Blueberries, Blowups And Babies
No, we did not run out of titles. With a complex set of issues overhanging the markets, we felt a somewhat puzzling title was fitting. Market participants appear confused, with polarized views as to whether the investment outlook is promising or ominous.
The wicked combination of surging demand and supply constraints has created imbalances causing unwanted inflation. Though a minor and anecdotal example, blueberries have risen in price and, worse, been absent altogether on several occasions from our local grocery store shelves.
Despite the dramatic rise in the inflation rate, the stock market has blown up, in a good way, rising to new all-time highs—in bubble-like fashion in certain sectors, reminiscent of the dot-com period—the lift in the markets since the pandemic lows driven by economic expansion and the strong earnings recovery. More recently, fearing excessive prolonged inflation, central banks around the world have begun to tighten monetary policies. In reaction, mostly to rising interest rates, many stocks have blown up, not in a good way—some declining materially from recent highs after reporting results that were poor or that simply didn’t meet overly optimistic expectations.
During the last economic cycle, from the Great Recession of '08/09 to 2020, developed countries around the world grew at a below-average pace. Poor demographics are partly to blame, inhibiting population growth. Too few babies have been born in the last number of years. Last year, the U.S. suffered the lowest population growth rate since 1776 (meaning ever). This does not bode well for the overall growth outlook.
Good, Bad, or Otherwise
A bit of inflation is good. Deflation is certainly less desirable. So monetary authorities, in response to the pandemic, pushed all their available levers to spur growth and reignite inflation. But now we’re left with a bit too much of a good thing.
Our pocketbooks will be impacted by higher prices for goods and services. Consumers may have to cut back on their blueberries, despite the fact that they’re extremely good for you. Though, just like broccoli and brussels sprouts, some people don’t care about what’s good for you. Perhaps they’re the same ones who’ve ignored the risks associated with overvalued or speculative (meme) stocks.
Blowups in the market can be good too. To profit on the upside and, though it doesn’t feel that way when it’s happening, normalization, on the downside—a cleansing which provides better investment opportunities. We don’t view the recent correction as the herd panicking. It appears to be normal course selling—profit taking—reactions to full valuations, or to ones that were extreme, and a pricing-in of higher interest rates and the likelihood of slower economic growth.
Our job, as asset managers, is to distinguish the wheat from the chaff, the signal from the noise, the baby from the bathwater. Babies are definitely good for you. Baths too. Bathwater, perhaps, not so much. And, in overall market corrections, when selling often becomes indiscriminate, especially near bottoms, the market tends to discard even high-quality stocks—throwing those beautiful babies out with the bathwater. We stand ready to catch them.
Market participants have been selling before gains go down the drain. Our recent mantra has been “Sell the rallies” not “Buy the dips” because we’ve been expecting much more than a dip. That’s not to say that we’ve been expecting a recessionary-based bear market—prolonged and pronounced negative returns while underlying values are falling. We’ve been anticipating a correction, albeit maybe a substantial one, since prices started falling from levels that were above our estimate of fair market value (FMV). With intrinsic values rising, it should ultimately provide confidence and temper declines because prices should only drop so far while underlying fundamentals are strong and values are increasing, catching up to prices.
An alternate title for this letter could have been “Disruptions, Debt and Demographics.” It's been the interplay of supply-chain bottlenecks during a demand spike, spurred by burgeoning debt, which has ignited inflation. And these same factors, along with prevailing demographics, should be at the root of the slower growth and disinflation that we expect in the months and years ahead.
Prices have lifted for cars (used ones too), houses, food, gasoline (led by oil), and just about anything commodity related. Core PCE, the broadest inflation measure, grew by a hefty 4.9% for December. Though, excluding Covid-sensitive items, it was a more restrained 2.4%. Both, much lower than the recent CPI figures above 7%. Thankfully, we are starting to see a leveling off in commodity prices. And in this area, high prices always bring about higher production which in turn lowers prices—a self-correcting mechanism.
Inflation has spiked, along with economic growth, because demand surged just after supply was dormant. Price rises were further heightened because of shortages relating to limited manufacturing capacity, clogged ports, flooding, droughts, and a shrinking labour pool. Some have left the workforce and, with unemployment so low in the U.S., there are 2 million more available positions than those searching for employment—search consultants are burning out.
Consumer spending should remain strong. Consumer balance sheets are healthy, the labour market is tight and wages are rising briskly. As the economy reopens, service-related spending should see a surge. The rate of economic growth should slow though from its unsustainable pace, but growth should nonetheless continue. As consumers and businesses alike become more comfortable with reopening, we expect a material shift of demand from goods to services. This should keep the economy buoyant—though a demand surge on the services side could keep inflation high in the near term which would force central banks to tighten aggressively.
