<July 18, 2022>
There are three things I remember most about my professor in college who taught investments. First, he wasn’t a professor. He was a small cap manager that accepted an invitation to teach the course for one year. Second, on the first day of class he threw a one-hundred-dollar bill on the floor. Chairs, desks, and students all went flying as a fight to capture the free Benjamin ensued. “You see, market inefficiencies can happen at any moment, but you have to be ready because they won’t last long,” he explained. And finally, I remember that he looked exactly like a popular comedian at the time, Jon Lovitz.
Jon Lovitz was best known as a cast member on Saturday Night Live (1985 to 1990). Personally, I remember him for his role in playing the SNL character, Tommy Flanagan. Tommy was a pathological liar that would make far-fetched claims and follow them up by saying, “Yeah, that’s the ticket.”
In 1985, Jon Lovitz introduced his character on SNL, saying, “Hello, I’m Tommy Flanagan. I’m a member of Pathological Liars Anonymous. In fact, I’m the President of the organization. I didn’t always lie. When I was a kid I told the truth, but then one day I got caught stealing money out of my mother’s purse. I lied. I told her it was homework and my teacher told me to do it. So, after that, lying was easy. I lied about my age and joined the Army. I was thirteen at the time, yeah. I went to Vietnam, and I was injured catching a mortar shell in my teeth, yeah. And they made me a three-star general! And then I got a job in journalism, writing for the National Enquire..er, Geographic! Yeah, I was making twenty thousand a ye…month! Yeah, in fact, I won the Pulitzer Prize that year! Yeah, that’s the ticket!”
As investors experiment with new and creative narratives to promote rising stock prices, we can’t help but be reminded of Tommy Flanagan. He would be proud. While several trial balloons have been floated, our favorite to date is recessions are good for stocks. As Tommy Flanagan would say, “Yeah, that’s the ticket!”
While we understand a recession would likely cause the Fed to stop tightening, we believe investors are underestimating the risks. In addition to rising loan losses, disappearing credit, bankruptcies, and a spike in unemployment, recessions have a way of decimating corporate earnings and stock prices. During the recessions of 2001-2002 and 2008-2009, earnings per share of the S&P 500 fell 25% and 50%, respectively. Stock prices followed, with the S&P 500 falling 49% from its peak during the tech bubble (March 2000-October 2002) and declining 57% from its peak during the housing bubble (October 2007-March 2009). Put simply, earnings matter and recessions are bad for earnings.
Over the past decade, fiscal deficits, negative real interest rates, low tax rates, and asset inflation have stimulated the economy and corporate earnings. Robust earnings have helped investors justify paying record high equity prices and valuations through much of the current market cycle. Although we’ve acknowledged earnings have been strong, we’ve also argued they’re artificially inflated and are above what we consider normalized. This was especially true last year.
Without question, profit margins and earnings soared in 2021. Aided by unprecedented fiscal stimulus and a Federal Reserve that maintained its emergency monetary policy during an economic and inflationary boom, earnings rose sharply throughout much of corporate America. With the economy as high as a kite, additional—in hindsight, unnecessary—monetary and fiscal stimulus was forced into the economy. As fun and easy as 2021 was for most investors, we believe it will ultimately be viewed as this cycle’s peak in the economy, stock market, and corporate profits.
As practitioners of normalizing earnings for valuation purposes, we believe there is tremendous risk in extrapolating 2021 profitability. In fact, if margins simply reverted to their 10-year average, S&P 500 profits would decline 25% from 2021 levels.
After creating the highest rate of inflation since 1981, the aggressive monetary and fiscal policies that led to the record earnings boom in 2021 have been put on hold. Businesses are finding themselves on their own to manage through an increasingly uncertain economy. While it’s very early in the process, we believe peak earnings will be one of the victims of an economy that is currently attempting to normalize. As we often do when it comes to macro trends, we’ll view this normalization process through the eyes of the approximately 300 businesses on our possible buy list.
Although earnings reports for most small cap stocks will be released in two to three weeks, early reports have been insightful and support our view that demand and profits are normalizing. In particular, we thought WD-40 Company’s (ticker: WDFC) results were helpful in illustrating the current operating environment. The company touched on several important trends we expect many of the small cap companies we follow will be reporting in upcoming earnings reports.
