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Oct. 4, 2022

The brutal selloff continues

There is still no end in sight to rate hikes, which is the single most important factor in the equity markets this year, even with all the macro issues going on. Rising rates are like a giant wet blanket draped over everything, limiting growth, increasing expenses, reducing the present value of future cash flows, and driving multiple contractions.

The recent hawkish commentary by Chair Powell seemed to surprise many, who were thinking that rate hikes might be winding down later this year. However, the Chairman made clear that the Fed will do anything necessary to combat inflation and the current narrative is that rate hikes will continue. There is essentially nowhere to be in either equities or bonds to avoid the pain that the rate hikes are causing and even the traditional “60/40” equities/bonds portfolio is down approximately 20% year-to-date.

Still an expensive market

Broadly speaking, bear markets tend to last 12-18 months and drop somewhere around 40% in value. Clearly, we are not there yet, and there is an old saying “in a bear market the guy who wins is the guy who loses least.” Recently I have been taking that to heart and raising cash, even for investors with lengthy time frames. Over time, markets tend to swing from overvalued to undervalued and even with 2022’s 25% drop (S&P 500) and 32% (Nasdaq) through September I think the major indexes are still expensive.

It would be unusual for a bottom to be in given many of the other indicators, such as the VIX (which measures volatility and hasn’t come anywhere near where it’s been in prior bear markets), and Buffett’s “market cap to GDP” ratio is still well above prior highs. In addition, the strengthening US Dollar will eat into the earnings of companies that have significant overseas operations, which is the case for several of the large cap tech companies.

Some silver linings

A few (possible) bright spots: 1) we have already taken a significant amount of froth out of the market and are steadily transitioning away from an overbought and highly liquid market; 2) the “migration to all things digital” theme is alive and well, if the CEOs of these companies are to be believed, and 3) the long end of the yield curve continues to trade below 4%, and in many commodities inflation has completely rolled over. For instance: gold is down 15%, lumber down 60%, copper down 30%, iron ore down 60%, DRAM down 45% and crude oil down 35%. Some freight rates have dropped nearly 75% from their peak.

Most importantly, select hyper growth names in a number of portfolios are well above their mid-year lows and I believe that the trends behind their growth will persist even in a recession. Among them: Bill.Com (“BILL”) is +47%, Cloudflare (“NET”) is +42%, Sentinel (“S”) is +37%, CrowdStrike (“CRWD”) is +26% and Datadog (“DDOG”) is +9%.

These companies are growing rapidly at scale with significant recurring revenues and were the first to correct last year. As such I would expect them to be the first to stabilize as well, provided their fundamentals continue to hold up. Valuations have come way down, from (roughly) 50x Enterprise Value/Forward Revenues to (roughly) 14x. This is not to say they can’t fall further, but cloud/cyber security is (and will continue to be) a priority for every company in the world and I think portfolios should have exposure there.

Meanwhile, the S&P 500 and the NASDAQ both closed at new lows at the end of the quarter.

Some history

Currently there is a healthy debate about whether the Federal Reserve has already gone too far and will be cutting rates next year. An example of that took place in 1995, after the Fed had doubled the Fed Funds rate from 3% in January 1994 to 6% in January 1995 and then began cutting rates in July 1995. After closing at 459 on December 30, 1994, the S&P 500 subsequently closed 1999 at 1469.

As Warren Buffett has said “Every decade or so, dark clouds will fill the economic skies, and they will briefly rain gold. When downpours of that sort occur, it’s imperative that we rush outdoors carrying washtubs, not teaspoons. And that we will do.”

On the other hand, there have been lengthy periods of sideways movement as well. For example, the DJIA closed 1964 at 874 and closed 1981 at 875.

My takeaway is that as long as the narrative remains that the Fed will continue on its path there will be pressure on equities. When the perception is that that narrative is winding down, I would expect a significant bounce in equity prices overall. However, there’s no telling when that will be and while most portfolios currently have significant amounts of cash, being entirely out of the market risks missing the first 25-35% bounce as the market will turn well before the economy does.

A few specifics

According to Cathy Wood the global advertising industry is a $150bn market ($70bn in the US) and yet despite the ongoing migration to CTV (Connected TV) and streaming, only 22% of ad spend is directed there. My favorite company in the space is the Trade Desk (“TTD”) and I expect to continue owning it.

Electric vehicles are increasingly popular and even with the 22% drawdown this year, Tesla (“TSLA”) has been a huge winner for Peattie Capital portfolios. I think TSLA is light years ahead of the competition and production and sales continue to ramp, even though over the weekend TSLA reported September sales which were about 4% below street expectations. Shares traded down 8% on that news Monday (10/3), but nonetheless I expect that TSLA will remain a core holding in most portfolios.

