During periods of inflated asset prices, patience is an essential tool for absolute return investors. In addition to avoiding eventual losses associated with overpaying, patience allows absolute return investors to act decisively when valuations revert and opportunities return. While patience may be required during certain periods of the market cycle, inactivity in the portfolio should not be confused with inactivity in the investment process. In other words, patient positioning is not a ticket to the beach or golf course! This is especially true for flexible and opportunistic strategies.
To my surprise, over my career I’ve found I’m often busiest when cash levels are highest and discounts to value are in short supply. During periods of patient positioning, I spend considerable time remaining current on my possible buy list and searching for new buy ideas. Furthermore, it’s a great time to update business valuations and improve the quality of opportunity sets. Instead of resting during periods of excessive overvaluation, absolute return investors should be preparing for the eventual transition from patient to aggressive positioning.
Being prepared takes considerable time and effort, but the rewards can be tremendous. Knowing an opportunity set well allows absolute return investors to act decisively and confidently when the bids disappear and the market cycle ends. During periods of market dislocations, market participants frequently panic, causing extraordinary volatility and uncertainty. During such chaotic periods, concentrating and following through on discipline becomes increasingly difficult. Knowing exactly what you’d like to own beforehand (and at what price) can be very beneficial once the market cycle concludes. Investors without a thoughtful and detailed strategy may find it difficult to act decisively and with reason. Instead of acting opportunistically, unprepared investors may freeze and miss the bounty the end of the cycle often brings.
During the current period of patient investing, I’m spending my days staying on top of my possible buy list and preparing for future investment opportunities. It’s a very labor intensive process. In fact, I just completed one of the busiest earnings seasons in recent memory. Over the past three weeks I reviewed and analyzed the quarterly reports and conference calls of the majority of stocks on my 300-name possible buy list.
Based on my review, operating results for most businesses in Q3 2017 were very similar to Q2 2017, with organic growth remaining in the low single-digits. Given the time and effort I allocated to this earnings season, I was slightly disappointed with my conclusion. Nevertheless, the process and information I gathered was very valuable and has increased my confidence in my business valuations and cycle positioning. While the financial markets and business operating environment are relatively uneventful and frankly, uninteresting, I’m prepared and ready to reallocate capital at a moment’s notice.
Below is a summary of several business trends I noticed during Q3.
- Consumer companies, on average, reported soft to mixed operating results. Most volumes and comparisons remain low single-digit positive to negative. It’s been a year since I noticed the consumer slowdown (see Elevated Consumer Discretionary Risk); therefore, it should not be surprising that comparisons are getting easier. Many companies reporting mid-single digit negative comps are now reporting low single digit negative to flat comps. Although results on average remain slow to no growth, overall I believe the operating environment and trend in consumer businesses improved slightly in Q3. Easy comps, persistent asset inflation, and wage growth may be contributing. I plan to research new consumer ideas now that earnings season has concluded. I’m especially interested in beaten down retailers (see Retail Survivor) with strong balance sheets.
- Similar to Q2, I again noticed growing signs of cost pressures and pricing action in Q3. Labor costs were mentioned most frequently, while raw material costs were also noticeably higher for many industrial companies. To be clear, I don’t believe inflation is spiking higher, but the trend has shifted. Specifically, the trend in inflation appears to have shifted from fears of deflation (2015-2016), to slow to moderate inflation. I believe costs and pricing is something to pay very close attention to as it relates to profit margins and systematic risk (equity and bond markets have clearly not priced in the risk of inflation, in my opinion).
- Industrial businesses had another good quarter. Companies tied to construction and aerospace/defense reported healthy results. Exports healthy, on average. The rebound in energy spending also contributed to improved results, but year over year growth has slowed (rig count rebound stalling).
- Investment in domestic energy infrastructure was satisfactory in Q3, but growth is moderating (more from difficult comps than slowdown in industry). Credit has returned and terms are favorable (especially considering the bust was only 1-2 years ago). Energy production is growing again, but cap ex growth more disciplined versus 2014 peak. Assuming $50 oil and $3 gas holds, I suspect 2018 capital expenditures will be similar to cash flows – growing moderately from 2017 levels. We’ll know more when most 2018 budgets are released with Q4 2017 results. Hedging programs are active for 2018, therefore, many E&Ps have already locked in a large portion of 2018 prices which should provide some visibility/stability for cap ex next year. Labor and material costs clearly increasing for industry. Lastly, offshore remains weak, but some mentioned the sector may be in the process of bottoming.
- Auto manufacturing slightly down to stable. There doesn’t appear to be strong conviction on future trends. Hurricanes may have stemmed the slight decline temporarily.
- Agriculture remains weak, but stabilizing.
- Transportation capacity utilization and pricing appears to be improving modestly. Higher transportation costs mentioned on several calls.
- Financials are doing well on average. For now, loan losses are manageable. I continue to believe there is a growing risk insurance companies are underwriting too aggressively to maintain premium growth. And of course their investment portfolios are tied to the bond and equity markets to different degrees. As such, I have a low degree of valuation confidence when using book value for insurance/financials.
- Technology results were mixed depending on end customer. I tend to avoid using technology results to help me form my opinion on aggregate profits and economic activity. Technology operating results are often not a good indicator given choppiness of their forecasts and results – their cycles can be very short and abrupt. Results and outlooks can change weekly.
- Currency was not a major factor in Q3.
Looking forward, outlooks and commentary suggest the economic and profit cycle will continue into Q4 2017. Barring a sharp decline in asset prices (financial markets and economy appear to be one and the same currently), I’m expecting approximately 3% growth in Q4. Overall, I believe Q4 will be similar to slightly better than Q3, with easier comps in consumer and slightly tougher comps in certain industrials and energy. Business outlooks appear more confident this quarter versus Q3. Again, this assumes asset prices remain inflated, as it appears market participants are committed to heading into year-end (performance panic season).
As always, if you’d like to read the management commentary and quarterly highlights that helped form my macro and profit cycle opinion, please request via email. Given its size (over 60 pages) it was again too lengthy to post.
Happy Thanksgiving!
Article by Absolute Return Investing with Eric Cinnamond