Highlights include a 9% decline in sales and 31% decline in earnings. Like many businesses, WD-40 noted it was facing difficult comparisons relative to last year. The company also updated investors on inflation, stating the environment remains challenging, with pressure on margins continuing.
Management said, “Inflationary cost pressures are broad-based and continue to increase with little sign of near-term relief. These operational challenges are not unique to WD-40 Company.” Cost increases were notable in specialty chemical, aerosol cans, warehousing distribution and freight, and labor. The company is combating rising costs with higher pricing and expects further price increases in upcoming quarters.
WD-40 also pointed out the negative impact from lockdown measures in Shanghai and the war in Ukraine. Further, currency was a drag on results, which we expect will be a common and increasingly impactful theme this quarter. And finally, like many businesses, inventories increased considerably versus a year ago ($96 million vs. $48 million). Commenting on their outlook, management said, “Unfortunately, we don't see any near-term relief in sight and expect the operating environment to continue to remain challenging.”
As it relates to cost trends, management stated, “So number one, we have seen no decrease in the price of our aerosol cans. We had a 60% increase, which we shared, in aerosol cans. So even though spot rates are moving, it has no impact whatsoever on the price. And the real issue here is, as we've shared, is the timing of the flow-through of the cost of goods and the offset of price increases.”
Commenting on oil prices, management said, “Yes, oil has been fluctuating between $100 and $120. But as you know it takes a lot—90 to 120 days to any impact of oil to flow into our system. So just because it's moved in the last couple of weeks, it has no impact. And in fact, yes, it went to $95 last week and it's back over $105 today.”
And while investors focus intently on the price of oil, management pointed out there are other costs to consider, stating, “So in this scenario, oil is not the thing that's had the biggest impact in the short term over the last few months. It's the impact of the cost of aerosol cans, the cost of plastics, the cost of filling fees, all of which have been flowing into our supply chain at varying times, in varying places from varying packages all around the world.”
We expect many of the businesses we follow will soon report trends similar to WD-40. We also believe the upcoming earnings season will confirm our belief that the earnings normalization process is well underway. Whether we’re officially in a recession, we’re not certain. However, we’re very confident 2021 earnings were inflated, and many 2022 earnings estimates will likely be revised lower. In such an environment, we are optimistic volatility and opportunities will increase. For instance, WD-40’s stock declined 15% on the day after its earnings announcement.
Investors, in our opinion, don’t really believe recessions are good for stocks. Instead, they believe a recession will clear a path to another round of Quantitative Easing (QE). A QE that doesn’t cause consumer inflation, only asset inflation. A QE that creates booms without busts. A QE that funds endless fiscal deficits and stimulus checks. A QE that solves climate change and erases social injustices. A QE that doesn’t misallocate capital to money-losing SPACs and NFTs of rocks. A QE that enables millions to retire early without shrinking the labor pool. A QE that doesn’t squash price discovery and free markets. A QE that puts central bankers on the front cover of magazines. A QE that monetizes trillions of debt without encouraging fiscal irresponsibility. A QE that doesn’t create asset bubbles, wealth inequality, and a housing affordability crisis. A QE that resuscitates the longest bull market in history and the earnings boom of 2021. A QE that makes investing easy again. Yeah, that’s the ticket!
Eric Cinnamond
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Definitions:
S&P 500: The S&P 500 Index, or Standard & Poor's 500 Index, is a market-capitalization-weighted index of 500 leading publicly traded companies in the U.S.
EPS: Earnings Per Share
Quantitative Easing (QE): A form of unconventional monetary policy in which a central bank purchases longer-term securities from the open market in order to increase the money supply and encourage lending and investment.
SPAC: A special purpose acquisition company (SPAC) is a company without commercial operations and is formed strictly to raise capital through an initial public offering (IPO) or the purpose of acquiring or merging with an existing company.
NFT: Non-fungible tokens (NFTs) are cryptographic assets on a blockchain with unique identification codes and metadata that distinguish them from each other.