Umicore is an $8bn Belgian company which specializes in materials of many types and has an extensive battery and battery recycling operation. To me it is a “back-door” way to play the exploding demand for electric vehicles. In June, Umicore announced a $5bn capital spend program, and shares have dropped 27% this year. So far, I only own Umicore shares in small amounts in a few portfolios, but this is one I will be watching closely and hope to own more.

A couple concluding thoughts

Some other tangential issues are that the mid-term election year is clearly the weakest year for equities in the four -year Presidential cycle, however it tends to do a little better after the mid-term elections are over in early November. The 3rd year tends to be the best. In addition, I expect there will be plenty of tax loss selling this year which could present some attractive long-term opportunities. For right now I continue to be very cautious, but I have a list of companies I’m interested in and think it’s pretty likely that some of that cash will be deployed before year end.

Please feel free to contact me with any questions or comments.

Bill

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June 28, 2022

An extraordinary six months

It’s been an extraordinary six months. No matter the asset class, size, location, or industry (except energy and large cap pharmaceutical companies) it’s been a bloodbath, with nowhere to hide. According to Cathy Wood of Ark Research, the bond market’s overall performance is its worst since 1788 (source: Ark Research monthly update, May 10, 2022. Note: I have been unable to confirm this). Even my most conservative accounts, which are almost entirely in cash, are down high single digits. While that may look relatively good, when inflation is 8%, the purchasing power of that cash is dropping rapidly.

As of June 24 close, the S&P 500 and Nasdaq are down 18% and 26% respectively, and most Peattie Capital accounts are down in line with the markets. More aggressively positioned ones are down even more. Peattie Capital Management manages separate accounts only, and tailors portfolios based on specific client goals, constraints and risk tolerance.

That said, the S&P 500 is now trading at roughly 15x forward earnings estimates, down from approximately 22x, and near where the P/E multiple has bottomed in previous corrections (a couple times in the 13-14x range). There’s no telling if that will be the case again, however, as in a recession earnings will drop. For example, $240 of S&P earnings and a 17 multiple gets the S&P 500 to 4,150. However, in a recession, current estimates are likely too high and if they are only $225, a 14 multiple produces an S&P of 3150.

This is not 2000-2002 when terrible companies with little more than eyeballs coming to their websites (think Pets.com) flourished. Nor is it 2008/09 when the financial system itself came under extreme pressure. 2022 is rather a changing environment after 40 years of declining interest rates and oceans of liquidity from the Federal Reserve at any sign of trouble, topped off by the extraordinary liquidity provided in response to Covid.

It’s important to remember that after the six rate hikes from early 1994-early 1995, which took the Fed Funds rate from 3% to 6%, the Fed eased shortly afterwards and in the subsequent five years the S&P 500 gained 34%, 20%, 31% 26% and 19% respectively.

Taming inflation through higher rates is still the Fed’s plan

Chairman Powell’s comments (so far) suggest to me that he will continue to raise rates to combat inflation and is willing to risk a recession to achieve that goal.

Already recessionary signs are appearing as aggregate demand is softening, and the commodity complex is rolling over. Among others, copper is down 19% from its March high, aluminum down 36%, nickel 47%, the CRB (Commodity Research Bureau) metals index is down 16%, and lumber is down 60% (Source David Rosenberg June 20, 2022).

Also, corporate bond spreads are widening, and consumer sentiment is at all-time lows, both of which indicate heightened concerns about a recession. An inverted yield curve is usually a good indicator of a recession and while that hasn’t happened yet, it is very flat as US Treasury yields from one year out to 30 years range from 2.80% - 3.30%.

One silver lining of a recession is that it might compel Chairman Powell to withhold further rate hikes. If that happens, or the market believes the Fed will pivot, it’s reasonable to expect a stronger market. In addition, massive selloffs like we’ve seen create very attractive opportunities, especially for long term investors. For example, leading homebuilders like D.R. Horton and Lennar are down over 40% this year and currently trade at only 4x their 2022 earnings estimates. Steel companies Cleveland-Cliffs (2.8x) and Steel Dynamics (3.3x) are even cheaper.

An oil comment

As far as I’m concerned, oil is an important key to inflation as oil and inflation have gone hand in hand in the past.

According to David Rosenberg (Early Morning with Dave June 21, 2022), from December 1986- October 1990, oil rose about 125% and inflation rose from 1.1% to 6.3%. From October 2006- July 2008 oil rose again by 125% and inflation jumped from 1.3% to 5.6%. In the current cycle, oil has risen roughly 110% and inflation has soared from 1.4% to 8.6%. The prior two times a recession followed the oil spike and this time we have a Federal Reserve raising interest rates as well.

I have avoided chasing the oil story and in June Chevron has dropped 20%, Exxon 18% and Devon 32%.

What’s next?

The risk of “selling everything” today is that the market will turn very quickly and powerfully, and selling would also beget the question of when to get back in. As Warren Buffett has famously said, “if you wait for the robins, spring will be over.” Furthermore, many clients still have enormous unrealized capital gains, and selling everything would trigger a big tax bill next spring for many.

