West of the Hudson
We mentioned in a recent monthly comment that we have been tracking an unrelenting divergence within corporate earnings, separating what we think of (in esoteric research-speak) as intangible versus tangible businesses, and (in plain-speak) as the haves versus have-nots. The haves are companies that remain at peak profitability, expanding their bottom lines despite the increased costs of disrupted supply chains, rising wages, and intense commodity inflation. They enjoy the tailwinds of secular demand and a growing market for their products. Have-not companies are not as fortunate and are what we think of (in esoteric research-speak) as utilities: companies that provide many of life’s daily necessities but lack price elasticity. These companies’ sales have rebounded to varying degrees, but their input costs, and therefore their cost of goods sold, have skyrocketed. These are the companies that continue to under-deliver, guide outlooks lower, and have been unable to maintain profit margins.
In the past two quarters, U.S. businesses (ex-finance) posted their widest margins since 1950. On earnings calls, plenty of executives complained about the squeeze from rising costs of labor and materials but, according to the Commerce Department, composite profits are still +37% year/year. Unsurprisingly, size is a factor and companies with greater market share have more pricing power. A Federal Reserve survey found that 85% of large firms reported passing on costs to customers, compared to less than 60% of small firms. Still, overall, it is remarkable that for all the talk about supply chains and wage/commodity inflation, the degree to which margins and earnings continue to expand is remarkable. Pricing power — the ability to pass costs on to customers without harming sales — has long been prized by investors, with Warren Buffett describing it as “the single most important decision in evaluating a business.” Demand remains robust, consumers thus far remain relatively insensitive to price changes and continue to show real demand, and supply-chain disruptions have begun to ease a little. It’s no wonder that despite another highly contagious Covid strain, the large-cap S&P 500 is +29% YTD, double the small-cap Russell 2000 index, as large cap businesses, unlike their small cap counterparts, are able to meet robust demand and maintain their profit margins.
The consensus of business operators we have spoken with or listened to on calls is that supply chain snafus should improve by late spring. They may be correct, but after so many delays and setbacks, we remain skeptical about certainty. The supply chain crisis intersects with labor shortages, energy prices and transport disruptions. Transport might be straightened out in a few months, but energy and labor seem to be longer-lasting problems. As we have seen with many issues during the past two years, large problems create peripheral problems that in turn create more unexpected problems.
No more is this true than in supplies for food and medicine. We discussed the medicine supply chain in a letter earlier this year, but only mentioned food in passing. You can’t speak about food without speaking about energy, and the tightness in global energy markets has resulted in high natural gas prices, sending costs for nitrogen-based fertilizers to all-time highs. Fertilizer prices are concerning for a few reasons discussed below but begins with the fact that more than half the world’s food crops require them and is relied upon by farmers for base grains — rice, wheat, corn, and canola.
We have spent 2021 obsessing over the apocalypse of disappearing workers, a creaky supply chain, rising costs, and a pandemic that will not end. It is hard to remember that there was once a time when we didn’t know what an antigen was. Covid has wreaked havoc, and it is not going to go away even as we learn to manage it better. As a client said recently, “we crave the normal, which is only the recent past.” And it is here that we jump off for this, our final letter West of the Hudson TM in 2021.
1. Profits v. Inflation
You need not be a professional investor to know that the scale of profits cranked out by American businesses is mind-boggling. Despite the pandemic, a savage earnings slump, and significantly higher wage, raw material, and freight costs (all helping push up economic inflation gauges), companies are reporting some of their best profitability in years. So even as ~70% of the recent management calls at S&P 500 companies blamed supply chain and other issues on hampering sales, executives have also seized on what a few have termed “a once in a generation opportunity” to raise prices to match and, in many cases, outpace higher expenses. According to FactSet, nearly two out of three of the biggest companies have reported larger profit margins so far this year than they did over the same stretch of prepandemic 2019. And nearly one hundred of these corporate giants are seeing 2021 profit margins that are at least 50% above 2019 levels.
One of our portfolio favorites — a well-known manufacturer of industrial life sciences instruments — reported lower volumes, yet price increases more than offset the expenses from supply chain snags and worker shortages. Meanwhile profit margins at another name brand industrial company we follow (but don’t own) have shrunk 300 basis points over the past twelve months despite three price hikes. These two examples beg the question: is the former example — the haves — sustainable, or is the latter — the have nots — a better gauge of what lies ahead?
