuck for so many years (2009-2016), it’s nice to see the clock is ticking again!


To summarize and highlight many of the inflationary pressures the companies in corporate America are experiencing, we recently released a new report on The Bottom-Up Economist. For those who haven’t subscribed, you can find the report on the following link (BUE September Report).

Thanks for checking out our new website and all of the feedback – it’s been very helpful. If you have any questions or would like to submit a request for future reports, please contact us at

Would You Rather with Warren Buffett

While working as a fund manager, I often watched Bloomberg TV at night to see where the futures were trading and if I missed any news after leaving the office. Out of habit and curiosity, I continue this routine today. On a recent and relatively uneventful evening, a portfolio manager was interviewed and asked about her opinion on the stock market. Her hedged response caught my attention. Specifically, the portfolio manager said she was “structurally constructive and tactically cautious”. Is this bullish or bearish? I couldn’t tell, but I wrote it down for the next time I’m asked an uncomfortable question.

Whether right or wrong, I’ve always respected investors with strong opinions. And there are certain investors whose opinions I always appreciate and seek. Opinions that you know you can trust and are unbiased. For most value investors, including myself, Warren Buffett comes to mind.

For those who missed it, I recommend watching Warren Buffett’s Bloomberg TV interview from last week. He was interviewed while visiting New York to dine with the winner of his annual lunch auction. The winner paid $3.3 million to have lunch with the Oracle of Omaha. Fortunately, I didn’t need to pay $3.3 million for Mr. Buffett to answer a question I’ve been eager to ask.

Specifically, David Westin of Bloomberg TV asked,

“One of the things you look at is the total value of the stock market compared to GDP. If you look at that graph it’s at a high point, the highest it’s been since the tech crash back in the late 90’s. Does that mean we’re overextended? Is it a better time to be fearful rather than greedy?”

What a great question, I thought. I couldn’t wait for his answer. Let him have it Warren! It’s your favorite valuation metric flashing red – tell everyone how expensive stocks have become! I was very excited to hear his response.

He replied,

“I’m buying stocks.”

Shortly after his response a red breaking news headline appeared on Bloomberg announcing, “Buffett: I’m Buying Stocks”. It wasn’t the answer I was hoping for or agreed with, but how can you argue with Warren Buffett? He’s a value investor many of us admire and strive to emulate. No one starts a client meeting with, “Hi, I’m a value manager and disagree with Warren Buffett. Please send me your money”.

The interview continued with Mr. Buffett discussing his long-term perspective, saying,

“I’m not buying them because I think they’re going up next year. I’m buying them because I think they’ll be worth quite a bit more money 10 years or 20 years from now. I don’t know if they’ll go up or down tomorrow, next week, next month, or next year. I do know they’re good businesses.”

In other words, if you hold high-quality stocks long enough, you should do well. Or at least relative to bonds. Warren Buffett explained,

“You have to measure investments in relation to each other. And your alternative for most people is fixed income and you get 3.02% or something like that for 30 years. So would you rather invest in a company which is earning 15 or 20 percent on their invested capital and compounding or would you rather have a 3% bond which could never earn more than 3%?”

A game of “Would You Rather” with Warren Buffett – how exciting! Unfortunately, Mr. Westin of Bloomberg didn’t play along. Nevertheless, I think it’s an important and timely “Would You Rather” question for investors. Specifically, at today’s prices, would you rather buy high-quality stocks or long-term bonds?

Based on how the question was phrased, the answer seems obvious. Of course I’d rather own an investment compounding 15% to 20% per year than a long-term bond yielding 3%. Who wouldn’t? However, it’s not that simple. More information is needed.

What about price? Even good businesses can be poor investments assuming one overpays. Just look at many of the high-quality stocks in the late 1990’s. Or how about the Nifty Fifty in the 1960’s? To make an informed decision and avoid overpaying, we must know the price we’re paying for these high return on capital businesses.

Based on my analysis of the stocks on my possible buy list, I believe high-quality businesses, on average, are very expensive. WD-40 Corp (WDFC) is an excellent example. Although I consider it a good business with superior returns on total capital and equity (41% ROE), its stock is trading near 43x earnings and 6x revenues. As an absolute return investor, what is more important, the company’s ROE of 41% or its earnings yield of 2.3%? Regardless of WD-40’s above average return on capital, I’m avoiding its stock and consider it expensive.