The overindebtedness of most developed countries does not auger well for economic growth rates. Debt this high normally acts to suppress growth. Pre-pandemic government debts were already too high and then they piled it on. The negative real yields (bond yields less the rate of inflation), which are extremely rare, should also be a concern. Rarely are negative yields seen during an economic expansion.
It won’t help interest rates that central banks will be purchasing fewer bonds and deficit spending will require continuous substantial government bond sales. Higher yields may be needed to attract purchasers but higher interest rates also act to restrain growth.
The debt and demographics (less population growth and more retirees which increase savings rates and lower consumer spending) are also growth inhibitors, not to mention that the pace of growth is projected to slow merely because the comparisons with previous quarters will become difficult. The decline in money supply should dampen growth. And, when growth rates subside, so too should inflation.
As interest rates rise and economic growth decelerates, valuations should compress, reverting from stretched levels. Even at its highs, the price-to-earnings multiple of the S&P 500 had declined from the beginning of last year because earnings growth outpaced the price increase of the index.
The correction we feared has commenced. Just as the herd mentality pushed stock prices too high, we expect an overshoot on the downside too. Despite the recent declines, the markets are not near typical investor capitulation readings. Volatility levels are typically higher near bottoms as well.
Stocks trading too high because of speculation have been hit particularly hard. Netflix, Tesla, Nvidia, eBay, Salesforce.com, PayPal, Twitter, Spotify, Meta Platforms (formerly Facebook), and PayPal have all fallen by at least 30% (some by more than 50%) from their highs.
That still leaves the tech index only halfway down toward a TRACTM floor, while the S&P 500 remains toppy, still at a ceiling in our work.
Taming broad-based inflation isn’t easy without the central banks excessively hitting the brakes. If we are not correct about inflation subsiding, then market valuations will have much further to fall because interest rates, a key factor in determining valuations, would rise materially.
In early January, short interest (percentage of stocks sold short) hit a new low—a sign that markets were too lopsided. For this reason, despite no negative signals from our Economic Composite or our Momentum Indicators (both designed to alert us to prolonged market downturns), we have left our hedge (short the U.S. stock market via ETFs in Growth accounts or inverse ETF holdings in registered or long-only accounts) in place. Valuations this high are a rarity, and we’ve been expecting a reversion. We did recently cover a portion of our hedges after the markets declined and look to cover the balance once the markets are more reasonably priced and close to floors.
In a bear market, the average S&P 500 decline is about 36%. Corrections, in non-recessionary periods, average around 15%. Since prices rose too far above underlying values, and interest rates are rising in response to inflation, the current correction could be above average. Any tempering in growth won’t be welcome either as it has direct implications for corporate earnings.
We are wary of stocks overly reliant on economic growth. Commodity stocks could suffer along with other cyclicals if growth rates abate. However, we hold positions, and are looking for others, whose earnings are expected to rise yet trade at substantial discounts to our FMV estimates. And, as the markets correct, we believe security and sector selection will be even more important to protect against overall market downdrafts.
The following descriptions of the holdings in our managed accounts are intended only to explain the reasons that we have made, and continue to hold, these investments in the accounts we manage for you and are not intended as advice or recommendations with respect to purchasing, selling or holding the securities described. Below, we discuss each of our new holdings and updates on key holdings if there have been material developments.
All Cap Portfolios—Recent Developments for Key Holdings
Our All Cap portfolios combine selections from our large cap strategy (Global Insight) with our best small and medium cap ideas. We generally prefer large cap companies for their superior liquidity and lower volatility. Importantly, they tend to recover back to their fair values much faster than smaller stocks, so they can be traded more frequently for enhanced returns. The smaller cap positions are less liquid holdings which are potentially more volatile; however, we hold these positions because they are cheaper, trading far below our FMV estimates making their risk/reward profiles favourable. There were no material changes in our smaller cap holdings recently.
All Cap Portfolios—Changes
In the last few months, we sold CoreCivic after it ran up to a ceiling and inflected down, reduced Headwater Exploration since it rose closer to our FMV estimate and the position became disproportionately large. We also made changes within our large cap positions all summarized in the Global Insight section below.
