Here are a few of my current observations and working assumptions:
Regardless of how telegraphed it was, a major world power invading another free sovereign nation is an enormously impactful historical event. It is best not to jump to any conclusions here and better to suspend judgment until this unfolds a little more. Media pundits are scrambling to come up with sound bites and a quick analysis and conclusions, but they are rarely very schooled or experienced in foreign policy. Many are saying this will be “over” in a matter of days or weeks. I don’t believe that for a second. For every action of this magnitude, there are likely going to be years of reactions ahead. I am not smart enough to figure out what those will be today and I don’t believe anyone else is either.
The Federal Reserve (Fed) has just been put in a difficult position. They saw a nascent inflation building last year, and they finally accepted that it was going to be more than just a short-term problem by November. Yet they have done little to date, in my opinion, to unwind their unprecedented level of accommodations and negative real rates! Now they are faced with new stresses on the global financial system, downward pressure on global GDP, likely falling inflation as weaker GDP and weaker demand brings abnormally high demand (post COVID) back in line with supply. So what do they do? Unwind Quantitative Easing (QE) and raise rates in the face of falling inflation and on oncoming recession? Not a good place to be. I think we should expect a change of tone from Chairman Powell.
To be sure, I have been in the camp of those who believe that we created this inflation with poorly thought out (and excessive) fiscal stimulus that boosted aggregate demand for goods well before the supply of labor, logistics, and materials had recovered from COVID shutdowns and restrictions. With that viewpoint in mind, I was assuming that as 2022 unfolded, we would see supply come back in line with demand, and we would see a big slowdown in the above-average pace of goods spending that took place over the past 18 months. If right, we would have seen demand slow, inflation abate, inventories build, and GDP wane. This would have been taking place at a time when the Fed was raising short-term rates and unwinding purchases of securities they amassed during QE. That seemed an unlikely backdrop to produce higher interest rates further out the curve (10-year, 30-year) despite the fact that most inflation hawks were suggesting we were headed back to 3%+ yields on the 10-year. As I always say, when GDP wanes, we normally see growth stocks outperform. So anticipating that this deceleration in GDP was ahead of us, we continue focusing on quality growth through depressed consumer services sectors and energy.
Today’s news throws a huge wrench into that outlook, and to most other outlooks as well. Everything needs to be recalibrated. Oddly, we might end up being right about lower inflation, lower global growth, and lower yields, but for the wrong reasons. The big wildcards are sanctions and energy. Sanctions on Russia are a challenge under normal conditions, but if we have learned anything since the invasion of Crimea, they mostly hurt European exporters and (as a result) the entire Eurozone economy. Russia doesn’t produce much that anyone wants other than oil, aluminum, and fertilizer. But because of Europe’s increasing dependence on Russia for energy, there will be an outsized bid for oil and gas from the rest of the world. If this continues to push crude prices upward (as it is today), this could not come at a worse time. My biggest fear was that the self-imposed restrictions on U.S. oil would eventually push prices to unsustainable levels ($120+). But I assumed this would happen slowly, giving other producing countries (The U.S.) time to react and possibly mitigate. But with crude touching $100 today, we now have to think about a realistic possibility that such a rise could come faster and snuff out GDP more rapidly. Perhaps the Fed could step in to offset this with higher rates.
The question on everyone’s mind is when to step in and what to start buying when they do. Before assessing what is cheap, one has to consider what is rich. And where most of the buying has been taking place over the past 8 months has been in sectors like energy, commodities, financials, utilities, and early-stage cyclicals and industrials. Where most of the pain has been taken is in the higher growth areas of consumer cyclicals, communications, and tech. In fact, over the past year, tech has been taken out to the woodshed on 5 occasions;
- When interest rates first started to come off their most depressed levels at the start of 2021.
- When the market began to rotate into cyclicals in the summer.
- When inflation started to report above trend.
- When Fed Chairman Powell changed his tune on rates and suggested a more hawkish tone.
- Over the past month as most high growers gave guidance that suggested more difficult comparisons ahead versus the high growth during the pandemic.
As a result, most high growers, in general and in tech in particular, are as oversold as we have seen them in the past 10 years. We have talked a lot about how far we have seen multiples on higher growth software as a service (Saas) stocks fall. Here is an update of a previously referenced chart that we monitor showing that price/sales multiples for this elite group are now back to levels not seen since the bottom of the pandemic panic or since mid-2018, when 10-year treasury yields were over 3%.
To be clear, the Saas stocks as a group are far cheaper than they were before the pandemic began in 2019. The question in my mind is when exactly we can expect this underperformance to end. Curiously, as the market began another brutal sell-off today, we saw our highest growth sleeve of innovative growers outperforming today by a wide margin (+320 basis points).
So how cheap can they get? As most of you know, our favorite metric is free cash flow, and a great metric to assess value is free cash flow yield. Our thinking is that if you can buy a stock that is growing free cash flow at double digits and gives you a yield competitive with a risk-free treasury bond (currently 1.9%) or an investment grade corporate bond (Goldman Sachs 10-year at 3.55%), then you have the makings of an attractive entry point. Through much of my career, most growth stocks traded at free cash flow yields well below comparable treasuries for the obvious reason of providing more growth. But that changed in the period of 2012-2017 as many high-quality growth names traded at free cash flow yields above comparable treasuries. We are seeing that same condition once again today, and the selloff of the past week has us starting to think we are getting close to a relative bottom for higher-quality growth names. We are seeing some of the depressed growth leaders of the past year now approach cash flow yields in the range of 4.5% and 8%.
I hope this is a helpful overview of our present thinking. Investing is a dynamic undertaking that requires constant re-assessments of the present environment, the future, and the relative attractiveness of stocks within our opportunity set. I hope all our clients understand that we are doing our best to thoughtfully make such reassessments and to take advantage of opportunities as they arise.
Tom Pence, Managing Director