In addition to price, I believe it’s important to consider the cyclical influences on return on capital. At this stage of the profit cycle there are many companies generating attractive returns. And it’s something we addressed in our most recent The Bottom-Up Economist report – on average, operating results for most businesses are favorable. However, acknowledging profits and returns on capital are healthy is not the same as acknowledging stocks are attractively priced. This is especially true if profits and returns on capital are unsustainable or near peak levels.

For example, Fannie Mae (FNM) was generating attractive returns on equity capital during the housing boom (averaging 15.8% ROE 2004-2006). Many investors believed the company’s retained earnings could be reinvested at double-digit returns on equity indefinitely. At least until the housing bubble popped. In Fannie Mae’s case, historical returns on capital were not an accurate guide of future returns.

To properly answer Mr. Buffett’s “Would You Rather” question, I’d also like to know if the 15% to 20% return on capital is on existing capital or on the reinvestment of new capital. There’s a big difference, especially as it relates to compounding. Currently, I’m aware of many companies generating 15% to 20% on existing capital, but fewer that can generate those type of returns when reinvesting profits. It’s one of the reasons so many companies have turned to buybacks and dividends. With a limited number of high return on capital projects, a large portion of free cash flow this cycle has been returned to shareholders.

Stock buybacks are an interesting topic as it relates to return on capital. As corporations spend hundreds of billions on stock repurchases each year, how have return on capital metrics, such as return on equity (ROE), been impacted? Given the amount of buybacks this cycle, is return on equity a reliable measure of business profitability and future returns on reinvested capital?

A good example is Altria (MO), which has reduced its balance sheet (capital) considerably over the years with significant buybacks. It currently has an extraordinarily high return on equity of 75%. It’s difficult to imagine Altria reinvesting profits into the business and earning 75%. Again, for compounding purposes, it’s important to differentiate between return on existing capital and return on reinvested capital. For many companies, including Altria, these are two very different numbers.

And finally, to properly answer Mr. Buffett’s Would You Rather question, I’d like to clarify if stocks and long-term bonds are our only options? Is patience also an option? Asked differently, instead of buying stocks generating an uncertain 3% normalized free cash flow yield, would you rather buy a 6-month T-bill yielding a certain 2.29%? I know what I’d rather own.

It’s been a difficult cycle for disciplined value investors. I’ve spoken with many and I can tell you they are tired, very tired. And I understand how many professional investors need a reason to own stocks regardless of price and valuation – fully invested mandates require it. Owning high-quality businesses generating high returns on capital sounds reasonable. And I’m certainly not qualified to disagree with an investment legend like Warren Buffett. But in this case, or this particular game of “Would You Rather”, I’m not buying stocks and will instead buy the long-bond yielding 3%. However, as soon as I buy the bond, I’m selling it and trading it in for a T-bill. 🙂

The Bottom-Up Economist

In my attempt to limit large valuation mistakes, I prefer normalizing cash flows instead of extrapolating recent corporate operating results far into the future.  My preference for normalizing is based on my belief that profit margins and earnings for most businesses are cyclical – influenced by credit and economic cycles. In effect, normalizing helps me avoid valuing businesses on peak or trough cash flows.

To normalize cash flows, it’s important to know where you are in the profit cycle. As such, it’s also important to have an opinion on the economic cycle. As regular readers know, I avoid using government economic data to form my macro views. Instead, I prefer viewing the economy through the eyes of business. Specifically, my economic and profit cycle opinion is developed through the analysis and aggregation of hundreds of company reports and management commentaries.

By focusing on the most recent corporate operating results and management discussions, I believe I’m better able to form a more timely and accurate assessment of the economy versus relying on government data, which is often adjusted and revised multiple times after its initial release. Because the bottom-up data is so fresh and is based on real world operating results and outlooks, I also believe I’m better equipped to discern macro trends before those who rely on government economic data (recent examples include consumer slowdown in 2016 and uptick in inflation in 2017-2018).