This analytic mystery offers short-term and long-term propositions. In the short-term, the issue is whether an economy that is running hot amidst shortages ultimately forces an end to the managerial consensus of the past two-decades, which has favored grinding down costs, keeping margins high, being stingy with investment, and maximizing cashflow. Rising investment is what economists want because it increases capacity and boosts the economy’s “potential”. Yet whether investors are prepared to accept higher capital expenditures at the expense of cashflow distributed to shareholders remains to be seen. We are for now unaware of any current conversations indicating that we should be concerned with an assault on free cashflow conversion or a withdrawal from a shareholder-friendly posture.
Nonetheless, if history has proven anything these past twenty years, outlooks can change rapidly. In this context, one of our favorite economic bulls, Ed Yardeni, recently asked, when it comes to 2022 earnings, “Does Covid = Y2K?” He refers to 1998-99 when we first became acquainted, and technology and telecom companies received an immense boost to profits from the scramble to fix a flaw in calendar programming code before the century rolled over from 1999 to 2000. The mad dash for hardware, software, and communication equipment led to a one-off spending explosion that Wall Street convinced investors was sustainable. Spending fell nevertheless, depressing earnings and stock prices. Recalibrating that time for today, Yardeni wonders if the boom in spending during 2020-21 pandemic response might be followed by an unanticipated earnings weakness later in 2022. We don’t see it in the forward estimates (unsurprising), but also don’t see history repeating itself if only because, unlike two decades ago, we believe that technology businesses will continue to see strong demand for their products from companies that are investing to increase productivity in the face of chronic labor shortages. This isn’t a new trend but we are seeing some pull forward in what has been an ongoing secular shift in automation and productivity enhancing technological investments.
The solution for many have-not companies is manage costs and raise prices, but covertly. Companies hope that by making price increases hard to evaluate, they can then escape notice and avoid a customer backlash. But we live in a time when customers have sharp eyes (and loud voices). When a company raises prices directly, some vigilant customer is bound to notice and complain on social media, no matter how small the increase or valid the reason. A few complaints could then spiral into a firestorm of outrage, upturning even the most carefully orchestrated price increase.
As one consumer staples CFO opined in a recent call, “the demand curve imposes its tyranny on every business. Raise prices and sales will begin to falter. Cut prices and customers will flock to you. It’s usually either higher sales or higher profit. The holy grail of pricing strategy is in finding ways to circumvent this seemingly ironclad economic law, to raise prices without losing sales.” That becomes even more crucial at times like now, when input costs are increasing quickly, and raising prices is necessary just to keep the business running.
It should be noted that higher prices aren’t the only factor pushing up profitability. Intense demand for many kinds of goods — technology, autos, and housing — are major drivers of economic growth and corporate profitability and, as volumes rise, fixed costs on rent and equipment are spread out over more units, generating bigger profits on each unit sold.
There are of course many critical industries where rising costs are unavoidable and harder to manage through. Such is the case with agriculture, where rising energy prices cast a long shadow on an industry where natural gas is ~80% of the cost of production. We tend not to think about it, but an extraordinary amount of energy is required to drill for oil, mine copper, erect infrastructure…and to grow, harvest, and transport food. History has not been kind to these times: spikes in energy prices tend to be followed by higher food prices, which in turn contribute to social instability (see the history of Europe).
High energy costs and transportation disruptions are well documented. Less attention has been given to the rising price of fertilizers, a critical input to food supply that threatens to keep food prices high. Like other current supply-demand imbalances, rising energy prices are the result of several idiosyncratic inputs, including the snap-back from pandemic demand running straight into the sea-borne supply chain disruption. But mainly it is a result of today’s investor: oil and gas companies have historically reinvested much of their profits into developing future production. The rate at which they do so has fallen considerably the last few years (and accelerated during the pandemic) because, as noted above, changing investor preferences, where shareholders increasingly demand buybacks and dividends, leaving less capital for future growth investments.
But this means less investment in future energy supplies, and this is where we find ourselves today: oil and gas companies are having their worst year in decades. The industry is on track to discover fewer than 5 billion barrels — its worst performance in 75 years — and reserves are dwindling, driving the ratio of proven reserves to production (a measure of how much extractable oil remains in the ground relative to annual production) to its lowest level this century.
Natural gas is the key feedstock for synthetic nitrogen fertilizers. But prices have skyrocketed due to lack of availability, cutting into fertilizer producer margins, and leading them to either cut back or, worryingly, halt production. The pandemic played a role too of course as the virus hindered the growing season. This resulted in low grain stocks just as demand returned and the year/year cost to produce a ton of ammonia increased (10-fold, from $100 per ton last summer to $1,000 today). Making matters worse, top exporters of crop nutrients such as China and Russia restricted or banned outbound flows to protect domestic supply — they represent ~25% of global supply — while mother nature has closed production around the U.S. gulf coast numerous times this year.
