Soft Serving a Hard Landing
<October 31, 2023>
If there was a list of the best jobs of all-time, serving ice cream would be near the top. While the pay is low, so is the stress. Working conditions are comfortable, and customer satisfaction is very high!
As luck would have it, I landed my first job at a local ice cream shop. During my interview the owner told me I’d only earn $3.50 an hour, but there were benefits. “What are the benefits?” I asked. The owner replied, “Free ice cream.” I couldn’t believe it. I walked in hoping to earn some gas money and left with an all-you-can-eat ice cream package!
The owner taught me well. Banana splits, milkshakes, fudge sundaes, ice cream cakes, clown cones—you name it, if it included ice cream, I could make it. The owner was also eager to teach me how to scoop ice cream to maximize profits. He showed me his trick with pride. “The key is not dipping straight down. Instead, move the scooper in a circular motion to create a thin layer of ice cream that folds into a ball. You see, while the scoop looks large, the middle is hollow!”
In addition to traditional ice cream, the store offered soft serve. Over time, I became a proficient operator of the soft serve machine and was often asked to make cones for other employees. To create an appealing tall cone, it’s important to fill the inside densely while forming a wide and supportive foundation. From a solid base, the cone builds gradually to a towering and narrow top. By using this method, I could make cones over a foot tall! Unfortunately, regardless of how much I practiced, there were limits. At some point the cone became too tall and risked going “splat” on the floor.
As we’ve watched the Federal Reserve tighten monetary policy, we’ve been impressed by how high interest rates have risen without the economy and stock market going “splat.” Reasons for the long lag in policy are numerous, including the large amount of fixed consumer and corporate debt built during the years of abnormally low rates. Elevated home and equity prices have also reduced the drag from higher rates. Rising interest income from U.S. Treasuries has been stimulative as well, with the added interest expense being placed on the “we’ll monetize it later” fiscal tab. Unemployment remains low, as companies have been reluctant to fire employees that were difficult to find only a year ago. Soaring government spending, especially on infrastructure, has also reduced unemployment and stimulated growth.
While many of this cycle’s cones appear to be holding up, other cones have already gone “splat.” The bond market has been a disaster, with many longer duration bonds falling over 40% from their highs. Businesses sensitive to interest rates have also suffered. Bank balance sheets are clogged with low-yielding loans and marketable securities, trapping capital and curtailing loan growth. Companies attempting to refinance debt are facing significantly higher interest expenses and often lower stock prices. Higher rates and inflated home prices have left the housing market frozen. Businesses selling to the lower and middle class are struggling as the rising cost of living devours discretionary income. While the rate of inflation has declined, significant scars, such as accumulated inflation and housing affordability, remain.
In our opinion, it’s only a matter of time before the economy and stock market follow the lead of the bond market and sectors that are already in recession. Once this occurs, we expect the Federal Reserve to do what it does best—come to the market’s rescue by cutting rates and reinstating quantitative easing. What comes next, we are less certain. While the market’s initial reaction may be similar to past bailouts, as we discussed in You Know We’ll Have a Good Time Then, we believe future rounds of rate cuts and debt monetization will carry much higher risks.
As we wait for the Fed to return to its easy money ways, several areas of the market are beginning to show signs of weakness and opportunity. Specifically, sectors sensitive to rising interest rates such as utilities, REITs, precious metal miners, and consumer discretionary have all been under pressure. While it’s not as broad-based as we’d like, several stocks in these sectors are down considerably, and in our opinion, represent value.
When assuming interest rate risk, we take several precautions. First, we’re attracted to businesses that have asset-heavy balance sheets or generate predictable full-cycle free cash flow. For example, while regulated utilities often carry debt, the debt is backed by consistent cash flow and valuable assets, such as power plants and transmission lines. We consider many of our recent purchases to be businesses that are asset-heavy or have sufficient cash flow to fund debt maturities.
Second, we prefer businesses with debt structures that reduce the risk of refinancing. Firms with debt maturing in the near-term without sufficient liquidity to fund the maturities should be avoided. Ideally, the company staggered its debt over multiple years and with long-term maturities. The debt structure of a recent purchase, Avista Corp. (AVA), is a good example. As illustrated below, its low-cost debt matures over several years and well into the future.
Third, we seek businesses that have sources of liquidity outside of the debt markets and bank credit lines. While cash is ideal, valuable assets such as farmland can also suffice. A recent purchase, Farmland Partners (FPI), expects to sell $190 million of its farmland this year, with part of the proceeds going towards debt reduction. Interestingly, and slightly off topic, we’re noticing more companies are choosing debt reduction over stock buybacks. It’s a growing trend that we expect will accelerate assuming interest rates and refinancing risk remain elevated. Although this would be a positive for balance sheets, it could remove one of this cycle’s most aggressive buyers of equities—corporations.
Fourth, we like businesses with few liabilities and are debt-free. Interestingly, we’ve discovered several companies in interest sensitive sectors that have seen their stocks decline even though they have debt-free balance sheets. For example, Equity Commonwealth (EQC) has no debt and $2.1 billion in cash on its balance sheet. Given it’s classified as a REIT, we believe the stock has followed its sector lower even though its cash balance and the optionality it provides has become increasingly valuable.
With interest rates rising, our opportunity set is improving. We are beginning to assume interest rate risk by investing in companies we believe will survive in a variety of economic and interest rate environments. We expect the economy and stock market will follow the decline in bonds and interest rate sensitive sectors. We’re not there yet, but we’re encouraged by the shifting economic and investment landscape. As opportunities increase, we plan to carefully build our cone of small cap stocks, while maintaining sufficient liquidity to take advantage of what we expect will be the main event—a hard landing and a sharp decline in the popular equity benchmarks. In other words, when this tall and unstable market cycle finally goes splat!
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Quantitative easing: A monetary policy in which the central bank increases the money supply in the banking system, as by purchasing bonds.
REIT: A real estate investment trust (REIT) is a company that owns, operates, or finances income-generating real estate.
Free cash flow: the cash that a company generates after accounting for cash outflows to support operations and maintain its business.
Weighted average maturity: The weighted average amount of time until the maturities of debt of a company or portfolio. The higher the weighted average maturity, the longer it takes for all of the bonds to mature.
Weighted average coupon: A measure used in the bond market which calculates the average yield to maturity of a pool of debt in terms of interest rates.
Asset-heavy companies: Businesses that have considerably more assets than liabilities.
The Bloomberg US Treasury 20+ Year Index: A bond index that measures the performance of US dollar-denominated, fixed-rate, nominal debt issued by the US Treasury with a maturity greater than 20 years.
Duration: A measurement of how many years for an investor to be repaid a bond’s price by the bond’s total cash flows. Duration can also measure the sensitivity of a bond’s or fixed income portfolio’s price to changes in interest rates.