Since Q2 2017, I’ve been providing readers with a quarterly summary of the current operating environment of the businesses in my opportunity set (300 small cap stocks). With the help of my former analyst, this quarter’s format has changed and has been placed on a new website.

In an attempt to improve the report, we generated a more detailed and comprehensive summary that incorporates my quarterly review process along with many of the larger cap companies my analyst follows. It’s our attempt to provide an alternative for investors and economists who remain highly dependent on government data to form their macro views and forecasts.

We’re very happy with how the report turned out. We put a lot of work into it and we’re hopeful readers will find it useful. We’ve also completed past quarterly reports since I’ve been providing summaries (beginning Q2 2017). These reports can be found on the website (The Bottom-Up Economist). Given the reports length (19 pages), we include a summary and tear sheet for those who do not have time to read the supporting data and commentary.

I provided a link below to download the report. Your feedback is always welcome and appreciated!

The Bottom-Up Economist Q2 2018 Report

Diverging Inflation Narratives

I was watching Bloomberg TV yesterday and a portfolio manager was asked about his current market outlook. He started by saying earnings growth is strong and inflation is subdued – a ripe environment for higher stock prices. This morning I read the following quote from James Bullard of the St. Louis Federal Reserve, “I just don’t see much inflation pressure”. Meanwhile, hundreds of companies in multiple industries are openly discussing the current inflationary environment, price increases, and a tight labor market. It’s as if Wall Street, the Federal Reserve, and corporate America live in different worlds.

It’s been approximately a year since I began noticing and writing about shifting inflationary trends (from a disinflationary environment in 2015-2016 to an inflationary environment in 2017-2018). While inflation has received more attention over the past few months, many investors and policy makers continue to assume inflation remains low and its recent uptick is temporary. With the dollar rising and certain commodities in decline, I’m open-minded and alert to another reversal in inflation (similar to late 2014); however, to date I am not seeing it. In fact, Q2 2018 operating results and outlooks support my belief that inflationary pressures are not subsiding, but are persisting and even spreading.

Rising average prices (see recent retailer earnings reports) are allowing many companies to pass on higher costs and grow revenues. Investment bankers beware. Companies may discover growing revenues through price increases is easier than taking on debt and acquiring. Price increases carry lower risk and are not capital intensive – better for margins and the balance sheet!

As price increases become more prevalent and acceptable, companies are becoming more comfortable asking for seconds and even thirds. As stated in past posts, inflation psychology is changing. In effect, it’s no longer poor business etiquette to ask for a price increase – it’s rational and understood.

Tariffs are also contributing to inflation and revenue growth. In fact, I’m beginning to wonder if tariffs are a clever way to grow sales and nominal GDP (and real GDP if inflation is underreported). Many management teams recently communicated their intentions to raise prices further assuming additional tariffs are implemented. For business, tariffs are just one more item they can point to justify raising prices.

Based on my bottom-up analysis, I believe the disparity between Wall Street and corporate America’s inflation narrative is growing. Furthermore, unless asset prices decline and the economy slows, I do not expect inflationary trends to reverse in Q3 2018. Company commentary and outlooks suggest the inflationary pipeline remains healthy and full. As such, I expect the Federal Reserve will continue to raise rates and proceed with its quantitative tightening (again, barring a sharp decline in asset prices – then all bets are off). As I wrote in Patience a Possible Win-Win approximately one year ago, I believe patient investors will either be rewarded with lower asset prices or higher interest rates. This continues to be the case, in my opinion.

Regardless of your views on inflation, I thought readers may be interested in learning how my macro views on corporate costs and pricing are developed. Instead of relying on government economic data, I prefer viewing the economy from the bottom-up, or through the eyes of business. Today I intended to list many of the inflation examples I noticed in my latest quarterly review, but the list was too long (near 100 examples and over 40 pages). If you’d like to learn more (especially if you “just don’t see much inflation pressure”), please shoot me an email and I’ll send some interesting and possibly enlightening weekend reading.

Thanks to a reader for picture/example of inflation psychology shift!

