Not too hot, not too cold seems to be the prevailing attitude among market participants today. The US economy closed out the first quarter at a red-hot 6.4% annualized rate of growth. The momentum carried right into the second quarter with expectations now for full-year growth at the same pace or higher. Concerns of accelerating inflationary pressures were assuaged by multiple Fed speakers as central bankers assured market participants that inflationary pressures were transitory.
Labor availability remains an issue for many of the companies in which we are invested. Despite high demand for labor as evidenced by the monthly Job Openings and Labor Turnover Survey (JOLTS) conducted by the Bureau of Labor Statistics, the unemployment rate remains stuck near 6%. With some state and federal unemployment benefits due to expire this fall, we anticipate more workers will reenter the labor force and fill the many current vacancies. The cost of hourly labor continues to rise in response to increased demand (below).
Other input costs such as raw materials (above right) and transportation have experienced price hikes – in some cases dramatic hikes – adding to concerns about the potential for inflation. Some may recall the late 1970s when the inflation “genie” got out of the bottle and inflation ran around 13.5%, wrecking economic havoc.
The Fed had previously guided to ”lower for longer” with respect to interest rates. This narrative has been called into question as inflationary pressures build. Yet, the bond market votes in favor of the transitory outlook, as the 10-Year US Treasury yield has softened in recent months, now trading at 1.35% (down from a recent high of 1.75% in April).
We are monitoring the situation closely. Higher interest rates at this point in the economic cycle would indicate market participants are anticipating slower economic growth and higher inflation ahead, whereas rates trending lower would suggest market participants are more concerned with slowing growth than with inflationary expectations. We tend to think recent inflationary pressures are transitory based on continued favorable global trade trends and technology-enabled labor productivity improvements. As substantial government stimulus transfer payments work through the economy and post-pandemic consumer spending trends normalize, we think supply chain pressures will abate and overall demand will again closely match supply, leading to a return to low levels of inflation. We are positioned to take advantage of this outcome.
Portfolio Update
We have continued to selectively trim our investment positions, raising more cash as valuations on both stocks and bonds remain elevated. We have taken some sizable profits this year, and have sold more bonds than stocks.
Interest rates remaining low has created a fevered demand for bonds, causing prices to rise to levels we believe are unsustainable. Selling into this strength has been a sensible strategy, leaving us more heavily in cash – a defensive position in the short run – and ready to step forward and make investments as opportunities arise.
Stock and bond prices move up and down on a daily basis due to imbalances in supply and demand. Over time, as businesses develop and generate additional earnings power, stock prices rise to reflect fundamental improvement. However, these improvements generally occur gradually. The day-to-day variability in stock and bond pricing is purely a reflection of market participants voting with their dollars to set a price they believe represents fair value for the business at that point in time.
We spend a great deal of time thinking about and understanding how business managers create value for shareholders. We ask both CEOs and CFOs of companies we speak with how they think value is created. There is no single correct answer to this question, which makes their answers all the more interesting.
Every public company publishes a set of financial statements – a balance sheet, an income statement, and a cash flow statement. We think shareholder value creation should be reflected and identifiable on one of these statements.
An increase in a company’s stock price is not synonymous with shareholder value creation. Again, stock price variability is a function of supply and demand. Shareholder value creation occurs when a company creates real economic value, which can be measured, and is evident in its operations. Over time, companies that create shareholder value generally see their stock price rise, but not necessarily in unison.
One of our preferred measures of value creation is shareholders’ equity on a per share basis. Shareholders’ equity is the final line item on a company’s balance sheet. In part, it reflects the sum of all earnings less historic dividends or shareholder distributions. Simply, shareholders’ equity per share measures the net worth a company has created.
There are many related assets and liabilities that need to be considered when looking at shareholders’ equity per share, but at a very basic level, this is a good metric to gauge how effective a management team has been in building value over time.
Lastly, and of great importance in the investment process, it is not sufficient to simply identify a company that creates value for shareholders (although this is important). It is critical to not overpay for a share of that company. In other words, a company that consistently creates shareholder value as measured by shareholders’ equity per share may trade at a large premium to its underlying value. Through the unbridled forces of market supply and demand, the stock price of a company may trade at an extreme valuation relative to its shareholders’ equity per share. For example, a company that has grown its shareholders’ equity from $10.00 per share to $15.00 per share may have experienced an increase in the price of its stock from $15.00 per share (1.5 times shareholders’ equity) to $60.00 per share (4.0 times shareholders’ equity).
Our two principal concerns as investment analysts are identifying company management that understands how to create business value, and to invest only when the company’s stock can be purchased at a favorable price in relation to the fundamental value.
From Our Library
We continue with our reading of Valuation: Measuring and Managing the Value of Companies by McKinsey & Company. The following passages support our thinking:
Certainly, irrational behavior can drive prices for some stocks in some sectors in the short term. And for shorter periods of time, even the market overall can lose touch with economic fundamentals. But in the long term, the facts clearly show that individual stocks and markets as a whole track return on invested capital and growth. For this reason, managers should continue to make decisions based on these fundamental drivers of value. By doing so, managers can also detect and perhaps exploit any irrational market deviations if and when they occur.
But individual groups of investors will earn very different returns, because they pay different prices for the shares, based on their expectations of future performance.
The expectation [factor] is the dynamic behind the adage that a good company and a good investment may not be the same. In the short term, good companies may not be good investments, because future great performance may already be built into the share price. Smart investors may prefer weaker-performing companies, because they have more upside potential, as the expectations expressed in the lower share prices [valuations] are easier to beat.
Firm Update
As the second half of the year gets under way, I’d like to recognize work anniversaries for the following GVIC Associates: Tom (seven years), Satendar (four years), JP (four years), and Kevin (one year). Earlier in the year, we recognized Stacy’s fourth anniversary and Naveen’s first anniversary, in addition to welcoming Ruchi to the firm. Global Value Investment Corp. is made of its people, without whom we would not have a firm. Our people are our greatest asset. We are a cadre of dedicated professionals with a collection of ideas borne from a desire to identify great investments. Each of our associates commits an extraordinary amount of time and energy in our overall pursuit of investment excellent.
Concluding Thoughts
We continue with our diligent efforts to identify attractive investments in this unusually chaotic environment. One of our core principles at GVIC is to remain calm, alert, and opportunistic. The past year has afforded several instances to exercise this discipline. We identified some particularly attractive bargains (companies trading at a discount to intrinsic value) during those days when great uncertainty prevailed. We are now enjoying some of the reward of those timely investments.
Please let us know if you have any changes in your investment objective or financial situation that warrant adjustments to your portfolio.
Thank you for the ongoing trust and confidence you have placed in us over the years to be prudent stewards of your capital.
Your Investment Research and Advisory Team
Global Value Investment Corp.