<April 29, 2021>
A few weeks ago, I had breakfast with an old friend and realtor, Chris. He just sold his beach property and wanted to meet to discuss potential investment ideas. He intended to build on the lot but sold after construction costs (including lumber) soared and offers became too irresistible.
Since Chris offered to pick up the tab for breakfast, I ordered an extra side of bacon in support our new holding, WH Group Limited (market-leading hog producer). With a hearty serving of bacon on the way, I felt obligated to give Chris my very finest investment idea. Fortunately, I just spent the past few days reading through earnings reports and conference calls, so I was up to speed on current business trends and where some of the value was hiding.
Chris: “So, what do you have for me?”
Me: “As you know, it’s slim pickings out there. Stocks have never been more expensive, while most bonds are providing negative real yields. And you know firsthand how crazy real estate has become.”
Chris: “Ok, so do you have any ideas or not?”
Me: “Of course I do. In fact, I’ve been thinking about this a lot and came up with a risk-free idea that can earn 3-5% this year.”
Chris: “Wow, that’s incredible. I’m getting 0% on my cash now. I’ll take it!”
Me: “All right, but keep in mind, it’s a little unconventional, but in my opinion, it’s one of the best risk-free returns out there.”
Chris: “Sounds great.”
Me: “Ok. Are you ready?”
Chris: “Yes. Tell me!”
Me: “Paper towels.”
Chris: “Paper towels?”
Me: “Yes, paper towels. I can almost guarantee you the price of paper towels will increase 3-5% over the next year. So in theory, if you buy paper towels today, you’ll receive a 3-5% holding gain on your inventory!”
Chris: “You can’t be serious! That’s it?”
Me: “Well, no, not exactly. In theory, you can apply this to many of the things you need that are rising in price. In other words, my best idea today is to buy things!”
Fortunately, Chris and I have been friends for a long time, and he still picked up the bill for breakfast. And while he may have been disappointed with my idea, it didn’t seem as crazy the following day when Kimberly-Clark (KMB) announced price increases on many of its consumer products. In fact, it turns out my 3-5% estimate was too conservative as Kimberly-Clark plans on raising prices mid-to-high single digits. That certainly beats a T-bill!
It’s going to be an interesting earnings season. While it’s early (especially for small caps), we expect rising costs, price increases, and supply disruptions will be a common theme. For example, WD-40 Corp (WDFC) recently announced a shortfall in sales in the Americas and blamed supply constraints.
Management explained, “In the United States, some of our third-party manufacturers have been experiencing increased absenteeism and labor shortages, which have resulted in slower line speeds, capacity constraints and increased competition for line capacity within the aerosol industry. In addition, we've been managing raw material shortages and transportation bottlenecks, which have impacted our ability to deliver products and meet some of our normal levels of service with our customers in some markets.”
We found WD-40’s comments on labor shortages particularly interesting. Labor shortages are popping up everywhere, with help wanted signs sprouting up like weeds in most retail and business districts. We’ve also noticed product shortages and service delays in our personal lives. Last week my son and I waited 25 minutes for a sandwich at Panera Bread. The manager apologized and gave my son a free brownie! I thanked her and wished her luck finding employees. Jayme shared a similar story last week. He forwarded an email from a leading home food delivery service informing him they were canceling his order. The cancelation notice stated, “Unfortunately, we had to cancel your order scheduled to arrive this week. As is the case with many industries during these unprecedented times, we have been experiencing unexpected labor shortages. We know how frustrating this must be, and we are truly sorry.”
With examples of labor shortages increasing throughout the economy, we’re baffled as to why certain economists and Federal Reserve members continue to focus on the slack in the labor market. For example, in a recent Wall Street Journal interview, Fed President Eric Rosengren said, “We still have a lot of labor market slack, the participation rate is still quite low relative to prior to the pandemic, and the unemployment rate is still at 6%.”
Who is right, businesses struggling to fill positions or economists relying on their macro data? As bottom-up economists, we view the economy through the lens of the 300 businesses on our possible buy list, not government data. We’ve found this bottom-up approach to be timelier and more useful than most macro reports, surveys, and top-down opinions. As such, we’ll side with what businesses are experiencing, and view the current labor market as extremely tight.
