<October 1, 2020>
The day most parents dread finally came. Last week, my 8-year old son and I had the “big talk.” You know the one, the one about inflation!
My son’s curiosity was stirred by the tooth fairy. When he loses a tooth, the tooth fairy leaves a silver coin under his pillow. After noticing a loose tooth last week, he asked me if the tooth fairy would bring him another silver coin. “As long as you behave and do well in school,” I said. He then asked what I received from tooth fairy when I was a kid. I told him a quarter. “A quarter!” he exclaimed, “You must have been a bad kid!” “No, I wasn’t a bad kid,” I said, “the tooth fairy simply adjusts for inflation.”
With a confused stare, he asked, “What’s inflation?” I explained, “Over time the supply of money increases and its value decreases.” Appearing even more confused, I thought an example was in order. “Remember when we went out for ice cream the other night?” “Yes,” he said. “Well, that single scoop on a sugar cone cost $4.50. When I worked at an ice cream shop in 1988, I served that exact ice cream cone for $1.10.”
My son then asked me why the price of ice cream has gone up so much. I explained that it wasn’t just the cost of ice cream. While the cost of its production has certainly gone up, so has the cost of transporting, storing, and serving it. In effect, there’s a lot that goes into an ice cream cone, starting with making its ingredients to the time it’s scooped at the ice cream parlor.
Now I was the one who was curious. Considering how many parts of the economy are involved in serving an ice cream cone (agriculture, production, distribution, real estate, and labor), it’s probably not a bad measurement of inflation over the past three decades. We’ll call it the ICCI, or the Ice Cream Cone Index.
After grabbing my calculator, I learned the annualized rate (1988-2020) was 4.5%. I remember many prices in 1988, as that’s when I started working and paying for things with my money! After thinking about and comparing 1988 prices to today’s, the four to five percent annualized increase in the ICCI seemed about right to me.
I went on to provide my son with other examples of the rising cost of necessities (yes, ice cream is a necessity!), such as housing, medical care, and tuition.
Following government economic data is quick and easy. However, as bottom-up analysts, we prefer a more labor-intensive approach. We gather our economic data, including data on inflation, from the hundreds of small cap businesses we follow and analyze. Historically, we’ve found economic data received from individual businesses is often timelier and more accurate than data published by government agencies. We’ve also found much of the government’s data is adjusted, smoothed, and backward-looking. By focusing on actual company results and real-time outlooks, we believe we have a competitive advantage over investors that are overly dependent on government reports and surveys.
While our bottom-up macro views are not the primary drivers of our decision making, they influence our business valuations. For example, having a good feel for where we are in the economic and profit cycle is essential in determining the normalized free cash flow of most businesses. Moreover, as it relates to inflation, understanding real world cost and pricing trends can improve our ability to accurately determine profit margins, and ultimately, our calculated worth of a business.
While acknowledging rising cost and pricing trends is important to our valuation process, there are few on Wall Street that benefit from reporting or promoting inflation. In fact, ignoring rising prices and warning investors of deflation is a much more lucrative endeavor. A successfully implemented deflation narrative can persuade investors to drive down real interest rates and their required rates of return. As required rates of return fall, stock and bond prices inflate, providing asset managers with higher assets under management (AUM) and higher fees.
The deflation narrative and negative real interest rates can also benefit policy makers and indebted governments. Governments benefit from the low cost of capital the deflation narrative and lower interest rates bring. Policy makers also benefit as negative real rates and inflated asset prices can stimulate the economy through excessive credit growth and the wealth effect (see: Asset Inflation Blvd). And finally, the deflation narrative puts central banks in a better position to fund fiscal deficits with printed money and debt monetization. Such actions would likely be considered irresponsible in an inflationary environment, possibly disrupting the currency and bond markets.
While many investors and policy makers continue to view the world through a deflationary lens, our opinion on inflation has not changed. If businesses are experiencing it and responding to it, inflation remains with us. While recent events driven by COVID-19 certainly caused many prices and costs to decline earlier this year, last quarter’s operating results and conference calls provided many examples of shifting inflationary trends. In particular, several companies we monitor reported rising average selling prices, fewer promotions, supply disruptions, and even labor constraints. Although there remain areas of deflation and oversupply in certain industries, such as energy, many of these industries are quickly reducing capacity, which in our opinion, will eventually lead to declining supplies and higher prices.
While Wall Street and central bankers may not be concerned about inflation, given our ability to hold cash when valuations are expensive, we take the risk of rising prices and negative real rates very seriously. Fortunately, with so many investors dismissing the possibility of inflation, traditional inflation hedges have remained reasonably priced, in our opinion. Whether it’s the successful dissemination of the deflation narrative, or simply the herd chasing growth stocks, we’ve been able to find value in asset-heavy businesses that we believe will perform well in an inflationary environment.
