Stocks continued to climb as fears of a recession waned. Bond markets were relatively quiet. Oil prices rebounded as traders were unsure whether OPEC would raise production as much as rumored when the next phase of embargoes of Russian crude takes place in early December.
Investors continue to digest the Fed’s intent to raise interest rates at a slower pace, even if the peak Fed Funds rate is higher than previously predicted. The consensus now views that as positive, reducing risks of a downturn of any severity. There also appears to be a stronger voice suggesting that inflation will decelerate at a much faster pace than previously expected, mirroring the rapid rise of 2020-2021. What was swift and “transient” on the way up might repeat itself on the way down. This assumes that the impacts of inflation directly tied to the Covid-19 pandemic disappear once the pandemic truly ends. Covid-19 hasn’t disappeared. A few hundred Americans still die daily from the disease, but except for crowded or at-risk venues like hospitals that still require masks, life in this country appears to have returned to normal. Several months ago, hundreds of container ships were lined up off West Coast ports. Today there are none. If there is too much inventory, today it is on retailer shelves, not sitting on the high seas.
We have also reverted to normal patterns. That process isn’t entirely complete. Offices aren’t full yet, but office-bound populations grow daily. There will be some permanent changes, mostly improvements in how we live our daily lives. The return to former normality helps some (e.g., anyone involved in travel) and hurts others (purveyors of goods used when quarantined). It will all even out soon. As it evens out and normality is restored, a bullish conclusion would suggest that pricing pressures, both up and down, should normalize as well. That may be partly true, but it will also take time. Your hairdresser who raised prices with little resistance last year needs to see some resistance if attempts are made to replicate the increases next year. We all got conditioned to accepting inflation. Now, collectively, assuming input prices are tame, it is up to the buyers to resist. They will, but it takes time.
This coincides with the Fed’s plan to raise rates slowly but keep them high for an extended period. The time to reduce rates will be when buyer resistance to higher prices is apparent. Whether that is next June or December is an open question. Right now, consumers still feel good. They are spending money. Retail sales overall are fine, although some categories like apparel, home, and electronics are notably weak. Americans are still traveling. Traffic this weekend will set records. But there are hints that the spending spree may be winding down. Savings rates are plunging. Americans are using what they saved during the pandemic. That nest egg is shrinking. Layoffs are rising. Expensive vacations vanish if one doesn’t have a job.
It’s still an open question whether we fall into recession or not. What is becoming clearer, however, is that any recession is likely to be shallow. Once the pace of inflation reverses, the Fed can take its foot off the brake. What investors still must recognize is that it should be a very long time before the Fed steps on the accelerator again. For that reason, earnings improvements in the coming years should be modest. Ultimately, valuation concerns will slow the current market advance. We may have set the bear market lows, but it isn’t all blue sky on the horizon. 1-2% real growth, coupled with 2-3% inflation, is not an easy environment to manage a business. A look at Bitcoin and the Tech sector of the stock market should remind us all that euphoric speculation is almost dead. That carnage may not be over.
Which leads me to a separate thought. In a capitalist world, new ideas are not tied to economic cycles, but funding often is. Great ideas led by experienced founders can raise capital in almost any market climate. Newer concepts without much substance get funded at euphoric moments. The SPAC craze of early 2021 is a perfect example. The message from venture capital or angel investors is almost always the same. Grow as fast as you can. Get known. Build a customer base. Establish a leadership position. Note, I said nothing about making money. That comes later after reaching critical mass…assuming critical mass can be attained. If revenues are rising rapidly, new businesses can go back to their funding community and ask for additional money, often at higher valuations. As the investing mood brightens, so do valuations. Everyone is a happy camper.
There comes a time, however, when the backers want to get paid. Under favorable market conditions, that might be done via a merger with a larger firm, or even via an IPO. But in bear markets, access to capital tightens. Cash must be conserved. Suddenly backers want to see cash flow.