In addition to a tight labor market, the combination of relentless asset inflation, soaring fiscal deficits, and direct monetary distributions to the public has made it increasingly challenging for many businesses to keep up with demand. Interestingly, we’ve found higher prices are not always effective in resolving supply and demand imbalances. Jayme’s food delivery service is a good example. Regardless of the price charged, the company simply didn’t have the necessary labor or capacity to fill his order.
Real estate is another example of higher prices failing to increase supply. In fact, the opposite has occurred. While prices for residential real estate have been increasing sharply, supply has been declining. Supply has gotten so tight in certain markets, bidding wars and offers above list prices are becoming more common.
A local real estate agent recently sent an email describing the market in Ponte Vedra Beach, Florida. He writes, “Consistent with this strong seller's market, prices have continued to rise at an alarming rate. During 2020, the average price per square foot for a Sawgrass home was $256; whereas, for the first three months of this year, it has been $333, or an increase of 30%. It seems as though price sensitivity went out the window last year, and there are many buyers that want to buy a place here regardless of the price.” And while 30% appreciation is above the national average, the median selling price of existing homes in the U.S. continues to rise sharply, jumping 17.2% in March! Meanwhile, the shelter component of the CPI, which makes up 24% of the index, only rose 1.7% over the past 12 months!
For many homeowners wanting to profit from the sharp rise in prices, it’s likely becoming tempting to sell. We can relate to this temptation, as our family took advantage of the 2005-2006 housing bubble by selling our house and renting for two years. While this cycle appears even crazier than the last housing bubble, this time around we’re not selling. There are several reasons. First, when we sold our house in 2005, risk-free rates were near 5%, allowing us to generate healthy interest income on our sale proceeds, which we used to subsidize our rent expense. With risk-free rates near 0% today, the sell and rent math makes less sense. Second, rental availability has declined, and rental rates have increased considerably. Unlike 2005-2006, finding an affordable rental has become much more difficult this cycle.
And finally, the Federal Reserve was not administering unlimited quantitative easing during the last housing bubble. In 2005-2006, printing money to “solve” our problems didn’t seem imaginable—it was something only Third World countries considered! Today, money printing is all too common among developed countries and has become an important risk to consider for those thinking about selling their homes and renting. For instance, what happens if you sell and during the next stock market decline, the Federal Reserve increases its quantitative easing to $3, $4, or $5 trillion a year? It’s become extremely difficult to predict how much money the Fed will create and how it will affect home prices and shelter inflation.
In our opinion, greed drove the last real estate bubble, while the current real estate bubble is being driven more by fear—the fear of being priced out of the market. With a Federal Reserve committed to doing whatever it takes (unlimited QE) to avoid another 2008-2009 crisis, there is simply too much money chasing too few homes. We joke locally, that yes, we could sell our homes and make a nice profit, but what do we do with the money? As it relates to real estate, it doesn’t buy much these days! In summary, while selling may work again this cycle, we find comfort in owning some real estate as a hedge against a Federal Reserve that in our eyes, doesn’t seem overly concerned about our rising cost of living.
With many financial assets trading near record prices and nosebleed valuations, we wouldn’t blame anyone for trading in some paper profits to buy things. Whether it’s investing in paper towels or replacing old appliances, swapping financial asset inflation to get in front of tangible goods inflation may not be as crazy as it initially sounded to my friend Chris. As long as the things purchased are needed and aren’t perishable, what’s the downside of buying in front of price increases? And if the Fed is wrong about inflation being transitory, estimated holding gains may prove conservative. Not to mention what underestimating inflation could do to stock and bond prices.
Eric Cinnamond
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Definitions:
Consumer Price Index (CPI): An index of the cost of all goods and services to a typical consumer, calculated and published by the United States Bureau of Labor Statistics; abbreviated CPI, and usually referred to by that acronym.
Zillow Observed Rent Index (ZORI): A smoothed measure of the typical observed market rate rent across a given region.