Trade wars, congested ports, unavailable input chemicals and high freight costs have made fertilizer harder to produce and deliver, resulting in a perfect storm for food prices, particularly as key crops such as wheat, corn and canola are extremely nutrient-intensive. Exacerbating the impact from production difficulties are low stockpiles and export bans, which further push prices higher in an unfortunate feedback loop.
Fertilizer supply is extremely time-sensitive. Crops generally benefit more from fertilizer treatments in the early phases of the planting season and their initial growth period. Delayed or missed application during the cycle results in lower yields, which tightens food supply and drives prices further still. Looking ahead, in order to limit the effects of the fertilizer’s crisis on crop yields in late 2022, the issue must be resolved before the application of fertilizer on the spring crops, which will occur in early spring 2022.
The tightness in global fertilizer markets and the corresponding impact on rising food prices is yet another pandemic-induced dislocation that the world will have to deal with in the near-term. And the fact that this is occurring at a time of already high food inflation, means this is more noise to sift through. Throw in heightened political uncertainty, which often accompanies rising food prices, and the investment environment becomes far more challenging.
3. Kinks in the Chain
We were recently introduced to an economics essay “I, Pencil” (Leonard Read, 1958) which explains the theory of Adam Smith’s “invisible hand” through the production of a lead pencil. The humble pencil requires inputs from experts in logging, mill work, mining, chemical production, power generation, transportation, and marketing. And all those inputs must be coordinated across time and space, and that’s just for a simple pencil! Now imagine what the apex of today’s cutting-edge technology — the semiconductor — necessitates.
I, Pencil aimed to show how a market that is guided by the invisible hand of prices can coordinate complex supply chains — delivering what is needed, when it was needed. As we have seen, when something like Covid delivers multiple supply and demand shocks, this thesis struggles to keep up. The worst of the disruptions occurred last spring, but supply chains continue to be roiled, especially in Asia, although the U.S. is hardly a model of efficiency at this time. While investors casually assume that businesses will re-shore some production, it will not only devour substantial resources, but doing so assumes pandemic conditions will never abate. So, despite the spread of new variants, corporations remain unwilling to relinquish their commitment to their supplier networks, nor shift away from their shareholder-friendly posture.
Nonetheless, with the digitization of all things — the advances in 5G, artificial intelligence, and everexpanding content requirements in nearly every aspect of the modern world — America today is alarmingly reliant on foreign producers of semiconductors. This has spawned national security and critical infrastructure anxieties in Washington, where calls for domestic investment in chip fabrication are growing. The U.S. share of global semiconductor manufacturing capacity is just 12% (down from 37% in 1990), while 75% of global semiconductor production capacity sits in four Asian countries: Taiwan, South Korea, China, and Japan. There are many legitimate reasons why this is so, including the sheer cost to build a new domestic chip factory which is, on average, 30% greater here than in South Korea, Taiwan, or Singapore, and 50% more than in China. Many rightly point to the cost differences as largely attributable to the availability of government incentives, which is why the U.S. Chamber of Commerce has been lobbying Congress to provide $52 billion in direct subsidies. There is some truth to this but recall that just-in-time manufacturing requires that all or most of the parts be in relatively close proximity.
Although American companies represent ~50% of the global semiconductor industry, many of the biggest names only design their chips, choosing instead to outsource the manufacturing to Asia, and that will not change in the near-term. While we may assume some manufacturing is re-shored (especially military and communications), new fabrication plants are years from completion and, more telling just ~6% of new global semiconductor capacity to come online in the next decade is expected to be located in the U.S. This is not supportive of any significant re-shoring. Indeed, as things stand, 40% of new chip-production capacity projected to be added in the next decade will be in China.
Semiconductor sales have increased as more auto manufacturers have prioritized the production of their high-end and electric vehicles, many of which contain 2,000 chips or more, which is twice the average number of chips found in an internal combustion engine vehicle. EVs and hybrids have doubled from 8% of global auto production in 2019 to about 20% today, and one can expect that growth to continue. And as noted above, despite the supply imbalance, semi manufacturers are operating 24 hours a day and sales are hitting record levels with global Q3 semiconductor sales up +28% year/year.
According to industry data, global chip manufacturers are projected to spend nearly $150 billion in capital expenditures in 2022, 30% higher year/year, 50% higher than pre-pandemic 2019, and more than double what the industry was spending five years ago. But according to the research, less than $1 of every $6 is earmarked for the so-called legacy chips facing the longest backlogs right now.