When times are good everyone talks about TAM. What’s TAM? It stands for total addressable market. Everyone wants to talk big. Larger opportunities invite higher valuations. Uber viewed its market originally as the taxi cab market. It entered with a new twist, using software and independent drivers to take significant share. It also priced its product right, meaning less than a comparable cab ride would be. It succeeded…up to a point. It gained share but didn’t make money. So, it raised prices and started using its drivers to deliver products like restaurant meals. It still doesn’t make money, but it is getting closer.
Some companies never get there. Either they overstate the addressable market or they don’t get the desired market share. Peloton bikes were very hot when we were all cooped up indoors during the pandemic. Gyms were closed. Its TAM was the total market for exercise equipment. Now, of course, there are few Peloton bikes in gyms, and the ones at home have been converted to clothing racks. Exercise equipment was always faddish. This time was no different. Carvana wanted to sell cars online. It built its iconic towers you see along busy roads, but its execution was poor. Both companies built an infrastructure that would support sales far greater than they ever achieved. They drank their own Kool-Aid and built too big an infrastructure. Now both are cutting back, trying to survive.
The problem with relatively new start-ups, like Peloton and Carvana, isn’t all that different than the problems faced today by the largest tech names like Amazon#, Google# and Meta Platforms#. Each saw no end to their growth. They spent heavily to support growth at high double-digit annual rates. But a softer economy, a maturing digital advertising market, and slow retail sales created a situation where costs were still growing at 20%, while sales growth fell closer to 10%, or even less. Each was caught in a different way, but the tales are remarkably similar. Now all three have to retrench. Each needs to cut spending to match growth in revenues. Critical projects that are the seeds for future growth will continue to be funded. Moonshots will get canceled or deferred.
When you manage a business properly, the focus is always on the bottom line. That doesn’t mean that early lifecycle losses shouldn’t be endured, but it does mean a focus on a path to profitability is always priority one. Maximizing profitability isn’t simply about cutting costs, it’s about rationalizing costs. No company will succeed by remaining stagnant. Legacy retailers must develop an online presence. They need to make it easy for customers to buy online and pick up at the store. Fast food restaurants need efficient drive-thru windows. Manufacturers must constantly improve their supply chains and automate where practical.
In today’s market all those great concept companies that haven’t built a path to profitability are dying. Those that have been profitable are recalibrating to bring costs in line with revenues. Meanwhile, old legacy companies that have long focused on growing free cash flow to the benefit of shareholders are thriving. Stocks making recent new highs include Exxon, IBM, and General Mills, hardly names a growth stock investor would be interested in.
Stock prices are the present value of future cash flows. Obviously, that is tied to the levels of profitability and growth. Companies like Costco# and McDonald’s# have been growth companies for decades. Others offer more stability than growth, like Coca Cola# and Procter & Gamble#. But all grow faster than GDP for one simple reason. Managements are focused on growth, innovation and future profitability. You need all three to succeed. Growth without profitability eventually leads to failure. Poor execution leads to a loss of customers and market share. I once spoke to a third grade class about investing. I asked them which is better, McDonalds or Burger King. Everyone gave the same answer. You can be a great investor in third grade! Good investors buy the steak, not the sizzle.
Before ending, I want to note the recent passing of one of our original partners at Tower Bridge Advisors, John Lloyd. When Charlie Rockey, Maris Ogg and I started the firm, our first step was to merge with Lloyd, Leith and Sawin, John’s firm. The three of us had known John for several decades. It was a perfect fit. John was a brilliant investor, totally dedicated to the needs of his clients. He always had a smile on, even when he was disagreeing with me, which wasn’t very often. John retired a few years ago but has remained close by physically and spiritually. He will be missed. His funeral is this Saturday at St. Peter’s Church, 313 Pine Street in Philadelphia. If you choose to go, parking is available entering from Lombard Street. The funeral will also be Livestreamed. If you would like to join remotely, go to the St. Peter´s Website, scroll down and then click on the button that will be there on the day of the service.
Today Miley Cyrus is 30. TV anchor Robin Roberts turns 62. Have a Happy Thanksgiving.
James M. Meyer, CFA 610-260-2220