September was come-to-Jesus moment for stock optimists. Stocks (the S&P500) lost nearly 10% in September alone. The selloff was triggered at the start of the month when Federal Reserve Chairman Jerome Powell spoke at Jackson Hole (which we discussed on our September letter) and continued all month long. It felt terrible. October, on the other hand, started with a bounce on Monday. This gained steam yesterday and we’ll explain we believe it could represent a turning point.
Let’s View the Current Market Through a Lens
A year ago, we made fun of the Fed for holding onto the view that inflation was transitory and being the only ones to think so. We ended up being right that inflation would be sustained. This nevertheless did not help us predict that the Fed would eventually pivot and embark on an aggressive interest rate hiking campaign, precipitating this year’s stock selloff. Fast forward to the present, the Fed appears to have already gone too far in the other direction. Interest rates increases have already fatally stabbed the heart of the housing market, in our opinion. And the equity market has also been smashed, as we mentioned. A recession in housing will have ripple effects in the economy, and financing and capital raises for companies will be severely curtailed by stock market conditions. Separately, the US dollar has appreciated dramatically against nearly all currencies. Together these factors should result in reduced economic activity and lower prices for imports in 2023. If we try to take a lesson from the Fed’s slow-to-respond behavior last year, which set up this year’s troubles, the current situation appears like the inverted mirror.
Labor Market Provides First Positive Signal of Any Kind in Months
We’ve discussed in several previous letters, notably last month, that breaking the labor market would be required to win vs. inflation. Inflation is pernicious and destroys value for savers, hurts those on fixed incomes (especially retirees), and negatively impacts consumers. Prior to 2022, we’ve lived through an extraordinarily long time (decades) without any meaningful inflation. This agreeable situation ended thanks to the overaction during the Covid panic and the flood of stimulus that accompanied it. Demand was boosted to unnatural levels. The supply of both goods and workers were depressed. Supply of goods is being corrected, more on that below in the discussion of Nike, but demand for employees has remained elevated. This has led to upward pressure on prices as companies have raised salaries and passed on higher operating costs to consumers. The Federal Reserve’s interest rate campaign is aimed squarely at squashing this wage-price cycle. Yesterday, we saw the first sign it’s working. Job openings (August data) fell more than one million sequentially. See chart below. While this is only one data point, it is very encouraging, especially as employment is a lagging indicator. If this trend continues, we’ll soon start to hear calls for Jerome & Co. to cease-and-desist with the rate hikes, which will in turn relieve pressure on stock prices.
Figure 1. Demand for labor has been a major factor behind the current inflationary conditions. While recent job openings were still well above pre-pandemic levels, the latest tick is lower, suggesting a correction is underway.
Valuations for Several Names Are Getting Very Interesting
Stocks get more attractive when the prices are lower, so why is everyone so negative? September ended with something of a stock selling mini climax. October has started off with two consecutive days of positive reversal. We can’t say whether September will prove to be the bottom (this will only be known in retrospect) but we can say that many stocks we watch appear to be attractive from a valuation perspective. To illustrate this in an incomplete anecdotal fashion, we composed the below table. It compares the change in stock prices, the change in expected earnings, and the change in P/E (price-to-earnings) for a group of widely held names over the past year. We can see that, on average, this group lost 28% of its value over the past 12 months. Meanwhile, forward looking earnings for the same group are higher by 4%. Consequently, the average P/E has contracted by nearly a third. If the value of a stock is determined by its earnings, there is no question the group appears more interesting. Two objections can be made. First, it can be argued, reasonably, that valuations were too high a year ago. Secondly, earnings estimates are probably, on balance, too high. We acknowledge truth in both these charges. Nevertheless, this does not alter the fact that stocks are much cheaper than a year ago and therefore much more attractive than they were. Taking some specific examples* from the table below, Google (GOOGL) is currently trading at a P/E of 16x, which seems very low for a company that most people use everyday and dominates critical components of the internet. Another one that jumps out at us is Disney (DIS) which has fallen 46% in price over the last year but has higher earnings estimates. DIS’ P/E has been cut precisely in half. Has the value of the Disney brand or the company’s future earnings and cash flow changed? Not in our view.
