Dear Mr. Smith
Background: Our CEO, John O'Connell read a research note this morning that he immediately knew our client, 'Mr. Smith', would enjoy. ‘Mr. Smith’ is an avid follower of markets, and often asks John for his opinion on current events, particularly when they are interpreted with a pessimistic lens by the popular financial media. John hadn't heard from ‘Mr. Smith’ recently, and this morning ‘Mr. Smith’ was on John's mind as he read a research report about consumers cracking under the pressure of high interest rates. John very much enjoys speaking to ‘Mr. Smith’ and, looking for an opportunity to catch up with him, sent him the following email along with the attached commentary from Ed Yardeni - a highly-respected US economist.
Good morning, ‘Mr. Smith’ !
I was thinking we had not spoken in a while, nor had you sent me a depressing article. I’m hurt. Nonetheless, I offer some facts to get the creative juices flowing.
It certainly is an interesting time. It is quite remarkable how pessimism can be so articulately spoken, and yet continue to be trounced by positive outcomes that surprise most —hence the positive results to your portfolio so far. The exuberance that threatened the durability of this strong performance has partially burned off, but not enough to make me feel like the ‘all clear sign’ is flashing GO. Most of the S&P 500 companies have reported earnings, and the net is that profits have come in about 8% above analyst’s estimates. The companies you own have reported excellent results and continue to justify their present valuations because they:
1. Have compelling products and services that a large number of people and businesses enjoy.
2. Have predictable revenue streams and stable cash flows.
3. Have defensible economies of scale, and thus pricing power.
4. Are run by experienced management teams who are focussed on growing their businesses over a long-term horizon, not on winning stock market popularity contests.
5. Invest a LOT of money (more than most) into their future endeavours.
6. Are running their companies as if things will get tough, and this has resulted in the happy outcome that, in spite of revenues growing at slower pace, their growing profits have expanded at a quicker pace, i.e. the proverbial increasing-net-profit, margin-expansion wonder.
Voila! Higher valuations.
When I studied finance, I was taught that businesses that demonstrated predictable cash flows were more highly valued than cyclical businesses. This is one reason we do not buy things that hurt when you drop them on your foot (commodities).
Perhaps those that worry about ‘sky high’ valuations should be a bit more specific? I really do believe we are operating in a world where smart management teams (why invest in anything else?) have cottoned on to the game Wall Street plays. They are now well-versed in the play book which is: under-promise and over-deliver by sticking to their game plan —not that of the 30-year-old MBAs and CFAs who have never run anything other than a 10k. I’ve done this for 40 years and I really have started to see a decreased variation in earnings by good companies. Admittedly this has also been abetted by government intervention (yes, I know, and to be addressed next) that smooths out the bumps. That does sound a bit like goldilocks, but then again that’s what we are seeing right now and what so frustrates the bears.
One of the interesting aspects of the world we live in is that politicians —on both sides of whatever argument they amuse themselves with— agree that spending money is good. All prefer to borrow money and half of them also like to give it away via lower taxes. Nearly everyone likes this, truth be told, because it benefits them and, given the massive sums involved, it mostly has floated everything.
Now, there have been 4 primary arguments as to why this government intervention is bad —all classic Macro 101 Economic arguments.
1. The government will borrow so much money that no one else will be able to afford to. This is the Crowding Out Syndrome. The boom in private credit (which will be a disaster) and the low interest rates that companies readily are able to access when they borrow money, mostly argue this theory should be removed from the textbooks.
2. Massive spending will create inflation. The government continues to spend at massive rates as they always have and yet market forces seem capable of increasing production at a fast enough pace to, over time, cause prices to ease. Now, it is true that prices are not easing as fast as some would like, but they are falling, and the components that seem to be the “stickiest” —like rents— are always slower to ease, but we are seeing it happen! I think economists should study a bit more commerce books and get beyond supply and demand curves.
3. As the below article (the point of all this drivel) points out, the consumer is diverse. They are not one person and all of them are different ages and in differing situations and do not look like those pools of fish you see in Nat Geo films, all going in the same direction at once. I’m not saying we/they are any smarter, but we just don’t all agree in which direction to swim and some of us are stronger swimmers because we eat the little fish. So goes the economy.
4. The attached Ed Yardeni article this morning, points out that there is a LOT OF MONEY SITTING AROUND IN INVESTMENT ACCOUNTS (like yours). Some of this is invested in government bonds and it’s paying out a lot of cash to said investors. Thankfully too, some of these investors are the companies that you own, and they happen to be sitting on billions upon billions of dollars of cash and are unable to invest it fast enough in productive assets. So, they make a tonne of money buying bonds when they are not buying the stuff made by the other companies you own. BTW it’s people like you who are feeling a little richer these days too!
To sum up, it feels fairly positive out there right now, but we are watching closely. Some of what Ed (below) speaks of —like Starbucks or Nike struggling— is more company specific (expensive coffee or increased competition for running shoes) than the consumer circling the toilet. There are changes happening out there. There always are, and that’s what we are focused on: change, who makes it, who anticipates it and who will benefit from it.
We feel that the companies you own are fairly valued from an investor’s perspective because they are investing and creating the change to remain dominant. That has always been the main driver of shareholder returns.
One last point; while watching the after hours trading of some of the businesses you own, it was fascinating to watch how the computers trading (it's mostly computers) reacted to every word said by the CEOs and CFOs. The algorithms are set to key off certain words and the phrase “heavy/increased investment” is most definitely presently a bad phrase!! Isn’t it interesting that the most successful companies ever, can be knocked down 15% in value in a microsecond for continuing to do what has made them what they are today; the most dominant, highly valued companies in the world — ever! It is only a matter of time until the computer programmers are run over by the forces of time and commercial reality.
Hope you are well and as always, thank you for being an client of Davis Rea!
P.S. I’m copying myself because this will likely form a letter to all our clients, so once again thanks to you!
P.P.S. I’m soon heading up north to the shack and would be pleased to drop by and see you.
Best wishes,
John