Hurts So Good

Near the later stages of a market cycle, if I don’t feel stupid and my portfolio doesn’t hurt, I’m probably not positioned appropriately. With short-term interest rates rising considerably over the past year, my patient positioning is beginning to feel a little too comfortable. At this stage of the cycle, I should be suffering more. As such, I recently reintroduced a painful position to my absolute return portfolio – a precious metal miner.

For asset managers who are currently experiencing shiny-happy performance and congratulatory client meetings, a beaten-down miner may be just the thing needed to scratch that contrarian itch. From a personal perspective, I’ve found a good time to make uncomfortable changes to a portfolio is often when performance looks best. And there’s nothing like a precious metal miner to create the right amount of angst and discomfort!

For most of the current market cycle, the only thing more painful than holding cash has been the precious metal miners. I held several miners in 2014-mid 2016. The pain was excruciating. At one point, the miners I owned were down -30%+ after they had already declined 50-60% at the time of purchase! It was the most challenging and controversial position I’ve ever taken. Frankly, I hated it. But value is value. And as many seasoned investors will attest, the best values are rarely presented as beautiful bouquets.

I wouldn’t be human if I didn’t feel reluctant to readminister the pain. To help me cope, I started with a small weight and plan to add to the position slowly as the price declines and discount to value increases. My slow and steady approach to positioning is based on experience. Historically, once I’ve determined commodity stocks are cheap, they typically become much cheaper! Picking the bottom in commodity stocks is extremely difficult – at least for me – so I prefer buying small positions and averaging down.

Another thing I’ve learned about commodity stocks is investors love or hate them – rarely do they remain near their valuation equilibrium. With such wishy-washy investor psychology, one can expect volatility and violent booms and busts. While the commodity prices themselves are partially responsible, I believe popular valuation techniques also contribute to volatility.

Many analysts use cash flow metrics to value commodity businesses, such as EBITDAX. Although cash flow is important, when attempting to value a commodity business with a high degree of confidence, I’ve found future EBITDAX to be too uncertain and volatile.

Early in my career I decided to part ways with EBITDA valuations. Capitalizing depreciation or depletion has never made sense to me, especially for commodity businesses (reserves must be replaced to stay in business). Instead of cash flow, I prefer using a less volatile valuation technique for asset-heavy commodity businesses. Specifically, I use replacement cost. In effect, my goal is to buy a dollar of reserves (oil, natural gas, gold, timber, etc) at a discount to the cost required to replace those reserves.

For example, if it costs $300 to find and develop an ounce of gold and I can buy a proven and developed ounce for $150 in the equity market, I’m interested. Focusing on developed mines with a sufficient history in production and operating costs can also reduce risk. Accumulating reserves by building a new mine often comes with uncertain production, operating costs, and financing. In effect, instead of taking the risk of building a new mine, I’d rather buy the reserves of a developed and operationally efficient mine selling at a discount. And that’s what I’m finding today in the mining sector. Proven and funded mines that are selling below the cost to find and develop their reserves.

To be clear, commodity businesses, such as miners, are very risky and carry tremendous operating risks. As such, I focus on commodity businesses with strong balance sheets that I believe can survive a prolonged period of depressed commodity prices. It doesn’t matter if you can buy an asset-heavy business at a large discount if the company doesn’t have the balance sheet required to survive the cycle. I’ve seen many commodity companies worth much more than their stock price go bankrupt in commodity bear markets. They simply ran out of time and liquidity. Ideally, I prefer commodity stocks and miners with no debt, but they’re almost as rare as the metals themselves!

With extreme pain and discomfort, I’m back in the precious metal miners (or I should say miner). Similar to past experiences with commodity stocks, I’m assuming the miners will continue to fall and I will not be able to time their bottom perfectly. My plan is to gradually add to the position during the decline, but will not exceed my pain threshold. In addition to my pain threshold, my weight will likely be limited by the number of small cap miners that pass my balance sheet requirements and other guidelines (mine locations, all-in costs, reserve life, etc.).

While the introduction of miners (or miner) will likely hurt in the near-term, given my patient positioning, I like the idea of owning asset-heavy businesses selling at a discount. In effect, I view my recent miner purchase as an investment and a hedge. A hedge against the Fed falling behind the curve (before the cycle ends) and a hedge against future central bank asset purchases (after the cycle ends).