For now, I expect to remain focused on companies where I have my highest conviction, and for the past few years, the most widely held names across Peattie Capital portfolios have been Microsoft (“MSFT”), Alphabet (“GOOG”) and Apple (“AAPL”). Based on what I know today, I expect to continue owning them.

Regardless of oil/inflation, I still believe that emerging technologies (electric vehicles, genomics, e.g.) the migration to all things digital, and the emergence of cloud computing provide the best opportunities for long-term capital appreciation. As Eric Savitz wrote (Barron’s June 20) “As recent earnings reports from Amazon, Microsoft and Alphabet made clear, demand for cloud-based computing services is both vast and expanding. The promise of the cloud - improved flexibility and reduced costs - is fundamentally changing the way every company handles computing.”

A few accounts own small positions in several high growth tech companies which specialize in data management and cyber/cloud security. I mentioned these companies in the Q1 newsletter, and while they are still down significantly for the year, they were first to correct last fall, and have now bounced 40% or so from their recent lows. I believe the macro headlines are masking some of the extraordinary developments and trends taking place right now.

For some accounts I have also begun sprinkling in some short positions and other hedges. In theory this sounds simple, but in practice the timing can be very difficult as bear markets typically have extraordinarily powerful brief rallies.

For more conservative accounts I continue to have a big cash position and own a variety of very large blue-chip companies like Eli Lilly (“LLY”), Johnson and Johnson (“JNJ”) and Pepsi (“PEP”), among others. One name I’m considering is Stanley Black and Decker (“SWK”) which is down 50%, trades well below the market’s and its own long term multiple, and has paid dividends every year since 1876. In addition, for the first time in many years I have also begun buying select fixed income such as 6-month Treasury bill which closed Friday yielding 2.44%.

A few examples of growth companies

BYD Holdings (“BYDDY”) is a Chinese electric vehicle manufacturer which recently discontinued manufacturing combustion engine cars. BYD focuses on the lower end of the market, and I particularly like that it manufactures its own batteries and semiconductors. Tesla just signed an agreement purchase batteries from them, and Warren Buffett has been a large shareholder for many years. BYD is expanding aggressively into Europe and already sells electric buses in the US.

Datadog (“DDOG”) provides security and data access in the cloud and is my favorite of the high growth companies I own. Revenues grew 84% and 83% the past two quarters, with free cash flow margins of 33% and 36% respectively, and it is profitable ($0.66 latest twelve months). No doubt revenue growth will slow, but with 80% gross margins and a net retention rate of 130, DDOG looks like a name to continue owning as long as cloud computing continues to grow quickly.

Invitae (“NVTA”) has the most upside of any company I know right now. Shares peaked at $60 in late 2020 and closed Friday just above $3. NVTA is working on integrating genetics into mainstream medicine and sells genetic tests in a variety of clinical areas, most notably cancer. In the Q1 earnings call, NVTA stated that they expected revenue of $650mm in 2022, representing 40% growth over 2021. They also discussed their success in reducing spending and expect overall expenses in the $600 million to $650 million range this year. NVTA doesn’t expect profitability for another two years, so they are focused on cash management. This is a highly speculative situation and not for every client, but the cost to sequence the human genome has dropped significantly as has the time required to do it. NVTA has important genetic data which they think will extend and save lives and is a forerunner of the future of health care.

I don’t own companies for their takeover potential, but a recent Jefferies report highlighted that the combined market cap of all biotech stock with less than a $5b market cap was roughly $350 billion, and the combined cash balance of the top 20 biopharma companies was approximately $300 billion. Said another way, those 20 companies could almost buy every one of the smaller ones.

Late last year an analyst at SVB Leerink estimated that the 18 largest US and European biopharma companies will end 2022 with approximately $500 billion in cash. The analyst, Geoffrey Porges, concluded those companies would have $1.72 trillion of M&A capacity.

Conclusion

Some of the sentiment indicators I follow haven’t reached the panic levels they’ve reached in other bear markets, so that gives me pause. However, the large cap leaders are growing double digits, have defensible businesses and are generating mountains of cash. For example, GOOG is expected to grow revenues 15% or more the next few years and trades about in line with the overall market. GOOG has an active buyback program and at the end of Q1 had $135 billion of cash on the balance sheet.

Very soon we will be seeing more inflation data, and a bond market with yields anchored in the 3% range suggests to me that inflation isn’t as entrenched as many fear. The market hates uncertainty more than anything and any comments from Powell clarifying his intentions could help reduce that uncertainty. For now, the narrative remains that we currently are facing recession or inflation, and until that narrative changes, there could be more pressure on share prices.

All that said, the very best opportunities and returns are created in times like this, when there are concerns and good companies as well as bad ones have been discarded. This is an opportunity for good stock picking to shine, and I remain excited about the prospects for Peattie Capital companies.

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