Nearly all the expected spending is going toward new capacity for chips built on cutting-edge technology, the type that have largely remained plentiful. The spending direction likely means a continually tight supply of run-of-the-mill chips used in non-EV cars, home appliances and gadgets. It also suggests the wait for orders may remain long. In an effort to fill the gap, two firms recently announced they will spend $7 billion to build a chip plant in Japan to make chips based on older technology, but the plant won’t be ready for production until late 2024 and won’t help solve the problems hampering production of cars and electronics today. While a significant outlay, it also doesn’t move the needle much in terms of overall global investment.
While the on-set of the pandemic caused massive industrial order cancelations leading to today’s production delays (auto manufactures being the largest), economists at GaveKal point out that the semiconductor shortage is not directly due to Covid. They note that the seeds of today’s imbalances were planted when the U.S./China trade war morphed into a tech war, creating uncertainty for semiconductor producers who reacted by limiting capital spending on legacy chips, preferring to wait and see. As with so many other industries caught in this trade war, the results of have been unbelievably disruptive.
• Final Thought
Fuel and food inflation, supply-chain bottlenecks and labor shortages are mainly symptoms of the same underlying problem: the unprecedented tug-of-war between the biggest demand surge since WW2 (a result of the post-Covid reopening fueled by the largest fiscal stimulus program in living memory), and a global break in the supply of inputs, as repeated Covid lockdowns devastated the intricate coordination required for just-in-time production. There is no convincing reason to believe that goods, services, commodities, and factors of production, that were in excess supply until 2019, suddenly and permanently disappeared from the world economy. Nobody can predict with confidence when supply and demand will come back into balance, but historical experience shows that market mechanisms are remarkably effective in bringing supply and demand into balance, and that overshooting prices caused by shortages are followed by undershooting prices amid excess supply.
Two winters ago, we were staring at a deflationary depression and fears of a modern plague gripped us all, causing farmers to cull their herds, rental agencies to purge their fleets, and manufacturers and retailers to cut their inventory. And then we had the re-opening and recurring rounds of fiscal giveaways, leading to massive demand growth at a time when production could scarcely keep up. Covid has done its part to define history, but it has not suspended history and we are in fact learning to adapt to a large degree. We’ve spent decades optimizing supply chains to carry a very specific amount of cargo during very specific times of the year across very specific modes of transportation. As soon as we exceeded the design capacity of those systems, it broke.
We end this as it began — the intangible haves versus the tangible have-nots where the large technology, healthcare, and select consumer companies continue to get larger and enjoy a bigger piece of the pie, while the economically sensitive, legacy asset-heavy firms remain volatile and unable to provide accurate guidance. This has created tremendous market bifurcation where just ten companies account for ~34% of the S&P500 market cap and six of those same companies account for 35% of the market’s 2021 total return. What this means is that a 1% gain in the ten largest stocks has the same contribution to the market’s aggregate return as a 1% gain in the bottom 90%. That is, the ten largest stocks carry the same weight as almost the rest of the stock market combined. This creates an illusion of performance and illustrates the risks passive investors take owning a stock index fund.
We noted in our first letter of 2021 that Tesla had higher valuation than the entirety of the global auto sector, and Airbnb carried a greater value than the entire global hotel sector. This remains true. We close the year by noting that Uber owns no cars, Airbnb owns no hotels, and Robinhood owns no exchanges (or traders, brokers, or financial advisors for that matter). This is in many ways the new economy — balance sheets that are heavy on intellectual property and mostly free of physical assets. While there are excesses in every cycle — we read that analysts expect VCs to burn upwards of $25 billion in funding to get groceries delivered to your house in eight minutes vs ten minutes in 2022 — those excesses are historically a simple rush to capitalize on the new trends, business models, and ways of enriching oneself.
The virus seems unlikely to go away. Like most viruses, it will probably keep circulating, with cases rising sometimes and falling other times. But we have the tools — vaccines, along with an emerging group of treatments — to turn it into a manageable virus, like the seasonal flu. The physical economy has been hard hit but, all the while, innovation continues to accelerate elsewhere.
In a very volatile year, with the ebb and flow of cyclical stocks mirroring the ebb and flow of Covid openings and closings, we remain in an organized position and continue to buy and hold around two uncomplicated, driving themes: growth companies with service-like characteristics, strong balance sheets and realistic earnings visibility (the up-market), combined with high cashflow generation, high dividend yield, GDP+ growth themes (the down-market).
We look forward to seeing you and discussing these themes in the New Year. In the meantime, from our families to yours, we wish you all peace, prosperity, and good health.
Hirschel B. Abelson Chairman
Adam S. Abelson Chief Investment Officer
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