Although most of our equity valuations are calculated by discounting future free cash flows (DCF), we also value businesses using a net asset valuation methodology. In such cases, we attempt to buy the net assets of a business at a discount to our calculated valuation. Businesses we value using this methodology are typically asset-heavy, such as those found in the financial, energy, and precious metal industries.
Currently, we are finding the largest discounts to our net asset valuations in the energy industry. Our interest in energy has grown over the past few months and since our original post “Opportunities in Energy” late last year. The decline in energy demand caused by the COVID-19 lockdowns has accelerated the industry’s downturn. Rig counts and exploration activity in the energy sector have collapsed. In our eyes, it’s not an industry recession, it’s a depression! Stock prices of energy companies have declined to levels and valuations we haven’t seen since the 2008-2009 financial crisis. As value investors, we’ve been encouraged by the sharp decline in energy stocks and our improving opportunity set.
It wasn’t too long ago that precious metal mining stocks were in a similar predicament. In fact, current investor sentiment and valuations in the energy industry remind us a lot of the precious metal miners in 2015. At that time, precious metal miners were also selling at significant discounts to our calculated net asset valuations. Negative research and media reports seemed to come out daily, with gold even being called a “pet rock” near the lows of the cycle. Of course, that all changed after gold miners bottomed and rallied sharply in 2016 and again in 2020. Although we can't predict the future, we wouldn’t be surprised if depressed energy companies with strong balance sheets (survivors) have a similar experience as they manage through the current downturn.
Some of our favorite investment ideas are often those that we believe professional investors are unwilling to buy due to the elevated career risk associated with looking different from their peers. In our opinion, there’s no better way to get fired as a professional money manager than to buy energy stocks today! Again, this was very similar to investing in precious metal miners in 2015. Below we compare the Arca Gold Miners Index in 2015 to the 2020 YTD stock price of one of our energy holdings as of our last disclosure (6/30/20), Helmerich & Payne (HP). Although HP’s stock may not rebound like the miners, we believe the investment is undervalued.
Another asset-heavy industry that has recently caught our attention is small cap financials and banks. While we haven’t been very interested in banks since the financial crisis, recent declines in financial stocks have placed many valuations near or below tangible book values. Although we’re uncertain if or by how much we’ll get involved, we’ve begun our initial due diligence on several small cap banks. And while some banks appear cheap, we are well aware many of their book values may decline in upcoming quarters as loan forbearances lapse and loan loss provisions increase (especially in commercial real estate). For now, we are more comfortable with the long-lived assets of the energy industry, but assuming the stock prices of small banks continue to fall, our view could change.
After our discussion about inflation, my son asked me about the value of the last silver coin he received from the tooth fairy. He was surprised to learn it increased to $25 from $15. “Is that inflation too?” he asked. “Yes, the value of money is declining in relation to your silver coin.” As my son walked away, I felt satisfied that I helped him better understand inflation and the devaluation of money.
A few minutes later my son returned. He had blood gushing from his mouth and a freshly pulled tooth in his hand. “Look dad, I lost another tooth!” Whether motivated by our discussion, or simply the higher price of silver, my son desperately wanted another silver coin to hedge against inflation!
In our opinion, the deflation narrative and unchecked central bank balance sheet expansions cannot coexist indefinitely. When the deflation narrative is finally put to rest, we expect others will follow my son’s lead—scrambling to find a way to own tangible assets. In the meantime, we are grateful the markets are putting asset-heavy companies up for sale. And for those who continue to rely on the deflation narrative and the tooth fairy (the Fed) to justify current asset prices, please be careful. When investors lose their teeth, it isn’t cute and it can be very expensive to repair!
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Definitions:
Russell 2000 Energy Index: Consists of energy-related businesses in the Russell 2000 Index, such as oil companies involved in the exploration, production, servicing, drilling and refining processes, and other fuels used in the generation of consumable energy.
Normalized Free Cash Flow: The average annual cash from operations minus capital expenditures a business is expected to generate over the trough and peak of its profit cycle.
Discounted Free Cash Flow (DCF): A valuation method used to estimate the value of an investment based on its future free cash flows. DCF determines the present value of expected future free cash flows using a discount rate, or required return.
NYSE Arca Gold Miners Index: A market capitalization weighted index comprised of publicly traded companies involved in the mining of gold and silver. It is not possible to invest directly in an index.
Price to tangible book value: The ratio of a company’s market capitalization divided by its shareholders equity less all intangible assets.
Real Interest Rate: An interest rate that is adjusted for inflation or the nominal interest rate minus the inflation rate.
Required Rate of Return: The minimum return an investor will accept for owning an investment
P/E: Price divided by earnings
CPI: The Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food, and medical care.