Global Insight (Large Cap) Portfolios—Recent Developments for Key Holdings
Global Insight represents our large cap model (typically with market caps over $5 billion at the time of purchase but may include those in the $2-5 billion range) where portfolios are managed Long/Short or Long only. A complete description of the Global Insight Model is available on our website. Our target for our large cap positions is more than a 20% return per year over a 2-year period, though some may rise toward our FMV estimates sooner should the market react to more quickly reduce their undervaluations. Or, some may be eliminated if they decline and breach TRAC™ floors. At an average of about 60 cents-on-the-dollar versus our FMV estimates, our Global Insight holdings appear much cheaper, in aggregate, than the overall market.
Global Insight (Large Cap) Portfolios—Changes
In the last few months, we made several changes in our large cap positions. We bought Alaska Air Group. We sold Principal Financial as it achieved our FMV estimate and also a portion of our Liberty Sirius XM to lower the weighting after its ascent.
Alaska Air Group has been a standout amongst its competitors. Its business model and financial discipline have made it the most profitable airline in the U.S. It even profited in Q4, despite Omicron, snowstorms, and staffing issues. As leisure and business travel resume, we expect strong profitability this year and '23 earnings should surpass '19 results.
The pandemic has been devastating for travel and leisure companies. The four biggest U.S. airlines lost over $31 billion in 2020 on a 63% drop in revenues. The major airlines were forced to raise billions in long-term debt. Yet, Alaska Air’s net debt at the end of '21 was 40% lower than in '19, moving its credit rating closer to investment grade. It also sports a low borrowing cost of 3.3% on its long-term debt, $3.5 billion in total liquidity, and a pension plan that is 98% funded. Our FMV estimate is $70, with more upside should margins recover even faster than we have modeled.
While remaining near all-time lows last quarter, high‑yield corporate bond yields have lifted to 5.4%. Our income holdings have an average current annual yield (income we receive as a percent of current market value of income securities held) of about 5%. Though most of our income holdings—bonds, preferred shares, REITs, and income funds—trade below our FMV estimates, attractive new income opportunities are still not easily found. We continue to wait for more attractive entry prices for investments we would like to purchase. As rates rise, spreads should widen, and bond prices fall. With share prices also correcting, we believe investment opportunities for our income accounts should present themselves.
We recently purchased AMC Entertainment Holdings 10% 6/15/2026 bonds. AMC is the largest theatre chain in the U.S. and operates internationally as well. The company has weathered the downturn for its business. Despite current operating losses, its meme stock status allowed it to raise equity, bolstering cash on hand to $1.6 billion. This, along with its ability to refinance its upcoming maturities (AMC just completed a 7.5% bond offering to repay its first lien obligations), should allow the bond we purchased to be refinanced well ahead of its maturity. The bond is callable beginning in mid '23. We are expecting a solid turnaround for AMC as the number of tickets sold should leap back toward pre-pandemic levels. The roster of new releases over the next year is highly promising and patrons should return in droves once they’re comfortable venturing out, which should be soon. We paid just under $94 for the bonds which we expect to trade closer to par as the company is likely to use its cash hoard to repurchase bonds. And seeing the bond called after June '23, at the $106 call price, is more likely than not since it would reduce expenses to use the cash on hand or refinance at a lower rate than this bond.
Gotta See the Baby
Though it’s normally “buy low sell high,” our recent playbook has read “sell high buy low.” We do, however, believe the normal playbook will soon be in use.
We look for new investment opportunities where securities have already suffered, often discarded because entire sectors are out of favour. We’re searching for the baby. As Seinfeld said, “Gotta See the Baby.”
Prices have been unusually high. From a top-down perspective, we have been concerned that a correction was overdue. And from our bottom-up analysis, we have found little in the last several months that warrants a new investment.
That has not stopped us from seeking out companies that have competitive advantages, a good growth outlook, and solid financials—waiting to pounce on opportunities when prices are sufficiently below our estimates of fair values. Our list of candidates is long—we’re pregnant with ideas—and can’t wait to see the babies.
Randall Abramson, CFA
Generation PMCA Corp.
February 15, 2022
All investments involve risk, including loss of principal. This document provides information not intended to meet objectives or suitability requirements of any specific individual. This information is provided for educational or discussion purposes only and should not be considered investment advice or a solicitation to buy or sell securities. The information contained herein has been drawn from sources which we believe to be reliable; however, its accuracy or completeness is not guaranteed. This report is not to be construed as an offer, solicitation or recommendation to buy or sell any of the securities herein named. We may or may not continue to hold any of the securities mentioned. Generation PMCA Corp., its affiliates and/or their respective officers, directors, employees or shareholders may from time to time acquire, hold or sell securities named in this report. It should not be assumed that any of the securities transactions or holdings discussed were or will prove to be profitable, or that the investment decisions we make in the future will be profitable or will equal the investment performance of the securities discussed herein. E.&O.E.