Earnings versus Earnings Power. Our Approach to Investing in Cyclical Companies During Challenging Periods.
Nike, Inc. (NKE) is among the best-run companies that we know but it is not immune to the outside world. There’s a good French verb, basculer, that describes what has happened to Nike’s business since the Covid panics. Basculer is what happens to a buoy out in the sea during a storm. It gets tossed back and forth but generally holds its position. Nike saw demand for its product surge during Covid, but the company was unable to fulfill that demand as many of its factories in Vietnam and other countries in Asia were closed for weeks at a time due to Covid lockdowns. Millions of pairs of shoes were never made. On top of this, shipping times from the Far East lengthened dramatically, along with the associated costs. A year ago, the company found itself without needed inventory and had to lower its sales forecast. Fast forward to the present, Nike now has the opposite problem as attempts to order more goods and a still-screwed-up supply chain created in inventory overages. Nike shared last Thursday that instead of missing out on potential sales like last year, this year it will be discounting heavily to clear product, and margins and earnings will be hurt. Investors responded in a predictable way, sending the stock, which was already down substantially, to a new low for the year. In fact, the Nike share price returned to the range it saw during the corona-panic. See figure 2 below. What the two red circles identify, in our view, are periods when the market temporarily forgot about Nike’s brand power, its global growth, its excellent financials, or its long-term outlook for cash flow and earnings, and instead just looked at what’s happening right now.
Some of the companies we own, like Nike, are exposed to cyclical demand. This means their sales and earnings will be lower during periods of economic weakness. If it were possible to predict when these periods start and stop, then it would make sense to sell NKE shares ahead of recessions and buy them back when the worst has passed. Our approach is to acknowledge we don’t know what will happen with macro. Instead, we rely on the best management teams running companies with durable business models to figure it out. Selling Nike shares because inventory arrived at the wrong time and in too great a quantity is a mistake, in our view. We look forward to the company’s long-term potential to grow earnings, which we believe is unchanged.
Figure 3. Periods of concern about immediate-term results have coincided with NKE shares hitting lows. Ask yourself: What were sellers thinking when they sold during the Covid-panic? No one will wear shoes in the future? What are they thinking today?
*Talk to your financial advisor about what is appropriate for your investment and risk profile.
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John Zolidis
President & Founder
Quo Vadis Capital, Inc.
John.zolidis@quovadiscapital.com
Mr. Zolidis founded Quo Vadis Capital, Inc., a Registered Investment Advisor (RIA) and research consultancy, in 2017. He started his career in finance in 1996 following degree studies in Philosophy at Kenyon College and the University of Oxford. He has followed U.S. consumer companies as a senior analyst since 1999, mostly on the sell-side, writing research for institutional investor clients. He also managed money in a buy-side role at a long-short equity fund over 2013-2014. He was named in the Wall Street Journal’s Best on the Street list in 2005. Mr. Zolidis and works from New York, NY and Paris, France or wherever he has his laptop.
October Travel update: Speaking in Athens, Greece, then traveling to London. Later this week I am headed to Athens to speak (in English) at a conference organized by the Greek Centre for Value Investing. This is a little different from the “idea conferences” I normally attend. At the idea conferences, the format is usually that each attendee presents an investment idea. In Athens I will be talking about the process of investing, with a focus on sources of errors as well as our approach to analyzing companies. However, since that sounds like it has the potential to be incredibly dull, I am trying to spruce up the talk using three hopefully humorous analogies to introduce the ideas. Fingers crossed that the sarcasm will translate. After Athens, a lower risk prospect is my flight to London to watch the Green Bay Packers take on the New York Giants. How many Packers fans can London absorb in one weekend? We’re going to find out. I will be sticking around post game for a few days of meetings. If you’re in Athens or London and want to meet up, please get in touch.
Two recent interviews: If you haven’t gotten enough of me yet, two friends recently interviewed me for their respective podcasts. You can find the video of my talk with value investor Guy Spier via this link. The discussion with Tilman Versch on his Good Investing Talks is here. Thanks!
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